Creditor Proofing Leads to Shareholders’ Personal Liability

An attempt to avoid payment of a company’s debt by setting up a new corporation to continue the company’s business can cause the company’s shareholders to be personally liable for the debt incurred.

The decision of the Ontario Superior Court in Chan v. City Commercial Realty Group Ltd., 2011 ONSC 2854, illustrates the “piercing of the corporate veil” to remove the limited liability of a company’s shareholders.    

In the Chan case, two bothers, Martin and Samuel Wygodny, were the directors, officers and shareholders of a Toronto real estate brokerage company City Commercial Realty Services (Canada) Ltd. (“City 1”) which unsuccessfully sued Chan and others, with costs being awarded against City 1. The cost award went unpaid. A new real estate brokerage company, City Commercial Realty Group Ltd. (“City 2”), of which Martin was the sole officer, director and shareholder, was set up to continue the business of City 1. Martin resigned as an officer and director of City 1 and transferred his shares in City 1 to Samuel. City 1 became inactive and its brokerage registration lapsed, while City 2 engaged in the same business as City 1, using the same premises, furniture, phone number, business name, signage, and some of the same personnel.

Chan and the others sued City 1, City 2 and the two brothers for the unpaid cost award, requesting the Superior Court to “pierce the corporate veil” and find Martin and Samuel personally liable for it.

In deciding against the brothers and making them personally liable for the unpaid cost award, the Court held that the “affairs of the companies appear to have been ‘dominated’ by one (Martin in the case of City 2) or both (in the case of City 1) brothers at the time of the alleged wrongful conduct”.

In holding that their conduct was improper and unjustly deprived the plaintiffs of their rights, the Court found (at para. 54 and 56) as follows:

I agree with the defendants that Martin and Samuel were not obligated to inject their own funds into City 1 to pay the cost awards. What they were not entitled to do was to quietly organize their corporate affairs in a way which provided them with all of the benefits of their real estate activities and none of the burdens. … The reorganization has enabled Martin and Samuel to continue their real estate business without interruption and without adverse financial consequences. The structure was developed and implemented while both were directors, officers and shareholders of City 1.  

Creditor proofing schemes which are designed to protect the assets of a business from the claims of creditors are often attacked under provincial fraudulent conveyance and creditor preference legislation, or by way of the oppression remedy afforded under corporation legislation. Although the plaintiffs in the Chan case initially sought an order setting aside the transfer of City 1’s business under the Ontario Fraudulent Conveyances Act, Assignments and Preferences Act, and Bulk Sales Act, those claims were not pursued at trial. Instead of pursuing an oppression remedy under the Ontario Business Corporations Act, the plaintiffs requested the Court to pierce the corporate veil using common law principles, arguing that City 1 was really the alter ego of Martin and Samuel.

In applying these principles, the Court (at para. 19, 20 and 22) stated as follows:

It is trite to say that generally a corporation is a separate legal person. Most of the time the identity, rights and obligations of companies and their shareholders are distinct. However, the rule is not inviolate and will not be applied if its result would be “too flagrantly opposed to justice”. The alter ego theory is designed to prevent the use of a corporate vehicle to achieve an objective which offends a right minded person’s sense of fairness. …Two elements must be proven by the plaintiffs in this case: first, that the activities of the companies were completely dominated by Martin and Samuel, and second, that they engaged in improper conduct that unjustly deprived the plaintiffs of their rights.  

In short, the Chan case is another useful reminder of the perils that the owners and managers of private companies may be inviting when they attempt to implement a creditor proofing scheme. Despite the ordinary expectations of company owners that they will not, as shareholders, be responsible for company liabilities, they may become personally liable, and their personal assets may then become subject to seizure, in particular circumstances should their creditor proofing efforts unjustly deprive a creditor of its rights. 

 

Residence of Family Trust for Tax Purposes

The residence of a trust for tax purposes is where the central management and control of the trust actually resides, and should no longer be solely determined by where a majority of the trustees reside.

The decision of the Supreme Court of Canada in Fundy Settlement v. Canada, 2012 SCC 14, provides some insight into how the residence of a trust should be determined.  

In the Fundy Settlement case (also known as Garron or St Michael Trust Corp.), the trustee of two family trusts owning the shares in two private Ontario holding companies was a corporation resident in Barbados. The beneficiaries of the trusts were residents of Canada, and the holding companies and trusts were set up as part of an “offshore freeze” of the shares of an Ontario operating company owned by the beneficiaries. The trustee only acted upon receiving instructions from the beneficiaries. When the shares of the two holding companies were sold, resulting in a capital gain of about $450 million, the trustee sought exemption from Canadian capital gains tax based upon the tax treaty between Canada and Barbados which requires that tax would only be payable in the country in which the seller was resident.

The Minister of National Revenue held the trusts were resident in Canada. An appeal by the trustee of the Minister’s assessment to the Tax Court of Canada was unsuccessful, as was its further appeal to the Federal Court of Appeal. On its appeal to the Supreme Court of Canada, the trusts were held to be resident in Canada even though the trustee was resident in Barbados. As with corporations, the Supreme Court decided that residence of a trust for tax purposes should be determined by where its real business is carried on, where the central management and control of the trust actually takes place. Since the central management and control of the trusts was exercised by the main beneficiaries in Canada and the trustee’s limited role was to provide administrative services with little responsibility beyond that, the trusts were held to be resident in Canada.

This approach runs counter to a prior decision of the Federal Court Trial Division (in Trustees of Thibodeau Family Trust v. The Queen, 78 DTC 6376) and to prior administrative practice of the Canada Revenue Agency (in Interpretation Bulletin IT-447) which held the residence of a trust should generally be located where its trustee resides.

However, the Supreme Court qualified its finding (at para. 15) as follows:

This is not to say that the residence of a trust can never be the residence of the trustee. The residence of the trustee will also be the residence of the trust where the trustee carries out the central management and control of the trust, and these duties are performed where the trustee is resident.

From a practical point of view, this qualification seems to suggest that the residence of the trustee will continue to provide the operative test in determining the residence of a trust when the trustee is doing what it is supposed to do, namely manage the trust and its properties. This qualification also seems to suggest that while there may be a presumption that central management and control resides in the place of residence of a trustee of a trust, it can be displaced where evidence to the contrary is available.

Therefore, when the trustee is carrying on the management and control of the trust in a location where the trustee is not resident, or when the trustee essentially abdicates its power to some third party located elsewhere, the approach used in the Fundy Settlement case can give rise to a different result. In other words, instead of the place where the trustees meet to make their decisions, the central management and control of a trust, and hence the residence of the trust, may be located where a third party (such as a beneficiary) directs the decision making on behalf of the trust. Having local agents “rubber stamp” documents may not be enough to provide evidence of central management and control.

While this issue of residency is important when deciding how a trust is taxed on an ongoing basis, it can also be important when the residency of a trust changes. Subsection 128.1(4) of the Income Tax Act provides for the deemed disposition of a trust’s property upon ceasing to be resident in Canada. It is for this reason that many family trust agreements attempt to ensure that the trust does not become a non-resident for tax purposes, since the trust may be deemed to have disposed of all of its property should it cease to be resident in Canada.

Since the residence of a trust has up until now (or at least up until the lower court decisions in the Fundy Settlement case were first released) ordinarily been determined by the residence of the trustees, many standard precedents of family trust agreements contain a provision requiring trustees to automatically withdraw should they cease to be Canadian residents.

While this mandatory withdrawal provision will likely continue to appear in family trust agreements, the preparation of such agreements will now also likely take into consideration the implications of the Fundy Settlement case and the extent to which the powers and discretion of the trustees may be restricted. If the management and control of the trust effectively resides with others, such as the beneficiaries, the residence of the trust for tax purposes may end up being somewhere other that the tax jurisdiction intended by the parties when setting up the trust.