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CALU Report - Estate Planning with Dynasty Trusts for American Beneficiaries

By Jim Yager and Ryan T. Carey, KPMG LLP [1]

With hundreds of thousands of Americans in Canada [2] and a similar number of Canadians in the United States, it is very likely wealthy Canadians will have beneficiaries in the United States that are subject to U.S. tax. Failure to consider the U.S. and Canadian tax implications may result in substantial Canadian and U.S. income taxes as well as subject the assets to two levels of U.S. wealth transfer taxes.[3] In this edition of CALU Report, Jim Yager and Ryan T. Carey of KPMG's International Executive Service group in Toronto discuss how a U.S. dynasty trust may offer a solution that can last for hundreds of years.

Table Of Contents


With hundreds of thousands of Americans in Canada and a similar number of Canadians in the United States, it is highly probable that a wealthy Canadian will have estate beneficiaries who are subject to tax. Failure to consider the U.S. and Canadian tax implications may result in substantial Canadian and U.S. income taxes and could subject the assets to two levels of U.S. wealth transfer taxes. A U.S. dynasty trust may offer a solution that can last for hundreds of years. A dynasty trust is a generation-skipping transfer trust that may continue to exist for multiple generations. The objective of a dynasty trust is to minimize U.S. wealth transfer taxes (including estate, generation-skipping and gift taxes) and thereby maximize the amount of wealth that can be transferred from one generation to the next. Dynasty trusts can be designed to last for one or two generations or for much longer. The duration of the trust is determined by the settlor, who may impart some flexibility in the trust's early termination terms. Non-U.S. persons, such as Canadian citizens and residents, have a unique opportunity to transfer non-U.S. situs assets to U.S. persons and defer U.S. wealth transfer taxes on assets transferred to a dynasty trust for centuries.

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The Dilemma

If a Canadian transfers wealth directly to a U.S. citizen or a non-U.S. citizen domiciled in the United States ("domiciliary"), that wealth will be subject to U.S. transfer taxes when it passes to others either as a gift during the U.S. person's lifetime or on death.[4] Wealth transfer taxes can substantially diminish a large estate with rates as high as 45 percent assessed on the gross estate.

If wealth is transferred to a Canadian-resident trust during the settlor's lifetime or on death, the following adverse Canadian and U.S. tax consequences may result:

The U.S. dynasty trust provides a potential solution to these dilemmas.

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U.S. Wealth Transfer Taxes

A properly designed dynasty trust will insulate the trust assets from U.S. wealth transfer taxes. Understanding the benefits of a dynasty trust requires knowledge of how the U.S. wealth transfer tax system operates.

The U.S. federal estate tax is an excise tax imposed on a decedent's taxable estate at death. The U.S. estate tax imposed on gross asset value is a stark contrast to the Canadian tax on death, which is paid only on unrealized capital gains of property held by a decedent. For U.S. estate tax purposes, the decedent's gross estate comprises all property wholly or partly owned by the decedent at the date of death. U.S. estate tax is imposed on the value of all property of U.S. citizens and all individuals domiciled in the United States, regardless of where the property is located (i.e., the tax is imposed on both U.S. and foreign-based assets). Estate tax must generally be paid within nine months of the date of death. Under current law, U.S. estate tax applies at rates of up to 45 percent on the fair market value of all assets owned at the time of death.[6]

A U.S. citizen's or domiciliary's gratuitous transfer of assets before death is subject to gift tax. The gift tax rates are essentially equivalent to the estate tax rates and are imposed on the fair market value of the property at the time of the gift.[7] However, the Economic Growth and Tax Reconciliation Act of 2001 decoupled the gift tax from the estate tax, effectively increasing the amount an individual is entitled to transfer free of estate taxes at death to $3,500,000 for 2009, while setting the amount an individual can transfer during his or her lifetime at $1,000,000.

U.S. tax law also imposes a tax on transfers that skip generations, partly to prevent individuals from setting up large dynasty trusts to defer payment of wealth transfer taxes well into the future or avoid such taxes altogether. The generation-skipping tax aims to ensure that U.S. wealth transfer taxes are paid each time wealth is passed from one generation to the next. The generation-skipping tax rate is set at the maximum U.S. estate tax rate, which is currently 45 percent. Generation-skipping tax is imposed on "generation-skipping transfers" made by a "transferor" to a "skip person." A skip person is generally an individual who is two or more generations below the transferor, such as a grandchild.[8] The generation-skipping tax can also apply to a transfer from a trust, if a distribution is made to a skip person.

The harsh generation-skipping tax generally makes it disadvantageous for a U.S. person to establish a large dynasty trust. However, the rules allow a non-U.S. person to effectively avoid the generation-skipping tax for both outright transfers and transfers in trust. This opportunity for a Canadian person to avoid generation-skipping tax and other wealth transfer taxes will be lost once the assets are transferred directly to U.S. citizens or individuals domiciled in the U.S. Dynasty trusts present a unique planning opportunity for non-U.S. persons to keep assets out of the U.S. wealth transfer tax net.

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Establishing a U.S. Trust

It is generally recommended that the trust be established as a U.S. resident trust in order to avoid the Canadian 21-year deemed disposition provisions and to avoid the adverse U.S. rules for distributions of accumulated income from foreign trusts. However, it is crucial to overall planning objectives that the trust not be deemed a Canadian resident trust pursuant to the Canadian non-resident trust rules of subsection 94(1) of the Act.[9]

Under U.S. tax law, a trust is a U.S. person if: (i) a court within the United States is able to exercise primary supervision over the administration of the trust ("the court test"), and (ii) one or more U.S. persons have the authority to control all substantial decisions of the trust ("the control test").[10] The terms of the trust instrument and relevant law must be applied to determine whether these tests are met.[11]

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U.S. Federal Income Taxation of Domestic Trusts

Trusts are categorized as either simple trusts or complex trusts. Simple trusts are required to distribute income currently.[12] Complex trusts may either distribute income currently or accumulate income for distribution in future years.[13] Both simple and complex trusts are allowed an income distribution deduction, which may reduce or eliminate a trust's taxable income for a tax year.[14] In the event a trust's current income is distributed to a beneficiary, the income must be included in his or her taxable income.[15] The distributed income retains the same character in the hands of the beneficiary as it had when earned by the trust.[16]

Income retained in the trust is taxed at graduated rates, which are extremely compressed when compared to the tax rates of individual persons. Trusts are subject to top marginal federal rates of 35 percent on income over $11,150, whereas individuals filing as "single" do not reach the 35 percent tax bracket until $372,950 of taxable income. Future distributions of accumulated, previously taxed income from a domestic trust will not be subject to further tax in the hands of the beneficiaries. Rather, the future distributions will be considered distributions of capital.

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Beneficiaries' Access to Dynasty Trust Funds

Dynasty trusts should be structured to avoid giving beneficiaries broad powers to access trust assets, which would cause the assets to be includable in the taxable gross estates of the beneficiaries. Any portion of the trust over which a beneficiary has general power of appointment will be includable in the beneficiary's gross estate and thus subject to U.S. wealth transfer taxes.[17] A general power of appointment is such a power exercisable in favour of the holder, the holder's estate, and creditors of the holder and the holder's estate.[18] If any beneficiary has the ability to withdraw funds from the trust, then such funds generally will be subject to U.S. estate tax at the beneficiary's death, even if the power was not exercised.

If a person is given a general power of appointment, it can be difficult, if not impossible, to extinguish it without adverse wealth transfer tax consequences. The exercise or release of a general power of appointment is generally considered to be a gift by the individual.[19] Such a gift is subject to the gift tax rules and may be taxed at rates as high as 45 percent of the gift's value. However, a general power of appointment disclaimed by an individual may not be taxable if the disclaimer rules of IRC section 2518 are satisfied.[20] These rules contain strict time limits and notification requirements and also require that the donee may not have accepted the interest or any of the benefits of the power of appointment.

There are several exceptions to the general rule that powers of appointment are includable in the gross estate of a power holder. The "ascertainable standard" exception provides that a power holder's ability to withdraw funds is not a general power of appointment if the withdrawal power is limited by an ascertainable standard related to the holder's "health, education, support or maintenance."[21] The ascertainable standard may also be used to allow a beneficiary to compel a trustee to make distributions, increasing a beneficiary's control over trust distributions without creating a risk of estate tax exposure.

Current or future beneficiaries may be given special powers of appointment that would allow the beneficiaries to appoint trust principal in favour of their descendants or other persons. Carefully constructed special powers of appointment can add flexibility to a trust without causing trust assets to be includable in a beneficiary's gross estate on his or her death. Special powers of appointment can give a beneficiary a means of terminating the trust in the future as long as the funds are not received by the beneficiary, the beneficiary's creditors, the beneficiary's estate, or creditors of the beneficiary's estate.

A beneficiary may be granted a "five-and-five power" in order to provide future flexibility to obtain distributions from a trust. This power gives a beneficiary the right to make an annual withdrawal limited to the greater of five percent of the value of the trust assets or $5,000. The use of a non-cumulative five-and-five power will not cause estate tax inclusion for those assets the beneficiary does not withdraw in years prior to the beneficiary's death.[22] power will generally cause an inclusion of the amount of assets the beneficiary was entitled to withdraw in the year of such beneficiary's death.[23] Careful drafting of the trust document may allow beneficiaries to avoid gross estate inclusion of an unexercised annual five-and-five power.[24]

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Jurisdiction Selection

Trusts are generally governed by state law rather than federal law. The question of which state law applies to a trust is not always easy to answer.[25] The situs of a trust is generally a critical factor. The situs of a trust is generally the principal place of administration,[26] so the trust will generally be subject to the law of the state in which the trust is administered.[27] Many factors influence trust situs selection, including the general reputation of the state legal system, creditor protection, investment flexibility, asset protection, fees, confidentiality and the applicability of the rule against perpetuities (the "Rule").

The common-law Rule provides that "no interest is good, if it must vest, if at all, not later than twenty-one years after some life in being at the creation of the interest."[28] In other words: "A nonvested interest is... valid if it is absolutely certain to vest, or fail to vest, not later than twenty-one years after the death of some [person who is alive] at the creation of the interest."[29] The Rule generally prevents a testator or settlor from creating a valid trust arrangement that will last more than about 100 years. Many states have either abolished or modified the Rule enough to allow the trust to continue perpetually.

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State Taxes

State income taxes can pose a significant cost on the operation of a trust. Most of the 50 U.S. states impose individual income taxes. Income tax rates vary by state and are imposed at rates ranging up to 10.3 percent.[30] Some states do not impose an individual income tax, including Alaska, Florida, Nevada, South Dakota, Texas, Washington (state) and Wyoming. Additionally, several states do not impose state income tax on income that is retained in the trust, rather than being distributed currently to beneficiaries, where the trust does not have beneficiaries or a settlor resident in that state.

Trust income that is distributed to a beneficiary typically retains the character it had at the trust level and the beneficiary is then generally subject to tax in the beneficiary's state of residence. Trusts that hold property in various states, are administered or resident in multiple states, or have beneficiaries in multiple states may be subject to taxation in multiple jurisdictions. Double taxation is often eliminated through state income tax credits. State taxation issues should be carefully considered before implementing a dynasty trust.

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Other Issues

A dynasty trust may be created as either a testamentary trust or an inter vivos trust. An inter vivos trust can be either fully or partially funded. A partially funded trust could receive additional testamentary transfers in the future on the death of the Canadian settlor. The primary advantages to establishing and partially funding a dynasty trust by lifetime transfer is that the settlor can choose the trustee, all parties can be involved in and agree to the trust agreements, and the complete funding of the trust may be expedited at the death of the settlor.

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Canadian Tax Implications and the Non-resident Trust Rules

Avoiding Canadian residence

To avoid Canadian taxation of the trust and the application of the 21-year deemed disposition rules, the dynasty trust should be structured to avoid Canadian residence. A trust can be either a factual resident of Canada or a deemed resident of Canada.

Factual Canadian Resident Trust

A trust can be considered a factual resident of Canada if it resides in Canada. A trust is generally considered to reside in the place where the trustee, executor, administrator, heir or other legal representative who manages the trust or controls the trust's assets resides. Generally, the residence of the trust beneficiaries and domicile of the settlor are not considered relevant except where a substantial portion of the management and control rests with them.[31]

Deemed Residence for Canadian NRTs

To prevent perceived abuses associated with Non-resident Trusts (NRTs), Canadian tax legislation includes provisions to tax certain income of NRTs.[32] Proposed rules have been drafted which widen the circumstances in which NRTs are deemed to be Canadian resident and substantially increase the complexity of the rules. The draft NRT amendments were initially proposed in the 1999 federal budget but have not been enacted at the time of writing.[33]

Generally, current subsection 94(1) of the Act treats a NRT as a Canadian resident trust in certain circumstances. If those conditions are not met, the NRT is not considered resident in Canada and thus only its Canadian source income is taxable in Canada. A NRT is treated as a Canadian trust only where all of the following conditions have been met:

The proposed NRT rules significantly extend the situations in which a trust will be deemed to be Canadian resident. A full review of the proposed NRT rules is beyond the scope of this paper. However, a summary of some of the relevant provisions is crucial for understanding how the proposed NRT rules will generally apply to a U.S. dynasty trust.

Under the proposals, a NRT could be considered a deemed resident of Canada merely by having a Canadian resident contributor, even if there are never any Canadian resident beneficiaries. In general, a NRT (other than an exempt foreign trust) will be subject to tax for a taxation year as a resident in Canada if such trust has a "resident contributor" or "resident beneficiary." Some key defined terms in the proposed legislation are as follows:[34]

Resident beneficiary - A resident beneficiary is a beneficiary who is resident in Canada.[35] However, a person can only be a resident beneficiary if there is a "connected contributor" to the trust. This definition is somewhat misleading since a resident of Canada who is a beneficiary of a non-resident trust will not be considered a resident beneficiary if there is no connected contributor. If there is a connected contributor and if it is crucial to avoid having a resident beneficiary, it may be prudent to include a provision in the trust to exclude any resident of Canada as a beneficiary of a trust.

Connected contributor - A connected contributor is an entity, including an entity that has ceased to exist, that is a "contributor" to the trust. A contributor is an entity that has made a contribution to the trust. Based on this definition, a deceased person would be a connected contributor if the decedent contributed to the trust during his or her lifetime or on death.

Resident contributor - A resident contributor is an entity that is, at that time, resident in Canada and a contributor to the trust. A person who no longer exists (such as a deceased person) is not a resident contributor, but, as noted, can be a connected contributor. The Canada Revenue Agency (CRA) confirmed this view in a technical interpretation.[36]

A question to the CRA at the 2007 STEP Conference asked whether a successor beneficiary could be considered a resident beneficiary, which could cause an otherwise non-resident trust to be considered resident. The CRA's position is that a "successor beneficiary," as defined in proposed subsection 94(1) of the Act, would not be considered a resident beneficiary. However, the CRA did point out that once the trust has a resident beneficiary, the trust will be deemed resident in Canada under the proposed legislation.[37] The CRA's position also confirms that a testamentary trust that is not factually resident in Canada will not be resident in Canada under the proposed NRT rules unless there is a Canadian resident beneficiary, as defined.

Treaty Residency

Article IV of the Canada-U.S. Tax Convention ("the Treaty")[38] addresses residency. The purpose of Article IV is to determine whether a person (including a trust) is considered a resident of Canada or the United States for purposes of the Treaty when the person is resident in both countries. Article IV is very specific in defining residence of a company or an individual but provides little guidance for determining the residence of a trust. Article IV(4) states: "Where [a trust] is a resident of both Contracting States, the competent authorities of the States shall by mutual agreement endeavour to settle the questionÉ." Neither Canada nor the United States has issued any guidance as to what determines residence of a trust for purposes of the Treaty. Seeking guidance from the competent authorities can be a difficult and extended process that may result in little or no relief. As illustrated in the Federal Court of Appeal case Robert Julien Family Delaware Dynasty Trust v. Minister of National Revenue,[39] the Treaty may not be relied on to provide relief from Canadian residence status under proposed section 94 of the Act. Neither competent authority nor the courts provided relief from dual residence taxation of the trust based on the provisions of the Treaty.

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Examples of Uses of Dynasty Trusts

Testamentary Dynasty Trust

Exhibit 1 below illustrates a typical dynasty trust structure for a testamentary transfer by a Canadian for the benefit of U.S. persons. In this structure, the Canadian's will provides that on his death, assets will be transferred to a U.S. resident trust for the benefit of U.S. citizens, U.S. residents and their issue. On the death of the Canadian, Canadian capital gains tax will arise on the deemed disposition of all personally owned assets. The net estate, after payment of taxes and administration expenses will fund a U.S. dynasty trust.

The dynasty trust may be discretionary as to income and principal. Assuming the beneficiaries have some wealth in their own rights and do not immediately need the trust income, the trust would accumulate income and add it to capital for trust accounting purposes. The accumulated income would not be subject to adverse U.S. tax consequences because the accumulated income rules only apply to foreign trusts. The trust may not have any state income tax liability on the accumulated income as long as the trust is administered in a state with favourable income tax rules and the beneficiaries are not resident in states such as California that tax beneficiaries' income retained in the trust.

Trust income and capital may be distributed to beneficiaries when they are in need of additional resources in the future. If such distributions are consumed by the beneficiaries, rather than being used to increase the size of their gross estate for U.S. estate tax purposes, then the trust distributions will not be subject to future U.S. estate tax. The dynasty trust allows distributions to be made to younger generations that would otherwise be subject to generation-skipping tax.

This straightforward application of the dynasty trust structure may result in significant state income and U.S. federal wealth transfer tax savings.

Dynasty Trust Structure for a Canadian Business

A Canadian may have his or her wealth tied up in a Canadian operating company ("Opco"). For many reasons, including asset protection, Opco may be held by a Canadian holding company ("Holdco"). This structure may be efficient for Canadian tax purposes, but it may present significant problems for U.S. beneficiaries of the estate. When Holdco is transferred to a U.S. dynasty trust, Holdco may be considered a controlled foreign corporation (CFC) or a passive foreign investment company (PFIC) for U.S. tax purposes.

CFC Issues

If Holdco is a CFC, a U.S. dynasty trust may have to recognize a deemed dividend, even when no cash dividends are paid. Every person who is a U.S. shareholder of a CFC and who owns stock in the CFC on the last day of its taxation year must include certain amounts in gross income under Subpart F of the IRC. One category of Subpart F income likely to be earned by Holdco is "foreign personal holding company income," which generally consists of dividends, interest and other passive items.[40]

A problem can arise if Holdco does not control Opco. As a U.S. shareholder of Holdco, the dynasty trust would have to recognize as subpart F income its pro-rata share of Holdco's dividends from unrelated parties as well as any gain from the sale of Opco. The trust would recognize this subpart F income as ordinary income and would not obtain preferential tax rates on any gains or dividends received directly by the U.S. trust.[41] A subsequent dividend payment by Holdco would not be taxable to the extent of "previously taxed income", which would be the income previously taxed under Subpart F.

Another problem of a Holdco structure is the loss of a basis bump on assets held by Holdco on the death of the shareholder of Holdco. U.S. tax law provides that the tax basis of assets acquired from a decedent is equal to the fair market value of the property at the date of the decedent's death.[42] Therefore, if a Canadian dies owning substantially appreciated shares of Holdco, the shares of Holdco will be bumped to fair market value at death. However, any assets owned by Holdco, such as shares of Opco, would not be adjusted. Consequently, a subsequent sale of the shares of Opco could result in a deemed dividend to U.S. shareholders of Holdco under subpart F. As discussed, the subpart F income would be taxed at ordinary tax rates rather than the beneficial capital gains rates.

PFIC Issues

If Holdco is not a CFC, it may be a PFIC. A PFIC may cause many problems for a U.S. shareholder, such as a U.S. trust. A foreign corporation is a PFIC if either (i) 75 percent or more of the gross income is passive, or (ii) more than 50 percent of the assets of the corporation produce passive income.[43] If a U.S. trust receives an "excess distribution" from a PFIC or directly or indirectly disposes of the shares of a PFIC, the trust would be subject to the harsh PFIC taxing regime unless the trust previously made a "qualified electing fund" (QEF) election. Generally, if a U.S. trust realizes a gain from the sale of a PFIC or receives an excess distribution from a PFIC, the income will lose any preferential capital gains character, will be subject to income taxes at very high marginal rates, and will also be subject to significant interest charges. A comprehensive discussion of the PFIC rules is beyond the scope of this paper.

Unlimited Liability Company (ULC) Solution

A ULC is a Canadian company whose shareholders have unlimited liability. ULCs may currently be formed in the provinces of >Nova Scotia or >Alberta. A ULC is treated as a corporation for Canadian tax purposes but may be treated as a partnership, or a disregarded entity for U.S. tax purposes.[44] As long as a check-the-box election is not filed to treat the ULC as a corporation for U.S. tax purposes, a ULC cannot be considered a CFC or PFIC. The legal implications of unlimited liability should be carefully considered before implementation.

A Canadian with a Holdco structure could continue Holdco into a ULC prior to his or her death to avoid adverse U.S. tax consequences when the Holdco shares are transferred to a U.S. trust. On his or her death, both the Holdco and Opco shares would receive a basis bump to their fair market values.[45] If Holdco is a disregarded entity, the decedent would be deemed to own the shares directly. If Holdco is considered a partnership, a timely filed election under IRC 754 would provide the bump in basis.[46]

As the owner of a partnership or disregarded entity, the U.S. trust would recognize the income of the ULC on a flow-through basis for U.S. tax purposes. Foreign tax credits, qualified dividends, and capital gains would flow through to the U.S. trust. For example, if a ULC pays Canadian income tax on the sale of shares of Opco, the U.S. trust may claim a foreign tax credit (subject to certain limitations) for the Canadian income taxes paid by the ULC to offset the U.S. tax liability.[47] This credit would not be allowed if the trust owns shares of a regular Canadian corporation which incurs a Canadian tax on the sale of shares.

Unfortunately, the recently ratified 5th Protocol to the Canada-U.S. Treaty ("the Protocol"), increases the Canadian withholding tax on dividends paid by a ULC to a U.S. shareholder from 15 percent to 25 percent after 2009. The Protocol denies treaty benefits paid by a "fiscally transparent entity" (FTE), such as the ULC in the above example.[48] Government commentary suggests that the Treaty may be changed in the future to alleviate the adverse impact of these provisions on non-abusive ULC structures.[49] Despite the elimination of the Treaty benefits under the Protocol, the ULC structure may provide sufficient benefits to justify its continued use.

Life Insurance

Many Canadian entrepreneurs acquire life insurance products in a Canadian holding company for tax-advantaged investing and to help fund Canadian taxes on death. Although such structures can be efficient for Canadian tax purposes, they can create adverse U.S. tax issues after death. U.S. tax law provides that gross income does not include amounts received under a life insurance contract, if such amounts are paid by reason of death of the insured.[50] However, if the insurance contract is held by a corporation, the death benefit will increase the corporation's "earnings and profits" (E&P).[51] E&P is a U.S. tax term that determines the extent a distribution from a corporation will be considered a taxable dividend.[52] As a general rule, the greater a company's E&P, the greater the risk of a U.S. shareholder being exposed to future income recognition. Consequently, it is desirable to avoid E&P. The ULC structure can be used to avoid E&P arising from death benefits.

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Canada and the United States impose different types of taxes on individuals at death. Careful planning is prudent when a wealthy Canadian wishes to transfer wealth to individuals on both sides of the border. Coordination of the two tax regimes can produce significant tax savings and avoid harsh tax consequences.

U.S. dynasty trusts can be a valuable estate planning tool for Canadians with family members or future U.S. resident beneficiaries. A U.S. dynasty trust may allow the family to preserve wealth by reducing the effective tax rates on trust income, avoiding the Canadian 21-year deemed disposition rule, avoiding the harsh U.S. income tax rules imposed on foreign trusts, and minimizing or eliminating U.S. transfer taxes on the death of future family members.

To maximize the benefits of a dynasty trust, state situs of the trust administration should be carefully considered. The primary factors driving situs selection are avoiding application of the rule against perpetuities, achieving creditor and spendthrift protection, and minimizing state income taxes. Application of the NRT rules must be considered in order to ensure the dynasty trust is not taxed in Canada and the U.S. tax rules must be followed to ensure the trust is considered U.S. resident.

Dynasty trusts have a variety of applications, from relatively straightforward uses such as passing family wealth held in the form of liquid assets to more complex applications involving estate freezes and passing closely held business interests to future generations. All Canadians who intend to pass wealth to U.S. citizens or residents should consider using a dynasty trust to preserve family wealth for future generations.

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About the Authors


Jim Yager, CA, CPA (Florida) is a Partner in KPMG's International Executive Service group in Toronto and may be reached by e-mail at jyager@kpmg.ca. Ryan Carey, LL.M, CPA (Colorado and Iowa) is a senior manager in KPMG's International Executive Services group in Toronto. Ryan is a licensed attorney in multiple U.S. jurisdictions and is admitted to the U.S. Tax Court. He may be reached by e-mail at rtcarey@kpmg.ca.


[1] The authors gratefully acknowledge the assistance of George Denier and Joseph Petrie of KPMG LLP for their assistance in preparing this paper. A more detailed discussion of the topic is available in the 2008 Canadian Tax Foundation Annual Conference Paper entitled, Dynasty Trusts for American Beneficiaries of Canadians, by the same authors.

[2] The 2006 Canada Census indicates approximately 250,000 Canadians aged 18 and over were born in the United States and about 316,000 individuals are of "American" origin. Source: www.statcan.gc.ca.

[3] U.S. estate, gift, and generation-skipping transfer taxes are collectively referred to herein as "U.S. wealth transfer taxes".

[4] ¤ 2056(a) of the U.S. Internal Revenue Code of 1986, as amended (herein referred to as "IRC"). ¤ 2056(a) allows the estate a deduction for bequests to a surviving spouse who is a U.S. citizen. IRC ¤ 2056(d)(2) allows the estate a deduction for transfers to a qualified domestic trust (QDOT) set up for the benefit of a non-U.S. citizen spouse. These provisions allow the estate tax to be deferred until the death of the surviving spouse or until assets are distributed from the QDOT.

[5] Subsection 104(4) of the Act.

[6] IRC ¤¤ 2001(a), (c), 2031(a). Each U.S. citizen or domiciliary has a unified credit amount that eliminates estate tax on the first U.S.$3.5 million of assets passing to beneficiaries on death. U.S. estate tax is scheduled to be repealed effective Jan. 1, 2010. However, absent further U.S. tax law changes, the repeal reverts effective Jan. 1, 2011 when the estate tax returns with a $1 million unified credit equivalent amount and a marginal estate tax rate of 55 percent. A complete discussion of the repeal legislation is beyond the scope of this paper. The remainder of this discussion is based on the U.S. estate tax treatment in effect at the time of this writing.

[7] IRC ¤¤ 2501, 2502.

[8] There are certain exceptions to this rule, such as a predeceased ancestor exception, which are beyond the scope of this paper.

[9] The proposed Canadian non-resident trust rules are analyzed below.

[10] IRC ¤ 7701(a)(30)(E).

[11] Treas. Reg. ¤ 301.7701-7(b).

[12] See IRC ¤ 651.

[13] See IRC ¤ 661.

[14] IRC ¤¤ 651(a), 661(a).

[15] IRC ¤¤ 652(a), 662(a).

[16] IRC ¤¤ 652(b), 662(b).

[17] IRC ¤ 2041(a)(2).

[18] IRC ¤ 2041(b)(1).

[19] IRC ¤ 2514(b).

[20] Treas. Reg. ¤ 25.2514-3(c)(5).

[21] IRC ¤ 2041(b)(1)(A), Treas. Reg. ¤ 20.2041-1(c)(2).

[22] IRC ¤ 2041(b)(2).

[23] Treas. Reg. ¤ 20.2041-3(d)(3).

[24] One such technique is to provide that a five-and-five power is only exercisable on the last day of the year and only if the beneficiary is alive on that date.

[25] See, for example, Restatement 2d Conflict of Laws 10, 1 Introductory Note.

[26] This is the general rule that applies to personal property held by a trust.

[27] Restatement 2d Conflict of Laws ¤¤ 271, 272.

[28] J. Gray, Rule Against Perpetuities ¤ 201 (4th ed. 1942). The Rule originated in England in feudal times over 300 years ago in the Duke of Norfolk´s Case in 1682. 3 Ch. Cas. 1, 22 Eng. Rep. 931 (Ch. 1682). The Rule exists in various degrees of harshness in both Canada and the United States.

[29] Moynihan and Kurtz. The authors acknowledge that the Rule cannot be easily reduced to an elementary concept for educational purposes even with this "simplified" explanation.

[30] California imposes a top marginal income tax rate of 9.3 percent. Individuals with annual taxable income in excess of $1 million must pay an additional one percent mental health services tax.

[31] Interpretation Bulletin IT-447, Residence of a Trust. Also see Thibodeau Family Trust v. The Queen 1978 CarswellNat 223, [1978] C.T.C. 539, 3 E.T.R. 168, 78 D.T.C. 6376, where the courts determined a trust to be a resident of Bermuda rather than Canada since the majority of the trustees resided in Bermuda.

[32] Subsection 94(1) of the Act.

[33] The proposed rules were set out in former Bill C-10 which requires reintroduction due to the recent Federal elections. In the 2009 federal budget the government announced that it would review the existing FIE and NRT rules in light of submissions it had received from an advisory panel on international taxation and others before proceeding. It is currently unclear whether a reintroduced Bill will be substantially the same as Bill C-10.

[34] The definitions below are provided in proposed legislation subsection 94(1).

[35] If the person was not resident in Canada for at least 60 months prior to the date of the contribution, the person would not be considered a connected contributor.

[36] See CRA Technical Interpretation 2003-0009935, dated Sept. 23, 2003.

[37] CRA Views, Conference 2007-0235241C6 Ð 2007 STEP Conference Ð Question 10 Ð Deemed resident trusts.

[38] Convention Between Canada and The United States of America With Respect to Taxes on Income and on Capital Signed on Sept. 26, 1980, as Amended by the Protocols Signed on June 14, 1983; March 28, 1984; March 17, 1995; July 29, 1997; and Sept. 21, 2007.

[39] Robert Julien Family Delaware Dynasty Trust (Trustee of) v. Minister of National Revenue, 2008 CarswellNat 3207, 2008 FCA 260, 2008 D.T.C. 6623 (Eng).

[40] IRC ¤ 954(a)(1).

[41] Notice 2004-70, 2004-44 IRB 724, 10/08/2004, IRC ¤ 1.

[42] IRC ¤ 1014(a).

[43] IRC ¤ 1297(a).

[44] Reg. ¤ 301.7701-2(b)(8)(ii)(1); Reg. ¤ 301.7701-2(a).

[45] IRC ¤ 1014(a).

[46] Reg. ¤ 1.754-1. It is recommended that a form 8865 be timely filed with the U.S. trust return with the appropriate election attached.

[47] IRC ¤¤ 901 and 904.

[48] Article IV(7)(b) of the Convention Between the United States of America and Canada with Respect to Taxes on Income and on Capital as amended by the 5th Protocol. Subparagraph 7(b) addresses whether the recipient of a payment that is made from a fiscally transparent entity to its owner is entitled to treaty benefits with respect to that payment. It provides that an amount of income, profit, or gain is not considered to be paid to or derived by a person who is a resident of a treaty country if: (1) the person is considered under the tax law of the other treaty country to have received the amount from an entity resident in the other treaty country, but (2) by reason of the entity being treated as fiscally transparent under the laws of the first treaty country, the treatment of the amount received by that person under the tax law of that country is not the same as its treatment would be if the entity were treated as not fiscally transparent under the laws of that country. See subsection 212(1) of the Act; Article X(2)(b) of the Treaty.

[49] The U.S. Joint Committee on Taxation explanations comment that the FTE rules were adopted to curtail abusive financing structures and concede that there are legitimate reasons for using ULC structures in non-abusive situations. The explanations further state that the Committee may wish to inquire whether a rule might have been negotiated in lieu of subparagraph 7(b) that would target abusive cross-border structures more narrowly without upsetting non-abusive structures. Explanations of Proposed Protocol To The Income Tax Treaty Between the United States and Canada, scheduled for a Hearing Before the Committee On Foreign Relations United States Senate, July 10, 2008, as prepared by the Staff of the Joint Committee On Taxation.

[50] IRC section 101(a).

[51] Reg. section 1.312-6(b).

[52] In the case of a CFC, the E&P determines the amount of income that can be recognized by an actual dividend, a deemed dividend under subpart F, investment in U.S. property, or ordinary income on the disposition of shares. The tax implications arising from E&P are quite complex and beyond the scope of this paper.

Copyright the Conference for Advanced Life Underwriting, April 2009