Tax planning with non-resident trusts

Certain clients can still benefit. In some cases, it’ll be a client who doesn’t set one up herself: think of someone who comes to Canada for school, gets a high-paying job here and permanently relocates, but is a beneficiary of a trust her parents established back home. But beware: such arrangements are lined with potential traps.

Resident vs. deemed resident vs. non-resident trusts

Trusts subject to Canadian tax pay the top marginal rate. The federal component is 29%; the provincial rate varies by province. In Ontario, combined federal and provincial tax is just over 49%; in Alberta, it’s about 39%. If a Canadian resident contributes assets to a trust that’s resident outside Canada, that trust is deemed resident Canadian for tax purposes.

Take an NRT located in the Bahamas that adds a Canadian resident contributor. The NRT’s then deemed resident, and becomes subject to Canadian tax. But, there’s no provincial tax because the trust isn’t resident in any province; so to compensate, Cadesky says, CRA requires the trust to add 48% of what it owes in federal tax. So, a trust that owes $100,000 in federal tax would owe an additional $48,000.

People in high-tax provinces like Ontario who can jurisdiction-shop should consider finding more tax-favourable homes for their trusts, such as Barbados or Alberta. (The Barbados trust would be an NRT, deemed resident for tax purposes; the Alberta one, a fully resident trust.)

How to choose? The first step is to calculate anticipated tax: for Alberta, it’s federal plus provincial rates; for Barbados, it’s Canada’s federal rate plus 48% of that amount, and any Barbados taxes (e.g., on Barbados-source income).

In both cases, add trust administration fees. It’s more time-consuming and expensive to set up a non-resident trust than a resident one.

Martin Rochwerg, a senior partner in the Tax Group at Miller Thomson in Toronto, notes the big Canadian banks have affiliates operating as independent trustees in popular low-tax jurisdictions offshore.

CRA strictly enforces trust residency rules. A 2012 Supreme Court ruling established that a trust’s residency is determined by where its “mind and management” are located. “This is normally where the trustees reside,” explains Cadesky. “So, it is possible to set up a trust that is resident in [a country or] province other than where the family resides, provided there are independent trustees.”

CRA has little patience for clients who get cute with the rules. Says Cadesky: “If someone is looking to set up a trust in Alberta, they [should] go to considerable lengths to ensure all the trustees were resident in Alberta, that the trust had a bank account in Alberta, that its address and place of management were there, and that trustees manage the trust without interference from the family that contributed the assets or [from] the beneficiaries.”

The same goes for an NRT, he adds. “CRA has a lengthy checklist of questions, [and] they’re quite probing. If you don’t have good answers, you’re liable to end up with the trust being [deemed] resident of the province where the family resides.”

A lucky client

Cadesky notes NRTs can exist if both the people who set up and contribute to the trust—parents, for example—and the trustees reside in a foreign country.

One typical case: a Hong Kong-based couple has three children, one of whom comes to Canada for an advanced degree. She then marries a Canadian and has a successful career here. Since the “mind and management” of the trust is offshore, and none of the contributors are Canadian residents, the trust is considered non-resident for tax purposes.

“She’s in an attractive position,” says Robert Reymond, a partner at Stikeman Elliott in London, U.K. She can receive tax-free distributions of trust capital, but she would need to report it to CRA on Form T1142 Information Return in Respect of Distributions from and Indebtedness to a Non-Resident Trust.

If she receives income distributions from the trust, they are taxed as income (and she would also file Form T1142). So, Reymond says, trustees should distribute capital whenever possible (see “Reap the tax benefits,”).

NRT horror stories

Opportunities to save tax through NRTs have dwindled, but these vehicles still feature in many horror stories. Take the case of a Canadian-resident couple with two children in university. The parents permanently relocate to the U.K., leaving the kids behind, who have no plans to move to the U.K. themselves. The parents’ advisor recommends U.K.-based trusts for estate planning. “But if they establish a trust [in the U.K.] within five years of emigrating from Canada, and the trust benefits their Canadian-resident children, the trust will be deemed resident and taxable in Canada on worldwide income,” Reymond explains. “It’s a real trap. You’ve left Canada, you filed your last return as a Canadian resident and you’re now living in the UK. […] Because you’ve established the trust within five years of leaving Canada, it stays within the Canadian tax net” because the beneficiaries are Canadian residents. Reymond notes this five-year rule could also wreak havoc for Canadian immigrants.

Say a French family has long-established, France-based trusts with the children as beneficiaries. One child moves to Canada for university and then stays here permanently. The parents later move to Canada.

If the parents contribute to their French trusts within five years prior to the date they move to Canada, “the trust is resident retroactively to the year in which they made that contribution,” says Reymond.

So, if they move to Canada in 2015 and their earliest contribution within the prior five-year period was in 2011, the trust is deemed Canadian resident, starting in 2011. That means it’s subject to the same tax consequences that would apply to a fully resident Canadian trust.

Cadesky has another horror story. Say there’s a family in Spain that’s had several trusts for many years. The entire family moves to Canada at the same time.

They know the immigration trust exemption is no longer available, but “what they don’t realize is their trusts become taxable from January 1 of the year they become resident,” says Cadesky. So, if they move to Canada on November 1, they still have to pay CRA tax for trust income earned from January 1 to October 31.

Families coming to Canada should consider reorganizing trust assets prior to January 1 of the year they move. This can mean paying dividends from holding companies, for instance, triggering tax at their home jurisdiction’s rate.

Cadesky says many newcomers don’t seek out Canadian advice until their immigration applications are approved and they’re preparing to move. “Then, it’s too late”—so they should do so at least a year prior to moving.

Reap the tax benefits

If your client’s receiving distributions from a bona fide non-resident trust, she’ll likely have a smaller tax bill than if she were a beneficiary of a Canadian resident trust. Lorne Richter, tax partner at Richter LLP in Montreal, illustrates how the two trust types are usually taxed.

Scenario #1: Canadian resident trust (no foreign ties)

Mom and Dad live in Ottawa and set up a $1-million inter vivos trust, which is taxed at the highest marginal rate. Their daughter Jill, a partner at a Toronto law firm, is beneficiary. The trustees are non-family members and fully independent. Interest income within the trust that isn’t distributed to Jill in the year it’s earned is taxed at approximately 50% in Ontario. If the trust earns $10,000 of interest income, CRA gets about $5,000 and the other $5,000 is classified as tax-paid trust capital.

Any amounts distributed to Jill in subsequent years from the initial $1 million in capital, or the $5,000 in new capital, aren’t taxed in the trust’s or Jill’s hands.

Dividends and capital gains are treated similarly to interest income, except that their preferential tax treatment applies. For example, on a capital gain of $60,000 not distributed to Jill in the year it was earned, the trust’s 50% tax rate would apply to half ($30,000) the gain, resulting in about $15,000 tax. The other $45,000 would be considered tax-paid capital.

If the trust distributes interest income, capital gains or dividends to Jill in the year they’re earned, she’s liable for the tax, not the trust. For instance, if the trust earns $12,000 of interest income in 2015 and distributes it to Jill the same year, it’s fully taxable in her hands. Since she’s in the top bracket, she’ll owe CRA about $6,000.

Scenario #2: Non-resident trust

In this case, Mom and Dad reside in a country that imposes no income taxes on trusts. The parents have never lived in Canada and do not plan to move here. They set up a trust with their daughter, Mara, as beneficiary. Mom and Dad are the only trust contributors. Mara’s an executive in Toronto. The trustees are fully independent and reside outside Canada.

Wrong way:

Since the trust is located in a tax haven, it pays no tax on interest income. But if it distributes the income to Mara in the same year it’s earned, she pays tax to CRA at her marginal rate. The same goes for capital gains on the taxable 50% portion: the trust pays no tax, but if it sells its stocks, for instance, and distributes a gain to Mara the year the gain is triggered, she pays capital gains tax to CRA.

Right way:

The trust earns interest income or triggers capital gains in Year 1. Instead of distributing to Mara, the trustee adds the earnings to trust capital. The following year, the trustee makes a distribution to Mara from the trust’s capital. Because Mara has received capital, there’s no tax owing, but she must report the receipt of the distribution to CRA on Form T1142. Richter notes the trustee’s resolution must say the distribution is from trust capital. The trust’s financial statements must also reflect this.

Tax rule overhaul

Canada’s trust rules underwent a sea change in 2007, explains Michael Cadesky, managing partner at Cadesky Tax. Pre-2007, three conditions had to be met for a trust to be resident:

1. Canadian resident contributes assets to the trust;
2. trust has Canadian beneficiaries; and
3. the beneficiaries and the contributor are related.

He notes “people spent a lot of time [trying] to not meet one of these [conditions].” So, the government scrapped requirements two and three. Now, there only needs to be one Canadian-resident contributor for the trust to be taxed. There’s also a 60-month rule that applies to former Canadian residents: if they set up a trust in their new country of residence within 60 months of leaving Canada, and the trust has Canadian-resident beneficiaries, CRA will deem the trust Canadian resident and tax it as such.