I. INTRODUCTION
Planning for clients with assets and beneficiaries in multiple jurisdictions requires knowledge of residency and the deeming rules that could alter its common law meaning. The interprovincial source rules for the taxation of individuals and trust income are critical in planning as investment income is taxed based on residency while business income is taxed based on its source.
The use of interprovincial trusts in tax planning can have benefits for clients in British Columbia given the significantly lower tax rates in Alberta for dividends. However, this type of planning requires careful consideration of tax issues including the rollover provisions available for certain types of trusts, the designations available to ensure income received by the trust is taxed in Alberta and avoidance of the reversionary trust rules in s.75(2) of the Income Tax Act (Canada).[1] This paper will also discuss new s.104(13.3) which was proposed in August 2014 by the Minister of Finance which could significantly restrict certain types of interprovincial trust planning.
II. RESIDENCY AND DEEMING PROVISIONS
A person’s liability for Canadian income tax under the Income Tax Act (Canada) is dependent on residency. A person resident in Canada is subject to Canadian income tax on his worldwide income[2] while a person not resident in Canada is subject to Canadian income tax only on his employment income in Canada, business income earned in Canada and dispositions of taxable Canadian property.[3]
A person is resident in Canada if he has sufficiently strong links to be considered to have a nexus with Canada. Residency is determined by the cumulative effects of multiple factors and one single factor is not determinative.
Residency is determined by common law, statutory deeming rules and tie-breaker rules as residency is not defined in the Income Tax Act (Canada). These topics will be discussed below with respect to individuals and trusts.
A. INDIVIDUALS
For individuals, the leading case is Thomson v. MNR, [1946] S.C.R. 209 where the Supreme Court of Canada held that a person is ordinarily resident in the place where in the settled routine of his life he regularly, normally or customarily lives. Relevant factors in this determination include location of family ties, social relationships, availability of a home and amount of time spent in a location.
Provincial income tax liability is generally calculated similar to federal income tax liability. For individuals, provincial residency is based on where an individual resides on December 31.[4] If an individual is resident in more than one province on December 31, his residency is based on where he has the most significant ties.[5]
The Canada Revenue Agency (“CRA”) administrative position on residency of an individual can be found in Income Tax Folio S5-F1-C1 (Determining an Individual’s Residence Status).
1. Deeming rules
When an individual does not have a sufficient nexus with Canada under common law, he may still be deemed to be resident in Canada under the Income Tax Act (Canada). For example, if a person sojourns in Canada for 183 days or more in a taxation year, he is deemed to be a Canadian resident.[6],[7]
A person could also be deemed not to be a resident of Canada if he is resident in Canada and another country but under the tie-breaker rules in a Canadian tax treaty is considered to be a resident of that other country.[8]
B. TRUSTS
A trust is not a separate legal entity under private law since it is a relationship between the settlor who gifts property to the trustee who holds the property for the benefit of the beneficiaries. However, under the Income Tax Act (Canada) and Income Tax Act (British Columbia), a trust is considered to be an individual.[9],[10]
For trusts, the leading case in determining residency is Fundy Settlement v. Canada 2012 SCC 144 (also known as Garron and St. Michael’s) where the Supreme Court of Canada held that the residency of a trust is determined by the same test for the residency of a corporation – i.e., based on central management and control. This represented a significant change from the long held belief by most tax practitioners that the residency of a trust was determined by where the majority of trustees were resident based on Thibodeau Family Trust v. The Queen 78 D.T.C. 6376 (FCTD). However, on a closer reading of Thibodeau, the conclusions in Fundy are not that far afield.
For trusts, provincial residency is determined similar to individuals (discussed above) – i.e., provincial taxation on its worldwide investment income based on its provincial residence on December 31.[11] However, if a trust is resident in more than one province, significant ties considered for individuals are not applicable to trusts. Rather, its residency is based on the residency of the settlor and beneficiaries, location of trust assets, reasons why a trust was settled in a particular province and jurisdiction for enforcement of legal rights. Generally, provincial residency can be determined by the superior court in the province.
The CRA administrative position on residency of a trust can be found in the recently released Income Tax Folio S6-F1-C1 (Residence of a Trust or Estate).[12]
1. Deeming rules
A trust not resident in Canada under common law can still be deemed to be resident in Canada for certain provisions of the Income Tax Act (Canada) under s.94 including liability for Canadian income taxes on its worldwide income. Generally, this applies where the trust has a “resident contributor” or “resident beneficiary”.[13]
If a non-resident trust is deemed to be resident in Canada under s.94(3), the trust is deemed to be resident of Canada and not resident of the other contracting state notwithstanding an applicable Canadian tax treaty.[14]
III. SOURCE RULES FOR TAXATION OF INCOME
A. FEDERAL INCOME TAX
As discussed above, a Canadian resident is subject to Canadian income tax on his worldwide income. For example, when a Canadian resident dies, generally he is deemed to have disposed of all his capital property (both inside and outside of Canada) at fair market value resulting in Canadian income taxes payable.[15]
B. PROVINCIAL INCOME TAX
For individuals and trusts, the allocation of a person’s provincial income tax is determined by federal regulations in the Income Tax Regulations (Canada). For example, British Columbia income tax depends on the “income earned in the taxation year in British Columbia” as defined in s.4(1) of the Income Tax Act (British Columbia) which depends on the definition of “income earned in the year in a province” as defined in s.120(4) of the Income Tax Act (Canada) which depends on the federal regulations in Part XXVI (Income Earned in Province by an Individual) of the Income Tax Regulations (Canada).[16]
Two factors that affect the provincial income tax payable by individuals and trusts is the type of income earned and whether the trust is factually resident in a province.
1. Type of Income
Provincial income tax on employment income and investment income (property income and capital gains) is generally dependent on a person’s provincial residency on December 31 each year. For example, an individual employed in Alberta but resident in British Columbia on December 31 would be subject to British Columbia income tax (not Alberta income tax) on his employment income.
Provincial income tax on business income is dependent on the source of the income (not on a person’s provincial residency). If an individual or trust has business income from a permanent establishment only in one province, then all business income is allocated to that province.[17] If that person has business income attributable to permanent establishments in two or more provinces, then the allocation of the business income to a particular province is as follows:[18]
Total business income x 50% x [gross revenue in the province + salaries in the province]
total gross revenue total salaries
2. Factual Residence in a Province
If an individual or trust is not factually resident in a province but deemed to be resident in Canada, provincial income tax may not be applicable.[19] However, this individual or trust would not be entitled to provincial tax credits or provincial benefits. Furthermore, this individual or trust would be subject to a federal surtax of 48%.[20] This results in an effective tax rate of 42.9% (which is lower than the top marginal tax rate in British Columbia of 45.8% in 2014).[21]
IV. TAX IMPLICATIONS OF REPATRIATING TRUST ASSETS TO CANADA
A non-resident trust may want to repatriate its assets back into Canada. This may be due to the recent elimination of the exemption providing a 60-month tax holiday for immigration trusts in the 2014 Federal Budget which proposed to amended the definitions of “resident contributor” and “connected contributor” in s.94(1) to remove this exemption.[22] Another reason that a non-resident trust may want to repatriate assets back into Canada is if the costs and complexity of administering a non-resident trust exceeds the benefits of lawfully minimizing Canadian income tax.
One way to repatriate assets of a non-resident trust back into Canada is to change the trustees from a non-resident trustee to a Canadian resident trustee, assuming such a change results in central management and control being exercised in Canada. The trust would become resident in Canada and subject to Canadian income taxes on its worldwide income. Some of the significant tax consequences on this trust immigration include a deemed year end for the trust[23] and a bump in the adjusted cost base of its assets to the fair market value at the time of immigration.[24]
If this trust holds shares in a holding company (rather than holding the assets directly), the trustees of the trust should consider distributing or liquidating the underlying assets in the holding company to the trust before the trust becomes a Canadian resident to avoid Canadian income tax applicable on this distribution or liquidation. For immigration trusts in 2014, care should be taken when distributing or liquidating assets from the holding company to the trust to ensure that a contribution[25] is not made before the trust becomes resident in Canada (on the change to Canadian trustees) since this would trigger an early end to the immigration trust exemption (at the time of contribution) and therefore unexpectedly subject the distribution or liquidation of the holding company to Canadian taxes.[26]
V. ISSUES SURROUNDING THE USE OF INTERPROVINCIAL TRUSTS
Tax planning often involves deferring or avoiding the payment of taxes, changing the tax characterization of receipts and expenditures or shifting taxation of income to a lower tax jurisdiction.
One of the main objectives of interprovincial trust planning is to shift income from a high-rate tax province to a low-rate tax province. Below is a table comparing the tax rates between British Columbia and Alberta in 2014:
| Ordinary Income | Capital Gain | Eligible Dividends | Non-Eligible Dividends | |
| BC | 45.8% | 22.9% | 28.7% | 38.0% |
| AB | 39.0% | 19.5% | 19.3% | 29.4% |
| AB Advantage | 6.8% | 3.4% | 9.4% | 8.6% |
The following is an example that will be referred to throughout the remainder of this section. If a $1,000,000 non-eligible dividend was issued to an individual resident in British Columbia at the highest marginal tax rate, he would have to pay taxes of $380,000 compared to if he was resident in Alberta where he would pay taxes of $294,000. This results in an Alberta tax advantage of $86,000.
As provincial income tax on investment income is based on residency (unlike business income which is based on source) an individual could consider becoming a resident of Alberta before December 31 of the year to obtain this tax savings. However, this would involve significant effort and change as the individual would have to sever his ties in British Columbia and establish new ties in Alberta in order to establish residency in Alberta.
Alternatively, rather than immigrating to Alberta, this individual could transfer his shares in the capital of the company to a trust resident in Alberta and have the Alberta trust receive and pay taxes on the $1,000,000 non-eligible dividend to take advantage of lower Alberta tax rates. There are many tax issues with this type of interprovincial tax planning. The tax issues that will be discussed in this paper are listed below:
- Avoid triggering a capital gain on the transfer of shares into the Alberta trust.
- Ensuring the dividend is taxed in the Alberta trust rather than the individual resident in British Columbia.
- Protecting the interprovincial trust planning against a CRA challenge.
- Effects of new proposed s.104(13.3).
A. AVOID TRIGGERING A CAPITAL GAIN
From the above example, the tax advantage of having the dividend taxed in an Alberta resident trust may be eliminated if the transfer of shares into the Alberta trust would trigger a capital gain. Generally, when assets are transferred to an inter vivos trust, there is a disposition at fair market value which triggers a capital gain on appreciated assets.[27] To avoid triggering this capital gain, the transfer of the shares in the capital of the company to the Alberta trust must occur on a rollover basis. A rollover may be available if the individual transferred his shares in the capital of the company to one of the following types of trusts:
1. A spousal trust where the individual’s spouse is entitled to receive all the income of the trust and no person except for the spouse can obtain the use of the capital of the trust before the spouse’s death.[28]
2. A self-benefit trust (where the transfer to the trust does not result in a change in beneficial ownership of the shares) or an alter ego trust where the individual (who must be at least 65 years old) is entitled to receive all the income of the trust and no person except for the individual can obtain the use of the capital of the trust before the individual’s death.[29]
3. A joint partner trust where either the individual (who must be at least 65 years old) and/or his spouse is entitled to receive all the income of the trust and no person except for the individual or spouse can use the income or capital of the trust before the death of the survivor.[30]
B. ENSURING THE DIVIDEND IS TAXED IN THE ALBERTA TRUST
Assuming the Alberta trust acquires the shares in the capital of the company on a rollover basis, the beneficiary (the individual or spouse) is entitled to receive all the income of the trust and therefore arguably income of the trust is payable to the beneficiary each year. As a result, regardless of whether the dividend is actually paid to the beneficiary of the Alberta trust, there could be an income inclusion to the individual or spouse beneficiary resident in British Columbia in the year the dividend is paid to the Alberta trust.[31] One way to avoid this income inclusion to the beneficiary resident in British Columbia and still have the dividend paid to the beneficiary is if the Alberta trust designates the dividend in its T3 trust tax return for it to be taxed in the trust (at the lower Alberta tax rate) rather than in the hands of the beneficiary (at the higher British Columbia tax rate) pursuant to s.104(13.1) (however see discussion of new proposed s.104(13.3) below).[32]
The s.104(13.1) designation by the trust is not available if the trust is a s.75(2) reversionary trust since the dividend would be deemed to be income of the individual resident in British Columbia (and not income of the Alberta trust).
The Alberta trust would be considered a s.75(2) reversionary trust if:
- the shares or property substituted for the shares in the capital of the company could revert back to the individual;
- the shares or property substituted for the shares in the capital of the company could pass to persons determined by the individual after the creation of the trust; or
- the shares in the capital of the company could not be disposed of without the individual’s consent or direction.
To avoid being a s.75(2) reversionary trust, the Alberta trust could be structured as follows:
- For a spousal trust, where only the individual’s spouse is entitled to the income and capital (before the spouse’s death), care should be taken to ensure that the individual is not the sole trustee or one of two trustees of the spousal trust.[33]
- For an alter ego trust, where only the individual is entitled to the income and capital (before the individual’s death), care should be taken to ensure that the individual is only an income beneficiary and not a capital beneficiary and that the individual is not the sole trustee or one of two trustees of the alter ego trust.[34],[35],[36]
- For a joint partner trust, where both the individual and his spouse are entitled to income and capital (before the death of the survivor of the individual and his spouse), the individual can be an income beneficiary while the spouse is both an income and capital beneficiary. The individual should also not be the sole trustee or one of two trustees of the joint partner trust.[37]
C. PROTECTING THE INTERPROVINCIAL TRUST PLANNING AGAINST CRA CHALLENGE
After the Fundy Settlement case the CRA implemented an audit program targeting Alberta trusts with beneficiaries resident outside that province. The CRA’s attack of these Alberta trusts included the following types of arguments:
- central management and control of the Alberta trust was outside the province where the trustees were resident;
- sham; and/or
- provincial GAAR applies which could result in provincial income tax in both provinces and double taxation.
As a result, care should be taken to ensure that the Alberta trust is properly set up and that central management and control of the trust is actually in Alberta and can be proven if there is ever a CRA audit.
D. EFFECTS OF NEW PROPOSED S.104(13.3)
In August 2014, the Minister of Finance introduced new proposed s.104(13.3) applicable for the 2016 and subsequent taxation years:
S.104(13.3) – Any designation made under subsection (13.1) or (13.2) by a trust in its return of income under this Part for a taxation year is invalid if the trust’s taxable income for the year, determined without reference to this subsection, is greater than nil.
New proposed s.104(13.3) provides that designations under s.104(13.1) and s.104(13.2) are invalid if the trust’s taxable income (determined as though the s.104(13.1) and s.104(13.2) designations are valid) for the year is greater than nil. This effectively limits the use of the s.104(13.1) designation to the extent that the trust has tax balances (e.g., loss carry-forwards) that can be utilized after the trust deducts amounts allocated to a beneficiary under s.104(6).
As a result of new proposed s.104(13.3), certain types of interprovincial trust planning will be limited as one of the main ways to avoid the income inclusion to a beneficiary from the dividend received by the Alberta trust was to use the s.104(13.1) designation. If proposed s.104(13.3) is enacted, alternative methods to avoid the income inclusion to beneficiaries must be utilized.[38]
VI. CONCLUSION
There are significant tax benefits with interprovincial tax planning arising from the lower rate of taxes in Alberta. This type of planning requires careful consideration of residency, source rules for interprovincial taxation, rollover provisions available for certain types of trusts, ensuring the income is taxed in Alberta and consideration of the new recently proposed s.104(13.3).
[1] R.S.C. 1985, c.1 (5th Supp.), as amended. All references herein, unless otherwise specified, refer to the Income Tax Act (Canada).
[2] S.2(1).
[3] S.2(3).
[4] S.2(1)(a) of the Income Tax Act (British Columbia).
[5] Significant ties include a dwelling place and where the individual’s spouse and dependants are located.
[6] S.250(1)(a).
[7] Other instances where a person could be deemed Canadian resident are described in s.250(1)(b) to (g) and s.250(4).
[8] S.250(5).
[9] S.104(2).
[10] Definition of “individual” in s.1(1) of the Income Tax Act (British Columbia) includes a trust or estate.
[11] The allocation of business income is based on its source and not the residency of the trust. See source rules for taxation of income below.
[12] This Folio is effective September 19, 2014 and open to public comment until December 19, 2014.
[13] These terms are defined in s.94(1). Examination of the rules when a trust is deemed resident of Canada under s.94 is beyond the scope of this paper.
[14] S.4.3 of the Income Tax Conventions Interpretations Act (Canada). This unilaterally overrides Canada’s tax treaties regarding residence of a trust if a trust is dual-resident by giving s.94(3) precedence.
[15] S.70(5).
[16] Regulations 2600 to 2607 of the Income Tax Regulations (Canada).
[17] Regulation 2603(1) of the Income Tax Regulations (Canada).
[18] Regulation 2603(3) of the Income Tax Regulations (Canada).
[19] For example, if the non-resident trust is deemed to be resident in Canada under s.94(3).
[20] S.120(1).
[21] 29% + 29% x 48% = 42.9%
[22] Proposed Amendment – 2014 Budget Resolution 28 (February 11, 2014) to apply to taxation years that end after February 11, 2014 or before 2015 provided certain conditions are satisfied (discussed further below).
[23] S.128.1(1)(a).
[24] S.128.1(1)(b). This ACB bump is not applicable to certain property such as taxable Canadian property held by the trust on immigration.
[25] Broadly defined in s.94(1).
[26] The 2014 Federal Budget Resolution 28 (February 11, 2014) provides that the elimination of the immigration trust exemption applies to taxation years that end on or after February 11, 2014 except that immigration trusts who have not made a “contribution” between February 11, 2014 and December 31, 2014 will continue to have the immigration trust exemption for taxation years that end before 2015.
[27] S.69(1) and paragraph (c) of the definition of disposition in s.248(1).
[28] S.73(1.01)(c)(i).
[29] S.73(1.01)(c)(ii).
[30] S.73(1.01)(c)(iii).
[31] S.104(13).
[32] There is no prescribed form for making the s.104(13.1) designation in the trust’s T3 tax return.
[33] To avoid the argument that s.75(2)(b) could apply since the shares could not be disposed of without the individual’s consent or direction if the individual was the sole trustee.
[34] Ibid.
[35] Care should be taken to ensure that the dividend that will be issued is considered income and not capital for trust law purposes so that the individual can actually receive the dividend since he will not be a capital beneficiary.
[36] Care should be taken to ensure that the dividend is not a deemed dividend from a share redemption because this could be considered property substituted for the shares in the capital of the company that is returned to the individual and therefore trigger s.75(2).
[37] To avoid the argument that s.75(2)(b) could apply since the shares could not be disposed of without the individual’s consent or direction if the individual was the sole trustee.
[38] For example, having the beneficiary waive his right to income in a year and have the tax-paid capital of the trust paid to the beneficiary resident in British Columbia in a subsequent year. However, this creates additional risks that would require further examination. For example, consideration of the applicability of s.75(2) and whether the beneficiary in British Columbia would be eligible to receive the tax-paid capital under the trust indenture should be carefully considered.