TAX PLANNING FOR IMMIGRATION TO CANADA. Jack Bernstein & Ron Choudhury Aird & Berlis LLP Toronto, Ontario

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1 TAX PLANNING FOR IMMIGRATION TO CANADA Jack Bernstein & Ron Choudhury Aird & Berlis LLP Toronto, Ontario *Submitted for presentation at the Pre-immigration Planning and Exit Taxation, Visas and Passport Shopping panel hosted by the Immigration and Nationality Law Committee and the Individual Tax and Private Client Committee during the 2014 Annual Conference of the IBA in Tokyo, October 2014 Canada s political stability and economy make it a logical choice for people wishing to immigrate to Canada from the U.K., Hong Kong, South Africa and other jurisdictions. In addition, Canada continues to be a destination for executives of multinational companies and for U.S. companies to temporarily relocate their executives. In view of the demand for Canadian residency and high Canadian personal tax rates, tax planning is an important issue for prospective newcomers to Canada. This article deals with certain tax issues relevant to new immigrants or residents to Canada, whether temporary or permanent. The article also discusses significant changes to tax laws over the last twelve months that are applicable to new residents to Canada. Residency A resident of Canada is subject to Canadian income tax on the resident s worldwide income. A person will become a resident of Canada at the time the person moves to Canada with the intention of residing in Canada. Any such person is considered to be ordinarily resident in Canada. The precise date of becoming a resident may depend on the date the person becomes a landed immigrant, moves to Canada or commences employment in Canada. For the year of immigration, the immigrant will be taxable in Canada on Canadian-source income received before the date of immigration and on world-wide income earned after the date of immigration. The first tax return of the new immigrant must be filed by April 30th of the year following the year of arrival. Personal exemptions will have to be pro-rated based on the time spent in Canada. A person who spends more than an aggregate of 182 days in a year in Canada may also be deemed to be resident in Canada throughout the year under the sojourning rule in paragraph 250(1)(a) of the Income Tax Act (Canada) (the Act ). However, such person may use the tiebreaker clause in Canadian tax treaties to argue that he/she is a resident of another country pursuant to such clause in the relevant Canadian tax treaty with that country, and thereby, relieve himself/herself of Canadian residency. An individual that immigrates to Canada will be a resident of Canada for only a part of the year unless such individual immigrates on January 1 of the year. The income of a part-year resident is determined under section 114 of the Act. Essentially, a part-year resident is taxed on worldwide income for that portion of the year in which such individual is a resident of Canada and on Canadian-source income for that part of the year in which the individual is a non-resident of Canada.

2 2 Section 114 treats an immigrant as having a taxation year that includes the part of the year during which the immigrant was resident in Canada as well as the part of the year during which the immigrant was non-resident but had income from Canadian sources. The taxable income of the immigrant for the year will be computed as if the immigrant was resident in Canada during the period of actual residency and the period in which he/she earned income from Canada as a nonresident. The other part of the year, i.e. when the immigrant was a non-resident and had no income connected to Canada is considered a separate year for tax purposes. In view of the part-year rule, an immigrant may wish to consider the timing of commencement of residency in Canada. For example, if an individual immigrating to Canada from the United States is considering selling a business in the U.S., the individual may wish to consider whether the tax payable will be more as a U.S. or as a Canadian resident. A person resident in Canada who subsequently moves to the U.S. or to another country will be subject to a departure tax in Canada. Basically, there is a deemed disposition of all assets other than Canadian real estate, Canadian resource property or timber resource property, capital property and inventory used in a Canadian business, employee stock options and rights to pension income. Some relief is available to a person who leaves Canada within five years of immigrating. The exemption is for an individual who resides in Canada for less than sixty months during the ten years prior to departure. Property owned by an individual at the time of immigration is exempt from departure tax in such circumstances as is a gift or bequest of assets received during the period of Canadian residency. Foreign Reporting Requirements The foreign reporting rules in the Act require most taxpayers that hold specified foreign property with a cost amount in excess of $100,000 to report such property annually. Certain taxpayers and certain foreign property are exempt from these reporting requirements. 1 Individuals will not be required to file foreign property information returns for the year in which they first become resident in Canada. Taxpayers with foreign affiliates are also subject to the reporting requirements. The foreign reporting rules do not apply to personal-use property of a person or partnership and therefore, do not require reporting of foreign residences used for personal purposes. However, such exemption does not apply to foreign residences owned by foreign corporations. The annual reporting requirements are intended to discourage Canadians from attempting to hide assets offshore in foreign trusts, foreign corporations or in foreign investments (e.g., bank accounts, stocks, etc.). The reporting requirements provide the Canada Revenue Agency ( CRA ) with an opportunity to audit additional offshore transactions with a view to either challenging them based on deficiencies in their structure or, alternatively, recommend that changes in the legislation be made to curb abuses. In order to ensure compliance, significant penalties may result for any violations of the reporting requirements. Significant resources are being provided to the CRA to detect and penalize unreported and untaxed foreign property holdings. 1 The specific exemptions are contained in the definitions of specified Canadian entity and specified foreign property in section

3 3 The foreign reporting requirements have the following effects: (a) (b) (c) (d) (e) Taxpayers with interests in foreign property such as shares, bank accounts and real property (other than personal-use property) in excess of $100,000 will be required to report and provide details of such holdings; Taxpayers with foreign affiliates (generally, a non-resident corporation at least 1% of any class of shares of which are directly or indirectly held by the taxpayer and the direct and indirect shareholding of the taxpayer and all non-arm s length persons in which is at least 10%) will have to provide additional financial and tax information with respect to each controlled foreign affiliate (generally, a foreign affiliate that is controlled by the taxpayer or would be so controlled under certain deeming rules); Beneficiaries of certain non-resident trusts will have to file an information return for the year in which they receive a distribution or a loan from such trusts; Persons who have transferred or loaned property to a non-resident trust will be required to file an annual information return in respect of the trust; and Persons must report transactions or series of transactions that relate to a business carried on in Canada in which such persons participated with a non-arm s length non-resident. An individual (other than a trust) is not required to file information returns reporting any of the above in the taxation year in which such individual first became resident in Canada. However, reporting is required for subsequent years. Immigration Trusts Until very recently, an immigration trust was a commonly-used planning structure used by prospective residents of Canada to exempt themselves from tax on certain income and capital gains for a period of up to 60 months from immigration. However, the Government of Canada announced in the 2014 Federal Budget (on February 11, 2014) that it will amend the Act to remove the tax benefits available to newcomers through the immigration trust structure. In particular, immigration trusts will now be subject to the Canadian non-resident trust rules such that the exemption available from those rules (and the resulting

4 4 beneficial tax treatment) will no longer be available to immigration trusts. This change is expected to significantly impact planning for new residents and prospective immigrants. The changes pertaining to immigration trusts proposed in the 2014 Federal Budget will be applicable in respect of trusts for taxation years: (a) (b) That end after 2014, if the trust is eligible for the tax benefits currently accorded to an immigration trust (i.e., the 60-month exemption still applies in respect of the trust) and no contributions are made to the trust on or after February 11, 2014; or That end on or after February 11, 2014, in any other case. In view of these rules, existing immigration trust structures must be unwound no later than December 31, Unwinding options may involve migrating the trust to Canada (by moving its trustees and/or management and control to Canada) or liquidating the trust and distributing its assets to the beneficiaries. Consideration should also be given to the restructuring of any downstream holdings of an immigration trust prior to any migration or liquidation of the trust. In particular, holding companies owned by a trust should be wound up such that the adjusted cost base (basis) of properties owned by such companies may be stepped-up to the fair market value of such properties at the time of such wind-up. Non-Resident Trust Rules and Foreign Investment Entity Rules The general thrust of the non-resident trust rules (in section 94 of the Act) is to ensure that income earned indirectly by Canadian taxpayers through foreign trusts is subject to tax in Canada in a manner that such income would have been taxed had it been earned directly by the Canadian taxpayer. The rules in proposed section 94 generally apply if a non-resident trust has a resident contributor or a resident beneficiary, each as defined in subsection 94(1) of the Act. The current definition of resident contributor includes all persons that are, at the determination time, resident in Canada and a contributor to the trust but excludes immigration trusts from its ambit. A proposed definition removes the exclusion for immigration trusts. A contributor is defined in subsection 94(1) as a person who has made a contribution to a trust. A contribution is in turn defined as a transfer or loan of property to a trust, whether made as a direct transfer or through a series of transactions. Arm s length transfers (as defined) are excluded from being a contribution. A resident beneficiary is defined in subsection 94(1) of the Act as a person who is, at the determination time, a resident of Canada and there is a connected contributor to the trust. Subsection 94(1) contains a proposed definition of connected contributor (that removes the exclusion for immigration trusts) that states that a connected contributor is a contributor to the trust other than a person all of whose contributions to the trust were made at a non-resident time of the person.

5 5 Non-resident time is also defined in subsection 94(1) in the context of a contribution to a trust and a particular time. It means a time at which the relevant person made a contribution to the trust that is before the particular time and at which the person was non-resident, if the person was non-resident throughout the period that began sixty months before the contribution time and ends at the earlier of sixty months after the contribution time and the particular time. In essence, this definition requires that the contributor be a non-resident for a period beginning sixty months prior to the contribution and ending at the earlier of sixty months after the contribution and the determination time. Prospective residents who are contributors to a foreign trust or beneficiaries of such trusts may subject such trusts to Canada s non-resident trust rules if they fall within the definition of resident contributor or resident beneficiary. While limited planning may be possible in this context, the resident contributor definition in particular allows for limited opportunity to plan out of these rules. The FIE rules in section 94.1 of the Act apply if a taxpayer has an interest in property known as offshore investment fund property that is a share of, an interest in, or a debt of a non-resident entity (or an option in respect of the same) and that may reasonably be considered to derive its value primarily from portfolio investments of that or any other non-resident entity, and it may reasonably be concluded having regard to all the circumstances that one of the main reasons for the taxpayer acquiring, holding or having the interest in such property was to derive a benefit from portfolio investments in such a manner that the taxes on the income or gain from such benefit is significantly less than the taxes that would have been applicable under the Act if such income or gain had been earned directly by the taxpayer. If applicable, section 94.1 requires an amount to be included in computing the Canadian taxpayer s income, calculated by multiplying the cost amount of the taxpayer s investment by an interest rate factor. The FIE rules may be applicable to investments of prospective residents in offshore investment fund properties. However, the purpose test in subsection 94.1(1) may apply to exempt such holdings from tax in Canada, particularly if the investments in offshore investment fund properties are long-standing investments. Tax Issues for U.S. Citizens or Green Card Holders 2 There are special Canadian and U.S. tax considerations for U.S. citizens and green card holders immigrating to Canada. It is assumed that the individual will be deemed to be resident in Canada under the U.S.-Canada Income Tax Convention (the Treaty ). As a U.S. citizen or green card holder, the person will be required to continue to file U.S. tax returns. 1. Passive Income 2 Although this article refers to U.S. tax laws and requirements, it is not meant to be a discussion of U.S. tax rules and the authors disclaim complete knowledge of any such U.S. rules. Taxpayers should consult their own U.S. tax advisors with respect to the impact of U.S. tax laws on immigration to Canada.

6 6 For U.S. purposes, the personal foreign investment company and Subpart F rules will continue to apply to the U.S. citizen or green card holder immigrating to Canada. In order to avoid the negative impact of these provisions, the U.S. citizen or green card holder may wish to ensure that all investment income is annually distributed to him/her. In addition, the Canadian FAPI rules will operate to attribute undistributed foreign passive income earned in an offshore (non-canadian) corporation or trust to the U.S. citizen-canadian resident. 2. Reporting Requirements Canada taxes income on the basis of residency and not citizenship. Thus, an immigrant to Canada will be required to file tax returns and pay tax on the basis of his/her residency in Canada unless he/she earned Canadian source income or disposed of taxable Canadian property as a nonresident. In Canada, each individual must file a separate tax return. There are personal tax credits available including a marital credit. There are no joint returns available in Canada for married individuals. In contrast, married individuals may be able to file a joint tax return in the United States. To the extent that a U.S. citizen must file both Canadian and U.S. tax returns, the individual will be subject to the higher tax of the two jurisdictions. Attempts to shelter income are often frustrated as a result of the different deductions which may be claimed on each return. Investments based on favourable provisions of the Act, e.g. flow-through shares, may be of no or little benefit to a U.S. citizen as a deduction for Canadian tax may not be available on the U.S. return. Some relief may be available for earned income. A U.S. citizen may claim the foreign earned income exclusion and not be subject to U.S. tax on up to US$99,200 (in 2014) of earned income subject to satisfying all of the qualifications to be eligible for the exclusion. Foreign tax credits should provide some relief against double taxation. However, a foreign tax credit for Canadian tax may generally not be claimed in excess of the U.S. tax that would have been payable on the income. As a result the higher tax rate of the two jurisdictions will apply. 3. Employee Stock Options The treatment of employee stock options and other benefit plans is different in Canada than in the U.S. although the Fifth Protocol to the Treaty clarifies the sourcing of stock options between the two countries. Paragraph 6 of the diplomatic notes forming Annex B to the Fifth Protocol states that stock option benefits will be apportioned on the basis of the employee s principal place of employment. Thus, the income from a stock option will be apportioned for tax purposes between the two countries on the basis of the days (from the grant to the exercise or disposition of the options) on which the individual s principal place of employment was in a particular country. For example, if an individual s principal place of employment was Canada on 70% of the occasion between the grant and exercise of an option and the U.S. on the other 30%, 70% of the income from the stock option will be taxable in Canada. The Fifth Protocol does not contain a definition for principal place of employment but it may mean the place where the employee

7 7 performs most of his/her services or the place where the employee reports for work most of the time. The competent authorities may however attribute income differently if they agree that the grant of an option was effectively a transfer of ownership of the securities, e.g. because the options were in-the-money. If an employee dies while holding stock options situated in the United States, any employment income in respect of the options will be deemed to be income from property situated in the United States. This ensures that Canada will provide a foreign tax credit for U.S. estate taxes levied on death. 4. Gift Tax and Estate Freezes Canada does not impose a gift tax or an estate tax. Gifts of property to family members are deemed to occur at fair market value. In the case of death, for Canadian tax purposes, at the instant before death there is a deemed disposition at fair market value of depreciable and nondepreciable capital property and land inventory except to the extent that a rollover to a spouse or an exclusive spouse trust is available. Although Canada does not impose a gift tax, a U.S. citizen resident in Canada will be subject to U.S. gift tax. A gift tax is not creditable for Canadian tax purposes. In addition, the Treaty does not offer any relief for gift tax against Canadian income tax. U.S. gift tax may also be exigible on a Canadian estate freeze. A typical estate freeze in Canada involves the issuance of redeemable and retractable fixed value preferred shares that may not pay a dividend followed by the issuance of common shares to the next generation or to a trust for minimal consideration. Although an estate freeze is easy to achieve for Canadian tax purposes, the typical Canadian freeze preferred shares issued to a U.S. citizen as part of the freeze may attract U.S. gift tax since the U.S. will probably treat the freezor as having made a gift equal to the entire value of the company. This is because the preferred interest would be valued at nil. To avoid US gift tax, the frozen preferred shares must yield a reasonable cumulative dividend and new common shares should be issued for consideration. The U.S. does however offer certain exclusions from gift tax. On an annual basis, up to US$145,000 of gifts to a non-citizen spouse are exempt from the tax (in 2014). An individual may also gift up to US$14,000 annually to other recipients (in 2014) without any gift tax. There is a lifetime exemption of US$5 million (which is indexed for inflation). 5. Capital Gains Exemption A U.S. citizen who resides in Canada may benefit from a C$800,000 Canadian capital gains exemption on the disposition of shares of a qualified small business corporation or qualified farm property. However, the capital gains exemption will not be recognized for U.S. tax purposes. The individual may however qualify for the long-term capital gain rate (20%) in the United States. 6. Corporate Holdings

8 8 If a U.S. citizen wishes to invest in a Canadian venture or hold an interest in a Canadian holding company, U.S. entities such as a limited liability corporation ( LLC ) should generally not be used. There is a risk of double tax as payments from Canada to a U.S. entity would be subject to Canadian withholding tax. Canada treats the LLC as a corporation for Canadian tax purposes. The Canadian resident will be fully taxable on all distributions from an LLC. Although the Treaty provides relief to the members of an LLC, Article IV(6) may not be applicable to a U.S. citizen resident in Canada and investing in Canada through an LLC. If a U.S. citizen or green card holder moves to Canada while continuing to hold shares of an LLC, the tax consequences may not be favourable if the income from the LLC is considered as FAPI in Canada. Canada will continue to treat the LLC as a corporation for purposes of taxing any inbound income to the immigrant from the LLC, thereby creating the possibility of FAPI and an immediate income inclusion. The immigrant will be taxed on the income of the LLC as earned (if FAPI) but should be entitled to a foreign tax credit in Canada (assuming that the individual has other U.S. income against which to utilize the foreign tax credit since the FAPI may not be distributed in the year in which it is included in the individual s income). If a Canadian holding company is formed to hold the shares of the LLC, the holding company will not be entitled to any foreign tax credit in Canada in respect of income from a share of the LLC/foreign affiliate (including any undistributed income considered FAPI for Canadian tax purposes). A Canadian holding corporation holding an interest in an LLC that is considered a partnership in the United States may also be subject to withholding under section 1446 of the Internal Revenue Code on effectively connected taxable income of the LLC (as income allocable to a foreign partner). If such income is considered FAPI in Canada, there will be no foreign tax credit in Canada since a foreign tax credit for FAPI is based on tax paid at the corporate level on the income and not tax withheld under section 1446 of the Internal Revenue Code. This will result in double taxation. If the LLC holds shares of a Canadian company, any income earned in Canada by the LLC will be subject to Canadian tax and may also be subject to a Canadian withholding tax, if the income is paid to the LLC in the form of dividends. Accordingly, it may be prudent to dissolve the LLC prior to immigrating to Canada if the LLC is a single-member LLC or to convert it to a limited partnership. An LLC or S corporation (described below) that elects to be treated as a disregarded entity in the United States may expose its unitholders/shareholders to withholding tax in the United States under section 1446 of the Internal Revenue Code. Section 1446 imposes a withholding tax on the effectively connected taxable income of a partnership for a taxation year if any portion of the income is allocable to a foreign partner (i.e. a partner who is not a United States person ). Considering that a United States person is defined to mean a citizen of the United States, section 1446 should not apply to a U.S. citizen resident in Canada since such person will continue to be a United States person (by virtue of U.S. citizenship) and hence, will not be a foreign partner. In addition, section 1446 does not apply to a single-member LLC since a singlemember LLC will not qualify as a partnership for U.S. tax purposes. A U.S. citizen-canadian resident should ideally not invest in Canada through a Subchapter S corporation ( S Corp ). An S Corp is an ordinary U.S. corporation that makes an election to be taxed under Subchapter S of the U.S. Internal Revenue Code, i.e. be treated as an S Corp. When

9 9 the election is made, an S Corp is treated as a flow-through for U.S. tax purposes such that its income will be taxed in the hands of its shareholders. The election to be an S Corp must be made by the corporation s shareholders and the corporation must meet certain conditions to be eligible for S Corp treatment. An S Corp is a corporation under U.S. corporate law and is treated as a corporation for Canadian tax purposes. An S Corp is also entitled to the benefits of the U.S.-Canada Tax Treaty. The Canadian tax authorities are of the opinion that an S Corp is liable to tax in the United States for purposes of Article IV (Residence) of the U.S.-Canada Tax Treaty and that the usage of an S Corp for tax avoidance purposes is unlikely due to the unique requirements of an S Corp (e.g. shareholders must be individuals who are U.S. citizens, residents or trusts with U.S. citizen or resident beneficiaries). 3 Moreover, it is liable by default to taxation in the United States on its worldwide income as a regular corporation and is only treated as a flow-through by reason of an election. Therefore, Canada extends the benefits of the Treaty to S Corps. If a U.S. citizen immigrates to Canada with an S Corp, there may be timing mismatches on taxation as Canada will tax the corporation whereas the U.S. will tax the U.S. citizen. However, the individual may request the Canadian competent authority under Article XXIX(5) of the Treaty to deem the S Corp to be a controlled foreign affiliate of the person and all its income to be FAPI. As a result, the timing mismatch between the imposition of Canadian tax on the income of the S Corp (when it is distributed to the U.S. citizen-canadian resident) and the imposition of U.S. tax on such income in the hands of the S Corp shareholders (when the income is earned by the S Corp) would be removed, thereby allowing for relief from double taxation. In addition to the above, if a Canadian resident is the sole director of a U.S. corporation or otherwise manages and controls such corporation from Canada (whether an S Corp, an LLC or an ordinary corporation), the corporation will be deemed to be a resident of Canada as a result of its central management and control being in Canada. The corporation may however be able to rely on Article IV(3)(a) of the Treaty to relieve itself from deemed Canadian residency on the basis that it was created under the laws of the U.S. 7. Principal Residence Exemption and Replacement Property Rule Canada has a principal residence exemption that exempts gains from the sale of a principal residence from tax in Canada provided certain conditions are met. Canadian residents may not deduct the interest relating to the purchase of a residence but are not taxable on the profit on resale. Although no Canadian tax arises on the sale of a principal residence in Canada, U.S. citizens can generally excluded up to US$250,000 ($500,000 for married individuals) of the gain on the sale of a principal residence from income tax in the United States. Thus, a U.S. citizen who is single or is married to a Canadian citizen may be exempt from U.S. tax on US$250,000 of the gain. A U.S. citizen married to a U.S. citizen or green card holder and filing a joint return for a taxable year may be exempt from U.S. tax on US$500,000 of the gain under certain circumstances. Provided required holding periods have been met, the balance of the gain is subject to U.S. tax at 3 CRA Doc. No , May 20, 1997.

10 10 long-term capital gains rates. For U.S. purposes, the interest pertaining to the Canadian residence may be deducted within prescribed limits. A U.S. citizen may be subject to the U.S. replacement property rule on the exchange of property. The replacement property rules in section 1031 of the U.S. Internal Revenue Code ensure that no gain or loss is recognized on the exchange of property held for productive use in a trade or business or for investment if such property is exchanged solely for property of like-kind that is to be held either for productive use in a trade or business or for investment. Canada has more restricted replacement property rules. The replacement property must replace a former business property and be located in Canada. A U.S. citizen resident in Canada who takes advantage of the U.S. replacement property rules may realize a taxable disposition in Canada. Planning Considerations A number of planning considerations must be considered by prospective immigrants or newcomers to Canada. Some of the more relevant ones are as follows: Foreign Companies 1. Avoid being the sole director or managing and controlling the company from Canada, if possible. Otherwise, ensure that the company can rely on a Canadian tax treaty to avoid being deemed to be a resident of Canada on the basis of central management and control. 2. Avoid creating a Canadian branch for the corporation by using the Canadian address of the immigrant as the corporation s Canadian location. Consideration should also be given to ensuring that the presence of the immigrant does not lead to a permanent establishment in Canada for the corporation. A permanent establishment may result if the corporation has an office or place of management in Canada or if it has employees or dependent agents concluding contracts in Canada. 3. Understand how foreign corporations are taxed in Canada. Avoid FAPI characterization if possible. 4. Avoid owning LLC units if possible. Avoid timing mismatches on S-Corp holdings by Trusts electing to treat all income as FAPI. 1. Understand the application of the non-resident trust rules and their applicability to any offshore trusts where the immigrant may be a contributor or beneficiary.

11 11 2. Avoid having the trust being deemed to be resident in Canada because its central management and control is in Canada (should always avoid being sole trustee of foreign trust). 3. Consider foreign trusts being set up in a manner that ensures that contributor is nonresident (e.g., parents). Consider tax-efficient distributions from such trusts (e.g., capital distributions). Personal Planning 1. Consider date of entry into Canada and implement planning steps prior to entry into Canada. 2. Consider wills and powers of attorney. For example, in order to ensure that a trust is a discretionary trust, the will of the parents of a taxpayer immigrating to Canada should be changed prior to immigration to ensure that payments are discretionary and that there is a gift over to the taxpayer while he/she is a non-resident. 3. Taxpayers working offshore should consider if offshore employment may delay Canadian residency for tax purposes. Spouses and children may move to Canada although this may be viewed by the CRA as an indicator of Canadian residency. 4. Create Canadian wills and powers of attorney. 5. For taxpayers moving from the U.S., consider gift and estate tax issues and the unique tax treatment of the U.S. for its citizens in conjunction with the tax regime in Canada (e.g., capital gains exemptions, replacement property rules and principal residence exemptions)

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