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NRT Rules:  Harsher Than You Think

By: David Louis, J.D., C.A., Tax Partner.
Minden Gross LLP

(*This release is based on an article published in Tax Notes, November 2004, Number 502, CCH Canadian Limited)

As most readers are aware, the Department of Finance has tabled proposed legislation in the area of non-resident trusts (“NRT’s”)[i] which, when enacted, will generally be effective for taxation years starting January 1, 2003. 

To be honest, like many practitioners, I tended to associate these ultra-complex proposals with Canadian-contrived tax structures – offshore freezes, tax haven funds and the like – until recently, that is.  However, as I am now acutely aware, the proposals can have frightening ramifications to legitimate foreign investment structures involving non-resident trusts – even if they have nothing much to do with Canada except investing in our country. 

Any non-resident trust with a Canadian nexus could be hit by the proposals.

A simple rollover may trigger the rules

Our lesson in the offshore trust rules began innocently enough.  Years ago, some far eastern clients had established an international trust as an investment platform in Canada and other jurisdictions.[ii]  There were no Canadian beneficiaries, and none of the funding came from Canada.  Non-resident trusts are often used for foreign investments in Canada; for example Canadian investments could be made from a non-resident estate.  The transaction we looked at was quite simple: essentially, it was desired to interpose a Canadian Holdco between the trust and the entity which invested in a Canadian business.  At first glance, apart from section 116 requirements, there didn’t seem to be much to this transaction other than a straight-forward section 85 rollover. 

 But the file wound up on the desk of my partner, Joan, who has a talent for picking up non-obvious issues.  As she pointed out, the rollover involved an issuance of shares by the Holdco to the trust.  This is deemed to be a transfer to the trust by Holdco under proposed paragraph 94(2)(g).  This means that, potentially, Holdco may be a “resident contributor” to the trust.  And if there is a “resident contributor”, the trust is deemed to be resident in Canada.  If so, it is taxable on its worldwide income.  This could be trouble, particularly if it turns out that the trust invests in a number of countries.  For example, even if the trust had incorporated foreign subsidiaries, as a Canadian resident, the FAPI rules could apply.[iii]

Exceptions, exceptions to exceptions

Once this potential problem became apparent, the next issue was whether the transfer (i.e., the issue of shares to the trust by Holdco) would be exempt from being considered to be a contribution to the trust - because it is an “arm’s length transfer”.  Maybe, but things were already uncomfortably complicated.  As practitioners who work in the area are well aware, the arm’s length transfer exceptions – like the rest of the offshore trust rules - are very tricky, and one false step can render the trust resident in Canada.  Worse still, the resident contributor (Holdco, in this case) is jointly and severally liable for the trust’s taxes.[iv]  

 This article is not intended to be a paper on the non-resident trust rules (if you want to read one, see below); but to make a long story short, it turned out, firstly, that these sorts of share exchanges are covered by a provision of arm’s length transfer rules dealing with exchanges.[v]  But as an exception, the arm’s length/exchange out does not apply to begin with for something called a “restricted property” – a concept which may often come into play for transactions like the one in question, where a non-resident trust transfers shares of a corporation into another closely-held corporation.[vi]  Even if this is not a problem, it must be reasonable to conclude that, had the parties (i.e., the trust and Holdco) dealt at arm’s length, the transferor (i.e., Holdco) would have been willing to make the transfer on basically the same terms and conditions.  Anyway, it turned out that what seemed at first to be a simple rollover became a very complex exercise, taking us into the very heart of the non-resident trust rules. 

 By the way, unless the transaction fits squarely into the arm’s length transfer exemptions, there may be also a resident contributor if a corporation issues debt (the issuing corporation is the transferor), an interest in a partnership is acquired (presumably the partnership is the transferor), and so on.  In fact, these rules may potentially apply (for example) to indirect transactions, e.g., if a trust forms a corporation and a Canadian third party makes a transfer or loan to the corporation[vii] or provides financial assistance to it (e.g., a guarantee)[viii] - even to services[ix] other than those covered by specific exemptions.[x]

Like falling off a log

If you’re getting the impression that falling into these provisions is as easy as falling off a log, you’re right.  This is precisely what the tax drones at the Department of Finance probably intended: looks to me like they were out to catch every Canadian tax contrivance imaginable involving offshore trusts - and saddle the infidels with a myriad of complexities and traps.  Fair enough (I suppose).  Trouble is, the rules may often end up catching trusts whose only nexus with Canada is its investments – same complexities, same traps.  

 But that’s not the end of it.  The entire history of the trust should be examined for offside transactions, even if it was formed years before these rules were made public: the rules respecting contributions, including those discussed above, have little in the way of grandfathering for transactions entered into before the rules were announced.  This means that something done, say, a decade ago, may mean that the trust is now resident in Canada.

My suspicion: if a non-resident trust is used as a Canadian investment vehicle, and the trust has been doing anything the least bit sophisticated, there is probably an issue lurking somewhere in its past – which may render it resident in Canada, with possible joint and several liability in store to those who participated in the transaction.[xi]  After all, if a simple rollover can be contentious, what else might be?

 Because these proposals are so new, at the moment, there isn’t much written on them that’s up to date.  However, a notable exception is a paper by Stephen W. Bowman entitled “NRT Update: Living with the New Section 94”.[xii]  This article was originally written before the latest round of proposals came out[xiii], but has been updated to take them into account.  A read through this paper will demonstrate how frightening the rules can be, both in their complexity and ramifications to innocent taxpayers: an interesting example is the discussion on how banking services might be problematic as “deemed contributions” to a non-resident trust.

I would go so far as to say that if you are doing business (including rendering services) and a trust is involved – and remember, indirect transactions can be problematic - you should enquire whether it is a Canadian resident.  If it is not resident, it is probably advisable to review the transaction with a tax advisor (who, needless to say, had better be intimately familiar with the NRT rules - in all of their breath-taking complexity).  Because of the possible joint and several liability of a Canadian contributor, Canadians who transact business with a non-resident trust could be in jeopardy.

To paraphrase Mr. Bowman: It remains to be seen how the international community, with its potentially wealthy immigrants to Canada and a growing population of families whose members are scattered across the globe, will respond when the ramifications of these rules become apparent

Thanks to Michael Goldberg and of course, Joan Jung.