Offshore trusts under attack

By Jennifer Smith
Illustration: Mike Constable

As the CRA challenges offshore trusts, many cases and appeals are working their way through the judicial system

In the Canadian context, the expression “offshore trust” generally denotes a trust whose primary beneficiaries are resident in Canada and a trust that has been formed under and subject to the laws of another country, usually a low-tax jurisdiction. Both the Department of Finance and the Canada Revenue Agency (CRA) have taken steps to prevent the use of such trusts to defer or eliminate Canadian income tax. Finance has developed proposed tightening amendments to the non-resident trust rules in Sec. 94 of the Income Tax Act and is negotiating tax information exchange agreements with a number of jurisdictions. The CRA has attacked offshore trusts using a variety of approaches, including the general anti-avoidance rule (GAAR). These complex cases are beginning to work their way through the judicial system, and so far the CRA is ahead, 2:1. The cases are of interest not only because of their impact on offshore trust arrangements but also because of the myriad of legal issues they address.

In Garron et al v. The Queen, 2009 TCC 450, the Tax Court of Canada held that the trusts in question were not resident in Barbados because their “central management and control” was in Canada, even though the trustee for both was resident in Barbados. As a result of this decision, two Barbadian trusts were denied the exemption provided in Article XIV(4) of the Canada-Barbados Treaty.

This case involved a typical offshore freeze. While Barbados is not a low-tax jurisdiction per se, it does not impose tax on capital gains realized by Barbadian residents. This fact, in combination with the treaty exemption, has made Barbados an attractive jurisdiction for offshore freeze transactions. The CRA has listed Barbadian freeze transactions on its items under review for the potential application of GAAR. However, GAAR was just one of several grounds of assessment in the Garron case, and did not form the basis of the decision.

In 1998, the owners of common shares of PMPL Holdings Inc., a Canadian corporation, converted their shares to fixed value preference, or freeze shares, with a redemption amount of $50 million. Two trusts with Canadian resident beneficiaries were settled by an individual resident in St. Vincent. The sole trustee of each trust was a corporation resident in Barbados. The trusts subscribed for shares of newly incorporated Canadian holding corporations, making them wholly owned. These corporations then subscribed for common shares of PMPL for nominal consideration, no doubt on the basis that the freeze shares represented the then current fair market value of PMPL.

Two years later, in 2000, the trusts disposed of most of the shares in the holding companies in an arm’s-length sale, realizing capital gains of more than $450 million. The trusts claimed the exemption in Article XIV(4) of the treaty, which provides that only the contracting state of which the vendor is a resident has the right to tax gains from the sale of certain property. This would mean that if the trusts were resident in Barbados, there would be no tax on the realized capital gain in either Canada or Barbados.

The Minister took the position that the treaty exemption did not apply and issued assessments to each of the trusts in respect of the gains. In addition to assessing the trusts, the Minister also assessed the preferred shareholders of PMPL (the other appellants) with respect to the same gains pursuant to subsection 75(2) of the Income Tax Act. These latter assessments were a protective measure only, there being no intent to tax the same gains more than once. The Minister based his assessments on the following alternative arguments: (i) the trusts were resident in Canada under general principles; (ii) the trusts were resident in Canada by virtue of Sec. 94 of the act; (iii) subsection 75(2) of the act applied to the other appellants; (iv) the GAAR applied; and (v) the sale proceeds should be reallocated from the trusts to the other appellants by virtue of section 68 of the act.

The tax court judge, Justice Woods held that the exemption in Article XIV(4) of the treaty did not apply because the trusts were resident in Canada. Although the corporate trustee of each trust was acknowledged to be a resident of Barbados, Judge Woods concluded that the central management and control of each trust was in Canada based on the evidence as a whole. She found that the corporate trustee’s role was limited to executing documents as required, and providing incidental administrative services. It was not expected to have responsibility for decision-making beyond that. In her view, “more likely than not,” the corporate trustee had agreed from the outset that it would defer to the recommendations of the Canadian principals. Among the many factors that the judge considered relevant was the fact that each Canadian principal (with his wife) had the power to replace the trust’s “protector,” the person who had the power to replace the corporate trustee.

This conclusion must be contrasted with the long-standing decision in Thibodeau Family Trust v. The Queen, 78 DTC 6376, where the Federal Court found that the residence for tax purposes of the trust was in Bermuda, on the basis that the majority of the trustees were resident in Bermuda and the trust document provided for majority decision-making on all matters involving trustee discretion. Judge Gibson’s obiter in Thibodeau appeared to reject the central management and control test on the basis that the fiduciary duties imposed upon trustees would not permit them to take direction from a third party.

Judge Woods found the Thibodeau decision to be insufficient authority for rejecting a central management and control test to determine trust residence. In her view, “adopting a similar test of residence for trusts and corporations promotes the important principles of consistency, predictability and fairness in the application of tax law” (Para. 160). This aspect of the decision is bound to be somewhat controversial, and could well form the basis of the appeal to the Federal Court of Appeal.

The decision that the trusts were resident in Canada was sufficient to dispose of the appeals, but Judge Woods went on to address some other issues raised. For purposes of this article, space permits us only to summarize her conclusions:

Sec. 94 did not apply to deem the trusts to be resident in Canada, since the trusts did not “directly or indirectly” acquire property from the Canadian principals. However, even if Sec. 94 had applied, this would not have affected the availability of the treaty exemption if the trusts were resident in Barbados. The test of residence in the treaty requires that the person or entity claiming treaty benefits be “fully taxable” in the residence country (see Queen v. Crown Forest Industries Ltd., 95 DTC 5389 (SCC)). Sec. 94 only applies to income from certain sources and does not make the trusts “fully taxable” in Canada.

Subsection 75(2) is an attribution provision that is applicable to reversionary trusts. It was held not to apply because there was no “acquisition of property” from the Canadian principals. Further, the exemption in Article XIV(4) takes precedence over the application of subsection 75(2).

With respect to the application of GAAR, the existence of a tax benefit and an avoidance transaction were conceded, so the only question was whether there was a misuse or abuse within the meaning of subsection 245(4). The Minister submitted that it was an abuse of the treaty to use the exemption in Article XIV(4) to avoid an anti-avoidance rule such as Sec. 94. Judge Wood disagreed, stating this approach would be contrary to that suggested by the Federal Court of Appeal in The Queen v. MIL (Investments) S.A., 2007 DTC 5437. “It does not make sense that a transaction that is subject to tax under the Act by virtue of an anti-avoidance provision necessarily constitutes a misuse or abuse of the Treaty” (Para. 373). If it had been intended that Sec. 94 should override the treaty, this should have been specifically mentioned in the treaty.

The Minister submitted that Sec. 68 should be applied to reallocate a portion of the sale proceeds to the other appellants, because the fair market value of the shares of PMPL at the time of the freeze was substantially greater than the value attributed to them. However, Judge Woods did not address the quantum that should have been allocated to the other appellants, stating that “in all the circumstances it would be preferable to defer a consideration of section 68 for another day” (Para. 399).

The final result is that the appeals of the trusts were dismissed and the appeals of the other appellants were allowed. The case is again being appealed.

Other recent offshore trust decisions
There are two other recent offshore trust decisions both of which are under appeal. In Antle et al v. The Queen, 2009 DTC 1305 the CRA successfully challenged a spousal trust arrangement whereby property was transferred by the taxpayer to a Barbados spousal trust tax-free and sold back to the taxpayer’s Canadian spouse in order to create a bump in the cost of capital property, relying on the capital gain exemption in the treaty. The tax court found that there was no validly constituted trust, and that, in any event, GAAR applied to the series of transactions undertaken by the taxpayers.

In the case of Morris et al v. MNR, 2009 DTC 5127, the Federal Court considered the withholding tax requirements under section 116 and came to the conclusion that when no tax is owed because of a tax treaty, the CRA has no discretion to refuse to issue a clearance certificate. In reaching this result, Justice Simpson concluded that the trust in that case was resident only in Barbados. In her view (at para. 38), a finding of dual residence “must be based on actual physical factors and there are no such factors linking the Barbados Trust to Canada.”

Conclusion
We can expect to see more offshore trust cases in the coming years, as well as appeals from the cases that have already been decided. These cases address a number of tax and legal principles, so their ultimate outcomes will be important to follow. For example, if the Garron decision is upheld, it will be necessary to examine, in each case, where the central management and control of a trust is exercised. This could prove to be an impediment to the use of trusts as tools in international and interprovincial tax planning. In addition, if the tax court’s interpretation of Crown Forest is correct, Finance’s proposed amendments to Sec. 94 will not be entirely effective.

Jennifer Smith, LLB, is an executive director in the Ottawa tax practice with Ernst & Young LLP. She can be reached at jennifer.j.smith@ca.ey.com

Technical editor: Trent Henry, tax managing partner, Ernst & Young