On October 21st, 2010 and November 17th, the Federal Court of Appeal released its decisions, respectively, in Paul Antle v. Her Majesty the Queen (2010 FCA 280) and St. Michael Trust Corp. v. Her Majesty the Queen (2010 FCA 309) (often referred to as the "Garron" case). In both cases, Canadian taxpayers implemented tax structures involving trusts settled in Barbados and sought to rely on the Canada-Barbados Income Tax Treaty (the "Barbados Treaty") to avoid paying tax on capital gains in Canada. In both cases, the Tax Court of Canada concluded that the steps taken were insufficient to realize this objective, and the taxpayers' further appeals to the Federal Court of Appeal were dismissed.
These cases provide important guidance on two fundamental issues that are critical to the success of any tax planning involving the use of a trust: (i) whether the trust is validly constituted and will be respected for tax purposes, and (ii) how the residence of the trust will be determined for tax purposes. In essence, these cases affirm the following broad principles:
- In order for a trust to be validly constituted, there must be certainty as to the intention to create a trust, certainty as to the subject-matter of the trust and certainty as to the object of the trust, and the trust property must in fact be transferred to the trustee.
- With respect to certainty of intention, the intention of the parties is determined by reference to all the facts, including the conduct of the parties and the terms of the relevant documents.
- Where parties to a transaction present it as being different from what they know it to be, this is sufficient for the transaction to be considered a "sham" and not respected for tax purposes.
- The residence of a trust is, for Canadian tax purposes, the place where the central management and control of the trust is actually exercised, which is not necessarily the place where the trustees reside.
In addition, in Garron the Federal Court of Appeal affirmed the notion that simple reliance on an exemption from tax afforded by one of Canada's tax treaties does not, in and of itself, constitute a misuse or abuse of that treaty for the purposes of the anti-avoidance rule contained in section 245 of the Income Tax Act (Canada) (the "Act").
Antle: Valid Constitution and Sham Trusts
In order to shelter the capital gain arising on the sale of shares in a private Canadian corporation to an arm's length Canadian purchaser, Mr. Antle employed what has been referred to as a "capital property step-up strategy". Pursuant to this strategy, Mr. Antle transferred his shares on a tax-deferred basis to a trust that had been settled in Barbados. Shortly afterwards, the trust sold the shares at fair market value to the trust's sole beneficiary, Mrs. Antle, who then sold the shares to the Canadian arm's length purchaser. The key to the strategy was that the gain on the sale of the shares was realized by the trust, which then sought to rely on an exemption from Canadian capital gains tax under the Barbados Treaty.
The Minister of National Revenue reassessed Mr. Antle on the primary basis that the trust had not been validly constituted. The Minister also took the position that even if the trust had been validly constituted, the arrangement was a sham and should not be respected for Canadian tax purposes. As a further alternative, the Minister took the position that the arrangement constituted abusive tax avoidance, and that any tax benefit otherwise available should be denied under the general anti-avoidance rule in section 245 of the Act.
At the Tax Court, Justice Campbell Miller found that Mr. Antle did not truly intend to settle the shares in trust with the trustee, and simply signed the requisite documents on the advice of his professional advisors with the expectation that by doing so he would avoid tax in Canada. Justice Miller further found that Mr. Antle never intended to relinquish control of the shares or the money resulting from the sale, and that he knew when he purported to settle the trust that nothing could or would derail the steps in the strategy. These findings were sufficient for the Tax Court to conclude that the trust was not validly constituted because it lacked certainty of intention and certainty of subject-matter.
On appeal, the Federal Court of Appeal agreed with the conclusion of the Tax Court that the trust had not been validly constituted. The Crown's sole attack against Justice Miller's conclusion in this regard was that it was based on circumstances external to the trust deed, which was otherwise clear and unambiguous. The Federal Court of Appeal dismissed this argument, and confirmed that courts are able to look to surrounding circumstances, including the conduct of the parties, in assessing whether the intent to settle a trust is present.
While not strictly necessary to decide the appeal, the Court also made a number of important observations concerning when an arrangement would be considered to be a sham, and therefore not recognized for tax purposes. The Court found that the trust constituted a sham on the basis that the trust deed did not reflect the true arrangement between the parties involved. Specifically, the parties to the arrangement knew with absolute certainty that the transactions would proceed as pre-ordained and that the trustee had no real discretion or control over the trust property. Significantly, the Court noted that the intent or state of mind required in order for there to be a sham need not go so far as to give rise to the common law tort of deceit. Further, there need not be criminal intent to deceive, as would be required in the context of a prosecution for criminal tax evasion. In order for there to be a sham, it suffices that the parties to a transaction present it as being different from what they know it to be. In this case, the Tax Court had determined that both the taxpayer and the trustee gave a false impression of the rights and obligations created between them; nothing more was required in order to hold that the trust was a sham.
With respect to the Minister's alternative position under the general anti-avoidance rule, at Tax Court Justice Miller expressed the view, in obiter, that the strategy was contrary to the Act's object, spirit, purpose and policy regarding the taxation of capital gains as well as contrary to the very essence of Canada's international tax conventions. The Federal Court of Appeal declined to comment on the applicability of the general anti-avoidance rule to the facts of this case.
Garron: The Residence of a Trust
This case involved a reorganization of the capital of a private Canadian operating corporation, the shares of which were indirectly held by Canadian individuals through two Canadian holding corporations. One of the primary objectives of the reorganization was to ensure that no Canadian tax would be payable on any future capital gain that could result from an increase in the value of the operating company. To accomplish this, the existing common shares of the operating company were exchanged for "freeze shares" redeemable for an amount equal to the fair market value of the existing common shares immediately before the reorganization took effect, and new common shares in the operating company were issued to two newly-formed Canadian resident holding corporations. Shares in these new holding corporations were then issued to trusts settled in Barbados. On the subsequent sale of the shares in the holding corporations to an arm's length purchaser, the taxpayer argued that the trusts were resident in Barbados and not in Canada, and that the substantial gains realized by the trusts were therefore not subject to Canadian tax by virtue of an exemption in the Barbados Treaty.
Unlike in the Antle case, the Minister did not pursue the position that the trusts were not validly constituted. Instead, the Crown's primary assertion was that the trusts were in fact resident in Canada on the basis that they were managed and controlled in Canada, and that the protection of the Barbados Treaty was therefore not available. The Crown took this position even though it did not dispute that the trustee of the trusts, St. Michael Trust Corp., was, in its own right and in relation to its own tax affairs, resident in Barbados and not in Canada. The Crown's alternative position was that even if the trusts were not resident in Canada, reliance on the Barbados Treaty in this manner would constitute abusive tax avoidance, such that the treaty benefit claimed by the taxpayers should in any event be denied under the general anti-avoidance rule in section 245 of the Act.
At the Tax Court, Justice Woods held that the residence of a trust for tax purposes is to be determined by applying a "central management and control test" similar to that applied in determining the residence of a corporation. Prior to this decision, it was generally accepted by the tax community that a trust is resident in the jurisdiction where a majority of its trustees reside or, in cases where the trust has only a single trustee, the jurisdiction where that trustee resides. This general rule was usually understood to be premised on the fact that the trustee is vested with the management and control of the trust property. Since this rule had never been conclusively upheld by a court to be a rule of invariable application, and since the Canada Revenue Agency has for many years expressed the view that management and control of a trust is an important factor in the residence determination, most tax professionals have generally been sensitive to this issue when advising clients regarding transactions involving offshore trusts.
The Federal Court of Appeal agreed with the conclusion of the Tax Court that a central management and control test should be applied in determining the residence of the trusts. In arriving at this conclusion, the Court noted that no case has conclusively rejected the central management and control test as an appropriate legal test for the residence of a trust in a situation where it was found, for example, that someone other than the trustee exercised management and control of the trust property, or that the trustee resided in one place but exercised the management and control of the trust property in another place. Accordingly, it may now be stated with authority that where a question arises as to the residence of a trust for Canadian tax purposes, it is appropriate to undertake a fact-driven analysis with a view to determining the place where the central management and control of the trust is actually exercised. As noted by the Federal Court of Appeal, this is consistent with the central theme of the jurisprudence on the determination of residence for tax purposes, which is that residence is fundamentally a question of fact.
The Federal Court of Appeal acknowledged that a line is to be drawn between, on the one hand, strong recommendations by the beneficiaries to the trustee, leaving the trustee free to decide how to exercise the powers and discretions under the trust, and on the other, where beneficiaries are really exercising the powers and discretions under the trust as regards its management and control. The Court cautioned that on which side of the line a case falls is a factual question, requiring consideration of the evidence in its totality. Therefore, while it should remain acceptable for the settler or beneficiaries to express their wishes, and even express them strongly, care should be taken to ensure that such expressions do not amount to directions that the trustee is expected to follow without question.
In this case, the Tax Court concluded, and the Federal Court of Appeal agreed, that the trustee did not exercise the main powers and discretion under the trust indentures. Rather, the trustee's true role was limited to executing documents as required and providing incidental administrative services. The trustee was not expected to have responsibility for decision-making beyond that. In fact, it was the Canadian resident beneficiaries who made the substantive decisions respecting the trusts, not the Barbados trustee. Accordingly, since management and control was exercised from Canada, the trusts were found to be resident in Canada for Canadian tax purposes.
The Federal Court of Appeal also expressed its views regarding the general anti-avoidance rule, which would have been relevant had it been determined that the trusts were not resident in Canada. In this regard, the Crown argued that the relevant provisions in the Barbados Treaty were designed to exempt only "true" non-residents from Canadian tax, that the Barbados Treaty was only intended to prevent double taxation and that the Barbados Treaty was not intended to permit the erosion of the Canadian tax base that could occur with the widespread use of this type of planning.
As in the Tax Court, the Federal Court of Appeal noted that the issue of whether the general anti-avoidance rule applies in this case turns on whether the series of transactions that would have resulted in the trusts becoming entitled to the treaty exemption is a misuse or abuse of the Barbados Treaty. The Federal Court of Appeal first observed that, in the Barbados Treaty, Canada has agreed not to tax certain capital gains realized by a person who is a resident of Barbados, and concluded that if the residence of the trusts is Barbados for treaty purposes, the trusts cannot misuse or abuse the Barbados Treaty by claiming the exemption. This approach is broadly consistent with that previously taken by the Federal Court of Appeal, and generally affirms it will be difficult for the Canada Revenue Agency to apply the general anti-avoidance rule to deny treaty benefits where there has been technical compliance with the applicable treaty provisions.