2021-0882201C6 STEP 2021 -Q2- Definition of Arm's Length Transfer

Principal Issues: Interpretation of paragraph (a) of the definition of “arm's length transfer” in subsection 94(1). In the example provided, would Father’s loan to the trust be an arm’s length transfer?

Position: Question of fact; however, very likely no.

Reasons: See below

Author: Dannehl, Dawn
Section: 94(1)

2021 STEP CRA Roundtable – June 15, 2021

QUESTION 2. Interpretation of the Definition of “Arm’s Length Transfer”

Section 94 of the Income Tax Act (“the Act”) is a provision designed to prevent the avoidance of tax on income which would otherwise be taxable in Canada, through the use of non-resident trusts.  In general, if a Canadian resident contributes property to a non-resident trust (other than an “exempt foreign trust” as defined in subsection 94(1)), the trust is deemed under paragraph 94(3)(a) to be resident in Canada for a number of purposes.  In addition, the contributor (other than an “electing contributor”) to the trust and certain Canadian-resident beneficiaries of the trust may all become jointly and severally, or solidarily, liable to pay Canadian tax on the income of the trust.

Consider a situation in which a resident of Canada (“Father”) makes a loan to a factually non-resident trust (“the Trust”) six months after the settlement of the Trust. The terms of the loan, including the interest rate, are consistent with the terms of a demand loan between arm’s length parties. 

We note that the October 2012 Department of Finance Explanatory Notes state:

Thus, for example, if any person receives a beneficial interest in a non-resident trust as a result of a particular transfer or loan of property or if it is reasonable to conclude that one of the reasons for the transfer was to facilitate the acquisition of such an interest, the transfer will not be an arm's length transfer.

Would CRA consider Father’s loan to the Trust to be an “arm’s length transfer” as defined by subsection 94(1), particularly when no trust beneficiary acquires an interest under the Trust as a result of this loan?  

Consider the following facts:

*    The settlor is, and has always been a non-resident;
*    To date, the settlor is the only contributor to the Trust;
*    The trustee (who is not the settlor, Father or a beneficiary) is a non-resident;
*    The central management and control of the trust rests with, and is exercised by the trustee;
*    The only beneficiaries of the Trust are the two children of Father. Both children are resident in Canada, and both were named beneficiaries in the trust deed when the Trust was settled;
*    Father has always been resident in Canada; and
*    Father and the trustee entered into an enforceable contract regarding the terms and conditions of the loan.

CRA Response

Paragraph 94(3)(a) deems a trust to be resident in Canada for the specific purposes mentioned therein, if the following conditions are met:

*    The trust is a factually non-resident trust;
*    The trust is not an “exempt foreign trust” as defined in subsection 94(1); and
*    The trust has either a “resident contributor” or a “resident beneficiary”: both of which are defined in subsection 94(1). 

For purposes of our response, we accept the assumptions that the Trust is a factually non-resident trust and that it is not an exempt foreign trust.  Thus, if the Trust has either a “resident contributor” or a “resident beneficiary” (footnote 1)  paragraph 94(3)(a) will apply.

Before it can be determined if Father is a “contributor” to the Trust, and therefore a  “resident contributor” to the Trust, the definition of “contribution” in subsection 94(1) must first be satisfied.  This definition contains three paragraphs - only one of which must be satisfied.  Given that Father has made a loan directly to the Trust, paragraph (a) of the definition applies (footnote 2) . 

However, if Father’s loan to the Trust is determined to be an “arm’s length transfer” as defined in subsection 94(1), Father will not be considered to have made a “contribution” to the Trust. 

The definition of “arm’s length transfer” contains two paragraphs, both of which must be satisfied in order for the transfer in question to be an “arm’s length transfer”. The question at hand deals specifically with paragraph (a) (footnote 3)  of the definition which reads as follows:

“arm's length transfer”, at any time by a person or partnership (referred to in this definition as the "transferor") means a transfer or loan (which transfer or loan is referred to in this definition as the "transfer") of property (other than restricted property) that is made at that time (referred to in this definition as the "transfer time") by the transferor to a particular person or partnership (referred to in this definition as the "recipient") if
(a) it is reasonable to conclude that none of the reasons (determined by reference to all the circumstances including the terms of a trust, an intention, the laws of a country or the existence of an agreement, a memorandum, a letter of wishes or any other arrangement) for the transfer is the acquisition at any time by any person or partnership of an interest as a beneficiary under a non-resident trust; and …

In our view, the wording of paragraph (a) does not support the interpretation that the test is that the beneficiary’s interest must be acquired as a result of the transfer being considered. The use of the term “reason” over “purpose” or “result” in this paragraph creates a broader, more restrictive test.  The word “reason” as used here implies a motive or justification for the transfer. Put differently, the issue is not whether the transfer causes a person or partnership to receive an interest in the trust – it is that a beneficiary’s existing or future interest in the trust motivates the transferor to make the transfer.  

In our view, this definition aims to ensure there is no nexus between the transfer and person or partnership that already has an interest in the non-resident trust or could have such an interest in the future.  When this is the case, it is our view that paragraph (a) fails and the loan or transfer is not an “arms length transfer”.

In respect of the situation described above, despite the fact that the terms of the loan are commensurate to what an arm’s length lender and borrower would agree on, for paragraph (a) to be satisfied, it has to be reasonable to conclude that none of the reasons why Father made the loan to the Trust is the fact that his children are beneficiaries under the Trust.

Although the determination of the reasons for the loan or transfer depends on “all the circumstances including the terms of a trust, an intention, the laws of a country or the existence of an agreement, a memorandum, a letter of wishes or any other arrangement”, we are of the view that a conclusion that Father has made an “arm’s length transfer” is highly unlikely given the relationship between Father and his children.  As such paragraph (a) will most likely fail, and the loan will not be an “arm’s length transfer”.  Therefore, Father will be considered to have made a “contribution” to the Trust and will be a “contributor” and a “resident contributor” to the Trust.  As such, pursuant to paragraph 94(3)(a), the Trust will be deemed to be resident in Canada for the purposes outlined therein.

Dawn Dannehl
Steve Fron
2021-088220

FOOTNOTES

Note to reader:  Because of our system requirements, the footnotes contained in the original document are shown below instead:

1  The definition of “resident beneficiary” requires that, in addition to a beneficiary who is resident in Canada,  there must be a “connected contributor” to the trust. If Father is a contributor for purposes of determining whether he is a “resident contributor”,  an analysis of the “resident beneficiary”  definition  is not needed.
2  Paragraph (a) provides that a contribution to a trust means a transfer or loan (other than an arm’s length transfer) of property to a trust by a particular person or partnership – in our case Father. 
3  We will focus on paragraph (a) and assume paragraph (b) is otherwise satisfied.

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