There has extremely significant development of late for all Canadian trusts which have, or might be expected to have, non-resident beneficiaries[1]. This is because of an answer by the Canada Revenue Agency (“CRA”), to a question at the Annual Conference of the Canadian Tax Foundation (“CTF”) in November of last year.
Surprisingly, as far as I can see, so far the reaction by the Canadian tax professional community regarding this has been quite mute. I suspect that most tax professionals have not fully considered the implications.
Before looking at the actual response by the CRA, let me review the background for those who do not necessarily practice in this area.
As a general rule, subject to certain exceptions[2], trusts are deemed to dispose of their property, for the purposes of the Income Tax Act (“the Act”), every 21 years for proceeds equal to the fair market value of such property[3]. This has been a feature of the Act ever since the taxation of capital gains was introduced in 1972. The purpose is to prevent the indefinite deferral of taxation of unrealized capital gains by the use of trusts.
The presence of this rule, and the implementation of steps aimed at avoiding the taxation of deemed gains resulting from its application, is an important aspect of tax planning involving family trusts.
The usual method of avoiding the recognition of capital gains, where it is available[4], would be to transfer appreciated property from the trust to beneficiaries, in satisfaction of their capital interests, at some time prior to the 21 year anniversary date. As a general rule, in such circumstance, the property will be transferred on a tax-free rollover basis under subsection 107(2) of the Act.
However, in connection with property transferred to a beneficiary who is not resident in Canada at the time of distribution, subsection 107(5) of the Act will generally preclude a tax-free rollout under subsection 107(2), except for certain specified types of property. The most common type of property allowed would be a direct interest in Canadian real estate. Shares in a Canadian corporation would never be allowed. Thus, with the extremely common scenario of a family trust being the common shareholder of a family controlled company (“Famco”), a tax-free rollout to a non-resident beneficiary would not be allowed.
Over the years, a common solution to this problem has been developed and widely used: rather than transferring the property (generally the Famco shares) directly to the non-resident beneficiary, it would be, instead, transferred to a Canadian corporation (“Canco”)[5] of which the beneficiary would be the sole shareholder. Thus, subsection 107(5) would have no application.
Most modern, sophisticated, trust documents are drawn in such a way that, a corporation of which a beneficiary is a shareholder, is also a potential beneficiary, even if not in existence at the time the trust was formed. Thus, the transfer to Canco should meet the requirements of subsection 107(2).
In cases where the trust document does not contemplate such a corporation as a beneficiary, it has been possible, in certain cases, to achieve the desired result by having the non-resident beneficiary transfer his or her interest in the trust to a Canco[6].
Now to turn to the CRA response at the CTF conference, which has been referenced as CRA document 2017-0724301C6. In a nutshell, even though such planning has been widely used, apparently without any opposition by the CRA, for many years, they don’t like it! They seem to have woken-up to the fact that it can lead to deferral of tax beyond what was intended.
More specifically, the CRA stated:
“In respect of the transactions described herein, any capital gains inherent in the Property distributed to Canco may be deferred beyond the 21st anniversary of the Trust and potentially beyond the life of the NR beneficiary or indefinitely. It is the CRA’s view that the intention of subsection 107(5) is to ensure that Canada maintains the ability to tax capital gains that accrue during the period that property is held by a Canadian resident trust and that the transactions described are not consistent with this intention. Further, these transactions contravene one of the underlying principles of the taxation of the capital gains regime which is to prevent the indefinite deferral of tax on capital gains and which is supported by subsections 70(5), 104(4) and 107(2). Accordingly, it is the CRA’s view that such transactions circumvent the application of subsections 107(5) and 107(2.1) in a manner that frustrates or defeats the object, spirit or purpose of those provisions, subsections 70(5), 104(4) and 107(2) and the Act as a whole. The CRA has significant concerns regarding these transactions and will consider the application of GAAR when faced with a similar set of transactions unless substantial evidence supporting its non-application is provided. In addition to the specific transactions described herein, it is the CRA’s view that GAAR may be applicable in respect of other situations involving the distribution of property from a family trust to a Canadian corporation with one or more non-resident shareholders.
Accordingly, unless substantial evidence supporting the non-application of GAAR is provided, the CRA will not provide any Advance Income Tax Ruling where such structure is proposed to be put in place.”
Although not stated in the extract above, one would think that the CRA and Finance would be concerned about the fact that it is not just “deferral” of tax that is involved. There is potential for complete avoidance of Canadian tax in situations where the Canco shares are not TCP. This could apply to a situation where the shares of Canco are sold by the non-resident as a way of disposing of his or her indirect interest in the shares of Famco, as well as a situation where they are deemed disposed of on death.
Accordingly, taxpayers involved in planning for Canadian trusts will have a new issue that requires careful consideration. In the past, we assumed we had a “backdoor” way of getting around subsection 107(5) in connection with avoiding the 21 year deemed disposition. That can no longer be assumed.
One chilling thought is that CRA, and the Ministry of Finance, might decide to ensure their position by introducing appropriate amendments to the Act. Presumably, they might recognize that their position regarding the application of GAAR is not 100% certain. For example, they could easily amend subsection 107(5) in such a way that a corporation resident in Canada would be treated as a non-resident for purposes of that provision if it had any non-resident shareholders.
Given this development, I offer the following observations:
- One way to avoid this issue in connection with typical discretionary family trusts might be simply to exclude non-resident beneficiaries from any distributions. That might be an easy solution in cases where those non-resident beneficiaries can receive a larger shares of their parents’ estate under their will(s) to compensate for being excluded from the trust.
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- In situations where the shares of Canco would be TCP, such as would normally be the case where Famco is a real estate holding company, one might take the position that the GAAR risk is quite low, given that there is not a high potential for tax deferral or avoidance. The CRA would have to base their claim for the application of GAAR on the theoretical potential for introducing other assets into Canco so that the shares are no longer TCP, or, if so, “treaty protected property”(“TPP”)[7]. It is questionable whether the CRA could win on that basis in the absence of any evidence that such maneuvers were planned.
- It is possible that a favorable Advance Income Tax Ruling could be obtained from the CRA, if the Canco shares will be TCP, and there is no reason to think that they will cease to be TCP or become TPP. Possibly some undertaking might be required.
- For taxpayers who are looking for certainty and not willing to incur any risk regarding the tax consequences of a rollout to a non-resident beneficiary, there is another possibility to consider if an Advanced Income Tax Ruling is not possible: they could transfer shares of Famco directly to the non-resident beneficiary and post security for the applicable tax, rather than paying it. Unfortunately, this option is only available if the Famco shares will be TCP at the time of distribution[8]. Where applicable, this would allow the payment of the taxes to be deferred (without interest) until the “balance due date” of the trust for the taxation year in which the beneficiary disposes of the shares[9]. The attractiveness of this route will largely depend on how easy it will be to provide the requisite security to the CRA.
- For new trusts that will be formed to hold Famco shares, serious consideration will now have to be given to the issue of whether children who are non-residents should be beneficiaries of that trust; should be direct shareholders of some Famco shares, or should receive other assets or bequests to compensate for being excluded from any interest in Famco.
- In certain cases, consideration should be given to freezing the trust’s interest in Famco and issuing new Common shares of Famco directly to non-resident beneficiaries. This could be used as a mechanism to compensate for the fact that such beneficiaries will not participate in any of the “freeze shares” in the trust that would be rolled out to the Canadian beneficiaries. There could be other reasons for a freeze as well.
- Another approach to compensating non-resident beneficiaries from being excluded in a future distribution would be to allocate a higher proportion of actual or deemed dividends emanating from Famco to such beneficiaries from the trust prior to any distribution. This might be particularly appropriate in situations where Famco will recover RDTOH as a result of dividend payments, and allow for a reduced Canadian tax rate applicable to such dividends.
- In addition to avoiding any deemed gain as a result of the 21 year deemed disposition, recent developments might provide another reason for wanting to wind-up the trust and distribute the Famco shares directly to beneficiaries. Namely, under the new “Tax on Split Income” (“TOSI”) regime that has started to apply this year, there is an exemption for dividends on “excluded shares”. In general, this will apply where the dividend recipient is over 25 and owns shares in the paying corporation that have at least 10% of votes and value of all shares of the paying corporation. For this exemption to apply, the dividend recipient must directly own such shares-they cannot be held via a trust.
Where there are non-resident beneficiaries, this may now be a problem. However, in such cases, it should usually be possible to use the exemption by just transferring a portion of the Famco shares to the Canadian resident beneficiaries. The balance of such shares could be left in the trust and dividends on those shares could be flowed out to non-resident beneficiaries. TOSI should have no application to the amounts allocated to the non-residents.
No doubt, as tax practitioners become accustomed to this new reality, many additional issues and possible approaches will arise.
[1] It can be of significance for non-resident trusts as well, but only if they own “taxable Canadian property” (“TCP”). The focus of this article will be on trusts that are resident in Canada.
[2] The most common exception is “spousal trusts”, where the deemed disposition generally occurs on the death of the spouse beneficiary.
[3] Subsection 104(4) of the Act.
[4] The most common situations where it would not be available would be where it is contrary to the terms of the trust; where the trustees are not willing; or where subsection 107(4.1) of the Act applies as a result of the settlor being a capital beneficiary or maintaining certain powers. If subsection 107(4.1) applies, the tax free rollover under subsection 107(2), discussed below, will only be available in limited circumstances.
[5] For U.S. resident beneficiaries it is common to use an “Unlimited Liability Corporation” (“ULC”) formed under the laws of one of the three Canadian provinces that have such entities. This is to facilitate optimal U.S. tax planning.
[6] In cases where the interest in the trust is TCP, an election under subsection 85(1) of the Act can be file to avoid triggering any capital gain. Here again, for U.S. resident beneficiaries, a ULC would normally be used.
[7] For example by introducing other assets so that less than 50% of value derived from real estate. The shares of Canco likely would be TCP for 60 months based on the “lookback” rule in the Act. However, Canada’s tax treaties normally do not have any lookback rule to determine property that can be taxed.
[8] Subsection 220(4.6) of the Act.
[9] Which could be the year in which that beneficiary dies.
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).
