Losing Family Trust (Case)
A reassessment was held by the Canadian Revenue Agency (CRA) against Robert Mandel and his business partner Ellen Pike. The assessment resulted in an increase of 15 million dollars on each of their taxable incomes. Even though the CRA didn’t like the tax planning they had done, both Robert and Ellen lawyered up to face these circumstances. Their story is discussed clearly in the Ontario Superior Court of Justice in Robert Mandel et al. v. 1909975 Ontario Inc. et al. 2020 ONSC 5343.
Many events had occurred during the case of Mandel, in fact, the judge who decided the application wasn’t even experienced in tax matters. However, we are going to go through this case and try to figure out what was going on during the time and what are the things we can learn from as well.
21st Anniversary Tax Planning (Introduction)
We’re going to start out with the case that happened in 1990, where a taxpayer used a trust to settle an estate that had been frozen. To do so the taxpayer did a 21st-anniversary tax planning in 2010 before the Tax on Split Income (TOSI) rule expanded.
All of that was implemented by both Mr. Mandel and Ms. Pike, as they used the 21st-anniversary tax planning to settle their trusts. However, for their luck, in 2020 the TOSI expansion and other issues were taken into consideration when implementing the 21st-anniversary tax planning. The other issues we will elaborate more on in this article.
Let’s lay down a hypothetical situation to understand the case at hand a bit more.
Let’s say that we have a person “Mr. X” and he owns all of the shares of XYZ corporation, which is running successfully and without any flaws. We must also add that Mr. X has three young children, Bobby, Clair, and Sam. Mr. X decides to run a “Plain Jane” estate freeze, in which he exchanges his shares from XXZ corporation for freeze shares and other redeemable nominal value shares. Afterward, a discretionary trust was established for new common shares of XYZ corporation, and Mr. X’s young children were the beneficiaries of that family trust.
Note that both Mr. X and his children were Canadian residents and not residents of another jurisdiction. Also, they’re not U.S. citizens nor do they hold a green card. These small details are very important to understand the case at hand.
Now after all of the facts have been stated let’s dig into the hypothesis’s case.
First of all, with Mr. X requiring a trust, he needs to consult his tax advisor before taking any further steps. His tax advisor addresses the matter that Mr. X had settled the trust in November 1990 and should take specific steps to avoid any assets being disposed of for the same amount of its fair market value, in November 2011. Furthermore, if XYZ shares increase in value then the trust might recognize a significant Tax Bill.
The first step the advisor insists on taking, is to divide the trust’s assets to one or more of the beneficiaries before the 21st anniversary of the settlement of the trust. This part depends on Mr. X’s judgment on how much each person from the beneficiaries should take without leaving anyone out. This could cause chaos among the children. So, to avoid this conflict the advisor suggests a second estate freeze where the three children receive freeze shares from XYZ corporation while the trust could gain new common shares of XYZ. However, the downside of this approach is that the CRA will require the holder of the freeze shares to redeem them at any time for an amount equal to the fair market. Of course, since more than one individual holds the freeze shares, this wouldn’t end well for XYZ corporation.
After a long discussion, the advisor suggests another solution. He, or she, can incorporate a new corporation “ABC” where they could request Mr. X’s children to transfer their freeze shares from XYZ to ABC corporation, in exchange for non-voting common shares of ABC. Afterward, they can give control of ABC to Mr. X with a shareholder’s agreement from him and his children. Even so, there’s still the fact of one of the children alienating, which might jeopardize the entire plan, for the child can seek relief by an oppression remedy in the courts.
Nevertheless, all of these circumstances and solutions are best discussed with a meeting with a family law lawyer.
Back to the Case
Even though the situation above was completely hypothetical, it still seems consistent with Mr. Mandel and Ms. Pike’s actions. However, both of the shareholders were prepared to allocate the shares equally among their children and not take the estate freeze option. Also, they both took precautionary steps to protect their children from marital difficulties, which in terms ended badly for them with the CRA.
Mr. Mandel and Ms. Pike each owned 25 percent interest in a different corporation “Welded Tube of Canada” through holding companies, which basically means that the shares are held by family trusts. Now, the Mandel and Pike families both decided to transfer those interests they have to various new corporations, as the 21st year of disposition was approaching. Each child from each family then went on distributing their trust shares from the initial holding company to the new holding company in exchange for one hundred non-voting common shares of the New Holding Company. It was then when Mr. Mandal, or Ms. Pike, signed for Class A voting shares for a price of $10 per company of the new holding companies. Then, of course, the relative parent did the same for 100,000 Class B convertible shares for a price of $100 per company.
According to the decisions taken by Mr. Mandel and Ms. Pike, they should receive control over the corporations where their children transferred their shares to. Furthermore, if one of their children had a marriage breakdown, the spouse of that child won’t share the assets held by the family trusts. All of those results and effects were possible because Mr. Mandel or Ms. Pike acquired 100,000 Class B Convertible Shares in their children’s, or child’s, corporation and only gave them 100 shares. That way the spouse of that child only receives 50 shares from the 100 in case of a marriage breakdown.
However, it hasn’t been clear to why the assessment of the CRA was as it is, even after facing the facts at hand. Moreover, it’s still very reasonable to believe that the Class A voting shares were indeed thin or skinny shares, and that the CRA believed that they had value. Nevertheless, they still dropped those beliefs and kept their primary stand position. Still, these shares were able to provide control, by law, over the new holding companies to the parents, and the Class B Convertible Share remains a mystery as we don’t know if they were voting shares or not. What we do know is that the subscription price was $100 per company but the Class B Convertible Shares could overpower the non-voting common shares by 50, and could be held by a spouse of one of the children. All of this suggests that the CRA may have assessed both Mr. Mandel and Ms. Pike according to section 15 of the Income Tax Act, because we think that the 100,000 Class B shares can be exchanged for non-voting shares that may have more value than the subscription price of $100. At least the application judge indicated that this was the case, and unfortunately didn’t provide an explanation. That’s why we’re only assuming these possibilities.
During the court discussion, they have referred to the shares that were acquired by both parties as “Controlling Shares.” Yet, it hasn’t been clear why the court would call them that unless, according to our assumption, they might be referring to the Class B Convertible Shares as “Controlling Shares.”
The OSCJ came forth with three issues at hand. One of the issues was whether the court should assume jurisdiction, but this assumption was declined for many reasons. The first reason was that the issue at hand was a tax assessment situation within Canada. The second issue was that the tax shares weren’t paid by both parties, as the court assumed. Which then made them take provincial legislation to resolve the tax dispute. The third issue was the fact that the tax court needs to determine whether the taxes were paid by both parties, and why the records show differently.
According to the decision of the Supreme Court of Canada, it states that they are in full jurisdiction of making any corrections to the records, which may lead to tax consequences. It’s also been done various times by the Superior Courts of the provinces. However, in some case, they weren’t allowed to do so because “if the taxpayer’s lawyers ask the CRA to hold the notice of objection in abeyance or ask the Department of Justice (the ‘DOJ’) to stay proceedings in Tax Court pending the resolution of a rectification application” then the Superior Courts of the provinces can’t continue with their rectifications.
After declining the OSCI’s first issue, they continued to address the rest of the three issues, which related to the fact that both parties (Mr. Mandel and Ms. Pike) never were controlling shareholders according to 97 of the Courts of Justice Act. However, this issue was also declined for both parties stated their argument clearly to the fact that they haven’t been paying tax shares. They said that subsection 23(3) of the Business Corporations Act of Ontario requires payment before shares can be issued; therefore the court had to agree, for also the records show that there wasn’t any dispute within the corporation and shareholders.
The third and final issue of the case was the rectification process that was argued by both parties according to section 250 of the OBCA. However, the court had rejected the request made by the two parties, and stated that “no authority was given for the proposition and that a remedy may be incorporated in a statute without changing its nature or the relevant principles for its application.” The court then sought out the SCC’s judgment in Fairmont and stated that this act could allow them to engage in impermissible retroactive tax planning. Therefore, the third issue was declined.
Note that there are some requirements according to the Fairmont for a rectification. In accordance with paragraph 38 of the SCC, they are:
That a prior agreement with definite terms should be present.
When the instrument was executed, the agreement was still in progress.
Recording the agreement was a failure for the instrument.
The instrument should carry out the parties’ prior agreement if rectified.
Nevertheless, the court didn’t address these requirements in an explicit matter, but the reasons indicate that both parties weren’t able to prove that the documents weren’t legally recorded properly. According to the documents, the court seemed to have found that the two parties agreed to acquire Class B convertible shares.
On the other hand, after the Fairmont decision for the four requirements, rectification applications have been successful, except for this case. Although the applicants must meet the four requirements exactly if they want the rectification to succeed.