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Income tax statutes often make use of fair or arms length consideration tests to distinguish legitimate transactions between related parties and illegitimate transactions. (Illegitimate transactions being the desire to confer a benefit on a related party by way of insufficient consideration to support the transaction). However relying on some basic financial theory, conferring a benefit in the form of a higher expected return on a related party is consistent with the tax act and could have some use in tax planning. Below I outline the basic premise of asset valuation, derivatives pricing and then provide an example of how these could be used to fund an offshore trust in a manner that is consistent with Section 94 ITA.

In most cases an assets value is based on measures of its expected return and risk. This leads to a basic rule of finance that a high risk/high expected return asset can be equal in value to that of a low risk/ low expected return asset. This raises the question, can we structure asset ownership between related entities such that the taxpayer residing in a high tax jurisdiction owns the low risk/low return asset and the related taxpayer in the low tax jurisdiction holds the high risk / high return asset?

Using this equation we can see that the Expected Return on the high return / high risk asset minus the expected return on the low return/low risk asset will be taxed at a significantly discounted rate. One way to ensure the high tax jurisdiction earns the lowest rate of return possible is to make use of a forward contract between related entities. Take for example a forward contract on a share of Apple Stock (a high risk / high expected return asset). It’s price is based on the principal that the short side (seller) owns the underlying asset and transfers the risk associated with that asset to the buyer. Thus having divested all risk associated with ownership of the asset; the sellers return should be equal to the risk free rate. (Ie government debt) The risk free rate is the lowest expected return possible and the buyer will earn (by virtue of the contract) the higher expected rate of return associated with the Apple Share. If the seller is resident in Canada and the Buyer in a tax free jurisdiction; the difference in expected returns will accrue in a tax free jurisdiction. The price of a one year forward contract (based on Apple Share value = 100 dollars, a 2% dividend on the Apple Stock and a 3% risk free rate) is 100 + $ 3.00 - $ 2.00 = $ 101.00.

A virtually unlimited number of high risk/ high expected return assets exist upon which a futures contract could be based. In the example the high tax jurisdiction retains the asset (Apple Shares). Another alternative would be a swap contract; with one leg paying out on the high return asset and the other paying out on the low return asset.

Another alternative is a deep in the money option contract on a low risk/low return asset. For example a 1000 dollar 1 year treasury note paying zero per cent interest; with a strike price of 500 dollars. In this case; the buyer (high tax) would pay the seller (low tax) an amount equal to 500 dollars plus a very small premium to compensate the seller for the risk associated with short position associated with the option contract. (The risk associated with this contract is very low due to the low volatility of one year treasury notes and their very low expected return). This contract results in a transfer of capital to the low tax jurisdiction. In this case the seller could invest the proceeds in a high risk/high return asset; and earn the difference between the anticipated expected returns at a zero tax rate.

In these examples, the issue of credit risk arises; and an amount to compensate the buyer would have to be built into the option premium to reduce the premium paid to compensate the buyer for this kind of risk. With respect to credit risk, this could be reduced by adding provisions in the forward contract with respect to the use of funds paid and requiring them to be held in trust until termination of the contract.

Also in these examples, fair consideration is given by the Buyer, and both of these transactions should be considered legitimate under related party tax statutes. The end result of these transactions is that significant value is moved to a low tax jurisdiction.

Consider the following example; focused on Section 94 of the Income Tax Act. A close friend of a Canadian taxpayer settles a trust with a nominal amount of cash; the Trustee is the close friend and beneficiaries are the Canadian taxpayer and his children. Canadian tax payer enters into a deep in the money option contract with the Trust (as described above). Consistent with the terms of the contract, a significant sum is paid to the trust. The close friend appoints a successor trustee that resides in a low tax jurisdiction, and the funds are invested. A trust organized in this manner does not trigger the deemed Canadian residence provisions of Section 94; there is no connected contributor as the Canadian resident has made an arms length transfer to the foreign trust.

DISCLAIMER: This document is written for general information only. It is not intended as legal advice or opinion.

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