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).

DEATH OF THE SHAREHOLDER – A REVIEW OF THE PIPE LINE STRATEGY

In December, 2012 I successfully obtained a pipeline ruling from CRA.  However prior to that I had written an article for the newsletter I edit titled "Privately Held Companies & Taxes", published on TaxnetPro, Carswell, a division of Thomson Reuters.  I have reproduced the article with permission here and hope you find it as interesting as I did in writing it.

Introduction

It is human nature to not contemplate the possibility of death even though it is a certainty rather than a possibility. Usually when a shareholder of Canadian Controlled Private Corporation (“CCPC”) contemplates estate planning such planning is often limited to an estate freeze and no consideration is given to post-mortem planning.  Post-mortem planning is important because under the Income Tax Act (“ITA”) – a deceased shareholder of a CCPC and their beneficiary would otherwise be double taxed on his/her holding in such CCPC.

Double taxation at death

Upon death, shareholders are deemed to have disposed of all of their assets immediately before death at fair market value to the estate of the deceased shareholder.  The tax on the capital gains triggered on the disposition is reflected on the terminal return of the deceased shareholder.  As the estate is deemed to have acquired the deceased’s shares at fair market value (“FMV”) at time of death, the adjusted cost base (“ACB”) of such shares is bumped up to the FMV at time of death.  If there is a purchaser for the shares then there would be no additional level of tax assuming that the acquisition would be at FMV equal to the FMV at time of death. 

However, it may be difficult to find a purchaser for the shares of a CCPC thus requiring a distribution of the CCPC’s retained earnings to the beneficiaries of the deceased shareholder and subsequent wind-up of the CCPC.  Winding up the corporation will trigger a second level of tax pursuant to subsection 84(2) of the ITA  because a redemption of the shares will be deemed a taxable dividend.  Subsection 84(2) comes into play because although the ACB of the deceased’s CCPC shares has increased, the paid up capital of such shares has  not increased to reflect the fair market value at death.  Nor would the ACB of the assets held by the corporation have increased.  The sale of such assets and distribution of the proceeds will trigger a taxable dividend regardless of the recent capital gains paid on the shares on the terminal return of the deceased shareholder.

The following example best illustrates the double taxation that is levied on a deceased shareholder’s corporate assets:

1.       Mr. A., a widower, dies owning all of the shares in Holdco, which is not a small business corporation.  Holdco holds cash of $100,000.  The fair market value of Holdco’s shares is $100,000 and Mr. A’s cost in the shares is $10.00. Mr. A leaves the company to his adult daughter S.

2.       Under the deemed disposition rules of subsection 70(5) ITA, the estate is deemed to have acquired Mr. A’s shares at a tax cost of $100,000 triggering  a capital gains on Mr. A’s terminal return of $99,900 .  As a resident of Ontario, Mr. A.’s tax on the taxable capital gain of $49,995 at the top marginal rate on income under $500,000 of 46.41%   would be $23,203 .

3.       Assuming no further tax planning – S’s cost base in Holdco’s shares would be  the FMV  at which the estate acquired the shares   A wind-up of Holdco would result in a taxable dividend pursuant to subsection 84(2) of the ITA to S.

Mr. A on his terminal return would have paid $23,203 on the $100,000 FMV of his shares which reflected the value of the assets held in the corporation at time of death.  On the receipt of the distribution of $100,000 cash, the daughter of Mr. A. would have to pay $32,570 in tax at the top marginal rate on income under $500,000 resulting in the $100,000 value of the corporation being taxed twice.

The “pipe line” strategy is a strategy used   to minimize exposure of the second level of tax pursuant to subsection 84(2).

The Pipe Line Strategy

The pipe line strategy avoids the triggering of a deemed dividend under subsection 84(2).  It is a post-mortem strategy whereby only capital gains tax is payable at death under the deemed disposition rules of subsection 70(5) of the ITA.  It allows for the extraction of assets equal to the gain realized on death on a tax-free basis.  This is achieved by the estate transferring the inherited shares to a new holding company in exchange for a promissory note equal to the ACB of the shares transferred.  In other words the pipe line strategy converts the ACB of the shares held by the estate into a loan allowing for the extraction on a tax-free basis the assets of the corporation equal to the ACB of the shares held by the estate.

The following example cited by the illustration of the 2009 APFF – Round Table on the taxation of financial strategies and instruments is as follows:

·         Assume the taxpayer is holding all of the shares of a taxable Canadian corporation (hereafter called “ACO”), which is not a SBC, having a FMV of $100,000 and a cost of $100;

·         ACO has cash totaling $100,000, no liabilities, $100 in capital stock and $99,900 in retained earnings;

·         At his death, the taxpayer is deemed to have disposed of his shares for $100,000 and realizes a capital gain of $99,900;

·         The estate of the taxpayer is deemed to have acquired the shares for an amount of $100,000, which corresponds to the cost and the fair market value of the shares for the estate;

·         The estate incorporates a new taxable Canadian corporation (hereafter called “BCO”) and subscribes to 100 common shares therein for $100;

·         The estate sells the shares of ACO to BCO for a price of $100,000 payable by the issuance of a non-interest bearing demand note.  No tax arises from this.

·         ACO is then wound-up into BCO and all of its property is transferred to BCO;

·         Upon receipt of the property of ACO, including the cash totaling $100,000, BCO repays the note of $100,000 which is payable to the estate;

·         BCO is then dissolved;

·         Estate gives the amount of $100,000 which came from ACO to the heir(s).

However tax law is never predictable.  Currently in order to obtain a favourable ruling not subjecting the distribution to subsection 84(2) or the GAAR provision of subsection 245(2), CRA has imposed a one year delay for the estate to wind the corporation up into the holding company.   (See rulings 2002-0154223, 2005-0142111R3, Round table discussion at the 2009 APFF – CRA document no. 2009-0326961C6 and 2011 STEPs Roundtable, Q.5 2011 – 0401861C6).

This one year delay is not mandated in the ITA and has caused concern within the tax community.  The one year wait would negatively affect cash companies as evidenced in at the 2011 Annual CTF Conference where CRA stated

“the context of a series of transactions designed to implement a post-mortem pipeline strategy, some of the additional facts and circumstances that in our view could lead to the application of subsection 84(2) and warrant dividend treatment could include the following:

•The funds or property of the original corporation would be distributed to the estate in a short time frame following the death of the testator.

•The nature of the underlying assets of the original corporation would be cash and the original corporation would have no activities or business ("cash corporation").”

Dr. Robert Macdonald v. The Queen, 2012 TCC 123

The validity of the one year waiting period was challenged in the recent case Dr. Robert Macdonald v. The Queen, 2012 TCC 123 (“Macdonald”).  This case, although it did not deal with a deceased shareholder nonetheless employed the pipe line strategy to extract cash from a cash corporation.  CRA challenged the transaction under subsection 84(2) (deemed dividend) and under the section 245(2)  (GAAR) of the ITA.

The pipe line was engaged because the taxpayer Dr. MacDonald was moving to the United States and had ceased his Canadian residency on the 25^th of June 2002.  He had been unable to sell the shares of his medical professional corporation to a third party.  The corporation held $525,068 in cash.  Dr. MacDonald’s ACB in his professional medical corporation shares was only $101.  The dilemma Dr. MacDonald faced was that the entire gain would be taxable in the United States due to his residency in the U.S.  Although he had sufficient capital losses carried forward, (his capital losses accumulated while a resident in Canada),  to offset the gain in Canada  such losses could not be used to offset the gain now taxable in the US. 

The doctor had a choice on whether to structure the extraction as a sale utilizing the pipe line strategy or through a windup meaning he would receive the cash as a dividend. The Tax Court of Canada (“TCC”) in considering the facts stated at paragraph 130:

The reality in this case is that aside from the Appellant’s use of losses, the tax on capital gains in New Brunswick in 2002 differed considerably compared to the tax on dividends. Indeed, in the case of a privately-held corporation, like PC, the lack of integration, at the time the subject transactions were undertaken, favoured capital gain treatment by some nine percent in New Brunswick relative to the tax on a dividend of the same amount.

The pipeline strategy was implemented by Dr. MacDonald’s advisors as follows:

1.       J.S., Dr. MacDonald’s brother-in-law, incorporated a numbered company 601 Ltd on June 20, 2002.

2.       On June 25, 2002, J.S. acquired Dr. MacDonald’s shares in his professional medical corporation (PC) by means of a promissory note to Dr. MacDonald.

3.       601 Ltd. acquired on the 25ht of June, 2002 the shares of PC from J.S.  J.S. received as consideration shares in 601 Ltd. and a note payable by 601 Ltd. in the amount of $525,068.

4.       PC declared two dividends on June 25, 2002, one in the amount of $500,000 and the other in the amount of $10,000.  PC issued two cheques to 601 Ltd. as the PC shareholder at the time the dividend was declared in partial payment of the $500,000 dividend.  601 Ltd. in turn endorsed the cheques to J.S. as partial payment of the 601 note and J.S. in turn endorsed the cheques to Dr. MacDonald as partial payment of the J.S. note.

5.       PC in conformity with the rules of the N.B. College of Physicians and Surgeons changed its name to a numbered company 509 N.B. Ltd as Dr. MacDonald was no longer a shareholder.

6.       A final dividend was declared on September 1, 2002 equal to the amount still owing on the 601 Ltd. note and an amount equal to the unpaid portion of the dividend declared on June 25, 2002 was paid as an acknowledged indebtedness to J.S. booked by 509 NB on direction of J.S. as an indebtedness to Dr. MacDonald.

7.       On July 15, 2002 509 NB paid by cheque  601 Ltd the amount of $10,000 which was deposited on the 27^th of August, 2002.

509NB prepared Articles of dissolution on July 31, 2002 and was officially dissolved on February 4, 2005.

The TCC strongly rejected CRA’s argument for the court to look through the transfer to J.S. and deem Dr. Macdonald to be the ultimate beneficiary of the distribution pursuant to subsection 84(2) of the ITA on the basis that this section is not a re-characterization provision.  The TCC at paragraph 61 and 62 held:

In any event, it is not the promise or foreseeability of a benefit while a shareholder that triggers the operation of subsection 84(2). The requirement of that provision is that there be a distribution or appropriation in any manner whatever for the benefit of a person who is a shareholder at the time of that distribution or appropriation. A structure undertaken while a shareholder that ensures, by a series of transactions, access to corporate funds to satisfy a debt created as a result of ceasing to be a shareholder, is not the same as being in receipt of such funds, or being in receipt of a benefit, qua shareholder.  Accordingly, it remains my view that the words of subsection 84(2) do not impose a requirement to re-characterize payments to a creditor as payments to a shareholder.

The TCC rejected CRA’s imposed one year wait rule in paragraph 78 to 80 as follows:

The CRA has issued advance income tax rulings that such post-mortem pipeline transactions will not be subject to subsection 84(2) if the liquidating distribution does not take place within one year and the deceased’s company continues to carry on its pre-death activities during that period. This post-mortem plan clearly parallels the Appellant’s tax plan in the case at bar. Both plans provide access to a corporation’s earnings in a manner that avoids dividend treatment. As well, both situations deal with a time of reconciliation – death and departure from Canada. The conditions imposed on the post-mortem transactions, if imposed in the case at bar, would show that the CRA’s assessing practice was consistent in trying to apply subsection 84(2). The message seems to be: do the strip slowly enough to pass a contrived smell test and you will be fine.

This is not a satisfactory state of affairs in my view. The clearly arbitrary conditions imposed are not invited by the express language in subsection 84(2). I suggest that they are conditions imposed by the administrative need not to let go of, indeed the need to respect, the assessing practice seemingly dictated by RMM. Make it “look” less artificial and the threat of subsection 84(2) disappears. This unsatisfactory state of affairs more properly disappears once it is accepted that subsection 84(2) must be read more literally in all cases and GAAR applied in cases of abuse.

The TCC further concluded that GAAR did not apply as subsection 84(2) did not expressly identify a tax benefit.  The fact is that the taxpayer, Dr. Macdonald, had a choice to extract the retained earnings by ways of a dividend or by way of as capital gains.  The TCC concluded at paragraph 132:

The tax avoidance and tax benefit resulting from a lack of integration in this case is systemic. There is no unintended tax slippage in this sense, and in such circumstances GAAR cannot be used to prevent a tax planned approach to accessing retained earnings. Said differently, neither subsection 84(2) nor GAAR can be used to fill a gap between two approaches to taxing an individual shareholder’s realization of accumulated after-tax funds in a company. There must be more. Subsection 84(2) does not employ language that attacks tax abuse issues arising from surplus strips. Section 245 does. As stated earlier in these Reasons – it is a better litmus test to identify strips that offend the spirit and objects of the Act read as a whole. Unless, an abusive tax benefit results from the avoidance series of strip transactions, the tax result stands undiminished. Avoidance transactions alone do not frustrate the principles set out in the Duke of Westminster.

Conclusion

What does this all mean?  Macdonald advocates that the post-mortem pipe line does not invoke subsection 84(2) as it is not a re-characterization provision authorizing a look-through of the steps undertaken to ensure the first shareholder is not ultimately subject to subsection 84(2).  That said it is prudent to follow existing CRA rulings which currently mandate the one year waiting period and to still obtain a ruling to substantiate that position.  After all, although the Tax Court’s decision is very convincing, its decision is being appealed.  On April 17, 2012 an appeal of the decision was filed with the Federal Court of Appeal.

The one year waiting period ensuring that the business continues to be carried on is essential to obtaining a favourable ruling.  As such when planning is undertaken, a shareholder of a CCPC must contemplate the corporation’s survival for one year after death and ensure that his or her heirs is aware of this requirement.  

Income Tax Treaty between Canada and Hong Kong Special Administrative Region of the People’s Republic of China

This article was first published in the December, 2012 edition of Carswell TaxnetPro's publication Private Companies and Taxes.

On the 11^th of November, 2012, the Government of Canada signed a tax treaty (“Treaty”) with Hong Kong.  The treaty will come into force the first day of January in the calendar year following the calendar year in which the treaty is ratified.  Hong Kong continues to enjoy a high degree of autonomy since its 1997 handover to China. Hong Kong is therefore not covered under the Canada – China tax treaty.  The Treaty as will be seen further in this article has more favorable withholding rates to that of the Canada – China Treaty.    The Treaty is similar to the tax treaties Hong Kong has entered to since 2009.  In 2009 Hong Kong was almost placed on the Grey List by members of the OECD as a jurisdiction that had committed to internationally agreed tax standards but had not implemented such standards.  The standard causing grief to the OECD members was “the exchange of information standard” based on Article 26 of the 2004 OECD Model Tax Treaty.  In order to avoid the possibility of being placed on the grey list which would have led to repercussions from member OECD states, Hong Kong was required to enter into 12 comprehensive income tax treaties so as to be regarded as a fully cooperating tax jurisdiction.  Hong Kong complied and has since 2009 entered into comprehensive tax treaties with more than 22 jurisdictions which include the Netherlands, Switzerland, China and Luxemburg.

All of Hong Kong’s tax treaties are based on the exchange of information standard contained in Article 26 of the 2004 OECD Model Treaty but deviate from Article 26 with the provision that the information exchanged must not be disclosed to any third jurisdiction for any purpose.  The exchange of information is only from the date the treaty is ratified and will not apply retroactively. 

The withholding tax rates in the Treaty are as following:

·        5% for dividends where at least 10% of the shares is held by the parent company;

·        10% for dividends paid in all other cases;

·        10% for interest charged between related parties – nil for interest between unrelated parties;

·        10% for royalty withholding.

However as Hong Kong does not have a withholding tax on dividends and interest, the focus of the rates is a reduction of the 25% rate imposed by the Income Tax Act on payments made from Canada to Hong Kong.  Currently the Canada – China Tax Treaty withholding rate is 10% for interest, dividends and royalties and as such the Hong Kong Treaty would be attractive to a Chinese corporation carrying on operations through a corporation in Canada.  However a careful read of the withholding provisions is mandatory to ensure compliance with the Treaty.

Although the Treaty does not contain a Limitation of Benefits clause the wording of a Limitation on Benefits clause is found in the royalty, interest and dividend articles.  This is seldom seen in treaties negotiated by Canada.  The purpose of a limitation of benefits clause is to ensure that a treaty is not used by an entity from a different jurisdiction that is not party to the treaty.    

For Canadian corporations carrying on business in Hong Kong through a corporation the Treaty will be good news as a Hong Kong corporation will qualify upon ratification of the treaty as a foreign affiliate situated in a designated treaty country.  This would allow dividends returning to Canada from the Hong Corporation’s active surplus to be exempt from tax in Canada. 

Sunita Doobay LL.B., LL.M., TEP, TaxChambers, Toronto

Shareholder Control: Per Fiction or USA?

Recently published in the Canadian Tax Highlights a Canadian Tax Foundation Publication and reproduced with permission here.

A CCPC classification is attractive for a variety of tax reasons, including the preferential small business deduction and the heightened SRED investment tax credit (ITC) of 35 percent (rather than 20 percent). The decision in Bioartificial Gel Technologies Inc. (2012 CCI 120) is of particular significance, because the TCC in Bagtech concluded that a unanimous shareholder agreement (USA) resulted in CCPC classification although on the facts more than 50 percent of the corporation’s shares were held by non-residents. (The TCC in Ekamant Canada Inc. (2009 TCC 408) concluded that there was no USA on the facts in that case.)

Bagtech was incorporated under the CBCA and in 2004 and 2005 claimed the 35-percent SR&ED ITC rate as a CCPC. Non-residents held 62.52 and 70.42 percent respectively of its voting shares, but pursuant to a USA the actual right to elect the majority of the directors was held by Canadian residents.

The concept of control is central to the CCPC definition in section 127. The term control itself is not defined in the Act and thus the courts have been left to wrestle with its meaning. For purposes of a CCPC, control is subdivided into a de jure test (control in law) and a de facto test (control in fact). Whenever the Act refers to a corporation as being controlled “directly or indirectly in any manner whatever”, the de facto test for control is triggered: otherwise the only appropriate test of control is the de jure test. Due to the foreign ownership of Bagtech’s shares, the relevant provision to determine control was paragraph (b) of the CCPC definition in 125(7), which calls for the de jure test for control. 

When determining de jure control under paragraph (b) of the CCPC definition, it is important to note that that paragraph creates an important legal fiction: all the shares held by non-resident persons and public corporations are deemed to be owned by a single fictional person. If that fictional person is found to hold de jure control over the corporation, it does not qualify as a CCPC. In reality, the shareholders whose shares are held by the fictional shareholder may or may not act together to control the corporation, or even have any relationship with one another whatsoever. (See “Control Further Dissected”, Canadian Tax Highlights, April 2006.)

Generally, de jure control is “the right of control that rests in ownership of such a number of shares as carries with it the right to a majority of the votes in the election of the board of directors.” (Buckerfield’s Limited, 64 DTC 5301, [1964] CTC 504). Prior to the SCC decision in Duha Printers (98 DTC 6334, [1998] 3 CTC 303), the factors for determining whether de jure control existed included the corporation’s governing statute and its share register, and any limitation laid out in the constating documents on the majority shareholder’s power to control the election of the board or the board’s power to manage the business and affairs of the corporation. 

A USA allows shareholders, by a unanimous agreement, to limit or take away all of the managerial powers of the corporation’s directors and to grant those powers to all or some shareholders (as was the case in Bagtech). A run-of-the-mill shareholders agreement, which is solely contractual in nature, is distinct from a USA, which the SCC in Duha said was “a corporate law hybrid, part contractual and part constitutional in nature.” Significantly, a USA has the power to bind current and future shareholders.  Duha established that a USA should be treated as a constating document of a corporation in determining whether de jure control exists. The SCC said that in order for a majority shareholder to lose de jure control, the USA must not allow that shareholder “to exercise effective control over the affairs and fortunes of the corporation in a way analogous or equivalent to the power to elect the majority of the board of directors.”  

In Bagtech the minister contended that a USA does not apply to paragraph (b) of the CCPC definition in subsection 125(7) for purposes of determining whether de jure control is present: the text and the purpose of that provision would be frustrated if the fiction of control it creates could be watered down by a USA that allocates the powers of directors to a group of shareholders that never includes the fictional shareholder. The TCC in Bagtech disagreed and concluded that that provision’s fictional shareholder is bound by a USA. The TCC reasoned that the CCPC definition is a general provision and the court’s role is to give effect to its legislative intent: the legal fiction of a hypothetical shareholder applies in all situations and thus the fictional shareholder is bound by a USA in the same way that the actual shareholders are bound.

Bagtech crystallizes what was decided in Duha: a USA should be treated as a constating document when determining de jure control and in order to conclude that a non-resident majority shareholder does not have de jure control, the USA must remove that shareholder’s ability to control the corporation in a manner equivalent to the power to elect the majority of the board of directors. In addition Bagtech specifically concludes that a USA applies to a fictional shareholder created under paragraph (b) of the subsection 125(7) CCPC definition. Will the Act be amended in light of Bagtech, as it was following the decision in Silicon Graphics? The policy behind the CCPC definition and related provisions is to afford Canadian residents preferential tax treatment under the Act. Any legislative change, however, will likely await the result of the appeal to the FCA that was filed on May 14, 2012. 

Sunita Doobay

TaxChambers, Toronto

Rajeeve Thakur

Miller Canfield Paddock & Stone LLP, Toronto

Austrian Private Foundation Not a Trust

Recently published in the Canadian Tax Highlights, a Canadian Tax Foundation publication and reproduced with permission here.


The FCA released its decision in Sommerer on July 13, 2012 (2012 FCA 207). The FCA dismissed the Crown's appeal, which challenged the TCC's conclusion (2011 TCC 212) on the application of subsection 75(2) and article XIII(5) of the Canada-Austria treaty.


In 1996, the father of Peter Sommerer (Mr. S), a Canadian resident, established a private foundation in Austria under the Austrian Private Foundations Act and capitalized the foundation with 1 million Austrian schillings of his own money for the benefit of Mr. S and his family. An Austrian private foundation may engage in investment activities that are consistent with its purposes, but it cannot engage in commercial activities; it is generally subject to the same income tax laws as other Austrian corporations but is exempt from Austrian income tax as long as it files an information return disclosing its beneficiaries. (A sale of corporate securities is tax-exempt in Austria if the sale occurs more than one year after acquisition.)


On October 4, 1996, Mr. S sold unconditionally to the foundation 1,770,000 shares of Vienna Systems Corporation for FMV at $1,177,050 and received $117,705 and a promise to pay the balance. In December 1997, the foundation sold 216,666 of the Vienna shares for $4.50 each to three individuals unrelated to the Sommerers, realizing a capital gain, and in December 1998 it sold the remainder to Nokia Corporation for $9.00 each, realizing a further capital gain. In April 1998, Mr. S sold unconditionally to the foundation 57,143 Cambrian Systems Corporation shares for $100,000. The foundation sold the shares to Northern Telecom in December 1998 for $14.97 each plus a further $4.12 per share conditional on certain milestones being met in 1999. That sale also resulted in a capital gain for the foundation.


The Canada-Austria tax treaty is based on the OECD model and provides that a gain from the sale of corporate shares is taxable only in the state where the seller resides: on the facts, the seller was the foundation based in Austria. The CRA sought to classify the foundation as a trust and argued that the trust's gains should be attributed to Mr. S pursuant to subsection 75(2) and thus brought within Canada's taxing jurisdiction. The CRA also argued that the treaty did not apply because Mr. S was a resident of Canada, not Austria.


The CRA failed to convince the TCC that the foundation should be characterized as a trust. The TCC said that the foundation was a corporation that held its property in trust for Mr. S and other beneficiaries. The TCC rejected the CRA's position that subsection 75(2) applied to Mr. S and concluded that that provision was intended to target a trust's settlor, who on the facts was the father, not Mr. S. The TCC said that the treaty overruled Canada's jurisdiction and established Austria as the taxing jurisdiction because both the father as settlor and the foundation/corporation as trustee were Austrian residents. Under the mind-and-management test, the TCC concluded that the corporation was an Austrian resident and that Mr. S did not exercise sufficient control to deem it to be a Canadian resident.


The Crown appealed to the FCA on the grounds that subsection 75(2) applied to Mr. S because (1) the TCC had concluded that the foundation held its property in trust for him and his family and (2) the proceeds from the sale were property substituted for the shares that he sold to the trust. The Crown argued that, for example, the proceeds of sale of the Vienna or Cambrian shares might one day be distributed to Mr. S, and thus he might receive property substituted (as defined in the Act) for the shares he had sold to the foundation. Attribution of the gain to Mr. S meant that the Canada-Austria treaty did not apply because he was a Canadian resident and the treaty protection extended to an Austrian resident only.


Mr. S disagreed with the TCC's conclusion that the foundation held its property in trust, but he chose not to argue the point and instead argued that subsection 75(2) did not apply to him and that the treaty would exempt him in any event. In obiter--the proposition was not the subject of submissions before the FCA--Sharlow J, writing for a unanimous FCA, concluded that it was doubtful that the foundation held its property in trust. She said that the foundation created under Austrian civil law resembled a corporation in Canada rather than a trust and that the rights of a member in a foundation resembled that of a shareholder in Canadian corporation:

Looking at the situation from another point of view, a shareholder or member of a corporation, as such, is not the beneficial owner of any property or the corporation, and has no legal or equitable claim to the corporate property (unless such a claim arises upon the declaration by the board of directors of a dividend, or when the dissolution of the corporation is imminent). Unless and until such an event occurs, a shareholder or member has only an inchoate right to receive distributions of corporate property from time to time at the discretion of the board of directors, and to share in the distribution of the corporate property upon its dissolution. The same can be said of the interest of a beneficiary or an ultimate beneficiary in the property of an Austrian private foundation. Nothing in the Austrian Private Foundations Act or the constating documents of the Sommerer Private Foundation gives Peter Sommerer a legal or equitable claim to the corporate property that is different from that of a shareholder or member of a corporation.

The fact that the father "as a practical matter . . . may well have achieved many of the objectives that could have been achieved in a common law jurisdiction by settling a trust" for Mr. S and his family did not mean that a trust was created at the foundation's establishment or when he sold the shares to it. Mr. S and his family more closely resembled a corporation's shareholders than a trust's beneficiaries with an equitable claim to the trust corpus. A foreign entity such as the foundation should be classified as a trust only if, under common law, a trust has been created. (Under common law, as summarized by the SCC in Air Canada v. M & L Travel Ltd. ([1993] 3 SCR 787), a trust is created only if three certainties exist: the intention to create a trust, the trust's subject matter, and the trust's object or beneficiary.) Sharlow J implicitly reflected the common law on the creation of a trust when she stated that "[a] corporation does not hold its property in trust for its shareholders or members, except to the extent that a trust deed or an analogous legal instrument imposes the legal and equitable obligations of a trustee on the corporation with respect to specific corporate property." She concluded that "[n]othing in the constating documents of the [foundation] or the law of Austria, as reflected in the record of this case, [supported] the conclusion that the right of the [foundation] to deal with its property is constrained by any legal or equitable obligations analogous to those of a common law trustee" or gave Mr. S a legal or equitable claim to the corporate property that was different from the claim of a shareholder or member of a corporation.


Although Sharlow J concluded that it was doubtful that the foundation held any property in trust for Mr. S, in the balance of her reasons she proceeded on the assumption--without deciding--that the father had settled a trust in favour of Mr. S and his family. In her analysis of subsection 75(2), she agreed with the TCC's Miller J that subsection 75(2) could not apply to a beneficiary of a trust who transfers property to a trust by means of a genuine sale and quoted his conclusion: "[O]nce properly unravelled and viewed grammatically and logically, the only interpretation is that only a settlor, or a subsequent contributor who could be seen as a settlor, can be 'the person' for purposes of subsection 75(2) of the Act." Sharlow J said that "to interpret subsection 75(2) so that it could apply to a beneficiary in respect of property that the trust acquired from the beneficiary in a bona fide sale transaction leads to outcomes that are absurd and could not have been intended by Parliament." The facts clearly showed that the foundation had purchased the Vienna shares with funds from the original endowment made by the father, who was not a resident of Canada, and thus subsection 75(2) did not apply.


Although that conclusion was sufficient to dismiss the appeal, Sharlow J commented on the Crown's treaty argument because the TCC had dealt with the issue. The Crown argued that the treaty provided no relief to Mr. S in the event that subsection 75(2) applied because he was not an Austrian resident. The Crown argued that the reservation under article XXXVIII(2), which allows Canada the right to tax residents of Canada on income and gains pursuant to section 91 (the FAPI rules), meant that the domestic attribution rules do not contravene a treaty that is based on the OECD model. If this argument had been successful, it would have created a groundbreaking precedent; but Sharlow J agreed with the TCC that "[t]here is no similar reservation relating to the attribution of income and gains under subsection 75(2), which means that Canada has not reserved the right to tax residents of Canada on income and gains attributed to them under subsection 75(2)." The FCA rejected the Crown's argument that foreign jurisprudence establishes that domestic attribution rules do not conflict with international tax conventions based on the OECD model. Instead, the court agreed with the international tax expert Karl Vogel that one must analyze each treaty and its reservation clauses before concluding that a specific domestic law overrides a treaty.


This is not the first time that the Crown has advanced the position that subsection 75(2) overrides a treaty's capital gains clause. In St. Michael Trust Corp. (sub nom. Garron Family Trust v. The Queen (2009 TCC 450)), the TCC discussed the interaction of subsection 75(2) and the relevant capital gains clause in article XIV(4) of the Canada-Barbados treaty. Woods J concluded that subsection 75(2) did not override that treaty's capital gains article, which was clearly drafted and reflected its object and spirit. She also said that the question to be asked was, "Did the Treaty's contracting states intend to reserve to themselves under Article XIV(4) a residual right to tax gains arising in the other contracting state?" and concluded that it did not: "I would also comment that the Treaty contains a specific override provision in reference to another attribution rule. Article XXX(2) provides an override in reference to the Canadian taxation of [FAPI] earned by non-resident corporations. If the drafters of the Treaty had intended an override for other attribution rules, they could have been specifically provided for it."


The issue of whether subsection 75(2) can override a treaty's capital gains article was first raised and rejected by the TCC in 2009. It was advanced by the minister in 2011 in Sommerer. It appears that the FCA has now settled the issue: subsection 75(2) does not override a treaty's capital gains article unless a clause in the treaty specifically carves out an exception for the application of subsection 75(2).


Sunita Doobay
TaxChambers, Toronto

Canadian Tax HighlightsVolume 20, Number 8, August 2012
©2012, Canadian Tax Foundation

Contemporaneous SR & ED Documentation

Recently published in the Canadian Tax Highlights and reposted here with permission is the following article on the documentation requirement when claiming SR&ED:


The recent decision of the TCC in Murray Arlin Dentistry Professional Corporation v. The Queen (2012 TCC 133) was heard under the informal procedure and thus has no precedential value. Nonetheless, the decision is a reminder of the need to maintain contemporaneous documentation to evidence the fact that research was performed by the SR & ED claimant.

The taxpayer was a professional corporation operating the dental practice of Dr. A, a periodontist who specialized in implants. Dr. A spent at least one day a week studying data produced by specialized software that tracked the success rates of implants and the variables that affected those rates. Woods J accepted that the doctor’s research was a useful addition to scientific knowledge; at issue was whether for the 2007 and 2008 taxation years the doctor could prove that he spent an average of 350 hours per year systematically carrying out that research.

Woods J noted that SR & ED is defined in subsection 248(1) to mean a “systematic investigation or search that is carried out in a field of science or technology.” The TCC’s decision in Northwest Hydraulic Consultants Ltd. (1998 CanLII 553) remains the leading case on the meaning of “systematic investigation.” In that decision, Bowman J said that “[a]lthough the Income Tax Act and the Regulations do not say so explicitly, it seems self-evident that a detailed record of the hypotheses, tests and results be kept, and that it be kept as the work progresses.”


The facts in Murray Arlin show that Dr. A carried out research and that he did so on at least one day each week; but he never documented the hours spent, nor did he provide a hypothesis on what “uncertainty” he was overcoming with the data that he collected. Dr. A was a prolific writer, lecturer, and participant in study clubs. He used about 50 of the possible 200 software variables—such as whether the patient smoked and the type of implant—to track success rates. He had records for about 12,000 implants performed by him (approximately 1,000 surgeries a year). The CRA submitted that Dr. A “failed to develop specific hypotheses prior to the data collection” and that there was insufficient evidence of the time spent by him studying the data. Northwest Hydraulic analyzed the need for technical risk or uncertainty and the need for the claimant to “formulate hypotheses specifically aimed at reducing or eliminating that technological uncertainty.” Although Dr. A testified briefly that he updated his research for his lectures, many of the lectures were not given to implant specialists and they had a marketing component. The evidence was far too vague to establish the time spent on analysis or data collection and thus the one-fifth allocation of salary: the software was “designed to present comparative tables at the press of a button. The actual time spent on applied research potentially might be very small.”  Woods J agreed with the minister that without a hypothesis there could be no systematic investigation, but she was reluctant to agree that such a narrow position precluded a finding that there was insufficient evidence of systematic investigation. 

The major obstacle to ruling in the taxpayer’s favour was the lack of documentation: “The main problem that I have with the appellant’s position is that there was very little detailed evidence regarding the analysis done in the years at issue and the time spent.”

Sunita Doobay
TaxChambers, Toronto