Volume 1, Number 2
The information in Tax Perspectives is prepared for general interest only. Every effort has been made to ensure that the contents are accurate. However, professional advice should always be obtained before acting and TSG member firms cannot assume any liability for persons who act on the basis of information contained herein without professional advice.
Changes to Canadian Taxation of Offshore Trusts
By Michael Cadesky, FCA, TEP
Cadesky and Associates LLP (Toronto)
Offshore trusts have long been a tax planning vehicle of choice for affluent clients. So in February 1999, when the Canadian government announced major changes to the taxation of offshore trusts, a shudder ran deep among tax advisers. And while somewhat modified and delayed by one to two years, the amendments maintain their original focus- to eliminate aggressive offshore tax planning by Canadians.
The new legislation will now apply starting in 2002, which, for those fleet of foot, gives some room for tax planning.
NEW IMMIGRANTS AND IN-BOUND TRUSTS
It is well-established policy that new immigrants to Canada are given a five-year tax exemption, through the use of an appropriately structured offshore trust. Furthermore, offshore trusts established by non-residents of Canada for Canadian beneficiaries are not subject to Canadian tax at all. Canadian residents may receive distributions of capital from such offshore trusts tax-free.
The original February 1999 proposals indicated that all distributions, whether income or capital, would be taxable to Canadian-resident beneficiaries. Fortunately, this proposal has been scrapped. Capital distributions from trusts will continue to be tax-free.
New or recent immigrants to Canada may continue to use offshore trusts and obtain a 60-month tax exemption. In addition, trusts established by persons who never become resident, either by will or during their lifetime, will be tax-free indefinitely.
Former residents now living outside Canada may set up a tax-exempt offshore trust to benefit Canadian family members after 60 months of non-residency (18 months if set up by will on death).
OUTBOUND TRUSTS DIRECTLY TARGETED
The draft legislation has far-reaching anti-avoidance rules to deter Canadian residents from establishing offshore trusts. Under current rules, a non-resident trust is subject to Canadian tax only if two conditions are met:
- it received property from a person who has been a Canadian resident for at least 60 months, and
- it has a Canadian-resident beneficiary.
Considerable intellectual energy has been spent by tax planners on structuring arrangements where one or both of these two conditions were not met.
One approach was to structure indirect arrangements where no Canadian resident person could be viewed as having transferred property to the trust. For example, an estate freeze could be structured whereby a non-resident purchased common shares of a company after the freeze and then contributed the shares to a non-resident trust. The trust arguably had not received property from a Canadian-resident person and, therefore, was not taxable.
This type of plan is now the focus of specific legislation. The intent is to deem the Canadian resident who is behind the scheme to have transferred property to the trust. Consequently, all non-resident trusts established by Canadian residents, including those settled by non-residents who have some indirect connection with a Canadian-resident individual or company, must be carefully reviewed.
The second popular approach was to establish a non-resident trust with no Canadian-resident beneficiaries. In some cases, the trust would allow for unspecified beneficiaries to be added at a future date. Although an amendment in 1998 targeted this approach, some structures still managed to avoid taxation.
The new legislation, after 2001, will deem a trust to which a Canadian resident has transferred property to be a Canadian-resident trust, whether or not there are Canadian resident beneficiaries. Therefore, if a Canadian resident establishes a trust with no Canadian beneficiaries, the trust will nevertheless be deemed to be Canadian-resident, and subject to Canadian tax.
The policy rationale for this approach is that Canadians have demonstrated an affinity for using of non-resident trusts to avoid Canadian taxation. If income is left in an offshore trust created somehow by a Canadian, it may well be earmarked for a fellow Canadian. Better to tax it than to leave the matter in doubt. However, if the income is actually paid out to non-resident beneficiaries, then, subject to certain limitations, it may escape Canadian taxation. The beneficiaries may of course pay tax on receiving this income, depending on the laws in force where they live.
For trusts caught in the transition from the old rules to the new, there are important transitional rules to be aware of. Property will be revalued to its fair market value on December 31, 2001, provided that the trust was not taxable under the existing rules and the property is not taxable Canadian property.
Two very important enforcement tools have been added by the new legislation. First, any Canadian who has contributed property to an offshore trust will be jointly and severally liable for the trust's tax, together with the trust and its beneficiaries (to the extent of distributions received). This allows for collection of tax from any Canadian resident who has participated in some way in the creation of the trust.
The second enforcement tool is expanded information reporting. Under previous rules, a Canadian who participated in the establishment of an offshore trust might have been able to avoid information reporting. Under the new legislation, the reporting rules have been broadened. In addition, if an entity other than a traditional trust has been used, such as a foundation, information reporting is still required.
It is very clear from the thrust of the legislation that the Canadian government is looking to make the tax system watertight in the area of offshore trusts, except where planning is specifically sanctioned (such as for immigrants and trusts established by non-residents of Canada).
The new rules are applicable to 2002 and subsequent years. All existing structures should be reviewed in advance of this.
A number of articles on this topic are available on our Web site.