Canada’s pursuit of afflu-ent taxpayers, like many other countries, allows Canadian tax authorities to reach into offshore trusts. Such trusts are often used to avoid domestic taxes, but in recent years, the Canada Revenue Agency has become more aggressive about attacking these arrangements, often successfully. However, a recent decision from the Tax Court of Canada suggests that careful drafting and attention to timing can do much to avoid the reach of the CRA in these cases.
The decision is of interest to financial advisors and tax planning specialists because it suggests that rules in the Income Tax Act that “attribute” amounts in these trusts back to the taxpayer are narrower than had been thought in the past. In other words, it may be much easier to shelter assets in these trusts.
The case has attracted wide comment within the tax community and has been appealed to the Federal Court of Appeal by the CRA. Christopher Falk, partner in the Vancouver office of McCarthy Tétrault LLP, notes that if the decision is not overruled at some point, tax planners who are setting up foreign structures should do so in a way that is sensitive to the analysis of trusts and the attribution rules in the case.
The decision deals with the affairs of Peter Sommerer, an Austrian national who moved to Canada in 1978 with his family and became a Canadian resident. The decision of Tax Court justice Campbell Miller describes Sommerer as “one of those energetic individuals whose mind is so full of business ideas, specifically connected to the hi-tech industry, that he cannot seem to actuate them fast enough. He left me with the impression of someone who cannot sit still for long, evidenced by standing throughout his three-and-a-half days of testimony. He sees one project up and going and is on to the next, be it a business venture or a PhD.”
Sommerer had been a prime mover in some of Canada’s most successful technology companies during the past two decades, including Mitel Corp. and Newbridge Networks Corp. As a result of those activities, the value of his shares in those companies, which were eventually sold to Nokia Corp. and Nortel Networks Corp. (both sales took place in December 1998), rose sharply within a short period.
Sommerer’s dispute with the CRA is over how the resulting capital gains should be taxed. That dispute centres on the nature of an entity created in Austria in 1996 by Sommerer’s father, Herbert, as well as the interpretation of attribution rules for trusts in the ITA. The Austrian entity was a private foundation, to which Herbert Sommerer contributed one million Austrian schillings of his own money. The foundation’s founding and supplementary documents stated the senior Sommerer was the founder, Peter Sommerer and his family were the beneficiaries, and that on revocation of the foundation, the ultimate beneficiaries were Peter Sommerer and his wife.
In 1996 and 1997, the foundation bought shares from Peter Sommerer at fair market value. Those shares were in two Canadian companies, Vienna Systems Corp. and Cambrian Systems Corp., which were associated with Sommerer’s business activities with Mitel and Newbridge. Those were the shares that were eventually sold by the foundation to Nokia and Nortel for hefty profits.
The CRA maintained that the foundation was actually a trust, and that it was caught by Section 75(2) of the ITA — an anti-avoidance rule providing that funds contributed to a trust by a person (usually, the taxpayer) who retains control over the trust, or to whom the property may revert at some point, are attributed back to that person for tax purposes.
The first question the judge had to address was whether or not the foundation, which was structured under Austrian law in a manner different from a Canadian trust, constituted a non-resident trust under Canadian tax law. Miller took a novel approach to that issue, finding that it did not matter how the entity was described in relevant legislation or its own documents; what was important was the relationship between the foundation and its beneficiaries. However, Miller agreed with the CRA that the foundation was indeed a trust.
But in a departure that some tax experts say is surprising, Miller interpreted Sec.75(2) to mean that only funds placed in the trust by the settlor at the time of its creation (in this case, Herbert Sommerer, a non-resident of Canada) could be considered for attribution for Canadian tax purposes. As a result, Peter Sommerer was not caught by the anti-avoidance rule in Sec.75(2).
This section, says Falk, has caused concern for many years because it is “very broad in its potential applications and sometimes harsh in its results.”
He adds that the rule potentially “stops me [a taxpayer] from putting property into a trust for my wife and children and having income and gains taxed in their hands if there is also a possibility that the property may revert to me and if I am the one who determines how the property is distributed.”
If Miller’s ruling is upheld on appeal, it would limit the impact of this section, and open up planning opportunities that were not thought to exist, Falk says: “This case is saying that this provision is not triggered in as broad a set of circumstances as CRA suggested and as many people assumed.”
Miller also ruled that — even if he was wrong about Sommerer not having to pay taxes under Sec. 75(2) — he would be shielded from tax under the terms of the Canada-Austria tax treaty. The judge’s decision concludes that gains from the sale of the shares are taxable only in Austria, the country in which the foundation is located. IE