Foreign Entity Characterization, Treaty Interpretation and Income Attribution
A recent Tax Court of Canada decision makes a number of determinations that are very significant in both a Canadian domestic and international tax context. These determinations touch upon the ability of parties to rectify retroactively a deficient contract, whether certain income attribution rules are triggered on a fair market value sale to a trust, the approach to foreign entity characterization, and the application of a tax treaty to prevent Canada from taxing a Canadian gain attributed to a resident of Canada pursuant to the Income Tax Act (Canada) (Act).
Some of the decisions reached by the Court and the Court’s approach to some of the issues were unexpected and, if upheld on appeal and followed in future decisions, will be significant in a broad range of circumstances.
In Sommerer v. The Queen, 2011 DTC 1162,  4 CTC 2068 (TCC), Mr. Justice Miller dealt with a Canadian resident taxpayer (Mr. Sommerer) who had been assessed by the Minister of National Revenue (Minister) in respect of a substantial capital gain arising on the sale by an Austrian foundation (i.e., a Privatstiftung) of shares of two Canadian corporations.
Simplified, in 1996, Mr. Sommerer’s father, a resident of Austria and a non-resident of Canada, used his own funds to establish the foundation for the benefit of Mr. Sommerer and others. The foundation was managed by an executive board comprised of three unrelated Austrian residents and guided by an advisory board of which Mr. Sommerer was a member. Coincident with the foundation’s establishment, the foundation purported to purchase from Mr. Sommerer shares that were subsequently sold by the foundation at a gain.
Originally, the Minister reassessed Mr. Sommerer on the basis that subsection 75(2) of the Act applied to attribute to Mr. Sommerer the gain on the foundation’s sale of the shares. Subsection 75(2) is a provision that, in general terms, attributes income and gains earned by a reversionary trust back to the person from whom the property, or substituted property, was received.
In the Reply to the Notice of Appeal, the Minister adopted as a new primary position the argument that Mr. Sommerer did not sell certain of the shares to the foundation until shortly before the third-party sale and that Mr. Sommerer realized a gain at that time on the basis of a non-arm’s length disposition deemed under the Act to occur at fair market value (i.e., the price paid by the third-party which was substantially in excess of the fair market value of the shares in 1996).
The issues considered by the Court were as follows:
- Whether the shares were sold by Mr. Sommerer to the foundation in 1996, as maintained by Mr. Sommerer, or 1998, as maintained by the Minister;
- Whether the arrangement whereby the taxpayer’s father endowed the foundation with funds for the purpose set forth in the foundation deeds could be viewed as a trust for Canadian income tax purposes;
- If a trust existed, whether subsection 75(2) applied to attribute to Mr. Sommerer the gain on the disposition of the shares by the foundation;
- If a trust existed and subsection 75(2) applied, whether the provisions of the Canada-Austria Income Tax Convention (Treaty) prevented Canada from taxing the capital gain realized by the foundation on the disposition of the shares; and
- Whether the foundation was Mr. Sommerer’s agent for the purpose of disposing of the shares.
In this article, we comment on the Court’s conclusions that a trust existed and that subsection 75(2) did not apply on the basis that the "person" in subsection 75(2) does not include a fair market value vendor such as Mr. Sommerer. We also comment on the Court’s conclusion that even if subsection 75(2) applied, Article XIII(5) of the Treaty precluded Canada from taxing Mr. Sommerer on the gain.
In respect of the other issues addressed in the decision, we note that: (i) the Court determined that the sale by Mr. Sommerer to the foundation occurred in 1996 and, in reaching that conclusion, the Court gave effect retroactively to an amending agreement that Mr. Sommerer and the foundation entered into after 1996 fixing some deficiencies in the initial agreement between the parties; and (ii) the Court determined that the foundation was not Mr. Sommerer’s agent for the purpose of disposing of the shares.
Foreign Entity Characterization
While the Canada Revenue Agency (CRA) has historically taken the position that an entity with separate legal identity and existence should be regarded as a corporation for Canadian income tax purposes, the CRA abandoned this position in 2008 in favour of a new "two-step approach" wherein (i) the characteristics of the foreign arrangement are determined under the foreign legislation, and (ii) those characteristics are compared with those of recognized categories under Canadian law so as to classify the foreign arrangement under one of those categories, notwithstanding that the foreign arrangement might lack some of the fundamental characteristics of the particular category1. Applying this approach, the Minister concluded that the foundation was a trust while Mr. Sommerer argued that it was a corporation.
Choosing to reframe the issue, the Court stated as follows:
[B]oth parties framed this issue as whether the [foundation] was a corporation or a trust. I suggest this is an inappropriate way of framing it. The [foundation] is a separate legal entity: a trust under Canadian law is not; it is a relationship describing how property is held. The [foundation] could be a trustee. The question is simply whether a trust existed, not whether the [foundation] is a trust or corporation.
Later, in respect of this issue, the Court stated that:
This should not be an issue of whether an Austrian Private Foundation under the [Austrian Private Foundation Act (APFA)], is a trust, let alone whether the [foundation] is a trust. That is the wrong question. The Appellant says it is a company; the Respondent says it is a trust. I have concluded that, depending on the terms of the Foundation Declaration and Supplemental Declaration, an Austrian Private Foundation could be considered a trust company, acting as trustee, and with respect to the [foundation], I find that that is as good a label as can be attached, when looking at it through the eyes of Canadian laws.
What needs to be analyzed, however, is not what the [foundation] is, but what relationship exists amongst the [foundation] (a separate legal person), Mr. Hebert Sommerer, and Mr. Peter Sommerer and the Sommerer family. Is there a trust relationship? Can Mr. Hebert Sommerer be seen as a settlor? Can the [foundation] be seen as a trustee, perhaps a corporate trustee? Can Mr. Sommerer be seen as a beneficiary? Do the three certainties, certainty of intention, certainty of subject matter, and certainty of objects exist? Are there any other characteristics of the Canadian trust that are missing in the Sommerer arrangement?
Having thus reframed the issue, the Court found that a trust relationship existed between Mr. Herbert Sommerer (i.e., Mr. Sommerer’s father, as settlor), the foundation (as trustee) and Mr. Sommerer and others (as beneficiaries). Interestingly, while the Court acknowledged the importance of the three certainties (namely, certainty of objects, subject matter, and intention), its analysis did not hinge on them. Rather, the "essential ingredients" of a trust under Canadian law identified and addressed by the Court were (i) segregated property, (ii) owned by a person (a trustee) having control of the property, (iii) for the benefit of persons (beneficiaries), (iv) to whom the trustee has a fiduciary duty enforceable by the beneficiaries. As stated by the Court:
If I find these essential features in the arrangement by which the [foundation] held [the shares], then I will have no difficulty finding the three certainties were met to create the trust. It is absolutely clear to me that there is certainty of subject matter and objects, and if the essential features of a trust are evident, then the intention of Mr. Herbert Sommerer to create a trust can be gleaned from the Foundation Declaration and the application of the APFA.2
In respect of the Court’s approach to this issue, it is, of course, quite possible for a foreign entity that is a corporation to act as a trustee in respect of property that is owned by the foreign entity but held for the benefit of others. What is noteworthy is that in reaching its conclusion on whether there was a trust, the Court rejected the entity-characterization approach that had been advocated by both parties, and that has been widely used in the tax community, whereby the relevant legislation and governing documents are assessed in determining whether the entity should be considered to be a trust or a corporation for purposes of the Act. Here, the Court reached the conclusion that the very legislation and governing documents that created the foundation (a legal entity akin to a trust company) also made the foundation a trustee (i.e., the Court did not find that there was a trust agreement, written or unwritten, separate from the entity’s constating documents).
This approach, if upheld on appeal and adopted in future decisions, may well prompt the CRA to revisit situations in which it has previously agreed that a foreign entity was not a trust. Where a foreign trust is not intended to be created, the approach should also prompt practitioners to proceed with great care, including clarifying that the foreign entity owns its property for its own benefit rather than for the benefit of third-parties and that any such third-parties are not owed fiduciary duties and have no rights of enforcement.
Subsection 75(2) — the "Person"
Having concluded that a trust existed, the Court considered whether subsection 75(2) applied to attribute to Mr. Sommerer the gain on the disposition of the shares by the foundation. The Court concluded that the provision did not apply on the basis that "the person" contemplated in subparagraph 75(2)(a)(i) did not include a fair market value vendor such as the taxpayer. More particularly, the Court reasoned as follows:
The nature of the trust, and whether it is of a type contemplated by subsection 75(2) […], is to be discerned at the time of creation. On the creation of the trust by a settlor, there can only be one person from whom property is received — the settlor. There is no other person. This does not however preclude the possibility of another person settling property in trust with the same trustee and on the same terms, but in such a case, I would suggest there is another trust created. In effect, by the opening words of subsection 75(2) […] only a settlor, or a contributor akin to a settlor is contemplated as being the defined person.
The narrow interpretation adopted by the Court is welcome given that there has long been a significant concern that, based on its wording, subsection 75(2) may extend to fair market value sales. Further, this interpretation is welcome as subsection 75(2) is an awkwardly worded anti-avoidance provision that, given the absence of a "purpose" requirement and the broad drafting of the provision, can be triggered inadvertently. Once subsection 75(2) has been triggered, the consequences can be extremely harsh (i.e., not only attribution of income and gains, but also an inability of the trust to distribute property to most beneficiaries on a tax-deferred basis). In some cases, the consequences can be impossible to rectify notwithstanding that there may have been no mischief.
Most, if not all, practitioners would likely agree that there is no policy rationale for applying subsection 75(2) to a fair market value vendor. However, the Court’s conclusion that a textual read of the provision supports the conclusion that only the settlor (or a subsequent contributor who could be seen as a settlor) can be "the person" for purposes of subsection 75(2) is less obvious, at least in the view of the authors. Since the Court’s reasoning on this point is somewhat difficult to follow and given the limited amount of subsection 75(2) jurisprudence, it will be very interesting to see whether, on appeal, the Federal Court of Appeal agrees with the conclusion.
The Court also concluded that if, contrary to its earlier conclusion, subsection 75(2) applied to attribute the foundation’s gains to Mr. Sommerer, the provisions of the Treaty would nonetheless prevent Canada from taxing the capital gains realized by the foundation. More particularly, the Court held that Article XIII(5) of the Treaty (being the general gains provision) overrode subsection 75(2) and that if the drafters of the Treaty had intended otherwise, they could have included a provision to that effect.
While the Minister sought to rely on the 2003 OECD Commentary which provides that domestic anti-avoidance rules like "substance over form", "economic substance" and the GAAR are "part of the basic domestic rules set by domestic tax laws" and are "not addressed in tax treaties and […] therefore, not affected by them," the Court followed the Federal Court of Appeal in Prevost (2009 D.T.C. 5053) and stated that a later OECD Commentary (such as the 2003 OECD Commentary in the case at issue) should only be of assistance if not in conflict with the Commentary in existence at the time the relevant treaty was entered into. As the Court found that the 2003 OECD Commentary and the 1997 OECD Commentary were very much in conflict, the Court restricted its analysis to the latter. That Commentary suggests that if a state intended that a domestic anti-avoidance provision remain applicable in the treaty context, it would have to incorporate it into the treaty.
In commenting on this case generally, the Court noted that:
It is not surprising the Government would be interested in Mr. Sommerer's activities, for, as acknowledged by the Appellant, had Mr. Herbert Sommerer revoked the Foundation shortly after the sale of the Vienna shares and distributed the funds to Mr. Sommerer and his wife, there would have been no tax payable by the Sommerers in Canada, if the distribution was considered to be from a non-resident trust. And indeed, I have found that the [foundation] was a trustee of a non-resident trust, but not a trust captured by the wording of subsection 75(2) of the Act. […] I have concluded subsection 75(2) of the Act does not apply to a beneficiary vendor of property at fair market value to a trust, but only to a settlor or subsequent contributor, who could be seen as a settlor. If this is an incorrect reading of subsection 75(2) of the Act, and it is meant to apply to beneficiaries such as Mr. Sommerer , then I find the Convention overrides that application in Mr. Sommerer 's case.
Not surprisingly given the planning opportunities that may be available if the Court’s conclusions on subsection 75(2) are correct, the Minister has appealed the decision to the Federal Court of Appeal on the basis that that the Court erred in (i) failing to find as a matter of law that, on a proper textual, contextual and purposive construction of subsection 75(2), any person who transfers property to a trust, whether by way of settlement or sale, falls within the purview of subsection 75(2), and (ii) finding that, as a matter of law, Article XIII(5) precludes the applicability of subsection 75(2).
1 See, for example, CRA Technical Interpretation 2008-0266251I7 (dated April 15, 2008) wherein the CRA concluded that a Liechtenstein foundation (i.e., a sifting) will generally be considered to be a trust for purposes of the Act, notwithstanding that such a foundation has a separate legal identity and existence.
2 This statement may be contrasted with the CRA’s statement in CRA Technical Interpretation 2008-0266251I that the certainty of intention test is not relevant when determining if a foreign entity is a trust. More particularly, the CRA stated as follows:
As the foreign legislation is not the same as the Canadian legislation, our view is that it is not relevant to apply the certainty of intention test when determining if a foreign entity is a trust because we would arrive at the conclusion that the parties had the intention to create the foreign entity that they created and which we need to classify.