Many affluent immigrants to Canada are beneficiaries of offshore trusts that have been established by family members overseas, either before or after they moved to Canada.
With proper care and planning, the income earned in those trusts can be totally exempt from Canadian tax, even if distributed to the Canadian resident beneficiary.
This assumes that the trust is not resident in Canada.
However, even if the trust is not resident in Canada based on common law rules, it can become a “deemed resident trusts” (“DRT”) if certain events occur. If that happens, the trust will be deemed resident in Canada for most purposes of the Income Tax Act (“the Act”[1]) and generally subject to Canadian tax on worldwide income[2].
Without proper planning and advice, the trust can inadvertently become a DRT in many ways.
If the Canadian beneficiary, or even any other Canadian resident generally, makes any “contribution” to the trust that will do it.
Generally, any transfer of property to the trust would constitute a “contribution”. However, so could the provision of services.
Less obvious events could also be “contributions”, such as the issuance of shares to the trust by a corporation resident in Canada[3] or the payment of dividends to it by such a corporation[4].
For example, with the change in the definition of “taxable Canadian property” that occurred in 2010, it might be tempting for a Canadian beneficiary of such a trust to cause it to invest in treasury shares of a new Canadian corporation that is being formed. The attraction would be the fact that the trust could be a source of needed capital and the fact that any capital gain that might ultimately be realized on the disposition of such shares would be exempt from Canadian tax.
As indicated above, giving in to such a temptation could make all income earned by the trust subject to Canadian taxation.
Unfortunately, Canadians involved with offshore trusts do not always get proper advice, and may not realize until long after the fact that they have inadvertently turned the trust into a DRT.
The results could potentially be disastrous.
However, it is possible that the damage of inadvertently becoming a DRT can be significantly mitigated if the trust becomes an “electing trust”. If so, special, and very complex, rules in paragraph 94(3)(f) will apply.
In essence, the result of such an election would be that the trust would be divided into two portions, “resident portion (“RP”) and the “non-resident portion”. Canadian tax will generally only be payable on the RP.
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This would require a determination of the income earned on the capital represented by the RP for the years during which the trust was a DRT.
This can be quite difficult in most situations because of co-mingling of funds, especially if many years have passed since the trust became a DRT.
However, compared to the consequences of the alternative, this could be a welcome “lifeline” for the trust and it beneficiaries.
One potentially problematic aspect of utilizing this provision is that, to be an “electing trust”, the trust must file an election with the tax return (T3) for taxation year in which it becomes a DRT. In a typical situation, the trustee(s) or beneficiaries will not realize that the trust has become a DRT for many years after the fact.
However, it would still seem possible for the DRT to file a T3 for the relevant year, even if it is many years late, and make a valid election There is no requirement that the return for the relevant year must have been filed on a timely basis for the election to be considered to be valid.
Nevertheless, what is not clear is whether or not, if the Canada Revenue Agency (“CRA”) is the one who first unearths the fact that a particular trust is a DRT, they would give the trustees the opportunity to late-file a T3 with an election , at that time, before issuing any assessments. Furthermore, if the CRA initially issues assessments of the DRT based on Canadian taxation being applied to all the income of the trust, would they reassess if a late-filed T3 with an election is filed after that time?
[1] All statutory references are to the Act
[2] Subsection 94(3).
[3] Subparagraph 94(2)(g)(i)
[4] In theory, a dividend payment can be deemed not to be a contribution if it meets the requirements of being an “arm’s length transfer” in subsection 94(1) (see particularly subparagraph “(b)(i)). This would likely apply to situations where the trust held shares of a Canadian public company that paid dividends. However, within the context of a private corporation in which the trust held shares, it is extremely unlikely that this exemption would ever apply.
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).