ASSET PROTECTION FROM A TAX LAW PERSPECTIVE
There are many pieces of legislation in Canada, both Federal and Provincial, that protect the interests of creditors. In general, these pieces of legislation provide that a conveyance of property to another person can be rendered voidable if it is treated as a form of fraudulent conveyance or preference on one creditor over another.
The Income Tax Act (the “Tax Act”) also provides the Canadian government protection against transfers made in face of an outstanding income tax liability. Pursuant to the Tax Act, where a person transfers property to a non-arms length person and at the time they owe money to the Canada Revenue Agency (“CRA”), the CRA can pursue the non-arms length recipient for the sum received up to the value of the property that was received. What makes this provision very onerous is the fact that there is no time limitation on the CRA to bring an action against the recipient of property. Where a Trust is the recipient of the property, and the taxpayer or transferor is beneficially interested in the Trust, the Trust and the taxpayer are deemed not to deal at arms-length and therefore the provisions of the Tax Act could apply.
For centuries, Trusts have been used for income tax and estate planning purposes and to protect assets from creditors. In essence, a Trust divides ownership of a property between legal and beneficial ownership. The trustee is the person who holds legal title to the property and the persons who are to benefit under the Trust receive the beneficial title. Trusts can achieve a number of planning goals including protection of family assets and/or to eliminate disputes at death, to protect assets against spousal claims on marital breakdown, to hold property for infants and provide for maintenance and education, to hold shares in investment holding companies or offshore entities, to reduce, negate or defer liability for taxes, and for other valid reasons. A Trust is also a great planning tool for asset protection. The fact that the legal interest is separate from the beneficial interest allows a person to benefit from the property held in the Trust, while at the same time not subjecting that property to claims from his creditors.
Although most Trusts provide a degree of protection for the assets held in the Trust, not all Trusts provide the same protection as that provided by a Trust established in a jurisdiction outside of Canada. The main difference between a claim against a transfer made to a Trust in Canada and one made to a Trust offshore is the limitation period applicable to the bringing of an action against the transfer. In many jurisdictions outside Canada, the limitation period provided to creditors to bring such an action is much shorter than in Canada, meaning that creditors have less time to react to the existence of an offshore Trust for purposes of trying to seize the assets in that Trust to pay out their creditor claim.
People have many different motivations to settle a Trust for asset protection purposes although generally, the Settlor’s main goal is to protect the property at issue from risks that the property would otherwise be exposed to. These risks include lawsuits, other legal proceedings, laws that restrict the ability of an individual to dispose freely of his property on death, political strife, and social instability. While it may be controversial to protect your assets in the face of matters pending, threatened, or expected, it should be completely permissible, and indeed feasible, to protect against the unanticipated problems of the future. In this respect, asset preservation is a form of insurance against unanticipated results, and a Trust may be the best available mechanism for obtaining that insurance.
Many jurisdictions that favour this type of creditor protection force a creditor or trustee in bankruptcy who wishes to set aside a conveyance to a Trust to sue in that particular jurisdiction, and have the court of that jurisdiction adjudicate the issue on the basis of its domestic law. In forcing a legal action to proceed in an offshore jurisdiction, the time limit of that offshore jurisdiction to bring such an action will also likely apply and make it more difficult for a creditor to successfully challenge such a transfer. Most of the jurisdictions that have enacted legislation that restricts the rights of creditors are former English colonies, and therefore their law is based on the English common law which is similar to that of Canada, subject to the time and other restrictions imposed with legislative amendments in each jurisdiction.
In determining in which jurisdiction to establish an asset protection Trust, a person must balance between finding a jurisdiction with laws that strongly restrict the rights of creditors, and finding a jurisdiction with economic and political stability. In making the determination, it is important to consider such factors as the statutory laws related to the limits on bringing an action, whether that particular jurisdiction honours foreign judgments, whether the rule against perpetuity applies, the quality of the trustee, and the political and economic stability of the jurisdiction.
Generally speaking, Trusts established in offshore jurisdictions for asset protection purposes are exempt from income tax in those jurisdictions. However, the Tax Act ensures that the income of a foreign trust settled by a Canadian resident continues to be taxed in Canada, notwithstanding the fact that the trustees may not be resident in Canada. Draft legislation in the Tax Act is designed to limit the ability of Canadians to use offshore Trusts to reduce or eliminate their Canadian tax liability. As a result, most offshore Trusts that are set up for creditor protection purposes will still be residents of Canada for income tax purposes.
Asset protection Trusts can achieve estate planning goals of individuals resident in Canada, while also providing a degree of creditor protection against unanticipated claims. These goals must be balanced against the continuing income tax liability on income earned by the Trust, and the additional costs of establishing and maintaining such Trusts.
This article was originally published in the June 10, 2008 edition of the Ottawa Business Journal.