Proposed Changes to Foreign Affiliate Dumping Rules: Individuals, Trusts and Estates May Now Be Caught

By MaryAnne Loney and Moe Denny 

The government is proposing changes to the Income Tax Act which could impact many Canadian corporations with foreign affiliates.

Of particular concern are situations where controlling interests in such corporations are owned by 

1. individuals emigrating from Canada, or 
2. trusts or estates where any beneficiaries may be, or may become, non-residents of Canada.

Anyone who thinks they could be caught should keep an eye out in the coming months to see what happens with these proposals. Depending on what changes are passed, some may wish to take steps to mitigate potential added tax costs.

Proposed changes to FAD rules

Since being introduced in 2012, the Income Tax Act’s Foreign Affiliate Dumping Rules (the “FAD” rules) were generally of little concern to most because of the rules limited applicability to circumstances with a non-resident parent corporation controls a corporation resident in Canada (a “CRIC”), which in turn invests in a foreign affiliate.

However, earlier this year, first in the federal budget in March and then in revised legislative proposals in July, the Department of Finance proposed changes to broaden the application of the FAD rules so they would not just apply to CRIC’s controlled by non-resident corporations, but also to cases where a CRIC is “controlled” by non-resident individuals, including through a trust or estates.

With respect to trusts and estates in particular, under the proposed FAD rules a trust or estate is assumed to be a corporation with a capital stock of 100 common shares (the “Contrived Shares”), and each beneficiary under the trust owns a portion of shares equal to their interest in the trust based on fair market value (“FMV”).

If the beneficiaries interest in the trust or estate is discretionary, then the FMV of each beneficiaries’ interest is deemed to be equal to 100% of the Contrived Shares unless the trust is

(i)                 a resident of Canada and

(ii)               “it cannot reasonably be considered that one of the main reasons for the discretionary power is to avoid or limit the application of” the FAD rule.

And no, it’s not entirely clear how one would prove that this second requirement has been met.

The proposed changes could cause the FAD rules to apply in several common situations, including, but not limited to, when:

• an individual controlling a CRIC with a foreign affiliate emigrates for personal or business reasons (such as to grow the foreign subsidiary), becoming a non-resident;
• a beneficiary of a discretionary family trust resident in Canada becomes a non-resident of Canada and the family trust controls a CRIC with a foreign affiliate; and
• the death of an individual results in control of a CRIC with a foreign affiliate being left to an estate with non-resident executors or beneficiaries.

If passed, the proposed amendments would be effective retroactively to March 19, 2019, the date of the 2019 budget.

What to do if you think you, your estate or your trust might be caught

The question is what should you do if you think you, your estate or your trust might be caught by these proposed changes.

The tax consequences of having the FAD rules apply are quite severe – resulting in constructive upstream dividends subject to non-resident withholding tax. As a result, it is almost certainly in taxpayers best interests to avoid their application if possible.

Should taxpayers, therefore, be reorganizing corporations, amending trust deeds and revising wills?!

Well… maybe not yet. The changes have not yet been implemented, and it is not certain what form they will finally take.

Due to the complex nature of the FAD rules and the fact that the proposed changes of the rules are fraught with unintended implications and uncertainty, the Joint Committee on Taxation of the Canadian Bar Association and Chartered Professional Accountants of Canada issued a submission to the government on May 24, 2019 outlining issues with the proposed FAD rules and provided recommendations for amendments.

On July 30, 2019, the Department of Finance released new proposed legislation to implement the proposed changes and have invited comments by October 7, 2019.

The July 30, 2019 proposed legislation appears to have partially addressed at least one of the main concerns tax professionals had with the initial proposed legislation: the proposed legislation released with the budget would have automatically had all beneficiaries of a discretionary trust deemed to own 100% of the Contrived Shares where the new July 30, 2019 proposed legislation provides an exclusion for Canadian trusts where it cannot reasonably be considered that one of the main reasons for the discretionary power is to avoid or limit the application of the FAD rules. That being said, without further guidance from the CRA and the Courts, it is unclear how useful that exclusion will actually be.

In any event, it is uncertain exactly what form the proposed changes to FAD rules will actually take. As a result, it is difficult to determine what changes, if any, would be advisable with regards to corporate structure, wills and trust deeds at this time.

However, it is definitely worth considering if you, your estate or trust might be caught and, if you think it might be, keep your eyes open for future posts on this blog addressing this topic further once we have more information.

This update is a general overview of proposed changes to the FAD rules and cannot be regarded as legal advice. Please contact MaryAnne Loney or Moe Denny to discuss any of the above items, or any of your other tax needs.

What Do The New Tax On Split Income (“TOSI”) Rules Mean For Trusts?

By: MaryAnne Loney

A recent tax change that has gotten a lot of attention is the tax on split income, or “TOSI”. Through design or inadvertently, many trusts will be affected by these rules. Many family trusts were set up at least partially to split income to family members. Even when income splitting is not an express purpose of the trust, where a trust owns property that earns money from the work or investment of a person (“source individual”) who is related to a beneficiary, there is a risk TOSI may apply.

Things Trustees and their advisors should know about TOSI

1.      TOSI doesn’t just apply to dividends

While dividends have gotten the most press, TOSI may apply to any income from a “related business”.

A related business is any business, whether operated personally or through a partnership, corporation or trust, where a source individual at any time during the year was “actively engaged on a regular basis in the activities” or in which he or she had a qualifying interest (for a corporation this is 10% or more).  TOSI may apply to any dividends, shareholder benefits, capital gains, or interest derived from a related business.

This means trustees need to look carefully at any source of income and ensure it is not caught under the TOSI rules. I recommend starting with the assumption that TOSI applies to any income, unless you can find a reason why it should be excluded.

2.      Beneficiaries of trusts cannot own “excluded shares” through a trust

One of the main exclusions to the TOSI rules is if the recipient owns “excluded shares”. Shares are excluded shares when an individual owns at least 10% of the shares of a corporation which meet specific criteria. Income earned on excluded shares, or gains earned on disposing of excluded shares, are not caught by TOSI.

Unfortunately, even if a trust owns shares that would otherwise be excluded shares, income allocated through the trust to a beneficiary on those shares owned by the trust will not qualify as shares “owned by the specified individual”, (and therefore not “excluded shares”) since the beneficiary and not the trust would be the specified individual.

This is a significant disadvantage of owning what otherwise might qualify as excluded shares through a family trust. In some cases, it may make sense to distribute shares owned by a trust to a beneficiary so they do qualify as excluded shares for that particular beneficiary.

3.      Some exclusions from TOSI will still apply to allocations from trusts

There are, however, exclusions that will still apply to payments through a trust.

While capital gains from a related business are now generally caught by TOSI, capital gains that qualify for the capital gains exemption are specifically excluded, including for allocations from trusts.

A second exemption is that if the income derives from a business which is an “excluded business” for the beneficiary, then it will not be caught by TOSI.

A business will be an “excluded business” if the beneficiary was actively engaged on a regular, continuous and substantial basis in the activities of the business in either the taxation year or any prior five taxation years.

While “actively engaged” is not defined, if the beneficiary works at least an average of 20 hours per week in the business (while the business operates), the beneficiary will be deemed to be actively engaged.

Recent CRA publications and responses to questions at conferences have also suggested that passive investment income earned on the investment of income from a related business, is not itself necessarily income from that related business.

This suggests that, with the right structure, investment income earned on income itself caught by TOSI could be an excluded amount.

Conclusion 

The new TOSI rules will make things more complicated for trustees and their advisors when it comes to allocating income to beneficiaries. Existing trusts should be re-examined to determine whether they should be restructured or their operations changed. Potential settlors, trustees and their advisors will need to more carefully consider whether setting up a new trust is the best option.

However, trusts will continue to be used for non-tax reasons where it is advisable to separate legal and beneficial ownership and, depending on individual circumstances, trust will continue to make sense in certain tax plans.