Blog + News

Fair market value transfers of property to trusts – The Federal Court of Appeal decision of Sommerer

Canadian tax practitioners often recommend the use of inter vivos trusts in tax and estate planning for private clients. Trusts, if planned and executed correctly, offer confidentiality protection, probate avoidance, income / capital gains splitting and potential tax deferral. Trusts are not for everyone. They require careful execution and administration but in the right circumstances trusts can offer flexibility for the private client in planning their affairs.

A common plan among entrepreneurial clients is to use a trust to hold shares of a private corporation. If the corporation pays dividends to the trust shareholder, income splitting may be realized with family beneficiaries (with some restrictions that are beyond the scope of this post). Another common plan is to establish a trust for the benefit of family members where a family member loans money to the trust at the “prescribed rate” of interest (currently at one percent but adjusted every quarter). If the trust pays the required interest to the family member debtor on a timely basis (no later than 30 days after the end of the year, i.e. January 30 of each year), then any investment income realized by the trust in excess of the prescribed rate of interest can be taxed in the trust beneficiaries’ hands as opposed to the debtor. The result is tax efficient income splitting.

All this assumes that the trust attribution rule under subsection 75(2) of the Income Tax Act (the “Act”) does not apply. Should it apply, then any income, loss, capital gain or capital loss realized on the trust property will attribute back to the person who transferred property to the trust. The application of subsection 75(2) will usually result in a non-effective income splitting result. Preventing subsection 75(2) from applying is key.

Subsection 75(2) provides:

Trusts [revocable, etc.] — Where, by a trust created in any manner whatever since 1934, property is held on condition

(a) that it or property substituted therefor may

(i) revert to the person from whom the property or property for which it was substituted was directly or indirectly received (in this subsection referred to as “the person”), or

(ii) pass to persons to be determined by the person at a time subsequent to the creation of the trust, or

(b) that, during the existence of the person, the property shall not be disposed of except with the person’s consent or in accordance with the person’s direction, any income or loss from the property or from property substituted for the property, and any taxable capital gain or allowable capital loss from the disposition of the property or of property substituted for the property, shall, during the existence of the person while the person is resident in Canada, be deemed to be income or a loss, as the case may be, or a taxable capital gain or allowable capital loss, as the case may be, of the person.

Although subsection 75(2) is a short read, practitioners have struggled for decades as to what exactly the correct interpretation of the provision is in various fact patterns. For example, can a beneficiary of a trust sell, at fair market value (“FMV”), property to a trust and have subsection 75(2) not apply? Good question.

The Tax Court decision of Sommerer addressed this question. See our June 9, 2011 blog for the facts of the case. The Tax Court found that subsection 75(2) did not apply to FMV transfers by a beneficiary to a trust. We stated the following in our previous blog:

… the Court excludes FMV transfers from the ambit of subsection 75(2), basing itself on one tax author who indicates that the usual object of subsection 75(2) is the settlor, though could apply to a subsequent transferor in the sense of a contributor. Because “contributed” signifies a voluntary payment made to increase the capital of the estate or trust, the Court reasons that FMV transfers are not caught by subsection 75(2). Thus, the taxpayer’s FMV share sale to the trust does not trigger subsection 75(2) attribution.

While that interpretation is certainly “taxpayer friendly,” many tax practitioners chose to wait for the Federal Court of Appeal (“FCA”) decision (given that the Crown appealed the Tax Court decision) before relying on it. On July 13, 2012, the FCA released its decision. The Crown’s appeal was dismissed. For private tax client practitioners, this decision is a must read. The FCA commenced its analysis of subsection 75(2) by laying out the policy intent of the provision:

[34] Broadly speaking, subsection 75(2) is intended to ensure that a taxpayer cannot avoid the income tax consequences of the use or disposition of property by transferring it in trust to another person while retaining a right of reversion in respect of the property or property for which it may be substituted, or retaining the right to direct the disposition of the property or substituted property. Subsection 75(2) operates by attributing any income or loss from the use of trust property, and any gain or capital loss on the disposition of trust property, to the person from whom the property, or property for which it was substituted, was received by the trust.

The FCA later analyzed FMV transfers of property to a trust. The Court’s comments in paragraphs 49 to 55 are very interesting and are reproduced below:

[49] In this case, the Crown contends that the application of subsection 75(2) applies also in respect of property that has been purchased by a trustee from a beneficiary at fair market value and held subject to the terms of the trust. In my view, 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.

[50] A series of examples will illustrate this point. (For the sake of simplicity, assume that to the extent the trust in these examples earns any income from the use of its property, the income is distributed to the beneficiaries on a current basis, so that no property of the trust represents retained income or property substituted for retained income.)

[51] An individual, Mary, settles a $10,000 trust for her children, naming them all as beneficiaries who are to share equally in all distributions of property of the trust, and naming herself as the sole beneficiary in the event that all of the children predecease her. In this case, subsection 75(2) would apply to attribute to Mary all of the income and losses of the trust from the use of its property, and all of the capital gains and losses realized by the trust on the disposition of its property (during her lifetime as long as she is resident in Canada).

[52] Now a complication is added. One of Mary’s children, Jack, donates a painting to the trust, stipulating that it is to be held subject to the existing terms of the trust except that if the painting is still held by the trust in ten years time, the painting would revert to Jack. The trust sells the painting five years later, realizing a capital gain on the sale. The capital gain is attributed to Jack pursuant to subsection 75(2) because it was realized on the disposition of property that the trust acquired from Jack subject to the terms of the existing trust, and also subject to the condition that the property could revert to him. It is important to observe that, because the painting was donated to the trust by Jack and the trust gave nothing to Jack in return, it cannot be said that the painting is property substituted for any property that the trust received from Mary, so there could be no attribution to Mary of any gain on the sale of the painting, or any income or gains associated with property substituted for the painting.

[53] Now suppose that Jack, instead of donating the painting to the trust, sells it to the trust for its fair market value with no conditions attached. The painting is sold by the trust at a time when Jack is the only child of Mary still alive. The trust realizes a capital gain on the sale. At that point, either Mary or Jack could become entitled to receive all of the property of the trust, depending upon which of them dies first.

[54] Under the conventional understanding of subsection 75(2), the painting would be considered property substituted for money that the trust received from Mary. That is because all of the property of the trust can be traced, through the substituted property rule, to whatever property Mary donated to the trust when it was settled. Because the painting and any property substituted for the painting could revert to Mary, subsection 75(2) would apply to attribute to Mary the capital gain on the sale of the painting. However, if the Crown’s interpretation is correct, it would be equally valid to say that because the trust received the painting from Jack when the terms of the trust were such that the painting could revert to him, subsection 75(2) attributes to Jack the capital gain on the sale of the painting.

[55] Thus, under the Crown’s interpretation of subsection 75(2), the same capital gain is attributed simultaneously to Mary and Jack. That cannot be. Nothing in subsection 75(2) contemplates an outcome involving the attribution of the same gain to more than one person. This double application of subsection 75(2) cannot be avoided by a discretionary use of subsection 75(2), because it is not a discretionary provision. It applies automatically to every situation it describes.

[57] I conclude that the Crown’s proposed interpretation is wrong because it is based on the incorrect premise that subsection 75(2) can apply to a beneficiary of a trust who transfers property to the trust by means of a genuine sale. Justice Miller reached the same conclusion through a comprehensive application of the principles of statutory interpretation to specific words and phrases in subsection 75(2). His main conclusion is stated succinctly at paragraph 91 of his reasons:

“… once 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 “the person” for purposes of subsection 75(2) of the Act.”

Assuming that the FCA decision Sommerer is good law, FMV transfers of property to a trust by a beneficiary should not be subject to the ambit of subsection 75(2). On its face, this is very good news for taxpayers who use trusts in their tax and estate planning affairs.

What does our firm think? We are, of course, happy with the FCA decision but are still contemplating the above paragraphs. The debate in our office has been whether the comments in paragraph 55 are the final word on this subject. On the one hand, the comments in paragraph 55 make sound, logical sense. On the other hand, there are numerous provisions in the Act that can result in double taxation (applications of subsection 15(1), section 67 and subsection 56(2) come to mind). Accordingly, is the conclusion that the taxation of the same trust income in the hands of two different beneficiaries sound enough logic to cause the application of subsection 75(2) to not apply when dealing with FMV transfers of property to a trust (appreciating that this was not the sole reason that the FCA relied upon in coming to its conclusion on this matter)? It will be interesting to see if the Crown seeks leave to the Supreme Court of Canada regarding this decision.

Overall, our firm will be taking a measured approach when advising on FMV transfers to trusts until such time that it becomes apparent that the FCA decision in Sommerer is good law.