The Supreme Court of Canada dismissed the taxpayers’ appeal in Fundy Settlement (also known as Garron or St. Michael Trust Corp.), deciding on April 12, 2012 that the relevant trusts were resident in Canada rather than Barbados for purposes of Canada’s Income Tax Act. In reaching its decision the court applied long standing principles for determining residency of corporations, and held that a trust is resident where its central management and control is exercised.
Two Canadian resident individuals, Garron and Dunin, were the principal shareholders of a Canadian operating company (PMPL). Following an “offshore freeze” transaction, the future increase in the value of PMPL accrued to shares of PMPL held by Canadian holding companies which in turn were held by trusts settled in Barbados. Garron and Dunin were each beneficiaries of their respective family trust, which had been settled for a nominal sum by a non-resident associate. The trustee of both trusts was St. Michael Trust Corp. (St. Michael), a licensed Barbados resident trust company with an office in Barbados. The Tax Court found that St. Michael only acted upon receiving instructions dictated by Garron and Dunin, and that its role was solely to act in an administrative capacity. The Canadian beneficiaries of the trust gave direct instructions to the investment advisers of the trusts. As part of an arm’s length sale of PMPL, the trusts sold the shares of the Canadian holding companies, realizing capital gains of about $450 million.
The taxpayers argued that these capital gains were exempt from Canadian tax under Article XIV of the Canada-Barbados Tax Treaty (the Treaty) on the basis that the trusts were resident in Barbados (and not in Canada) for purposes of the Treaty. Specifically, the taxpayers argued that the residence of the trusts for purposes of the Income Tax Act (and consequently the Treaty) should not be in Canada since the trustee (St. Michael) was resident in Barbados. That position was supported by a prior decision of the Federal Court Trial Division (Thibodeau Family Trust) 1 and the prior administrative practice of the Canada Revenue Agency (CRA) which suggested that residence of a trust should generally be considered to be located where its trustee resides. 2
The CRA argued that the trusts should be considered resident in Canada, either on the basis of general principles or on the basis of a rule (section 94) that applies to deem certain non-resident trusts to be resident in Canada for certain Canadian tax purposes where the trust acquires property, directly or indirectly, from a Canadian resident beneficiary of the trust. In the alternative, the CRA argued that benefits under the Treaty should be denied under Canada’s general anti-avoidance rule (GAAR).
The Lower Court Decisions
Both the Tax Court of Canada 3 and the Federal Court of Appeal 4 held that the trusts were resident in Canada on the basis that the central management and control of the trusts was exercised in Canada.
At the Tax Court, Justice Woods confined the prior decision in Thibodeau Family Trust, which determined residency of a trust based upon the residency of the majority of the trustees, to its facts. Instead, Justice Woods held that a trust’s residence should be determined in a manner similar to that of a corporation, i.e., based on where the central management and control of the entity actually abides. Justice Woods found that the Canadian resident beneficiaries, and not the Barbados resident trustee, made all “the substantive decisions respecting the Trusts.” 5 While this was sufficient to dispose of the case, Justice Woods also found that the deeming rule in section 94 did not apply as the trusts did not acquire property “directly or indirectly” from Garron or Dunin. Furthermore, Justice Woods rejected the Minister’s GAAR arguments.
At the Federal Court of Appeal, Justice Sharlow disposed of the taxpayers’ appeal by confirming the correctness of the application of a central management and control test to determine that the trusts were resident in Canada. Under the alternative argument, Justice Sharlow indicated that section 94 would apply to deem the trusts to be resident in Canada for purposes of the Income Tax Act, but that deemed residence would have been overridden by the Treaty. Essentially, Justice Sharlow found that section 94 does not result in a trust being fully “liable to tax” in Canada for purposes of the Treaty’s residence definition, because section 94 creates a less comprehensive tax base than generally applies to Canadian residents (since the tax base excludes foreign active business income). On this basis, the trusts would not have been resident in Canada for Treaty purposes and therefore could have availed themselves of the Treaty exemption available to Barbados residents. Justice Sharlow also indicated that the GAAR would not apply to deny such treaty benefits, reasoning that if the trusts had been resident only in Barbados for Treaty purposes, the trusts could not be considered to misuse or abuse the Treaty by claiming a capital gains exemption that Canada had explicitly negotiated as being available to Barbados Treaty residents.
The Supreme Court of Canada Decision
The Supreme Court of Canada upheld the lower courts’ selection of the central management and control test as the appropriate test for trust residency. As alluded to by the court, residence is the main jurisdictional basis for imposing Canadian tax on worldwide income. Residence of a person is generally a question of fact, although residence may also be determined under the Income Tax Act based on certain deeming rules. For individuals, factors such as nationality, physical presence, location of family home and social connections, among others, are considered in determining residence. For corporations, residence is generally determined based on where the central management and control of the corporation actually abides. 6 For a corporation, central management and control is generally exercised by a board of directors, such that a corporation will generally be resident where its board of directors exercises its responsibilities (i.e., where it meets and makes its decisions). For trusts, residence should generally be in the jurisdiction where the trustees meet and make their decisions (assuming that the trustees exercise central management and control of the trust). However, in the case of a corporation or trust central management and control may be exercised by someone other than the directors or trustees who is resident and making decisions in another country. 7 In that case, the residence of the corporation or trust may be in that other country.
The Supreme Court of Canada upheld the lower courts’ conclusion that St Michael’s limited role of providing administrative services, combined with the exercise of management and control functions by the Canadian resident beneficiaries, meant the trusts were centrally managed and controlled in Canada and therefore resident in Canada. The court rejected the taxpayers’ argument that a trust is fundamentally different than a corporation as it is not a separate legal person, noting that for tax purposes a special rule (section 104) deems the trust to be an individual and therefore a person. The taxpayers also argued that trustee residence should be determinative of trust residence since the Canadian tax legislation closely identifies a trust with its trustee. To this, the court responded that (a) this was mainly for administrative convenience, and should not be elevated to a substantive legal principle that would govern all tax-related features of trusts, such as residence, and (b) furthermore, the legislation is clear that the (deemed) person being taxed on the trust’s income is the trust and not the trustee.
Having thus addressed the taxpayers’ arguments for treating trusts and corporations differently for residence purposes, the court went on to note similarities between both types of taxpayers: (1) both hold assets that are required to be managed; (2) both involve the acquisition and disposition of assets; (3) both may require the management of a business; (4) both require banking and financial arrangements; (5) both may require the instruction or advice of lawyers, accountants and other advisors; and (6) both may distribute income, corporations by way of dividends and trusts by distributions. According to the court, these common attributes, as well as general principles of consistency and fairness, justify treating trusts and corporations alike for purposes of determining residence.
Since the court determined that the trusts were resident in Canada under a common law test, it indicated that it was unnecessary for it to comment on the alternative arguments, under section 94 and GAAR. The court noted that its silence in this regard should not be taken as an endorsement of the Federal Court of Appeal’s treatment of these issues. Accordingly, it remains uncertain whether the Supreme Court of Canada would apply GAAR to deny treaty benefits in similar situations where a trust has central management and control outside of Canada, or whether tax treaties would override the rule in section 94 that may generally deem a non-resident trust to be resident in Canada. With respect to the latter issue, draft section 4.3 of Canada’s Income Tax Conventions Interpretation Act will, if enacted, ensure that tax treaties do not override the rule in section 94 by generally deeming affected trusts to be resident in Canada, and not resident of the other contracting state, for purposes of applying Canada’s tax treaties.
While the lower courts expressly determined that the central management and control test as applied to determine corporate residence should be applied to trusts “with such modifications as are appropriate,” the short decision of the Supreme Court does not include that observation but simply applies the central management and control test to trusts.
Where trustees are resident in a jurisdiction which is intended to be the jurisdiction of residence of the trust and the trust beneficiaries, assets or asset manager are in another jurisdiction, the same care must be taken as in the corporate context to ensure that the trustees have the requisite experience to manage the trust, meet periodically to review and approve significant decisions in respect of the trust and document such meetings and decisions.
The Supreme Court of Canada’s decision suggests that although central management and control of a corporation or trust is generally located where directors or trustees meet and make their decisions, it may be located elsewhere if substantial decisions are made by someone other than the directors or trustees. This may occur, for example, where a third party (such as a shareholder or beneficiary) directs the decision making on behalf of the corporation or trust, essentially usurping the functions ordinarily carried out by the directors or trustees. While the Supreme Court’s judgement is remarkably short, the decision highlights the importance of ensuring that directors or trustees ultimately make their own decisions, which will generally require them to have sufficient expertise and be provided with sufficient information to make informed decisions. The decision-making process should be appropriately documented and should be consistent with the established legal relationships.