The Quebec government is going after $500 million in unpaid taxes plus interest after closing a loophole that allowed out-of-province residents to shelter income in so-called “Quebec trusts.”

The unprecedented action was announced in May by Quebec Revenue Minister Lawrence Bergman, based on legislation that is retroactive. It affects approximately 150 trusts that have not paid provincial taxes during the past three tax years.

Beneficiaries of some of these trusts will, no doubt, be worried about the ability of their trusts to pay the upcoming tax bill. Meanwhile, trustees of trusts affected by the change will have to decide whether to move their trusts to a different province.

If you have a client who is either a beneficiary or a trustee of a Quebec trust, you should urge the client to get legal and tax advice concerning the trust’s status. The location of the trustees and beneficiaries and the location of the trust assets need to be considered.

It may make sense to move the trust to a province with lower tax rates than Quebec’s. It may also make sense to move it closer to the beneficiaries and the trust assets. The place in which the majority of the trustees live generally determines the residence of the trust. New trustees may have to be named.

The “loophole” at issue was created largely by the fact that Quebec has a separate tax regime. Unlike other Canadian provinces, which piggyback on the federal tax collection system, Quebec collects its own taxes.

In other provinces, trustees file a trust tax return. A trust is a separate taxpayer from the trust’s beneficiaries. The trust pays federal and provincial taxes determined by whether the trust distributes any income to the beneficiaries or keeps it within the trust. As a general rule, federal and provincial tax legislation allow trustees to pay trust income out to the beneficiaries while filing an “election” for any trust income taxes to be paid by the trust.

However, as Quebec has a separate tax system, trusts distributing to non-Quebec residents were able to make the election on the federal level only and pay only federal taxes, says Barbara Novek, partner with Sweibel Novek Tax Lawyers LLP in Montreal. The equivalent election wouldn’t have to be made with Quebec’s Revenue Ministry, she says. That way the trust could avoid provincial taxes altogether.

Meanwhile, because the beneficiaries were not Quebec residents, they weren’t required to pay into Quebec tax coffers, either.

Outside Quebec, this kind of trust/tax planning came to be known as simply Quebec trusts, and some law and tax-consulting firms had a small sideline setting these up. No wrongdoing can be alleged because these trusts were following the law. The loophole is a leftover from efforts made by the Quebec government in 1999 to crack down on tax evasion.

Bergman is not alleging tax evasion in this instance, but he has told Quebec media there has been an “abuse of the law.”

And now Quebec Revenue wants that tax money.

It’s quite possible that the Quebec government found out what was going on under its nose from the federal government, which would not want to be seen as abetting provincial tax avoidance.

“This move is aimed at eliminating perceived provincial tax abuse,” says Phil Nadler, accountant and partner in the Montreal office of RSM Richter LLP.

Aside from the immediate tax hit, there is also a possibility that “double taxation” will arise out of this legislation. For example, the government of a non-Quebec resident beneficiary may challenge the legality of any given Quebec trust. Using provincial anti-avoidance tax rules, it may decide that the trust has been merely an avoidance scheme. As a consequence, it could tax all the trust income in the hands of the beneficiary.

Meanwhile, the Quebec tax amendments state that all trusts that have used this loophole will be “deemed” to be trusts. Accordingly, three years’ worth of back taxes and interest will be imposed — a tax double whammy.

Experts say it will be difficult to challenge Quebec’s move. The province doesn’t have a separate tax court system, so any challenge would have to be made through the Quebec civil court system. And the Quebec government is likely to dig its heels in right up to the Supreme Court of Canada if necessary, says a Quebec tax lawyer.

@page_break@Any challenger — either a beneficiary or a trustee acting on behalf of a trust — would need the time, energy and money for years of litigation. And chances are slim that a court would have much sympathy for such a challenge.

There has been a lot of political lobbying directed at Quebec City to get the province to change its position ever since the amendments were announced, says a Toronto tax lawyer whose firm has prepared Quebec trusts for its Toronto clients: “But it’s going nowhere. IE