As noted in Tax Update September 2012, the Federal Court of Appeal (FCA) determined in Sommerer1 that subsection 75(2) of the Income Tax Act (Canada) (ITA) did not apply to a fair market value sale of property to a trust.2 As a consequence, capital gains and other income of a non-resident trust could escape taxation in Canada even where a resident of Canada was a beneficiary of the trust and was the person from whom the trust had acquired the property that gave rise to the gain or other income.
In Budget 2013, the government stated that the decision in Sommerer "was not in accordance with intended tax policy." Accordingly, Budget 2013 proposes to amend the provisions of the ITA dealing with non-resident trusts to ensure that such gains and income would be subject to taxation in Canada.
By way of background, we note that the ITA provides that income realized by one person will, in certain circumstances, be attributed to and taxable in the hands of another person. Subsection 75(2) is one of the provisions providing for such attribution. Generally, the provision attributes a trust’s income or loss, as well as its taxable capital gains and allowable capital losses, from property to the person from whom the property (or property for which the property was substituted) was received.3 The provision applies where a person transfers property to a trust and it is possible that the property will revert to the person from whom it was received. The provision can also apply where the person retains the ability to control when or to whom the property will be disposed of by the trust.
In Sommerer, the FCA stated that "to interpret subsection 75(2) so that it could apply to a beneficiary in respect of property that the trust acquired from the beneficiary in a bona fide sale transaction leads to outcomes that are absurd and could not have been intended by Parliament".
Most practitioners would likely agree that there is no policy rationale for applying subsection 75(2) to a fair market value sale; however, the wording of the provision is, at best, unclear and, prior to Sommerer, it was the position of the Canada Revenue Agency (CRA) that the provision applied in these circumstances.
The FCA’s conclusion that a fair market value sale is not within the scope of subsection 75(2) was, therefore, extremely welcome from a tax planning perspective. What was not welcome from the government’s perspective was the result that capital gains and other income of a non-resident trust could escape taxation in Canada where a resident of Canada was a beneficiary of the trust and was the person from whom the trust had acquired the property that gave rise to the gain or other income.
Fortunately from a tax planning perspective, Budget 2013 does not propose to amend subsection 75(2) to apply to fair market value sales. However, "[t]o respond to the decision in Sommerer and to protect the integrity of the tax rules that apply where a Canadian-resident taxpayer maintains ownership over property held by a non-resident trust", Budget 2013 proposes to (i) limit the application of subsection 75(2) to Canadian resident trusts (other than non-resident trusts that are deemed to be resident in Canada pursuant to section 94), and (ii) amend the proposed rules in the ITA applicable to non-resident trusts so that they apply to the kind of situation contemplated in Sommerer.
Section 94 and subsection 107(4.1)
The Technical Amendments Act, 2012 (Bill C-48) currently proposes extensive amendments to the provisions of section 94 (i.e., the "non-resident trust" or "NRT" provisions of the ITA) applicable to non-resident trusts effective generally for trust taxation years ending after 2006. Simplified, where section 94 is engaged, it will deem an otherwise non-resident trust to be resident in Canada for certain specified purposes, thereby making the trust liable for Canadian taxes on income that would not otherwise have been taxed under the ITA.
Section 94 will apply generally to a non-resident trust where, during the year, the trust has either:
- a "resident contributor" (i.e., a taxpayer resident in Canada who is a "contributor" to the trust); or
- a "resident beneficiary" (i.e., a Canadian beneficiary provided that there is also a contributor to the trust with certain defined connections to Canada).
Budget 2013 proposes to amend the proposed NRT provisions to provide in new subsection 94(8.2) that any transfer or loan of property (regardless of the consideration provided) made directly or indirectly by a Canadian resident taxpayer to the trust will be treated as a transfer or loan of "restricted property" by the taxpayer to the trust if the trust holds the particular property on condition that the particular property or property substituted for the particular property:
- may revert to the particular person, or pass to one or more persons or partnerships to be determined by the particular person; or
- shall not be disposed of by the trust during the existence of the particular person, except with the person’s consent or in accordance with the person’s direction.
Since the transfer is deemed to be a transfer of "restricted property", an "arm’s length transfer" exception to the proposed NRT provisions will not apply. As a result, the Canadian resident taxpayer will generally be treated as having made a contribution to the trust and, subject to very limited exceptions, the proposed NRT provisions will apply.
Moreover, Budget 2013 proposes to amend subsection 107(4.1) to apply in such circumstances. As currently enacted, subsection 107(4.1) is an onerous provision that generally prevents a tax-deferred roll-out of any property of a trust if subsection 75(2) has applied to the trust and the particular person in respect of whom subsection 75(2) has applied is in existence.4 Pursuant to the Budget 2013 amendments, subsection 107(4.1) will be engaged if either subsection 75(2) or new subsection 94(8.2) has applied in respect of the trust.
The amendments to section 94 and 107(4.1) are proposed to be effective for taxation years ending on or after March 21, 2013.
While the Budget 2013 amendments are fairly focused in that they do not propose to amend subsection 75(2) to apply to fair market value sales, the consequences of the Budget 2013 amendments are nonetheless potentially far-reaching. At a minimum, they will require careful consideration of any direct or indirect dealings between non-resident trusts and Canadian resident taxpayers (or trusts or partnerships of which Canadian resident taxpayers are beneficiaries or members, respectively).
As with existing subsection 75(2), the proposed amendments to subsection 94 do not include a "purpose" requirement. Accordingly, it is very likely that the proposed NRT rules will be engaged inadvertently and in circumstances in which there is no "mischief". Where the rules are engaged, the trust will – at best – be subject to potentially onerous reporting and tracking requirements and may become liable for substantial Canadian income taxes.
Furthermore, the provisions, as drafted, do not appear to be limited to property transferred or loaned on or after March 21, 2013. Accordingly, while the provisions are stated to apply to taxation years that end on or after March 21, 2013, a transfer or loan made prior to March 21, 2013 may have the effect of causing the trust to be resident in Canada for such taxation years, notwithstanding that the transfer or loan complied with the detailed provisions of the ITA and proposed amendments existing at the time the transfer or loan was made. In addition, transfers or loans made prior to March 21, 2013 may have the effect of engaging subsection 107(4.1) and, as a consequence, precluding a tax-deferred roll-out of property from the trust. In this respect, the retrospective application of the rules is not unlike the retrospective application of subsection 107(4.1) when it was first introduced and for which only very limited relief was ultimately granted by the government.