Outside edge

Canada encourages wealthy and talented immigrants with tax-policy-permitting foreign income to accumulate in a non-resident trust tax-free for up to five years. There are also attractive options through non-resident trusts for wealthy foreign families wishing to benefit family members living in the country.

Canada’s rules for taxing offshore trusts have been undergoing a fundamental review since 1999. In October 2012, the federal government released the eighth version of draft legislation amending the non-resident trust rules. These rules are due to become effective (retroactively) on ?1 January 2007.

If adopted, the draft legislation will substantially revise the Canadian taxation of offshore trusts. It limits opportunities for tax avoidance by deeming certain trusts not resident in Canada under general law to be resident where a person resident in Canada transfers or loans property or provides financial assistance or services to an offshore trust.

The additional requirement under the existing rules that there must be ?a Canadian-resident beneficiary of the trust is dropped for most purposes ?in the draft legislation. Canada, unusually, imposes reporting and ?tax-paying requirements directly on ?the offshore trustees.

Non-resident gifts

Gifts or bequests made by a non-resident to a Canadian resident through a trust remain attractive for Canadian beneficiaries under the draft legislation. The trust should not be deemed resident in Canada where the trust’s sole Canadian connection is a beneficiary resident in Canada. Canadian resident beneficiaries should not be taxed on the receipt of capital distributions (as determined for Canadian tax purposes) including income and gains from prior years capitalised by the trustee. All distributions (whether of capital or income) must be reported.

By contrast, where a gift or bequest is made to the Canadian directly, the Canadian will be subject to tax in Canada on worldwide income (and gains) earned from the gift or bequest.

Thus, non-residents gifting assets to Canadians or making provision for Canadians in their will should consider transferring the property to a trust ?for the benefit of the Canadian, rather than directly.

Five-year trust

The draft legislation keeps the current attractive exception for a trust with non-resident trustees funded exclusively by a new immigrant to Canada. Such a trust is not generally taxable in Canada for a period of up to five years after the settlor becomes a Canadian resident.

The offshore trust will be deemed resident and taxable in Canada from the beginning of the tax (that is, calendar) year in which the settlor’s fifth anniversary as a Canadian resident occurs.

If the (sole) settlor decides to leave Canada within five years or if the settlor dies within this period, the trust would never be deemed resident in Canada. Should the settlor leave Canada they would cease to be a Canadian taxpayer; unlike the US, which continues to tax US citizens living abroad.

Distributions during the five-year period follow the same attractive rules as discussed above. A Canadian resident beneficiary can receive capital distributions (as determined for Canadian tax purposes) without tax in Canada, though the distribution would be reportable.

A ‘five-year immigration trust’ is usually unwound at the end of the five-year period, unless there are non-tax reasons for maintaining the structure. The structure can generally be unwound with little (or no) Canadian tax, and assets can be distributed to the settlor (or possibly another Canadian beneficiary) with a tax cost equal to the value of the assets at the time. Therefore, careful planning may avoid Canadian tax on the asset portfolio held by the trust for the first five years of a settlor’s residency in Canada.

From an immigration perspective, new residents meeting the physical presence requirements may apply for Canadian citizenship after three years.

Former residents

Under the draft legislation, a trust would be deemed resident in Canada where it:

• received a contribution from a Canadian resident within 60 months of the person leaving Canada; and

• had a Canadian resident beneficiary.

This ‘look back’ period is reduced to 18 months where a trust is created on the death of an individual. A former Canadian resident wishing to establish a trust for the benefit of a Canadian resident could (as an interim measure) provide for creating a trust in their will and, when the 60 months have elapsed, form the trust. This would permit ?the settlor to achieve their estate-planning objectives while mitigating ?tax in Canada.

Alternatively, where a former ?resident does establish a trust within ?60 months of leaving Canada and the rights of Canadian residents to benefit from the trust arise solely on the death of the settlor, the trust should not be deemed resident in Canada until the settlor’s death.

Grandfathered trust

The worldwide income (and gains) of a trust deemed resident under the draft legislation will be subject to tax in Canada. However, a trust can generally deduct from its income distributions to beneficiaries of trust income.

Income distributions may be subject to Canadian non-resident withholding tax at a rate of 25 per cent (unless reduced by a tax treaty), except where the trust is grandfathered from the withholding tax and income distributions meet certain other requirements. A trust will generally be grandfathered if it was created before 30 October 2003 and no ‘contribution’ (broadly defined) was made to the trust by any person (whether or not Canadian resident) after 17 July 2005.

Accordingly, a grandfathered trust should not be subject to tax in Canada if it annually distributed all its income and realised gains (as determined for Canadian tax purposes) to non-resident beneficiaries. This would be attractive ?if the beneficiary lives in a low (or no) tax jurisdiction.

Exceptions are also made where a Canadian resident establishes an offshore trust for non-resident dependants who are mentally or physically infirm and ?for a trust created as a consequence of the breakdown of a marriage for the benefit of the non-resident (former) spouse and children.

So, individuals planning a move to Canada should look at the attractive ‘five-year immigration trust’ regime. ?But they must do so in the context of the tax environment of the country they are leaving.

A UK resident should consider UK capital gains tax on the transfer of assets to a trust as well as inheritance tax if they are domiciled in the UK. Trustees need to be vigilant to ensure that planning objectives are achieved.

Canada’s rules for taxing offshore trusts are becoming more complex and draconian in their application to trusts established by Canadian residents. But there is significant opportunity for the settlor who lives outside the country (and former residents who have been away for more than five years) and wants to benefit a Canadian resident.