Unguarded border, well-guarded wealth
Many of us who advise clients on moving to Canada from the US are faced with the issue of US revocable trusts. Most high-net-worth clients coming from the US have established a US revocable living trust to hold most, or even all, of their assets. The problem arises when these US individuals become Canadian residents, as the taxing rules in the two countries differ in this area. Without proper review and planning, this can lead to double taxation.
A US revocable trust is commonly set up in the US for privacy and probate purposes. Usually the US person who transferred property to the trust is also a trustee and beneficiary of the trust. Generally, the trust provides for estate planning after the person’s death and the person’s will directs that all property not already in the trust be transferred into the trust on the person’s death.
For US tax purposes the trust is considered a US grantor trust, which is ignored for US income tax purposes. All income, losses and expenses are claimed on the US person’s US individual tax return. However, for Canadian tax purposes, the trust is commonly considered a separate taxable entity and is treated as a Canadian resident trust when the US person immigrates to Canada. The difference in taxation is problematic when US individuals move to Canada and they have previously created a US revocable trust.
Cross-border tax implications
Let us use the example of Stan and Shirley, who are US citizens and until this year were US residents. Stan takes a job in Canada and he and Shirley, along with their two minor children, become residents of Canada. Years ago Stan and Shirley set up a US revocable living trust to hold all of their assets. They created the trust to assist with probate planning and to provide for their family on their deaths.
The trustees of the trust are Stan and Shirley. During his lifetime, Stan is entitled to all the income and capital of the trust as it relates to property (or substituted property) he transferred into the trust. There are mirror provisions for Shirley regarding the property she has transferred to the trust.
Once Stan and Shirley become Canadian residents, the following rules will apply.
The trust will be considered factually resident in Canada for Canadian income tax purposes because its trustees are Stan and Shirley. A trust is resident where its control is located. Assuming Stan and Shirley fulfil their duties as trustees and do not delegate their responsibilities to another person, they will be considered to have control of the trust.
The persons controlling the trust will be residing in Canada, so the trust will be considered factually resident in Canada. This means the trust is likely to be considered a dual resident of Canada and the US. The trust will need to file a trust income tax return in Canada and report all income earned on the trust property.
For Canadian tax purposes the trust’s cost base of its property will equal the fair market value of the property when Stan and Shirley immigrated to Canada.1 Therefore, the property will have a different cost base for US and Canadian tax purposes.
Subsection 75(2) of the Canadian Income Tax Act, otherwise known as the reversionary trust rules, will apply to Stan and Shirley’s trust. This requires that Stan and Shirley report, on their Canadian individual income tax returns, the income or gain earned in the trust on the assets they contributed to the trust. The result is that for both Canadian and US tax purposes Stan and Shirley will report the income on trust property personally. They should be able to claim the necessary foreign tax credits to alleviate double taxation on the income.
For Canadian tax purposes the trust may be required to file Form T1135, ‘Foreign Income Verification Statement’, to report foreign assets held with a combined cost greater than CAD100,000. Frequently, individuals such as Stan and Shirley do not move their investments from the US, but leave them invested with their current US advisor. Therefore, a US revocable trust will often have a T1135 filing in Canada. Failure to file the form carries an annual penalty of CAD2,500.
If Stan and Shirley are willing to name another US person, or a US trust company, as trustee of the trust, they may be able to have their trust considered an immigration trust for Canadian income-tax purposes. Such trusts are exempt from Canadian income tax for up to five years of the contributor’s residency in Canada.
To qualify, the trust cannot be considered factually resident in Canada. Therefore, control of the trust must reside outside Canada. If Stan and Shirley appoint US trustees for the trust it is important that they actually control the trust and are not just acting as agents of Stan and Shirley.
The Canadian deemed residency rules also need to be reviewed to determine whether they will apply to the trust. This may be an issue if Stan and Shirley had previously resided in Canada.
If Stan and Shirley want the trust to be considered a non-resident of Canada, the trustees would need to be changed, and certain terms in the trust may also require amendment.
Even if Stan and Shirley are no longer trustees of the trust there would be some concern, in light of current case law, that the powers given to Stan and Shirley under the trust may be extensive enough to cause the trust to be considered factually resident in Canada. In other words, if Stan and Shirley want the trust to be considered a non-resident of Canada, the trustees would need to be changed, and certain terms in the trust may also require amendment.
In addition, to take advantage of the five-year grace period, the income from the trust cannot be distributed to Stan and Shirley in the current year. If income is so distributed, or even payable, Stan and Shirley must report it on their Canadian returns. Therefore, a careful review of the trust document is required to determine whether the income can be accumulated in the trust.
The advantage of ensuring immigration trust status should be weighed against the costs associated with new trustees and potential trust revisions. The first step is to determine how much tax can be saved by not paying Canadian tax for up to five years. Stan and Shirley, being US citizens, will continue to be subject to US income tax on the income earned in the trust. Therefore, the savings will arise only to the extent that the US income tax on the income earned is less than the Canadian tax payable on the income. An example of where there may be savings is if the trust is heavily invested in tax-free municipals bonds which earn interest that is not taxable in the US but would be taxable in Canada. In addition, dividends from non-Canadian shares may be taxed at a lower rate in the US than in Canada.
If the trust does remain a US trust, to take advantage of the immigration trust rules Stan and Shirley may be required to file Form T1141 for contributions to the trust or Form T1142 for distributions from the trust.
Depending on the amount of time Stan and Shirley plan to reside in Canada, there may be double-tax implications in the future. For US estate tax purposes the property is still considered to be owned by Stan and Shirley on death. Therefore, US estate tax may be payable on the death of the second to die on the value of the assets in the trust. However, for Canadian tax purposes, the tax would not arise until the property is sold or on the 21st anniversary of the trust. The outcome is tax potentially arising at different times and by different taxpayers, resulting in double taxation.
If Stan and Shirley intend to stay in Canada temporarily, the trust may be subject to Canadian departure tax on its assets when Stan and Shirley move back to the US. On departure from Canada, the trust would no longer be a Canadian resident trust and the Canadian departure tax rules would apply.
If Stan and Shirley held the property personally on entry to Canada, no departure tax would be payable on those assets if they leave Canada within five years. This rule does not apply to assets held in a trust for Stan and Shirley’s benefit, so departure tax may arise on such assets on their departure from Canada, even though that tax would not have arisen had they held the assets personally.
If Stan and Shirley intend to reside in Canada long term they may wish to consider unwinding the trust structure before or soon after arriving in Canada. There should be no adverse tax consequences to transferring the assets to Stan and Shirley from the trust.
However, if the trust is wound up, Stan and Shirley will probably need to update their wills, as this type of trust is usually used as a will-replacement vehicle. Stan and Shirley may wish to revisit their wills nonetheless, given their new residency status as Canadians.
When dealing with US clients in Canada, it is always important to ask whether they have created living trusts. Often the clients do not view these as separate entities and may not think to tell you of their existence. This can lead to adverse tax consequences in the future and can destroy an otherwise well thought out estate plan.
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