26 August 2004 Internal T.I. 2004-0060281I7 - 94 vs. Health & Welfare Type Trusts

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.

Principal Issues: 1. are participants "beneficially interested" in the trust? 2. if the funds can revert to the employer, is the employer "beneficially interested" in the trust? 3. is the fair market value of the beneficial interest less than 10%? 4. is the transfer an "arm's length transfer" as per proposed subsection 94(1)

Position: 1. yes 2. yes 3. no 4. no

Reasons: 1. 248(25)(a) 2. 248(25)(b) 3. logic 4. one of the reason is for an entity to acquire an interest as

									August 26, 2004
International Tax Directorate					Pascal Tétrault
344 Slater Street, 6th Floor
Ottawa, Ontario								

Attention:  Linda Smith
									2004-006028

The Old and the New Section 94 as Applicable to Health and Welfare Type Trusts

We are writing in response to your email of February 3, 2004 regarding the above captioned matter. This letter is part of a series dealing with non-resident trusts that are failing to meet all of the conditions stated in Interpretation Bulletin IT-85R2 - Health and Welfare Trusts for Employees.

You have asked our comments regarding the operation of subsection 94(1) of the Income Tax Act (the "Act") as generally applicable for trust taxation years prior to 2003 and on the proposed subsection 94(3) of the Act found in the Legislative Proposals Relating to the Income Tax Act published in October 2003 by the Honourable John Manley, P.C., M.P. Deputy Prime Minister and Minister of Finance (for ease of reference, we will refer to the proposed legislation). You also requested our comments on proposed section 94.1 of the Act.

With respect to subsection 94(1) of the Act, you have asked more specifically: (i) whether the participants in the arrangement described below can be considered as beneficiaries according to that subsection; (ii) whether the employer can be considered as a beneficiary of the trust when the contributions to the trust can revert to the employer; and (iii) whether paragraph 94(1)(c) or (d) applies.

The facts under issue involve a corporation, XXXXXXXXXX, (the "Corporation") resident in Canada which created a trust (the "Trust") for the benefit of its two directors, who are related persons. The Trust is resident in Barbados and the Declaration of Trust states that the intention is to create a "purpose trust" within the meaning of the International Trusts Act, L.R.O. (Barbados). The Declaration of Trust specifically refers to another document, the Plan, stating the extent of the benefits provided and the names of the directors subject to those benefits.

The taxpayer's representative challenges the application of subsection 94(1) of the Act on two grounds. It is submitted that the employees are not beneficiaries of the Trust. To qualify as such, the employees must have a "right" as a beneficiary under the Trust, whereas, in this case, the employees only have a right under the Plan to receive disability benefits. The Trust is merely a vehicle to hold the assets. Under Barbados law, the Trust is established for a purpose, which is to hold the Plan funds pending a claim for disability. It is submitted, as an alternative argument, that the fair market value of each beneficial interest in the Trust is less than 10%. This is because the participants only have a share in the income and the capital of the Plan to the extent that they qualify for a benefit as a result of sickness or accident.

With respect to the new trust regime, the taxpayer's representative submits that the transfer of property to the Trust is an "arm's length transfer", thereby preventing proposed subsection 94(3) form applying.

COMMENTS

We fail to see any merit in the submissions made on behalf of the taxpayer. We are therefore addressing each issue raised.

i) Subsection 94(1) of the Act: the old rules

We are dealing with an entity which purports to be a purpose trust within the meaning of the International Trusts Act, L.R.O. (Barbados). In order for subsection 94(1) of the Act to apply in respect of an entity, such entity must be a trust for the purposes of the Act. In the Canadian common law jurisdictions, a purpose trust will be recognized if its purpose is charitable. In the present case however, notwithstanding the use of the expression "purpose trust" in the trust indenture, the certainty of object is met because the Trust was created for the benefit of a class of person who are the directors of the company. In addition, the Trust specifically refers to the Plan where the names of the two beneficiaries are stated.

One of the conditions for subsection 94(1) to apply is that one of the persons "beneficially interested" in the trust be resident in Canada. The expression "beneficially interested" is defined under subsection 248(25) of the Act, which states in part:

(a) a person or partnership beneficially interested in a particular trust includes any person or partnership that has any right (whether immediate or future, whether absolute or contingent or whether conditional on or subject to the exercise of any discretion by any person or partnership) as a beneficiary under a trust to receive any of the income or capital of the particular trust either directly from the particular trust or indirectly through one or more trusts or partnerships;

This definition is broad. However, the argument made on behalf of the taxpayer, as we understand it in the context of an analysis of subsection 94(1), is that the directors of the Corporation are not beneficially interested in the Trust but they are beneficiaries of the Plan. We cannot agree with this argument. The Trust and the Plan are inextricably interwoven. The Trust is established to provide benefits as set out in the Plan and the trustees have a duty to pay all benefits payable in accordance with the Plan. The Trust specifically states that it is established for the purposes of providing benefits to the directors of the Corporation. It is clear that the two directors of the Corporation could compel the trustees to discharge their duties stated in the Declaration of Trust.

In the context of the definition of "beneficially interested", the directors have a right under the trust that is contingent upon the happening of an event, either sickness or an accident, to receive any income or capital of the Trust. Accordingly, we are of the view that for the purposes of subsection 94(1), the directors are beneficially interested in the Trust.

On the issue of beneficial interest, you have also asked whether the Corporation can be considered as being "beneficially interested" in the Trust if the funds can revert to the Corporation. In those circumstances, we find that paragraph 248(25)(b) of the Act would generally deem the Corporation to be beneficially interested in the Trust.

The second argument of the taxpayer's representative regarding subsection 94(1) is that the fair market value of the beneficial interest of a beneficiary is less than 10% of the aggregate fair market value of all beneficial interests in the Trust because a beneficiary's right to income or capital is based upon the happening of sickness or an accident. This argument refers to subparagraph 94(1)(d)(i) of the Act, which states:

(d) in any other case, for the purposes of subsections 91(1) to (4) and sections 95 and 233.4,
(i) the trust shall, with respect to any beneficiary under the trust the fair market value of whose beneficial interest in the trust is not less than 10% of the aggregate fair market value of all beneficial interests in the trust, be deemed to be a non-resident corporation that is controlled by the beneficiary,

This subparagraph requires a comparison to be made between the fair market value of all beneficial interests in the Trust with that of the beneficial interest held by the concerned beneficiary. In this case, there are two individuals being beneficially interested in the Trust, both having quasi-identical rights in the Trust. A third person, the Corporation, because of the possible reversion of the trust funds, albeit in a residual fashion, is also considered to be beneficially interested in the Trust. The determination of the fair market value of a beneficial interest in a trust must take into consideration a number of factors. However, in this case, we believe it is reasonable to take the position that the fair market value of each of the employees' beneficial interest in the Trust is al least ten percent. Confirmation of the value of each parties' beneficial interest should nevertheless be made with expert valuators within the Canada Revenue Agency.

We must however stress that paragraph 94(1)(c) is applicable in this case and not paragraph 94(1)(d) of the Act. In the present case, the Plan can be terminated at any time and for any reason by the Corporation, thereby resulting in the funds being distributed as follows: firstly, to pay for the expenses incurred on the winding-up of the Trust; secondly, to satisfy the existing liabilities of the Trust prior to termination; and thirdly, as determined by agreement between the Corporation and the trustees. We feel that after the Corporation's decision to terminate the Plan, the income or capital could be distributed to any of the persons beneficially interested in the Trust, as determined by the trustees and the Corporation in their absolute discretion, triggering the operation of paragraph 94(1)(c) of the Act.

ii) Proposed subsection 94(3) of the Act: the new regime

The new regime's charging provision requires for a non-resident trust to have either a resident contributor or a resident beneficiary. Proposed section 94 relies extensively on providing specific meaning to various words used. One key definition of the new regime is found in the expression "arm's length transfer". The taxpayer's representative submits that their scenario is falling within the ambit of that definition and, more specifically, of paragraph (a) and subparagraphs (b)(iv) and (b)(vi) of proposed subsection 94(1). The definition of "arm's length transfer" in proposed subsection 94(1) of the Act reads in part as follows:

"arm's length transfer", at any time by an entity (referred to in this definition as the "transferor") means a transfer or loan (which transfer or loan is referred to in this definition as the "transfer") of property (other than a restricted property) that is made at that time (referred to in this definition as the "transfer time") by the transferor to a particular entity (referred to in this definition as the "recipient") where

(a) it is reasonable to conclude that none of the reasons (determined by reference to all the circumstances including the terms of a trust, an intention, the laws of a country or the existence of an agreement, a memorandum, a letter of wishes or any other arrangement)for the transfer is the acquisition at any time by any entity of an interest as a beneficiary under a non-resident trust; and
(b) the transfer
[...]
(iv) is a transfer
(A) in exchange for which, the recipient transfers or loans property (other than a restricted property) to the transferor, or becomes obligated to transfer or loan property (other than a restricted property), and
(B) for which it is reasonable to conclude
(I) having regard only to the transfer and the exchange that the transferor would have been willing to make the transfer if the transferor dealt at arm's length with the recipient, and
(II) that the terms and conditions, and circumstances, under which the transfer was made would have been acceptable to the transferor if the transferor dealt at arm's length with the recipient,
[...]
(vi) is a payment of an amount owing by the transferor under a written agreement the terms and conditions of which, when entered into, were terms and conditions that, having regard only to the amount owing and the agreement, persons dealing at arm's length would have entered into, if the transfer is not a transfer described in paragraph (2)(g),

This definition can be divided into three parts. Firstly, the introductory paragraph requires a transfer or loan of property from an entity to another. Secondly, paragraph (a) requires that a reasonable person would not come to the conclusion that one of the reasons for the transfer is the acquisition of an interest as beneficiary under a foreign trust. And thirdly, paragraph (b) enumerates a number of possible scenarios under which the transfer must fall.

The taxpayer's representative submits that paragraph (a) of the definition of "arm's length transfer" is met because the Corporation is not transferring the funds to acquire an interest as beneficiary under the Trust. He further submits that if anyone has acquired an interest as a beneficiary, it is the participating employees. We disagree with this conclusion and are rather of the view that one of the reasons for the transfer is for the Canadian directors to acquire an interest as beneficiary under the Trust.

The reasonableness found in paragraph (a) of the definition of "arm's length transfer", is not restricted to the entity making the transfer. On the contrary, this test must be applied vis-à-vis "any entity". The meaning of "entity" being defined to include a natural person, we must conclude that the directors fall within that category and that one of the reasons for the transfer was for them to acquire an interest as beneficiary under the Trust.

In the present case, we find that both the resident contributor test and the resident beneficiary test of proposed subsection 94(3) are met. The Trust, which is not an "exempt foreign trust" described in proposed paragraph 94(1)(f) of that definition, will therefore be deemed resident of Canada for the purposes and provisions listed in proposed subsection 94(3) of the Act. One of the provision listed in proposed subparagraph 94(3)(a)(iv) is the definition of "non-resident entity" in proposed subsection 94.1(1), which works so as to provide precedence of the new non-resident trust regime over the new foreign investment entity regime.

We hope the foregoing comments are of assistance.

Eric Allard-Pouliot
Acting Section Manager
for Division Director
International and Trusts Division
Income Tax Rulings Directorate
Policy and Planning Branch