2014-0526171I7 Resettlement of a Trust

Principal Issues: Whether the subject trust was resettled under the common law on XXXXXXXXXX, such that the carried forward losses claimed were not deductible.

Position: In our view, yes.

Reasons: The sale by the holder of the majority beneficial interest in the commercial trust as at that date changed the whole substratum of the trust.

Author: Kohnen, Phil
Section: 104(4) and 245(4)

                                                                                                                                     August 9, 2016

XXXXXXXXXX                                                                                                             HEADQUARTERS
                                                                                                                                     Income Tax Rulings Directorate
                                                                                                                                     Phillip Kohnen
                                                                                                                                     (613) 670-8916

                                                                                                                                     2014-052617

      Resettlement of a trust

We are writing in response to your March 21st, 2014 request for our comments as to whether certain tax year ended XXXXXXXXXX capital losses reported by the XXXXXXXXXX (the “Trust”) may be applied in its XXXXXXXXXX and subsequent years. More specifically, you wanted to know the following:

*     Whether there was a resettlement of the Trust as at XXXXXXXXXX; or

*     Whether there was a resettlement of the Trust as at XXXXXXXXXX.

It is our view, as explained in greater detail below, that under the common law, the Trust was resettled on XXXXXXXXXX when the holder of a majority beneficiary interest sold all of its interest in the Trust because the transaction changed the whole substratum of the Trust. While we recognize that the two original beneficiaries were not specifically prohibited from disposing of their capital and income interests in the Trust by selling it to someone else, it is our view that in doing so the intention of the two original settlors was completely set aside. The trust is a commercial trust and the intention of the settlors was to have the trustee hold and invest the capital of the trust for the benefit of two specific beneficiaries, namely, the original settlors themselves and this is no longer the case after XXXXXXXXXX.

Our understanding of the facts is as follows:

1.    On XXXXXXXXXX, the Trust, a commercial trust, was established by XXXXXXXXXX (“Corp”) and XXXXXXXXXX (“Ltd”). Corp was a XXXXXXXXXX corporation while Ltd was a XXXXXXXXXX corporation. Pursuant to the terms of the trust deed of the Trust (the “Trust Deed”), Corp and Ltd were both income and capital beneficiaries of the Trust on respectively a XXXXXXXXXX basis. At the time the Trust was established, Corp and Ltd jointly contributed and/or committed to contribute directly or indirectly the following properties to the Trust:

*     CDN $XXXXXXXXXX in cash on a XXXXXXXXXX basis by Corp and Ltd respectively; and

*     beneficial interest in XXXXXXXXXX (the “Land Properties”) located in XXXXXXXXXX beneficially owned on a XXXXXXXXXX basis by Corp and Ltd respectively.

2.    The business object of the Trust was to develop XXXXXXXXXX.

3.    The XXXXXXXXXX (“Limited”), a XXXXXXXXXX corporation, was appointed as trustee of the Trust. It is our understanding that the Land Properties were registered in the name of XXXXXXXXXX (the “Agent”), a Canadian Corporation, as bare trustee and agent of Limited. Limited had XXXXXXXXXX employees and the shareholders of Limited, directly and indirectly, were Corp and Ltd on the same XXXXXXXXXX basis. The share capital of Limited consisted of XXXXXXXXXX ordinary shares with a nominal value of XXXXXXXXXX $XXXXXXXXXX and fully paid and allocated as follows:

*     XXXXXXXXXX ordinary shares (the “Corp Shares”) held directly and indirectly by Corp; and

*     XXXXXXXXXX ordinary shares (the “Ltd Shares”) held directly and indirectly by Ltd.

Based on the above, Limited was a corporation controlled by Corp, the majority shareholder and therefore, the Trust was controlled, indirectly by Corp since its inception.

4.    We have no first-hand information as to trust laws as they are applied in XXXXXXXXXX. However, the representations and warranties provided by Corp to Inc pursuant to Article XXXXXXXXXX of the Rights Agreement detailed in part in paragraph 7 below, included, inter alia, the following:

*     Clause XXXXXXXXXX stated that the Trust had not filed any income tax returns nor other returns with any governmental authority in XXXXXXXXXX and was not required by law to file any such returns;

*     Clause XXXXXXXXXX stated that since XXXXXXXXXX, Limited had not filed any income tax or other returns or reports with any governmental authority in XXXXXXXXXX (other than its corporate annual report) and except the corporation annual report, Limited was not required by law to file any such returns and to the best of Corp’s knowledge, information and belief, Limited had not filed any income or other returns or reports on or before XXXXXXXXXX; and

*     Clause XXXXXXXXXX stated that neither the Trust nor Limited were subject to assessment for any taxes, fees, charges of any kind whatsoever in XXXXXXXXXX save and except only an annual fee for filing the corporation annual report of Limited required to maintain the corporate existence of Limited and save and except only an “estimated assessable profits tax” which had been wrongly assessed against Limited in the amount of XXXXXXXXXX $XXXXXXXXXX. Limited was not liable to pay “estimated assessable profits tax”, because Limited had never owned any assets (except as trustee of the Trust), Limited did not carry on business for its own account and Limited had never earned a profit.

5.    It is our understanding that Ltd was not able to put up the cash portion of its initial capital contribution commitment in the amount of CDN $XXXXXXXXXX. To meet this obligation and with the concurrence of Corp, Ltd borrowed the $XXXXXXXXXX from a Canadian chartered bank in XXXXXXXXXX using the Land Properties as collateral. In return, Corp received from Ltd as security, a charge against the Ltd Shares and Ltd’s beneficial interest in the Trust. It is our understanding that in XXXXXXXXXX, Corp settled on behalf of Ltd, using its own funds, Ltd’s outstanding bank loan balance of $XXXXXXXXXX. Corp retained as security, the charge against the Ltd Shares and Ltd’s beneficial interest in the Trust. It is also our understanding that in XXXXXXXXXX Corp took Ltd to court in XXXXXXXXXX in order to recover the $XXXXXXXXXX plus interest or failing that, to ask the court for legal ownership of the Ltd Shares and Ltd’s beneficial interest in the Trust.

6.    By XXXXXXXXXX, Corp acknowledged the fact that the relevant government approval for the XXXXXXXXXX project was not forthcoming and started looking for a buyer for the Land Properties. Between XXXXXXXXXX, Corp was not successful in finding a buyer.

7.    On XXXXXXXXXX, Corp, as controlling shareholder of Limited, entered into a rights agreement (the “Rights Agreement”) with XXXXXXXXXX (“Inc”), an unrelated party. The indirect sole shareholder of Inc was XXXXXXXXXX. Although the tentative closing date of the Rights Agreement was XXXXXXXXXX, the agreement ultimately closed earlier on XXXXXXXXXX. In consideration of a purchase price of CDN $XXXXXXXXXX, Inc acquired among other things the following:

*     all of the majority beneficiary interest of Corp in the Trust and the related majority beneficial interest of Corp in the Land Properties held through Agent;

*     all of the Corp Shares and all of the rights held by Corp in the Ltd Shares, the minority beneficiary interest of Ltd in the Trust and the related minority beneficial interest of Ltd in the Land Properties held through Agent that were associated to the legal claims of Corp to recover the amount of $XXXXXXXXXX plus interest from Ltd (Inc also retained an option to take over from Corp the court proceedings noted in paragraph 5 above that were in progress at the time in XXXXXXXXXX);

*     an outstanding mortgage claim against the Trust on the Land Properties but not exceeding a total of CDN $XXXXXXXXXX on closing; and

*     amounts receivable by the Trust directly or indirectly from Corp not exceeding a total of CDN $XXXXXXXXXX on closing.

8.    Based on the Rights Agreement detailed above and subject to any subsequent but unlikely legal claims Ltd might have, Inc was effectively acquiring the following:

*     all of the Corp Shares in Limited on closing;

*     the majority beneficiary interest of Corp in the Trust on closing; and

*     subject to the outcome of the court proceedings in XXXXXXXXXX, all of the Ltd Shares in Limited and the minority beneficiary interest of Ltd in the Trust (in fact, as noted in paragraph 13 below, the case was concluded in favour of Corp and final judgment was issued on XXXXXXXXXX).

9.    On XXXXXXXXXX, the Agent entered into a sale purchase agreement (the “Sale Agreement”) with the City of XXXXXXXXXX (the “City”) for the purchase by the City of the Land Properties held by Agent as bare trustee of Limited for CDN $XXXXXXXXXX. The Sale Agreement closed coincidentally on XXXXXXXXXX, the same closing date designated for the Rights Agreement. It is worth noting the following:

*     The authorized signatory for Agent for the Sale Agreement was XXXXXXXXXX, the indirect sole shareholder of Inc.

*     It is our understanding that the legal counsel of Inc/XXXXXXXXXX represented Agent in the transaction and that the net proceeds from the trust account of the said legal counsel in respect to the transaction went to three bank accounts in a direction signed by XXXXXXXXXX:

XXXXXXXXXX

XXXXXXXXXX

XXXXXXXXXX

10.   Although the closing of the Rights Agreement and the Sale Agreement on the Land Properties occurred on the same date, XXXXXXXXXX, it is clear from the foregoing that on that same day, the Rights Agreement closed ahead of the Sale Agreement. That is, when the Rights Agreement closed, Inc became the majority beneficiary of the Trust and controlling shareholder of Limited as trustee of the Trust and thus controlled the final execution of the Sale Agreement.

11.   The Trust filed the first of two XXXXXXXXXX T3 returns for the short year ending XXXXXXXXXX based on the fact that the Trust became a resident trust when Inc, a Canadian resident corporation, acquired control of Limited as at XXXXXXXXXX as noted above. Until then, the Trust had filed its T3 returns as a non-resident trust. As at year end, the Trust reported the following:

*     Non-capital loss carry forward totaling $XXXXXXXXXX; and

*     Net capital loss carry forward of $XXXXXXXXXX from a capital loss in XXXXXXXXXX of $XXXXXXXXXX that had created a net capital loss of $XXXXXXXXXX.

12.   The Trust then filed the second of its two XXXXXXXXXX T3 returns for the year ending XXXXXXXXXX. It is our understanding that in this second return, the Trust reported the sale of the Land Properties noted in paragraph 9 above with a sale price of $XXXXXXXXXX. As at year end, the Trust reported the following:

*     Non-capital loss carry forward totaling $XXXXXXXXXX; and

*     Capital loss for the year of $XXXXXXXXXX, which resulted in a net capital loss of $XXXXXXXXXX.

13.   On XXXXXXXXXX, the court in XXXXXXXXXX issued an order under a judgment transferring ownership of the Ltd Shares to Corp and Ltd was then dissolved as a corporation. On the same date and as part of the Rights Agreement, Inc became the sole shareholder of Limited and the sole beneficiary of the Trust.

14.   It is our understanding that the Trust acquired one rental property in XXXXXXXXXX and another in XXXXXXXXXX. Starting in XXXXXXXXXX, the Trust began issuing T3 slips for rental income distributions to Inc as sole beneficiary. It is also our understanding that in XXXXXXXXXX, the Trust transferred one such property at fair market value (“FMV”) for shares of a related company and also reported a deemed disposition at FMV of the other property pursuant to subsection 104(4) of the Income Tax Act (the “Act”).

15.   For the year ending XXXXXXXXXX, based on the transactions noted in paragraph 14, the Trust reported a capital gain of $XXXXXXXXXX, for a net taxable capital gain of $XXXXXXXXXX. When applying losses of other years to a year in which there is a capital gain where the inclusion rate (“IR”) was different (in the current case the XXXXXXXXXX inclusion rate was XXXXXXXXXX), the available net capital losses from XXXXXXXXXX had to be adjusted by an adjustment factor (“AF”). The adjustment factor in the current case would be XXXXXXXXXX. The Trust reported a net capital loss carry forward of $XXXXXXXXXX when it filed its return for the taxation year ended XXXXXXXXXX. This included the following:

      Year ended                        Net Capital Loss         IR                            AF                           Adjusted Net Capital Loss
                                                 (rounded)                                                                                  Available in XXXXXXXX

      XXXXXXXXXX                  XXXXXXXXXX            XXXXXXXXXX       XXXXXXXXXX        XXXXXXXXXX

16.   It is worth noting that pursuant to article XXXXXXXXXX of the Trust Deed, the Trust shall be irrevocable and shall terminate and the trust estate distributed to the beneficiaries immediately before the twenty first (21st) anniversary of the effective date of the Trust Deed, that is, immediately before XXXXXXXXXX assuming that the Trust was settled on XXXXXXXXXX. Based on its tax filings, there is no indication that Trust reported itself as having terminated at that time. However, we note from the documents you have provided that the Trust was amended on XXXXXXXXXX to provide that the distribution to beneficiaries and termination of Trust must occur by XXXXXXXXXX (rather than before its 21st anniversary).

Our Comments

Resettlement of the Trust by reference to the common law

Other than as noted in paragraph 16 above, it is our understanding that there has been no formal variation of the Trust Deed. The sale by Corp of its majority beneficiary interest in the Trust to Inc was neither explicitly allowed nor disallowed under the terms of the Trust Deed. Therefore, in our view, it is appropriate that audit should consider whether there was a resettlement of the Trust either on XXXXXXXXXX by reference to the common law.

XXXXXXXXXX

In the present situation, article XXXXXXXXXX of the Trust Deed states that the “XXXXXXXXXX.  Article XXXXXXXXXX defines the two beneficiaries as Ltd (XXXXXXXXXX% income and capital) and Corp (XXXXXXXXXX% income and capital). Article XXXXXXXXXX provides that the Trustee holds the Trust Estate XXXXXXXXXX. Article XXXXXXXXXX sets out the powers of the Trustee, however this article does not contain a power to amend or vary the trust.

Many common law jurisdictions have over the years enacted legislation which provides for the variation of a trust (most Canadian provinces possess such legislation). We do not have any information as to the XXXXXXXXXX legislation on this issue if any. However, to the extent the Trust Deed provided for the investment of the trust capital for the benefit of two specific beneficiaries (Ltd and Corp), it is our view that a change in the beneficiaries would change the foundation of the Trust.

As noted above, the two original beneficiaries were not specifically prohibited from disposing of their capital and income interests in the Trust by selling it to someone else. However, in doing so the intention of the two original settlors is completely set aside. The intention of the settlors, as clearly spelled out in the Trust Deed, was to have the trustee hold and invest the capital of the trust for the benefit of two specific beneficiaries, the two original settlors themselves, and this is no longer the case.

Additionally, only Corp sold its capital and income interests through the Rights Agreement. Ltd was not a party to the Rights Agreement. The disposition by Corp of its capital and income interests was not authorized by the Trust Deed. Under common law, a trustee has (amongst other duties) the duty to act impartially between beneficiaries and to adhere to the terms of the trust.

Based on the foregoing, it is our view that under common law, the Trust was resettled on XXXXXXXXXX when Corp disposed of its majority beneficiary interests in the Trust to Inc because the transaction changed the whole substratum or “raison d’etre” of the Trust. Note that we have consulted with CRA Legal Services and they support this view.

General anti-avoidance rule in section 245 of the Act

In The Queen v Mackay et al (“Mackay”) 2008 DTC 6238 FCA, the court stated as follows:

This appeal is a consolidation of twelve appeals from a judgment of Justice Campbell of the Tax Court of Canada (2007 TCC 94) involving transactions similar to those considered in Mathew v. Canada, [2005] 2 S.C.R. 643, 2005 SCC 55 and OSFC Holdings Ltd. v. Canada (C.A.), [2002] 2 F.C. 288 [[2002] 2 FC 288], [2001] 4 CTC 82 [2001] 4 CTC 82], 2001 DTC 5471 [2001 DTC 5471] . In those cases, the Minister of National Revenue was held to have been correct to use the general anti-avoidance rule (the "GAAR") in section 245 of the Income Tax Act, R.S.C. 1985, c. 1 (5th Supp.) to disallow the transfer of losses from a corporation to taxpayers unrelated to that corporation. The transactions in issue in these twelve cases resulted in a similar transfer of losses, but Justice Campbell held that the GAAR did not apply. The issue is whether Justice Campbell erred in law in reaching that conclusion.

I conclude that the avoidance transaction in this case was abusive within the meaning of subsection 245(4) of the GAAR. It follows that the Minister was correct to reassess the respondents to disallow the deduction of the transferred losses.

Based on the foregoing, we propose that the effective transfer of losses of the Trust to benefit the unrelated new majority/sole beneficiary of the Trust should be subject to GAAR. XXXXXXXXXX.

XXXXXXXXXX

For your information, unless exempted, a copy of this memorandum will be severed using the Access to Information Act criteria and placed in the Canada Revenue Agency’s electronic library. After a 90-day waiting period, a severed copy will also be distributed to the commercial tax publishers for inclusion in their databases. You may request an extension of this 90-day period. The severing process will remove all material that is not subject to disclosure, including information that could disclose the identity of the taxpayer. Should the taxpayer request a copy of this memorandum, they may request a severed copy using the Privacy Act criteria, which does not remove taxpayer identity. Requests for this latter version should be e-mailed to: ITRACCESSG@cra-arc.gc.ca. In such cases, a copy will be sent to you for delivery to the taxpayer.

We trust that these comments will be of assistance.

Yours truly,

Phillip Kohnen, CPA, CMA, TEP
for Director
Trust Section I
Financial Industries and Trusts Division
Income Tax Rulings Directorate
Legislative Policy and Regulatory Affairs Branch

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