Untangling the web

 

In recent years, the Canadian government has moved to increase the reporting required in respect of trusts.^[1] Starting in respect of the 2023 tax year, significantly more information will have to be included in trust reporting to the Canada Revenue Agency (CRA) and fewer trusts will be exempt from reporting. These compliance obligations will be in addition to the existing comprehensive reporting obligations applicable to FIs under the US Foreign Account Tax Compliance Act (FATCA), implemented in Canada by reporting requirements under Part XVIII of the Income Tax Act (ITA); and the OECD’s Common Reporting Standard (CRS), implemented under Part XIX of the ITA.

To assist FIs, the CRA has issued guidance in respect of both Part XVIII and Part XIX; it has not yet issued guidance in respect of the new trust reporting rules. On 10 March 2022, the CRA released an update to this FATCA guidance and CRS guidance (the New Guidance).^[2] The New Guidance replaces the CRA’s previous FATCA guidance and CRS guidance that was released on 10 July 2020 (the Prior Guidance).

New trust reporting rules

Changes to Canada’s trust reporting rules were first announced in the 2018 federal budget. Although they were to initially apply to the 2021 taxation year, they were deferred and will now apply to the 2023 taxation year and those that follow. The new rules (modified from the initial proposals) were implemented by the Fall Economic Statement Implementation Act, 2022 (the FESIA),^[3] which received Royal Assent on 15 December 2022.

Former rules

The former rules provided that a trust tax return (a T3) was to be filed if the trust was subject to Canadian tax and, in the taxation year, the trust:

• had tax payable;
• was requested to file;
• was resident in Canada and has disposed of a capital property or incurred a taxable capital gain;
• was non-resident but has disposed of capital property or incurred a taxable capital gain (minus exclusions under s.150(5) of the ITA);
• was deemed to be a resident trust;
• held property under s.75(2) of the ITA;
• had provided a benefit of more than CAD100 to a beneficiary; or
• received income from the trust property and had a total income of more than CAD500 from all sources, income of more than CAD100 allocated to a single beneficiary, made a distribution of capital to a beneficiary or allocated any portion of income to a non-resident beneficiary.

Accordingly, many trusts with assets that are not generating income on an annual basis (such as private company shares, precious metals or real estate that is not rented out) were not required to file tax returns for the tax years prior to 2022. In addition, bare trusts, which are generally ignored for taxation purposes, were not required to file returns.

Application of new rules

Section 35 of the FESIA states that s.150 of the ITA, which provides for the rules for filing returns, is amended to include the new trust reporting rules.

Accordingly, trusts that are ‘resident in Canada and are express trusts or for civil law purposes a trust other than a trust that is established by law or by judgement’ must file returns of income for each year unless they fall under the new exceptions listed in s.150(1.2).

Bare trusts

Previously, bare trusts were generally not required to file T3s. Although bare trusts will continue to be ignored for the purposes of whether tax is payable by a trust (as provided in the new s.104(1) of the ITA), the new s.150(1.3) provides that the new trust reporting rules apply to bare trusts. A bare trust is defined as ‘an arrangement under which a trust can reasonably be considered to act as agent for all the beneficiaries under the trust with respect to all dealings with all of the trust’s property’.

Information required to be filed

The new trust reporting rules (at s.204.2(1) of the ITA) require every trust, aside from the exceptions in s.150(1.2), to provide the name, address, date of birth, jurisdiction of residence and tax information number (i.e., social insurance number for individuals or business number for businesses) or the account number assigned to a trust for each person who in the year is a trustee, beneficiary or settlor of the trust; or ‘has the ability to exert influence over trustee decisions regarding the appointment of income or capital of the trust’.

According to the explanatory notes issued when the new rules were tabled, a person with the ability to exert influence over trustee decisions would generally include a protector of a trust.

Acknowledging that, in some cases, it will not be possible to ascertain the information in respect of each beneficiary of a trust, including contingent beneficiaries, the legislation provides that the requirement to provide information in respect of beneficiaries is met in the following circumstances:

• Where information is provided for beneficiaries whose identity is known or ascertainable by the person filing the return at the time of filing.
• Where the beneficiaries are all members of an Indigenous group, community or people who have rights under s.35 of the Constitution Act, 1867, the person filing the return has provided a sufficiently detailed description of the class of beneficiaries to determine with certainty whether any particular person is a member of that class of beneficiaries.
• For a trust that does not fall under the list of exceptions but has units that are listed on the designated stock exchange, the person making the return has included information of the beneficiaries of the units that are not listed on the designated stock exchange.
• For beneficiaries whose identity is unknown or ascertainable with reasonable effort by the person making the return, the person filing the return has provided sufficiently detailed information to determine with certainty whether any particular person is a beneficiary of that trust (i.e., the class has been sufficiently described).

Exceptions

Previously, most trusts that did not earn income in a given year were exempt from reporting. The list of types of exempt trusts under the new trust reporting rules is far more circumscribed.^[4] Exempt trusts include:

• Trusts that have been in existence for less than three months at the end of the year.
• Trusts that hold assets less than CAD50,000 throughout the year in listed assets (cash, publicly traded debt, mutual fund corporation shares or units, etc.) Notably, this does not include shares in a private company and it is arguable as to whether gold and silver coins that are often used to settle a trust would be included in the exception.^[5]
• Certain charitable trusts.
• Mutual fund trusts.
• Segregated fund trusts.
• Master trusts.
• A unit trust with all units listed on a designated stock exchange.
• An employee life and health trust.
• Trusts governed by registered plans (such as deferred profit sharing plans, pooled registered pension plans, registered disability savings plans, registered retirement savings plans, tax-free savings accounts and registered education savings plans).
• Lawyers’ general trust accounts (not segregated accounts).
• Graduated rate estates (GREs) and qualified disability trusts.

Based on industry discussions with the Department of Finance Canada, it is clear that the intention was to have as limited a list of exceptions as possible.

Penalties for false statement or omission

There are now significant penalties for failing to file or making a false statement. Subsection 163(5) provides that:

‘A person or partnership is liable to a penalty if the person or partnership

(a)  knowingly or under circumstances amounting to gross negligence

(i)  makes — or participates in, assents to or acquiesces in, the making of — a false statement or omission in a return of income of a trust that is not subject to one of the exceptions listed in paragraphs 150(1.2)(a) to (o) for a taxation year, or

(ii)  fails to file a return described in subparagraph (i); or

(b)  fails to comply with a demand under subsection 150(2) or 231.2(1) to file a return described in subparagraph (a)(i).’

Under subsection 163(6), the penalty is equal to the greater of CAD2,500 or ‘5% of the highest amount at any time in the year that is equal to the total fair market value of all the property held by the trust referred to in subsection (5) at that time’.

Analysis

The new trust reporting rules raise significant issues for trusts, including those involving FIs.

Issues regarding bare trusts

The definition of a bare trust under the ITA is potentially different from the common-law notion of what a bare trust is. It will be important for bare trustees to separate this from other agency situations. A rule of thumb, generally, is that a bare trust situation exists where there is an agency relationship with a separation of legal and beneficial ownership. However, it is likely that there will be differing views between the CRA and potential filers in terms of the application of the provision to certain situations. As the definition requires the bare trustee to act for ‘all the beneficiaries under the trust with respect to all dealings with all of the trust’s property’, it may be that some potential filers seek to limit application of the provision by structuring the arrangement such that the definition does not apply to them. Time will tell whether the courts will accept such structuring.

There is limited guidance in respect of what the bare trust filing will look like, as taxes will not be owing so the standard T3 form will likely not apply in the usual way. Unless an exception applies, bare trusts apply in a broad range of situations and the new provisions could apply to:

• ‘in trust for’ accounts (FIs should consider looking at their formal/informal trust policies and procedures);
• situations where one corporation holds bank accounts, etc., notionally for other members of a corporate group;
• former trustees who hold property for beneficiaries after a trust is wound up, such as beneficiaries who cannot be found (this can be fairly common for FIs in a fund context with foreign tax recaptures and similar issues);
• nominee corporations owning land or other assets on behalf of other parties;
• land transfer tax and probate purposes for private clients (notably to FIs, some of their clients will put investment accounts under the names of nominee corporations to try to get personal investment accounts under a secondary will and avoid probate fees); and
• accounts opened or investments made by investment dealers in the dealer’s name in trust for their clients.

In each of these situations, bare trustees and the beneficial owners will have to consider when annual compliance obligations outweigh the benefits (usually convenience, cost savings and privacy) of the use of bare trusts.

Change of status of trust

There are specific exemptions for certain types of trusts (mutual fund trusts, master trusts, registered plans, etc.). However, where a trust no longer qualifies as an exempt type of trust, reporting will be required unless another exemption can be found; e.g., where a trust loses its status as a mutual fund trust or if a registered plan is deregistered due to non-qualifying investments or the expiry of the one-year period after the plan holder’s death.

Winding up existing trusts

Trustees may seek to avoid the application of the rules by winding up the trust. However, winding up an inter vivos trust in 2023 may not remove the obligation to file under the new rules.

Trustees will have to work through the rules as they apply to the particular trust. See, in particular, s.249(1) of the ITA. The new provisions indicate filing is required after 30 December 2023. It is unclear how this is to be interpreted where trusts are wound up before 30 December 2023, as the definition of a taxation year for a trust is ‘a calendar year’.

Note that the CRA’s technical interpretation on the wind-up of year-end inter vivos trusts, published in 2012, provides:^[6]

‘We note that paragraph 104(23)(a) [now repealed] supports a conclusion that the tax year of a testamentary trust ends on the date of final distribution of its assets, however, the law does not support a similar conclusion in respect of an inter vivos trust.’

This is a dated publication and may not accurately reflect the view of the CRA. If it does, note that it is a CRA technical interpretation, not law, but may give some guidance as to how the CRA will view this issue.

Nonetheless, many clients are looking at winding up now and limiting the number of years the filing has to be done. Given that GREs are exempt and have off-calendar year-ends, trust companies acting as executor should be careful about the 36-month rule (and the other GRE rules). Many estates may try to distribute prior to the expiry of the GRE to avoid the application of the rules, though this may be impractical.

Identity of beneficiaries

There is a broad definition of beneficiaries and reasonable efforts must be made to determine the beneficiaries and provide the information required. This could be a particular issue for discretionary trusts or other trusts with classes of beneficiaries. As a solution, some may seek to limit beneficiaries. For new trusts, some may consider having a narrow group of beneficiaries with a power of appointment; however, there are issues there as well, such as the potential resettlement of trust and the potential deemed disposition to other beneficiaries to navigate.

For existing trusts, varying a trust to limit beneficiaries may trigger a taxable disposition to other beneficiaries. Though limited to a particular set of facts, the CRA provides:^[7]

‘Notwithstanding the fact that the variation to Subject Trust will not, in and by itself, result in a disposition of any of the property of Subject Trust, it is our view that the variation will result in the disposition, within the meaning of subsection 248(1) of the Act, of a portion of each Beneficiary’s interest in the Subject Trust at the time the variation is made.’

Accordingly, a specific analysis of the terms of the trust, the provincial variation statutes, and the application of the ITA will be required to determine whether such a variation will cause a disposition.^[8]

Definition of settlor

The interpretation of the term ‘settlor’ is broader in the new trust reporting rules than under trust law.

Subsection 17(15) of the ITA provides that:

‘[a] “settlor” in respect of a trust at any time means any person or partnership that has made a loan or transfer of property, either directly or indirectly, in any manner whatever, to or for the benefit of the trust at or before that time, other than, where the person or partnership deals at arm’s length with the trust at that time, (a) a loan made by the person or partnership to the trust at a reasonable rate of interest; or (b) a transfer made by the person or partnership to the trust for fair market value consideration.’

This definition captures non-arm’s-length persons who have:^[9]

• participated in an estate freeze in favour of a trust;
• sold or loaned money or property to the trust or to a corporation or partnership the shares of which are owned by the trust; or
• paid expenses on behalf of the trust, regardless of whether those expenses were subsequently reimbursed.

Other persons to be reported

The rules also require disclosure of persons who have the ability to exert influence over trustee decisions regarding the appointment of income or capital of the trust. This is exceedingly broad and could potentially serve to include protectors, persons executing letters of wishes in respect of the trust or other advisors. There is limited guidance on this point (other than on the point of protectors in the explanatory notes) and it is likely that case law will be required to better define the limits of this provision.

Delegated filing

The trustees of the trust are obligated to make the filing. If a delegate is to make the filing, it has to be through the CRA authorised representative process. It is likely that an agency agreement or other delegation on its own would not be sufficient.

FATCA and CRS reporting requirements

Under the New Guidance, there is now additional clarity as to the obligations of FIs in respect of FATCA and CRS reporting requirements.

Death of an account holder

FIs must provide information about reportable financial accounts, which is defined as any account maintained by an FI subject to certain exceptions. The New Guidance clarifies the treatment of an account held by a person who has died.

When an account holder dies and the FI has not received a formal notification of death, the FI must continue to treat the account as being held by the individual. The account will have the same status that it had prior to the account holder’s death (e.g., if the account was reportable while the individual was alive, it must continue to be treated as reportable after the account holder’s death and until such time that the FI is notified of the death). Once the FI receives notification of the account holder’s death, the deceased’s account is deemed to be closed (even if it is not actually closed). If the account is reportable, the account closure must be reflected in the information return.

After the FI closes the deceased’s account, the account may be converted or its assets transferred into an estate account. The New Guidance has also clarified the treatment of an account held by an estate. If the estate is using the account solely to distribute assets and manage the affairs of the deceased person, it is not considered a financial account. Accordingly, there will be no due-diligence or reporting obligations in respect of the account. On the other hand, if the account is not being used solely for asset distribution or estate administration, it will be considered a financial account and the due-diligence and reporting obligations will apply.

Family trusts

It is notable that under Canada’s legislative framework, most family trusts will not qualify as FIs. This differs from the general position of the OECD and has been highlighted by the OECD peer review report. At this point, Canada has stood firm in respect of excluding most family trusts from the definition of FI.

Self-certifications

A self-certification is a written declaration by the account holder that provides various pieces of personal information, including tax residency status. FIs are required to obtain a self-certification from an account holder within 90 days of the account opening or the occurrence of a ‘change in circumstances’, which occurs when the FI obtains any information that causes it to know or have reason to know that the original self-certification is incorrect or unreliable.

Penalties for failure to obtain a self-certification

Failure to obtain a self-certification may subject the FI to a CAD2,500 penalty under each of the FATCA and CRS schemes (for a maximum cumulative penalty of CAD5,000 for each undocumented account). In the New Guidance, the CRA has stated that it will not assess the penalty on FIs that take ‘effective measures’ to obtain a self-certification from the account holder. The CRA states that an ‘effective measure’ may include closing or freezing accounts with missing self-certifications.

However, FIs may be relieved from collecting a self-certification where an account holder wants to open a new account. This exception may apply where an individual or entity already has an existing account with the same FI or a related FI in Canada, and the FI can rely on the self-certification obtained for the existing account.

The following conditions must be satisfied in order for the FI to take advantage of this new account relief:

• The account holder already holds the existing account with the FI or a related entity of the FI in Canada.
• The opening of the new account does not require the provision of any new, additional or amended ‘customer information’ by the account holder (other than for CRS purposes).
• If the new account is subject to anti-money laundering or know-your-client procedures, the FI is permitted to satisfy those procedures by relying on the procedures performed in connection with the existing account.
• The FI and its related entities in Canada must treat the new account and existing account as a single account. This requires the FI to have internal processes allowing it to know that the statuses for both accounts are inaccurate if the FI has reason to believe that the status for either of the accounts is inaccurate and treat both accounts as a single account when applying any account thresholds.

In the New Guidance, the CRA has further elaborated on the second condition discussed above. In particular, the CRA defined ‘customer information’ as ‘information about the identity of the account holder’ that does not include ‘the nature or characteristics of the account or investment such as altering the mix of investments within an account’.

Furthermore, the CRA expressed its view that, due to the requirement of new or amended customer information for the conclusion of a new insurance contract, the new account relief will not apply. Similarly, the relief will not apply where the existing account is a depository account and the new account is a custodial account, because the account holder will likely be required to provide information on their risk profile for the new account.

Verbal self-certifications for telephone account openings

Some FIs open accounts by telephone and capture a verbal self-certification for those purposes (e.g., the FI obtains a voice recording or digital footprint to confirm that a self-certification was completed). The Prior Guidance stated that the FI must retain any verbal self-certification for the required retention period unless the FI:

• secures and appropriately retains a self-certification in an alternative format from the account holder; or
• informs the account holder in writing of how it has recorded the account holder’s status and instructs the account holder to notify it if its record is incorrect.

The New Guidance removes the second exception.

Online self-certifications and electronic signatures

FIs may collect the self-certification electronically. An electronic self-certification must still include the account holder’s signature.

The New Guidance has clarified the rules pertaining to ‘electronic signatures’. An electronic signature is anything unique to the account holder for which a record can be kept; it may be numeric, character-based or biometric. For example, a client’s personal identification number is an electronic signature.

The New Guidance also clarifies that FIs should only accept electronic signatures in three scenarios. First, where the account holder sends the electronic signature using the email address most recently provided by the account holder to the FI. Second, where the account holder provides the electronic signature in the FI’s presence (e.g., the account holder signs on a tablet using their finger). Finally, where the account holder provides the electronic signature through an access controlled, secured electronic location (e.g., the FI provides the account holder with access to a secure website that is accessible only by the account holder).

Additionally, the New Guidance clarified that a self-certification requires the account holder’s Canadian Taxpayer Identification Number (TIN) only in situations where the account holder is a reportable person. As a result of this change, account holders are not required to provide a Canadian TIN if Canada is their only jurisdiction of tax residence.

RBI/CBI schemes

Residence- and citizenship-by-investment (RBI/CBI) schemes allow individuals to obtain citizenship or residence by making local investments or paying a flat fee.^[10] FIs were previously required to make further inquiries to confirm the reasonableness of a self-certification where the account holder listed a CBI/RBI jurisdiction as its jurisdiction of tax residence. This appeared to be the case even if the CBI/RBI jurisdiction was not the only jurisdiction of tax residence identified by the account holder on the self-certification. The CRA has clarified in the New Guidance that these further inquiries are only required when the account holder claims to solely reside in a jurisdiction offering a CBI/RBI scheme.

Controlling persons and discretionary beneficiaries

When the account holder is a trust, its controlling persons include the beneficiaries. In the case of discretionary beneficiaries, they are considered controlling persons only for the calendar years in which they receive a distribution. Because of this, the CRA previously required an FI to have internal procedures allowing it to be notified when a distribution is made to a discretionary beneficiary in a given year.

The New Guidance provides two specific examples of such internal procedures. One example is where the FI seeks annual refreshment of the self-certification so that the trust or trustee re-certifies whether any discretionary beneficiaries are controlling persons. The second example is where the FI requires the trust or trustee to provide a new self-certification whenever the trust has made or will make a distribution to a discretionary beneficiary, and this requirement is made a condition of holding the account.

FIs that become reporting FIs

FIs may cease to be a non-reporting FI and become a reporting FI, such as where an FI with a local client base ceases to meet the criteria to be a deemed-compliant foreign FI. In these scenarios, the New Guidance clarifies that the relevant cut-off date for reviewing accounts is the beginning of the following reportable period. For example, if the reportable period begins on 1 January of each year and the FI becomes a reporting FI at some point in 2021, the FI’s first reporting period is 1 January 2022 to 31 December 2022. For financial accounts opened on or after 1 January 2022 (i.e., the beginning of the following reporting period), the FI applies the new account due-diligence procedures. For any financial account it maintained on 31 December 2021, the FI applies the pre-existing account due-diligence procedures.

Completing returns for accounts with missing US TINs

Previously, FIs were advised to enter ‘000000000’ or ‘AAAAAAAAA’ in the US TIN field of the information return if the reportable account had a missing US TIN. Paragraph 12.62 of the New Guidance outlines six new codes that were developed by the US Internal Revenue Service for accounts that lack a valid US TIN.^[11]

However, the New Guidance confirms that the use of these new codes is optional and using them does not necessarily mean that the FI will not be considered to be significantly non-compliant with their obligations under Part XVIII of the ITA.

Anti-avoidance provisions

Sections 268 and 280 of the ITA set out anti-avoidance provisions for the purposes of FATCA and CRS compliance, respectively. In general, the anti-avoidance rule applies when a person enters into an arrangement or engages in a practice of which the primary purpose can reasonably be considered to be an avoidance of a FATCA or CRS obligation. Where the anti-avoidance rule applies, the person is nonetheless subject to the FATCA or CRS obligation despite the particular avoidance arrangement or practice.

The New Guidance provides two specific examples where the anti-avoidance rule would apply to FIs:

• In the absence of any commercial reason, the FI does not create any electronic records for lower-value accounts so that an electronic record search would not yield any results.
• In the absence of any commercial reason, the FI maintains computerised systems artificially dissociated to avoid application of the entity account aggregation rules.

Account holders should also take care, as they may also be caught by the anti-avoidance rule. The New Guidance gives an example involving an entity account holder transferring amounts out of a pre-existing account before the end of the calendar year and into the pre-existing account after the end of the calendar year. If it is reasonable to conclude that the account holder initiated the transfers to manipulate the year-end account balance to be less than the reporting threshold for pre-existing accounts, the anti-avoidance rule applies.

Conclusion

As international stakeholders work together to manage the tax implications of a digital world, the FATCA and CRS reporting requirements in Canada continue to evolve. For example, the OECD has recommended that Canada amend its definition of investment entity to include all relevant entities under the OECD’s Standard for Automatic Exchange of Financial Account Information in Tax Matters, not simply entities that promote or represent themselves to the public as an investment entity.^[12] At a later date, Canada may be called upon to amend the framework further.

As COVID-19 pandemic restrictions continue to ease, it is expected that the CRA will enhance on-site audits of FIs for FATCA and CRS compliance. In order to avoid any non-compliance penalties, it is imperative for individuals, trustees and advisors to stay on top of these guidelines and ensure that internal policies and procedures are consistent with the New Guidance.