11 April 1994 Internal T.I. 9401547 - TESTAMENTARY TRUST AND ARM'S LENGTH RELATIONSHIP

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:

-testamentary trust and arm's length relationship
-application of subsection 55(3)(a)

Position TAKEN:

-specific fact situation-trust is not related to a surviving brother-55(2) applies

Reasons FOR POSITION TAKEN:

-based on budget of Feb. 22, 1994 and wording of the Act

					April 11, 1994

	Winnipeg District Office	Head Office
	Audit Division 	Rulings Directorate
V. Plant
	Attention:  Joe Gaspar	(613) 957-8953

					940154

Testamentary trust and arm's length relationship

This is in reply to your memorandum dated January 17, 1994 addressed to the Avoidance Services Section of the Taxation Programs Branch which was forwarded to us for reply.

The memorandum concerns an enquiry you received from a XXXXXXXXXX who is proposing a series of transactions which involves section 55 of the Income Tax Act ("the Act"). His proposed plan is as follows.

Holdco owns common shares in Opco which Holdco controls.

The common shares of Holdco were owned equally by two brothers. Holdco, however, was controlled by the father of the two brothers by virtue of voting preferred shares.

One brother has died and under his Will the common shares which he owned go into a testamentary trust where the trustees are the surviving brother and father. The testamentary trust is a qualifying spousal trust under subsection 70(6) of the Act, such that all of the annual income is required to be paid out to the deceased brother's spouse so long as she lives and on her death the trust property is divided among the deceased's children. While the spouse is living the trustees have the power to encroach upon capital in favour of the spouse.

The following is proposed. The testamentary trust will incorporate a Newco and subscribe for one common share for $1.00. The testamentary trust will then transfer its common shares in Holdco to Newco on a section 85 rollover in return for more common shares of Newco. Holdco will then purchase back its common shares owned by Newco. This will result in a deemed dividend to Newco since the paid-up capital of the Holdco common shares is nominal. Assuming there is not enough "safe income", subsection 55(2) of the Act would apply to deem part of the dividend to be a capital gain unless the exception in paragraph 55(3)(a) applies.

XXXXXXXXXX analysis

There would not appear to be any disposition of any property to any person with whom Newco is dealing at arm's length.

He believes that a more difficult issue is whether there has been a significant increase in the interest in any corporation of any person with whom Newco has been dealing at arm's length.

a)Newco's new shareholding in Holdco should not be a problem since Newco and Holdco should be at non-arm's length since the father controls Holdco and Newco is controlled by the testamentary trust which has father and the surviving brother as its trustees.

b)The surviving brother's increase in interest in Holdco should not be a problem since the surviving brother should be at non-arm's length with Newco, since Newco is controlled by the testamentary trust which has as its trustees the surviving brother and father.

c)The testamentary trust has acquired a shareholding in Newco and indirectly (albeit temporarily) in Holdco and in Opco. The testamentary trust itself should be non-arm's length with all these corporations since its trustees are the father and surviving brother. However, can it be said that the spouse of the deceased brother has obtained a significant increase in these corporations? If it can be said that she has obtained a significant increase in these corporations, is she in any event dealing at non-arm's length with these corporations? XXXXXXXXXX has submitted that she has not obtained a significant increase in these corporations and that in any event she does deal at non-arm's length with these corporations so that the exception in paragraph 55(3)(a) of the Act applies.

XXXXXXXXXX reasons as the why paragraph 55(3)(a) of the Act applies:

(i) The spouse only has a life interest in the testamentary trust and is the potential object of a power of encroachment. It should not be considered that the spouse obtained an interest in Newco within the meaning of subparagraph 55(3)(a)(ii) of the Act. For instance, in paragraph 1 of Interpretation Bulletin IT449-R, it is stated that "where property is held in trust for the benefit of one or more persons it is the Department's view that such property normally vests indefeasibly in the trust and not in a beneficiary thereof." It seems entirely remote to suggest she has obtained an interest in Holdco or Opco.

(ii) The spouse should be considered as dealing at non-arm's length with Newco for two reasons. One is that Revenue Canada states in Interpretation Bulletin IT-419 that "unless the facts indicate the contrary", a beneficiary of a trust is considered not to be at arm's length with the trust. Taking this one step further, one would expect Revenue Canada to be of the view that a beneficiary of a trust is also not at arm's length with a corporation (Newco) that is controlled by the trust. Whether one could make the same argument apropos of the beneficiary's dealings with other corporations (Holdco and Opco) controlled by the persons who are the trustees is not clear to XXXXXXXXXX

(iii)There is an argument that the spouse of the deceased brother should be still considered a child of the father by virtue of paragraph 252(1)(e) of the Act and therefore at non-arm's length with all the corporations. This is supported by the case of Estate of Mary Jane Gale v. M.N.R. 85 DTC 28(Tax Court) and Re: Crowthers (1978) 1 W.W.R. 262 (B.C. Supreme Court). However, Revenue Canada's Interpretation Bulletin IT-419, paragraph 5, states that upon the death of a child the in-law relationships cease so that a child's spouse is no longer a child of the taxpayer.

Comments of the District Office

You believe that, based on the facts provided, it would be a question of fact whether Newco and Holdco deal at arm's length. Since the trustees and beneficiaries of the trust are all related individuals and Holdco is controlled by the deceased son's father, you believe that it could be argued that Newco and Holdco do not deal at arm's length. In your opinion, an arguable position could be taken that paragraph 55(3)(a) of the Act applies.

You do however have some areas of concern as to the applicability of paragraph 55(3)(a).

(i)It is your understanding that the intent of the exception in paragraph 55(3)(a) of the Act is to allow transactions involving no real change on a global basis in economic ownership to be exempt from the rules in subsection 55(2). The proposed series of transactions appear to involve a real change in economic ownership.

(ii)The intent of the exceptions in paragraph 55(3)(a) take issue with transactions involving siblings. As a result of the deeming provisions in paragraph 55(5)(e) of the Act, transactions involving siblings and their corporations are placed on the same footing as transactions involving any other unrelated party. Notwithstanding the rules in section 251 of the Act, paragraph 55(5)(e) provides that, for the purposes of section 55 of the Act, brothers and sisters (which includes brother-in-law and sister-in-law per paragraphs 252(2)(b) and (c) of the Act) are deemed to deal with each other at arm's length. The series of transactions proposed are in essence a disposition between siblings in that the deceased son's estate is disposing of its economic interest in Holdco and the surviving son is acquiring an economic interest in Holdco (ie. surviving son's interest in the common shares of Holdco is increased from 50% to 100%).

Our Comments

It appears that the interpretation sought by XXXXXXXXXX relates to a proposed transaction to be undertaken by specific taxpayers, so his attention should be brought to Information Circular 70-6R2 dated September 28, 1990 and the Special Release thereto dated September 30, 1992, issued by Revenue Canada, Customs, Excise and Taxation. We will provide confirmation with respect to proposed transactions involving specific taxpayers only in response to a request for an advance income tax ruling. We therefore suggest you offer him the following general comments.

His attention should be drawn to the draft legislation tabled in the House of Commons as part of the budget of February 22, 1994. Certain changes to paragraphs 55(3)(a) and (e) have been proposed which appear to have a significant impact on the above proposed transactions.

The legislation proposes to replace subparagraphs 55(3)(a)(i) and (ii) of the Act by the following:

"(i) a disposition of property to a person to whom that corporation was not related,

or

(ii) a significant increase in the interest in any corporation of any person to whom the corporation that received the dividend was not related; or"

The legislation proposes to replace paragraph 55(5)(e) of the Act by the following:

"(e)in determining whether 2 or more persons or a person and a partnership are related to each other and in determining whether control of a corporation has been acquired by a person or group of persons,

(i)persons shall be deemed not to be related to each other if one is the brother or sister of the other;

(ii)where at any time a person is related to each beneficiary under a trust whose interest in the trust at that time has vested indefeasibly in the beneficiary, the person and the trust shall be deemed to be related at that time to each other;

(iii)a trust and a person shall be deemed not to be related to each other unless they are deemed by subparagraph (ii) to be related to each other; and

(iv)persons who are related to each other solely because of a right referred to in paragraph 251(b) shall be deemed not to be related to each other.

These proposed changes are applicable to dividends received after February 21, 1994 unless the dividends are received as part of a series of transactions or events that was required on February 22, 1994 to be carried out pursuant to a written agreement entered into before February 22, 1994.

In relation to the above proposed changes, and assuming these changes are enacted as drafted, we have the following general comments:

a)The fact that the father and the surviving brother are the trustees of the testamentary trust is not relevant for the purposes of the "related" test in paragraph 55(3)(a) of the Act. The important test is whether the person is related to each trust beneficiary whose interest in the trust at that time has vested indefeasibly in the beneficiary in determining whether the person and the trust are related at that time to each other.

b)There appears to be a significant increase in the interest that the surviving brother has in Holdco. At the end of the series of proposed transactions, the surviving brother owns 100% of the common shares of Holdco rather than his original 50%. Newco is the corporation receiving the dividend. It must be established whether the surviving brother is related to Newco. He would be related to Newco if he were related to the trust, because Newco and the trust are related by virtue of subparagraph 251(2)(b)(i) of the Act, since the trust owns 100% of the shares of Newco. However, since the surviving brother is not related to any of the trust beneficiaries (nieces, nephews, ex-sister-in-law), then he is not related to the trust by virtue of proposed subparagraphs 55(5)(e)(ii) and (iii) of the Act. It therefore appears that subsection 55(2) would apply to the dividend received by Newco, by virtue of proposed subparagraph 55(3)(a)(ii), since the surviving brother is obtaining a significant increase in his interest in Holdco, and the surviving brother is not related to Newco.

c)XXXXXXXXXX has indicated that there is an argument that the spouse of the deceased brother should still be considered a child of the father by virtue of paragraph 252(1)(e), a position he believes is supported by the case of the Estate of Mary Jane Gale v. M.N.R. 85 D.T.C. 28 (TCC) and Re: Crowthers (1978) 1 W.W.R. 262 (B.C. Supreme Court). We wish to point out that our position in paragraph 5 of Interpretation Bulletin IT-419, which states that upon the death of a child the in-law relationships cease so that a child's spouse is no longer a child of the taxpayer, is based on the decision of the Tax Appeal Board in Pembroke Ferry Limited v. M.N.R. 52 DTC 255 which was cited with approval by the Tax Court of Canada in The Estate of Karna May v. M.N.R. 88 DTC 1189. Consequently, until this matter is decided by a higher court it remains our view that the surviving spouse is not related to her former father-in-law.

d)We are also unable to agree with XXXXXXXXXX suggestion that by virtue of the fact that the surviving spouse only has a life interest in the testamentary trust she does not acquire an interest in Newco. We would point out that the legislation does not require her to acquire shares of Newco to acquire an interest in it. In our view since the surviving spouse is entitled to all income of the trust during her lifetime and the trustees have the power to encroach upon trust capital in her favour, she has an interest in all property owned by the trust, including Newco.

e)XXXXXXXXXX has indicated that there would not appear to be any disposition of any property to any person with whom Newco is dealing at arm's length (or to whom Newco is not related, under the proposed legislation). We do not agree with this statement, since when Holdco repurchases its common shares owned by Newco, subsection 84(9) deems that Newco has disposed of those shares to Holdco, and it does not appear that Newco would be related to Holdco.

We trust you will find our comments helpful.

for Director
Reorganizations and Foreign Division
Rulings Directorate
Legislative and Intergovernmental
Affairs Branch

c.c. J.G. Pearson
Chief
Avoidance Services
Attention: R.G.J. Clark