“Puppet trustees” get another chance

The practice of sheltering income from Canada’s tax man by setting up what amount to nominal trustees in a tax haven like Barbados was dealt a severe blow in a recent court case. But the Supreme Court of Canada has decided to hear the case anew, a decision that may breathe new life into a common tax planning strategy among Canada’s wealthy.

Garron Family Trust et al. v. The Queen involved two offshore trusts where the trustees resided in the balmy tax haven, and the beneficiaries in Canada. They arranged to have the capital gains from the disposition of assets realized by the Barbados-based trusts, and then applied for an exemption from Canadian taxes under the Canada-Barbados Income Tax Agreement. The tax man would have none of it, and the Tax Court of Canada agreed in a 2009 ruling. The Federal Court of Appeal later affirmed this judgment.

The crux of the ruling was that the trust was managed and controlled by beneficiaries residing in Canada, making Canada, not Barbados, the actual residence of the trust. This undercut any claim to the sheltering of capital gains under the Canada-Barbados Income Tax Agreement.

“In [the Garron case], the Court shifted away from the generally accepted, long-standing, common law basis for determining trust residency based on trustee residence, to a residency determination based on the location of the central management and control of the trust,” Janette Pantry and Rebecca Levi of Blakes, Cassels & Graydon LLP explain in a commentary on the Tax Court of Canada’s landmark decision.

Pantry suggests advisors should take note that one of the considerations that factored into the determination that the beneficiaries managed and controlled the trust is that the trustees and beneficiaries shared the same financial advisors.

While this does not in itself warrant the conclusion that the trust was controlled by the beneficiaries, it certainly adds fuel to the fire when considered in the context of the evidence showing a highly passive role for the trustees.

“The court inferred that the beneficiaries were talking directly with the investment advisors regarding the accounts, and that it was the beneficiaries and not the trustees who held sway over their management,” Pantry said.

Advisors working for both the beneficiaries and trustees of the same trust should refrain from taking instructions regarding the management of the trust from the beneficiaries, she adds. “Advise the beneficiary to make their recommendations to the trustees for their consideration. The advisor should only take instructions on the management of investments in the trust from the trustees.”

Puppet Trustees

“Certain trusts have had so-called puppet trustees, where they reside in one place, but the real administration of the trust is occurring somewhere else. And people have tried to fall back on the so-called puppet trustees in determining residence. The central management and control test overrides that,” says Kim G. C. Moody, a chartered accountant and trust and estate practitioner at Moodys LLP Tax Advisors.

Moody notes that there is a great deal of debate among practitioners concerning whether the central management and control test is appropriately applied to trusts.

“I would say I’m on the fence. I hope the Supreme Court of Canada lays out a very clear test in terms of how the residency of a trust should be determined,” he said.

Moody points out that the use of the central management and control test in the Garron case was an application to trusts of the residency test applied to corporations. “It’s not clear to me that the corporate analogy is an appropriate analogy for a trust. I welcome the Supreme Court’s decision to review and clarify this line of argument,” he said.

“Trustees owe a fiduciary responsibility to the beneficiaries of the trust. This requires the trustee to make a myriad of decisions. Provided the trustee actually decides the issues in question, should it matter how this decision is reached or who they may turn to for assistance or consultation? Again, hopefully the Supreme Court provides guidance on this issue,” Moody added.