Canadian trusts are commonly used in Canadian estate and succession planning. While effective for Canadian planning, they often create additional disclosure requirements or adverse U.S. tax consequences when one or more trust parties live outside Canada.
To determine how a trust is taxed for U.S. purposes, first determine whether it is a U.S. or foreign trust. A trust is a U.S. trust only if it meets both the court test and the control test: a U.S. court must be able to exercise primary supervision over the trust’s administration, and U.S. persons must control the trust. Most Canadian trusts will not meet the court test and therefore are treated as foreign trusts for U.S. tax purposes.
As a foreign trust, the trust is generally subject to U.S. tax only on U.S. effectively connected income (for example, U.S. business income and rental income). Even without U.S.-source income, a trust may create U.S. tax and reporting obligations if it has U.S. grantors (contributors) or U.S. beneficiaries. The outcome depends on whether the trust is treated as a grantor or non-grantor trust.
Grantor trust status is determined by the trust agreement and the rules in IRC §§ 671–679. Common examples include a trust established by a U.S. person for U.S. beneficiaries, or a trust where a contributor retains certain powers or a reversionary interest. To the extent a trust is treated as a grantor trust, that portion is treated as owned by the grantor, and the grantor reports the trust’s income and deductions on their individual tax return. If a U.S. person is treated as the owner of a foreign grantor trust, they generally must file IRS Forms 3520 and 3520-A. These filings can carry significant penalties (in some cases, up to 35%–40% based on the applicable reporting failure).
A foreign non-grantor trust is any foreign trust that is not treated as a grantor trust. For U.S. tax purposes, it is a separate taxpayer, and beneficiaries are generally taxed when income is distributed to them. When a distribution is made to a U.S. beneficiary, the beneficiary generally must file IRS Form 3520. Form 3520 also carries significant potential penalties (up to 35% of the reportable distribution in certain cases).
If a foreign non-grantor trust has U.S. beneficiaries, it may be subject to anti-deferral (“throwback”) rules. The trust must track undistributed net income (UNI): income not distributed in a given year is added to a UNI pool. If UNI is later distributed to a U.S. beneficiary, the beneficiary may owe additional tax and an interest charge designed to approximate the tax that would have applied had the income been distributed when earned.
U.S. tax rules for foreign trusts are complex and can involve significant reporting penalties. Plan carefully before establishing or funding a trust with U.S. grantors or beneficiaries. For help evaluating your specific situation, please contact us.
If you have questions about current or prospective U.S. investments, we can help. Please contact Philip Mei, Partner to learn more.
