Reap the tax benefits of non-resident trusts

If you’re receiving distributions from a bona fide non-resident trust, you’ll likely have a smaller tax bill than if you were a beneficiary of a Canadian resident trust. Lorne Richter, tax partner at Richter LLP in Montreal, illustrates how the two trust types are usually taxed.

Scenario #1: Canadian resident trust (no foreign ties)

Mom and Dad live in Ottawa and set up a $1-million inter vivos trust, which is taxed at the highest marginal rate. Their daughter Jill, a partner at a Toronto law firm, is beneficiary. The trustees are non-family members and fully independent. Interest income within the trust that isn’t distributed to Jill in the year it’s earned is taxed at approximately 50% in Ontario. If the trust earns $10,000 of interest income, CRA gets about $5,000, and the other $5,000 is classified as tax-paid trust capital.

Any amounts distributed to Jill in subsequent years from the initial $1 million in capital, or the $5,000 in new capital, aren’t taxed in the trust’s or Jill’s hands.

Dividends and capital gains are treated similarly to interest income, except that their preferential tax treatment applies. For example, on a capital gain of $60,000 not distributed to Jill in the year it was earned, the trust’s 50% tax rate would apply to half ($30,000) the gain, resulting in about $15,000 tax. The other $45,000 would be considered tax-paid capital.

If the trust distributes interest income, capital gains or dividends to Jill in the year they’re earned, she’s liable for the tax, not the trust. For instance, if the trust earns $12,000 of interest income in 2015 and distributes it to Jill the same year, it’s fully taxable in her hands. Since she’s in the top bracket, she’ll owe CRA about $6,000.

Scenario #2: Non-resident trust

In this case, Mom and Dad reside in a country that imposes no income taxes on trusts. The parents have never lived in Canada and do not plan to move here. They set up a trust with their daughter, Mara, as beneficiary. Mom and Dad are the only trust contributors. Mara’s an executive in Toronto. The trustees are fully independent and reside outside Canada.

Wrong way:

Since the trust is located in a tax haven, it pays no tax on interest income. But if it distributes the income to Mara in the same year it’s earned, she pays tax to CRA at her marginal rate. The same goes for capital gains on the taxable 50% portion: the trust pays no tax, but if it sells its stocks, for instance, and distributes a gain to Mara the year the gain is triggered, she pays capital gains tax to CRA.

Right way:

The trust earns interest income or triggers capital gains in Year 1. Instead of distributing to Mara, the trustee adds the earnings to trust capital. The following year, the trustee makes a distribution to Mara from the trust’s capital. Because Mara has received capital, there’s no tax owing, but she must report the receipt of the distribution to CRA on Form T1142. Richter notes the trustee’s resolution must say the distribution is from trust capital. The trust’s financial statements must also reflect this.