Canada: Supreme Court Of Canada Upholds New Test For Residency Of Trusts

The Supreme Court of Canada (the SCC) released its decision in Fundy Settlement v. Canada (a.k.a. St. Michael Trust Corp. or Garron Family Trust). A unanimous panel of seven judges dismissed the taxpayer's appeal, as had the two courts below. This decision confirms the original ruling of Woods J. of the Tax Court of Canada (the Tax Court) that the "central management and control" test used to determine residency of corporations for tax purposes also applies to the determination of the residence of trusts.

Facts

This case – one of two companion cases with substantially similar facts – dealt with a family trust settled by an individual resident in St. Vincent, for the benefit of Canadian resident beneficiaries. The trustee of the family trust, St. Michael Trust Corp. (St. Michael), is a corporation resident in Barbados. When the trust disposed of the shares of two Canadian resident corporations, the purchaser withheld and remitted C$152-million of the proceeds pursuant to section 116 of the Income Tax Act (Canada) (the Act), presumably on the assumption that the trust was a non-resident of Canada. St. Michael applied for a refund of these funds on the basis that the trust was a resident of Barbados and exempt from Canadian income tax on the gain realized pursuant to the Canada-Barbados Income Tax Convention (the Convention). The Canada Revenue Agency (CRA) refused the request for a refund, taking the position that the trust was resident in Canada and owed Canadian income tax on the capital gain realized on the disposition.

Decision of Supreme Court of Canada

The SCC's unanimous decision focuses on the question of the appropriate legal test for determination of the residence of a trust (for a complete discussion of the Tax Court decision, please refer to our October 2009 Blakes Bulletin: Tax Court of Canada Decisions Relating to Non-Resident Trusts). St. Michael argued that the residence of the trust must be the same as the residence of the trustee for two reasons: (i) trusts, unlike corporations, are not "persons", making the central management and control test inapplicable to trusts, and (ii) the effect of subsection 104(1) of the Act is to treat a trust as essentially identical to its trustee for all purposes, including residence. The SCC rejected both of these arguments.

The SCC acknowledged in response to the first argument that at common law a trust has no legal personality. However, subsection 104(2) of the Act deems a trust to be, in respect of trust property, an individual. Therefore, a trust is clearly deemed to be a person (an individual) for purposes of the Act.

St. Michael's second argument relied on subsection 104(1) of the Act, which provides that in the Act "a reference to a trust or estate ... shall, unless the context otherwise requires, be read to include a reference to the trustee, executor, administrator ...". The SCC held that no provision of the Act, including subsection 104(1), established a legal rule requiring that the residence of a trust must be the residence of the trustee. The SCC relied on the charging provision in subsection 2(1) of the Act, referring to tax being payable by a "person resident in Canada", to support the conclusion that it is the residence of the taxpayer whose taxable income is being subject to tax, i.e., the trust and not the trustee, that must be determined.

The SCC pointed to several similarities between trusts and corporations to justify the application of the same "central management and control" test to determine their residence for tax purposes. The SCC also agreed with the Tax Court that the adoption of a similar test for trusts and corporations promotes the "important principles of consistency, predictability and fairness in the application of tax law."

Therefore, as with a corporation, a trust will be considered resident in the place where "its real business is carried on", which the SCC, citing both Canadian cases and decisions of the House of Lords, confirmed is "where the central management and control actually abides." In the corporate context, central management and control will generally be exercised where the board of directors exercises its responsibilities. However, where the facts are that central management and control is exercised by a shareholder who is resident and making decisions in another country, the corporation will be found to be resident where that shareholder resides.

Applying this test to the present case, the SCC noted that the Tax Court found as a fact that the main beneficiaries of the trust exercised the central management and control of the trusts in Canada, and that St. Michael had a limited role with little or no responsibility. The Tax Court found that St. Michael's role was to execute documents as required and provide incidental administrative services, and it was generally not expected that St. Michael would have responsibility for decision-making beyond that. Although there was no explicit evidence that this was the case, the Tax Court came to this conclusion based on the evidence as a whole including the failure of the appellants to provide evidence establishing otherwise. Woods J. noted in her decision that although the administrative nature of the trustee arrangement was likely unwritten, it was effectively enforceable through a protector mechanism that allowed the protector to replace the trustee, and the protector itself could be replaced by the beneficiaries. The Tax Court also found that, more likely than not, St. Michael had agreed from the outset that it would defer to the beneficiaries' recommendations, and that the beneficiaries also understood this to be the arrangement.

The factors the Tax Court considered in concluding that St. Michael had a limited role were as follows:

1. Internal Memoranda Indicating Limited Role: There were internal memoranda setting out the intentions of St. Michael, and these documents showed that St. Michael's role would be more limited than contemplated in the trust indentures. Specifically, it was found that the internal memoranda indicated that St. Michael's role in respect of the arm's-length share sale was administrative in nature and that St. Michael would not make distributions to certain beneficiaries without the consent of other beneficiaries.

2. Trust Investments Appeared To Be Under Control of the Beneficiaries: The evidence also suggested that investment of the share sale proceeds was under the direction of certain Canadian resident beneficiaries of the trust because the investment advisers were the same as the applicable beneficiaries' investment advisers and the advisers appeared to have been selected and directed by these beneficiaries rather than by St. Michael.

3. Tax Advisers Appeared To Be Directed by the Beneficiaries: The evidence suggested that the tax minimization plans developed by the tax advisers were under the direction of certain of the beneficiaries of the trust rather than St. Michael.

4. No Documentation Was Provided as Evidence that St. Michael Played an Active Role: There was no documentary evidence that St. Michael had any involvement beyond executing agreements and providing administrative services.

5. St. Michael's Expertise in Managing Trust Assets Was Questionable: For a significant period of time, St. Michael had been an arm of an accounting firm, and was likely formed to complement the tax services offered by the firm. The Tax Court found that it was questionable on the evidence whether the firm had any expertise in managing trust assets.

6. Oral Testimony Was Not Inconsistent with the View that St. Michael Had a Limited Role: The oral testimony was also consistent with the view that St. Michael had a limited role because it appeared that St. Michael was not sufficiently informed of matters related to the share sale transactions, the beneficiaries seemed to have little interest in what St. Michael was doing, St. Michael appeared to have done minimal due diligence (e.g., on investments of the trust) to ensure that its fiduciary obligations were being complied with and St. Michael did not appear knowledgeable about the trust's investments.

While residence of a trust may in some cases be in the place of residence of the trustee where the trustee carries out the central management and control of the trust, that was not found to be the case here.

The SCC explicitly declined to deal with two other arguments raised by the Crown. One dealt with a specific anti-avoidance rule in section 94 and the other involved the general anti-avoidance rule in section 245 (the GAAR). The SCC noted it did not need to deal with these points, but added the extra comment that the SCC's decision not to address these issues should not be taken as an endorsement of the reasons of the Federal Court of Appeal (the FCA) on those matters.

Unlike the Tax Court judge, the FCA had applied a very broad reading of the words "the trust ... has ... acquired property, directly or indirectly in any manner whatever" in paragraph 94(1)(b) of the Act. Under that broad reading, the SCC concluded that a shift in the value of the shareholdings of the corporations owned by the trusts in this case constituted an acquisition of property by the trusts. The FCA held that if the central management and control test did not apply to the trust in this case, the trust would be deemed a resident of Canada for certain purposes under subsection 94(1). Yet the trust would still be considered a resident of Barbados under the Conventionbecause of the limited purposes for which the deeming rule in subsection 94(1) applied. On that basis, the trust would have been exempt under the Convention from Canadian income tax on the gain realized on the share disposition. The FCA further held, with very limited discussion, that the GAAR would not apply to these transactions. This holding was consistent with that of the Tax Court.

Some Implications of the Decision

1. Need to Re-Examine Trust Relationships
The SCC's decision puts to rest any doubt that the legal test applicable to determine a trust's residence for tax purposes is the central management and control test. Taxpayers that have relied exclusively on the residence of a trustee as being determinative of the residence of a trust should re-examine their arrangements.

2. Need for Legal Substance
It is clear that the issue of legal "substance" remains critical for the threshold question of establishing residence. The SCC's decision demonstrates that a presumption that central management and control resides in the place of residence of a trustee of a trust (or by analogy, the place where the board of directors of a corporation meets) can be displaced where evidence to the contrary is available. Trusts or corporations wishing to establish residence in a treaty jurisdiction should ensure that meaningful decisions regarding the management of these entities are made in that jurisdiction. Evidence of physical meetings in the jurisdiction and that relevant information is being provided to permit meaningful decisions to be made is important to support the residence of trusts and corporations in a particular jurisdiction. As this decision emphasizes, having local agents that merely "rubber stamp" documents will not be sufficient to establish central management and control in a particular place. By contrast, the recent decision of the Tax Court in Velcro Canada Inc. v. Her Majesty the Queen (for a detailed discussion of this case, please refer to our March 2012 Blakes Bulletin: Velcro Canada Case: Latest Chapter in Treaty Shopping) seems to have placed less emphasis on the governance of a holding company for purposes of determining beneficial ownership of certain payments for treaty purposes.

3. Test for Residence of Corporations Not Incorporated in Canada
This decision also has implications beyond the trust context. Although it was widely understood and assumed for many years that the "central management and control" test applied to the determination of residence of corporations for Canadian tax purposes, this decision provides one of the few higher-court confirmations of this principle. The decision now provides definitive and unambiguous authority for the application of the "central management and control" test to corporations where residence is not determined by a deeming rule in the Act.

4. Possible Effect on Provincial Tax Rates for Domestic Trusts?
In recent audits of Canadian resident trusts, the CRA has taken the position that trusts are resident in the province of residence of the beneficiaries, rather than the province of residence of the trustee. This affects the provincial tax rate applicable to the trusts. It will be interesting to see how the CRA applies the SCC's decision in this context.

5. Topics for Another Day
This decision leaves the issues of the interpretation of section 94 of the Act and of the application of the GAAR in a treaty context to be addressed, if at all by the SCC, in future cases.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

We wish to acknowledge the contribution of Ed Kroft to this publication.