Establishing a trust can be beneficial for individuals and corporations alike. Sometimes, trusts can help individuals and corporations reap tax benefits they otherwise would not be able to realize. Likewise, however, the law sometimes changes. 

In a recent case before the Supreme Court of Canada, two corporations were unable to use the equitable remedy of rescission to undue transactions involving a family trust that did not end up saving their dividends from tax liability.

The Income Tax Act contained an apparent loophole for family trusts

The main issue, in this case, was “whether taxpayers are also barred from obtaining other equitable relief…sought to avoid unanticipated adverse tax consequences arising from the ordinary operation thereon of the Income Tax Act.” In 2008, the owners of two companies using the same tax advisor put in place a plan that would protect corporate assets from creditors and tax liability. The plan sought to take advantage of two provisions in the Income Tax Act:

75 (2) If a trust, that is resident in Canada and that was created in any manner whatever since 1934, holds property on condition

(a) that it or property substituted therefor may

(i) revert to the person from whom the property or property for which it was substituted was directly or indirectly received (in this subsection referred to as “the person”), or

(ii) pass to persons to be determined by the person at a time subsequent to the creation of the trust, or

(b) that, during the existence of the person, the property shall not be disposed of except with the person’s consent or in accordance with the person’s direction,

any income or loss from the property or from property substituted for the property, and any taxable capital gain or allowable capital loss from the disposition of the property or of property substituted for the property, shall, during the existence of the person while the person is resident in Canada, be deemed to be income or a loss, as the case may be, or a taxable capital gain or allowable capital loss, as the case may be, of the person.

112 (1) Where a corporation in a taxation year has received a taxable dividend from

(a) a taxable Canadian corporation, or

(b) a corporation resident in Canada (other than a non-resident-owned investment corporation or a corporation exempt from tax under this Part) and controlled by it,

an amount equal to the dividend may be deducted from the income of the receiving corporation for the year for the purpose of computing its taxable income.

The law changed, leaving the companies’ family trusts at risk of tax liability

Both companies created a holding company to purchase shares in the operating companies, a family trust for which the holding company was a beneficiary, and a loan to the trust for the purchase of shares in the operating company. The operating company’s dividend was paid to the trust under section 75(2). From there, the trust claimed a deduction of those dividends under section 112(1). Effectively, those sums would not be subject to income tax.

However, in 2011, the law changed with a decision by the Tax Court of Canada. This decision ruled that section 75(2) could not be applied to the property sold to a trust. The Canada Revenue Agency reassessed the family trusts and issued notices of reassessment that included tax liability for the dividends. After unsuccessfully objecting to this finding, the family trust sued for rescission of the transactions (including the dividend payments). At the initial hearing, an order was made rescinding the transactions “on the basis of a mistake about their tax consequences.” The chambers judge relied on Re Pallen Trust to apply the test for equitable rescission, which resulted successfully for the family trust. This decision was upheld by the British Columbia Court of Appeal. The Attorney General of Canada appealed.

The case that changed the law

In Canada v Sommerer, the Federal Court of Appeal held that the purpose of section 75(2) of the Income Tax Act is the following:

Broadly speaking, subsection 75(2) is intended to ensure that a taxpayer cannot avoid the income tax consequences of the use or disposition of property by transferring it in trust to another person while retaining a right of reversion in respect of the property or property for which it may be substituted, or retaining the right to direct the disposition of the property or substituted property. Subsection 75(2) operates by attributing any income or loss from the use of trust property, and any gain or capital loss on the disposition of trust property, to the person from whom the property, or property for which it was substituted, was received by the trust.

Despite this finding, in Re Pallen Trust, the general consensus of the tax community weighed in favour of the applicants with regard to section 75(2). The British Columbia Court of Appeal found that the Canada Revenue Agency would not have reassessed dividends paid to trust absent the decision in Canada v Sommerer. The order for rescission was granted because the parties were operating within the common understanding of the provision at the time their actions were taken, only to learn the gravity of those actions later on.

Equity cannot be used to remedy a mistake in tax consequences

The Supreme Court of Canada found that the British Columbia Court of Appeal was incorrect in its decision. The basis of its determination was that equity could step in to remedy a mistake in tax consequences. According to Justice Brown, this is incompatible with the law.

Justice Brown acknowledged that equitable principles prevent unconscionable conduct that might be supported by “an unyielding common law.” Equity, in other words, was designed to ensure fairness when the common law cannot. It is not available for all transactions, however. For instance, equitable maxims require that those requesting equitable relief do so with “clean hands.”

The problem with the present case is that there is nothing unconscionable with regard to the usual operation of tax laws and transactions that individuals freely agree to. As the Supreme Court previously stated in Canada (Attorney General) v Fairmont Hotels Inc, “Tax consequences flow from freely chosen legal arrangements, not from intended or unintended effects of those arrangements, whether upon the taxpayer or the public treasury.” Taxpayers should not be allowed to go to court to receive benefits they cannot receive from the ordinary operation of the law. This is especially the case if court remedies are sought merely to correct actions they would not have taken if they knew better. Therefore, the Court of Appeal erred in its ruling that equity can provide a remedy for tax mistakes. Justice Brown, on behalf of the majority, allowed the appeal.

Contact the Lawyers at Tierney Stauffer LLP For Help Administering a Trust

The law frequently changes, so it’s important to consult with experienced legal representatives to ensure your affairs are arranged by the law. Tierney Stauffer LLP uses a client-focused approach and provides innovative guidance through the estate planning and administration processes. Our lawyers provide practical and honest advice to clients and represent their interests in all levels of court in addition to other forums. We have extensive experience working with clients in estate planning matters and representing them in litigation should it become necessary. Call us at 1-888-799-8057 or contact us online to set up a consultation with a member of our team.


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