In order to protect its tax base, the Canadian government taxes foreign trusts on the disposition of taxable Canadian property, and taxes certain foreign trusts on their income as if the trusts were resident in Canada. By taxing foreign trusts, Canada frustrates those tax planning strategies that move capital offshore to escape Canadian taxation. By imposing tax on the disposition of taxable Canadian property, Canada is able to tax capital growth realized in Canada.
In order for an offshore trust to fall within the tax net of Canada, the following two conditions must be present:
• a beneficiary is a Canadian resident, a corporation or trust that deals at non-arm’s-length with a Canadian resident, or a controlled foreign affiliate of a Canadian resident, at any time in the taxation year, and
• the trust acquired the property from that beneficiary (or individual at non-arm’s length to the beneficiary) who was resident in Canada at any time during the 18 month period before the trust’s taxation year-end, and, in the case of an individual, who was resident in Canada for any period(s) of more than 60 months.
This deeming rule catches most tax strategies that entail Canadians simply placing capital into an offshore trust while retaining access to the capital by naming Canadian beneficiaries. While there are a few exceptions, they are generally somewhat remote and beyond the scope of this article.
In a recent court decision, the Canadian tax net was extended to two foreign trusts that were established to avoid the conditions listed above. The taxpayers’ strategy was unsuccessful because the decision-making and control over the trust assets was exercised from Canada. A summary of the relevant facts is as follows:
• Two Canadian individuals (unrelated but shareholders of the same company) settled two offshore trusts in Barbados to hold the common shares of the company issued as part of an estate freeze. St Michael Trust Corporation acted as trustee for the Fundy Settlement and the Summersby Settlement.
• The underlying operating company grew in value and was eventually sold. The two offshore trusts realized substantial capital gains, claimed that the capital gains were exempt from taxation in Canada (as disposition of taxable Canadian property) pursuant to the Canada – Barbados Tax Treaty, and claimed refunds of tax withheld and remitted by the purchaser of the company.
The Canada Revenue Agency (CRA) assessed the trusts as being liable for income tax in Canada on the basis that the trusts were resident in Canada. The CRA took the position that irrespective of the factual residency of the trustees, the mind and management of the trusts was in Canada because all of the important decisions with respect to the disposition of the company were made in Canada.
The taxpayer appealed the CRA’s assessment to the Tax Court of Canada, who affirmed the assessment, stating that the responsibility for the trust’s decisions was carried out not by the Barbados-resident trustee, but by two of the trust’s beneficiaries who were resident in Canada. The taxpayer appealed the Tax Court’s decision to the Federal Court of Appeal who affirmed the lower court’s decision. The Federal Court of Appeal stated that the residence of a trust may not always be determined by the residence of its trustees and the test of central management and control should be applied. Finally, in April of 2012, the Supreme Court of Canada heard an appeal of the case and again affirmed that the residence of a trust should be determined based on the central management and control test.
This case has important implications to all trust planning. No longer will a simple test of trustee residence be applied, but rather the location of mind and control will be a factor to be considered. This applies to offshore trusts as well as interprovincial planning involving locating trusts in other provinces.