2017-0705431E5 funds held in settlement account

Principal Issues: 1. Do funds held in trust as a result of a judgment in a class action suit qualify as a tax exempt trust under paragraph 149(1)(w) of the Act?

Position: 1. Requirements of 149(1)(w) do not appear to have been met.

Reasons: 1. General comments provided as it is not a ruling.

Author: Holloway, Lena
Section: 149(1)(w); 150(1.1); 150(1); 204

XXXXXXXXXX                                                                                                            Lena Holloway, CPA, CA
                                                                                                                                    2017-070543
June 28, 2017

Dear XXXXXXXXXX:

Re:  Trust funds to compensate members of a class action suit

This is in reply to your correspondence of May 23, 2017, requesting our views on the application of paragraph 149(1)(w) of the Income Tax Act (the “Act”). You had asked us to confirm your interpretation of the applicability of paragraph 149(1)(w) of the Act to a specific scenario outlined in your letter as follows:

Scenario

- A law firm involved in class action litigation receives settlement funds from the defendant;

- The settlement funds are held in a settlement trust fund;

- The settlement trust fund is solely for compensating class members and none of these funds will be used for any other purpose;

- Under the Class Proceedings Act of the Province of XXXXXXXXXX the settlement of the class proceedings must be approved by the Court;

- The terms of the settlement and the payment of the settlement funds are pursuant to the settlement agreement and a final Order of the Court;

- During the period from the receipt of the settlement funds from the defendant and the time the claims are paid in full, the settlement funds earn interest income from the financial institution that holds the trust funds; and

- A T5 slip is issued annually to the “law firm in trust” in respect of these funds.

It is your opinion that the interest earned on these funds is exempt from tax under paragraph 149(1)(w) of the Act and that the law firm is neither required to prepare T5 slips for the class members, nor are they required to prepare and file a T3 return in respect of these trust funds.

Our comments

The comments which follow in this letter will provide general comments about the provisions of the Act.  Our comments do not confirm the income tax treatment of a particular situation, but are intended to assist you in making that determination.  The income tax treatment of transactions will only be confirmed by this Directorate in the context of an advance income tax ruling request submitted in the manner set out in Information Circular IC70-6R7, Advance Income Tax Rulings and Technical Interpretations.

Paragraph 149(1)(w) provides for an exemption from taxation under Part I of the Act, for “a trust established as required under a law of Canada or of a province in order to provide funds out of which to compensate persons for claims against an owner of a business identified in the relevant law where that owner is unwilling or unable to compensate a customer or client, if no part of the property of the trust, after payment of its proper trust expenses, is available to any person other than as a consequence of that person being a customer or client of a business so identified.”

The requirements a trust must satisfy in order to be exempt under the provision can be summarized as follows:

1)  There must be a trust.

2)  The trust must be established as required under the laws of Canada or of a province.

3)  The trust must be established to provide funds out of which to compensate persons for claims against the owner of a business.

4)  The business must be identified under the relevant law.

5)  The payout from the trust must be provided for where the owner of the business is unwilling or unable to pay a customer or client of the business.

6)  No part of the property of the trust, after the payment of proper trust expenses, may be available to any person other than as a consequence of that person being a customer or client of a business so identified in the relevant law.

With respect to the first requirement, the existence of a trust is determined by the relationship between the settlor, the trustees and the beneficiaries and is a question of fact.

If we assume that a valid trust exists in this case and the first condition is met, we do not believe the second requirement of paragraph 149(1)(w) would be met in this case as the settlement trust fund would not have been “established as required under the laws of Canada or of a province”.  Paragraph 149(1)(w) requires that a trust must have been created or brought into existence as required under a law of Canada or a province rather than by court order.  The Department of Justice explains the role of our Court system at http://www.justice.gc.ca/eng/csj-sjc/ccs-ajc/01.html:

“Canada’s judiciary is one branch of our system of government, the others being the legislature and the executive. Whereas the judiciary resolves disputes according to law – including disputes about how legislative and executive powers are exercised – the legislature (Parliament) has the power to make, alter and repeal laws.” (emphasis added)

It is our view that the words of paragraph 149(1)(w) require that a trust be set up according to or pursuant to a specific law rather than pursuant to a court decision facilitating the administration of the law.  There is no law in this case specifically requiring a trust to be established to provide funds out of which to compensate persons for claims against the owner of a business.  Furthermore the law must identify the particular business and as such paragraph 149(1)(w) is not intended to shelter from taxation all income that may arise from funds required to be held in trust by court order.

Given that the Class Proceedings Act does not specifically require a trust to be set up to compensate those with claims from a specific business, but rather the terms of the settlement and the payment of the settlement funds are pursuant to “the settlement agreement and a final Order of the Court”, we do not believe the settlement trust fund as described would qualify as a trust exempt from Part I tax under paragraph 149(1)(w) of the Act.

You also enquired about the filing requirements of such a trust.  The requirements for filing of the T3RET – Trust Income Tax and Information Return are set out on page 16 of the T4013 T3 - Trust Guide 2016 and can be found on the Canada Revenue Agency’s (CRA) website at http://www.cra-arc.gc.ca/E/pub/tg/t4013/t4013-16e.pdf.

The general requirement for a trust to file a return is provided for in paragraph 150(1)(c) of the Act and section 204 of the Income Tax Regulations (C.R.C., c. 945) (the “Regulations”).  However, subsection 150(1.1), as it applies to a Canadian resident trust, provides that the trust is required to file an income tax return pursuant to paragraph 150(1)(c) if tax is payable by the trust or if the trust disposes of capital property or realizes a capital gain. Furthermore, subsection 204(1) of the Regulations provides that every person having control of or receiving income, gains or profits in a fiduciary capacity must file a return. Therefore, a T3 return is required to be filed by the trustees of a trust where they have control of or are in receipt of income, gains or profits of the trust.

The above comments represent our view of the law as it generally applies. While we hope that our comments are of assistance to you, please note that this is not an advance income tax ruling and, accordingly, is not binding on the CRA.

Yours truly,

Phillip Kohnen
for Division Director
Financial Industries and Trusts Division
Income Tax Rulings Directorate
Legislative Policy and Regulatory Affairs Branch

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