Here is an interesting experiment to try: ask an average Canadian accountant or lawyer about “Part XII.2 tax”. I am betting that you will get a blank stare. To me, that would be no surprise at all! In fact, even those who regularly practice in the tax area are generally fairly clueless about this obscure tax unless they deal with cross-border trust issues in depth.
However, starting this year (2016), this tax has become more significant and the chances of it rearing its ugly head are much greater. Why? Until last year, it only applied to inter-vivos trusts-not to testamentary trusts. However, starting in 2016, it can apply to testamentary trusts[1] as well.
In a nutshell, the purpose of Part XII.2 tax is to prevent non-residents from achieving a substantial reduction in Canadian taxes by earning certain types of income through a Canadian trust.
Envision the following scenario:
Mr. F. is a non-resident of Canada. He operates a business in Canada as a sole proprietorship. He makes over $300,000 per year net profit from that business each year. He pays an average tax rate of about 38% on his income.
What would happen, instead, if he formed a Canadian-resident trust to carry on the business? The trust would be subject to tax at the highest marginal rate on income retained in the trust (53.5% in Ontario). However, taxation at the trust level could be avoided on any income that is paid or payable to Mr. F., as the beneficiary of the trust, in the year that it is earned[2]. In the absence of Part XII.2 tax, this would mean that Mr. F. would pay a maximum tax rate of 25% on the income under Part XIII of the Act, and possibly a lower rate if a tax treaty applied.
Because of this fact, Part XII.2 of the Act will generally apply to a Canadian resident trust that earns certain types of income “designated income” (“DI”) if any portion of such income is paid or payable to a non-resident beneficiary.
DI consists most commonly of net income from the following sources[3]:
- taxable capital gains from “taxable Canadian property” ;
- the rental of Canadian real properties;
- businesses carried on in Canada
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In situations where the DI is paid or payable to beneficiaries in the relevant year, the tax under Part XII.2 is equal to 36% of 100/64 time the amount of such DI that is so distributed.
The tax under Part XII.2 is allowed as a deduction in computing the trust income for the year that it is paid.
The assumption implicit in the formula would be that 64% of the DI would be paid to beneficiaries, and 36% would be retained in the trust to pay the Part XII.2 tax.
Below is the example of the operation of Part XII.2 tax that appears in my book Canadian Taxation of Non-Residents[4]:
All of the net income of an inter vivos trust resident in Canada is derived from the rental of Canadian real estate. In a particular year, it has earned $10,000 of net income, and paid out that amount, less an allowance for $3,600 Part XII.2 tax, to its sole beneficiary, who is a non-resident (resident in a non-treaty country).
Assuming the trust deducts the $6,400 income distribution to the beneficiary, it will have no net income, for tax purposes, after deducting the $3,600 Part XII.2 tax liability, and therefore no tax liability under Part I.
Accordingly, the total tax burden on such income will be:
Part XII.2 tax, as computed above $3,600
Part XIII tax of 25% of $6,400 distributed to beneficiary 1,600
Total tax $5,200 (52%)
It should be noted that as long as there is any non-resident beneficiary of the trust that receives a distribution of DI, all of the DI distributed will result in Part XII.2 tax, including ay portion distributed to beneficiaries resident in Canada. Because of that, resident beneficiaries may claim a tax credit for their share of Part XII.2 tax[5], and that credit claimed will be treated as additional trust income[6]. The result for resident beneficiaries should be the same as if they had received their share of the DI without any burden of Part XII.2 tax.
[1] Subject to a continuing exception for “graduated rate estates” (i.e. generally an estate during the first 36 months of administration).
[2] Subsection 104(6) of the Income Tax Act (“the Act”)
[3] Subsection 210(1) of the Act.
[4] The 5th Edition of this book should be available from Wolters Kluwer Canada this July.
[5] Subsection 210.2(3) of the Act, assuming designated by the trust in respect of the beneficiary in its T3 return for the year.
[6] Subsection 104(31) of the Act.
ABOUT THE AUTHOR OF THIS ARTICLE
Michael I. Atlas, CPA,CA,CPA(ILL),TEP
Michael Atlas is one of the most prominent international tax experts in Canada. He advises accounting and law firms all across Canada, as well as select private clients (corporate and personal) worldwide. He can be reached by phone (416.860.9175) or email (matlas@TaxCA.com).
