3 November 2000 Internal T.I. 2000-0023997 - Non-resident bearing loans immigrant to NRT

Please note that the following document, although believed to be correct at the time of issue, may not represent the current position of the CRA.
Prenez note que ce document, bien qu'exact au moment émis, peut ne pas représenter la position actuelle de l'ARC.

Please note that the following document, although believed to be correct at the time of issue, may not represent the current position of the Department.

Prenez note que ce document, bien qu'exact au moment émis, peut ne pas représenter la position actuelle du ministère.

Principal Issues:

1.validity of a trust set up by an immigrant to Canada
2. application of the attribution rules
3. transfer pricing issues related to the non-interest bearing loans made by the non-resident settlor

Position:

1. the trust may not be valid when the impact of the letter of wishes on the trust is considered
2. 75(2) may apply as a result of the control exercised by the settlor through the letter of wishes
3. the transfer pricing rules may apply as a result of the lack of interest charged on the loans

Reasons:

the analysis is specific to this particular trust such that reference to the reasons given in the document should be considered

			November 3, 2000

	International Tax Directorate	HEADQUARTERS
	Compliance Programs Branch	Annemarie Humenuk

	Attention:  Stan Gingrich
			2000-002399

XXXXXXXXXX

This is in response to your memorandum of May 2, 2000, as clarified in our telephone conversation of August 25, 2000 (Gingrich\Humenuk) concerning the validity of the above mentioned trust and the application of subsections 69(3), 75(2), 94(1) and 247(2) of the Act.

All statutory references in this memorandum are references to the provisions of the Income Tax Act, R.S.C. 1985 (5th supp.) c. 1, as amended.

Our understanding of the relevant facts is as follows:

1. XXXXXXXXXX.

2. Under the terms of the trust deed, XXXXXXXXXX is neither a beneficiary of the trust nor is she eligible to be a beneficiary of the trust. As a result, she is not beneficially interested in the trust within the meaning of subsection 248(25). The trust is fully discretionary and the beneficiaries include XXXXXXXXXX husband, children, sister, sister-in-law, nephew and niece.

3. According to the XXXXXXXXXX T1141 information return filed by XXXXXXXXXX, she made cash loans totalling $XXXXXXXXXX to the trust company during XXXXXXXXXX prior to becoming resident in Canada. The loans were secured by non-interest bearing promissory notes payable on demand. During the same time period, she also transferred $XXXXXXXXXX in stocks and investments to the trust company in exchange for non-interest bearing promissory notes

payable on demand XXXXXXXXXX). It is not clear from the information return whether these transfers represented a sale of property to the trust for fair market value consideration, the proceeds of which were secured by the demand notes, or whether such property was lent to the trust. While the financial statements for the trust show the stocks and investments as a loan payable to the settlor, the accompanying schedule of investments indicates that the property was sold to the trust. You may wish to clarify this point for the reasons discussed below under the headings "Attribution Rules" and "Transfer Pricing". The total value of the property transferred or loaned to the trust company during XXXXXXXXXX was $XXXXXXXXXX.

4. XXXXXXXXXX immigrated to Canada in XXXXXXXXXX.

5. Financial statements were submitted for the trust for the period XXXXXXXXXX.

6. Assuming no break in XXXXXXXXXX residence in Canada, it is expected that the trust will be deemed to be resident in Canada under paragraph 94(1)(c) for the XXXXXXXXXX taxation year since XXXXXXXXXX will have been resident in Canada for more than 60 months by the end of XXXXXXXXXX and the other conditions described in paragraphs 94(1)(a) and (b) will also be met. Similarly, the trust would have been deemed to be resident in Canada for the XXXXXXXXXX taxation year under the proposed changes to section 94 found in the draft legislation released on June 22, 2000; but as noted in the Department of Finance Press Release 2000-064 dated September 7, 2000, these amendments are now expected to be effective for taxation years commencing after 2001.

As a result of the transactions described above, the majority of the trust's property was acquired through transactions involving the issuance of non-interest bearing promissory notes to the settlor. It would appear that the purpose of structuring the transactions in this manner was to avoid paying Canadian income tax on the investment of the immigrant's property for the taxation years of the trust which end in a year in which the settlor is resident in Canada but has not been resident in Canada for one or more periods of time exceeding 60 months in total. You asked us to consider whether the purported trust created by deed dated XXXXXXXXXX constitutes a trust for the purposes of the Act. You also asked if we could suggest any other approach by which this type of arrangement could be challenged.

Validity of the Trust

At common law, a trust is established where the three certainties are met: certainty of intent to create a trust, certainty of subject matter and certainty of objects. With respect to the case at hand, the certainty of subject matter and the certainty of objects are evidenced by the $XXXXXXXXXX initial settlement and the clear statement in the trust deed of the identity of the beneficiaries. Normally a written trust deed is sufficient evidence to establish the certainty of intent to create a trust, especially where the settlor is alive and able to credibly confirm his or her intentions. However, as stated on page 9 of the book by Peter Willoughby, Misplaced Trust, it is a matter of conjecture at this time as to whether a trust may be set aside where it is accompanied by a letter of wishes which is at variance with the trust deed.

The wording of the letter of wishes signed by XXXXXXXXXX, which accompanies this particular trust deed suggests that she intended to retain control over the assets purportedly placed in the trust. To the extent that her intent was to retain control over the assets, one might reasonably argue that the certainty of intention to create a trust has not been met (i.e., it is difficult to reconcile this particular letter of wishes with an intent to transfer control of the property to the trustees). The letter indicates that it is XXXXXXXXXX wish or intent that she be consulted in all matters concerning the trust during her lifetime, including investment decisions and the timing and amount of any distributions to be made from the trust. The letter also provides very specific information concerning her wishes with respect to the distribution of the trust property in the event of her death.

While a letter of wishes is generally considered to be non-binding, consideration must be given to the settlor's intent in determining the validity of any of the powers given to a person in a trust deed. This suggests that the trustees, and corporate trustees in particular, may not be able to capriciously ignore a "letter of wishes" from the settlor without risking breach of trust or mala fides (the concept of mala fides, as described in the article "Trusts - Powers, Amendments and Variations" by H. Carr and E. Hoffstein, encompasses more than bad faith or fraud; the courts typically use it to ensure that the fundamental purpose of the trust is not defeated - and the purpose of a trust requires an understanding of the settlor's purpose and intent). Because of the possibility that a letter of wishes may impact on the validity of the trust deed, a letter or memorandum of wishes is often unsigned and is normally not witnessed. One reason for having a letter of wishes signed and witnessed is to ensure that the wishes so expressed can be enforced in the event that the trustees do not carry out their duties in accordance with such wishes. The fact that this particular letter of wishes was signed and witnessed on the day of the trust's creation suggests that it should be construed as part of the trust deed itself.

If this particular letter of wishes forms part of the terms of the trust, the issue is whether the additional terms as set out in that document alters the nature of the relationship between the trust company and XXXXXXXXXX to the extent that the relationship is actually one of agency rather than of trust or whether subsection 75(2) applies as a result of such additional terms. The following passages from Scott, The Law of Trusts, 4th ed. (1987) illustrates the difference between agency and trust:

"An agent acts for, and on behalf of, his principal and subject to his control; a trustee as such is not subject to the control of his beneficiary, although he is under a duty to deal with the trust property for the latter's benefit in accordance with the terms of the trust, and can be compelled by the beneficiary to perform this duty. The agent owes a duty of obedience to his principal; a trustee is under a duty to conform to the terms of the trust (Vol. 1, p. 88).

...

A person may be both agent of and trustee for another. If he undertakes to act on behalf of the other and subject to his control he is an agent; but if he is vested with the title to property that he holds for his principal, he is also a trustee. In such a case, however, it is the agency relation that predominates, and the principles of agency, rather than the principles of trust, are applicable (Vol. 1, p. 95)."

Based on the letter of wishes, it would appear that the trust company is acting as agent for XXXXXXXXXX. In the alternative, the requirement to consult with XXXXXXXXXX on both investment decisions and the timing and amount of any distributions to the beneficiaries suggests that the property cannot be distributed during her lifetime without her consent and that she has retained the ability to determine who will receive the property subsequent to the execution of the trust deed. As a result, even if it is determined that a valid trust exists, the inclusion of the letter of wishes as part of the terms of the trust would result in the application of subsection 75(2).

Even if this particular letter of wishes does not form part of the terms of the trust, it expresses XXXXXXXXXX intentions with respect to the investment and disposition of the property in significant detail. Since the trustees have a duty to exercise any powers given under the terms of the trust in light of the purpose of the trust and the settlor's intent in creating the trust, it seems clear that they would have a duty to consult and presumably, to follow any instructions given by XXXXXXXXXX. To the extent that the trust company cannot exercise the powers set out in the trust deed without such consultation, it may be that the relationship between XXXXXXXXXX and the trust company is one of agency. If this is so, the trust is invalid and any income earned on the property is that of XXXXXXXXXX.

Although the XXXXXXXXXX trust legislation contains specific provisions to ensure that the laws of other jurisdictions (including that of Canada) do not override the law of the XXXXXXXXXX for the purpose of determining the validity of a trust or the capacity of a settlor, a cursory review of that legislation did not reveal any provision which would deem a trust to exist where the certainty of intention was not otherwise established. In addition, the provisions in the XXXXXXXXXX trust legislation relating to jurisdiction do not extend to jurisdiction over the administration of the Act.

You may wish to obtain more information concerning the actions of the trustees with regard to the administration of the trust to date, particularly with respect to consultations with XXXXXXXXXX. To the extent that the actions of the trustees and the minutes of any meetings of the trustees indicate that they are simply following the instructions in the letter of wishes, the trust may be considered invalid for lack of certainty to create a trust. However, it is not clear that the courts will necessarily support such a finding.

Attribution Rules

As stated in response to question 8 at the 1991 Canadian Tax Foundation Round Table, when an individual makes a genuine loan to a trust or a bona fide sale of property, the unpaid proceeds of which are secured by a promissory note, subsection 75(2) will not apply solely by reason of an agreement to repay the loan or pay the balance of the outstanding debt. On the other hand, subsection 75(2) would apply when property is loaned to the trust on the condition that it may be returned at a later date. Thus, subsection 75(2) would not apply to a loan of cash secured by a promissory note solely by reason of the fact that the trust is required to repay the loan but it would apply to a loan of property, such as publicly traded shares, where the terms of the arrangement are such that the property or property substituted for that property is to be returned to the lender at a later date.

While subsection 75(2) does not usually apply to loans or transfers of property solely by reason of an agreement to repay the loan or pay the unpaid proceeds from the disposition, where the terms of the trust are such that there is a possibility, however remote, that the person who transferred the property to the trust may reacquire the property (or property substituted for such property), subsection 75(2) applies even though the person may have received consideration equal to the fair market value of the property so transferred (see document E9601665 issued by this Directorate for further details). This includes the situation where the individual who transfers or loans the property to the trust is beneficially interested in the trust within the meaning of subsection 248(25). However, under the draft legislation released by the Department of Finance on June 22, 2000, subsection 75(2) will not apply to any income earned in a taxation year that begins after 2000 by an immigrant trust (i.e., a trust that is non-resident for the purpose of computing its income for the year even though a person who is resident in Canada at the end of the year has contributed property to the trust). As stated above, XXXXXXXXXX is not beneficially interested in the trust and thus it is our view that subparagraph 75(2)(a)(i) would not apply to attribute the trust's income to XXXXXXXXXX for the period under review (although subsection 75(2) may apply for the reasons discussed above under the heading "Validity of the Trust").

We considered the application of section 74.1 and subsection 56(4.1) to the income earned by the XXXXXXXXXX Trust. While section 74.1 would likely apply to any income allocated to XXXXXXXXXX husband or to any of XXXXXXXXXX nephew, niece or children who are under the age of 18 as beneficiaries of the trust and subsection 56(4.1) would likely apply to any income allocated to her sister, sister-in-law or to any of her children, niece or nephew who are over 18 as beneficiaries of the trust, there is no indication of any distribution to any of these individuals in the XXXXXXXXXX taxation years. As a result, neither of these provisions would apply to attribute income to XXXXXXXXXX during this period.

Transfer Pricing

We also considered the application of the transfer pricing rules in subsections 69(3) and 247(2).

For taxation years which began before 1998, the circumstances under which subsection 69(3) applied included the situation where a non-resident had the use of property belonging to a taxpayer with whom the non-resident was not dealing at arm's length and the non-resident had neither paid nor agreed to pay for the use of that property. In our view, an interest-free loan of property by an individual who is resident of Canada to a non-resident trust could fall within that description. However, subsection 69(3) would not apply to the situation where a non-resident trust agreed to pay an amount for property but that amount was not paid at the time of the transfer and no interest was charged on the outstanding debt. This is because, in the second situation, the non-resident did not have the use of the taxpayer's property and had agreed to pay an amount for the transfer of the property (even though the amount was not paid at the time of the initial transfer).

For taxation years that begin after 1997, the transfer pricing rules are found in section 247 rather than subsection 69(3). The rules in subsection 247(2) are sufficiently broad to include situations not covered by subsection 69(3), including the second scenario mentioned in the previous paragraph. Under subsection 247(2), the amount of interest payable on an amount of indebtedness owing by a non-resident trust with whom the taxpayer does not deal at arm's length can be adjusted to reflect the amount that would be payable if the parties were dealing at arm's length when either of the conditions in paragraph 247(2)(a) or (b) apply. As a result, a reasonable amount of interest can be included in the taxpayer's income from a debt owing by a non-resident trust with whom the taxpayer is not dealing at arm's length even though the taxpayer has not charged any interest on the outstanding debt (i.e., it is not necessary to distinguish between an interest-free loan and a non-interest bearing debt arising from the disposition of property).

While we have discussed the transfer pricing issue with Ken Major, Manager of the Foreign Section of this Directorate, we suggest that you consult the Transfer Pricing and Competent Authority Division of your Directorate directly if you determine that subsection 69(3) or 247(2) may apply to impute income to XXXXXXXXXX since they are responsible for the CCRA's practices relating to the transfer pricing legislation.

For your information a copy of this memorandum will be severed using the Access to Information Act criteria and placed in the Legislation Access Database (LAD) on the CCRA's mainframe computer. A severed copy will also be distributed to the commercial tax publishers for inclusion in their databases. The severing process will remove all material that is not subject to disclosure including information that could disclose the identity of the taxpayer.

Should your client request a copy of this memorandum, they can be provided with the LAD version or they may request a copy severed using the Privacy Act criteria which does not remove client identity. Requests for this latter version should be made by you to Jackie Page at (819) 994-2898. The severed copy will be sent to you for delivery to the client.

T. Murphy
Manager
Trusts Section
Resources, Partnerships and Trusts Division
Income Tax Rulings Directorate
Policy and Legislation Branch

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