Supreme Court of Canada renders decision on trust residency

May 18, 2012
On April 12th, 2012, the Supreme Court of Canada dismissed the taxpayers' appeals in Fundy Settlement v Canada, 2012 SCC 14 (also referred to as St. Michael Trust Corp. v The Queen, or the "Garron" case), and upheld the decision of the lower courts that a trust is, for Canadian tax purposes, resident in the jurisdiction where the central management and control of the trust actually takes place. As the case illustrates, this is not necessarily the jurisdiction where the trustees reside.

Background

This case involved a reorganization of the capital of a private Canadian operating corporation, the shares of which were indirectly held by Canadian individuals through two Canadian holding corporations. One of the primary objectives of the reorganization was to ensure that no Canadian tax would be payable on any future capital gain that could result from an increase in the value of the operating company. To accomplish this, the existing common shares of the operating company were exchanged for "freeze shares" redeemable for an amount equal to the fair market value of the common shares immediately before the reorganization was implemented, and new common shares in the operating company were issued to two newly-formed Canadian resident holding corporations. Shares in these new holding corporations were then issued to trusts settled in Barbados.

When the trusts disposed of the shares in the Canadian holding corporations, the purchaser withheld approximately $152 million of the purchase price and remitted this amount to the Minister of National Revenue pursuant to section 116 of the Income Tax Act (Canada) (the "Act") on account of the potential Canadian tax on the capital gains realized by the trusts on the sale of the shares. The Barbados trustee sought the return of the withheld amount pursuant to an exemption from Canadian capital gains tax under the Canada-Barbados Income Tax Treaty (the "Treaty") on the basis that the trusts were resident in Barbados and not in Canada. According to the relevant exemption, tax would only be payable by the trusts in the country in which they were resident for purposes of the Treaty.

The Decision of the Supreme Court

The Supreme Court of Canada agreed with the lower courts that the residence of a trust for Canadian tax law purposes should be determined by the principle that a trust is resident where its real business is carried on, which is where the central management and control of the trust actually takes place. In settling this issue, the Supreme Court has confirmed that the "central management and control" test, which has been the common law test for determining the residence of a corporation since the 1906 decision of the House of Lords in De Beers Consolidated Mines Ltd. v Howe, is also applicable to trusts. In this regard, the Supreme Court agreed with Justice Woods (the judge of first instance at the Tax Court of Canada) that adopting a similar test for trusts and corporations promotes the important principles of consistency, predictability and fairness in the application of tax law.

Prior to this case, it was generally accepted by the tax community that a trust is resident in the jurisdiction where a majority of its trustees reside. However, since this rule had never been conclusively endorsed by a court, and since the Canada Revenue Agency has for many years expressed the view that management and control of a trust is an important factor in the residence determination, most tax professionals have generally been sensitive to this issue when advising clients regarding transactions involving offshore trusts. As a result of the Supreme Court's decision, it is now clear that for Canadian tax purposes, a trust will be resident in the jurisdiction in which the substantive decision-making regarding the trust takes place. As acknowledged by the Federal Court of Appeal in this case, this will often require a line to be drawn between, on the one hand, strong recommendations by the beneficiaries to the trustee, leaving the trustee free to decide how to exercise the powers and discretions under the trust, and on the other, where beneficiaries are really exercising the powers and discretions under the trust as regards its management and control.

In this case, all levels of court accepted that the Barbados trustee did not exercise the main powers and discretions under the trust indentures, but rather limited its involvement to the execution of documents and the provision of administrative services. As determined by the Tax Court of Canada, the primary beneficiaries, either directly or indirectly through their advisors, exercised central management and control of the trusts in Canada. As a result, notwithstanding that the sole trustee appointed was a trust company resident in Barbados, the trusts were found to be resident in Canada for purposes of the Act and the Treaty.

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