This case involved a typical offshore freeze. While Barbados is not a low-tax jurisdiction per se, it does not impose tax on capital gains realized by Barbadian residents. This factor, in combination with the Treaty exemption, has made Barbados an attractive jurisdiction for offshore freeze transactions. The Canada Revenue Agency (CRA) has regularly listed Barbadian freeze transactions on its items under review for the potential application of the general anti-avoidance rule (GAAR). However, as we will discuss, the GAAR was just one of several grounds of assessment in this case, and did not form the basis of the FCA’s decision.
In 1998, the owners of common shares of PMPL Holdings Inc., a Canadian corporation, converted the shares to fixed-value preference shares with a redemption amount of $50 million. Two trusts with Canadian beneficiaries were settled by an individual resident in the Caribbean island of St. Vincent.
The sole trustee of each trust was a corporation resident in Barbados. The trusts subscribed for shares of newly incorporated Canadian holding corporations. As a result, these companies were wholly owned by the trusts. The corporations, in turn, subscribed for shares of PMPL. These transactions were effected at nominal consideration.
In 2000, as part of an arm’s-length sale of PMPL, the trusts disposed of the majority of the shares in the holding companies, realizing capital gains of over $450 million. The trusts claimed the Treaty exemption, which provides that “gains from the alienation of any property, other than those mentioned in paragraphs 1, 2 and 3, may be taxed only in the Contracting State of which the alienator is a resident.”
The Minister took the position that the Treaty exemption did not apply, and issued assessments to each of the trusts in respect of the gains. The Minister also assessed the preferred shareholders of PMPL (the other appellants) with respect to the same gains. These latter assessments were made as a protective measure only, with no intention of taxing the same gains more than once.
The Minister based his assessments on the following alternative arguments:
- The trusts were resident in Canada under general principles.
- The trusts were resident in Canada by virtue of section 94 of the Income Tax Act.
- Subsection 75(2) of the Income Tax Act applied to the other appellants.
- The GAAR applied.
- The sale proceeds should be reallocated from the trusts to the other appellants by virtue of section 68 of the Income Tax Act.
Tax Court decision
The Tax Court judge, Justice Judith Woods, held that the Treaty exemption did not apply because the trusts were resident in Canada. Although the corporate trustee of each trust was acknowledged to be a resident of Barbados, Justice Woods concluded that the central management and control of each trust was in Canada based on the evidence as a whole.
She found that the corporate trustee’s role was to execute documents as required, and to provide incidental administrative services. It was generally not expected that it would have responsibility for decision-making beyond that. In her view, “more likely than not,” the corporate trustee had agreed from the outset that it would defer to the recommendations of the Canadian principals.
Among the many factors that the judge considered relevant was the fact that each Canadian principal (and his wife) had the power to replace the trust’s “protector,” the person who had the power to replace the corporate trustee.
This conclusion must be contrasted with the longstanding decision in Thibodeau Family Trust v the Queen (78 DTC 6376), in which the Federal Court found that the residence of the trust for tax purposes was the jurisdiction of residence of the majority of the trustees. The judge in Thibodeau appeared to reject the central management and control test on the basis that the fiduciary duties imposed on trustees would not permit them to take direction from a third party.
Justice Woods noted that if the judge’s comments in Thibodeau were meant to apply to all cases regardless of the facts, she could not agree, since trustees do not always comply with their fiduciary duties. She stated, “I have concluded that the Thibodeau decision is insufficient authority for me to reject a central management and control test to determine trust residence. In fact, as I will explain, in my view there are very good reasons why the judicial test for residence that has been developed in a corporate context should also apply to trusts.” (paragraph 157)
In her view, “adopting a similar test of residence for trusts and corporations promotes the important principles of consistency, predictability and fairness in the application of tax law.” (paragraph 160)
The decision that the trusts were resident in Canada was sufficient to dispose of the appeals, but Justice Woods went on to address some of the other issues raised. With respect to the application of the GAAR, the existence of a tax benefit and an avoidance transaction were conceded, so the only question was whether there was a “misuse or abuse” of the Treaty. Justice Woods disagreed with the Minister’s finding of abuse, stating that this approach would be contrary to that suggested by the FCA in The Queen v MIL (Investments) S.A. (2007 FCA 236). “It does not make sense that a transaction that is subject to tax under the [Income Tax] Act by virtue of an anti-avoidance provision necessarily constitutes a misuse or abuse of the Treaty.” (paragraph 373)
The result was that the Tax Court dismissed the appeals of the trusts and allowed the appeals of the other appellants.
The taxpayers appealed to the FCA.
Federal Court of Appeal decision
In a unanimous decision, the FCA dismissed the taxpayers’ appeals. Justice Karen Sharlow agreed with Justice Woods that a central management and control test should be applied in determining the residence of the trusts. Based on the evidence before her, it was reasonably open to the trial judge to conclude that the trusts were resident in Canada.
Like the Tax Court judge, Justice Sharlow dealt with the alternative grounds of assessment that the Minister raised. Because these matters did not form the basis of the decision, they will not be discussed here.
It is interesting to note, however, that like the Tax Court, the FCA concluded that the GAAR did not apply. The claiming of the Treaty exemption in the face of section 94 was not considered to be a “misuse or abuse.” If the residence of the trust was assumed to be in Barbados for Treaty purposes, the trust could not be considered to have misused or abused the Treaty by claiming the exemption.
What the decision means
The most important aspect of this decision is the FCA’s confirmation that the residence of a trust is to be determined by reference to its central management and control, and not necessarily the residence of the trustees. This determination is based not only on the relevant written documentation, but also on the actions of the parties. Proper implementation and follow-through are crucial when tax minimization or tax avoidance strategies are in play.