Unfortunately, taxpayers sometimes play fast and loose with the legalities surrounding family trusts. Sometimes trustees purport to make allocations of income from a trust to its beneficiaries. The beneficiaries treat the amounts allocated as income for the purposes of the Income Tax Act (Canada) (the “Act”). The allocated amounts, however, somehow end up in the hands of other individuals, often the parents of the beneficiaries in question. The parents are often also the trustees of the trust who made the allocations (fiduciary obligations be damned).
This is unfortunate because the CRA, when it audits a trust, will look closely at its allocations of income to determine who actually enjoyed the benefit of them. If the auditor sees that the amounts supposedly allocated to the beneficiary of a trust actually ended up in the bank account of someone else, the auditor will usually reassess that someone else on the basis that they received a benefit from the trust in question. For an example of a diversion with dire consequences, see my post here.
Laplante v R, 2017 TCC 118, aff’d 2018 CAF 193, is another species of the same kind of case. In Laplante, the formalities were observed, but the Court concluded that it should ignore the formalities because they were something like a sham.
Mr Laplante was a successful business who, in 2004, effected a reorganization under which a trust for various family members became a shareholder of his software company. The beneficiaries of the trust included two of his siblings, his brother-in-law, his cousin and a niece. The company was sold in January, 2008, and as a result the trust realized a taxable capital gain of about $2.9 million. The gain realized was eligible for the capital gain exemption. Mr Laplante’s accountant prepared a memo in 2008 that, among other things, outlined the tax savings to be had if the beneficiaries of the trust claimed the capital gain exemption in respect of any gains allocated to them by the trust.
On December 25, 2008, the trustees of the trust signed resolutions allocating $258,605 of the taxable capital gain the trust had realized to Mr Laplante and $75,000 to each of his three children. The remainder of the gain was allocated to his spouse, his siblings, his brother-in-law, his niece and his cousin. Each of these beneficiaries signed over to Mr Laplante the trust cheques presented to him or her in payment of the amount allocated. They executed deeds of gift making a gift of the amounts to Mr Laplante. Mr Laplante’s accountant prepared their tax returns to report the taxable capital gains that had been allocated to them and to claim the capital gain exemption in respect of the gains. Mr Laplante paid the minimum tax incurred by the beneficiaries in 2008 as a result. The beneficiaries later recovered the minimum tax, and they kept what they recovered.
The CRA reassessed Mr Laplante outside the normal reassessment period on the basis that the beneficiaries had accepted a “mandate” from Mr Laplante to particiapte in a “simulation”. These are Quebec civil law concepts that resemble the common law “sham” doctrine. A “simulation” exists if there are two different agreements, one of which is an “apparent” agreement, which the parties use to deceive third parties, and the other being a “secret” agreement, which expresses the actual agreement between the parties. The parties must also have an intention to deceive third parties regarding the nature of the apparent agreement and the existence of the secret agreement. In this case, the CRA took the position that the secret agreement was the “mandate” from Mr Laplante.
The Court held that the beneficiaries of the trust had in fact accepted a “mandate” (a legally-binding direction) from Mr Laplante to receive a $375,000 allocation from the trust, use their capital gain exemption to shelter the amount received and then return the net amount to him. In fact, one of the beneficiaries testified that Mr Laplante had asked his family members “to give him their capital gains exemption” (¶75).
As for intention, the Court wrote as follows (at ¶80):
The intentional element is the co-contracting parties’ intent to deceive third parties regarding the existence or content of an agreement. However, it is not necessary to demonstrate that the co-contracting parties intended to deceive the Minister by way of the simulation. The co-contracting parties’ intent to deceive third parties is established by demonstrating the existence of a secret contract that was not disclosed to the third party, in this case the Minister.
Mr Laplante and his relatives never told the CRA about the secret agreement. Rather, he claimed that the trust had allocated amounts to the beneficiaries and that then they had gifted those amounts to him.
The Court concluded, then, that the CRA was right to reassess Mr Laplante on the basis that he had received the distributions in question. The Court also held that the CRA was entitled to reassess outside the normal reassessment period (presumably on the basis that the “simulation” was the kind of intentional misrepresentation contemplated by subsection 152(4) of the Act that permitted such a reassessment).
Of course, the conclusion in Laplante depends heavily on civil law concepts that do not apply in Ontario. It is not difficult, however, to imagine the CRA trying to make a similar argument in a common-law jurisdiction using the sham doctrine. The common law argument around the same set of facts would likely run along similar lines. The taxpayer’s relatives did not make intend to make a gift, and they did not make a gift because the real understanding or agreement amongst the parties was that the relatives would receive the allocations from the trust as an agent for the taxpayer. The relatives had a legal obligation to turn the funds over to the taxpayer. But in that case, if the relatives were not the true recipients of the funds, it would follow that the taxpayer was the person required to include the allocations in income for the purposes of the Act.
Postscript 2019 07 16 Tax Interpretations notes that, in another, similar case, the Quebec Court relied on the purported payees acting as “accommodation parties” or agents of the trust beneficiary. The family trust in question issued cheques to the young-adult beneficiaries who endorsed the cheques to their father, a trust and co-beneficiary of the trust. The father purported to spend the funds on items of benefit to the children, but the Court upheld a reassessment that included the amounts in his income. The Court did not resort to the “simulation” concept. Caplan v. Agence du revenu du Québec, 2019 QCCQ 3269