Trust Residency — "Central Management and Control"
The Federal Court of Appeal (FCA) recently1 confirmed that, in determining trust residence for purposes of the Income Tax Act (Canada) (Act), the established common law test for corporate residency should be applied such that a trust is resident in the country where its central management and control (CMC) is exercised. The FCA confirmed the lower court’s rejection of the view commonly expressed in the tax community that the residence of a trust is determined solely by reference to the residence of the trustee.2
The facts in the Garron case are outlined in our discussion of the Tax Court of Canada decision in International Tax Update. The issue before the court was whether two trusts established under the laws of St. Vincent were subject to Canadian tax on gains from the disposition of certain property. Both trusts had a corporate trustee that was incorporated, licensed and resident in Barbados, as well as beneficiaries that were Canadian residents. The trusts disposed of shares of Canadian holding corporations that owned shares of PMPL Holdings Inc., realizing substantial capital gains. For non-residents of Canada, the holding company shares were "taxable Canadian property" under the Act such that the gains on their disposition would be subject to Canadian income tax. However, Article XIV(4) of the Canada-Barbados Income Tax Agreement (1980) (Treaty) provided an exemption from Canadian income taxation on such gains for persons who were Barbados residents for purposes of the Treaty.
The key issue in the appeal was whether the trusts were resident in Canada under common law principles. If they were not, the further alternative issues were (i) whether they were deemed to be resident in Canada by virtue of Section 94 of the Act (such that the trusts would be subject to tax under Part I of the Act); (ii) if they were so deemed, whether the Treaty would override the provisions of the Act imposing tax as a consequence of such deemed Canadian residence; and (iii) whether the general anti-avoidance rule (GAAR) applied, on the basis that there would be an abuse of the Treaty if the trusts were able to claim relief from Canadian taxation under Article XIV(4).
Common Law Residency Test
There is very little jurisprudence that considers the determination of residence for tax purposes, and the limited case law that exists was not — at least in the eyes of the Tax Court judge — dispositive. This is why she felt the need to look at the legal residency tests in other contexts to help determine the residence of the trusts in this case.
The FCA began its analysis by stating that the residence of any person is a question of fact, the determination of which requires consideration of factors that point to, or away from, an economic or social link between the person and the particular country. Specific legal principles for determining residence may apply in certain circumstances, but those specific rules do not eliminate the need to consider all the relevant facts.
In the case of an individual, the relevant factors to consider in determining residency include nationality, physical presence, location of business or the family home, mode of family life, and social connections.
The leading case that considered the residency of a corporation is DeBeers,3 in which the House of Lords found that the case law relating to the residence of an individual was also instructive in determining corporate residency, as follows:
In applying the conception of residence to a company, we ought, I think, to proceed as nearly as we can upon the analogy of an individual. A company cannot eat or sleep, but can keep house and do business. We ought, therefore, to see where it really keeps house and does business … the real business is carried on where the central management and control actually abides.
Thus the residence of a corporation is determined primarily by finding the location of its CMC, which is usually where the corporate directors exercise their management and control responsibilities in the manner contemplated by the governing law of the corporation. If the functions of the corporate directors are usurped, and management and control is exercised in fact by a person who is not a director, the corporation may be found to be resident where such person resides or operates.4
The FCA then went on to consider the residence of a trust. While recognizing that there are cases in which a trust was found to be resident in the place where the trustee resides, the FCA observed that none of those cases elevate the residence of the trustee to an "invariable legal test" for determining the residence of a trust. The FCA also concluded that the relevant passages from the Federal Court’s Thibodeau case decision (which are routinely cited as the express judicial rejection of CMC test for determining the residence of a trust) was either speaking to the narrower question of determining residence as between multiple trustees — or was simply incorrect.
The FCA preferred to adopt a residency test for trusts by analogy to the corporate test established in DeBeers to require a determination of where the trust "keeps house and does business," i.e., where the powers and discretions of the trustee are really being exercised, the place where CMC of the trust actually abides. The residence of the trustee may in most cases be that of the trust, but not necessarily, and to impose such a rigid legal test would be inconsistent with the central theme of the case law, i.e., that residence fundamentally is a question of fact.
Having established that CMC is the appropriate standard for determining the residence of a trust, the FCA then considered whether the Tax Court had correctly applied the test to the facts. The FCA listed the factors the Tax Court considered5 and concluded that the trustee did not exercise the main powers and discretions under the two trusts. Rather, these powers were exercised by Canadian residents such that CMC of each trust resided in Canada. The FCA acknowledged that each factor, considered in isolation, would not be sufficient to locate CMC of the trusts elsewhere from the residence of the trustee, but that all of the factors considered together pointed in the same direction:
However, there is a line to be drawn. On one side of the line are recommendations, even strong ones, by the beneficiaries to the trustee, leaving the trustee free to decide how to exercise the powers and discretions under the trust. In that case, the trustee is still managing and controlling the trust. On the other side of the line the beneficiaries are really exercising the powers and discretions under the trusts, managing and controlling the trusts, and displacing the appointed trustee. As mentioned above, on which side of the line a case falls is a factual question, requiring consideration of the evidence in its totality.
The FCA found that the evidence led to no other conclusion, given the paucity of evidence as to the formation and operation of the trusts and the failure to call key witnesses who could have shed light on these matters.
Accordingly, the FCA dismissed the appeals. However, as alternative arguments were fully argued by counsel, the FCA expressed its opinion on them even though its conclusion on the common law residence issue was dispositive of the appeal.
Statutory Residency Test
The first alternative argument was whether the trusts were deemed residents of Canada under subsection 94(1) of the Act. The Tax Court held that the deeming rule did not apply because one of the requirements for the provision to apply did not apply to the trusts in this case — there was no direct or indirect acquisition of property by either trust from a Canadian-resident beneficiary or certain classes of Canadian-resident persons who were related to a beneficiary.
At the time the parties introduced the trusts into the PMPL ownership structure, a "freeze" transaction was undertaken pursuant to which the existing PMPL shareholders exchanged their common shares for Class A preference shares having an aggregate fixed redemption price of $50 million, which is the amount the parties understood to be the then-current value of PMPL. The trusts, through their respective Canadian holding companies, then acquired other classes of PMPL shares (Class B and C) for nominal consideration on which the future value of PMPL would accrue.
The Tax Court determined that, as a factual matter, the aggregate value of PMPL at the time shares were issued to the two trusts was more than $50 million, the implication being that the freeze transaction effected a transfer of value from the original PMPL shareholders to the trusts, through their indirect shareholding of the Class B and C shares, by an amount equal to the difference between the true value of PMPL at the time and $50 million. However, the Tax Court concluded that the acquisition of property requirement was not met because the transfer of value occurred at the Canadian holding company level rather than at the trust level. To conclude that there was an indirect property transfer in the circumstances would require a piercing of the corporate veil.
The FCA disagreed with the Tax Court. The FCA interpreted the phrase "acquired property, directly or indirectly in any manner whatever" in the context of paragraph 94(1)(b) very broadly so as to capture "every possible means by which" there was a shift in economic benefit. The FCA noted that this interpretation did not imply any change to the legal principle that the property of a corporation is not the property of its shareholders. On the facts of the case, the corporations were "the instruments" by which the trusts obtained the economic benefit of the shares of the Canadian corporation. Accordingly, paragraph 94(1)(c) was held to apply to deem a trust that was otherwise a non-resident of Canada to be a resident of Canada.
Treaty Override
Notwithstanding the FCA’s conclusion that subsection 94(1) applied to deem the trusts to be resident in Canada for purposes of the Act, the FCA agreed with the Tax Court’s conclusion that the trusts would still be considered to be residents of Barbados for purposes of the Treaty according to well-established principles of treaty interpretation and, therefore, entitled to the benefit of the Article XIV(4) exemption from Canadian income taxation on any gains arising on the disposition of the Canadian holding company shares. The deemed residence rule in subsection 94(1) was held to be substantially limited by its terms – it does not deem a foreign trust to be a person resident in Canada for all purposes and, consequently, falls short of displacing the definition of residence under a tax treaty.
GAAR
GAAR was the final alternative basis that the CRA relied on to support Canadian taxation of the capital gains. The sole issue on the basis for reassessment was whether there was a misuse or abuse of the Treaty. As discussed in detail in our earlier update, the Tax Court rejected each of the submissions for supporting a finding of misuse or abuse of the Treaty. The FCA agreed, concluding that if the trusts were resident in Barbados under the Treaty, the trusts could not be considered to have misused or abused the Treaty by claiming the treaty exemption from Canadian capital gains tax.
Conclusion
As we commented previously, the Garron decision provoked discussion in the Canadian tax community due to its questioning of a fundamental matter that had been generally accepted, i.e., that the residence of a trust is determined by the residence of its trustee. As noted by the FCA, it may well be that, in most cases, the residence of the trustee is a sufficient basis in fact for determining the residence of the trust. The challenge was to determine what other test might be applied in cases such as this one. Subject to further appeal, the FCA has confirmed that the CMC test is the appropriate test.
The CMC test as applied to a trust is arguably not new, but rather is in keeping with the true test of residency of a person – the link between the person and a particular country. We expect that most tax practitioners would not have relied exclusively on the residence of the trustee when advising on the creation of offshore trusts, and would have taken steps to ensure that decisions were, in fact, made outside Canada.
Although the discussion of treaty interpretation and GAAR was obiter, we expect that tax practitioners will take significant comfort from the analysis. Essentially, both levels of court determined that, if a person can establish that it is a resident of a country under the terms of a tax treaty, the taxpayer should be entitled to all the tax treaty benefits to be enjoyed by a resident of that country, subject to any specific restrictions expressed in the relevant treaty such as limitation-of-benefit (LOB) clauses. In the absence of LOB clauses and subject to further appeal of this case, challenges by the Canada Revenue Agency that a taxpayer has engaged in "treaty shopping" may be more difficult to sustain. The Department of Finance may consider whether LOB clauses are now necessary. Given the number of tax treaties and the slow progress of treaty negotiation, it would be a difficult policy to implement.
Antle Upheld
The International Tax Update that discussed Garron outlined in detail the Tax Court decision in Antle, which similarly involved the use of a non-resident trust to avoid Canadian income tax. The Antle decision was recently upheld by the FCA, which agreed with the Tax Court that the trust in that case had not been properly constituted. The FCA did not, however, agree with the Tax Court’s obiter conclusion that the transaction was not a sham. The FCA considered that the test for sham was met where parties to a transaction "present it as being different from what they know it to be."7
1St. Michael Trust Corp. v. R., 2010 FCA 309, released November 17, 2010, affirming 2009 DTC 1568 (TCC), sub nom. Garron Family Trust v. The Queen.
2Thibodeau Trust v. Canada, 78 DTC 6376 (FCTD) is the case typically cited as the judicial authority for this proposition.
3De Beers Consolidated Mines Ltd. v. Howe, [1906] AC 455 (HL).
4Unit Constructions Ltd. v. Bullock, [1960] AC 351 (HL).
5 See Tax Update (Volume 1, Issue 5).
6 See Crown Forest Industries Ltd. v. R., [1995] 2 SCR 802.
7 Antle v. The Queen, 2010 FCA 280 at para. 20.