It is fairly common to come across a person with a plan that allows them to avoid paying Canadian tax by directing funds to an offshore tax haven country. However, if this plan sounds too good to be true, it probably is. If you are considering directing client funds to an offshore investment or plan, you need to understand the nature of the investment or plan, how it works and what the tax implications are.

Three fundamental points must be kept in mind if your client is considering any possible plan that purports to avoid Canadian tax.

First, Canadian residents are subject to tax on their worldwide income. Income from a deposit or investment, no matter where it is located (such as a bank account in the U.S. or U.K.), is subject to Canadian tax. However, to avoid double taxation, Canada typically allows a tax credit for the foreign tax paid on that income. A number of investments may also trigger deemed income if the investment does not generate actual income.

Second, if a foreign corporation is controlled by a Canadian shareholder (or their family or any unrelated group of up to four Canadians), the shareholder’s share of any investment income that corporation earns is subject to Canadian income tax, regardless if the corporation distributes the income to them.

For example, let’s say your client, Emanuel, is a Canadian-resident individual who owns a Cayman-resident corporation — he must pay Canadian income tax on any investment income the corporation earns. If tax is incurred in the foreign jurisdiction on the income, to avoid double taxation, the Canadian system will reduce the amount of Canadian tax incurred. These rules are not intended to increase the amount of tax paid by Emanuel but to eliminate Emanuel’s ability to defer or eliminate Canadian tax. Accordingly, if an amount is included in Emanuel’s income because of these rules, Emanuel can claim a deduction when the corporation actually distributes the income.

Third, a Canadian who invests in a foreign corporation or other entity that is not controlled by Canadians, such as a Cayman-resident mutual fund, can be deemed to have received a prescribed amount of income from that fund annually. Proposed amendments expand the scope of these rules. The prescribed annual amount is not intended to create double taxation but to eliminate the deferral of Canadian tax. Therefore, both the current rules and the proposed amendments allow a deduction when income is distributed and consequently included in the Canadian taxpayer’s income.

Special rules

Special rules deal with funds that a Canadian contributed to a foreign trust. Proposed amendments to these rules are currently under review by Canadian authorities. If enacted in their current form, they will significantly expand the scope of the rules. In particular, the proposed rules can apply to many common transactions that are not intended to avoid or defer Canadian tax.

Any offshore structure that includes a trust that is not resident in Canada can be deemed to be resident in Canada for Canadian tax purpose, making it subject to tax in Canada on its worldwide income. Even if the foreign trust is not deemed resident in Canada, any Canadian beneficiaries may be deemed to have received income for Canadian tax purposes in respect of their interest in the trust. These rules, unlike those noted above, can result in double taxation.

The lone general exception to Canada tax policy of taxing income earned offshore is with respect to business income earned outside of Canada by a corporation. For example, if your client — a Canadian resident (individual or corporation) — incorporates a company to conduct business in a foreign country, the income the corporation earns will not be subject to Canadian tax until:

  • it is distributed to the shareholder; or
  • the shareholder disposes of shares of that corporation.

The Canadian tax system is a “voluntary” tax system. However, to improve compliance for offshore investments, a number of special reporting requirements apply. If the required forms are not filed by a taxpayer who has offshore investments, significant penalties can be assessed—in addition to the tax that should have been paid. Other more severe penalties punish failure to report income properly.

While few structures do defer or avoid Canadian tax and are in accordance with the Canadian tax system, these exceptions are rare, particularly for investment income earned outside Canada on funds transferred or invested by a Canadian resident. However, because of the complexity of the rules, interested clients should understand the ins and outs before implementing any offshore plan that purports to earn investment-type income offshore.

Bruce Harris is a partner in the high-net-worth tax services practice of PricewaterhouseCoopers LLP.

(08/13/09)