Current Cases- Part 3 JOHN SAUNDERS

Transcription

1 2012 BC Tax Conference Current Cases- Part 3 JOHN SAUNDERS First Published by the Canadian Tax Foundation in the 2012 British Columbia Conference Report (Toronto: Canadian Tax Foundation, September, 2012) - Delivered at the 2012 British Columbia Tax Conference September 24 and 25, Vancouver, BC

2 2 ST. MICHAEL TRUST CORP. (GARRON TRUST). 1 Introduction The main issue was whether capital gains realized by two Barbados trusts could be taxed by Canada because the trusts were resident in Canada. The Tax Court, FCA and SCC all held that they could on the basis that the test for tax residency was not where the majority of trustees resided but rather where central management and control was exercised. As a legal principle this seems fairly straightforward, but, practically speaking, it can make make the determination of the residency of a trust much more difficult. Moreover, there remains some uncertainty regarding whether "control" in the above context means control of the trust relationship versus control of the trust s property. Both the Tax Court and Federal Court of Appeal said (albeit in obiter dictum), that the Barbados Treaty would have trumped section 94 and the GAAR if the trusts had been resident in Barbados and the Tax Court said that the treaty would have trumped 75(2), a principle which the court in Sommerer agreed with. The Supreme Court of Canada neither approved nor disapproved of the Tax Court and FCA findings on these other issues. Nevertheless, the Department of Finance introduced draft amendments to the Income Tax Convention Interpretations Act whose effect will be to unilaterally amend Canada's tax treaties which do not have a specific provision allowing Canada to tax income with respect to trusts not resident in Canada. Facts The case involved two estate freezes of Canadian companies using Barbados trusts. The two freezes took place in 1998 at $50 million following a valuation by a qualified valuator at an accounting firm. One taxpayer rolled his common shares in Opco to a holding company; the other taxpayer s Opco shares were already owned by his holding company. Opco exchanged all of its common shares owned by the two holding companies for redeemable retractable preferred shares with a price adjustment clause and new non-voting common shares of Opco were issued to two newly incorporated Canadian holding companies, which then issued new common shares to the two Barbados trusts for a nominal amount. The trusts were fully discretionary trusts. The trustee was a Barbados trust company. Each freezor was a discretionary beneficiary of the trust for his family. Each trust was settled by a non-resident. Each trust provided for a "protector" who could replace the trustee. The protector of both trusts was a nonresident. The protector could be replaced by the adult beneficiaries. The trusts sold their shares two years and four months after the freeze, realized capital gains of more than $450 million and claimed an exemption from Canadian tax pursuant to the Barbados treaty. 1 Garron Family Trust v. The Queen 2009 DTC 1087(TCC), St. Michael Trust Corp., as Trustee of the Fundy Settlement and St. Michael Trust Corp., as Trustee of the Summersby Settlement (Appellants) v. Her Majesty the Queen (Respondent) 2010 DTC 5189 (FCA), St. Michael Trust Corp., as Trustee of the Fundy Settlement and St. Michael Trust Corp., as Trustee of the Summersby Settlement (Appellants) v. Her Majesty the Queen (Respondent) 2012 DTC 5063 (SCC).

3 3 Issues Each issue is discussed below followed by the finding of each court that considered that issue. Tax Residency of the Trusts Tax Court Decision On Residency The Tax Court Judge said that the relevant time to determine residency was when the shares were disposed of but, without explanation, went on to say: "[188] It is appropriate to consider the facts and circumstances at that time, but it is also useful to look at them over a longer period. I have placed little weight, though, on facts and circumstances after the assessments were issued." The Tax Court rejected the taxpayers argument that the residence of a trust should be determined as where the majority of trustees reside. under the 2 case; i.e. Instead, it held that the test was the same as for corporations; i.e. where the central management and control actually abides. In doing so, it also said: [180] It is difficult, and perhaps unwise, to express a definitive statement of principle based on judicial decisions on management and control, which are quite fact dependent. It is probably fair to conclude, however, that in order to find that management and control is located with shareholders, courts generally require something more than evidence of shareholder influence. (emphasis added). The Tax Court then proceeded to analyze the factual evidence before concluding that management and control of the trusts was located in Canada. It went through a laundry list of facts which pointed to central management and control abiding in Canada. The only witnesses who testified on the factual issue were the clients and the current president of the Barbados trust company. The Court said that the clients were self-interested and that the trust company president had very little knowledge of the trusts during the relevant period. Two tax specialist lawyers for the clients were mentioned in the context of their absence to give testimony on the factual issue. The Court said: "[215] There are many other individuals who could have shed light on this issue... " "[217] I am troubled that no further witnesses were called. It leaves me to infer that none of them would have provided evidence that was favorable to the appellants. [244] Based on the evidence as a whole (and the lack thereof), it is likely that the due diligence that St. Michael undertook was quite limited.. [262] in these appeals the appellants led very little evidence as to the formation and operation of the Trusts. In these circumstances, there is no basis for concluding that St. Michael did not agree to assume a limited role in the management of the Trusts. 2 See Nicholas Bayard Dill and James Appleby Pearman, both of the Parish of Pembroke, in the Islands of Bermuda, Trustees of the Thibodeau Family Trust (Plaintiffs) v. Her Majesty the Queen (Defendant) 78 DTC 6326 (FCTD)

4 4 FCA Decision On Residency The FCA agreed with the Tax Court on the residency issue: I conclude therefore that where a question arises as to the residence of a trust for 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. (emphasis added) The FCA reviewed the Tax Court Judge s factual laundry list before saying that some of the factors considered by her were common characteristics of ordinary trusts which, considered in isolation, would not have been sufficient to consider the management and control of the trust to have taken place in Canada. It described the fact that the beneficiaries had a right to appoint a protector who had the power to replace the trustee as a "common safeguard" which would not by itself be enough to find that the beneficiaries were "in control of the property of the Trusts", before saying: "[68] However, there is a line to be drawn. On one side of the line are recommendations, even strong ones, by the beneficiaries to the trustee, leaving the trustee free to decide how to exercise the powers and discretions under the trust. In that case, the trustee is still managing and controlling the trust. On the other side of the line the beneficiaries are really exercising the powers and discretions under the trusts, managing and controlling the trusts, and displacing the appointed trustee. As mentioned above, on which side of the line a case falls is a factual question, requiring consideration of the evidence in its totality." (emphasis added). SCC Decision On Residency The SCC agreed with the Tax Court and FCA on the residency issue: [15] As with corporations, residence of a trust should be determined by the principle that a trust resides for the purposes of the Act where its real business is carried on (De Beers, at p. 458), which is where the central management and control of the trust actually takes place (emphasis added). Section 94 Issue #1 - Had the Trusts Indirectly Acquired Property From Canadian Residents? Tax Court Decision On Section 94 Issue #1 The Crown submitted that the trusts were subject to section 94 because each had acquired property, directly or indirectly from a person resident in Canada; i.e. the Canadian resident freezors. The Minister argued that the fair market value of the shares at the time of the freeze was significantly more than $50 million and accordingly the freezors had transferred existing value and hence property to the trusts under the principle in the Kieboom 3 case, or, alternatively, that even if existing value had not been transferred the (future) "growth rights" in Opco had been transferred and that these "growth rights" were "property" under the principal in the Romkey 4 case. The taxpayers argued that "growth rights" are not property. 3 Her Majesty the Queen (Appellant and Respondent by Cross-Appeal) v. Albert Kieboom (Respondent and Appellant by Cross-Appeal) 92 DTC 6382(FCA). 4 Barry Romkey and Brian Romkey (Appellants) v. Her Majesty the Queen (Respondent) 2000 DTC 6047(FCA)

5 5 The Tax Court said that it was not necessary to consider the Romkey argument because existing value had been transferred and that, moreover, Romkey had left "some questions unanswered" in regard to the issue of whether a transfer of property, in the form of future growth rights, would occur where no existing value is transferred since the FCA in Romkey had "explicitly" deferred consideration of this issue. The Court dismissed the valuation testimony of the valuator who had done the $50 million valuation at the time of the freeze. I would also mention that I have concerns about the independence of Mr. Hatges in relation to his opinion. Mr. Hatges was with KPMG and/or KPMG Corporate Finance Inc. at all relevant times. KPMG had a significant business relationship with PMPL as PMPL s auditors in 1998, and the firm had also provided tax advice to Mr. Dunin and Mr. Garron. [92] A further concern is that in providing an opinion for purposes of these appeals, Mr. Hatges was essentially defending the valuation that he had previously prepared for PMPL to assist with the 1998 reorganization." The Tax Court found that the shares were worth significantly more than $50 million at the time the freeze and that although the preferred shares contained a price adjustment clause, the price had not been adjusted before the time of the sale. The Tax Court therefore concluded that there had been a transfer of property under the Kieboom principal. Regarding whether Romkey had held that "growth rights" were "property", the Court said that Romkey "leaves some questions unanswered in this regard" and that, in any event, it was not necessary to consider whether Romkey had extended the principal in Kieboom, because there had been a movement of value in this case. Nevertheless, the Tax Court said that neither of the freezors had directly or indirectly transferred property to the Barbados trusts. One of the freezors already owned his shares in Opco through a holding company; i.e. the freeze was directly done by this holding company and not by its shareholder, the freezor. The Court said if there was a transfer property, it was the holding company that made the transfer, not the freezor. The other freezor had owned his Opco shares personally before he rolled them to a new holding company, which then froze its interest in Opco by exchanging its Opco common shares for Opco preferred shares, after which a new holding company subscribed for Opco growth shares and his Barbados trust subscribed for shares in this new holding company. The Court said that the rollover by the freezor of his Opco shares to the first new holding company was a transfer of property by him, but that nevertheless the subscription for the post-freeze growth shares by the trust in the second new holding company was not an acquisition of property by the trust from him, notwithstanding the use of the words "directly or indirectly" in the provision. The Tax Court preferred a more restrictive interpretation of this phrase, given the uncertainty that would arise if the Minister s position were accepted since "determining ownership of property through a chain of corporations is a murky exercise with unclear results." FCA Decision On Section 94 Issue #1 The FCA disagreed with the Tax Court and held that the taxpayers had indirectly transferred property to the trusts.

6 6 [80] In my view, Parliament chose the words directly or indirectly in any manner whatever in paragraph 94(1)(b) deliberately to capture every possible means by which the wealth and income earning potential represented by the shares of a Canadian corporation can move to a non-resident trust from a Canadian resident beneficiary of the trust or a person related to that beneficiary. Section 94 Issue #2 - Would the Treaty Have Trumped Section 94? Tax Court Decision On Section 94 Issue #2 The Minister submitted that if the trusts had been resident in Barbados section 94 would have applied and the trusts would not have been entitled to the treaty exemption because section 94 deemed the trusts to be resident in Canada. The taxpayers argued that under the Crown Forest Industries Ltd. 5 principle, a person is not resident in Canada for purposes of a treaty unless the person is liable to Canadian taxation on its worldwide income and accordingly the treaty exemption would apply. The Tax Court agreed on the basis that the trusts were not liable to tax by virtue of section 94 in the same way as trusts resident in Canada under general principles. FCA Decision On Section 94 Issue #2 The FCA agreed with the reasoning of the Tax Court that if the trusts had been resident in Barbados and section 94 applied, they would nevertheless have been entitled to protection under the Barbados Treaty because section 94 did not deem them to be resident in Canada for all purposes. Would the Treaty Have Trumped Subsection 75(2)? Tax Court Decision on Whether Treaty Would Have Trumped Subsection 75(2) The Minister argued that if the trusts themselves were not subject to Canadian tax, the beneficiaries were pursuant to the attribution provision in subsection 75(2). The Tax Court said first that (notwithstanding the inclusion of the word "indirectly" in the provision), subsection 75(2) did not apply for the same reasons as section 94 did not apply (presumably because it felt that there had not been a direct or indirect transfer property to the trusts and hence they had not "received" property from the taxpayers). But it also said that if subsection 75(2) did apply, the provision in the Barbados treaty restricting the taxation of gains to only the contracting State of which the alienator was resident would have applied to exempt the beneficiaries from tax since otherwise the result would be incompatible with the primary objective of the treaty; ie to minimize double tax. [333] The Minister submits that the Treaty was not intended to have this result because it would result in Canada ceding its right to tax its own residents. [334] The question could be rephrased in the following manner. Did the Treaty's contracting states intend to reserve to themselves under Article XIV(4) a residual right to tax gains arising in the other contracting state? [335] I would have thought that the answer to this is no. [336] The interpretation suggested by the Minister is not compatible with one of the primary objectives of the Treaty which is to minimize the potential for double taxation. [337] The position of the Minister potentially frustrates this objective, and contravenes the plain meaning of Article XIV(4). 5 The Queen v. Crown Forest Industries Ltd., 95 DTC 5389 (SCC).

7 7 [338] I would also comment that the Treaty contains a specific override provision in reference to another attribution rule. Article XXX(2) provides an override in reference to the Canadian taxation of foreign accrual property income earned by non-resident corporations. If the drafters of the Treaty had intended an override for other attribution rules, they could have been specifically provided for it. FCA Decision On Whether Treaty Would Have Trumped subsection 75(2) The subsection 75(2) issue was not addressed in the FCA decision because the Crown did not cross appeal on this issue. Did the GAAR Trump the Treaty? The Minister argued the GAAR on the basis that the treaty had been abused. The taxpayers said there had been no misuse or abuse of the treaty. (The Minister also tried to argue that the structure had misused and abused subsection 75(2), but the Court would not consider this argument because the Minister had not raised it in his pleadings.) Tax Court Decision on Whether the GAAR Trumped the Treaty The Tax Court said that the Minister must identify an object, spirit or purpose of the provision that he was claiming had been abused. The Court cited MIL Investments 6, in particular this quote: "... The appellant urged us to look behind this textual compliance with the relevant provisions to find an object or purpose whose abuse would justify our departure from the plain words of the disposition. We aren't able to find such an object or purpose." The Tax Court said that it was not persuaded that the treaty had been misused or abused. It said: "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". The Tax Court said that the Minister's position was contrary to OECD commentary, which suggested that it was up to countries to amend their treaties to deal with perceived abuses. The Court said that the Minister's argument would result in a selective application of the treaty to residents of Barbados, depending on criteria other than residence and had the trusts been resident only in Barbados, the treaty contemplated that the exemption would apply to them." The Minister relied on RMM Canadian Enterprises 7 The Tax Court distanced itself from that case, noting that Judge Bowman himself had later distanced himself in Evans 8. The court underlined this portion of Boman s decision in Evans, where he commented on McNichol 9 and RMM : In any event, reference to these two early cases does not in my view satisfy the onus that the Supreme Court of Canada has placed on the Crown." 6 The Queen v. MIL (Investments) S.A., 2007 DTC 5437 (FCA), affirming 2006 DTC 3307 (TCC) 7 97 DTC 302(TCC) DTC 1762 (TCC) 9 97 DTC 111(TCC)

8 8 FCA Decision on Whether the GAAR Trumped the Treaty The FCA agreed with the Tax Court and said: "If the residence of the Trusts is Barbados for treaty purposes, the Trusts cannot misuse or abuse the Barbados Tax Treaty by claiming the exemption." TAXPAYER COMMENTS 1. This decision illustrates the risk of building a tax plan on the basis of a single case (Thibodeau) which was, at the time the plan was implemented, twenty years old. 2. The Tax Court Judge's comments dismissing the testimony of the KPMG valuator because KPMG had a business relationship with the taxpayers and because the valuator was testifying with respect to the valuation that he had done are troubling. Who better to testify on the valuation than the valuator who did it? What to make of the comment that there was concern with his testimony because he was "defending" his valuation? Does this mean that the testimony of any valuator with respect to a valuation done by him is to be discarded as being self-interested? Is the Court saying that taxpayers must get a second (retrospective) valuation? Is the Court saying that when estate freezes are done, clients should be referred to valuators in another firm? 3. The Tax Court Judge s comments regarding the fact that the lawyers who set up the plan did not testify are also troubling. If they had testified, would their testimony, like that of the valuator, also have been rejected as self-interested? What useful testimony could they have given when the issue was the factual ongoing administration of the trusts after they had been set up? Why would the Tax Court Judge think that they would have anything to do with the ongoing administration of the trusts? 4. The inability of the taxpayers to produce a knowledgeable representative of the Barbados trust company for the years in question was not helpful. As a practical matter, one should always consider that the ultimate success of a tax plan where factual issues will likely be in play may depend upon the availability for testimony of key individuals or employees a decade after the fact. These individuals may then be unable or unwilling (e.g. an employee who was subsequently fired) to testify. 5. Regarding the factual test of "management and control", what does "control" mean; i.e. control of the trust's assets or control of the trust? Individuals who fund trusts often want protection in the form of a power to fire the trustees. What effect will such a power have on "control", in the context of the residency of the trust and what effect does such a power have in other contexts? Control of the assets of the trust and control of the trust are not necessarily the same thing. The current trustees of a trust may control the assets of the trust by virtue of their legal but not beneficial ownership of those assets and the consequent ability to convey them, but ultimate de facto control may rest with another person who has the power to fire the trustees and hire replacement trustees. For example, the issue in the 1977 Robson Leather 10 case was whether two corporations dealt at arm s length. The shares of one of the corporations were owned by a trust, the shares of the other corporation were owned by Mr. Robson. The Crown argued that the arm's-length issue depended on whether Mr. Robson controlled that corporation. He was one of three trustees and the trust had no majority rule clause so trustee decisions required unanimity, but he had the power to replace trustees. The FCA agreed with this statement made by the FCTD: DTC 5106 (FCA)

9 9 In my opinion, however, in deciding the larger issue before me. I must look at the practical and business reality of the operation of the trust. By demanding retirement of trustees, or even the threat of such demand, or the knowledge in the co-trustees that the ultimate power was always in Mr. Robson, I have no doubt that Mr. Robson, for practical and legal purposes, controlled the trust and, therefore, controlled Robson Leather. I add the caveat here, that share control alone, (or absence of it), is not necessarily conclusive; it is a factor to be considered in determining questions of arm's length". (emphasis added). The FCA went on to say: On the whole of the evidence, therefore, the practical answer to the question as to whether or not the directing mind in the impugned transaction was the same person for both the vendor and purchaser is that it was. That person was Charles Robson by virtue of his de facto control of the trusts, the various corporations to which I have referred and of Lorenzen. For this reason I agree with the learned Trial Judge that the transaction of sale of the U.S. patent rights owned by Appel Process, to the Appellant was not at arms' length and the assessment of the Respondent was properly made. (emphasis added) It is unclear what the Tax Court Judge meant by "legal" control of the trust, but it is submitted that he could not have thereby meant that Mr. Robson had de jure control of the corporation whose shares it owned since this would have made the corporations related and therefore incapable of dealing at arm s length. 11 Mr. Robson had the right to replace trustees; he did not have the right to control how they voted. Nevertheless, based upon the reasoning in Robson Leather, a power to replace trustees held by a nonresident would likely constitute de facto control of the trust by the non-resident. thereby disqualifying a company whose shares were owned by the trust as a Canadian Controlled Private Corporation. Again, the FCA said in St Michael that the fact that the beneficiaries had a right to appoint a protector who had the power to replace the trustee was a "common safeguard" which would not by itself be enough to find that the beneficiaries were "in control of the property of the Trusts". Indeed, it is hard to see how a right to replace trustees would give an individual control of the property of a trust, as opposed to control of the trust. Nevertheless, such a power, if held by Canadian resident, would hardly buttress an argument that the trust in question was not resident in Canada. But what if the power could only be exercised after the end of any taxation year? Arguably (unless exercised) the power would be irrelevant to the determination of the residency of the trust or CCPC status in any particular taxation year. There are many situations where the residency of a trust will be important. Consider a trust with nonresident beneficiaries, two Canadian resident trustees and a non-resident beneficiary or protector with the power to the replace trustees. The 21 year deemed disposition date is approaching. The trust owns 100% of the shares of Canco which has various assets, including some Canadian real estate. It is a close call whether, on the deemed disposition date it could be said that at any particular time in the 60 preceding months more than 50% of the value of Canco's shares was attributable to the Canadian real estate; i.e. it is a close call whether on the deemed disposition date Canco's shares will be Taxable 11 See subsections 251(1) and (2). See also Duha Printers (Western) Ltd. (Appellant) v. Her Majesty the Queen (Respondent) 98 DTC 6334(SCC)

10 10 Canadian Property to the trust. If the trust is resident in Canada the Canco shares could only be transferred out to a non-resident beneficiary prior to the 21 year deemed disposition date on a taxable basis. A subsection 220(4.6) election could be made to post security for the taxes payable until an actual disposition if the Canco shares were TCP, but if the shares were not TCP the selection would not be available. 12 However if the shares were not TCP and the trust was not resident in Canada, the deemed disposition would not trigger any Canadian taxes. 6. Notably, the Tax Court said that rather than deciding that (future) growth rights constituted property, Romkey had explicitly deferred consideration of this issue. If giving away future growth rights (the essence of every estate freeze) does constitute a transfer of property, a property transfer would occur in every estate freeze even if no existing growth had been transferred to the trust in the course of the freeze (because the freezor received preferred shares equal to the fair market value of the common shares at the time of the freeze). 13 In Kieboom, existing value was transferred. In Romkey it wasn t. Romkey quoted this passage from Kieboom: By this transfer of property to his wife, he [the taxpayer] divested himself of certain rights to receive dividends should they be declared. Hence, when the dividends were paid to the wife in 1982, that was income from the transferred property and was rightly attributable to the taxpayer (emphasis added) Unfortunately, Romkey then went on to say: [18] It thus appears that a transfer of property had been accomplished by the taxpayer in two different ways: in the form of "a portion of the [taxpayer's] ownership of equity in his company" and by divestiture "of certain rights to receive dividends should they be declared. With respect, this appears to be an incorrect interpretation of the above passage from Kieboom. "This" transfer of property in the Kieboom passage appears to refer to the transfer of existing value. The Kieboom passage does not say that divesting oneself of rights to receive dividends should they be declared is itself a transfer property; rather it merely says that a transfer of property will occur where other shareholders subscribe for shares for less than their fair market value so that when dividends are declared on the new shares the dividends will be income from that transferred property. A right to receive dividends if they are declared is arguably not a present chose in action capable of being "transferred". It is the writer's view that the FCA decision in Romkey is troubling because parts of the decision are logically inconsistent with the rest of the decision. CRA has said that despite Romkey, "subsection 74.1(2) will generally not apply to attribute, to a freezor, dividends paid on shares held by a trust for minor children as part of a typical estate freeze, provided that the shares held by the trust are issued for an amount equal to their fair market value and are paid for with funds that are not obtained from the freezor" 14 (the Kiddie Tax may apply). But if in fact Romkey is right, then CRA is deliberately ignoring the application of this provision. It is the writer's view that CRA should either cease attempting to apply Romkey selectively and instead decide whether to completely disavow it or not. 12 see Ronda Rudick "New TCP Definition: 21-Year Trust Rule" 2010 Canadian Tax Highlights 18 (7) p. 7/8. 13 If Romkey does stand for this, then income splitting with a spouse would be caught notwithstanding the deliberate exclusion from subsection 74.4(2) for property transfers to corporations which are (and remain) Small Business Corporations and 74.4(2) and the Kiddie Tax could apply simultaneously. 14 Document # "Romkey Estate Freeze".May 8, 2001

11 11 7. The Tax Court said that if the trust had been resident in Barbados the treaty would have trumped subsection 75(2), section 94 and the GAAR. The FCA said that the treaty would have trumped section 94 (even though it said that there had been a transfer of property to the trusts) and the GAAR. Again, the Supreme Court of Canada neither approved nor disapproved of the Tax Court and FCA findings on these issues, but the reasoning of the Tax Court and FCA is persuasive. In short, if the trusts had been resident in Barbados, according to the Tax Court and the FCA, the plan would have worked. 15 The FCA in Sommerer (see below) agreed (again in obiter dictum) that 75(2) (had it applied) would not have trumped the Austrian Treaty. Like the Barbados Treaty, the Austrian Treaty did not have a specific exemption allowing Canada to tax income of trusts. Again, this is obiter dictum, but in the writer s view the reasoning is persuasive. These treaties, unlike some treaties, did not contain specific exceptions that would have allowed Canada to tax Canadian resident beneficiaries with respect to the income of a trust resident in the other contracting State. If a taxpayer cannot benefit from the protection of a treaty provision afforded to residents of a contracting state unless the taxpayer is taxable on his worldwide income by that state, it is not logical to argue that taxpayers who are not taxable on their worldwide income by a contracting state are nevertheless taxable by that state notwithstanding a specific provision to the contrary contained in a treaty which that state has with another country. 8. Note that in Howson, 16 the issue was whether an amount received by a trust was a contribution or a loan. The Crown conceded that if the amount had been a loan, subsection 75(2) would not have applied, but it argued that the amount was a contribution. Nevertheless, again in obiter dictum, the Court said that a loan would not be caught by subsection 75(2). Interestingly, the provision makes no reference to a loan, but is written in terms of by the Trust property is held on condition it may revert, etc. It stands to reason that a bona fide loan is, on its face, not subject to reversion by the terms of the Trust. It returns to the lender by operation of the loan itself and the law of creditor rights. 9. If the Tax Court and FCA in Garron and Sommerer are right, without changes to Canada's tax treaties which do not contain an exception to the general provision the trusts may only be taxed in the contracting state in which they are resident, a Canadian resident taxpayer could settle a discretionary trust for himself and his family which is factually resident in a country with which Canada has a tax treaty and which taxes trusts on their worldwide income 17 (but at a lower rate than the rate that would be payable if the trust resided in Canada), without fearing exposure to section 94, subsection 75(2) or the GAAR. The Department of Finance therefore proposed a unilateral override to these treaties. Draft legislation released August 27, 2010 proposed to add section 4.3 to the Income Tax Conventions Interpretation Act as follows, applicable after March 4, "Application of section 94 of the Income Tax Act 15 CRA did not assess a capital gain when the freeze was done under paragraph 85(1)(e.2) or paragraph 86(2)(c) on the basis that the freezors preferred shares were not worth the value of the frozen common shares. As the FCA held that there had been a transfer property, these provisions could have caught the transfer of value at the time the freeze was done. 16 Jean Howson (Appellant) v. Her Majesty the Queen (Respondent) 2007 DTC For a discussion of how the Crown Forest case may impact eligibility for treaty protection with respect to treaties other than the Canada-US Convention, see Barrie Philip "Choosing the Most Effective Foreign Tax Jurisdiction for Canadian Residents", Canadian Tax Foundation, 1997 British Columbia Tax Conference.

12 12 Notwithstanding the provisions of a convention or the Act giving the convention the force of law in Canada, if a trust is deemed by subsection 94(3) of the Income Tax Act to be resident in Canada for a taxation year for the purposes of computing its income, the trust is deemed to be a resident of Canada, and not a resident of the other contracting state, for the purposes of applying the convention (a) in respect of the trust for that taxation year; and (b) in respect of any other person for any period that includes all or part of that taxation year. The Explanatory Notes say: The Income Tax Conventions Interpretation Act contains rules that govern the interpretation of certain provisions of the tax treaties concluded by Canada. It is important that the treaties be applied consistently and in conformity with the intentions of Canada and its treaty partners. To make consistent application easier, the Income Tax Conventions Interpretation Act sets out a number of interpretive rules and definitions. The Income Tax Conventions Interpretation Act is amended to add new section 4.3. New section 4.3 clarifies that the law of Canada is such that, notwithstanding the provisions of a convention or the Act giving the convention the force of law in Canada, a trust that is deemed resident in Canada under new subsection 94(3) of the Income Tax Act will be a resident of Canada and not a resident of the other contracting state for the purposes of applying the convention. This amendment is intended to ensure consistent application of Canada's treaties and in a way that conforms to a principal objective of Canada's tax treaties, namely of preventing tax avoidance and tax evasion." In the writer's view, when a contracting state unilaterally overrides a contractual provision in a treaty with another contracting state to tax income despite the treaty, it takes chutzpah to describe the purpose as being to make the interpretation of the treaty "easier" and "in conformity with the intentions of its treaty partners while at the same time making no reference to the fact that a primary purpose of tax treaties is to prevent double taxation. This purpose, in cases where the other contracting state would also levy taxes on the trust s income (because the trust was factually resident in that state) could be defeated unless the other contracting state voluntarily abandoned its jurisdiction to tax the trust, although Finance would probably argue that as long as Canada allows a full credit for taxes paid in the other contracting state there would be no double taxation. However it is possible that taxes might be payable in the two states by different taxpayers (e.g. the trust in one state and its beneficiaries in another state) in which case if double taxation means juridical double taxation (i.e. taxation on the same income by the same taxpayers) there would be no double taxation whereas if double taxation means economic double taxation (i.e. taxation on the same income by different taxpayers), there would be. It appears that this issue is unresolved; see the following discussion of the Sommerer case. If a treaty partner does not challenge this, can a Canadian resident taxpayer? A discussion of this topic is beyond the scope of this paper. For a brief discussion, see "Unilateral Treaty Override" in the October 2010 issue of Canadian Tax Highlights Phil Halvorson "Unilateral Treaty Override", volume 18, number 10, October 2010, Canadian Tax Foundation.

13 13 SOMMERER 19 Sommerer was handed down by the Federal Court of Appeal on July 13. The deadline for filing a leave application to the Supreme Court of Canada expires on October 1. Issues The main issue was whether 75(2) applied to attribute gains (in this case realized by a non-resident trust) on property that had been sold to the trust for fair market value by a Canadian resident beneficiary. More interesting issues were whether, if subsection 75(2) had applied, it would have trumped the Austrian Treaty and whether "double taxation" in the treaty context means juridical double taxation; i.e. taxation by two jurisdictions of the same gain in the hands of the same taxpayer, or economic double taxation; i.e. taxation by two jurisdictions of the same gain in the hands of two different taxpayers. Decision Did subsection 75(2) apply to attribute gains realized by a trust on property purchased by it for fair market value? The Court held that it didn't.it's decision is summarized in these two paragraphs: "[48] Subsection 75(2) must be interpreted and applied to give effect to its language, read in its proper context and with a view to giving effect to its intended purpose. As mentioned above, subsection 75(2) generally is intended to ensure that a taxpayer cannot avoid the income tax consequences of the use or disposition of property by transferring it to another person in trust while retaining a right of reversion or a right of disposition with respect to the property or property for which it may be substituted. A common example of the application of subsection 75(2) is the settlement of a trust where the settlor is also a beneficiary with an immediate or contingent right to a distribution of the trust property. In that situation, and in many other situations contemplated by paragraphs 75(2)(a) and (b), subsection 75(2) achieves its intended purpose. [49] In this case, the Crown contends that the application of subsection 75(2) applies also in respect of property that has been purchased by a trustee from a beneficiary at fair market value and held subject to the terms of the trust. In my view, to interpret subsection 75(2) so that it could apply to a beneficiary in respect of property that the trust acquired from the beneficiary in a bona fide sale transaction leads to outcomes that are absurd and could not have been intended by Parliament." 19 Sommerer v. R.2011 D.T.C (TCC), 2012 FCA 207

14 14 Did 75(2) Trump The Treaty? Does double taxation means juridical double taxation or economic double taxation? First, the FCA said that even if subsection 75(2) had applied,, Canada would be precluded from taxing the Canadian resident beneficiary on attributed gains under the particular treaty in question (the Austria treaty) because Article XIII(5) provided (with certain exceptions) that gains from the alienation of property can only be taxed in the contracting state in which the alienator (in this case the Austrian resident trust) resided. The Crown had argued that although the trust was eligible for treaty protection as an Austrian resident, the Canadian resident beneficiary to whom it was seeking to attribute the trust's income was not entitled to treaty protection because he was not resident in Austria. The FCA agreed with the Tax Court decision that this was not a logical interpretation of the treaty because the treaty specifically reserved the right to tax section 91 FAPI, but it did not reserve the right to tax subsection 75(2) attributed trust income, whereas 56 of Canada's 88 treaties did have a specific provision allowing Canada to tax income with respect to a trust. Accordingly, the trust, as an Austrian resident was the relevant taxpayer for treaty protection purposes. The taxpayer's second argument on the Treaty issue was that taxing an attributed gain in the hands of the Canadian resident beneficiary would result in economic double taxation because the gain would also be taxed in the hands of the trust by Austria and that this would thwart one of the purposes of the treaty, which was to avoid double taxation. This argument was also made in the Tax Court. The Crown had countered in the Tax Court by arguing that Article XIII (5) only applied to protect juridical double taxation; i.e. taxation by two jurisdictions of the same gain in the hands of the same taxpayer, but that it did not apply to economic double taxation; i.e. taxation by two jurisdictions of the same gain in the hands of two different taxpayers. The Tax Court Judge did not address the juridical versus economic double taxation issue; indeed, he made a point of saying that he wouldn't go there: "This could lead to a discussion worthy of an extensive paper, but it is not a path that I feel I need to go down." The FCA was not deterred by the Tax Court Judge's caution. In two paragraphs, the FCA suggested that the purpose of the treaty was to avoid economic double taxation. Curiously, it said that it was following the approach of the Tax Court Judge on this issue! "The OECD model conventions, including the Canada-Austria Income Tax Convention, generally have two purposes the avoidance of double taxation and the prevention of fiscal evasion. Article XIII (5) of the Canada-Austria Income Tax Convention speaks only to the avoidance of double taxation. Double taxation may mean either juridical double taxation (for example, imposing on a person Canadian and foreign tax on the same income) or economic double taxation (for example, imposing Canadian tax on a Canadian taxpayer for the attributed income of a foreign taxpayer, where the economic burden of foreign tax on that income is also borne indirectly by the Canadian taxpayer). By definition, an attribution rule may be expected to result only in economic double taxation. [67] The Crown s argument requires the interpretation of a specific income tax convention to be approached on the basis of a premise that excludes, from the outset, the notion that the convention is not intended to avoid economic double taxation. That approach was rejected by Justice Miller, correctly in my view. There is considerable merit in the opinion of Klaus Vogel, who says that the meaning of double taxation in a particular income tax convention is a matter that must be determined on the basis of an interpretation of that convention (Klaus Vogel on Double Taxation Conventions: A Commentary to the OECD

15 15, UN, and US Model Conventions for the Avoidance of Double Taxation on Income and Capital, 3rd ed. (The Hague: Kluweer Law International, 1997))." TAXPAYER COMMENTS 1. The FCA s obiter dicta on the treaty issue is consistent with the obiter dicta of the Tax Court Judge in Garron, who said that if the trust in that case had been resident in Barbados, a plain reading of the treaty in question would have resulted in treaty protection of subsection 75(2) attributed gains. The Tax Court Judge in Garron also went on to say that the Crown's suggested interpretation of the treaty "is not compatible with one of the primary objectives of the Treaty, which is to minimize the potential for double taxation". There was no discussion in Garron of whether double taxation in the treaty context means juridical double taxation or economic double taxation and this issue was not addressed by the FCA or the SCC when Garron was appealed. But there is previous case law on this issue which said that double taxation means juridical double taxation rather than economic double taxation. In Cudd Pressure 20 the FCA said: "The main purpose of the OECD Convention is to provide a means of uniformly settling the most common problems which arise in the field of international juridical double taxation". In Scott Jones and Ascot Enterprises 21 the FCA said (in the context of a domestic subsection 56(2) reassessment) : I do not agree with counsel that to apply subsection 56(2) would lead to double taxation. Double taxation exists where a single payment is taxed twice in the hands of the same taxpayer. See Perrault v. R., [1978] C.T.C. 395, 78 D.T.C (F.C.A.). Here, the benefit would be taxed once in the hands of Ascot pursuant to subparagraph 69(1)(b)(i) and once in the hands of the applicant pursuant to subsection 56(2). Only one year ago, the Tax Court Judge in Studer (not the same Judge 22 as in Garron) said: The purpose of these provisions is to avoid juridical double taxation, referring to circumstances in which a taxpayer is liable for tax on the same amount in more than one jurisdiction. To take advantage of the tax relief provided in the treaty provision a taxpayer must be able to show that he has had to pay tax on the same amount in the two jurisdictions subject to the treaty." It is discouraging that neither Sommerer or Garron referred to any of these cases. This is an important issue, and not just in the treaty context. For example, see the discussion of Finance's unilateral treaty override regarding section 94. Moreover, if double taxation's means juridical double taxation and the Crown's interpretation of Romkey is correct, taxes on income attributed to a parent under subsection 74.3 and the Kiddie Tax would not be double taxation DTC DTC DTC 1248

16 16 MACDONALD 23 (under appeal to the FCA) Introduction This case involved the sale of the shares of a company whose only assets were cash and near cash. The purchaser was the brother-in-law of the vendor. Depending upon one's viewpoint, this was simply a share sale resulting in capital gains to the vendor or a dividend strip. The Tax Court viewed it as a simple share sale. The Tax Court decision is under appeal. Facts The taxpayer was going to become a resident of the United States. Absent pre-emigration planning, this would have produced a deemed disposition of the shares of a medical company which he owned ("PC"), without a commensurate increase in the basis of the shares for US tax purposes. PC's assets were converted to cash, accounts receivable and accounts payable. The taxpayer was advised to sell his shares to an arm's length purchaser but that proved impossible. The taxpayer sold his shares to his brother-in-law for $10,000 less than the book value of its assets in return for a non-interest-bearing promissory note. The brother-in-law then transferred the PC shares to a holding company that he had incorporated ("Holdco") in return for a Holdco promissory note. Holdco then caused PC to pay it dividends which Holdco used to pay off the note that it had given to the brother-in-law by paying off the note that the brother-in-law owed to the taxpayer (evidenced by endorsing checks and appropriate journal entries). The taxpayer sheltered the gain on the sale of his PC shares with available capital losses. When the dust settled, Holdco retained $10,000. The taxpayer admitted that the sale of the PC shares by the taxpayer to his brother-in-law was a nonarms length transaction 24 Issues The Minister included the sale proceeds in the taxpayer's income as a dividend, either under subsection 84(2) as funds or property of a corporation that had been "distributed or otherwise appropriated in any manner whatever to or for the benefit of the shareholders on the winding up, discontinuance or reorganization of its business" or, failing that, pursuant to the GAAR, on the theory that subsection 84(2) evidenced a policy intent that it was abusive to extract corporate surplus by capital gains rather than dividends. The Crown also argued that it was abusive to utilize the taxpayer's available capital losses in this manner but the Court found this argument "bizarre" given that if the taxpayer had done nothing the capital gains triggered on the deemed disposition from going non-resident would have enabled him to use the losses. 23 Dr. Robert G. MacDonald (Appellant) v. Her Majesty the Queen (Respondent) 2012 DTC It is unclear why this was described as an admission since it was impossible for the them to deal with arms length - see paragraph 251(1)(a), paragraph 251(2)(a) and paragraph 251(6)(b).

17 17 Decision The Tax Court said that although the taxpayer and his brother did not deal at arm's length, there was no suggestion that the terms of their agreement would have differed if they had dealt at arm s length. The Court held that subsection 84(2) did not apply because the taxpayer was no longer a shareholder when he received the funds: rather he received the funds as a creditor. This is the same reasoning as that of the Tax Court in Geransky. 25 The Court also held that that the GAAR did not apply because subsection 84(2) did not evidence a policy intent that "dividend stripping" was per se abusive (thereby disagreeing with McNichol) 26. The following quotes from the judgment addressed the issue of whether dividend stripping is per se abusive: "[101] The GAAR analysis will only be complete, in my view, if I address the Respondent's underlying concern in this appeal head-on, namely the issue of surplus stripping per se. I will deal with that concern, under a separate "abuse" heading where I have concluded that it is doubtful whether in an integrated corporate/shareholder tax system, a surplus strip per se can be said to abuse the spirit and object of the Act read as a whole. [128] Insisting that the maintenance of a dividend regime per se is required to maintain the integrity of the scheme of the Act in the context of the distribution of retained earnings on a winding up or discontinuance of a business, requires that subsection 84(2) be found to operate beyond its express language. I have found to the contrary. That sits well, in my view. A proper reading of the subject provisions dictates only one approach: find the abusive benefit and look to GAAR to maintain the integrity of the scheme of the Act in the context of the distribution of retained earnings on a winding up or discontinuance of a business. [129] While that should be the end of the matter, there is another aspect of the anti-surplus stripping position, which is at the heart of the Minister's concern with the instant appeal, that I feel compelled to address. [I30] The reality in this case is that aside from the Appellant's use of losses, the tax on capital gains in New Brunswick in 2002 differed considerably compared to the tax on dividends. Indeed, in the case of a privately-held corporation, like PC, the lack of integration, at the time the subject transactions were undertaken, favored capital gain treatment by some nine percent in New Brunswick relative to the tax on a dividend of the same amount. The question could arise then as to whether a surplus strip per se can be abusive just because it frustrates the operation of two very different tax regimes. [I31] That might invite a different approach as to how GAAR needs to operate or a different construction of subsection 84(2). In my view, any such change in approach would be wholly unwarranted. [132] The tax avoidance and tax benefit resulting from a lack of integration in this case is systemic. There is no unintended tax slippage in this sense, and in such circumstances GAAR 25 Dennis Geransky (Appellant) v. Her Majesty the Queen (Respondent) 2001 DTC 243(TCC) at paragraph DTC 111 (TCC)