By Sunita Doobay
Recently published in the Canadian Tax Highlights, a Canadian Tax Foundation publication and reproduced with permission here.
The FCA released its decision in Sommerer on July 13, 2012 (2012 FCA 207). The FCA dismissed the Crown’s appeal, which challenged the TCC’s conclusion (2011 TCC 212) on the application of subsection 75(2) and article XIII(5) of the Canada-Austria treaty.In 1996, the father of Peter Sommerer (Mr. S), a Canadian resident, established a private foundation in Austria under the Austrian Private Foundations Act and capitalized the foundation with 1 million Austrian schillings of his own money for the benefit of Mr. S and his family. An Austrian private foundation may engage in investment activities that are consistent with its purposes, but it cannot engage in commercial activities; it is generally subject to the same income tax laws as other Austrian corporations but is exempt from Austrian income tax as long as it files an information return disclosing its beneficiaries. (A sale of corporate securities is tax-exempt in Austria if the sale occurs more than one year after acquisition.)On October 4, 1996, Mr. S sold unconditionally to the foundation 1,770,000 shares of Vienna Systems Corporation for FMV at $1,177,050 and received $117,705 and a promise to pay the balance. In December 1997, the foundation sold 216,666 of the Vienna shares for $4.50 each to three individuals unrelated to the Sommerers, realizing a capital gain, and in December 1998 it sold the remainder to Nokia Corporation for $9.00 each, realizing a further capital gain. In April 1998, Mr. S sold unconditionally to the foundation 57,143 Cambrian Systems Corporation shares for $100,000. The foundation sold the shares to Northern Telecom in December 1998 for $14.97 each plus a further $4.12 per share conditional on certain milestones being met in 1999. That sale also resulted in a capital gain for the foundation.The Canada-Austria tax treaty is based on the OECD model and provides that a gain from the sale of corporate shares is taxable only in the state where the seller resides: on the facts, the seller was the foundation based in Austria. The CRA sought to classify the foundation as a trust and argued that the trust’s gains should be attributed to Mr. S pursuant to subsection 75(2) and thus brought within Canada’s taxing jurisdiction. The CRA also argued that the treaty did not apply because Mr. S was a resident of Canada, not Austria.
The CRA failed to convince the TCC that the foundation should be characterized as a trust. The TCC said that the foundation was a corporation that held its property in trust for Mr. S and other beneficiaries. The TCC rejected the CRA’s position that subsection 75(2) applied to Mr. S and concluded that that provision was intended to target a trust’s settlor, who on the facts was the father, not Mr. S. The TCC said that the treaty overruled Canada’s jurisdiction and established Austria as the taxing jurisdiction because both the father as settlor and the foundation/corporation as trustee were Austrian residents. Under the mind-and-management test, the TCC concluded that the corporation was an Austrian resident and that Mr. S did not exercise sufficient control to deem it to be a Canadian resident.
The Crown appealed to the FCA on the grounds that subsection 75(2) applied to Mr. S because (1) the TCC had concluded that the foundation held its property in trust for him and his family and (2) the proceeds from the sale were property substituted for the shares that he sold to the trust. The Crown argued that, for example, the proceeds of sale of the Vienna or Cambrian shares might one day be distributed to Mr. S, and thus he might receive property substituted (as defined in the Act) for the shares he had sold to the foundation. Attribution of the gain to Mr. S meant that the Canada-Austria treaty did not apply because he was a Canadian resident and the treaty protection extended to an Austrian resident only.
Mr. S disagreed with the TCC’s conclusion that the foundation held its property in trust, but he chose not to argue the point and instead argued that subsection 75(2) did not apply to him and that the treaty would exempt him in any event. In obiter–the proposition was not the subject of submissions before the FCA–Sharlow J, writing for a unanimous FCA, concluded that it was doubtful that the foundation held its property in trust. She said that the foundation created under Austrian civil law resembled a corporation in Canada rather than a trust and that the rights of a member in a foundation resembled that of a shareholder in Canadian corporation:
Looking at the situation from another point of view, a shareholder or member of a corporation, as such, is not the beneficial owner of any property or the corporation, and has no legal or equitable claim to the corporate property (unless such a claim arises upon the declaration by the board of directors of a dividend, or when the dissolution of the corporation is imminent). Unless and until such an event occurs, a shareholder or member has only an inchoate right to receive distributions of corporate property from time to time at the discretion of the board of directors, and to share in the distribution of the corporate property upon its dissolution. The same can be said of the interest of a beneficiary or an ultimate beneficiary in the property of an Austrian private foundation. Nothing in the Austrian Private Foundations Act or the constating documents of the Sommerer Private Foundation gives Peter Sommerer a legal or equitable claim to the corporate property that is different from that of a shareholder or member of a corporation.
The fact that the father “as a practical matter . . . may well have achieved many of the objectives that could have been achieved in a common law jurisdiction by settling a trust” for Mr. S and his family did not mean that a trust was created at the foundation’s establishment or when he sold the shares to it. Mr. S and his family more closely resembled a corporation’s shareholders than a trust’s beneficiaries with an equitable claim to the trust corpus. A foreign entity such as the foundation should be classified as a trust only if, under common law, a trust has been created. (Under common law, as summarized by the SCC in Air Canada v. M & L Travel Ltd. ( 3 SCR 787), a trust is created only if three certainties exist: the intention to create a trust, the trust’s subject matter, and the trust’s object or beneficiary.) Sharlow J implicitly reflected the common law on the creation of a trust when she stated that “[a] corporation does not hold its property in trust for its shareholders or members, except to the extent that a trust deed or an analogous legal instrument imposes the legal and equitable obligations of a trustee on the corporation with respect to specific corporate property.” She concluded that “[n]othing in the constating documents of the [foundation] or the law of Austria, as reflected in the record of this case, [supported] the conclusion that the right of the [foundation] to deal with its property is constrained by any legal or equitable obligations analogous to those of a common law trustee” or gave Mr. S a legal or equitable claim to the corporate property that was different from the claim of a shareholder or member of a corporation.
Although Sharlow J concluded that it was doubtful that the foundation held any property in trust for Mr. S, in the balance of her reasons she proceeded on the assumption–without deciding–that the father had settled a trust in favour of Mr. S and his family. In her analysis of subsection 75(2), she agreed with the TCC’s Miller J that subsection 75(2) could not apply to a beneficiary of a trust who transfers property to a trust by means of a genuine sale and quoted his conclusion: “[O]nce properly unravelled and viewed grammatically and logically, the only interpretation is that only a settlor, or a subsequent contributor who could be seen as a settlor, can be ‘the person’ for purposes of subsection 75(2) of the Act.” Sharlow J said that “to interpret subsection 75(2) so that it could apply to a beneficiary in respect of property that the trust acquired from the beneficiary in a bona fide sale transaction leads to outcomes that are absurd and could not have been intended by Parliament.” The facts clearly showed that the foundation had purchased the Vienna shares with funds from the original endowment made by the father, who was not a resident of Canada, and thus subsection 75(2) did not apply.
Although that conclusion was sufficient to dismiss the appeal, Sharlow J commented on the Crown’s treaty argument because the TCC had dealt with the issue. The Crown argued that the treaty provided no relief to Mr. S in the event that subsection 75(2) applied because he was not an Austrian resident. The Crown argued that the reservation under article XXXVIII(2), which allows Canada the right to tax residents of Canada on income and gains pursuant to section 91 (the FAPI rules), meant that the domestic attribution rules do not contravene a treaty that is based on the OECD model. If this argument had been successful, it would have created a groundbreaking precedent; but Sharlow J agreed with the TCC that “[t]here is no similar reservation relating to the attribution of income and gains under subsection 75(2), which means that Canada has not reserved the right to tax residents of Canada on income and gains attributed to them under subsection 75(2).” The FCA rejected the Crown’s argument that foreign jurisprudence establishes that domestic attribution rules do not conflict with international tax conventions based on the OECD model. Instead, the court agreed with the international tax expert Karl Vogel that one must analyze each treaty and its reservation clauses before concluding that a specific domestic law overrides a treaty.
This is not the first time that the Crown has advanced the position that subsection 75(2) overrides a treaty’s capital gains clause. In St. Michael Trust Corp. (sub nom. Garron Family Trust v. The Queen (2009 TCC 450)), the TCC discussed the interaction of subsection 75(2) and the relevant capital gains clause in article XIV(4) of the Canada-Barbados treaty. Woods J concluded that subsection 75(2) did not override that treaty’s capital gains article, which was clearly drafted and reflected its object and spirit. She also said that the question to be asked was, “Did the Treaty’s contracting states intend to reserve to themselves under Article XIV(4) a residual right to tax gains arising in the other contracting state?” and concluded that it did not: “I would also comment that the Treaty contains a specific override provision in reference to another attribution rule. Article XXX(2) provides an override in reference to the Canadian taxation of [FAPI] earned by non-resident corporations. If the drafters of the Treaty had intended an override for other attribution rules, they could have been specifically provided for it.”
The issue of whether subsection 75(2) can override a treaty’s capital gains article was first raised and rejected by the TCC in 2009. It was advanced by the minister in 2011 inSommerer. It appears that the FCA has now settled the issue: subsection 75(2) does not override a treaty’s capital gains article unless a clause in the treaty specifically carves out an exception for the application of subsection 75(2).
TaxChambers LLP, Toronto
Canadian Tax HighlightsVolume 20, Number 8, August 2012
©2012, Canadian Tax Foundation, published with permission
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