Offshore trusts can be an attractive vehicle for estate planning. However, care must be taken to ensure that an offshore trust complies with Canadian tax law.

What is a trust?

A trust is a legal arrangement whereby a person (the “settlor”) gives property (the “trust property”) to another person (the “trustee”) to hold for the benefit of one or more other persons (the “beneficiaries”). The trustee manages the trust property for the benefit of the beneficiaries. A formal trust is created by a legal document, usually in the form of a “trust deed”, which sets out the trustee’s obligations. A trust can be either a fixed interest trust or a discretionary trust. In the latter, the trustee has discretion to decide who among the beneficiaries receives income and capital from the trust property, how much each person receives and when. The settlor may give guidance to the trustees as to how that discretion should be exercised, often through a “letter of wishes”. A fixed interest trust sets out clearly and unequivocally who should receive what property at what time and in what manner. In both cases, the trust deed establishes what powers of investment management the trustees have and what compensation they will receive for their services. The beneficiaries of a trust can be individuals, such as the children or spouse of the settlor, or charitable or other permitted purposes. A trust may also have a “protector” who is normally a trusted friend or professional advisor of the settlor and who acts as a type of advisor to the trustee, depending on the scope of the rights and obligations established in the trust deed. The protector often has the power to add or remove trustees and to approve distributions to the beneficiaries.

What is an offshore trust?

Trusts are generally resident where a majority of the trustees (or the sole trustee) resides. Therefore, an offshore trust is simply a trust which has a majority of trustees resident in an offshore jurisdiction. Offshore means anything outside Canada.

How do you set up an offshore trust?

An offshore trust is established the same way as any other trust by a settlor transferring trust property to trustees pursuant to a trust deed for the benefit of beneficiaries. In an offshore jurisdiction, professional trustees usually carry liability insurance and have experience in managing trust property. Trustees generally receive compensation by way of an acceptance fee plus an annual fee based on either the value of the trust property and/or the income generated each year. Estimates of expenses vary, but you should expect several thousand dollars per year.

Taxation of an offshore trust

Offshore trusts (known in technical terms as “non-resident trusts”) are the subject of detailed rules in the Income Tax Act. Comprehensive changes to section 94 of the Income Tax Act have been developed in recent years with the changes effective as of January 1, 2003. Now, any trust which has a Canadian “resident contributor” or a “resident beneficiary” will be deemed to be resident in Canada (notwithstanding the actual residency of the trustees) and will therefore be required to pay tax in Canada. This is a significant change in the taxation of offshore trusts. The terms “resident contributor” and “resident beneficiary” (and the related term “connected contributor”) are very broadly defined in the new provisions in the Act and will generally capture any direct or indirect settlement of or a beneficial interest in an offshoretrust. The deeming provisions in section 94 will make such a trust taxable in Canada on its worldwide income each year at the high marginal rate, regardless of where that income is earned. This will likely eliminate the use of offshore trusts as a tax-efficient means of deferring and/or avoiding income tax on capital gains and investment income for residents of Canada.

Two specific types of offshore trusts are exempted from the recent changes to the Income Tax Act. These are pre-immigration trusts (created by an individual immigrating to Canada - these trusts receive a maximum five-year exemption from taxation in Canada) and so-called “granny trusts” (trusts settled by a person who has never been and will never be a resident of Canada to benefit Canadian resident beneficiaries). Specific advice about these types of trusts should be sought.

What are the continuing benefits of an offshore trust?

Despite the recent changes to the Income Tax Act, there are still significant benefits to an offshore trust.

• Asset Protection

  Asset protection is the main benefit of an offshore trust. If a settlor establishes the trust at a time when there are no current or known contingent claims by creditors against the settlor, the trust property will generally be protected against such claims in the future. Typically, there is a “look-back” period where the trust can be unravelled to cover claims of creditors. In some jurisdictions, such as the Bahamas, a relatively short (2 years) limitation period exists. After that time the trust property should be effectively sheltered. Care must be taken in establishing an asset protection trust to ensure that the settlor has no significant ongoing control over the trust property, the trust is irrevocable, discretionary and controlled only by the trustee and that the trust property is actually transferred to the offshore jurisdiction. You should consider as well whether powers given to a protector or directions given by a settlor in a letter of wishes make the trust vulnerable to attack. Asset protection trusts are generally tax neutral.

• Confidentiality
  In general, trusts are confidential because they are not registered or filed in a public office. Offshore trusts take confidentiality a step further. Statutory confidentiality laws in certain offshore jurisdictions provide the justification for trustees to refuse to disclose information about the trust to third parties. However, in certain circumstances Canadian resident beneficiaries of an offshore trust may have to disclose their interest in the trust to the Canada Customs and Revenue Agency.

• Probate Avoidance
  Because the trust deed determines what happens to the trust property in the event of the settlor’s death, an offshore trust, like most other trusts, avoids probate with respect to that property, thereby minimizing probate taxes and the delay of the probate process.

Are there downsides to an offshore trust?

The main downside to any trust, including an offshore trust, is the loss of control over the assets forming the trust property. Because the settlor gives legal control over the assets to the trustee (subject to the terms of the trust deed), the settlor loses the power to make investment and other decisions with respect to the trust property. Cost is also a factor as the costs and fees to setup and operate an offshore trust are typically higher than with a Canadian trust. The use of a protector and/or a letter of wishes can help to mitigate the loss of control.

What are the best jurisdictions for establishing an offshore trust?

Many people point to Bahamas as the premier jurisdiction for offshore trusts. Bahamian trust law is modern and promotes confidentiality and asset protection. Other good jurisdictions for an offshore trust include the British Virgin Islands, the Cayman Islands, the Cook Islands, Jersey, St. Kitts-Nevis and the Turks and Caicos Islands.

Click here to contact Richard S. Niedermayer and the Atlantic Canada offices of Cox & Palmer