Financial advisors and others who assist affluent families with tax planning in the context of trusts and private family companies may find some recent decisions from the Tax Court of Canada (TCC) useful; all deal with situations in which taxpayers were looking for ways to shelter the fruits of significant business or professional gains. Although success for these taxpayers was mixed, the cases do suggest that Canadian courts are striving to balance the interests of entrepreneurs with fair taxation.

In essence, these decisions seem to suggest that highly artificial structures created solely to avoid tax, with no other legitimate purpose (such as avoiding creditors or double taxation), will not be allowed. However, when taxpayers are using acceptable ways to reduce taxes on large gains, these may well be permitted, even if the structures employed are highly intricate. The cases also suggest that the Canada Revenue Agency (CRA) may not use general powers, such as the general anti-avoidance rule (GAAR), to plug what it views as holes in the tax system where that system is not being abused by the taxpayer; that function is for legislators.

SCC upholds rules on residence of offshore trusts

In what is likely the most significant of these recent decisions, the Supreme Court of Canada (SCC) upheld and clarified a broad new rule for the residency of off-shore trusts, originally handed down by the TCC. The April 2012 decision makes it abundantly clear that trusts will now be resident for tax purposes in the country where the “central management and control” of the trust is carried out, not necessarily where the trustee resides.

Thus, Canadian clients who use an offshore trust to shelter or reduce taxes must ensure that the trust is actually managed from the foreign location if they wish to reap offshore tax benefits. It will no longer be enough that the trust and the trustee are physically located in the foreign, low-tax, location.

The case, St. Michael Trust Corp. et al. v. The Queen, was closely followed as it wound its way through the courts. (The case was also known as Garron Family Trust. See Tax court revises the rules on residence of offshore trusts, IE November 2009). At stake was $152 million in taxes that were withheld when the trust assets were sold to a third party.

Lawyers for the trust had argued that the proper test for residency of the trust was the conventional one that has usually applied under Canadian law: the physical location of the trustee. However, the CRA argued that, since all significant decisions made by the trust were controlled by the beneficiaries, who lived in Canada, the trust should be treated as resident in Canada and therefore subject to Canadian taxes.

TCC Justice Judith Woods agreed in a 2009 decision, as did the Federal Court of Appeal in 2010. Both of those courts concluded that the test for the residence of a trust should be the same as the test for residence of a corporation: where the central management and control of the corporation occurs, regardless of where it is formally headquartered. Woods noted in her ruling that corporations and trusts have many elements in common, which essentially boil down to “the management of property.”

In reaching its unanimous decision, the SCC stated: “We agree with Woods J. that adopting a similar test for trusts and corporations promotes ‘the important principles of consistency, predictability and fairness in the application of tax law’….As she noted, if there were to be a totally different test for trusts than for corporations, there should be good reasons for it. No such reasons were offered here.”

Family trusts and the GAAR

In another April decision involving family trusts, the CRA tried to apply the general anti-avoidance rule to a family trust. In McClarty Family Trust, the taxpayer had used a complex series of transactions to transform income from his engineering company to capital gains paid out to his three minor children.

The taxpayer, Darrell McClarty, had been involved in an acrimonious dispute with his former employer, who had threatened him with legal action over the alleged theft of intellectual property. At trial in the TCC, McClarty argued that the series of transactions, which involved the creation of several companies, the trust, and a series of circular loans, was designed to protect his assets from creditors, in a manner that attracted the least possible tax.

The CRA, however, alleged that the transactions amounted to abusive tax avoidance: the final effect of the transactions was to pay out capital gains — not more highly taxed dividends — to McClarty’s three minor sons.

In holding for the taxpayer, the tax court concluded that McClarty had genuine reasons for wishing to creditor-proof his assets in a tax-efficient manner. The court also suggested that the CRA may not use the GAAR when the rules against income splitting with minor children cannot be applied (the “kidde tax.”) In a note on the case, Dan Misutka, a tax expert with law firm Fraser Milner Casgrain LLP, stated: “[The TCC] did note that to the extent that there was a gap in the legislation, which allowed for the distribution of capital gains to minor beneficiaries of a trust in a manner that was not taxable under [the kiddie tax provisions] of the Act, it was inappropriate for the Minister to use the GAAR to fill in the gaps.”

The pipeline strategey

Yet another April tax court case appears to be positive for clients whose wealth is held in a private corporation.

Canadian heart surgeon Robert MacDonald had to close down his Canadian-based medical services business — worth more than $500,000 — after deciding to relocate to the United States for family reasons.

In the normal course, MacDonald would have been subject to double taxation: Canada’s rules would have imposed a deemed disposition of the company’s shares on MacDonald’s departure, while the U.S. requires an actual sale: thus, he would have been exposed to tax in both Canada and the U.S. on the same income.

To avoid this result, MacDonald sold his shares in his personal corporation to his brother in law. He was then able to set off existing capital losses against the capital gain, resulting in no tax.

Similar transactions, known as the “pipeline” strategy, are sometimes used to reduce the taxes payable when the controlling shareholder of a private corporation dies. In simple terms, the strategy avoids the potential of long-term double taxation that can arise as a result of the application of two rules: deemed disposition of shares on death, and the winding up rule under s.84(2), which deems certain amounts paid out on a winding up to be dividends.

The pipeline strategy is also designed to lower taxes by treating assets removed from a private corporation — sometimes called a surplus strip — as capital gains instead of dividends. In recent years, the CRA has questioned the use of the pipeline strategy.

The CRA alleged that the amounts should be treated as dividends, under s. 84(2) and that GAAR should apply. In holding that the CRA had generally misinterpreted the correct application of s. 84(2) in the case of pipeline strategies — as well as its application to MacDonald’s tax planning — Justice J.E. Hershfield referred to the CRA’s allegation of abusive tax planning as “bizarre.” Essentially, the court concluded that MacDonald’s tax plan put him in the same position under Canadian law as if there had been a deemed disposition of his shares. Further, the judgment states that MacDonald achieved this result by “legally effective means.”

In a note on the case, Douglas Forer, a lawyer with McLennan Ross LLP, concluded: “[The case] encourages taxpayers, and tax planners, to use tax plans, such as the pipeline strategy, as an acceptable means of arranging one’s affairs. It also emphasizes that the [CRA’s] view of the act, no matter how forcefully expressed, can be wrong: the [CRA] may have an opinion, but it is not the law.”