Personal Trust Audit Issues

Wendy StewartOntario Regional Coordinator – Trust Program

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Topics for Discussion

1. Garron Case – Residency of a Trust

2. Antle Case – Proper Trust Constitution

3. Loans to Personal Trusts

4. “Paid” or “Payable” Amounts

5. Section 116 Certificates for estates

Garron Family Trust, 2009 DTC 1287 (TCC); 2010 FCA 309 (FCA)Trust residence determined based on location of central management and control, not residence of trustee.

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Trusts

For tax purposes, trusts are deemed to be taxpayers for the calculating tax, but they are not a legal person or entity in the same way as individuals and corporations.

There has always been uncertainty around determining where a trust is resident for tax purposes.

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Residence of a Trust

The residence of a trust is a question of fact Historically, a trust’s residence has generally

been determined based on where the majority of Trustees of the trust are resident.

There are no statutory guidelines, regulations, or rules that establish criteria to determine whether a trust is resident in Canada, or indeed to determine, if the trust is resident in Canada, where in Canada it resides.

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Thibodeau Family Trust, 78 DTC 6376 (FCTD)

For Canadian income tax purposes a trust will be resident where a majority of the trustees are resident, provided that:

• A majority decision on all matters of the trustees' discretion is permitted;

• The trustees have full powers of management and control over the trust; and

• The trustees actively exercise those powers.

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Garron Family Trust, 2009 DTC 1287 (TCC)

Owners of a CCPC decided to implement an offshore “estate freeze’ in 1998

Canadian owners retained value and new shares were issued to Barbadian trust corporation

The plan was any new growth would escape Canadian taxation, as the trusts were not resident in Canada

The tax treaty with Barbados would exclude the gain on the private company shares from Canadian taxation

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Garron Facts…con’t

In August 2000 an arm’s length purchaser acquired all the shares for proceeds equal to $532 million with the bulk of proceeds paid to the Barbadian trusts

Capital gains do not attract tax consequences in Barbados

Trust position - they were not subject to Canadian tax either because they were non-resident and the gains were treaty-protected under the Canada-Barbados Income Tax Agreement.

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Justice’s Decision

Justice Woods in Garron decided that the residency test for corporations, management and control, ought to apply equally to trusts because;

• The characteristics of a trust and a corporation are quite similar in that, at a basic level they both manage property;

• Adopting a similar test of residence in Canada for trusts and corporations promotes the important principles of consistency, predictability and fairness in the application of tax law; and

• The judge was not satisfied that there were any good reasons for adopting a totally different test of residence for trusts than there is for corporations.

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TCC Decision

Justice Woods in Garron concluded that the trustee was not exercising the main powers and discretions of the trustees under the trust indentures. 

Rather its true role was “to execute documents as required, and to provide incidental administrative services”, and it was not expected to “have responsibility for decision-making beyond that”

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Meaning of Management and Control

Effective management occurs where key decisions are made notwithstanding that a Trustee may be making certain low level decisions elsewhere

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Federal Court of Appeal

November 17, 2010 FCA upheld the decision found in TCC, in particular

• “that where a question arises as to the residence of a trust for tax purposes, it is appropriate to undertake a fact driven analysis with a view to determining the place where the central management and control of the trust is actually exercised.” 

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Implications

the residence of a trustee will not suffice to establish the trust's residence for tax purposes.

relevant for determining trust residency not only

at the federal level, but also with respect to inter-provincial trust arrangements

Canada Revenue Agency and Canadian courts will now be applying a test of central management and control.

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Role of the Practitioner

it will be necessary to ensure that the trustee has sufficient independent decision-making power.

Be prudent to compile express evidence to support this arrangement

Antle et al. v. The Queen, 2009 TCC 465; 2010 FCA 280Court finds that trust not validly constituted and concludes that GAAR would have applied

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Justice Miller TCC

“If the capital property step-up strategy [used by the taxpayers in this case] is considered acceptable tax planning, then there would be two tiers of taxation of capital gains in Canada:

one tier for those whose capital gain can justify professionals’ fees to implement the strategy, in which case there is no tax on a capital gain in

Canada; the second tier for everyone else, in which case

capital gains are subject to tax in accordance with Part I of the Act.

This is an unacceptable result to the Respondent. The real question before me is whether it is for the legislators to introduce legislation to defeat such a result, or can existing legislation and jurisprudence be relied upon by the Courts to do so?”

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Antle Facts A Canadian resident husband purported to sell his shares

in the capital of a corporation to a trust resident in Barbados

He purported to transfer his shares to a spousal trust on a rollover basis.

The trust, in turn, sold the shares to the wife for a note. The wife then sold the shares to a third party purchaser

for cash and paid off the note to the offshore trust. The offshore trust would make a distribution of capital to

the wife of the note proceeds, again theoretically so that the wife could receive that distribution of capital on a tax-free basis.

Since Barbados does not tax capital gains, no tax would be paid on any of the transactions.

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Three Certainties Test

• Intention• Subject Matter• Object

AND there must be a a completed transfer of the subject property by the contributor to the Trust

This is why we always ask to view the settled property!!

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What to review

Conduct of the Parties will help to determine the Settlors true intent

• Does the Settlor’s actions demonstrate the use of the Trustee as Agent to reach the desired result eg. Income splitting to minimized taxation

• Is the Trustee just a player in the transaction or does he/she have real decision making powers

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First Position – Trust not properly constituted Settlor (Antle) did not properly settle the shares Director’s resolution to effect the transfer of the

shares was backdated Share certificate did not indicate a transferee Share certificate was not delivered until after the

purported settlement of the trust Share certificate was not delivered to the Trustee

but directly to the Third Party purchaser

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Second Position – Trust was a Sham

The Trustee not have any real discretion as the matters were pre-ordained

The trustee received the shares on the basis that the sole beneficiary had already agreed to buy them and the transaction was therefore void of discretion

The sole purpose of the transaction was to avoid tax

Sham’s require an element of deceit and it is necessary for the Settlor and Trustee to be parties to the sham – Trustee was a pawn and therefore not a Sham

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Third Position - GAAR

Effectively applied due to the fact the Act and the Treaty contemplate payment by Canadian residents of Canadian Income Tax on a gain arising on the sale of property held by a Canadian marital unit, however, did not contemplate running property through a Barbados and returning it to the Canadian marital unit for the sole purpose of escaping the Canadian payment of tax.

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Implications

Where a trust is perceived as having been settled for tax purposes, CRA auditors and the courts will scrutinize the arrangements and transactions very closely

CRA now adopts the “Antle doctrine” of false impression as another line of inquiry in audits and another ground for assessment.

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Audit Procedures

Mandatory audit steps include:

1. ensuring all formalities are strictly complied

2. with and the timing of various steps are given due attention and

3. executed accordingly

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Court Comments

“ This conclusion emphasizes how important it is, in implementing strategies with no other purpose than avoidance of tax, that meticulous and scrupulous regard be had to timeing and execution. Backdating of documents, fuzzy intentions, lack of transfer documents, lack of discretion, lack of commercial purpose, delivery of signed documents distributing capital from the trust prior to it’s purported settlement, all frankly miss the mark by a long shot. They leave the impression of elaborate window dressing,

In short, if you are going to play the avoidance game, it is not enough to have brilliant strategy, you must

have brilliant execution”

Amounts Paid or Payable

104(24) compliance allows 104(6) deduction

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Income of a Trust

The CRA has strict interpretations as to what is considered payable, and legal documents must be in place prior to the end of the year to meet

these requirements.

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General Rule on Income of Trust

Income, including taxable capital gains will be taxed in the trust unless one of four conditions is satisfied:

1.The income is paid or payable to a beneficiary

2.The income is deemed payable to an infant

3.A preferred beneficiary elects to pay tax on accumulating income

4.The trustee makes payments in respect of property, which he or she is required, under the terms of the trust instrument, to maintain for the use of a beneficiary

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Allowable Deductions

Paragraph 104(6)(b) of the ITA allows income allocations to beneficiaries to be deducted from the income of the trust.

Such amounts deducted must be included in the beneficiary’s income pursuant to subsection 104(13).

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Meaning of “Amount Payable”

The meaning of "an amount payable in a taxation year" is defined in subsection 104(24) as an amount:

(a) that is paid in the year to the person to whom it was payable, or;

(b) with respect to which the person to whom it was payable is entitled in the year to

enforce payment.

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Payments made to Third Parties

In the case of minor beneficiary, the trustee may decide to make payments to third parties or to the parent as a reimbursement for an expenditure.

CRA will accept certain third parties payments as payments made directly to a beneficiary, provided that the expenditures were incurred for the benefit of the beneficiaries.

In order to ensure that third party payments are deductible, the trustee must consider the nature of the payment and maintain proper books and records to substantiate the deduction.

Loans to a Personal Trust

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In general, the trust is established when a person (the settlor) transferred a property to the control of trustees to hold for the benefit of one or more beneficiaries.

The settled property is usually kept separately from all assets of the trust.

General Rules

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Certainty of Subject Matter

Common Law requires a valid trust must meet the Three Certainties in order to be considered a valid trust.

Failure to provided evidence of the settled property would void the trust agreement due to the trust failing to meet the Certainty of Subject Matter under common law.

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Non Arms Length Loans

The Income Tax Act provides attribution rules will NOT apply provided:

• Interest is charged at a rate equal to or greater than the lesser of:

(i) the prescribed rate as described in regulation 4301(a).

(ii) the rate that would be been agreed upon between parties dealing with

each other at arm’s length.

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Borrowed Funds

To provide the necessary financing to purchase income generating property, the trust would normally borrow the monies from arm’s length or non-arm’s length party.

It is important to keep in mind the type of loan the trust wishes to obtain as this may trigger tax implications (For example, attribution rules).

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Payment of Interest

In order to avoid the attribution rules the interest payable in respect of the loan must be paid no later than 30 days after the taxation year end of the trust.

Section 116 Certificates for Estates

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Resident Trust and Resident Beneficiaries

No necessity to apply for section 116 certificate as estate is not distributing to non resident

beneficiaries

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Resident Trust and Non Resident Beneficiary The non resident beneficiaries ONLY may be required to

apply for a Section 116 Certificate depending on the source of the capital interest:

Based on the changes to the definition of Taxable Canadian property, March 4, 2010 a capital interest in a trust is no longer taxable Canadian Property unless if at any time in the previous 60 month period, 50% of the FMV of the capital interest in the trust is derived from any combination of: 

• Canadian real or immovable property • Canadian resource property • timber resource property • options or interests in any of the above

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Non Resident Estate with Canadian Taxable property and Non Resident Beneficiary

The non-resident beneficiary may be required to apply for a Section 116 Certificate depending on

the source of the capital interest (see above)

The non-resident beneficiary will be required to apply for a Section 116 Certificate as the cash will be derived from the sale of real property.

www.cra-arc.gc.ca/tx/nnrsdnts/menu-eng.html

Discussion and Questions