Ian Pryor, Perley-Robertson, Hill & McDougall llp (Headline) Ian Pryor, Perley-Robertson, Hill & McDougall llp (Text)

For some time, Canadians have been using off-shore trusts to achieve certain objectives, most notably; protecting assets from potential creditors and, of course, deferring and/or reducing tax.

Off-shore trusts are an effective vehicle that, if structured properly, may allow Canadian taxpayers to take advantage of the significantly lower tax rates in jurisdictions such as Bermuda, Barbados, the Cayman Islands and Guernsey, to name a few. These jurisdictions generally have lower or no income, capital gains or estate taxes and have local financial institutions or offices of Canadian and International financial institutions that have experience acting as trustees.

However, establishing an off-shore trust is not as simple as vacationing to a tropical destination and depositing some money with one of these financial institutions. The rules applicable to these structures are not straightforward and a series of proposed amendments to these rules will likely make the voyage to these tropical destinations much more difficult to navigate.

Brief History of Proposed Amendments

The Department of Finance originally put forward proposals to broaden the application of rules that deem off-shore trusts to be resident in Canada in the 1999 budget. Additional amendments to the sections of the Income Tax Act (the "Act") governing foreign entities and non-resident trusts have been proposed on an ongoing basis since that time. As part of this ongoing process, the Minister of Finance introduced Bill C-33 in November 2006. Bill C-33 was then reintroduced in the most recent session of Parliament as Bill C-10 on October 29, 2007 (the "Bill").

The Canadian House of Commons adopted the Bill on the day it was reintroduced and it was put before the Senate for First Reading the very next day. However, at Second Reading the Senate referred the Bill to the Standing Senate Committee on Banking, Trade and Commerce. At the most recent Committee Meeting on January 30, 2008, the Chair of the Senate Committee informed that meetings involving the Department of Finance, select Committee members and certain industry experts were ongoing and that the Senate Committee was not ready at that time to proceed with a clause-by-clause consideration of the Bill. What this means is...more waiting.

Taxpayers and advisors alike are left to assume that the Bill will ultimately receive Royal Assent, with potentially minor revisions. As such, taxpayers must assume that the proposed amendments under the Bill are to apply to trust taxation years that begin after 2006.

Under the Act and the Bill, there are three specific sets of rules which all taxpayers and tax advisors should consider prior to implementing an off-shore structure or to ensure that a pre-established structure is not caught. The first two sets of rules have tax implications for individual taxpayers, while the third set will impose tax liability on a trust itself. These rules are listed below, followed by a very brief and simplified discussion of each:

1) The foreign accrual property income ("FAPI") rules under section 91;

2) The foreign investment entity ("FIE") rules under section 94.1; and

3) The non-resident trust ("NRT") rules under section 94.

The FAPI Rules

To briefly summarize, section 91 of the Act requires that a Canadian taxpayer include in his/her income the participating percentage of FAPI of every share owned by the taxpayer in a controlled foreign affiliate. FAPI includes, among other things, income of an investment nature such as interest, dividends, royalties and certain rents.

Under the Bill, a taxpayer may be deemed to have a participating interest in a controlled foreign affiliate where they are a beneficiary under a non-resident trust and certain conditions are not met.

If these rules apply, a taxpayer may be forced to include a percentage of the investment income (FAPI) earned by a trust in his/her income, whether they receive any income from the trust or not.

The FIE Rules

Similar to the FAPI rules discussed above, the FIE rules were designed to tax investment income accumulating offshore on a current basis. For subsection 94.1 of the Act to apply, a taxpayer must have a participating interest in a "foreign investment entity".

A foreign investment entity includes any non-resident entity unless "investment property" constitutes less than half the carrying value of all its property at the end of a year, or throughout the year, its principal undertaking was not carrying on an "investment business".

"Investment property" includes currency, various financial products and shares of capital stock of a corporation. An "investment business" is defined for the purposes of the FIE rules as a business, the principal purpose of which is to derive its income or profits from investment property, the disposition of investment property and other less common forms of investment.

Similar to the FAPI rules, the FIE rules could apply to a beneficiary of a trust who may never receive any income or capital from a trust.

Imagine a situation where Uncle Bill, who lives in England, establishes a trust for you and your cousin Jenny, who also lives in England. The trustee of the trust, Edward, is given the discretion to distribute the trust income and capital as he sees fit, but the trust deed states that if Edward fails to exercise that discretion then the trust assets are to be distributed equally between you and Jenny. During the trust period, Edward makes some shrewd investments and earns $200,000 a year in interest. However, Edward never distributes any income to you, but rather takes a liking to Jenny, who gets all $200,000 every year.

Pursuant to the proposed amendments under the Bill, you are potentially subject to the FAPI and the FIE rules and will have to include $100,000 in your income for each taxation year, even though you never received a penny of it. Some comfort should be taken in the fact that if both sets of rules apply then the FAPI rules take priority and you won't have to include the $100,000 in your income twice!

We can see from the example and discussion above that the proposed amendments to the FAPI and FIE rules could have very broad application and, in some cases, could apply to situations where it doesn't seem quite fair to the uninformed individual taxpayer.

The NRT Rules

From the trust perspective, under the current rules in the Act, a trust will be deemed a resident of Canada if it has a "resident contributor" and a "resident beneficiary". As a result a trust will not be taxable in Canada unless both definitions are satisfied.

However, the proposed amendments under the Bill state that where a non-resident trust has either a "resident contributor" or a "resident beneficiary", the trust will be deemed to be resident in Canada. This means that if either definition is satisfied, the trust will be subject to Canadian tax on its worldwide income.

The definition of "resident beneficiary" requires that the beneficiary be a resident of Canada and that there be a "connected contributor". The definition of "connected contributor" requires that a contribution be made by an entity to the trust while the entity is a resident of Canada. As a result, the key factor in determining whether a trust is caught by the proposed rules under both definitions is whether there is a contributor to the trust who is a resident of Canada.

A "contributor" is an entity that makes a contribution to a trust. A "contribution" to a trust can occur in two different ways, first, by falling under the definition of "contribution" in subsection 94(1) and second, through the extensive deeming provisions found in subsection 94(2) of the Bill.

The definition of "contribution" and the deeming provisions will not be discussed here; rather this discussion simply provides a broad overview of the potential application of the proposed amendments under the Bill.

Individual taxpayers and trusts alike who face the potential of being taxed under these rules should seek the advice and counsel of a professional with expertise in the area of tax and estate planning to ensure they don't face severe and unexpected tax consequences as a result of the Bill becoming law, whenever that may be.

Ian Pryor

613-566-2273

ipryor@perlaw.ca