Clients who use offshore trusts to shelter wealth should take note of two recent decisions from the Tax Court of Canada. Although these cases resulted in wins for the Canada Revenue Agency, it seems likely that taxpayers who structure these trusts more carefully in the future can continue to benefit from them.

The judgments should be treated as strong warnings that simply shuffling paper won’t work when it comes to creating tax-exempt offshore trusts; they must be genuine and not set up merely to side-step the reach of the CRA.

One case in particular, Garron Family Trust v. The Queen, is viewed by legal experts as significant. The case, says tax-planning specialist Janette Pantry of Blake Cassels & Graydon LLP’s Vancouver office, “is a wake-up call if a client has a trust, and residence of the trust is important.”

For the residence of the trust to withstand a challenge by the CRA, the role of the offshore trustee must be more than merely administrative; as a result of Garron, the new test of residence is where the primary management and control of the trust takes place. From a practical perspective, Pantry says, that means that offshore trustees should keep evidence of the fact they are making decisions independently.

Indeed, if Garron is upheld — it has been appealed, with a decision expected toward the end of next year — the case will mark a sharp turn in the rules that apply to offshore trusts.

For most of the past two decades, tax planners have proceeded on the basis that the physical location of the trustee is the test when it comes to the residence of the trust for tax purposes. If the trustee was based in a tax haven (such as Barbados, where the Garron trustee was located), the trust paid taxes under the tax haven’s laws — usually none.

This may explain why the decision in Garron appears to have taken so many in the tax-planning community by surprise. It has also led to discussions of what comes next.

“There are a lot of trusts that need to take a look at this decision and determine how or if it affects them,” Pantry observes. If residence of a trust is important, she adds, “A lot of people will need to look at what they have been doing. They may not necessarily have a problem, but they need to ensure they’ve kept evidence that the trustee is really the one making the decisions with respect to the assets of the trust.”

In Garron, two Canadian businessmen with a successful auto-parts business executed an estate freeze. The company was reorganized to create two classes of shares, with the voting shares held by the two businessmen. The non-voting common shares, assessed at $50 million at the time, were transferred to a newly created trust that was registered in Barbados. The businessmen and their families were the beneficiaries. Two years later, in 2000, the common shares were sold to a third party for $532 million, generating a potential capital gain of $450 million. The evidence showed that most of the gain occurred after the creation of the trust.

Under Barbados law, gains from the sale of property are not taxed. A tax treaty between Canada and Barbados provides that gains are taxed under the laws of the country in which the trust is resident.

The ensuing challenge by the CRA turned on a tussle over the definition of “resident.” The CRA argued that Canada’s tax treaty with Barbados did not apply in this case, as the trustee corporation was merely a compliant entity that was under the central management and control of the beneficiaries, who resided in Canada. The CRA argued that the “central management and control” test, which has long applied to corporations, should apply to trusts.

Justice Judith Woods agreed with the CRA. She referred to a number of factors that led to her conclusion about true control of the trust, including: a mechanism that allowed the beneficiaries to replace the trustee; internal memos showing that the beneficiaries were making the decisions about the sale to the third party in 2000; that the proceeds of the sale appeared to be under the control of the Canadian beneficiaries; the absence of documentation showing that the trustee’s role was more than administrative; and oral testimony that indicated the beneficiaries had little interest in what the trustee was doing.

@page_break@Still, Pantry says she is somewhat surprised that the court arrived at the conclusion that the beneficiaries were controlling the trust assets, given a lack of explicit evidence on that point. She also notes that the increasing attention being paid to offshore transactions by the CRA could mean there are more such cases: “I think we will see a lot more tax cases involving international transactions. We already are seeing more.”

Another recent Tax Court decision dealing with offshore trusts was resolved somewhat differently but also in favour of the CRA.

In Antle et al v. The Queen, shareowner Paul Antle was on the brink of selling his interest in an oil-exploration company with significant accrued gains. To avoid capital gains taxes, he executed a series of transactions designed to increase the tax cost of the shares, thus lowering the gain. In the initial step, the shares were transferred to a Barbados trust in favour of his wife. Under the trust documents, the transaction was deemed to be a spousal rollover; as a result, no taxes were payable by Antle’s wife.

The trust then sold the property to Antle’s wife in exchange for a promissory note. She sold the property to the buyer of Antle’s company for the same amount and paid off the trust; the trust then distributed the funds to Antle’s wife, tax-free. Unlike Garron, virtually all of the gains had occurred in Canada, before the transfer to the trust.

The CRA argued that the trust itself was not validly formed. The court agreed, noting that none of the three requirements to establish a trust — intention, subject matter and object — had been established. The trust documents did not even use the proper language to make effective the transfer of the shares to the trust. The result in this case was less of a surprise, Pantry says. It was appropriate that the gain in Antle should be taxed in Canada, she adds, because that is where all of the value had accrued. IE