"2013 and 2014 saw significant changes to the taxation of trusts in Canada that will continue to have a significant effect on the practice of trust and estate planning. Many of the income splitting and tax planning opportunities for testators and non-residents, which were previously widely used and relied upon, have now been either modified or eliminated."
Inter vivos and testamentary trusts are used frequently in Canada to implement a variety of estate and tax planning strategies. Over the past few years, however, amendments to Canada’s Income Tax Act (the ITA), and case law have altered the effectiveness of the use of trusts in certain circumstances. In the following, we discuss the recent changes to the taxation of testamentary trusts, amendments and cases relating to non-resident trusts, the elimination of the immigration trust, and the impact these changes have on estate and trust planning in Canada.
The New Taxation of Testamentary Trusts Regime
Until the recent changes to the ITA take effect in 2016, an estate and each testamentary trust established under a will are taxed at graduated rates in the same way as an individual. This has, historically, provided testators with the ability to plan for income splitting upon their death between the estate and its beneficiaries. This has been a popular and widely used estate planning tool, until recently, when the Department of Finance introduced amendments to the ITA that eliminate the favourable tax treatment of most testamentary trusts.
The federal government announced in the 2013 Budget that it would review the taxation of testamentary trusts, expressing the concern that the use of testamentary trusts or the delay in administering estates was provoked by a wish to reduce income tax payable. Consequently, the government suggested that testamentary trusts be taxed at the same top tax rate as inter vivos trusts.
In the 2014 Federal Budget, the government announced that it would go ahead with the transition discussed above and eliminate the graduated rates afforded to testamentary trusts. Based on the amendments to the ITA released in August 2014 (the Amendments), only the estate of a deceased will be taxed at graduated rates and only for a period of 36 months after the date of death, at which time the estate will be subject to the highest marginal rates of tax on any income. One exception provided for in the Amendments is that trusts established for the benefit of disabled beneficiaries that meet certain requirements will maintain entitlement to the graduated rates of tax. The elimination of the graduated rate taxation of testamentary trusts is a significant change and one that carries equally significant implications in estate and tax planning across Canada.
As a result of this change in tax treatment, if the tax treatment is the same or comparable practitioners should consider establishing such trusts during their clients’ lifetime, as opposed to waiting until their death. Inter vivos trusts offer many similar benefits to their testamentary counterparts, as well as additional benefits in expediting administration and reducing estate taxes and fees. Confidentiality is appealing to many clients and is offered by both testamentary and inter vivos trusts alike. Further, by settling inter vivos trusts, the distribution of assets from the trust can generally occur more quickly than under a will if it requires probate before any distribution to beneficiaries can occur. Moreover, an inter vivos trust can provide the same non-tax benefits enjoyed by testamentary trusts, such as protecting children from a previous relationship in the situation of a blended family and safeguarding beneficiaries who are not financially sophisticated or have substance-abuse problems. In addition, in Ontario such trusts would have the additional benefit of moving the assets out of the individual’s estate and, consequently, reducing the amount of probate fees payable.
Despite the utility of inter vivos trusts in fulfilling estate planning goals, as discussed above, testamentary trusts are still necessary and useful in circumstances where beneficiaries under a testator’s will can or should not receive their respective interests outright. Practically speaking, where this is the case, income in such a testamentary trust can be allocated out to the beneficiaries of such trust and taxed at the beneficiaries’ graduated rates under subsection 104(13) of the ITA. While this is not as effective as the trust itself being treated as an individual taxpayer, it still provides a tax-effective way to provide for a client’s beneficiaries.
It is important to remember that under the ITA, a Canadian trust (with the exception of spousal, alter ego and joint partner trusts) is subject to a deemed disposition of all of its assets every 21 years. Practitioners must be aware of this rule and its implications when advising clients in favour of settling inter vivos or testamentary trusts. The application and effect of this rule was not changed by the elimination of graduated rate taxation of testamentary trusts, but it is always important to consider when advising clients about the settlement and administration of trusts (whether inter vivos or testamentary).
Non-Resident Trusts (NRTs) in Canada
The Canadian rules applying to the taxation of offshore trusts went through multiple iterations starting with draft revisions in 1999 and becoming law, in 2013, with retroactive effect (subject to limited grandfathering) to taxation years beginning in 2007. Prior to 2009, for Canadian tax purposes, a trust was generally regarded as being a resident of the jurisdiction in which the majority of the trustees are resident. However, in Garron Family Trust v The Queen (Garron), the Tax Court of Canada (confirmed by the Supreme Court of Canada) applied a test similar to the common law residency test for corporations and confirmed that a trust is resident where its central management and control actually abides. As a result, ensuring that a trust is non-resident under the common law is no longer as simple as it once was. A determination of the trust’s central management and control must be made before considering the NRT rules in the ITA, since a trust settled in a foreign jurisdiction may be resident in Canada pursuant to Canadian common law.
Canada has complex rules dealing with preventing the avoidance or deferral of tax by Canadian residents through the use of planning techniques involving offshore trusts. After well over a decade of debate, consultation and consideration, on 26 June 2013, Bill C-48 received royal assent. Bill C-48 is an omnibus tax bill that includes, among other measures, revised rules for the taxation of NRTs in Canada (the NRT Rules). Retroactive to 1 January 2007, the NRT Rules amend section 94 of the ITA and establish measures aimed at restricting the use of offshore or NRTs as a means of limiting or deferring the payment of income taxes in Canada. Under these rules there continued to be an exception for trusts where the Canadian resident contributor to the trust had been a resident of Canada for less than 60 months in the aggregate in their lifetime. This 60-month tax holiday was commonly referred to as the “Immigration Trust” exception; however, the definitions regarding the taxation of NRTs in the 2014 Federal Budget amend the definitions of “connected contributor” and “resident contributor” eliminating the use of immigration trusts, as described below.
Generally, where a trust is not resident in Canada in accordance with the Garron principles, newly adopted section 94 of the ITA sets out certain conditions in which an otherwise NRT would be deemed to be a Canadian trust and subject to Canadian income tax. In contrast to the replaced section 94 of the ITA, there are two different tests that can result in the NRT being deemed to be resident in Canada for Canadian income tax purposes:
• where there is a “resident contributor,” who transfers or loans property to the trust; or
• where there is a “resident beneficiary” of the trust, which has a two-part test – the trust has a beneficiary resident in Canada and there is a “connected contributor” to the trust.
In the event that there is either a resident contributor to the NRT or a resident beneficiary, the NRT will be deemed to be resident in Canada and liable to tax under subsection 94(3) of the ITA.
In particular, when caught by the deeming provisions, an NRT is deemed to be resident in Canada throughout the particular taxation year for the purposes of: (i) computing its income for the particular taxation year, (ii) determining its liability for tax under Part I of the ITA and (iii) for determining the liability of a non-resident person for tax under Part XIII of the ITA.
In addition, each person who is at any time in the particular taxation year a resident contributor to the NRT or a resident beneficiary under the NRT is jointly and severally liable with the NRT for the NRT’s Canadian tax.
Given the increasingly multi-jurisdictional nature of many clients, the rules that deem NRTs to be resident trusts are very important. Consideration must be given to the manner in which these trusts are established, the individuals who are contributors and beneficiaries and the assets being held in trust for the beneficiaries.
Until this year, the Canadian government continued to maintain a special exception to the NRT rules viewed as a way to attract high net-worth immigrants to Canada. While, like all other residents of Canada, immigrants must pay tax on their worldwide income or capital gains earned, Canada permitted immigrants to use a qualified non-resident trust. These were frequently referred to as “immigration trusts” and protected the income earned in such a qualified trust from Canadian taxes for up to 60 months. Subject to the 2014 Federal Budget, the immigration trust and its corresponding tax incentives have been eliminated.
Previously, the manner in which the immigration trust operated was as follows. The immigrant could be the settlor of the trust. The beneficiaries of the trust were typically the immigrant and his or her family. The trust would most often be resident in a low- or no-income and/or capital gains taxing jurisdiction for the duration of the 60-month exemption, regardless of where the immigrant and his or her family resided during such time. In this respect, the immigrant could take full advantage of the tax savings.
Under the 2014 Federal Budget, the 60-month exemption will be removed from the NRT rules for taxation years ending after 10 February 2014. As a result, an immigration trust will be deemed resident in Canada and subject to taxation on its worldwide income. Limited relief is available for immigration trusts that were established and funded before 11 February 2014. In those cases, if there are no contributions made to the trust after 10 February 2014, the trust can continue to benefit from the exemption until 31 December 2014. Starting 1 January 2015, the trust will become subject to worldwide income taxation.
It is therefore important that prior to 1 January 2015, all outstanding immigration trusts be reviewed in order to consider any tax planning opportunities or different wind-up strategies. In addition, if the decision made is to allow the trust to become a deemed resident of Canada on 1 January 2015, it is worthwhile for the client to consider that absent the tax benefits, the trust may still be a practical and useful tool for asset protection and overall succession planning.
With the elimination of the immigration trust, “granny trusts” (ie, trusts established by close relatives who are not and have never been residents of Canada for their Canadian resident children or grandchildren) may become more popular. A properly constructed inter vivos or testamentary granny trust will not be caught by the deeming provisions of the Canadian NRT Rules. Thus the granny trust will be able to accumulate and earn income tax-free offshore (depending on the jurisdiction), for the benefit of the Canadian resident beneficiaries. As long as there is no resident contributor or connected contributors, and therefore no “resident beneficiary” as the rules define them, these types of trusts will only be taxable on the income attributable to property acquired by the trust from Canadian residents and Canadian source income. Granny trusts are a useful planning tool for international families, especially in light of the elimination of immigration trusts as an effective tax planning structure in Canada.
2013 and 2014 saw significant changes to the taxation of trusts in Canada that will continue to have a significant effect on the practice of trust and estate planning. Many of the income splitting and tax planning opportunities for testators and non-residents, which were previously widely used and relied upon, have now been either modified or eliminated. The practice of trusts and estate planning is, however, dynamic and flexible and will therefore adapt to these new rules. Strategies and structures for effective estate planning are still available and will continue to develop in light of these changes, and estate practitioners will continue to offer effective and tax-efficient solutions to our clients.
Thank you to our associate, Rae Rechtsman, for her invaluable assistance with this article.