Tax Consequences of Carrying on Business through a Disregarded Entity in the United States

Reproduced from the April edition "Private Companies and Taxes"

It is common for Canadian corporations when expanding into the United States to conduct their U.S. operations through a Delaware Limited Liability Company (“LLC”) or through a Nevada LLC.  This article will discuss the tax consequences of utilizing an LLC.

An LLC is an American hybrid structure inspired by the Limited Liability Partnership structures of Central and South America which are often referred to as “Limitada”.  An LLC combines the characteristics of a corporation with that of a limited partnership. The LLC has similarities to a corporation or a limited liability partnership as it provides a shield for a member’s personal assets from creditors of the LLC.  Owners of an LLC are referred to as members and can be individuals, corporations or other LLCs.  Generally, members do not have to be residents of the U.S. and there is usually no limit on the number of members.  Most States also allow for a single member LLC.  LLC legislation differs from State to State with the result that each State may impose different eligibility requirements to form an LLC. State taxation of LLCs also differs from State to State.

An LLC with only one member will be treated as a disregarded entity for U.S. income tax purposes unless the LLC elects to be treated as a corporation on I.R.S. Form 8832.  An LLC with two or more members is treated as a partnership unless it elects otherwise on Form 8832.  A disregarded entity’s activities are treated in the same manner as a sole proprietorship, branch, or division of its owner (IRC Reg. 301-7701-2(a)).

Illustration

LLC carries on an active business selling widgets manufactured in Canada to arm length customers in the U.S. It also earns royalty income from a licensing agreement with U.S. widget manufacturers.  In 2012, LLC earned $100,000 net from selling widgets and LLC also earned $50,000 in royalty income.  For purposes of the illustration, it is assumed that Canada considers the LLC to be a U.S. corporation and that the LLC is not deemed to be Canadian Corporation under the mind and management rules.

  

Canadian Tax Treatment

For Canadian income tax purposes the LLC is deemed to be a U.S. corporation and a controlled foreign affiliate (“CFA”) of Canco. 

The characteristic of the income earned by the CFA will determine the tax treatment accorded to the income in Canada.  Under the Foreign Affiliate Rules contained in the Income Tax Act a foreign affiliate’s income can be from property, a business other than active business income or from the carrying on of an active business.  The first two sources of income are characterized as passive unless there are sufficient employees on the ground earning such income in the foreign jurisdiction to re-characterize the income as active.  The classification of passive versus active is important as this determines the treatment of the income in Canada.  Dividends from earnings of an active business carried on will be deemed to be from exempt surplus and will not be subject to Canadian income tax on repatriation.  Passive income, or as the Income Tax Act titles it, foreign accrual property income (“FAPI”) is taxed in the hands of the shareholder (which can be an individual or a corporation) when earned by the CFA.  In other words, one is taxed on FAPI income whether or not such income has been distributed.

In our example, CanCo will only need to include into income for its 2012 year end - $50,000 of the licensing income as this will be deemed FAPI income.  There is nothing in the facts that states that the licensing royalties are active business earnings.  Should LLC distribute the $100,000 as a dividend then the amount received in Canada will not need to be included into CanCo’s taxable income calculation, as it is traceable to earnings from an active business and is therefore derived from exempt surplus.

 

U.S. Tax Treatment

In the U.S. a non-U.S. person is subject to U.S. income tax where such person earns:

·         Income effectively connected to a U.S. trade or business;

·         Fixed or Determinable Annual or Periodical (“FDAP”) income which consists of passive income such as dividends, interest, rents, royalties.

The concept of “effectively connected” income, or ECI, is applicable only to a foreign (a Non-U.S.) corporation or a foreign (a Non-U.S.) individual engaged in a U.S. trade or business.  ECI is subject to the progressive tax rates of IRC §11 (corporate tax rates) or IRC §1 (individual tax rates).  Non-business income which is typically referred to as FDAP income is taxed at the flat rate of 30% under §881 (corporations) or under §871 where the taxpayer is an individual or at a lower tax treaty rate.  Under the Canada – U.S. Income Tax Convention (“Tax Treaty”) the 30% rate will be reduced to the Tax Treaty rate of 5% for dividends, 0% for interest and royalties for payments from a wholly owned subsidiary to its Canadian parent.

LLC as a branch will not only be subject to the graduated rates of IRC §11 on income earned in the US but it will also be subject to the branch profits tax which is imposed on its “dividend equivalent amount (“DEA”). The term DEA is a statutory defined term – see IRC §884(b) – and is intended to be equal to the amount that would have been distributed by the branch had it been a U.S. subsidiary. This article will not discuss the DEA calculation. LLC will be deemed to be remitting a dividend for each of its taxation years equal to the DEA even if it does not actually remit. The DEA is only levied on amounts surpassing $500,000 Canadian dollars (Treas. Reg. §1.884-1(g)(4)(iv)(B). Any amount over Cdn $500,000 will likely be subject to a 30% withholding tax pursuant to Article IV(7) which in essence denies treaty benefits to a Canadian owned LLC.

The royalty payment paid to U.S. LLC will, however, not be able to benefit from the reduced Tax Treaty rate pursuant to IRC §894(c) as such payments are deemed to not be to CanCo, but to a disregarded entity. See IRC Reg. §1.894-1(d)(1) which states:

The tax imposed by sections 871(a), 881(a), 1443, 1461, and 4948(a) on an item of income received by an entity, wherever organized, that is fiscally transparent under the laws of the United States and/or any other jurisdiction with respect to an item of income shall be eligible for reduction under the terms of an income tax treaty to which the United States is a party only if the item of income is derived by a resident of the applicable treaty jurisdiction.  …. An item of income paid to an entity shall be considered to be derived by the entity only if the entity is not fiscally transparent under the laws of the entity's jurisdiction ….

CanCo will therefore be subject to a 30% withholding tax on the $50,000 royalty income earned by LLC. 

The purpose of the above illustration is to outline the potential pitfalls when structuring operations through an LLC in the United States.  Practitioners often readily assume the LLC is a flow through for U.S. purposes but fail to take into consideration the punitive provision of IRC §894(c) and the CFA rules under the Income Tax Act where such LLC earns passive income.

Sunita Doobay

TaxChambers, Toronto

Sunita can be reached at sunita.doobay@taxchambers.ca

Interest Deduction Denied: Swirsky

In Swirsky (2013 TCC 73) the TCC concluded that interest paid on a loan incurred for the purpose of a share purchase was not deductible under subparagraph 20(1)(c)(i). The decision touches upon the issue of whether the gross expected dividend return on shares places a limit on the deductibility of interest expense related to their purchase.

Mr. Swirsky, the taxpayer, held shares in Torgan Construction Limited, a corporation actively engaged in real estate development. The taxpayer incorporated Torgan in 1974 and his wife became an equal shareholder a few years after their marriage. The 1989 decline in the real estate market created the very real possibility of bankruptcy to the taxpayer. Just before the market peaked, the taxpayer and Mr. Cohen embarked on an ambitious development and each provided joint and several personal guarantees to a bank. The project was cancelled and when the taxpayer learned from Mr. Cohen that he was creditor proof, he had reasonable concerns that the bank would seek to collect the entire loan amount under his personal guarantee. The taxpayer sought to place the Torgan shares out of the lender’s reach by selling them to his wife and by using the sale proceeds to pay down shareholder loans that he owed to Torgan.

Torgan had not made a practice of paying dividends and instead paid bonuses and extended significant shareholder loans to the taxpayer to achieve the deductibility of amounts paid out of its income. Arguably on the facts a preference existed, because Mr. Swirsky knew that he was potentially facing bankruptcy, his wife believed that bankruptcy was imminent, and the transaction was entered into to preserve family income, but the court concluded that the transaction was an effective creditor-proofing measure.

In Shell ([1999] 3 SCR 622) the SCC concluded that four requirements support an interest deduction under paragraph 20(1)(c): (1) the amount must be paid in the year or be payable in respect of the year of deduction; (2) the amount must be paid pursuant to a legal obligation to pay interest on borrowed money; (3) the borrowed money must be used for the purpose of earning non-exempt income from a business or property; and (4) the amount must be reasonable in light of the first three requirements. 

The TCC in Swirsky focused on the third requirement: whether the borrowed money was used for the purposes of earning non-exempt income. Based on Ludco, although personal intention is not determinative, the TCC in Swirsky said that clearly the wife  purchased the shares without any understanding of their potential for income. And there was little objective history of the payment of dividends on those shares before their transfer to the wife. Interestingly, dividends were paid on the shares after their transfer. The TCC largely ignored the post-transfer conduct, but pointed out that the first dividend paid was a non-taxable capital dividend, and the first taxable income after the shares’ transfer occurred in 2003, over seven years after the transfer’s final stage. (The accountants advised to transfer the shares in three tranches in order to match the shareholder loans outstanding.) According to the TCC, Ludco required that there must be a reasonable expectation of income at the time that the investment was made.

On the facts presented, there is a strong implication that the wife agreed to purchase the shares in order to facilitate a creditor-proofing transaction, independent of any desire to earn income. The TCC also concluded that the spouses agreed between themselves that the wife would not be responsible for the loan costs. The court concluded that thus it was more likely than not that the wife was not concerned with the shares’ income-earning potential at the time of their purchase.

The TCC appears to be correct in concluding that based on a lack of dividend history, a reasonable buyer could not anticipate income, and thus the wife had no reasonable expectation of earning income from the shares acquired with the loan. The wife’s lack of understanding of the economic consequences augments the conclusion that there was no reasonable expectation of earning income from the shares. Arguably a history of dividend payments prior to the transfer might have resulted in a different conclusion because it would justify an objectively supported and reasonable belief that the shares would earn income. However, the focus on dividend payments as the predominant source of income from shares may seem too narrow in the context or a personally held corporation, because many taxpayers earn different types of income from a corporation, such as salary, bonuses, loans, and dividends. Salary and bonuses are generally used to entice employees to reach their top performance.

In our view the TCC in Swirsky was correct to focus on dividends. The CBCA provides two economic rights that must be allotted to classes of shares: the right to receive any dividend declared by the corporation and to receive the remaining property of the corporation on dissolution. Other rights, such as a conversion right or a right of redemption, attach to the share, not the shareholder (Bowater Canada Ltd v RL Crain Inc (1987), 62 O.R. (2d) 752, 46 D.L.R. (4th) 161, 26 O.A.C. 348, 39 BLR 34). Thus while most other forms of compensation, such as salary and bonuses, are tied to acts done on the corporation’s behalf, dividends are the product of two factors. First, the directors must decide to declare a dividend, further to their obligation to manage the business and affairs of the corporation. Second, the shareholder must own a share that has the right to participate in the dividend declared. If both elements are present, the principle of equality demands that the share receive the dividend (McClurg, [1990] 3 SCR 1020) and no further acts by the shareholder on the corporation’s behalf are required to justify the payment of the dividend (Neuman, [1998] 1 SCR 770).

Sunita Doobay

TaxChambers, Toronto

Darcy L. MacPherson

Faculty of Law, University of Manitoba

Amended Ontario Estate Tax

Republished with permission from the Canadian Tax Foundation.  First published in the March, 2013 edition of the Canadian Tax Highlights, a Canadian Tax Foundation publication.

Ontario’s estate administration tax, better known as the probate tax, was created in 1998 under the Estate Administration Tax Act (EATA). The latest EATA amendments (Bill 173) became effective after 2012 and appear to create new issues for taxpayers.  Ontario taxpayers reacted vigorously when the province trebled what was then known as the probate fee from 0.5 to 1.5 percent on estate assets whose value exceeded $50,000. The probate rate increase arguably triggered planning efforts to ensure that assets were not subject to the fee. Moreover, the probate fee itself was directly and successfully challenged in Eurig Estate (Re) ([1998] 2 SCR 565), in which the SCC held that although the probate fee was a constitutionally authorized direct tax, it had come into force through the lieutenant governor in council and had not originated in the legislature as mandated by the Constitution Act, 1867. The SCC gave Ontario six months to rectify the legislation in recognition of the financial hardship for the province if it could not retain the fees that it had collected over the years. Ontario responded by implementing EATA: the probate fee became a legislatively imposed direct tax that retroactively ensured the legality of the already collected probate fees (but specifically exempted the Eurig estate).

The term “probate” is a universally accepted legal synonym for proof—authentication by a court order that the will on which third parties are being asked to rely is the last effective will, and a declaration that certain executors and trustees are in control. (In Ontario, the former grant of letters probate is now referred to as a certificate of appointment of estate trustee, either with or without a will.) However, a will’s essential validity does not depend on its probate, and an un-probated will may be recognized and accepted by third parties who hold assets of value that devolve under the will.  For years, the probate system relied on valuations that were left to the discretion of executors and their advisers.  For example, if the value of a modest old house was estimated to be $200,000 for probate purposes but the house was later sold for $50,000 over or under the estimate, only $750 in probate fees (at 0.5 percent) was at stake.

A formal valuation was frequently seen as a waste of estate resources, and the payment of additional corrected probate fees and requests for refunds of overpayment were routine and non-contentious. A sworn affidavit of value of realty and personalty supported the application for probate; that requirement was in keeping with the system’s self-reporting nature and relied on the integrity of the practitioners who advised (and deposed) the executors. What was to be included in and excluded from the valuation was not always legislatively clear. The practices of deducting an outstanding mortgage on real estate and excluding insurance payable to a named beneficiary arose from small-print wording in Ontario’s probate application form. Whether registered plans such as RRSPs and RRIFs with named beneficiaries were excluded by analogy to insurance was debatable, and many practitioners may have excluded them because they were subject to income tax.

The bulk of value in most ordinary estates still passes to beneficiaries without the payment of probate, whether via joint tenancy, a joint bank or investment account, designation of a beneficiary to insurance or a registered plan, or a gift inter vivos. More valuable estates employ more sophisticated will substitutes such as family trusts and alter ego and joint partner trusts.  For some time, wealthy international families with multijurisdictional estates have structured multiple-situs wills based on statutory provisions that were intended to accommodate foreign executors. For example, if the representatives of a foreign estate come to Ontario seeking to administer assets located in the province (such as a cottage in Muskoka), they do not need to re-probate the entire foreign estate in Ontario; instead, they can seek a limited grant of probate whose authority is limited to the particular Ontario asset that they want to administer. The probate taxes payable are calculated on those limited assets. Since the 1990s, the “limited grant of probate” format has been used in Ontario to establish dual concurrent wills, although the dual-will strategy is largely unknown to legal practitioners outside the estates and tax areas.

The primary concurrent will recites that it applies to all assets except for those that are defined and covered by the secondary will. The primary will is submitted to the probate process, and probate is paid on the declared values of the primary estate. For example, shares of a private company may be the subject of a secondary will if the company is run by family members who are not concerned about court authentication of the deceased’s will.  Ontario unsuccessfully challenged the dual-will splitting of an otherwise probatable estate in 1998 in Granovsky Estate v. Ontario (1998 CanLII 14913 (ONSC)) and abandoned its appeal of the decision. Greer J, a senior and respected estates judge, confirmed that there was no obligation to pay probate taxes and that a will can be valid with or without probate. Probate was paid in exchange for the benefits of the court authentication process.

However, if an asset can be administered without the authority of a probated will, the executors are not required to apply for probate or to pay probate tax.  The planning for and drafting of two or more concurrent wills is complex, time-consuming, and expensive, and the so-called dual will is thus used only if the projected tax savings warrant its use—for example, if a valuable private corporation forms part of the estate. In an era of ongoing budget deficits, Ontario’s apparently continuing struggle with the collection of probate tax gave rise in its 2011 budget to EATA amendments in Bill 173, which became effective after 2012. The amendments in section 4.1 bring EATA’s enforcement under the jurisdiction of the minister of revenue, but they go beyond harmonization and centralization of monitoring and enforcement.

The section 4.1 amendments adopt the minister of revenue’s assessment powers under the Ontario Retail Sales Tax Act. The minister can assess or reassess the estate in the four years following the probate tax’s due date (section 4.5(1)). However, EATA does not contain a clearance certificate similar to that provided for in the Income Tax Act, and thus the minister can apparently assess and seek to collect additional probate tax from the beneficiaries after the estate assets have been distributed but within the four years after the probate tax fell due. Traditional wisdom says that an estate trustee is liable in a representative capacity only and not personally, but commentators have raised the possibility that the beneficiaries may have legal recourse against the estate trustee personally. (See, for example, Barry S. Corbin, “Estate Administration Tax—The Nightmare Begins,” www.oba.org/en/pdf/sec_news _tru_may11_a1_EAT.pdf.) Given the minister’s broad powers, there may be disagreement over an estate’s valuation for probate, especially if a private corporation is involved. Inspectors appointed under the minister have the same powers set out in sections 31(1) to (2.2) of the Retail Sales Tax Act to inspect books, records, and property at any premises where the estate’s goods, books, and records are kept (section 4.7).

Because the assessment period is four years, it is unclear how this provision will be enforced after the assets are distributed. Clearly, the trustee must keep meticulous records—a requirement also essential for a trustee’s EATA due diligence defence—but a trustee will be reluctant to distribute all estate assets before the four-year assessment period expires. Holdbacks may not be sufficient to cover the unpaid tax in the case of undervaluation. A new EATA provision (section 5.1(3)) allows for the exchange of information with provincial and federal government entities. Any trustee who provides a false or misleading statement may be subject to imprisonment or a fine, but may rely on the due diligence defence if “the statement or omission was false or misleading and in the exercise of reasonable diligence [the trustee] could not have known that the statement or omission was false or misleading.”  The practical compliance burden created by a new duty to provide information has raised concern in the tax community. EATA section 4.1(2) provides that “[i]f an estate representative makes an application for an estate certificate, the estate representative shall give the Minister of Revenue such information about the deceased person as may be prescribed by the Minister of Finance.” No regulations have yet been released. It is hoped that the ministry will consult with practitioners before implementation in order to avoid imposing an increased burden on the probate court system and greater delays in the issuance of certificates of appointment of estate trustee. In our view, additional information obtained under section 4.1(2) should not invalidate the dual-wills strategy, which has not been specifically addressed under EATA.

The estate administration tax is levied on the “value of the estate” (a reference is made to the definition of “value of an estate” in section 32 of the Estates Act). Section 32 has not been changed since it was considered in Granovsky, and section 32(3) clearly provides for a limited grant of probate: “Where the application or grant is limited to part only of the property of the deceased, it is sufficient to set forth in the statement of value only the property and value thereof intended to be affected by such application or grant.” In contrast, some other high-probate provinces’ legislation is directed at the dual-wills structure and other strategies. For example, section 86(2) of the Nova Scotia Probate Act expressly provides that the probate tax is imposed “on all assets of the deceased person that pass by a will or wills or that are transferred or will be transferred to a trust under a will or wills.” Even the beneficiary of substantial estate property may hesitate to assume an estate trustee’s role under the amended EATA. Increasingly, affluent testators may plan in order to remove their estate from the reach of the Ontario EATA.

Sunita Doobay

TaxChambers, Toronto

Glenn M. Davis

Toronto

Ten Plus Years to Enactment

Recently published in the Canadian Tax Highlights, a Canadian Tax Foundation Publication and reposted with permission here:

In Edwards (2012 FCA 330) the FCA reversed the TCC motions judge and granted to the taxpayer an adjournment of the hearing of his appeal to the TCC on the merits. The taxpayer sought to adjourn the trial pending enactment of proposed ITA amendments.

In 2003 the taxpayer contributed cash of $3,150 to a leveraged donation program; he was provided with a charitable donation receipt in the amount of $10,000 and claimed the receipted amount for a donation credit. Upon reassessment the minister denied the full credit on the basis that the donation did not qualify as a gift within the meaning of section 118.1 because the taxpayer was deemed to have received a benefit and, alternatively, because section 245 denied the credit. In 2002 the federal government had announced its intention – effective from the date of announcement - to amend the act to deal with leveraged donation programs and the 2012 budget showed an intention to enact those amendments. The CRA had been treating those proposals as if they were enacted, but a taxpayer who is not assessed favourably based on proposals cannot appeal and challenge the minister’s view because the proposals are not in fact law.

On April 23, 2008, the taxpayer commenced an appeal to the TCC under the informal procedure but it was moved to the general procedure upon the Crown’s request. The Maréchaux case was proceeding through the courts at the same time and the taxpayer in Edwards received an abeyance when the taxpayer in Maréchaux was denied leave to appeal to the SCC. The taxpayer in Edwards sought a further abeyance and in July 2012 moved to adjourn the TCC hearing for a maximum of one year from November 26, 2012 on the possibility that the December 2002 proposed amendments would be enacted by then.    

Proposed subsections 248(30), (31) and (32) may allow a credit for the actual cash donated net of the “advantage” received as a result: on the facts the taxpayer argued that he should receive a credit for $3,150, the amount of cash he donated. The technical notes provide that the amendments “are intended to reflect the policy that the amount eligible for an income tax benefit to a donor, by way of a charitable donation deduction or credit or a political contributions tax credit, should reflect the economic impact on the donor (before considering the income tax benefit) of the gift or contribution.” The CRA said that Mr. Edwards lacked the donative intent required to establish the existence of any donation.

The motions judge concluded that denying the adjournment would potentially prejudice the taxpayer by denying him the benefit of arguing that the legislation applied and possibly making the CRA more receptive to settlement. Also the denial might necessitate further litigation for other taxpayers. However, that potential prejudice was outweighed by the public interest in the administration of justice that was inherent in tax litigation proceeding in a timely manner, particularly because tax deductions for $500 million of donations might be affected. According to the TCC, about 18,000 taxpayers participated in similar programs and some 8,000 had been reassessed. Mr. Edwards’ case was selected as the lead case for 8 other appeals held in abeyance pending his appeal to the FCA. The motions judge said that “thousands of other taxpayers are waiting in the wings.” Furthermore the motions judge noted that the appeal involved transactions that occurred almost 9 years ago and the appeal was first set down over two years ago. At the time of the motion’s hearing, “there was very little indication that the legislation will be enacted soon” or if the proposals even applied to Mr. Edwards.

The FCA acknowledged that the granting of an adjournment is generally within the motions judge’s discretion and discretionary decisions of a trial or motions judge are generally subject to significant deference on appeal. The FCA concluded that the motions judge did not commit an error in principle, misapprehend the facts, or otherwise reach an unreasonable decision in the exercise of the broad discretion conferred on her. The trial in Edwards was meant to be a test case: thousands of taxpayers were situated similarly. Perhaps most significantly, on November 26, 2012 - five days before the appeal’s hearing - the proposals and other technical amendments received first reading as Bill C-48; this was a new fact that had not and could not reasonably have been put before the motions judge in July 2012. Moreover if Mr. Edwards’ appeal was heard before the proposals were enacted, another lead case would have been chosen and therefore refusing the adjournment would not promote judicial economy. The introduction of Bill C-48 substantially reduces the uncertainty around the proposals’ enactment and thus an adjournment would cause less prejudice to the public interest in the timely administration of justice. Moreover further delay may have been inevitable because it was not clear that the TCC could reschedule a hearing within the next 12 months in any event.

           

The FCA went on to say that

…there seems something fundamentally unfair in the CRA's administration of proposed amendments to the Income Tax Act for the past ten years as if they were already law. A taxpayer is not able to challenge a decision by the CRA that the proposed amendments do not apply to the circumstances of the taxpayer. I emphasize, however, that I am expressing no view as to whether Mr. Edwards will benefit from the proposed amendments when and if they are enacted.

It seems appropriate for the government to make tax changes retroactive to their announcement in order to prevent taxpayers from re-organizing their affairs to avoid a change’s intended effect. However, in this case the government announced a statement of its intent – which may differ from the court-determined legislative intent – and for a decade the CRA seems to have adopted that stated intent and treated the proposals as if they were enacted law.  

The FCA did not offer insight into any recourse that the taxpayer might have in such cases other than to say that the result seemed fundamentally unfair. Retroactivity is an expectation by a government that its citizens will govern their behaviour based on rules that are not yet law and is also a concession to practical realities: (a) a government must annually decide fiscal priorities, and how to achieve them; (b) the process of transforming priorities into enacting legislation takes time; and (c) the effectiveness of fiscal policy suffers without retroactivity to prevent tax planning and other devices from circumventing policy during the gap between announcement and enactment. However, this rationale assumes that the intervening period is a reasonable length of time. What is a reasonable time frame is a matter for further discussion but is not likely to be made specific by the courts. The FCA has commented on the unfairness of the situation; whether the government will respond and give taxpayers some means of redress is yet to be seen.

Sunita D. Doobay

TaxChambers LLP, Toronto

Darcy L. MacPherson

Faculty of Law, University of Manitoba, Winnipeg

The amendments to the Ontario Estate Administration Act

I will be publishing an article on this topic but wanted to provide in the mean time a link to a presentation I gave to the CMAs here in Toronto a few weeks ago.

When will Canada implement pet trust legislation?

On November 22, 2012, my beloved Rottweiler Paco passed.  He was diagnosed with osteo sarcoma (bone cancer) in October.  The cancer had spread into his lungs.  He would have been 7 on January 19, 2013.  His diagnosis and then death hit me hard.  We had never been informed of this type of cancer by the breeder or by his vets despite the fact that research has deemed this form of cancer as fairly prevalent in large breeds such as the German Shepherd and the Rottweiler.  Not sure what we could have done to prevent him passing from osteo sarcoma but maybe knowledge of this cancer would have enabled us to have caught the cancer at an earlier stage thereby prolonging his life.

He was smart – would open the refrigerator whenever there was filet mignon and help himself and there would be none left for us.  After his diagnosis I ensured that he had filet mignon every night.  Although I had hoped for a miracle we had no choice but to say goodbye once the fentanyl (a drug stronger than morphine) could not mask his pain.  His death emphasized the fragility of life and the intense grief we all felt at the diagnosis and passing and continue to feel illustrate the love we had for him and the love one typically has for a pet.  Although I outlived Paco, I always worried what would happen to him if we were all to pass and leave him behind.  Canada unlike the United States does not have legislation allowing us to create a statutory pet trust which would allow us to settle a trust with our pets as beneficiaries.    

Canada lags behind the United States where to use the language from the Animal Legal Defense Fund valid trusts can be created for “non-human animals”.    The District of Columbia including 41 States ( Alabama, Alaska, Arizona, Arkansas, California, Colorado, Connecticut, Delaware, Florida, Hawaii, Idaho, Illinois, Indiana, Iowa, Kansas, Maine, Maryland, Michigan, Missouri, Montana, Nebraska, Nevada, New Hampshire, New Jersey, New Mexico, New York, North Carolina, North Dakota, Ohio, Oregon, Pennsylvania, Rhode Island, South Carolina, South Dakota, Tennessee, Texas, Utah, Vermont, Virginia, Washington and Wyoming) recognize these trusts as valid.  This recognition of the validity of a trust created for the welfare of non-human animals allowed Leona Helmsley to establish an inter vivos trust under New York State law for the care of her dog of Trouble which was later funded with $12 million as directed by her will.    This amount was reduced to $2 million by the Court when her will was challenged.    

When funding a pet trust in one of the States or in the District of Columbia several considerations need to be made.  The cost of the care giver, will a residence need to be purchased to enable all pets plus the caregiver to reside in the same location.  A valuable overview of issues to be considered by practitioners drafting a trust fund and the settlor of a pet trust are found in HelmsleyPet Trust raises Issues for Owners of all Income Levels  by Frances Carlisle. This article also points out that an inter vivos trust is preferred over a testamentary trust.  An inter vivos trust is created during the life time of the settlor and allows for the care of the animal during the life time of the settlor where the settlor is incapacitated and is thereby unable to look after the animal.

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The aforementioned however does not work in Canada.  In Canada a non-human animal cannot be a beneficiary of a trust as an animal cannot enforce the terms of the trust.  I currently don’t have a solution on how to ensure the welfare of one’s pets here in Canada after passing.  I would encourage that we lean on our policy makers to enable a statutory pet trust in Canada similar to the United States.

Can a Charitable Foundation with a Single Trustee be designated as a Public Foundation?

Recently published in the Canadian Tax Journal and reproduced with permission here.

Introduction

The Federal Court of Appeal recently released its decision in Sheldon Inwentash and Lynn Factor Charitable Foundation v. Canada. At issue in the case were the requirements for a charitable foundation to qualify as a “public foundation” for the purposes of the Income Tax Act.

The Effect of the Designation

There are several differences between a private charitable foundation and a public foundation. The main difference from a non-tax perspective is that a private foundation is typically funded by related individuals while a public foundation is typically funded by unrelated parties.

From a tax perspective, there are several additional differences. One important difference is that the Act strictly prohibits a private foundation from carrying on any business. A public foundation, on the other hand, may carry on a business related to the charitable objects of the foundation.

Another notable difference from a tax perspective is that a private foundation, unlike a public foundation, cannot issue donation receipts for non-qualifying securities unless and until such securities are disposed of within 60 months of the date on which the donation was made. A non-qualifying security for these purposes is a security, obligation, or share of a non-arm’s-length corporation. In other words, where a shareholder of a related corporation gifts his or her shares to a private foundation, the donor is unable to take an immediate tax benefit from this transaction, and if the foundation does not  dispose of the  qualifying shares within  the  statutory  time frame, the tax advantage to the donor will be lost.

The Facts

In Sheldon Inwentash, an inter vivos trust was settled by Mr. Inwentash and capitalized by him, his spouse (Lynn Factor), and /or entities controlled by them. While the trust qualified as a charitable foundation and a registered charity under the Act, the min- ister designated the trust as a private foundation, as opposed to a public foundation, in large part on the basis that the trust had only one trustee.

Pursuant to paragraph 172(3)(a.i), the trust appealed the designation directly to the Federal Court of Appeal.

Analysis

The Current Statutory Ambiguity

The court considered the intent of Parliament with respect to whether a charitable foundation with a single trustee could be designated as a public foundation. The Act does not explicitly address this issue. However, section 149.1 does define the term “public foundation” to mean, essentially, a charitable foundation of which

1. more than 50 percent of the directors, trustees, officers, or like officials deal with each other at arm’s length, and

2. not more than 50 percent  of the capital contributed  was paid by a related group.

Neither  the definition nor any other provision of the Act specifies whether a public foundation  must have a minimum number  of directors, trustees, etc., in order to meet the first requirement.

A charitable  foundation  that  is not a public foundation  is considered  to be a “private foundation,” as defined in section 149.1.

The Court’s Decision

Textual Interpretation

The appellant’s main argument was that, while the trust had only one trustee, on the basis of the wording of the definition of “public foundation,” this did not constitute a violation of the arm’s-length requirement.

The court disagreed. The court held that the intention of Parliament was to ensure that public foundations have more than one trustee. There were three reasons for this. First, it is implicit in the reference in section 149.1 to “more than 50% of the . . . trustees” that there be more than one. Second, section 149.1 states that all of the trustees and other like officials should be dealing with “each other”; if the trustees are required to “deal with each other,” there must be more than one. Third, if the trustees must deal with each other at arm’s length, there is a requirement of multiple trustees. One cannot be at arm’s length from oneself. The court therefore held that there must be more than one trustee.

During the oral argument, counsel for the appellant suggested that the court should read out or not apply certain words in the definition when there was only one trustee. Yet the legislature is presumed not to speak in vain. Every word in the statute is generally considered to be in the statute for a reason [Ruth Sullivan,  Sullivan on the Construction of Statutes, 5th ed. (Markham, ON: LexisNexis Canada, 2008), at 530.].  This, the court held, was a reason not to accept the statutory interpretation put forward by the appellant.

It appears that Dawson JA was prepared to decide the case on this textual interpretation, but she chose to extend her analysis:

In my view, by the use of this language Parliament has precisely and unequivocally evidenced its intent that public foundations must have more than one trustee (or director, officer or like official). This means that the ordinary meaning of the words used should play the dominant role in the interpretation of the definition. For completeness, however, I will review the statutory context and purpose of the definition.

Context and Purpose

The court held that the statutory context and the purpose of the “public foundation” definition clearly indicated that, in choosing different treatment of public and private foundations, the federal government was concerned about potential abuse through self-dealing transactions.[1]

Charitable foundations can be used to mask self-dealing transactions and avoid taxes for the principals behind the foundation. The court provided two examples of such transactions:

 1. having the charity rent premises from the donor at high rent; and

2. investing in low-yield debt or equity of the donor’s business.

The court reviewed a publication from the Department of Finance and concluded that by creating public and private foundations, Parliament was balancing a desire to promote philanthropy with a concurrent desire to limit the potential for avoidance schemes.[2] A requirement for multiple trustees/managers[3] is one way to ensure that one party cannot control the work of the foundation at issue, and thus to reduce the likelihood of self-dealing transactions. If many people are involved in filling management positions and in giving money, there will likely be multiple layers of oversight of the activities of the charitable foundation.  This makes it more difficult for any individual or group to arrange the affairs of the foundation so as to benefit that individual or group, rather than the charitable purposes for which the foundation was created. If these safeguards against the possibility of self-dealing are in place, the designation of “public foundation” will give greater latitude to the charity. Conversely, if the setup and operation of the charitable foundation is unlikely to prevent self-dealing by its founders, or by other individuals or groups, the law provides specific restrictions  (as noted above) that are designed to remove the tax benefits that may otherwise have been part of the reason for creating the foundation in the first place. Therefore, the law creates an incentive for oversight and commitment to charitable purposes, rather than an opportunity for self-dealing.

A parallel concept to the distinction in the Act between a “public” and a “private” charitable foundation can be found in corporate law. In that context, the same nomenclature is often used in popular discourse to describe the distinction between corporations subject to public securities regulation and other corporations. Generally, there are different rules governing the control of public corporations. For example, under the Canada Business Corporations Act (“CBCA”), “distributing  corporations”  (which generally would all be “public” corporations) are expressly required to have at least three directors, at least two of whom must not be either officers or employees of the corporation.

The point of this requirement is to ensure that management[4] is accountable to persons who are not dependent on the corporation for their livelihood.[5]  In a “public” or “distributing” corporation, a solicitation of funds from the public is made.[6]  At the same time, the involvement of most shareholders in the corporation is minimal and intermittent, through shareholder meetings.18  Yet shareholders are the residual beneficiaries of the activities of the corporation.19 Thus, certain safeguards are put in place to ensure that the members of management do not enrich themselves at the expense of the shareholders.20  In the simplest terms, the use of outside directors (who are neither part of management nor employed by the corporation) is designed to discourage self-serving behaviour. In the same way, public foundations are subject to a less restrictive regulatory regime under the Income Tax Act than that applied to private foundations, presumably on the basis that the involvement of arm’s-length directors and funding from third parties will prevent any self-dealing that would allow unwarranted tax benefits.

The Interpretation Act Argument

The appellant argued that section 33(2) of the federal Interpretation Act applied. That provision states that “words in the plural include the singular.” The court rejected this argument, relying on section 3(1) of the Interpretation Act, which states as follows:

 (1) Every provision of this Act applies, unless a contrary intention appears, to every enactment, whether enacted before or after the commencement of this Act [emphasis added].

The court held that the use of the terms “more than 50%,” “deal with each other,” and “at arm’s length” in the definition of “public foundation” clearly indicated a contrary intention to the application of section 33(2) of the Interpretation Act.

Conclusion

Sheldon Inwentash is an example of a case where the court reached the right result on the facts before it, using a textual, contextual, and purposive interpretation. However, in the end, it is not likely a decision that will present a major obstacle to taxpayers, since it should be easy for a foundation to appoint two arm’s-length trustees. Rather, it is the second branch of the “public foundation” definition (whether as currently drafted or as proposed in technical amendments released on July 16, 2010)[7] that will present the bigger obstacle. While this second branch was at issue in Sheldon Inwentash, the court decided that it need not address it, given its finding on the first branch.

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[1] CBCA section 120 provides a series of procedural and substantive requirements to validate a self-dealing transaction. Absent compliance with this provision, under both the statute (CBCA section 120(8)) and the common law (Aberdeen Railway Co. v. Blaikie Bros., [1843-60] All ER 249 (HL)), the transaction will be invalidated by the court.

[2] The court cited Canada, Department of Finance, Discussion Paper: The Tax Treatment of Charities (Ottawa: Department of Finance, 1975). In addition to the issues identified by the court, the discussion paper contained the following comments (at 9, paragraphs 20-21): “The creation of such [private] charities may have significant tax consequences. Most importantly, the charity is exempt from all taxes on its income, subject to the distribution rules which normally require that 90 per cent of the annual income be paid out each year. Other tax consequences follow from the fact that subsequent contributions to the charity are tax-deductible within prescribed limits and that bequests are, in some provinces, free of succession duties. It has become evident in recent years that a few taxpayers have been abusing the opportunity to establish private charities. The most common abuse has been in arranging investments and expenses to ensure that the charity has little income and pays out a relatively small sum annually in comparison to its capital. This may be done by having the charity invest in low-yield debt or equity of the donor’s business, by renting premises from the donor at high rent, by paying family members high salaries for relatively little work or by lending money to family members at low rates of interest.”

[3] In our view, the words “directors, trustees, officers or like officials” in the definition of “public foundation” in section 149.1 is meant to cover all categories of management personnel. Regardless of the title given to the person (director, officer, trustee), or the legal form used (corporation, trust, or other legal form of a charitable foundation), if the person is reasonably part of the management team of the foundation, he or she is subject to the rules that are designed to reduce the likelihood of self-dealing with the foundation. For further discussion, see the text following note 5 below.

[4] “Management” in this case refers to the collectivity of directors and officers of the corporation who manage its strategic directions as well as its day-to-day affairs. See J. Anthony VanDuzer, The Law of Partnerships and Corporations, 3d ed. ( Toronto: Irwin Law, 2010), at 15 and 254-55. Section 102(1) of the CBCA requires that directors either manage or supervise the management of the business and affairs of the corporation. Practically, it is far more common for directors to do the latter while leaving day-to-day management concerns to the officers of the corporation. The board of directors often meets a limited number of times throughout the year to review the affairs of the corporation and make large-scale strategic decisions: VanDuzer, supra, at 255. Therefore, depending on how the power is divided, both officers and directors effectively have management power.

[5] Officers and employees are generally expected to devote most (if not all) of their professional efforts to the business and affairs of the corporation, and it is their actions that often determine corporate success. The appointment of non-executive directors, as required by CBCA section 102(2), is therefore intended to provide an important check on the power of officers and other employees. For a fuller discussion of the role of non-executive directors in governance in both theory and practice, see, for example, Derek Higgs, Review of the Role and Effectiveness of Non-Executive Directors (London: Department of Trade and Industry, January 2003).

[6] Jeffrey G. MacIntosh and Christopher C. Nicholls, Securities Law ( Toronto: Irwin Law, 2002), at 139 and 254.

[7] Canada, Department of Finance, Legislative  Proposals To Amend the Income Tax Act and Related Legislation To Effect Technical Changes and To Provide for Bijural Expression in That Act (Ottawa: Department of Finance, July 16, 2010), part 1, subclause 109(1).