Applying the CMC Test: Some Guidelines

The following article, written by James Murdoch, was first published by STEP Canada in the May 2012 edition of STEP INSIDE, the quarterly publication of the Society of Trust and Estate Practitioners (Canada):

On April 12, 2012 the Supreme Court of Canada confirmed in Fundy Settlement. v. The Queen 2012 SCC 14 that the central management and control test (“CMC Test”) applies to determine the residency of a trust for Canadian tax purposes.  As a result, every trustee of a trust with a Canadian connection should consider where central management and control of the trust abides.  This is relevant both for non-Canadian trusts with Canadian connections and for domestic Canadian trusts where provincial residency may be at issue.

The Fundy Settlement case has gone through several irksome name changes (Garron Family Trust at the Tax Court of Canada and St. Michael Trust Corp. at the Federal Court of Appeal).  Although the Courts have been unable to agree on the name, they had no disagreement as to the outcome.  The seven judges on the Supreme Court of Canada panel, the three judges on the Federal Court of Appeal panel and the trial judge all agreed that the CMC Test should apply to determine the residence of a trust for purposes of the Income Tax Act (Canada).  Given the trial judge’s decision was viewed as somewhat radical and a change in law (in Thibodeau Family Trust v. The Queen 78 DTC 6376, the CMC Test was expressly not applied to determine trust residence), the unanimity of the appeal courts in upholding the judgment is remarkable.

There is not a great deal of guidance in any of the judgments as to how to apply the CMC Test to a trust.  The purpose of this article is to take what guidance has been provided and attempt to formulate some guidelines on how to establish and maintain trust residence in a jurisdiction.

Who controls the Trust?

One of the more troubling aspects of the judgments, for those seeking certainty, is that the Courts did not grant any presumption that the trustee exercises the central management and control over a trust.  For example, one might have expected the Courts to say, by virtue of the trust’s legal ownership of the trust property, that the trustee has central management and control over the trust unless the trustee role is usurped.  In fact, none of the judgments considered the trustee’s legal ownership of the trust property to be particularly relevant.  In conflating trusts and corporations, the Court directs us not to search for who controls the trust property but who manages or supervises the business of the trust.

In the corporate context, most corporate statutes will include a provision similar to section 115(1) of the Business Corporations Act (Ontario) to the effect that “subject to any unanimous shareholder agreement, the directors shall manage or supervise the management of the business and affairs of the corporation”.  Thus, the directors of a corporation are vested with central management and control of the corporation by statute, and typically reinforced by the articles.  No similar legislation exists in relation to trusts.  The CMC Test wants to know who controls the business and affairs of the relationship that is the trust, in the same way that it seeks to know who controls the business and affairs of the legal fiction that is a corporation.  It is always possible (as in Unit Construction Co. Ltd. v. Bullock [1960] A.C. 351) that notwithstanding legal responsibilities, the facts will reveal that directors have been bypassed or their roles usurped, but these circumstances will be rare.  In the trust context, the legal responsibilities vis-à-vis the trust, as opposed to the trust property, may not be spelled out because trust law does not require it.  Unlike company law, trust law does not create a person and therefore does not speak in terms of who manages or controls the business and affairs of the trust, it is concerned only with the management or control of trust property, which, as indicated above, may be irrelevant in applying the CMC Test.

As a result, there is potential for chaos in that the CMC Test seeks to know who has management and control of a trust, that the management and control of trust property is irrelevant, that private trust law, preoccupied as it is with the relationship between trustees, beneficiaries and the trust property, will not provide a satisfactory answer, and that Canadian courts in determining the question of central management and control of a trust will start with a blank slate, searching widely for the party with the greatest influence and power over trust affairs, and for the place where such party wields such influence and power.  This would make a mockery of the Courts’ stated promotion of “consistency, predictability and fairness in the application of tax law” and would result in a very different application of the CMC Test from that applied to corporations.

This seems an unlikely route for Canadian courts to embark upon, but it cannot be ruled out as a possibility.  The balance of this article is designed to set out steps that trustees should take to assert, and be seen to assert, control over the management of a trust within the trustee’s home jurisdiction.

Decision Making

The Court’s reluctance to make presumptions regarding a trustee having central management and control over a trust is understandable in one respect – a trust is a very flexible arrangement and duties and decision making authority may be widely dispersed.  For example, in Delaware and other U.S. states it is not uncommon for a trust to provide, by its terms, that the trustee has no authority to make investment decisions (such decisions to be made by the “Investment Advisor(s)”) or to make distributions (such decisions to be made by the “Distribution Advisor(s)”).  Split decision-making of this nature may be desirable for any number of non-tax reasons, but will wreak havoc on attempts to apply the CMC Test to trusts, at least where the decision making occurs in more than one jurisdiction.

There was no split decision making under the terms of the trust indenture in Fundy but there was a key finding made by the Judge that the trustee had agreed to limit its role to an administrative capacity and that the trustee had agreed to defer to the principal beneficiaries on actual decision making. This finding was based principally on a Trustee’s Memorandum under which the Trustee expressed the intention (1) to hold the Trust’s principal investment (shares in a Canadian corporation) until “such time as the other shareholders… decide to sell their shares”, (2) to seek the investment advice of the principal beneficiary from time to time, and (3) that the primary consideration in making distributions should be the best interests of the principal beneficiary.

It is ordinarily not inappropriate for a trustee to consult with or take advice from beneficiaries.  However, any indication that discretion or decision making has been fettered will be relevant to the application of the CMC Test.  It is imperative that trustee memoranda and letters of wishes not have this effect, or be seen as having this effect, if the intention is that trust residence follow the residence of the trustee.

Some advisors recommend that trustee memoranda be used to record the wishes of beneficiaries, rather than letters of wishes, on the theory that the latter may be viewed as evidence that the beneficiary was directing decision making.  This seems debatable in light of the finding in Fundy.  A letter of wishes that is carefully drafted to be wholly precatory may be preferable to a trustee note under which the trustee appears to be voluntarily fettering his authority for unspecified reasons.

A letter of wishes should be carefully considered by the trustees to determine if it is appropriate for the trustees to take the wishes of the writer into consideration when making decisions.  If so, a decision may be made by the trustees to consider the wishes expressed in the letter as one of the relevant factors to be taken into account when making a decision.  This decision should itself be documented in a trustee minute.  The minute should express that the decision to retain the letter for future consideration does not mean that the wishes will necessarily be carried out when making decisions.

Corporatization of the Trust

It is the practice in perhaps every jurisdiction for corporate boards of directors to hold, at minimum, annual board meetings and for minutes to be kept of the decisions made at such meetings.  This practice is much less common with trustees.  The trial judge in Fundy bemoaned the lack of evidence, saying there was “virtually no documentation that would support [the] view that [the trustee] took an active role in managing the trusts.”  This evidentiary problem may exist in any number of situations, particularly where the trustee has been focused more on confidentiality and liability concerns than on the need to demonstrate central management and control.  The application to trusts of the corporate test for residence means that trusts need to start acting more like corporations.

Thus, the trustee of the trust should hold regular meetings and all decisions pertaining to the trust should be made and, importantly, recorded at such meetings.  In the case of a single institutional trustee, the meetings would consist of the relevant decision makers, be that the trustee’s board of directors, a distribution committee or any other internal decision-making body.  This represents a distinction from the corporate situation (where there is a single board of directors) in that the trustee may, depending on its size and sophistication, have different officers making different decisions in relation to the same trust.  The key issue here is that those decisions be made at meetings held within the jurisdiction in which the trustee is resident, or at least, if that is entirely impractical, outside of the beneficiary’s jurisdiction.  Where the trustee is an individual, decisions should be made by written resolution executed in the trustee’s jurisdiction.

The frequency of meetings will vary from trust to trust, based on the requirements of the trust.  In many cases, a trust’s sole activity will be to hold, often for a very long time, shares of an investment company, a piece of real estate or other passive investment.  In the Thibodeau case, the judge cited Underhill on the Law of Trusts and Trustees in noting that a trustee cannot adopt a “policy of masterly inactivity”.  One might suggest that for trustees to pass the CMC Test in cases of passive long-terms holds that they need adopt a policy of masterly activity.

This would involve meeting at least annually on the following points:

1. Discussion and adoption of investment policy;
2. Discussion of the performance of investments in relation to trust’s investment policy and where relevant, with a view to the balance between income and capital appreciation;
3.  Determination of whether the investment(s) should be retained or sold;
4. Where voting shares are held, consideration of the performance of directors and election or re-election decisions made;
5. Discussion of beneficiary circumstances, any letter of wishes (as discussed above) and distribution decisions;
6. Appointment of accountants, bankers, and other advisors, and
7. Review and approval of financial statements.

The trustee meetings should occur in the trustee’s home jurisdiction and without the attendance of beneficiaries, protectors, investment managers or advisors.  Regular meetings with such parties can continue and be recorded, but it should be clear from minutes that actual decisions are made at the trustee meetings.  In theory, provided decisions are made, and seen to be made, by the trustees at the trustee meetings in the jurisdiction, the trustees should be free to travel outside the jurisdiction to meet with beneficiaries and advisors.  However, defensive practice would suggest that it is much better that all such meetings occur in the trustee’s jurisdiction or at least on neutral ground.

As always, documentary evidence of the sort described above, that is not otherwise backed up by that intangible quality called “substance” will remain vulnerable to challenge.  However, as a result of common practices in trustee governance emphasizing confidentiality over all other factors, there will be many structures where real substance exists but cannot be proven by the documentary evidence available.  Trustees of trusts with Canadian connections should be reviewing their internal processes and record keeping that will ensure they can pass a CMC Test.