Offshore trusts can still fall within Canada's tax net

There's nothing like a good landmark to steer you in the right direction.

When Carolyn, the kids and I drive to Alabama (her brother lives there), I always know we're getting close to Birmingham when we come to a particular landmark. It's a large billboard advertising a small local airline that offers short-haul flights at really cheap prices. The sign reads "Movies and food are over-rated," "the kids will love our inflatable slides," and "our planes may be older, but there's nothing like experience." That landmark always makes me glad we drove.

On April 12, a new landmark was established in the world of tax. It'll provide guidance to taxpayers for years to come. I'm talking about a Supreme Court of Canada (SCC) decision in a case known in tax circles as the Garron case.

The principle

One of the most fundamental questions that every government must ask is this: Who should be liable to pay tax? Most governments have adopted the same answer to the question: If you reside in a country, you should pay tax there. (The U.S. is a rare exception where individuals are taxed if they are citizens, regardless of where they live. Oh, and the U.S. also taxes those who reside there.)

The common principle is that a person who derives economic and social benefit from living in a place should owe an economic allegiance to that place. And so, Canada – like most countries – taxes based on residency.

The problem? Determining whether you're resident in Canada for tax purposes can be tough because it's generally a question of fact and subject to the interpretation of the Canada Revenue Agency (CRA) or the courts (with some rare exceptions where certain people are deemed to be resident here).

The case

Determining residency is even tougher when we're talking about an entity that isn't a person with a family and a home to live in. What if you're a corporation? Or a trust? The Garron case, formally referred to as Fundy Settlement v. Canada, 2012 SCC 14, is the story of two family trusts that purported to be resident in Barbados, not Canada, and therefore claimed to escape the Canadian tax net.

The trustee of the trusts is St. Michael Trust Corp., resident in Barbados. The beneficiaries of the trusts are residents of Canada. The trusts sold shares in two Ontario corporations and realized substantial capital gains in the process. The purchaser was required to withhold and remit taxes to the Canadian government on account of these capital gains – to the tune of $152-million.

St. Michael Trust Corp. requested a refund of the $152-million in taxes paid based on an exemption from Canadian capital gains tax under the Canada-Barbados tax treaty. Under the treaty, tax is only payable in the country in which the seller was resident. St. Michael claimed that, because it was resident in Barbados, the trusts were resident in Barbados and there should be no tax owing in Canada.

The decision

The SCC decided in favour of the government here. The SCC came to the conclusion that the trusts in question were in fact resident in Canada. This is a departure from the historical approach to determining the residency of a trust. Historically, it's the residence of the trustees that was considered to be the key factor in determining where the trust itself was resident, and therefore where the trust should face tax.

In this case, however, the court drew a parallel between the residence of a trust and the residence of a corporation. While there's a dearth of judicial authority on the question of the residency of a trust, the residency of a corporation is well established to be where its central management and control resides. The CRA showed that the central management and control of the trusts in this case was carried out by the main beneficiaries, who were resident in Canada, and that St. Michaels Trust Corp. – the trustee – was considered to be carrying out an administrative function only.

Applying the same principle that applies to corporations, the SCC decided that the residence of trusts should also be determined by where central management and control resides.

Thousands of Canadians have established trusts. Most were not established offshore, but some, for example, have set up trusts in Alberta to take advantage of Alberta tax rates, yet control the trusts from other provinces. It behooves all who have trusts to consider where those who truly control the trust reside since that's where tax will likely be paid going forward.