Canadian Taxation of Non-Resident Trusts: A Critical Review of Section 94 of the Income Tax Act

Under recent amendments to the rules in section 94 of the Income Tax Act (Canada) governing the taxation of non-resident trusts, if a Canadian resident contributes property to a non-resident trust, the contributor, the non-resident trust, and certain Canadian-resident beneficiaries of the trust may become jointly and severally liable to pay Canadian tax on the worldwide income of the trust, which will be deemed to be a resident of Canada for income tax purposes. This article provides a critical review of the proposed amendments, which are considered on the basis of domestic and international legal and tax policy principles, and assesses the structural approach adopted in the legislation on the basis of a comparative analysis of the provisions with the US grantor trust rules in section 679 of the Internal Revenue Code and the Treasury regulations thereunder. The article suggests that two fundamental aspects of the approach adopted in amending the provisions governing the taxation of non-resident trusts are inappropriate and should be reconsidered. The first of these is that the rules may now apply even if a foreign trust has no Canadian-resident beneficiaries. The second is that a trust subject to the application of the provisions will be deemed to be resident in Canada for income tax purposes and liable to tax in Canada on its worldwide income. Before the proposed amendments, the assertion of the deemed residence of a trust subject to the provisions was supported by a requisite precondition that a trust have at least one resident beneficiary in order to attract application of the anti-avoidance rule, a requirement that was appropriate in that the beneficial ownership of trust property implies the continuing nexus justifying taxation by the jurisdiction of residence of the taxpayers to whose benefit the accumulation of income derived from the trust property may ultimately be considered to accrue. As a result of the proposed amendments, an entity may now be deemed to be resident in Canada, and subject to tax on its worldwide income, solely by virtue of a relatively nominal transfer of property to the trust by a Canadian resident. In this regard, the rules represent a substantial divergence from international practice. The author argues that the legislative framework adopted represents an overreaching assertion of Canadian taxing jurisdiction, which is likely to result in significant compliance difficulties for taxpayers as a result of the breadth of application of the amended provisions, and that the amendments are theoretically inconsistent with both domestic and international tax policy principles. The rules as proposed are likely to increase the scope for the potential application of conflicting taxing regimes of multiple jurisdictions with respect to a single taxpayer, and may lead to inconsistencies and uncertainty in the application and interpretation of Canada's tax treaties. The author concludes that the non-resident trust rules should not be predicated upon the assumption that non-resident personal trusts involving Canadians are created primarily for tax-avoidance reasons, but rather should apply only in circumstances in which there is potential for erosion of the Canadian tax base through the avoidance or deferral of Canadian tax, either as a result of a disposition of property in respect of which a Canadian-resident transferor retains significant control or by virtue of a presumed level of notional control considered to result from the jurisdictional nexus implied by the fact that Canadian-resident persons are beneficially interested in the non-resident trust. The author considers whether an alternative legislative approach, such as an expansion of the current attribution rule in subsection 75(2) of the Act, the adoption of an aggregate attribution-based approach such as a modified version of the grantor trust rules in section 679 of the Code and regulations, or the imposition of a refundable tax, would be more effective in deterring inappropriate uses of non-resident trusts in circumstances in which a Canadian-resident contributor does retain actual control over the transferred property, would be generally more consistent with tax policy principles, and would be less likely to give rise to unfair or arbitrary results.

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