International Tax Planning

Transcription

1 canadian tax journal / revue fiscale canadienne (2013) 61:2, International Tax Planning Co-Editors: Pierre Bourgeois* and Michael Maikawa** Canadian Taxation of Income Earned and Distributed by a SubseCTIon 94(3) Trust Tony Schweitzer and Jesse Brodlieb*** Non-resident trusts with certain connections to Canada have long been subject to Canadian tax. Since 1999, the government of Canada has proposed to overhaul the Canadian taxation of non-resident trusts, most recently with draft legislation released on October 24, The purpose of these new rules is to cast a wider net for the Canadian taxation of nonresident trusts. The authors briefly review trust residence issues and the taxation of non-resident trusts under the existing rules, and then present an in-depth discussion of the proposed legislation. The authors main focus is on the taxation of income earned in and distributed by a non-resident trust that is deemed to be a resident of Canada for Canadian tax purposes. Different rules apply depending on the source of the income, the residence of the beneficiary, and whether the income is retained in or distributed by the trust. Keywords: Trusts n non-residents n distributions n beneficiaries n taxation n amendments Contents Introduction 462 Residence of Trusts 463 Common Law 463 Section 4.3 of the Income Tax Conventions Interpretation Act 464 The Existing Legislation 465 Discretionary Trust 466 Non-Discretionary Trust 466 The Proposed Legislation 467 Resident Contributor 467 Resident Beneficiary 469 * Of PricewaterhouseCoopers LLP, Montreal. ** Of PricewaterhouseCoopers LLP, Toronto. *** Of Dentons Canada LLP, Toronto. 461

2 462 n canadian tax journal / revue fiscale canadienne (2013) 61:2 The Taxation of Income Earned by a Subsection 94(3) Trust 470 Overview 470 Resident Portion 471 Distributions by a Subsection 94(3) Trust 472 Income Not Payable to a Beneficiary 472 Income Payable to a Canadian-Resident Beneficiary 472 Canadian-Source Income Payable to a Non-Resident Beneficiary 474 Example 476 Conclusion 478 IntroduCTIon On October 24, 2012, Canada s Department of Finance released a revised version of proposed legislation 1 that would replace existing section 94 of the Income Tax Act. 2 The proposed legislation confirms that Finance remains committed to enacting a new regime for taxing non-resident trusts 3 and their beneficiaries where the settlor of the trust or the beneficiaries have a sufficiently close connection to Canada that, from a policy perspective, the income earned by the trust should be taxed in Canada. The current proposals appear to be the last stage of a legislative odyssey that began with the 1999 federal budget; it is likely that they will receive relatively swift passage through Parliament under the present majority Conservative government. 4 Once enacted, the new provisions will implement broad changes to the taxation of nonresident trusts in Canada effective for the 2007 and subsequent taxation years. 5 In this article, we provide an overview of key aspects of the proposed legislation with specific reference to the income tax consequences of distributions by nonresident trusts to their beneficiaries. If a non-resident trust is subject to the proposed legislation, the source of its income and the residence of its beneficiaries will be critical in determining their respective tax liabilities. A trust with Canadian-resident beneficiaries will generally be able to deduct from its income amounts paid or payable to those beneficiaries, resulting in no tax at the trust level. Where income is paid or payable to non-resident beneficiaries, the trust s Canadian income tax liability will depend on whether the 1 Canada, Department of Finance, Notice of Ways and Means Motion To Amend the Income Tax Act, the Excise Tax Act and Related Legislation, October 24, 2012 (herein referred to as the proposed legislation ). 2 RSC 1985, c. 1 (5th Supp.), as amended (herein referred to as the Act ). Unless otherwise stated, statutory references in this article are to the Act. 3 In this article, non-resident trust means a trust that is not resident in Canada under common-law rules, but is deemed to be resident in Canada under proposed subsection 94(3). 4 The proposed legislation is part of an omnibus technical tax amendments bill that was introduced in Parliament as Bill C-48, the Technical Tax Amendments Act, 2012, on November 21, Under the current proposals, certain eligible trusts will be allowed to elect that a slightly modified version of the new provisions will apply to taxation years that end after 2000 and before 2007.

3 international tax planning n 463 income is from a Canadian source or a non-canadian source. If the income is from a Canadian source, the trust will be subject to part i tax whether or not the income is distributed, even though the payer of the income is required to withhold and remit tax on behalf of the trust under part xiii. For non-canadian-source income, the trust may have to withhold and remit tax under part xiii on payments made to non-resident beneficiaries. Most of Canada s income tax treaties (other than the Canada-us treaty) will only reduce, not eliminate, the part xiii tax. The proposed legislation will apply to trusts that would otherwise not be subject to Canadian income tax under existing law. 6 The proposed legislation is broader in scope than current legislation because an outbound trust (a trust settled by a resident of Canada for a non-resident beneficiary) will now be subject to Canadian income tax. 7 Also, certain inbound trusts (settled by a non-resident for a beneficiary who is a resident of Canada) that are not subject to Canadian income tax under the existing legislation will be subject to the proposed legislation, if the contribution is not made at a non-resident time of the contributor. This article consists of four main sections. In the first section, we review recent legislative and jurisprudential developments in respect of the residence of trusts. In the second section, we provide a brief overview of existing section 94. In the third section, we review the main charging provision of the proposed legislation. Finally, in the fourth section, we review the taxation of a trust under the proposed legislation, which depends on, among other things, whether the income is retained in the trust or is distributed to beneficiaries. Residence of Trusts Common Law The purpose of both current section 94 and the proposed legislation is to tax income of a trust that would not otherwise be taxable in Canada. It stands to reason, then, that this legislation is relevant only to non-resident trusts. Therefore, the first determination under either the current or the proposed regime is whether the trust is resident in Canada under common law. Recently, the Supreme Court of Canada held in Fundy Settlement 8 that a trust is resident where the central management and control of the trust takes place. 9 In the context of a trust established by or for the 6 The purported extension of Canada s taxation jurisdiction has been a criticism of the proposed legislation. See, for example, Elie Roth, Canadian Taxation of Non-Resident Trusts: A Critical Review of Section 94 of the Income Tax Act (2004) 52:2 Canadian Tax Journal For a discussion of the implications of both (an earlier version of ) the proposed legislation and changes to the common law to certain outbound trust structures, see Geoffrey J.R. Dyer, Is Offshore-Trust/Estate Planning Dead? in Report of Proceedings of the Sixty-First Tax Conference, 2009 Conference Report (Toronto: Canadian Tax Foundation, 2010), 32: Fundy Settlement v. Canada, 2012 SCC This is understood to be the same test that is applicable to corporations: De Beers Consolidated Mines, Limited v. Howe, [1906] AC 455 (HL).

4 464 n canadian tax journal / revue fiscale canadienne (2013) 61:2 benefit of a resident of Canada, if management and control of the trust is exercised in Canada, the trust will be subject to Canadian income tax on its worldwide income as an individual, 10 irrespective of the application of the current legislation or the proposed legislation pertaining to non-resident trusts. Section 4.3 of the Income Tax Conventions Interpretation Act Assuming that a trust is a non-resident of Canada under the Fundy analysis, a consequence of deeming the trust to be resident in Canada is that this result may conflict with an assertion of residence by the jurisdiction in which the trust is factually resident. In other words, a trust may be a resident of two countries. Such a trust may seek relief from double taxation under a tax treaty. A deemed resident trust is not taxable in Canada on the most comprehensive basis imposed under Canadian law (taxation on worldwide income) because certain amounts are excluded from its tax base. Accordingly, a trust that is deemed to be a resident of Canada arguably is not liable to tax in Canada within the meaning of Canada s tax treaties. 11 To avoid this potential conflict, Finance has introduced proposed section 4.3 of the Income Tax Conventions Interpretation Act (itcia). 12 Proposed section 4.3 of the itcia provides that, effective March 5, 2010, notwithstanding the provisions of one of Canada s tax treaties (or an act of Parliament giving force to a treaty), a trust that is deemed to be resident in Canada under proposed subsection 94(3) is deemed to be a resident of Canada for treaty purposes and deemed not to be a resident of the other contracting state for the purposes of applying the particular treaty. The explanatory notes issued with the proposed legislation state that section 4.3 clarifies that the law of Canada is such that, notwithstanding the provisions of a tax convention or the Act giving that convention the force of law in Canada, a trust that is deemed resident in Canada under new subsection 94(3) of the [Act] will be a resident of Canada... for the purposes of applying the convention. 13 The use of the word clarifies in the explanatory notes suggests that, in Finance s view, a trust that is deemed to be a resident of Canada has never been able to assert 10 Subsection 104(2). 11 In Crown Forest Industries Ltd. v. Canada, [1995] 2 SCR 802, the court held that liable to tax means liable to tax on the most comprehensive basis imposed by a state. In Antle v. The Queen, 2009 TCC 465, the Tax Court of Canada agreed in obiter with the taxpayer that a trust that is deemed resident under existing section 94 is not liable to tax in Canada within the meaning of the Canada-Barbados tax treaty and therefore not a resident of Canada for treaty purposes. 12 RSC 1985, c. I-4, as amended (herein referred to as ITCIA ). 13 Canada, Department of Finance, Explanatory Notes Relating to the Income Tax Act, the Excise Tax Act and Related Legislation (Ottawa: Department of Finance, October 2012), at clause 26 (emphasis added).

5 international tax planning n 465 treaty entitlement in contesting its residence. Another view is that proposed section 4.3 of the itcia amounts to a one-sided amendment of Canada s tax treaties in cases where a treaty would otherwise provide a different result. 14 If proposed section 4.3 of the itcia survives judicial scrutiny, it will resolve some complex issues of dual trust residence that will arise under Canada s tax treaty network following the effective date of the amendment. 15 Most of Canada s tax treaties do not have specific tiebreaker rules to deal with dual resident trusts. 16 In such cases, reference is usually made to the competent authorities to determine (or endeavour to determine, as the case may be) the residence of the trust. 17 The Existing Legislation Current section 94 is a modest piece of legislation compared to the proposed legislation. It applies where 18 a beneficiary of a trust 19 is n n n a person resident in Canada, a corporation or a trust with which a person resident in Canada does not deal at arm s length, or a controlled foreign affiliate of a person resident in Canada, and the trust has received property, directly or indirectly, from a person who n was or is related to the beneficiary described above (including aunts, uncles, nephews, and nieces); 14 See Phil Halvorson, Unilateral Treaty Override (2010) 18:10 Canadian Tax Highlights It may be possible to argue that there is treaty relief available for a trust deemed resident in Canada under proposed subsection 94(3) for taxation years of the trust ending before March 5, Given that the effective date of the proposed legislation is for the 2007 and later taxation years, this may lead to inconsistent results. 16 In addition, the interaction between subsection 250(5) and proposed ITCIA section 4.3 should be considered. 17 Under the Canada-US tax treaty, for example, article IV(4) provides, Where by reason of the provisions of paragraph 1 an estate, trust or other person (other than an individual or a company) is a resident of both Contracting States, the Competent authorities of the States shall by mutual agreement endeavour to settle the question and to determine the mode of application of the Convention to such person. See the Convention Between Canada and the United States of America with Respect to Taxes on Income and on Capital, signed at Washington, DC on September 26, 1980, as amended by the protocols signed on June 14, 1983, March 28, 1984, March 17, 1995, July 29, 1997, and September 21, 2007 (herein referred to as the Canada-US tax treaty ). In Perry v. Canada (National Revenue), 2008 FCA 260, the refusal of the Canada Revenue Agency (CRA) to engage with the US Internal Revenue Service on this point was upheld on the basis that the trust was not liable to Canadian tax under existing section 94 and therefore could not be a resident of Canada for the purposes of the treaty. 18 Subsection 94(1). 19 Including a person who is beneficially interested in a trust as defined in subsection 248(25).

6 466 n canadian tax journal / revue fiscale canadienne (2013) 61:2 n was resident in Canada at any time in the 18 months before the end of the year (or before death in the case of an individual, or before the date of winding up in the case of a corporation or a trust); and n in the case of an individual, has been resident in Canada for more than 60 months, in the aggregate, in his or her lifetime. If these conditions are met, the income tax consequences will depend on whether the non-resident trust is a discretionary trust or a non-discretionary trust. Discretionary Trust If the non-resident trust is discretionary, 20 then pursuant to paragraph 94(1)(c), the trust will be subject to Canadian income tax on 1. the trust s taxable income earned in Canada, the trust s foreign accrual property income, income earned by the trust on shares of foreign affiliates, 23 and 4. amounts required to be included as a result of an investment by the trust in an offshore investment fund property. 24 Foreign-source active business income earned by the non-resident trust is not subject to Canadian income tax pursuant to paragraph 94(1)(c). Non-Discretionary Trust If the trust is non-discretionary, then it is deemed to be a non-resident corporation having a single class of shares divided into 100 shares, with each beneficiary owning a pro rata number of shares corresponding to the fair market value of such beneficiary s interest in the trust. 25 Where a beneficiary s beneficial interest in the trust has a fair market value of at least 10 percent of the aggregate fair market value of all beneficial 20 A trust is considered to be a discretionary trust where, pursuant to paragraph 94(1)(c), the amount of the income or capital of the trust to be distributed at any time to any beneficiary of the trust depends on the exercise by any person of, or the failure by any person to exercise, any discretionary power. 21 As defined in section As defined in section 95. Clause 95(1)(c)(i)(B) provides modifications to the definition of foreign accrual property income for the purposes of applying the rules to a deemed resident trust. 23 Pursuant to subsections 91(1) through (3). 24 As defined in section Section 94.1 will be amended somewhat by the proposed legislation. 25 The CRA s view is that a trust will not be considered to be a discretionary trust (that is, the trust will be subject to income tax under paragraph 94(1)(c)) if the discretionary power with respect to the distribution of income or capital relates only to the timing of the payments, rather than to the determination of the amount of income or capital that is to be distributed to a beneficiary : CRA document no E5, September 16, 2008.

7 international tax planning n 467 interests in the trust, the trust is deemed to be a non-resident corporation controlled by that beneficiary for the purposes of, among other things, subsections 91(1) through (4) and section 95. As a result, depending on the relative fair market value of a beneficiary s beneficial interest in the trust, either the controlled foreign affiliate taxation regime or, depending on the circumstances, section 94.1 could apply. A significant consequence of the application of the current version of section 94 is that, in either scenario, non-canadian active business 26 income earned by a non-resident trust is not taxable in Canada. By contrast, a Canadian resident would be subject to Canadian income tax on worldwide income, including income earned from an active business carried on outside Canada. The Proposed Legislation 27 Generally, under proposed subsection 94(3), a non-resident trust will be deemed to be a person resident in Canada for enumerated purposes where there is either a resident contributor to the trust or a resident beneficiary under the trust. 28 In the remainder of this article, we refer to these deemed trusts as subsection 94(3) trusts. The distinction between discretionary and non-discretionary trusts in the current legislation is not relevant under the proposed legislation. Resident Contributor A resident contributor at a particular time means a person that is, at that time, resident in Canada and a contributor to the trust. A contributor is defined to mean a person that has made a contribution to the trust. In order to be a resident contributor, a natural person must still be alive at the relevant time, since a deceased person is not resident anywhere. 29 A contribution by a particular person or partnership to a trust is defined to mean n n a transfer or loan of property to the trust by the person or partnership (other than certain arm s-length transfers), and certain indirect transfers or loans to the trust (excluding arm s-length transfers). 26 As defined in subsection 95(1). 27 For an analysis of the 2010 version of the proposed legislation, see Bruce M. Harris, Kathy M. Munro, and Angela M. Ross, Section 94: An Analysis of the Latest Proposed Rules for Non-Resident Personal Trusts, in Report of Proceedings of the Sixty-Second Tax Conference, 2010 Conference Report (Toronto: Canadian Tax Foundation, 2011), 16:1-44. The 2007 version of the proposed legislation, which ultimately passed in the House of Commons but did not receive Senate approval, was the subject of a paper by Charles C. Gagnon, The New Non-Resident Trust Rules, in Report of Proceedings of the Fifty-Ninth Tax Conference, 2007 Conference Report (Toronto: Canadian Tax Foundation, 2008), 21: Unless otherwise noted, these and other defined terms referred to in the discussion that follows are found in proposed subsection 94(1). 29 See, for example, CRA document no , September 23, 2003.

8 468 n canadian tax journal / revue fiscale canadienne (2013) 61:2 Proposed subsection 94(2) provides rules of application relating to the transfer of property to a trust for the purposes of the proposed legislation. These rules refer specifically to various types of transactions, including, for example, the provision of certain guarantees or services to a trust or the issuance of shares by a corporation. Where there is a resident contributor to a non-resident trust, that trust is subject to Canadian tax pursuant to proposed subsection 94(3). 30 An exclusion from the definition of resident contributor retains Canada s exemption for so-called immigration trusts. Generally, a resident contributor at any time does not include an individual (other than a trust) who at that time has not been a resident of Canada for more than 60 months in the aggregate in his or her lifetime. This exclusion (and a parallel exclusion in the definition of connected contributor, described below) enables new residents of Canada to establish a non-resident trust to earn income free from Canadian tax for a maximum of five years after becoming a resident of Canada. 31 Pursuant to amendments to the Act and proposed legislation announced in the 2013 federal budget, 32 certain arm s-length transfers of property to a non-resident trust will result in the trust being deemed resident in Canada under proposed subsection 94(3). Proposed subsection 94(8.1) provides that proposed subsection 94(8.2) will apply where a person resident in Canada has retained control over property transferred to the trust or where the property may revert to that person. Under proposed subsection 94(8.2), such property will be deemed to be a transfer or loan of restricted property to the trust, whether or not the transferor received fair market value consideration. Since a transfer of restricted property cannot be an arm s-length 30 Proposed section 94.2 provides rules for the taxation of investments in certain commercial non-resident trusts by Canadian residents. These trusts are not subject to proposed section 94 because they are included in the proposed definition of exempt foreign trust under paragraph (h) of that definition. Certain trusts may also be prescribed under paragraph (i) of that definition for this purpose. The proposed legislation does not currently prescribe any such trusts. 31 Precluding the operation of existing or proposed section 94 is not the only consideration in establishing an immigration trust. Numerous attribution rules in the Act have potential application to such trusts. Subsection 75(2), which attributes income and gains of a reversionary trust back to the contributor of the property, has historically been a concern for immigration trusts. In Howson v. The Queen, 2006 TCC 644, the taxpayer successfully defended an attempt by the CRA to apply subsection 75(2) to an immigration trust, although the court did not disagree with the general proposition that subsection 75(2) could apply to an immigration trust. The proposed legislation excludes immigration trusts from the application of subsection 75(2) pursuant to proposed paragraph 75(3)(c.3) for taxation years ending before March 21, The 2013 federal budget announced that subsection 75(2) would be amended to exclude from its ambit all non-resident trusts (including immigration trusts) for taxation years ending on or after March 21, 2013: Canada, Department of Finance, 2013 Budget, Budget Plan, March 21, 2013, annex 2: Tax Measures: Supplementary Information and Notices of Ways and Means Motions ( Personal Income Tax Measures Non-Resident Trusts ). In addition, so-called granny trusts that is, trusts established by persons who are not residents of Canada, for the benefit of one or more residents of Canada continue to be excluded from Canadian income tax under the proposed legislation provided that there is no resident contributor or resident beneficiary. 32 Supra note 30.

9 international tax planning n 469 transfer, this proposed amendment will result in the trust being deemed resident in Canada under proposed subsection 94(3). In addition, such a trust is not permitted to roll out the trust property on a tax-deferred basis to a person other than the contributor of the property. Resident Beneficiary As indicated above, even if there is no resident contributor to a trust, a non-resident trust will be deemed to be a person resident in Canada for the purposes of the proposed legislation if there is a resident beneficiary under the trust. The definition of resident beneficiary sets out a two-part test; first, the trust must have a beneficiary who is resident in Canada; 33 and second, there must be a connected contributor to the trust. A connected contributor is a contributor to the trust, subject to certain limited exclusions, where the contribution was not made at a non-resident time of the contributor. 34 A contribution will be made at a non-resident time of a contributor if the contributor was not resident in Canada for the 60 months before the contribution and is not resident in Canada at the particular time in which the trust s status under section 94 is determined or 60 months after the contribution is made, 35 whichever is earlier A resident beneficiary is a person (other than a successor beneficiary or an exempt person) who is beneficially interested in the trust and who is resident in Canada. Beneficially interested for these purposes is defined in subsection 248(25) as modified by the definition of beneficiary in proposed subsection 94(1). (See supra note 19 and the related text.) A successor beneficiary is defined in proposed subsection 94(1) to mean a person who is a beneficiary under a trust solely because of a right of the person to receive any of the trust s income or capital, if under that right the person may receive that income or capital only on or after the death of an individual who is alive and is a contributor to the trust, or is related (including aunts, uncles, nieces, and nephews) to a contributor to the trust, or who would have been related to a contributor to the trust if every individual who was alive before that time were alive at that time. For the CRA s interpretation of this provision (under an earlier draft of the proposed legislation), see CRA document no C6, July 22, An exempt person is one of the various, generally tax-exempt, entities listed in the definition of that term in subsection 94(1). A mutual fund trust is also an exempt person. 34 An individual (other than a trust) who has been a resident of Canada for no more than 60 months in aggregate is excluded. This exclusion provides an additional mechanism for immigration trusts where the settlor of the trust is not a resident of Canada at the specified time. 35 Pursuant to the definition of non-resident time in proposed subsection 94(1), the 60-month period prior to the contribution is reduced to 18 months where the contributor has ceased to exist (that is, has died, in the case of an individual, or has been wound up, in the case of a corporation). 36 Under proposed subsection 94(10), a contribution made at a non-resident time by a person who subsequently becomes resident in Canada within 60 months of the contribution is deemed to have been made at a time other than a non-resident time of the contributor. This rule has been described as particularly harsh. See William I. Innes and Dessislav Dobrev, Observations on Section 94, in Report of Proceedings of the Fifty-Eighth Tax Conference, 2006 Conference Report (Toronto: Canadian Tax Foundation, 2007), 29:1-83.

10 470 n canadian tax journal / revue fiscale canadienne (2013) 61:2 The Taxation of Income Earned by a SubseCTIon 94(3) Trust Overview The charging provision of the proposed legislation is proposed subsection 94(3). Generally, when proposed subsection 94(3) is applicable, the trust will be subject to Canadian income tax. However, rather than deem a subsection 94(3) trust to be a person resident in Canada for all purposes, proposed subsection 94(3) deems the trust to be a person resident in Canada for certain specified purposes. More specifically, where in a particular taxation year a trust is a non-resident of Canada and there is a resident contributor to the trust or a resident beneficiary under the trust, the trust is deemed be a person resident in Canada for the purposes of 1. section 2, 2. computing the trust s income for the particular taxation year, and 3. determining the liability of the subsection 94(3) trust for purposes of part i. Taken together, these deeming rules provide that a subsection 94(3) trust will be required to compute and pay Canadian tax on its worldwide income as though it were an individual resident in Canada for the year. Additional rules in proposed subsection 94(3) deem the trust to be a person resident in Canada for the purpose of applying various provisions to its beneficiaries. Subsections 104(13.1) through (28) and 107(2.1), relating to the computation of the income of the trust and its beneficiaries, apply as though the trust were a person resident in Canada. Where a trust is a subsection 94(3) trust, various rules that would otherwise apply to beneficiaries of the trust are deemed to apply as though the trust were resident in Canada. For example, the trust is deemed to be a person resident in Canada for the purposes of determining n a beneficiary s adjusted cost base in its capital interest in the trust, n a beneficiary s liability under section 94.1, n the ability of a beneficiary of a non-resident trust to elect out of rollover treatment in accordance with subsection 107(2.002), and n a beneficiary s liability under section 115. These rules may conflict with rules that apply to resident trusts if they are not excluded from the application of the proposed legislation. A subsection 94(3) trust is deemed to be a person resident in Canada for the purposes of determining the trust s liability under part xiii on amounts paid or credited to the trust, and in applying part xiii in respect of an amount paid or credited by the trust to any person. This is discussed in detail below. In addition, for the purposes of divisions i and j of part i, which relate to returns, assessments, payments, appeals and court appeals, and foreign affiliate and foreign property reporting, a subsection 94(3) trust is deemed to be a person in Canada.

11 Resident Portion international tax planning n 471 The proposed legislation bifurcates a subsection 94(3) trust according to the residence of the contributor of its property. Generally, property contributed at a contributor s non-resident time will form the non-resident portion of the trust. All other contributions will form the resident portion. The proposed legislation imposes income tax on amounts earned from property that forms the resident portion of a subsection 94(3) trust. However, the trust may be taxable on other income earned in Canada because section 115 applies to the non-resident portion. The proposed legislation contains a number of complex rules relevant to determining whether certain property of the trust forms part of the resident portion. Any trust property not forming part of the resident portion falls into the non-resident portion. Specifically, under subparagraph (a)(ii) of the definition of resident portion, a number of deeming rules include in the resident portion certain property where there has been a deemed transfer under proposed subsection 94(2). Proposed clause 94(2)(a)(ii)(b), for example, provides that for the purposes of these rules, a transfer to a trust includes a transfer or loan by a person or partnership whereby an obligation, or potential obligation, of the trust is decreased. Because the deemed transfer does not result in an actual transfer to the trust, there may not be any actual property in the trust to represent the deemed transfer to the trust. Subclause (a)(ii)(a)(ii) of the definition of resident portion addresses this issue by providing that the trust must select a property having a fair market value at least equal to the absolute value of the relevant decrease in liability or potential liability of the trust, and that property then forms part of the resident portion. Where the trust fails to so select, the minister of national revenue is authorized to make the selection. A detailed review of these rules is beyond the scope of this article. 37 Under the proposed legislation, a subsection 94(3) trust having both a non-resident portion and a resident portion can elect to be an electing trust. Such an election is irrevocable. An electing trust will be able to treat its non-resident portion as a separate trust that is not resident in Canada. It appears that the purpose of this election is to provide greater delineation of the subsection 94(3) trust s non-resident portion and resident portion. The election must be made in the first taxation year of the trust in which the trust is deemed to be resident in Canada under proposed subsection 94(3). There does not appear to be an ability for a subsection 94(3) trust to make an election in a subsequent taxation year. It is not clear how this rule would apply where a trust is deemed to be resident in Canada on a retroactive basis under proposed subsection 94(10). Presumably, the cra would administer the rules to allow the trust to include an election in its return for the year in which the trust is first deemed to be a subsection 94(3) trust, although the return might not be filed for 37 For a more detailed discussion on this point, see Gregory Wylie, Matias Milet, and Tim Barrett, Latest Amendments to the Non-Resident Trust and Offshore Investment Fund Property Rules, International Tax no. 67, December 2012, 5-11.

12 472 n canadian tax journal / revue fiscale canadienne (2013) 61:2 several years after the year in which the contribution was made. It is also not clear how a trust would make the election if it were found by a court to have been a subsection 94(3) trust in an earlier year. Distributions by a Subsection 94(3) Trust Proposed paragraph 94(3)(a) contains a number of provisions relating to the taxation of income in the trust and the distribution of income to beneficiaries. Figure 1 illustrates the decision path for determining the appropriate taxation of income received by a subsection 94(3) trust. Income Not Payable to a Beneficiary Proposed subparagraph 94(3)(a)(i) provides that a subsection 94(3) trust is deemed to be resident in Canada throughout the trust s taxation year for the purposes of section 2; therefore, a subsection 94(3) trust is subject to Canadian income tax under part i. 38 As a result, section 122 provides that a subsection 94(3) trust is liable to Canadian federal income tax on all of its income at a flat rate of 29 percent, currently the top marginal rate applicable to individuals. In addition, subsection 120(1) must be considered. It provides that the tax rate on the income of an individual other than income earned in a province is subject to an additional tax equal to 48 percent of the tax that would otherwise be payable under part i. This raises the rate on income earned outside a province by an individual, including a trust, to percent. 39 In contrast to the taxation of, say, an Ontario resident, who is subject to Canadian income tax on his or her worldwide income, subsection 2(1) imposes income tax only on income earned on the resident portion of the subsection 94(3) trust. In respect of all other income, the trust will be taxed pursuant to subsection 2(3), which limits taxable income to that earned from a business carried on in Canada or from the disposition of taxable Canadian property, both as determined under division d (section 115 and following). Income Payable to a Canadian-Resident Beneficiary A subsection 94(3) trust will ordinarily be able to reduce its Canadian income tax by claiming a deduction under subsection 104(6), which allows a trust to deduct an amount that became payable in the year to a beneficiary. The amount is included in the beneficiary s income pursuant to subsection 104(13). Under subsection 104(24), an amount is considered to be payable for this purpose if it is paid in the year to a beneficiary or if the beneficiary is legally entitled to enforce payment. The effect 38 A subsection 94(3) trust is also deemed to be a person resident in Canada for the purposes of determining the liability of such a trust to tax under part I. Section 2 is the main charging provision of part I % + (29% 48%) = 29% % = 42.92%.

13 international tax planning n 473 Part I tax at the trust level (taxed in accordance with ordinary principles at 42.92%) No FIGURE 1 Determination of the Taxation of Income Received by a Deemed Resident Trust Under Proposed Subsection 94(3) Subsection 94(3) trust (resident portion only) Is the income of the trust payable to a beneficiary? Yes Is the income from a source within Canada? No Yes Is the beneficiary a resident of Canada? Is the beneficiary a resident of Canada? No Yes No Yes Part XIII tax at the beneficiary level (15% to 25%, subject to article XXII of the Canada-US treaty) Part I tax at the beneficiary level (marginal rate) Part I tax at the trust level under subsection 104(7.01) (15% or 25%) Part I tax at the beneficiary level (marginal rate)

14 474 n canadian tax journal / revue fiscale canadienne (2013) 61:2 of the subsection 104(6) deduction for a subsection 94(3) trust is that, in many cases, the trust will not be subject to Canadian income tax. Canadian-Source Income Payable to a Non-Resident Beneficiary Where the beneficiary to whom the income is payable is a non-resident of Canada, proposed subsection 104(7.01) will limit the amount of the subsection 104(6) deduction. 40 Where a subsection 94(3) trust distributes all of its income to beneficiaries, its part i tax liability will arise under proposed subsection 104(7.01) to the extent that amounts are made payable to a beneficiary who is not resident in Canada. Proposed subsection 104(7.01) specifies the maximum amount that a subsection 94(3) trust is entitled to claim as a deduction under subsection 104(6). First, the trust s designated income 41 is calculated. The trust s designated income is the maximum amount that the subsection 94(3) trust can claim as a deduction. Thereafter, the amount of the trust s designated income is reduced by the formula a b, where a is an amount paid or credited to the trust that would otherwise be subject to part xiii 42 giving rise to part xiii tax if the trust were not deemed to be resident in Canada for that purpose, and that becomes payable in the year by the trust to a nonresident beneficiary; and the value of b depends on the residence of the beneficiary to which the amount is paid or payable. Where the trust can establish to the satisfaction of the cra that the non-resident beneficiary is resident in a country with which Canada has a tax treaty that limits the rate of Canadian income tax on the amount paid, element b equals In any other case, 0.6 is to be used. A complex interaction of rules results in proposed subsection 104(7.01) acting as a proxy for part xiii withholding tax on amounts paid from a Canadian source that ultimately is paid or payable to a non-resident beneficiary of a subsection 94(3) trust. Proposed paragraph 94(4)(c) specifically provides that a subsection 94(3) trust is not deemed to be a person resident in Canada for the purposes of determining the 40 The explanatory notes, supra note 13, at clause 10, state that the purpose of proposed subsection 104(7.01) is to ensure that subsection 94(3) trusts are not used inappropriately to distribute Canadian-source income to non-resident beneficiaries free of Canadian income tax. 41 As defined in section Pursuant to proposed subparagraph 94(3)(a)(viii), a subsection 94(3) trust is deemed to be a person resident in Canada in respect of amounts paid or credited to the trust within the meaning of part XIII. Accordingly, part XIII withholding tax does not apply to a subsection 94(3) trust.

15 international tax planning n 475 liability of any person (other than the trust) under section 215. Subsection 215(1) imposes a requirement on the payer of an amount subject to part xiii tax to withhold and remit the appropriate amount to the cra. 43 Accordingly, a Canadian-resident corporation that pays a dividend to a subsection 94(3) trust (for example) is required to withhold 25 percent from that payment. For example, where shares of a corporation resident in Canada form part of the resident portion of a subsection 94(3) trust and the corporation declares a $100 dividend on those shares, the trust will receive $75 in net cash after the payer corporation has withheld in accordance with subsections 212(2) and 215(1). In accordance with proposed paragraph 94(3)(g), the cra will apply this withheld amount to the trust s part i tax liability, if any, for the year. Although there has been withholding, the trust s income from the dividends is $100. If the trust pays (or makes payable) the $100 to a non-resident beneficiary, proposed subsection 104(7.01) will apply, effectively imposing part i tax on the subsection 94(3) trust by limiting the subsection 104(6) deduction on the distributed amount. Where proposed subsection 104(7.01) so applies, the amount paid or payable by the subsection 94(3) trust is an exempt amount in accordance with paragraph (b) of that definition in proposed subsection 94(1). Therefore, for the purposes of the amount of Canadian-source income paid to a non-resident beneficiary of the subsection 94(3) trust, the trust is not deemed to be a person resident in Canada, and therefore there is no withholding obligation on the trust under paragraph 212(1)(c). Accordingly, because the initial amount withheld by the corporate payer is credited against the subsection 94(3) trust s part i tax liability, there should normally not be any additional level of tax arising on the amount subsequently flowed out to a nonresident beneficiary. Presumably, where there is no ultimate part i tax liability of the trust (because, for example, all of the income is paid to a beneficiary who is a resident of Canada), the withheld amount would be refunded. This provision avoids potential mistiming issues that can occur in obtaining a refund where there is an overpayment of part xiii tax. 44 Proposed subsection 104(7.01) does not apply to the income of a subsection 94(3) trust from a source outside Canada. In that case, a distribution of the trust s income will be fully deductible to the trust where the paid or payable test is met. Regardless of the source, income distributed by a subsection 94(3) trust to a beneficiary who is a resident of Canada is ordinarily fully deductible to the trust. Since proposed subparagraph 94(3)(a)(ix) deems a subsection 94(3) trust to be a person resident in Canada for the purposes of applying part xiii in respect of an amount paid or credited by the trust to any person, a distribution by the trust on 43 The proposed legislation includes an amendment to subsection 215(1) to ensure that payments by a resident of Canada to a subsection 94(3) trust are liable to the ordinary withholding and remittance obligations that apply where the recipient is a non-resident of Canada. 44 Under subsection 227(6), a taxpayer must request a refund of overpaid part XIII tax within two years from the end of the calendar year in which the amount was paid.

16 476 n canadian tax journal / revue fiscale canadienne (2013) 61:2 non-canadian-source income can result in part xiii withholding tax where the payment is to a beneficiary who is not resident in Canada for the purposes of the Act. 45 As noted above, the domestic withholding tax rate on trust distributions is 25 percent; however, in many cases this will be reduced by treaty to 15 percent. Article xxii(2) of the Canada-us tax treaty 46 provides that Canada cannot impose a withholding tax on a distribution from a trust to a us-resident beneficiary on income arising outside Canada. The application of article xxii is potentially clouded by subsection 212(11), which deems the amount paid or credited by a trust to a non-resident to have been paid or credited as income of the trust regardless of the source. In addition, article xxii provides relief for amounts distributed out of income, whereas the Canadian domestic rule enables the trust to claim the deduction where the amount is payable in the particular year to the beneficiary. However, the cra has in the past stated that this exemption from Part xiii tax applies to income credited to a us resident beneficiary which includes income payable in the particular year to the beneficiary for the purposes of subsections 104(13) and 104(24) of the Act, provided [that] the person to whom it was payable was entitled in that year to enforce payment thereof. 47 Example As a further illustration of the application of the proposed legislation to distributions by a subsection 94(3) trust, consider a subsection 94(3) trust that has received $300 in income in the form of taxable dividends from a corporation resident in Canada, the shares of which form part of the trust s resident portion. The corporation would have been required to withhold $75 from the dividends. The trustees allocate $100 of the dividend income to a beneficiary resident in the United Kingdom, a country with which Canada has a tax treaty. A second allocation is made to a Canadianresident beneficiary. The remaining $100 is allocated to a beneficiary who is resident in the Cayman Islands, a non-treaty country. All of the allocations are payable by the trust to the respective beneficiaries within the meaning of subsection 104(24), and a subsection 104(19) designation is made in respect of the dividend income. Table 1 illustrates the impact of the proposed legislation in this scenario. As can be seen, the application of proposed subsection 104(7.01) results in the trust, and not the non-resident beneficiaries, having a tax liability under part i The exclusion for an exempt amount does not apply to a distribution paid after 2003 and is not referred to in proposed paragraph 104(7.01)(b) (subject to limited grandfathering under paragraph (c) of the definition of exempt amount ). 46 Supra note See CRA document no , September 21, Pursuant to proposed paragraph 94(3)(d), a resident contributor to or a resident beneficiary of a subsection 94(3) trust is jointly and severally liable for the trust s tax. However, there does not seem to be any provision in the Act that would make the beneficiaries in this example liable for the trust s tax. This may simply be a concession to the fact that there is some limit to Canada s

17 Table 1 Taxation of a Distribution by a Deemed Resident Trust Under Proposed Subsection 94(3) Residence of beneficiary Amount paid or payable Factor for element B of subsection 104(7.01) international tax planning n 477 Reduction of subsection 104(6) deduction Part I tax on trust income (at 42.92%) Canada... $ na nil nil a United Kingdom (treaty country)... $ $35.00 $15.02 Cayman Islands (non-treaty country)... $ $60.00 $25.75 Total... $ $95.00 $40.77 b a There is, of course, part I tax on this distribution; however, it is the beneficiary and not the trust who is liable for the tax. b Under this scenario, the fisc is enriched by about 0.35 percent (an additional $0.77 in tax on $200 of income) by imposing part I tax on a subsection 94(3) trust instead of imposing part XIII tax on the beneficiaries. If both beneficiaries in this example were residents of a non-treaty country, the subsection 94(3) trust would be liable to $51.50 of part I tax, meaning that an additional 0.75 percent in tax is collected under part I compared to the amount collected under part XIII. The cra has already collected $75 from the trust in the form of the part xiii tax remitted by the payer corporation. This amount is sufficient to eliminate the tax liability of the subsection 94(3) trust for the year. The additional $34.23 withheld by the corporate payer would be refundable to the trust. As noted above, pursuant to paragraph 212(1)(c), a 25 percent withholding tax is imposed on income of or from a trust to the extent that the amount is included in computing the income of the non-resident under subsection 104(13) or can reasonably be considered to be a distribution of a capital dividend received by the trust from a taxable Canadian corporation. In this example, a trust that is resident in Canada under Canadian common-law principles would be required to withhold and remit $15 in part xiii withholding tax from the payment to the uk-resident beneficiary 49 and $25 from the beneficiary ability to tax non-residents without a connection to Canada. Conversely, a domestic trust that fails to withhold the correct amount under part XIII tax is jointly and severally liable with the non-resident beneficiary for payment of the unpaid balance. 49 Under article 20 of the Canada-UK income tax convention, Canada s withholding tax rate on income from an estate or trust resident in Canada received by a resident of the United Kingdom who is the beneficial owner thereof is limited to 15 percent. See the Convention Between the Government of Canada and the Government of the United Kingdom of Great Britain and Northern Ireland for the Avoidance of Double Taxation and the Prevention of Fiscal Evasion with Respect to Taxes on Income and Capital Gains, signed at London on September 8, 1978, as amended by the protocols signed on April 15, 1989, October 16, 1985, and May 7, 2003.

18 478 n canadian tax journal / revue fiscale canadienne (2013) 61:2 who is a resident of the Cayman Islands. 50 As with all tax under part xiii, the tax liability is ultimately the non-resident s; however, the trust is liable to a penalty for failure to properly withhold and remit the correct amount and is liable for the nonresident s tax with a statutory right of recovery. Conclusion Canada has previously asserted its right to tax certain trusts that are not resident in Canada. Recent developments in common law as well as the introduction of proposed section 4.3 of the itcia extend Canada s taxing jurisdiction in respect of non-resident trusts. The proposed legislation is complex. The taxation of a subsection 94(3) trust will depend on the source of its income and on the residence of its beneficiaries. The proposed legislation will, if enacted, further extend Canada s taxing jurisdiction. 50 Generally, income distributed out of a trust loses the character of the underlying source and is treated as income from a trust, although, where properly designated, a dividend from a taxable Canadian corporation can retain its character in the beneficiary s hands under subsection 104(19). However, this rule does not apply for the purposes of part XIII withholding tax.