August 23, 2024 Canada proposes changes to enhanced trust reporting requirements and post-mortem tax planning by a trust
Proposed income tax technical legislative amendments that the Department of Finance released on 12 August 2024 provided some welcome news with respect to the enhanced trust reporting requirements and existing limitations in post-mortem tax planning strategies commonly undertaken by certain trusts. Careful reading of the proposals is recommended, as certain categories of bare trusts will still be required to file, beginning again in 2025 after the proposed one-year legislative repeal. This Tax Alert provides a brief overview of the proposed amendments. Interested parties are invited to provide comments to the Department of Finance on the proposed legislative amendments by 11 September 2024. For more information on the other draft legislative proposals released on 12 August 2024, see EY Global Tax Alert, Canada Department of Finance releases draft legislation for 2024 budget and other measures, dated 21 August 2024. Enhanced trust reporting requirements Legislative amendments enacted in 2022 impose additional reporting requirements on many express trusts (i.e., trusts that are created with the settlor's express written or verbal intent, as opposed to other trusts arising by operation of law), including many agency and other commercial relationships, for tax years ending after 30 December 2023. The broad and comprehensive requirements also apply to bare trusts and other informal trust and agency relationships1. While administrative relief was given to the 2023 tax return filing for bare trusts only a few days before the 2 April 2024 filing deadline, the 2022 legislative amendments had otherwise remained in force. The enhanced reporting requirements mandate the filing of a T3 Trust Income Tax and Information Return and additional disclosure on an annual basis. Under the enhanced rules, express trusts subject to the additional reporting requirements must disclose detailed information for each trustee, beneficiary and settlor of the trust, as well as any person who has the ability to exert influence over trustee decisions regarding the allocation of trust income or capital in a year. With limited exception under the additional reporting requirements, the enhanced requirements prove to be cumbersome for many trusts and trustees. The proposed legislative amendments released on 12 August 2024 aim to expand and clarify the relieving exceptions to the requirements. Exempted express trusts Under the proposed amendments, the list of express trusts that are exempt from the enhanced reporting requirements in subsection 150(1.2) of the Income Tax Act (the Act) is expanded and includes trusts that meet the following conditions:
As a result, smaller trusts without any corporate trustee, corporate beneficiary and assets that meet the above criteria with a total fair market value of CA$250,000 or less would be exempt from the enhanced reporting requirements. Moreover, amendments have been proposed for smaller trusts that hold assets with a total fair market value of CA$50,000 or less to also be exempt from the enhanced reporting requirements even if those trusts have corporate trustees or if each beneficiary is not an individual who is related to each trustee. Under the existing legislation, the "small trust" exception only applied where the trust held certain types of property; the proposed amendments have removed any exclusions based on the types of property held for the "smaller" trusts. In addition, the exception for trust accounts used by professionals, such as lawyers, who are required to hold funds for the purposes of regulated activities is extended to include certain client accounts. In particular, a specific trust account will be exempt from the enhanced reporting requirements if the only asset the trust holds throughout the year is money not exceeding CA$250,000. This proposed enhancement may be of limited value to lawyers who hold specific segregated funds or trust accounts in GICs or other comparable investments, as the exclusion only applies to "money" and does not extend to investment contracts such as a GIC. It is unclear whether this limitation was or was not intentional given the extension and specific reference to GICs for the related family ownership enhancement. An exemption is also added, for greater certainty, to exclude statutorily created trust relationships, such as those of bankruptcy trustees or provincial guardians. The above proposed relief applies to tax years ending after 30 December 2024. Bare trusts Certain welcome changes are also found in the proposed amendments with respect to bare trusts. Despite enhanced relief, the proposed amendments would still result in large categories of bare trust filings required for certain sectors, such as the investment real estate sector. Under the current rules, subsection 150(1.3) of the Act has the general effect of making a bare trust subject to the reporting requirements in section 150 of the Act. Subsection 150(1.3) provides that a bare trust includes an arrangement where the trust can reasonably be considered to act as an agent for its beneficiaries with respect to all dealings in all the trust's property. The proposed amendments repeal the existing requirements for bare trusts in subsection 150(1.3) for tax years ended after 30 December 2024 and introduce new proposed subsections 150(1.3) and (1.31) for tax years ending after 30 December 2025. As a result of these proposed changes, bare trusts will be exempt from the enhanced reporting requirements for the 2024 tax year, and the number of bare trusts that will be subject to the filing requirements for 2025 and later tax years will be reduced.2 Broadly speaking, the proposed amendments introduce the concept of "deemed trust" to address bare trusts and clarify what constitutes a bare trust arrangement. A bare trust would only be subject to the enhanced reporting requirements if it is a deemed trust. As noted in the Department of Finance explanatory notes, the changes are intended to provide clarity on the arrangements that are subject to the reporting requirements. Specifically, under proposed subsection 150(1.3) of the Act, an express trust is deemed to include an arrangement where one or more persons, referred to as the "legal owner," have legal ownership of property that is held for the use of, or benefit of, one or more persons or partnerships. In addition, under the arrangement, the legal owner is reasonably considered to act as agent for the persons or partnerships who have the use or benefit of the property. Such an arrangement is often referred to as a "bare trust arrangement" and is referred to as a "deemed trust" in the proposed amendments. Each of the legal owners is deemed to be a trustee of the trust, and each person or partnership that has the use or benefit of the property under the arrangement is deemed to be a beneficiary of the trust. Because an express trust is deemed to include a bare trust, the enhanced reporting rules applicable to express trusts would also apply to deemed trusts. However, proposed subsection 150(1.31) provides exceptions from the enhanced reporting rules to certain bare trusts or deemed trusts if certain conditions are met. Some notable conditions include an arrangement for a tax year if:
Lastly, the amendments propose to require that the prescribed information be provided for a partnership that is a beneficiary of a trust. When coupling the complexities of the proposed amendments, traditional use of a corporate bare-trustee model for real estate ownership will still result in the requirement to file a trust income tax return, as the arrangement does not fit any of the specific exclusions. Definition of settlor Lastly, relief is provided through the proposed amended definition of "settlor." Under the enhanced reporting requirements, a trust must report, among other things, information with respect to the settlors of the trust. The existing definition of "settlor," as defined in subsection 17(15) of the Act, includes any person or partnership that has loaned or transferred property (directly or indirectly) to or for the benefit of the trust. An exception is provided for a person or partnership that deals at arm's length with the trust and made a loan to the trust at a reasonable interest rate or a transfer to the trust for fair-market-value consideration. This definition may be broad enough to capture individuals who undertook common Canadian tax and estate planning strategies, such as an estate freeze,3 or those who loaned even a nominal amount of money to a trust or corporate entities indirectly owned by the trust, with which they do not deal at arm's length. The proposed amendments narrow the definition of settlor (in new proposed subsection 204.2(3) of the Income Tax Regulations) to provide an exception for persons and partnerships that made transfers to the trust for fair-market-value consideration or pursuant to a legal obligation to make the transfer. Such persons and partnerships will not be considered settlors for purposes of subsection 204.2(1) of the Regulations as long as they receive fair-market-value consideration for the transfer, irrespective of whether they have an arm's-length or a non-arm's-length relationship with the trust. The proposed definition would apply for tax years ending after 30 December 2024. Post-mortem tax planning undertaken by a trust A major consideration in post-mortem planning is the deemed disposition of property on death at fair market value. On the death of the owner of a private corporation, capital gains and the related income taxes would arise due to the deemed disposition. Taxes would become payable again when the shareholder's estate extracts funds from the private corporation, resulting in double taxation. There are generally two strategies to address the double taxation: the loss carryback strategy under subsection 164(6) of the Act and the pipeline strategy. Both strategies have limitations under the current legislation, and the proposed amendments released on 12 August 2024 aim to address certain limitations. Loss carryback strategy under subsection 164(6) of the Act Broadly speaking, under the loss carryback strategy, a graduated rate estate (GRE) can elect to carry back a capital loss from the first year after the death of the shareholder to the terminal year of the deceased. The election is available to the extent the capital loss exceeds any capital gains that arise in the first tax year of the GRE. The capital loss carryback can offset capital gains realized from the deemed disposition on death. However, only net capital losses incurred in the first year of the GRE can be carried back to the terminal tax return. This timing restriction presents a significant challenge to executors and trustees who plan to take full advantage of the subsection 164(6) planning strategy. Specifically, for subsection 164(6) to apply, the executor or trustee must dispose of properties held by the GRE within the first tax year of the GRE. Practically speaking, many executors and trustees often encounter delays in administering the GRE and may not be in a position to dispose of any properties within the first tax year of the GRE, hence losing the opportunity to use the subsection 164(6) loss carryback strategy. The proposed amendments would allow executors and trustees three tax years to dispose of properties of the GRE. In other words, the net capital losses incurred in any of the three first tax years of the estate could be carried back to the terminal year of the deceased. This would certainly provide welcome relief, giving executors and trustees more time for dispositions while benefiting from the loss carryback opportunity under subsection 164(6) of the Act. Pipeline strategy The pipeline strategy (explained further below) can be used to avoid double taxation but, as a result of the anti-surplus-stripping rules in section 212.1, the strategy does not appear to be effective when the GRE has a nonresident beneficiary. Section 212.1 is an anti-avoidance rule designed to prevent the stripping of taxable corporate surplus out of Canada as a tax-free return of capital through a nonresident's non-arm's-length transfer of shares from one Canadian corporation to another. The rule deems certain non-share consideration paid to be a dividend paid, subject to withholding tax, and reduces the paid-up capital of the shares of the purchaser corporation that may otherwise have been increased as a result of the transaction. Broadly speaking, a pipeline strategy is generally implemented by having the GRE sell the shares of a Canadian private corporation (Canco) held at the time of the shareholder's death to a new Canadian corporation (Newco) in exchange for a promissory note equal to the GRE's adjusted cost base of the Canco shares, which is generally equal to the fair market value of the shares at the time of death. When the required conditions are met, income tax would only be payable with respect to the deemed disposition on death of the shareholder, rather than when the funds are extracted from Canco or Newco. Any extraction of funds will occur by way of the repayment of the promissory note, which is usually on a tax-free basis. However, when the GRE disposes of the Canco shares to Newco, each beneficiary of the GRE is deemed to have disposed of their proportionate interest in Canco in exchange for their proportionate share of the consideration from Newco (i.e., the promissory note payable by Newco). Consequently, the conditions of section 212.1 would be met when there is a nonresident beneficiary. The nonresident beneficiary would be deemed to have received a dividend from Newco to the extent that the nonresident beneficiary's proportionate share of the promissory note from Newco exceeds the paid-up capital of the nonresident beneficiary's proportionate interest in the Canco shares. As a result, Canadian withholding tax would become payable on the deemed dividend to the nonresident beneficiary. This result clearly defeats the intention to avoid double taxation. The Department of Finance announced in a comfort letter in December 2019 that it would seek to correct this unintended result. The correction has been included in the package of proposed technical amendments released on 12 August 2024; specifically, an exception from the application of section 212.1 is afforded to a conduit, such as a decedent's GRE, when the GRE disposes of shares of a Canadian corporation that it acquired on, and as a consequence of, the individual's death and the individual had been resident in Canada immediately before death. This proposed amendment will facilitate post-mortem estate planning. The proposed amendments are applicable to dispositions that occur after 26 February 2018, and a related application rule would allow a written application for a refund of excessive Part XIII tax paid to be made within 180 days of the enactment of the proposed amendment, irrespective of the time limit that would otherwise apply to such applications under subsection 227(6) of the Act.
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