The recent Tax Court of Canada decision in Brent Kern Family Trust v The Queen examines the application of the attribution rule in subsection 75(2) of the Income Tax Act (the "Act"). The decision is significant in that it affirms the Federal Court of Appeal (the "FCA") decision in Sommerer v The Queen, in which the FCA substantially narrowed the application of the rule.
In general terms, subsection 75(2) applies in circumstances where there is the possibility that property transferred to a trust will revert back to the settlor, the settlor retains the ability to determine the beneficiaries, or the property cannot be disposed of without the settlor's consent. When the rule applies, the Act deems any income or loss on property transferred by the settlor to the trust (or any taxable capital gain or allowable capital loss on such property) to be attributed back to the settlor. Prior to the FCA's decision in Sommerer, the wording in subsection 75(2) was generally considered broad enough to capture any transfer of property to a trust by any person (including persons other than the settlor), regardless of whether consideration was given by the trust in exchange for the transfer.
In Sommerer, the FCA held that the attribution rule is not engaged where the property is transferred by a beneficiary of a trust to the trust in exchange for valuable consideration. This ran counter to the Canada Revenue Agency's ("CRA") administrative position that the rule generally applied to all such transfers. In Brent Kern, the Court considered Sommerer in determining whether subsection 75(2) was engaged.
The Transaction in Brent Kern
The Appellant, The Brent Kern Family Trust (the "Brent Trust"), was involved in a series of transactions whereby property was transferred to the Brent Trust and to another trust (the "Kern Trust") for "valuable consideration". The Brent Trust was established for the benefit of K, his family and an operating company ("Opco"). The Brent Trust held common shares in a related holding company ("Holdco") and the Kern Trust held common shares of Opco.
The taxpayers in Brent Kern sought to apply a technique that would have resulted in dividends being treated as "tax free" intercorporate dividends for income tax purposes, despite having been paid out to individuals. This was to be accomplished by using subsection 75(2) 'backwards' to deliberately attribute dividend income back to a corporation for income tax purposes, despite such income having been paid out to an individual. To accomplish this, Opco declared a dividend in favour of the Kern Trust which allocated the amount to Holdco, which in turn declared a dividend in favour of the Brent Trust.
The taxpayers sought to attribute the income from the second dividend back to Opco for income tax purposes rather than having such income taxed in the trust, resulting in a tax-free intercorporate dividend despite the dividend having been received by the Brent Trust. The basis for attributing the dividend back to Opco was that the rule in subsection 75(2) applied: Opco had sold the shares of Holdco to the Brent Trust, Opco was also a beneficiary of the Brent Trust, and the dividend paid by Holdco was income from the property transferred by Opco to the Brent Trust (such property being the shares of Holdco). Because the dividend was considered to be attributed back to Opco, the Appellant (the Brent Trust) did not report any income from having received the dividend.
The Minister of National Revenue (the "Minister") took the position that subsection 75(2) was not applicable because of the decision in Sommerer. The Minister also advanced the alternative position that the transactions triggered the application of the General Anti-Avoidance Rule ("GAAR"), in that the transactions constituted an abuse or misuse of subsection 75(2).
Overview of TCC Analysis and Decision
The Appellant in Brent Kern raised a number of arguments as to why subsection 75(2) should apply on the facts, despite the FCA's holding in Sommerer. It argued that Sommerer was an exceptional case due to the complexity of the facts; that the FCA's decision in Sommerer was motivated by a desire to avoid double taxation, which was not at issue in Brent Kern; that the FCA's statements in Sommerer were obiter in terms of their uniform application to all transfers for fair market value; and that the courts in Sommerer did not have an opportunity to conduct a full textual, contextual and purposive interpretation of subsection 75(2) because of deficient pleadings.
The Court, while describing as "valiant" the Appellant's efforts to distinguish Sommerer, disagreed with all of the arguments raised by the Appellant. In particular, the Court held that the facts in the two cases were not distinguishable, that the avoidance of double taxation was not determinative in Sommerer, that the reasoning in Sommerer applies to every situation described in subsection 75(2), and that the courts in Sommerer had in fact conducted a detailed textual, contextual and purposive analysis of the rule.
The Court concluded, consistent with the holding in Sommerer, that subsection 75(2) does not include as a 'person' a beneficiary who sells property to a trust for valuable consideration. The Court also confirmed, in response to the Appellant's additional argument that the decision in Sommerer was simply incorrect (as opposed to distinguishable), that the Tax Court of Canada was not free to disregard the FCA's decision in Sommerer and that it was bound to apply the statements of the law as handed down by the FCA.
The Court found that subsection 75(2) does not apply to the dividend received by the Brent Trust. Opco had received valuable consideration on the transfer of property to the Brent Trust and was an enduring beneficiary under the Brent Trust. The dividend income received by the Brent Trust was not attributable to Opco, but remained to be taxed in the hands of the Brent Trust itself. The court declined to consider the issues relating to GAAR as the issue was moot given the Court's conclusions on the non-application of subsection 75(2).
It is perhaps unfortunate that the Court in Brent Trust was not required to consider whether GAAR would have applied to the structure sought to be implemented by the taxpayers. One can envision the same structure as the one described above being implemented without the trust paying fair market value consideration to the transferor corporation in exchange for shares received from the transferor corporation, in which case Sommerer may not apply. It remains to be seen whether the Court would consider such a structure to constitute a misuse or abuse of subsection 75(2) or of the provisions of the Act as a whole.
However, the decision is reassuring for taxpayers who may have relied on Sommerer in the course of a transfer of property to a trust – for example, on the sale of property by a beneficiary of a trust to the trust in exchange for fair market value consideration. The decision is also relevant to certain planning techniques that rely on Sommerer in the course of an estate freeze in order to sell shares of a corporation to a family trust rather than having the family trust subscribe for new shares in the corporation. Taxpayers may now be more comfortable relying on the Court's decision in Sommerer, particularly given the Minister's successful reliance on Sommerer in denying the application of subsection 75(2) to a transfer for valuable consideration in Brent Trust.
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