At Halloween, kids learn pretty quickly that all it takes to get candy from their neighbours are the magic words “trick or treat.” However, every once in a while a trick-or-treater will come across a neighbour who will not give out treats without seeing a trick in return.
Tax law is a lot like that annoying neighbour. In tax planning, it is not enough to put magic words in a document. Actions matter too. The parties signing a document must also follow through on its meaning.
This is illustrated in a recent case called Garron Family Trust. This case concerned two principals of a Canadian business who wanted to avoid income tax by transferring a large part of the ownership of their business to offshore trusts.
To achieve this goal, the principals followed an elaborate tax plan. Each had a trust set up for him and his family, and the trusts acquired an interest in the principals’ business.
The tax plan relied on a court decision which suggested that a trust resides where its trustees are located. To establish offshore residence, a Barbados-based accounting firm was appointed as the sole trustee of the two trusts. However, the principals were uncomfortable with giving control of a large part of their assets to someone else, so the terms of their trusts essentially gave them the power to remove their trust’s trustee.
The principals later sold their business. After the sale, they argued that the trusts were exempt from paying tax on their capital gains because they were resident in Barbados.
The Tax Court disagreed. It rejected the location of trustees as the test for trust residence, finding instead that a trust resides in the location of its “central management and control.” Under this test, the residence of trustees is important in determining a trust’s residence. However, it will not decide the issue, if key decisions affecting the trust are not made by the trustee.
Using this test, the Court held that the trusts were located in Canada. In reaching this conclusion, the Court was persuaded by evidence that the accounting firm was selected as a trustee to provide administrative services rather than to be responsible for key decisions. The Court was also persuaded by the principals’ ability to replace the trustee, and by evidence that each principal controlled his trust’s investment decisions.
In essence, the Court found that the principals wanted the “treat” of avoiding income tax by transferring assets to an offshore trust without performing the required “trick” of transferring a substantial amount of control over those assets to their trustee.
This decision may be appealed. Tax planners will closely follow an appeal because, if upheld, the Tax Court’s decision could alter the way that trust residence has been generally understood for over thirty years. This could affect tax plans involving off shore and inter-provincial trusts.
These types of trusts can be useful and legitimate tools for tax planning. However, people using them are faced with the tension between the desirability of retaining control over their assets and the need to provide a trustee with sufficient control of the assets for their trust to be recognized as a resident of another jurisdiction.
When trick-or-treating with your tax planning, reliance on magic words will likely result in a slammed door. You can’t get a “treat” without performing the required “trick.” As the recent Tax Court case illustrates, failure to do so can have some very scary consequences.
-- Ryan D.C. Green
The above article provides general commentary of an educational nature. It does not constitute advice for any specific person or any specific set of circumstances. Because circumstances vary, readers should consult professional advisers in order to obtain advice that is applicable to their specific circumstances.
