Tax practitioners are wading through 350-plus pages of proposed new federal rules for non-resident trusts and foreign investment entities — the fifth version released by Ottawa — hoping to figure out yet again what it all means for their clients.
Many advisors are incorrectly assuming their clients won’t be affected by the new rules unless they are using the exotic tax-planning services of an offshore tax haven, says Paul LeBreux, chairman of the Society of Trust and Estate Practitioners (Canada) and president of Toronto-based Global Tax Law Professional Corp.
“A word of caution,” he says. “Don’t be too quick to dismiss the fact that these rules could apply to your clients. They affect trusts broadly.”
It is not just the advisors of super-wealthy clients requiring complex international tax planning who need to be concerned. Any clients who have set up NRTs for the usual purposes, such as preserving wealth for a spendthrift child or protecting assets from creditors, will be affected. And so will clients who are the beneficiaries of NRTs.
The bottom line, says LeBreux, is that any client who has a tax plan that has an international component — such as a trust structured and managed in the U.S. — needs to consider the potential impact of the proposed legislation.
“Non-resident discretionary trusts are still the most common and the most effective international tax-planning tool for high net-worth individuals who want to increase their after-tax wealth,” he says. International tax structures use NRTs to avoid Canadian taxation, he adds, especially if trusts are set up in jurisdictions in which income taxes are not levied.
Historically, NRTs that received contributions from Canadian residents were liable for paying Canadian taxes if one of the beneficiaries was also a Canadian.
The new rules are designed to tax foreign income, especially “passive” investment income, as part of the taxpayer’s “world income,” which must be reported on a Canadian tax return.
Under the new regime, says LeBreux, an NRT will be deemed resident in Canada if the NRT receives property or a loan, directly or indirectly, from a Canadian resident (defined as a “resident contributor”), irrespective of the residency of the beneficiaries.
“This is a marked change to the existing NRT provision,” he says, “which generally applies if a person resident in Canada has contributed to a non-resident trust, and one or more beneficiaries of the trust are resident in Canada.”
An NRT may also be deemed resident in Canada, says LeBreux, even without a resident contributor, when the NRT receives funds from a “connected contributor,” defined as either a resident who made a donation within 60 months leaving Canada or a person that becomes a Canadian resident within 60 months of making the contribution.
Notably, to have a “resident beneficiary” under the trust, there must be both a beneficiary who is a Canadian resident and a connected contributor.
The contributor to the trust, the trust itself and any Canadian beneficiaries will be jointly liable for all taxes and any interest and penalties. As well, any person who transfers property to an NRT will be required to disclose the transfer to the Canada Revenue Agency.
When it comes to foreign investment entities, the rules are extremely broad, say tax practitioners. Entities that could be caught in the FIE web of rules include “investment businesses” and “investment properties.”
An investment business is generally defined as a business whose principal income is generated from interest, dividends, rents, royalties or any similar return on investment, as well as income from the insurance or reinsurance of risk, or profit from the selling of investment property.
For investment advisors, it is important to note that mutual funds based in offshore jurisdictions will be caught by the FIE rules, says Michael Atlas, a chartered accountant and sole practitioner in Toronto. “The client will have to deal with reporting the income.”
He says this will generally entail reporting investment income using one of three calculation methods:
> the CRA’s default method using an annual prescribed rate (5%, at present — meaning the CRA assumes a return equal to 5% of the initial cost of the investment on the investment this year). But, says Atlas, for investments that were owned on Jan. 1, 2003, the prescribed rate will be applied to the market value of the the investment rather than the initial cost;
@page_break@> the “mark to market” method, which recognizes annual increases or decreases in the market value of the investment as ordinary income, unless substantially all of the change in value can be attributed to a change in capital instead of income.
> the “accrual” method. Taxpayers must make this choice on their tax return for the first “applicable” year of holding the investment.
However, it’s important to note the accrual method is also based on the taxpayer’s proportional interest in the income of the FIE. Many tax practitioners have stated that getting that exact amount from the investment business may be quite difficult. Therefore, if and when the legislation actually passes, one of the first two methods will probably be used.
The initial announcement about new NRT/FIE rules dates back to February 1999, and the rules have gone through many variations since then. In the 2005 federal budget, Ottawa said the latest version of the rules would be retroactive to Jan. 1, 2003, and clients will be able make their calculation election on a retroactive basis, too. The July 2005 version, the fifth that has been released, reflects “minor changes” to the previous versions, says LeBreux. It straightens out some of the technical details.
For advisors of clients from wealthy families that have holding companies with complex webs of offshore subsidiaries and investments, figuring out how the new rules will apply can be a nightmare, concede many tax practitioners who specialize in international taxation.
Most practitioners find the latest proposed rules hopelessly complex, so much so that the rules may also discourage many clients.
Some clients may decide not to comply with them. They will prefer to keep their affairs hidden, and risk being found out rather than engage in the complexities of compliance.
However, the fact that Ottawa has now released five versions demonstrates its serious intent to move forward with the regime. “There was a lot of speculation, especially with a federal election looming, that this legislation might disappear,” says LeBreux. But not so.
However, with an election in the near future, it is hard for practitioners to judge how to react to the latest version. Will the proposed rules change again — or be abandoned — after an election?
It is even becoming difficult for practitioners to know how to comply while the legislation remains in limbo.
The existing forms used for NRTs and FIEs are complex and time-consuming, they say, and the CRA is supposed to be releasing new forms. “We understand that certain forms are presently waiting to be released by the CRA, pending the NRT and FIE legislation becoming law,” says Kim Moody, a chartered accountant and partner with RSM Richter LLP in Calgary.
The compliance cost for some clients could conceivably double or even triple, says Moody, and this means that cost of the new rules could outweigh the value of having an offshore trust. IE
Ottawa fine-tunes new rules for foreign investment
Confusion aplenty in the tax industry as accountants sift through yet another massive set of proposed rules from Ottawa
- By: Stewart Lewis
- November 1, 2005 November 1, 2005
- 15:35