FCA Update: Foreign Entity Characterization, Treaty Interpretation and Income Attribution
In the September 12, 2011 issue of Tax Update, we commented on the 2011 decision of the Tax Court of Canada (TCC) in Sommerer,1 which dealt with the ability of parties to rectify retroactively a deficient contract, whether certain 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 capital gain attributed to a resident of Canada pursuant to the Income Tax Act (Canada) (ITA).
In commenting on the case generally, the TCC stated:
It is not surprising the Government would be interested in Mr. Sommerer's activities, for, as acknowledged by the Appellant, had [Mr. Sommerer’s father] 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) […] I have concluded subsection 75(2) […] 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) […], and it is meant to apply to beneficiaries such as Mr. Sommerer, then I find the [Canada-Austria income tax treaty (Treaty)] overrides that application in Mr. Sommerer 's case.
As noted in our prior comment, the minister of national revenue (Minister) appealed the TCC’s decision to the Federal Court of Appeal (FCA) on the basis that the TCC erred in finding that:
- subsection 75(2)2 was not engaged by a fair market value sale of property to a trust by a capital beneficiary thereof; and
- even if subsection 75(2) applied to attribute a gain to the taxpayer, the Treaty precluded Canada from taxing the taxpayer on the attributed gain.
In this issue, we comment on the recently released decision of the FCA which affirms the TCC’s decision but for somewhat different reasons.3 As discussed below, the FCA makes a number of determinations that are very significant in both a Canadian domestic and international tax context. The FCA also resolves, by way of very strong dicta, some of the uncertainty created by the TCC decision as to the existence of trusts in the context of non-Canadian entities.
Simplified, and by way of summary:
- The taxpayer (Mr. Sommerer) was a resident of Canada and a non-resident of Austria.
- Mr. Sommerer’s father was a resident of Austria and a non-resident of Canada.
- In 1996, Mr. Sommerer’s father used his own funds to establish an Austrian foundation (i.e., a Privatstiftung) 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 either a member or an active participant.
- Coincident with the foundation’s establishment, the foundation purchased shares from Mr. Sommerer in exchange for fair market value proceeds.4
- In 1998, the foundation sold the shares to a third-party purchaser and realized a significant gain on the sale.
- The Minister assessed Mr. Sommerer on the gain on the basis that:
- the foundation was a trust;
- subsection 75(2) applied to attribute the trust’s gain to Mr. Sommerer by reason of the fair market value sale by Mr. Sommerer to the trust; and
- the Treaty did not protect Mr. Sommerer from Canadian tax on the gain.
Foreign Entity Characterization
While the Canada Revenue Agency (CRA) was previously of the view that an entity with separate legal identity and existence should be regarded as a corporation for Canadian income tax purposes, the CRA modified this position in 2008 in favour of a new "two-step approach" wherein:
- the characteristics of the foreign arrangement are determined under the foreign legislation, and
- 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 category.5
Applying this approach to the facts in Sommerer, the Minister concluded that the foundation was a trust, while Mr. Sommerer argued that it was a corporation.
The TCC found that a trust relationship existed between Mr. Sommerer’s father (as settlor), the foundation (as trustee) and Mr. Sommerer and others (as beneficiaries). Significantly, the TCC reached this conclusion after having reframed the issue 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.6
The issue of whether the foundation held its property in trust was not argued before the FCA.7 Accordingly, the FCA declined to express a final opinion on the point but noted that, in its view, the TCC’s conclusion was "doubtful." As stated by the FCA:
Because of the manner in which this appeal was argued, the proposition that the [foundation] holds its property in trust was not the subject of submissions, and I will express no final opinion on whether it is correct. However, I will say that in my view it is a doubtful proposition.
[A]n Austrian private foundation is a juridical person with the legal capacity to own property in its own right and to deal with its property on its own account. The legal right of an Austrian private foundation to deal with its own property is the same as the legal right of a Canadian corporation to deal with its own property. That is so despite the fact that the board of an Austrian private foundation must manage its affairs in furtherance of the purposes stipulated in its constating documents. The board of directors of a corporation is similarly constrained, in the sense that it must manage the affairs of the corporation in its best interests, subject to any terms and conditions in its constating documents.
A corporation does not hold its property in trust for its shareholders or members, except to the extent that a trust deed or an analogous legal instrument imposes the legal and equitable obligations of a trustee on the corporation with respect to specific corporate property. Assuming it is theoretically possible for an Austrian private foundation to hold its property in trust (that is, subject to conditions that are analogous to the legal and equitable obligations of a trustee in a common law jurisdiction), that possibility cannot be realized unless those conditions are formally established. Nothing in the constating documents of the [foundation] or the law of Austria, as reflected in the record of this case, supports the conclusion that the right of the [foundation] to deal with its property is constrained by any legal or equitable obligations analogous to those of a common law trustee.
Looking at the situation from another point of view, a shareholder or member of a corporation, as such, is not the beneficial owner of any property or [sic] the corporation, and has no legal or equitable claim to the corporate property (unless such a claim arises upon the declaration by the board of directors of a dividend, or when the dissolution of the corporation is imminent). Unless and until such an event occurs, a shareholder or member has only an inchoate right to receive distributions of corporate property from time to time at the discretion of the board of directors, and to share in the distribution of the corporate property upon its dissolution. The same can be said of the interest of a beneficiary or an ultimate beneficiary in the property of an Austrian private foundation. Nothing in the Austrian Private Foundations Act or the constating documents of the [foundation] gives Peter Sommerer a legal or equitable claim to the corporate property that is different from that of a shareholder or member of a corporation. [underlining added]
As noted in the discussion of the TCC decision in our prior comment, it should be 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 was noteworthy about the TCC’s analysis was that it rejected the entity-characterization approach that had been advocated by both parties (and widely used in the tax community) whereby the relevant legislation and governing documents are assessed in determining whether the entity should be considered a trust or a corporation for purposes of the ITA. Instead, the TCC reached the conclusion that the very legislation and governing documents that created the foundation (a legal entity) also made the foundation a trustee (i.e., the TCC did not find that there was a trust agreement, written or unwritten, separate from the entity’s constating documents).
While the FCA’s comments resolve some of the uncertainty created by the TCC’s decision as to the existence of trusts in the context of non-Canadian entities, both decisions highlight the need to proceed with great care when engaging in cross-border planning. Since the tax consequences could be drastically different depending on how the foreign arrangement is characterized, careful planners may wish to clarify that, in circumstances where a foreign trust is not intended to be created, 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 contractual rights of enforcement.
Subsection 75(2) — The "Person"
Notwithstanding its view that the existence of a trust was doubtful, the FCA considered whether subsection 75(2) applied to attribute to the taxpayer the gain realized by the foundation on the assumption that there was a trust of which the taxpayer was a beneficiary.
The FCA affirmed the TCC’s decision that "the person" contemplated in subsection 75(2) did not include a fair market value vendor. The issue arises generally since the wording of subsection 75(2) is, at best, unclear.8
While both courts concluded that subsection 75(2) did not apply to a fair market value vendor, the FCA focused on the context and purpose of the provision whereas the TCC considered context and purpose but focused on the text of the provision.9 Also noteworthy given the relative dearth of case law on subsection 75(2) is that the TCC and the FCA may have ascribed to subsection 75(2) slightly different purposes. Whereas the TCC stated that subsection 75(2) is "an avoidance provision that denies the taxpayer the use of a trust to defer and perhaps avoid tax," the FCA stated as follows:
Subsection 75(2) must be interpreted and applied to give effect to its language, read in its proper context and with a view to giving effect to its intended purpose. […S]ubsection 75(2) generally is intended to ensure that a taxpayer cannot avoid the income tax consequences of the use or disposition of property by transferring it to another person in trust while retaining a right of reversion or a right of disposition with respect to the property or property for which it may be substituted. […]
[…T]o interpret subsection 75(2) so that it could apply to a beneficiary in respect of property that the trust acquired from the beneficiary in a bona fide sale transaction leads to outcomes that are absurd and could not have been intended by Parliament.
Nothing in subsection 75(2) contemplates an outcome involving the attribution of the same gain to more than one person. This double application of subsection 75(2) cannot be avoided by a discretionary use of subsection 75(2), because it is not a discretionary provision. It applies automatically to every situation it describes.
Both the TCC and the FCA concluded that if, contrary to their earlier conclusions, 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 gain realized by the foundation on the third-party sale. More particularly, both courts 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.10
Before the TCC, 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." However, the TCC followed the FCA’s decision in Prévost11 and stated that a later OECD commentary (such as the 2003 OECD Commentary in the case at issue) should be of assistance only if not in conflict with the commentary in existence at the time the relevant treaty was entered into.12
Before the FCA, the Minister argued that:
- the Treaty was intended to avoid juridical double taxation (i.e., imposing on a person both Canadian tax and foreign tax on the same income), but the Treaty did not extend to economic double taxation (e.g., imposing Canadian tax on income attributed to a Canadian taxpayer where the economic burden of foreign tax paid by a third-party on that income is also borne indirectly by the Canadian taxpayer);
- the taxpayer was not the "alienator" and, also, was not a resident of Austria, so was not protected from Canadian taxation;
- the reservation clause in relation to the attribution of income and gains under the foreign accrual property rules was not necessary but was included only for greater certainty; and
- foreign jurisprudence establishes that domestic attribution rules do not conflict with international tax conventions based on the OECD model.
The FCA rejected each of these arguments and held that the meaning of "double taxation" in a particular income tax convention is a matter that must be determined on an interpretation of that convention. As stated by the FCA:
The Crown’s argument requires the interpretation of a specific income tax convention to be approached on the basis of a premise that excludes, from the outset, the notion that the convention is not intended to avoid economic double taxation. That approach was rejected by Justice Miller, correctly in my view. There is considerable merit in the opinion of Klaus Vogel, who says that the meaning of "double taxation" in a particular income tax convention is a matter that must be determined on the basis of an interpretation of that convention.
Having regard to the Treaty specifically, the FCA held that it could apply to prevent Canada from imposing tax on a resident of Canada. This taxpayer-friendly interpretation of the Treaty should serve as a useful precedent for tax planners in other contexts.
As at the time of writing, the Minister has not sought leave to appeal the decision to the Supreme Court of Canada.
1 Sommerer v. R.,  4 CTC 2068, 2011 DTC 1162 (TCC), aff’d 2012 FCA 207, 2012 DTC 5126 (FCA).
2 In general terms, subsection 75(2) is a provision that attributes income and gains earned on property by a reversionary trust to the person from whom the property (or property for which the property was substituted) was received. The provision is intended to apply where a person transfers property to a trust and it is possible that the property will revert to the person from whom it was received. The provision can also apply where the person retains the ability to control when or to whom the property will be disposed of by the trust.
3 The unanimous judgment of the FCA was authored by Sharlow J.A. and was released on July 13, 2012.
4 Before the TCC, the Minister adopted as its primary position the argument that Mr. Sommerer did not sell certain of the shares to the foundation until 1998 (i.e., the year in which the foundation sold the shares to a third-party) and that Mr. Sommerer realized a gain at that time on the basis of a non-arm’s length disposition deemed under the ITA 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). However, the TCC determined that the shares were sold by Mr. Sommerer to the foundation in 1996, as maintained by Mr. Sommerer. This finding was not appealed by the Minister.
5 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 ITA, notwithstanding that such a foundation has a separate legal identity and existence.
6 Later, in respect of this same issue, the TCC stated:
This should not be an issue of whether an Austrian Private Foundation under the [Austrian Private Foundations Act] 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?
7 Mr. Sommerer disagreed with the conclusion that a trust existed but chose, perhaps for tactical reasons, not to argue the issue before the FCA.
8 Subsection 75(2) refers to the person from whom property was "received."
9 The TCC decision was notable in that the Court not only reached its conclusion as to the non-applicability of subsection 75(2) on a textual read of the provision, it stated that once the section was "properly unraveled and viewed grammatically and logically, the only interpretation is 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)" (underlining added).
10 The TCC also noted that 56 of Canada’s 88 tax treaties had a provision which would allow Canada to tax gains attributed to a Canadian resident pursuant to subsection 75(2).
11 Prévost Car Inc. v. R., 3 CTC 160, 2009 DTC 5053 (FCA).
12 As the TCC found that the 2003 OECD Commentary and the 1997 OECD Commentary were very much in conflict, the TCC 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.