Who can you trust? Two court decisions affect family trusts
Managing your management fees
Principal residence … principally tax free

Welcome to another edition of Privately Speaking — Tax Insights, bringing tax ideas and guidance to the owners and managers of private companies in Canada. As the Canadian economy continues to strengthen, my colleagues look at three very interesting tax issues — I invite you to share this release with anyone who will be interested to learn about the increased CRA scrutiny of family trusts, the use of management fees within a corporate group and the strategy to consider when owning more than one principal residence.

The authors, our editorial team (noted in the margin) and your local contacts are all pleased to discuss these issues or any other tax matters that concern you. Please feel free to contact any one of us.

Enjoy the newsletter,

Jim MacGowan, National Tax Leader, Private Company Services

Who can you trust? Two court decisions affect family trusts

By Faisal Jamal

In December 2009, we alerted you to the increased audit activity being undertaken by the Canada Revenue Agency (CRA) with respect to inter-vivos trusts (i.e., a trust created during a person’s lifetime). In particular, we drew attention to the CRA’s focus on:

1. The issuance of promissory notes — are they valid?
2. Amounts indirectly paid to beneficiaries or other similar payments — are they deductible to the trust?
3. The status of the accounting records, minutes and settlement property of the trust — are they complete?

Two court cases have fueled the CRA’s focus in two key areas: residency and validity.

Residency
The old common law test that a trust’s residency is determined by the residence of the trustees has been challenged. A recent court case (Garron), which was upheld by the Federal Court of Appeal, established that determining the residency of a trust should be similar to determining the residency of a corporation. As a result, the relevant question is no longer, where do the trustees reside, but, in what jurisdiction does the “central management and control” reside?

While Garron dealt with a trust situated outside Canada, the CRA is also applying this test to determine the provincial residence of trusts. In particular, the CRA is reviewing trusts that claim to be residents of provinces such as Alberta, which enjoys a lower tax rate structure. To determine residency, the CRA is assessing the qualifications of the trustees, their ability to make decisions about the trust, and whether or not they have control over the assets of the trust. In short, a notional or figurehead resident trustee will no longer suffice.

Validity
Similar to the three certainties of life — birth, taxes and death — there are three certainties in the formation of a trust to ensure its validity:

1. Certainty of intention — the intent to create a trust and give up control
2. Certainty of subject matter — what is the property being given up?
3. Certainty of object — who are the beneficiaries?

The validity of a trust was explored in another recent court case, Antle, which analyzed the first two certainties noted above:

1. Certainty of intention — the court found that the taxpayer did not intend to give up control of the subject property
2. Certainty of subject matter — the court further found that title to the property in question was never actually transferred

As a result, in Antle The Federal Court of Appeal  labelled the trust a sham. More than ever,  trustees should ensure that trust documentation is thoroughly prepared and meets the three certainties. Specific attention should be paid to the location of the original settlement property to ensure it is safeguarded and that control is transferred to the trustees — title to property held by the trust should be registered to the trust. Furthermore, the actions of the trust should be properly documented. For example, if the trust makes distributions to its beneficiaries in the form of an assignment of promissory notes, these notes should be initially documented and settled within a reasonable time frame. Also, if cash is recorded as distributed to beneficiaries, then the mere recording of the distribution by journal entry will not suffice; it should actually be withdrawn from the various bank accounts.It is important to ensure your trust is in order and the “i’s” are dotted and the “t’s” are crossed. We recommend annual consultation with your trusted tax advisor to ensure that all is in order with your family trust.

Faisal Jamal is a tax senior manager in Calgary.

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Managing your management fees

By Robert Leombruno

Management fees are a powerful tax planning tool. However, case law has provided ammunition to the Canada Revenue Agency (CRA) in their review of  inter-corporate management fees. As such, proper execution is crucial when undertaking any tax planning using management fees.

Corporate groups commonly use management fees to shift income and expenses between companies. While such fees can help with risk management by keeping excess cash out of an operating company, corporate groups can also defer taxes by creating a company that earns management fees and accesses the small business deduction. However, if the rules surrounding management fees are not properly considered double taxation can occur; i.e., the company paying the management fee would not be allowed a tax deduction while the company providing the management service would still be required to include the management fee into income.

The CRA will generally allow management fees to be deductible to the extent that they are incurred for the purpose of gaining or producing income and provided they are “reasonable in the circumstances”. Even an expense that is specifically deductible under the Income Tax Act may be partially or fully disallowed if it is considered unreasonable.

While the CRA has a long-standing practice of not challenging the reasonableness of salaries or bonuses paid to a principal shareholder who is active in the corporation’s business, their position is that this practice would not extend to intercorporate management fees. To be fully deductible, any fees and/or bonuses paid to corporate shareholder-managers by an operating company (Opco) must be reasonable given the services actually rendered by the holding company (Holdco) through its employees. The resulting profits of Holdco may be distributed to the shareholder-employees of Holdco where the general practice of the corporation is to distribute profits of the company to shareholder-employees in the form of bonuses or additional salary. If the management fee from Opco to Holdco is not reasonable in the light of the services rendered, the unreasonable portion would not be deductible by Opco.

There have been significant court rulings surrounding the deductibility of management fees. The case law is clear that the deductibility of management fees should not be taken for granted. At a minimum, for the management fees to be deductible, bona fide management services are necessary for the payer in its income-earning activities. These services must actually be provided by the payee to the payer, should actually be paid, must be reasonable in amount, and should be documented pursuant to a written contract, the terms of which are adhered to.

Factors affecting the reasonableness of management fees include:

1. The nature of the management services
2. Whether the management services were performed on or off site
3. A comparison to similar operations in similar markets in terms of efficiency, profits, etc.
4. Effort applied and the responsibilities of the provider of the services
5. Special expertise or know how held by the service provider
6. The portion of the profit that reflects the expertise and quality of the management services performed
7. Existence of a management-services contract

Documentation is key. We recommend that a formal management agreement be signed by the two parties and that this agreement include the nature of the services provided and the number of hours to be spent providing the services. Furthermore, this agreement should be supported by a corporate resolution authorizing the management services or payment for the services.

While management fees are a powerful tool to implement corporate strategy and tax planning, the mismanagement of intercorporate management fees could be costly and problematic.

Robert Leombruno is a tax senior manager in Burlington.

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Principal residence … principally tax free

By Mylene Tremblay

As many taxpayers know, the sale of a principal residence is usually tax free. What most people do not know is that to qualify as a principal residence a property does not have to be the one in which the taxpayer spends most of his/her time.

Taxpayers can claim the principal residence exemption on the sale of their principal residence if all of the following conditions are met:

• During the year, the taxpayer owns the property
• The residence is ordinarily inhabited during the year by the taxpayer, or his or her spouse, common-law partner, ex-spouse, former common-law partner, or child
• A designation is made in the taxpayer’s tax return for the year of the sale

So, what qualifies? A house, condominium, mobile home, trailer, houseboat, and cottage are all typical examples. Even a home in the U.S. or another foreign country could qualify. The tax authorities take the position that a secondary residence may be considered “ordinarily inhabited” even if the taxpayer only lives there during vacations, provided that the property is not primarily owned to generate income. As a result, a secondary residence can be rented out occasionally without losing eligibility for the principal residence exemption.

In addition, the definition of “principal residence” includes up to half a hectare (about 1.25 acres) of land on which the residence is situated. If the total land area on which the residence is located exceeds half a hectare, the land is not usually eligible as a component of the principal residence, unless the taxpayer can show that the excess area is necessary for use of the residence.

According to the rules, since 1982 only one residence can be designated a principal residence per family per year. A taxpayer who owns two or more properties must determine which will be designated the principal residence for each year. However, the designation does not have to be made annually — it only needs to be made when selling one of the residences. At that time you would need to review the annual increase in value for both homes, and make a rough estimate of when the second property is likely be sold. This review, coupled with a few “what if” models using the exemption formula, would assist in your decision.

Even if only one property can be designated as the principal residence in a given year, the exemption calculation formula provides for the addition of one exemption year. Intended to preserve the exemption during the year in which an individual sells his/her residence and buys another one, this rule also gives taxpayers who own multiple properties the benefit of an additional exemption year with respect to any of their residences.

In conclusion, if you own more than one residence, you should determine the current and future capital gain for each to evaluate the tax consequences that would arise if each were sold. That way, the principal residence exemption can be maximized and your tax burden minimized.

Mylene Tremblay is a tax manager in Montreal.

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This publication is produced by Deloitte & Touche LLP as an information service to clients and friends of the firm, and is not intended to substitute for competent professional advice. No action should be initiated without consulting your professional advisors. Your use of this document is at your own risk.