The Tax Court of Canada decision in Lee v The Queen, 2018 TCC 230 clarified the concept of sham in the context of transactions undertaken to give effect to a tax plan. The decision draws a line between tax avoidance transactions and deceitful transactions. It held that Courts should not interfere with avoidance transactions, save for the application of specific anti-avoidance rules or the general anti avoidance rule (“GAAR”) in the Income Tax Act, whereas deceitful transactions are subject to the Court’s scrutiny based upon the sham doctrine.
The Appellant in Lee was the settlor of a spousal trust (the “Trust”) established in the Province of Quebec for the benefit of his spouse, a resident of British Columbia. The Trust was settled in furtherance of a tax planning strategy known as a ‘Quebec Truffle’, where, due to the interplay between the existing provisions of the Income Tax Act and the Quebec Tax Act, amounts paid or payable to beneficiaries who were non-residents of Quebec (“non-resident beneficiaries”) could be taxable to the trust without the imposition of provincial tax. This resulted in significant tax savings as the trust was only liable to pay federal taxes, while the non-resident beneficiaries were not liable to pay any tax on amounts paid or payable to them.
Mr. Paris, a retired KPMG partner and Quebec resident, was the Trustee of the Trust. The Appellant gave a cheque in the amount of $2,000 to Mr. Paris on December 8, 2003, which was deposited into a bank account registered under the Trust’s name. The Trust Deed was executed in the presence of a Quebec Notary on December 10, 2003 and filed with the relevant government authority in Quebec. Subsequently, the Appellant transferred 36,000 class F redeemable shares of Briel Investments Inc. (“Briel”) to the Trust. The shares had an aggregate redemption value of $18,000,000.
Mr. Paris requested the redemption of 36,000 class F shares from Briel, generating deemed dividends of around $16,000,000 to the Trust. The dividends were made payable to the Trust’s beneficiary by way of a promissory note, and the Trust elected that such dividends be taxed in the Trust. Subsequently, the Trust lent $18,000,000 to Briel, generating interest income to the Trust, which was again paid to the trust’s beneficiary but subject to an election to be taxed in the Trust.
The Minister assessed Mr. Lee for dividend and interest income reported by the Trust in respect of the 2003, 2004 and 2005 taxation years on the basis that either (i) the settlement or transfer of property to the trust was a sham; or (ii) the trust was not properly constituted under Quebec law.
In considering the existence of ‘sham’ as a basis for the Minister’s assessments, the Tax Court first referred to the Supreme Court of Canada decisions in Stubart Investments Ltd. v The Queen and Continental Bank Leasing Corporation v Canada, affirming that a sham transaction can only be found where there is an element of deceit so as to create an illusion calculated to lead the tax collector away from the true nature of the transaction. Based on these decisions, a sham transaction is one where the parties misrepresented the legal relationships in the documents that describe those relationships, such that the transactions do not have the legal consequences that they purport to have.
The Court also referred to the decision in Faraggi v The Queen, where the concepts of ‘sham’ and ‘abuse’ were distinguished to the extent that where there is a sham transaction, the Court’s interference is warranted, whereas such interference is not appropriate with respect to an avoidance transaction, except for cases where one or more anti-avoidance rules are invoked.
Lastly, the Court referred to the Federal Court of Appeal decision in Antle v The Queen, a case where a trust relationship was held to be a sham following the Court’s finding that the settlor did not intend to give any discretionary powers to the trustee. This finding was based on the fact that several preordained transactions such as the distribution of trust’s capital to the trust’s beneficiary were arranged prior to the signature of the Trust Deed.
The facts in Antle were distinguished from the facts in Lee insofar as the testimony of the Appellant and the Trustee in Lee demonstrated that both of them had a clear understanding that the property would be irrevocably transferred to the Trustee for the benefit of the Trust’s beneficiary. Further, all the transactions were properly documented, and Mr. Paris hired advisors to make sure that his decisions in respect to the trust property were legally and financially sound.
In Lee, the Court concluded that the Trustee had the experience and expertise to consider the best interests of the beneficiaries; and the decision to follow a predetermined course of action was still a decision independently made by the Trustee. The Court went on to affirm that even if the Appellant’s sole reason for creating the trust was to save tax, that is not in and of itself evidence of a sham. Further, the Trust was validly constituted under Quebec law, as patrimony was irrevocably transferred to the trustee for a particular purpose, pursuant to Article 1260 of the Civil Code of Quebec.
The decision in Lee is an important landmark, as it represents a departure from the understanding that legal relationships giving effect to a tax plan could be easily disregarded based on a ‘sham’ argument. A transaction will only be considered a ‘sham’ where there is an element of deceit, whereby the parties to the transaction present legal rights and obligations in a manner that does not reflect the rights and obligations that they intended to create. The Courts are not justified in ignoring transactions that properly reflect the parties’ intentions, even if these transactions were entered into for the sole purpose of saving tax.