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Brent Kern Family Trust: FCA Dismisses Appeal

In Brent Kern Family Trust v. The Queen (2014 FCA 230), the Federal Court of Appeal dismissed the taxpayer’s appeal with reasons delivered from the bench. The taxpayer had argued that the decision of Canada v. Sommerer (2012 FCA 207) should not apply in this case and, in the alternative, that Sommerer was wrongly decided and ought not to be followed.

Brent Kern Family Trust was a case in which the taxpayer undertook a series of transactions whereby a taxpayer (Mr. K) completed an estate freeze for two corporations (the underlying facts are described in detail in the Tax Court decision (2013 TCC 327)).

Following the estate freeze, two family trusts were set up each with Mr. K and his family as beneficiaries as well as each trust having a separate corporate beneficiary. Next, each of the trusts subscribed for common shares in the corporate beneficiary of the other trust.

Once the structure was in place, a dividend was flowed through the structure and, as a final step, one of the trusts paid funds to Mr. K but relied on the application of subsection 75(2) of the Act to deem the dividend income received by the trust to be income in the hands of one of the corporate beneficiaries. Accordingly, if subsection 75(2) of the Act applied, the income would not be subject to tax as a result of section 112 of the Act and Mr. K could keep the gross amount of the funds.

In the decision rendered at trial, the Tax Court held that Sommerer case applied and subsection 75(2) of the Act did not apply on the basis that the trust purchased the property in question for valuable consideration and no “reversionary transfer” occurred.

In Brent Kern Family Trust, the Court of Appeal found that there was no reviewable error in the trial judge’s finding that Sommerer applied, that the Court of Appeal in Sommerer “spent considerable time analyzing the text, content and purpose of subsection 75(2)”, and no reviewable error had been brought to the Court’s attention in the present case.

The Court of Appeal dismissed the taxpayer’s appeal and upheld the Tax Court’s decision.

We note also that at least one taxpayer has brought an application in a provincial court to correct a transaction where the taxpayer never intended for Sommerer to apply. In Re Pallen Trust (2014 BCSC 405), the B.C. Supreme Court rescinded two dividends, the effect of which was to eliminate the tax liability in the trust. Re Pallen Trust is under appeal to the B.C. Court of Appeal.

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Brent Kern Family Trust: FCA Dismisses Appeal

Further thoughts on the Fundy Settlement decision: Supreme Court offers a nuanced view of trust residence

In Garron Family Trust v. The Queen (2009 TCC 450), Justice Judith Woods of the Tax Court of Canada came down with a very broad new rule for determining the residence of trusts.

[162]  I conclude, then, that the judge-made test of residence that has been established for corporations should also apply to trusts, with such modifications as are appropriate. That test is “where the central management and control actually abides.”

This was viewed widely as a repudiation of the historic test based on the residence of the trustee. Many tax professionals thought that the test for residence of a trust required a determination of the residence of the majority of the trustees and where their functions were performed, and that it was not necessary to go beyond this test.

The Federal Court of Appeal in St. Michael Trust Corp. v. Canada (2010 FCA 309) appeared to endorse Justice Woods’ new legal test but in a somewhat guarded fashion:

[63]    St. Michael Trust Corp. argues that a test of central management and control cannot be applied to a trust because a trust is a “legal relationship” without a separate legal personality. I do not accept this argument. It is true that as a matter of law a trust is not a person, but it is also true that for income tax purposes, a trust is treated as though it were a person. In my view, it is consistent with that implicit statutory fiction to recognize that the residence of a trust may not always be determined by the residence of its trustee.

[64]    St. Michael Trust Corp. also argues that the residence of the trust must be determined as the residence of the trustee because section 104 of the Income Tax Act embodies the trust, as taxpayer, in the person of the trustee. In my view, that gives section 104 a meaning beyond its words and purpose. Section 104 was enacted to solve the practical problems of tax administration that would necessarily arise when it was determined that trusts were to be taxed despite the absence of legal personality. I do not read section 104 as a signal that Parliament intended that in all cases, the residence of the trust must be the residence of the trustee.

When the Supreme Court of Canada granted leave to appeal, some tax professionals were puzzled.  These tax professionals believed that it was unlikely the decision would be reversed since the Crown had a very strong factual case that the trusts in question were managed in Canada by the trust beneficiaries.  The decision released on April 12 by the Supreme Court (Fundy Settlement v. Canada, 2012 SCC 14) in fact dismissed the appeal in somewhat cursory fashion.

[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.  As indicated, the Tax Court judge found as a fact that the main beneficiaries exercised the central management and control of the trusts in Canada.  She found that St. Michael had only a limited role ― to provide administrative services ― and little or no responsibility beyond that (paras. 189-90).  Therefore, on this test, the trusts must be found to be resident in Canada.  This is not to say that the residence of a trust can never be the residence of the trustee.  The residence of the trustee will also be the residence of the trust where the trustee carries out the central management and control of the trust, and these duties are performed where the trustee is resident.  These, however, were not the facts in this case.

[16]    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” (para. 160).  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.  [Emphasis added]

On a close reading it is arguable that the Supreme Court has gently tempered the new rule set out by Justice Woods and, to some extent, by the Federal Court of Appeal.  Where the trustee does what it is supposed to do, including managing the trust and its properties, the operative test remains the residence of the trustee.  It would seem that only where the trustee carries on those “management and control” activities in a place other than where the trustee is resident, or where the trustee abdicates many of its powers to a third party, that Justice Woods’ new test becomes relevant.

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Further thoughts on the Fundy Settlement decision: Supreme Court offers a nuanced view of trust residence

GAAR Did Not Apply In Respect of Capital Gains Allocated to Minor Beneficiaries of a Family Trust

On March 21, 2012 the Tax Court of Canada issued judgment in the decision of McClarty Family Trust et al v. The Queen. The Minister of National Revenue (the “Minister”) had applied the general anti-avoidance rule (the “GAAR”) in section 245 of the Income Tax Act (the “Act”) to re-characterize capital gains reported by the McClarty Family Trust (“MFT”) as taxable dividends. However, the Court agreed with the appellants’ submissions that the transactions in issue were undertaken primarily for the purpose of placing Darrell McClarty, the father of the minor beneficiaries of the MFT, beyond the reach of creditors and allowed the appeal.

The Minster’s argument was that pursuant to a series of transactions, Darrell McClarty was able to split business income with his minor children in a manner that avoided the tax on split income in section 120.4 of the Act (as it existed in 2003 and 2004).

Darrell McClarty was the owner of all of the issued and outstanding Class A voting shares of McClarty Professional Services Inc. (MPSI). The MFT owned all of the issued and outstanding Class B, non-voting common shares. MPSI, in turn, owned 31% of Projectline Solutions Inc., which earned business income from the provisions of geotechnical engineering services.

In 2003 and 2004, the MFT received stock dividends consisting of Class E common shares of MPSI. The Class E shares had low paid-up capital and a high redemption value. After the Class E shares were received by the MFT, the MFT sold them to Darrell McClarty for fair market value, realizing capital gains. The capital gains were then distributed to the minor beneficiaries of the MFT, and thereby not subject to tax under section 120.4 of the Act.

Through a series of loans between Darrell McClarty, MPSI and the MFT, Mr. McClarty ended up owing $104,400.37 in outstanding promissory notes to the MFT and the MFT had outstanding promissory notes in the amount of $96,000 owned to its minor beneficiaries. The Minister argued that the creditor protection objectives were essentially ineffective and that the circular flow of loans disguised the true intention of the plan, which was to distribute funds to minor beneficiaries in a manner that would not subject them to the tax on split income in section 120.4.

However, the Court accepted Mr. McClarty’s evidence that he was motivated to protect assets from his former employer, who was a potential judgment creditor in relation to allegations of improper use of software belonging to the former employer. The Court also agreed that because of the liabilities of Mr. McClarty and the MFT noted above, the creditor protection objectives were achieved.

It was also argued that the protection from creditors would have been achieved simply by paying dividends to the beneficiaries of the MFT and therefore the declarations of stock dividends amounted to avoidance transactions. However, the Court accepted the Appellants’ argument that the transfer of wealth from MPSI was undertaken to provide protection from creditors without attracting significant tax costs. The transactions were not avoidance transactions because it was acceptable to undertake creditor proofing transactions in a manner that attracted the least possible tax. Furthermore, the transaction would never have occurred in the absence of the need to protect MPSI’s assets.

The Court therefore concluded that because there were no avoidance transactions under subsection 245(3) of the Act, there was no need to continue the analysis to determine if there was abusive tax avoidance. However it 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 section 120.4 of the Act, it was inappropriate for the Minister to use the GAAR to fill in the gaps.

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GAAR Did Not Apply In Respect of Capital Gains Allocated to Minor Beneficiaries of a Family Trust