By: Peter Megoudis, LLM, BCL, LLB,
Director of Expatriate Tax
There is a common misconception among many Canadian individuals that they can avoid being taxed in Canada on their investment income if they set up a trust outside Canada (“offshore”). That is rarely the case actually. If the trust is managed from within Canada, the trust becomes factually resident of Canada; in such a case, the income is subject to Canadian taxation either in the hands of the Canadian contributor (through a “75(2) attribution”), or (where there is no attribution) in the hands of the trust or the beneficiary to whom the income is allocated. Even where the trust is managed outside Canada, it can still be deemed to be resident of Canada if either (a) the contributor is currently resident in Canada (even if the contributions were made long time ago as a non-resident), or (b) there is a beneficiary who is currently resident in Canada and contributions were made by a person (called the “connected contributor”) who was either (i) a Canadian resident at the time, or (ii) had been a Canadian resident in the past five years, or (iii) will become (or became) a Canadian resident in the five years following the contribution; in such a case, the income will be subject to tax either in the hands of the trust or the beneficiary to whom it is allocated.
At the same time, there is still an opportunity to have a trust set up for the benefit of Canadian beneficiaries that, if designed properly, can distribute income or capital gains to Canadian resident beneficiaries without triggering Canadian tax, either in the hands of the trust or the beneficiary. Such a trust is commonly known as a “granny trust”. For example, say that a granny trust earns $200,000 a year in investment income. If it carefully manages the timing of the distributions, it can distribute such income or gains to the Canadian beneficiary free of Canadian tax.
Of course, once the funds are distributed to the Canadian beneficiary, he or she will be taxable in Canada on any income earned by investing those funds. However, this can be postponed by simply having the trust postpone making such distributions and reinvesting the income itself. In this way, a granny trust functions like a tax free savings account (TFSA), in that income can grow tax free and then be distributed tax free, but without any annual limits as to how much contributions can be made to such trust. In fact, the tax benefit applies equally whether it is $1,000 or $1,000,000 that is being contributed to the trust (although, obviously, the quantum of the tax savings increases with the amount of investment income earned). There will thus be an opportunity to use such trust to accumulate wealth at a faster pace than if the investments were held directly by a Canadian, or through a Canadian trust.
Further, a granny trust can be set up both in cases where the Canadian beneficiary has recently come, or will be moving to, Canada, and where such beneficiary has always been a resident of Canada. It may be a trust that has already been established for the benefit of the Canadian beneficiary before they came to Canada, or a trust that is established now while the beneficiary is a resident.
A note of caution though: it is important that such trust not become factually nor deemed resident of Canada. It thus must be managed from outside Canada. This generally means that a Canadian resident cannot have control or powers over the trust.
Further, there cannot be ANY contributions to the trust that were made by someone who is currently a Canadian resident, or by someone who made the contributions in the five years prior to becoming a resident or the five years following their departure from Canada. Thus, they can be made by a family member who was never, and will never become, a Canadian resident. Or, they can be made by a family member who has not been a Canadian resident in the past five years, and does not intend to return to Canada.
As a result, it is basically designed for foreign persons who want to transfer wealth to their Canadian family members in a tax efficient way. Instead of transferring the wealth directly (whether as a gift, or inheritance), which would trigger Canadian on the ongoing investment income, they could transfer it through the trust.
Finally, consideration should be given as to any foreign tax implications of establishing such a trust. For example, one would want to avoid setting up the trust in a country that would impose local taxation on its income. Further, some countries, such as the US, tax the contributor on income earned by certain types of trusts, even if they are established outside that country. As a result, one must determine the trust taxation rules applying to the country of residence of both the trust and the contributor.
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