In technical interpretation 9704835 (CCH Window ¶5212), the CRA points out that the Income Tax Act provides for a rollover of goodwill at cost. The deceased’s estate cannot elect out of the rollover. As a result, the exemption cannot be used to increase the cost of goodwill for which the exemption might have otherwise been available during the deceased’s lifetime (eg farm quota).

The CRA states in the technical that it has referred the matter to the Department of Finance presumably for a possible legislative amendment. I’m sure Finance will be addressing the matter Real Soon Now.™

The CRA likes to stir things up every now and then with this project or that initiative to ensure compliance among various groups of taxpayers. The latest stirring relates to trusts and their administration, and it serves as a sharp reminder to lawyers that tax compliance is not only the province of accountants.The CRA trust initiative was the result of the Auditor General’s 2005 report, which recommended that the CRA give more attention to the audit of trusts. In response, the CRA created a “regional trust team” in the Golden Horseshoe and began auditing trusts. The audits identified so many issues with trust tax compliance that the program has now been expanded to encompass all of Canada. In September, 2010, the CRA appointed a Trust and Estate Coordinator for the Ontario Region who is responsible for coordinating trusts and estates compliance audits.

What are CRA auditors looking for? Apparently, the issues to be addressed include whether the trust was properly constituted (as per Antle v. R[1]), the location of the trust’s residence (for example, where are Alberta trusts really resident, especially in light of Garron v. R[2]), whether the trust’s income is being reported properly and whether deductions were properly claimed.

The CRA technical positions on trusts that seem to animate the audits are definitely persnickety. For example, trust lawyers will know that a trust, in computing its income for a taxation year, is entitled to deduct amounts that it makes payable in the year to beneficiaries of the trust. The CRA takes the position that “legal documents must be in place prior to the end of the year to meet [this] requirement”.[3] The CRA insists that all trusts must maintain proper books and records to substantiate payments like these, which books and records include financial statements, trust accounting records, bank statements, cancelled cheques, applicable loan documents, trustees’ resolutions and original documents to substantiate all deductions.

The CRA has also stated that “failure to provide evidence of the settled property would void the trust agreement due to the trust failing to meet the Certainty of Subject Matter under common law” [sic].[4] Can you find the gold coin used to settle a trust 18 years ago? Can your client? What property should you use to settle a trust to guarantee that you can prove, years later, that that property was in fact delivered to the trustees in connection with the execution of the trust agreement?

If the CRA’s comments in this regard seem ominous, it is only because the Agency has, apparently, found many cases where trusts cannot find the settlement property or prove that the other niceties were observed. The CRA approach must be understood against the background of the Antle case, where the taxpayer’s aggressive avoidance planning foundered on poor execution among other things. The Federal Court of Appeal’s decision in Antle is particularly encouraging for the CRA in this regard because it stoutly re-affirms the “sham doctrine” (the notion that, if the real legal relationships between parties are other than those they present to the world, then the latter can be ignored). In Antle, the taxpayer purported to settle a trust for his wife where the trustee was offshore. The court, however, found that the taxpayer really did not intend to settle a trust and the trustee did not really intend to act as a trustee. Garron is to similar effect. In Garron, the taxpayers intended to settle offshore trusts, but the court held that the real “central mind and management” was in Canada, and so the trusts were really resident in Canada.

In connection with its trust audits, the CRA has been requiring taxpayers to complete detailed questionnaires. For example, the questionnaire for trustees includes the following questions:

1. Who contacted you to enquire about your services as trustee?

2. What date did you become a trustee of this trust?

3. Why were you selected to become a trustee? Who selected you?

4. Did you consult independent legal counsel before agreeing to become the trustee or signing any of the documents? Provide details and documentation as applicable.

5. What was your role, function and responsibility in regard to each transaction in the trust?

Some of these appear to be trick questions. Imagine the result if the trustee answering the questions never learned about his or her role as a trustee from the lawyer who drew the trust.

The CRA says that its audit efforts have uncovered many instances where the attribution rules have applied in respect of trusts. This short article cannot begin to address the ways in which the numerous attribution rules in the Income Tax Act could apply to a trust. Lawyers, however, need to keep in mind that client education about the nature of trusts, careful attention to detail and clear reporting are key preventative measures for ensuring that these rules do not apply. Clear reporting and a paper trail are crucial because, in the end, the CRA, in the absence of suitable evidence (or any evidence) can make assumptions about the facts and assess accordingly. The onus is then on the taxpayer to prove the CRA wrong. The taxpayer must bring forward the evidence — that is, for the most part, the appropriate documentation — to show that the CRA’s allegations are incorrect.[5]

Traditionally, tax compliance — defined as the preparation and filing of tax returns — has been regarded as the purview of accountants. It is suggested that, at least as far as trusts and estates are concerned, that definition of tax compliance needs to be expanded and lawyers need to take on the role that only they can play. Accountants will likely remain largely responsible for filing tax returns, but if a trust is audited, the paper trail that the lawyer has created will be at least as important as the tax returns. Indeed, if the trust was created for tax planning purposes — to income split or to multiply the capital gain exemption, for example — the work the lawyer has done will be the keystone. It is the lawyer who must educate clients about the role of a settlor, the duties of trustees and the entitlements of beneficiaries. It is the lawyer who must assist with documenting properly the creation of the trust. And it is the lawyer who must assist trustees with the exercise and documentation of their discretionary, fiduciary powers by helping with the maintenance of a trust “minute book” during the lifetime of the trust.

Now if only we can convince our clients that they will need to pay for the work necessary to keep them out of trouble!

[2] 2010 FCA 309 (http://goo.gl/3QQ54). For a discussion of the Tax Court decisions in Antle and Garron, please see my article in the December, 2009, issue of the HLA Journal. The article can also be found on my blog at http://goo.gl/y8QUh.

[3] Presentation by Wendy Stewart, CRA Ontario Regional Coordinator Trusts and Estates, Kitchener-Waterloo Tax Practitioners Breakfast, November 18, 2010 (the “Stewart Presentation”).

[4] The Stewart Presentation.

[5] For an example of these principles in action, see Rajah v. The Queen, 2005 TCC 637, which I discuss on my blog at http://goo.gl/ff5oB.

• The initiative was initiated because of the Auditor General’s 2005 report, which recommended that the CRA give more attention to the audit of inter vivos trusts.
• In response to the report, the CRA created a “regional trust team” in the Golden Horseshoe. Garron and Antle had nothing to do with the initiative.
• What are auditors looking for? Apparently, the issues to be addressed include whether the trust was properly constituted (for example, can you find the trust’s gold coin?), the location of the trust’s residence (for example, where are Alberta trusts really resident, especially in light of Garron), whether the trust’s income is being reported properly and whether deductions were properly claimed.
• The CRA confirmed that the use of trusts for aggressive tax planning is a concern as well.
• The CRA stated that the initiative will continue because its activities so far have confirmed that trusts do present a significant compliance risk for the tax system.

In The Queen v. Cumming, [1976] DTC 6265 (FCTD), the Court held that a CPP death benefit is not a ‘death benefit’ for the purposes of the Income Tax Act. As a result, the $10,000 exemption provided by the Act for a death benefit is not available for CPP death benefits. Instead, the full amount of the latter type of benefit, which is a benefit received under the CPP for the purposes of the Act, must be included in income as required by clause 56(1)(a)(i)(B) of the Act. This point is addressed in the commentary for line 19 of the trust return in the T3 guide.

In CRA technical interpretation 2004-0060161, the CRA addresses several issues relating to trusts and capital dividends, including whether a return must be filed by a trust that receives a capital dividend and no other ‘income’. In the technical, the CRA responded as follows:

The T3 Trust Guide summarizes when a trust should file a T3 return. Paragraph 150(1)(c) and subparagraph 150(1.1)(b)(i) of the Income Tax Act, R.S.C. 1985 (5th supp.) c. 1 (the “Act”) indicate that a trust is required to file a return for a taxation year where tax is payable for that year. Paragraph 150(1)(c) of the Act has to be read in conjunction with Regulation 204 which provides that “every person [...] receiving income, gains or profits in a fiduciary capacity, or in a capacity analogous to a fiduciary capacity, shall make a return in prescribed form in respect thereof”. Although a capital dividend does not have to be included in the trust’s income according to subsection 83(2) of the Act, the trust is required to file a return and to designate the amount of the dividend in the year that it becomes payable to a beneficiary (subsection 104(20) of the Act and page 32 of the T3 Guide).

The response is clear as far as it concerns the case where a trust receives a capital dividend and then pays it out in the same year to its beneficiaries. The CRA believes that a return is necessary because the trust must designate the dividend under subsection 104(20) of the Act.

What about the case where a trust receives a capital dividend and does not pay it out in the same year? Instead, the trust adds the amount to its capital. It may “pay the dividend” in a subsequent year by encroaching on capital. Is a return necessary in the year the capital dividend is received? A trust return should not be necessary, given the provisions of paragraph 150(1)(c) of the Act, but the technical interpretation above is not clear on this issue.

In a typical freeze, Father and Mother exchange their Common Shares of Opco for Opco Special Shares with a fixed redemption amount. Any future growth in the value of Opco’s issued shares is supposed to accrue to the new Common Shareholders (usually the Next Generation). It is also quite common for Father and Mother to retain voting control of Opco so that they can keep an eye on their Special Share investments.

The effectiveness of the freeze depends on the value of the Special Shares being fixed. If the Special Shares share in the growth of the value of Opco, the freeze has not served its purpose because the Next Generation will not be receiving that growth.

In general, the Special Shares used in a freeze will be redeemable and retractable for a fixed amount and entitled to non-cumulative dividends equal to a fixed percentage of the redemption amount of the shares. The share may or may not be entitled to vote. See, for example, CRA advance tax ruling ATR-36 (“Estate Freeze”).

What is the position if Mom and Dad’s Special Shares are entitled to unlimited dividends and Mom and Dad control Opco? In Winram v. M.N.R., [1972] D.T.C. 6187 (F.C.T.D.), Gibson J. considered the liability of an estate for estate tax when the deceased died owning nine of the 1,000 issued shares of a corporation. The issued capital of the corporation consisted of 990 Class B shares, which were participating and non-voting and 10 Class A shares, which were participating and voting. The deceased held nine of the latter shares at his death; his wife held the remaining issued shares. It appears the estate took the position that the nine Class A shares were worth only 9/1000 of the entire value of the corporation. The Minister assessed on the basis that the value of the nine Class A shares was much greater than that. The Minister contended that, because the husband could control the issuer, he could divert dividends to himself and, in effect, take all of the value of the corporation for his own benefit. As a result, the value of his shares was significantly higher than the value ascribed to them by the estate.

The trial judge found in favour of the Minister. First, the judge noted the following about the governance of the corporation:

Until the date of death of the deceased and at all material times prior thereto also, the Articles of Association of the company provided at Article 3 that no share might be transferred except with the consent of the Board of Directors “who (might) . . . in their absolute discretion refuse to register the transfer of any share”; at Article 6 that the holders of non-voting shares did not have the right to vote; at Article 17 as amended that in the case of an equality vote that the Chairman had a second or casting vote; at Article 18 that “a Director interested in any contract or arrangement under consideration may be counted to make up the quorum although he shall not vote thereon”; and at Article 20 that dividends might be declared by ordinary resolution and that “dividends so declared may be equal for each class of share or not equal and dividends may be declared on one class of share without dividends being declared on another class of share”.

The judge’s decision is neatly summarized in the headnote of the case:

The wife of the deceased could not, by wilfully refusing to attend a properly called directors’ meeting, prevent the deceased from transferring the nine class A shares of which he was the owner, or from declaring dividends whereby the company would pay out 910 of the surplus to himself. Even if she did attend such a meeting, the deceased, because of his casting vote, could take these steps. Such action would not have been an abuse of his power in respect of the class B shareholders as they did not have an inalienable right to any part of the dividends declared, nor would it have been a breach of the deceased’s fiduciary duty as a director for he would have also been acting in his capacity as a shareholder and would therefore be free of any constructive trust. Also, any dividends declared on class A voting shares at a properly called directors’ meeting would not have been an abuse by the majority of the class A holders over the rights of the minority of class A holders.

Winram dealt with two classes of shares, both of which were fully participating. Perhaps the court would have arrived at a different conclusion if the shares had been redeemable and retractable for a fixed amount. Moreover, the decision has been distinguished in another case involving similar circumstances (see Shepp v. The Queen, [1999] D.T.C. 510 (T.C.C.)).

But why wonder about the status of Winram? It would seem prudent simply to ensure that the freeze shares have a dividend cap. If the freezor wishes to continue to share in the value of the corporation going forward, it would be better to put an estate “gel” in place or leave the freezor with some portion of the Common Shares.

Perhaps the most important tax issue for a corporate beneficiary is Part IV tax. If Holdco is subject to Part IV tax on dividends it receives from Opco because the former is a beneficiary of a trust, then not much has been accomplished from a tax perspective. No deferral is available because of the imposition of the refundable tax, and the individuals involved would have been better off simply paying dividends to themselves to effect creditor-proofing and reduce excess redundant assets.

To avoid Part IV tax, Holdco must be connected with Opco, and Holdco will be connected only if it satisfies either the 10% votes and value test or it controls Opco.

To satisfy the 10% votes and value test, Holdco must own shares of Opco. The CRA, however, takes the position that the beneficiary of a trust does not own the trust’s property. Holdco, then, if it “holds” shares of Opco only as a beneficiary of a trust, can never satisfy the 10% votes and value test. For example, assume that Steve is the owner of all of the shares of Holdco, which is the beneficiary of a trust that owns 30% of the issued shares of Opco. The remaining 70% of the shares of Opco are held by an individual with whom Steve deals at arm’s length. In these circumstances, Holdco will not be connected with Opco because it does not own any Opco shares.

Holdco will be connected with Opco only if Holdco controls Opco under subsection 186(2) of the Income Tax Act (Canada) (the “Act”). Holdco will control Opco only if persons not dealing at arm’s length with Holdco own more than 50% of the shares of Opco having full voting rights in all circumstances.

Holdco is deemed not to deal at arm’s length with the trust of which it is a beneficiary as per paragraph 251(1)(b) of the Act. Subsection 186(2) states that, for the purposes of its definition of control, Holdco will be deemed to own all of the shares held by a person with whom Holdco does not deal at arm’s length. Of course, in our example above, Holdco will be deemed to own only 30% of the issued shares of Opco, which is unhelpful from the standpoint of Part IV tax. The position would be different if the trust held 70% of the issued shares of Opco. In that case, Holdco would be deemed to own the shares, and so it would be deemed to control Opco. Holdco would be connected with Opco, and the CRA accepts that any dividends paid by Opco to the trust that are then allocated to Holdco would be free of Part IV tax (assuming that Opco did not receive a refund of tax in respect of the dividends declared).

What happens if two brothers, A and B, each own all of the shares of their respecting holding corporations (HoldcoA and HoldcoB), which in turn are beneficiaries of trusts (TrustA and TrustB) that own 50% each of Opco? Neither TrustA nor TrustB controls Opco by itself for the purposes of Part IV: neither owns more than 50% of the voting shares of Opco. The Holdcos, however, will be related to each other (per paragraph 251(6)(a), subparagraph 251(2)(c)(ii) and paragraph 251(1)(a) of the Act). In addition, paragraph 251(1)(b) of the Act provides that

a taxpayer and a personal trust (other than a trust described in any of paragraphs (a) to (e.1) of the definition “trust” in subsection 108(1)) are deemed not to deal with each other at arm’s length if the taxpayer, or any person not dealing at arm’s length with the taxpayer, would be beneficially interested in the trust. [Emphasis added]

In the example above, HoldcoA and HoldcoB are deemed not to deal at arm length with each other. As a result, HoldcoA is deemed not to deal at arm’s length with TrustA and TrustB. HoldcoA is deemed not to deal at arm’s length with TrustB because HoldcoA and HoldcoB are related and HoldcoB is beneficially interested TrustB. HoldcoA, then, is deemed to control Opco under 186(2), and any dividends paid from Opco through TrustA to HoldcoA should not be subject to Part IV tax (assuming that Opco doesn’t have RDTOH).

In light of this evidence, the Tax Court had little trouble concluding that the “legacy” was really a fee for performing the office of an executor or liquidator and that the CRA had been correct to reassess the taxpayer to require him to include the amount in income for tax purposes. The Court reached this conclusion despite the fact that the CRA had agreed that an identical “legacy” provided through the will of another of the taxpayer’s relatives was not taxable. (The Court referred to Klassen v. The Queen, 2007 FCA 339, for the proposition that “The Minister is not bound by a previous decision of one of its officials, if that decision was erroneous.”)