On September 21, 2007, the Canadian and US Governments signed the Fifth Protocol (the “Protocol”) to the Canada-US Income Tax Treaty (the “Treaty”). The Fifth Protocol will become law when it is ratified by both governments. For example, if the Protocol is ratified in 2007, it will become effective on January 1, 2008. Some grandfatherly, or transition rules, apply.

The Protocol will have significant effects on cross-border estate planning. The following summarizes, generally, the changes to be made to the Treaty:

Elimination of Withholding Tax on Interest

Cross-border interest is currently subject to a 10% withholding rate. The Protocol will eliminate withholding tax on interest paid between unrelated parties.

Mandatory Arbitration

One of the purposes of the Treaty is to proscribe each country’s jurisdiction to tax to ensure that double taxation does not arise on a single source of income. Under the present rules, the CRA and IRS are permitted to agree in cases where the Treaty does not resolve an issue between them. If the authorities do not agree, there is no further mechanism requiring resolution of the dispute. Under the Protocol, taxpayers can compel the authorities to refer their dispute to binding arbitration.

Taxpayer Migration

When an individual emigrates from Canada to the US, he or she is deemed to dispose of all capital property at fair market value, thereby triggering any accrued capital gains. The Treaty is silent as to the tax effects of this deemed disposition rule from a US perspective.

The Protocol now allow a Canadian to elect to be treated for US purposes of having disposed of and reacquired these capital properties as fair market value. This will allow for a step-up in cost basis of those assets to their fair market value, thereby preventing any double taxation in the US of any pre-emigration gains.

Limited Liability Companies (LLCs) and other Hybrid Entities

LLCs and other hybrid entities are treated as corporations under the tax laws of Canada. By contrast, the US treats them as partnerships to allow for a pass-through treatment of income and losses. The Treaty makes so specific provision for hybrid entities.

Under the Protocol, income earned in a source country through a hybrid entity will be treated as having been earned by the investor in his country of residence. If the investor is not taxed on that income in his country of residence, it will be deemed not to have been earned by the investor.

Pension and other Deferred Income Plans

Some individuals may live in one country but work in another. In addition, some individuals may move from one country to the other on a short-term basis to accommodate their work. These individuals may make contributions to pension plans and other retirement arrangements in the country where they work or reside. The Treaty currently provides no rules with respect to whether such contributions are tax deductible.

The Protocol provides that contributions made by such individuals in their country of work will be tax deductible in such individuals’ country of residence. In addition, short-term emigrants may, for up to five years, deduct, for the country of work purposes, contributions made to a plan in the other country.

Stock Options

The Treaty currently provides no rule for individuals who are granted employee stock options while employed in one country, and who then works for the same employer (or a related employer) in the other country before exercising the stock option.

The Protocol provides that income arising from the stock option benefit will be pro rated between the two countries based on the time spent by the employee in each country. Such time will be measured between the date of granting of the option and the date of its subsequent exercise.

Administration of a trust or estate where the trustee and all of the beneficiaries are resident in Canada is a relatively straightforward exercise. However, modern families commonly have members dispersed around the globe, meaning many Canadian personal trusts and estates have beneficiaries outside of Canada. Dealing with non-resident beneficiaries presents unique challenges for trustees, as distribution of property to them involves a number of tax issues that are not encountered with resident beneficiaries.

Distributions of Income

Income of a trust distributed to a Canadian-resident beneficiary generally becomes taxable to that beneficiary and is not subject to tax in the trust. Furthermore, in most cases the income retains its character, so that dividends, for example, received by the trust and distributed to a beneficiary are taxed as though the beneficiary had received the dividends directly.

When distributing income to a non-resident beneficiary, however, the trustee must withhold tax under Part XIII of the Income Tax Act. The withholding rate under the Act is 25% for all distributions of income. However, if there is a tax treaty between Canada and the country in which the beneficiary lives, the rate may be lowered, often to 15%.

The relevant provisions of the Act also state that amounts paid by a trust to a non-resident beneficiary are deemed to have been paid as income of the trust, regardless of their original character. As a result, withholding tax will apply to amounts received by a trust and distributed to a non-resident beneficiary even in cases where withholding tax would not have applied if the amount had been paid directly to the non-resident beneficiary.

The liability for withholding tax arises when the trust income is paid or credited to the non-resident beneficiary. Payment must be made to Canada Revenue Agency by the 15th of the following month. Failure to withhold or remit the appropriate amount will cause penalties and interest to apply.

Distributions of Capital

Although some exceptions apply, a trust may generally distribute capital property to its Canadian-resident beneficiaries without tax. Property that has appreciated in value may be transferred on a rollover basis so that the trust does not realize a capital gain and the beneficiary inherits the property’s historic cost base.

However, the rollover provisions do not apply to most distributions of trust property to non-resident beneficiaries. If property could be rolled over to non-resident beneficiaries, then gains accrued in Canada might never be subject to tax in Canada. Therefore, the trust becomes liable for tax on accrued capital gains when the property is distributed, as the distributed property is deemed to be disposed of at fair market value. Certain property over which Canada maintains a jurisdiction to tax, most notably Canadian real property, can still be rolled over to non-resident beneficiaries.

This is further complicated by the fact that a taxable portion (50%) of a capital gain realized by the trust on the distribution of property may be considered for tax purposes to be income payable to the beneficiary on which Part XIII withholding tax will apply. The trust may therefore withhold and remit Part XIII tax at the appropriate rate on this amount instead of paying regular tax under Part I on the capital gain. In most cases, the withholding rate under Part XIII will be lower than the trust’s tax rate under Part I. The other 50% of the gain is not subject to tax and may be distributed without further tax.

There is one other compliance issue that is sometimes overlooked on distributions to non-resident beneficiaries. On receipt of the distribution the non-resident beneficiary is deemed to dispose of a capital interest in trust, and therefore is required to apply for a section 116 clearance certificate (the same certificate required when non-residents dispose of Canadian real property). The trust is deemed to be the “purchaser” of the interest and is required to withhold and remit 25% of the gross proceeds (the amount of the distribution) unless the certificate is obtained. In most cases, the beneficiary will have no gain to report when requesting the certificate, and will not have to pay taxes to obtain the certificate. However, if the distribution is made without withholding and without obtaining the clearance certificate, the Canadian-resident trustees can be subject to penalties and interest.

The following is a potpourri of lawyer obligations when retaining clients’ wills for safekeeping.

1. How long must a client’s will be retained by a lawyer who is retaining their client’s will for safekeeping?

At law, under the Wills Act, R.S.B.C. 1996, c. 489 or otherwise, there are no requirements that lawyers or law firms retain originals or copies of wills that they prepare for their clients for safekeeping. As such, there are no requirements as to the length of time that a will must be kept by lawyers who have retained their client’s will for safekeeping.

Section 4.06(5) of Chapter 4 (Estates) of the Law Society of British Columbia’s PLTC Practice Material states that:

2. What should a lawyer do with a client’s will if the lawyer discovers through a wills notice search that a later will was prepared?

Section 4.06(4) of Chapter 4 (Estates) of the Law Society of British Columbia’s PLTC Practice Material states that:

A lawyer needs to take due care before destroying a client’s will as revocation of a will by a subsequent will or codicil may not be unconditional. If the revocation is subject to a condition that is not fulfilled, the revocation does not take effect. In addition, a subsequent will may be found to be invalid by a Court if it has not been drafted or executed in accordance with the Wills Act. In these circumstances, the previous will has not been revoked by the client and destroying their client’s will may result in the lawyer being held liable under the law of negligence by breaching their duty of care owed to their client or to potential beneficiaries who failed to inherit under their client’s will.

Therefore, if a lawyer finds through a wills notice search that their client prepared a later will, the lawyer may safely destroy the previously prepared will if the later will revokes the previously prepared will unconditionally. In the alternative, a lawyer may also choose to contact their client directly to obtain express written instructions to destroy the previously prepared will.

3. Does a lawyer who retains a client’s will for safekeeping have a duty at law to keep track of their client?

At law, under the Wills Act or otherwise, a lawyer who is retaining a client’s will for safekeeping does not have a duty to keep track of their client.

4. Does a lawyer who retains a client’s will for safekeeping have to send their client notice when disposing of their will?

At law, under the Wills Act or otherwise, a lawyer who is retaining a client’s will for safekeeping does not have a duty to send notice to their client when disposing of their client’s will.

However, a lawyer may wish to make it their practice to send their clients notice when disposing of their wills that the lawyer retained for safekeeping with a clause disclaiming further responsibility for the safekeeping of their will. In addition, a lawyer may also choose to make it their practice to return the copy of the will to their client disclaiming further responsibility for the safekeeping of their will instead of disposing of the will to allow the client to choose whether to dispose of the will or retain it for their records.

5. Can the duties of a lawyer to retain a will for a client’s safekeeping be altered by contractual agreement?

At law, under the Wills Act or otherwise, there are no prohibitions against lawyers entering into a contractual agreement with their clients regarding the conditions of safekeeping the client’s will.

Section 4.06(2) of Chapter 4 (Estates) of the Law Society of British Columbia’s PLTC Practice Material states that:

The Law Society of British Columbia advises lawyers in their Practice Materials to enter into contractual agreements with their clients regarding the storage of their client’s will, applicable storage costs and the delineation of the lawyer’s responsibilities regarding the safekeeping and storage of their client’s will.

Section 4.06(2) of Chapter 4 (Estates) of the Law Society of British Columbia’s PLTC Practice Material also outlines some best practices for lawyers retaining their client’s will for safekeeping:

Best practice indicates that if you retain the will in safekeeping, you should:

(a) ensure that the will is stored in an appropriate place and that you have a copy in another location;

(b) insist on filing a wills notice;

(c) ensure that you have negated in writing any obligation to the client that might be implied by retaining the will to keep the client informed of any changes to the law that might affect the estate planning effected under the will or otherwise; and

(d) maintain a wills index system to readily ascertain the location of the will when required, which should include the following information:

(i) name and address of testator;
(ii) index number of the wills file;
(iii) name and address of executor;
(iv) date of execution of will; and
(v) exact location of will. (emphasis by author)