THE UNIVERSITY OF CALGARY FACULTY OF LAW

CORPORATE TAX COURSE MATERIALS

Professor Catherine Brown

Winter 2012

These Materials are for student use only The excerpts of the articles reproduced in these Materials are used with the permission of the Canadian Tax Foundation (Canadian Tax Journal, Conference Reports, Tax Highlights, Tax for the Owner Manager)

Table of Contents
I. The Corporate Taxpayer.......................................................................................................1
Is it a Corporation?..........................................................................................................................1 Entity Classification Evolves...........................................................................................................1 1. Residence..................................................................................................................................3 Determining the Residence of Members of a Corporate Group........................................3 i. Statutory Test.........................................................................................................................6 ii. The Common Law Position...................................................................................................7 iii. Corporate Continuance and Immigration..............................................................................8 iv. Corporate Residence Policy.................................................................................................9 A Tax Policy Perspective On Corporate Residence..........................................................9 2. Tax Rates for Corporations.......................................................................................................12 i. Basic Rates of Taxation.......................................................................................................12 ii. Provincial Taxation..............................................................................................................14 iii. Combined Rates of Taxation..............................................................................................15 iv. Resident in a Province........................................................................................................16 3. Integration.................................................................................................................................18 Integration & The Tax Treatment of Income ...........................................................................19

II. Classification of Corporations for Tax Purposes...........................................................23

1. Status of Corporations..............................................................................................................23 Interpretation Bulletin IT-391R - Status of Corporations..................................................24 2. The Meaning of "Control"..........................................................................................................25 i. Common Law Principles.......................................................................................................26 a. De Jure Control.............................................................................................................26 Buckerfields Limited et al. v. M.N.R...............................................................................26 b. Control Through a Corporate Entity..............................................................................31 Vineland Quarries and Crushed Stone Ltd. v. M.N.R......................................................31 c. Testing the Limits..........................................................................................................41 Donald Applicators Ltd. Et al. v. M.N.R...........................................................................41 d. The Role of Constating Corporate Documents..............................................................46 Duha Printers Ltd. v. Queen...........................................................................................46 e. The Role of Other Factors in Determining Control........................................................68 ii. Simultaneous Control (Ultimate Control).............................................................................73 a. The Common Law Position...........................................................................................73 Parthenon Investments Ltd.............................................................................................73 b. The Legislative Response.............................................................................................74 Silicon Graphics v. R......................................................................................................76 3. Canadian-controlled private corporation (CCPC)......................................................................92 IT-458R2 Canadian-Controlled Private Corporation.....................................................92 4. The Small Business Deduction...............................................................................................116 i. The Concept of Active Business Income............................................................................117 Canadian Marconi Company v. The Queen....................................................................119 McCutcheon Farms Ltd. v. The Queen...........................................................................124

ii Shamita Inc. v. R.............................................................................................................129 1996 CarswellNat 2759, (sub nom. Shamita Inc. v. R.) [1998] 2 C.T.C. 2974 (Tax Court of Canada)..........................................................................................................................130 ii. Specified Partnership Income............................................................................................130 iii. Specified Investment Business.........................................................................................133 a. Meaning of Specified Investment Business................................................................133 Temax Investments Inc. & Mayon Investments Inc. v. M.N.R.......................................133 Langille v. Canada........................................................................................................136 489599 B.C. Ltd. v. R. .................................................................................................138 Lerric Investments Corp. v. R.......................................................................................150 iv. Personal Service Business...............................................................................................154 Dynamic Industries Ltd. v. R.........................................................................................155 609309 Alberta Ltd., Appellant and Her Majesty the Queen, Respondent 2010 ..........161 Professional Incorporation............................................................................................167 2009-0315011E5 - Professional corporation's entitlement to the small business deduction .....................................................................................................................168 v. The Small Business Deduction..........................................................................................170 Interpretation Bulletin IT-73R6 - The Small Business Deduction...................................170 vi. Special Provisions............................................................................................................175 a. Qualified Small Business Shares................................................................................175 b. Capital Gains Deferral - Eligible Small Business Investments.....................................176

III. Associated Corporations...............................................................................................177

1. Purpose of Rules....................................................................................................................177 2. Subsection 256(1)...................................................................................................................177 Association and Control..............................................................................................................180 Interpretation Bulletin IT-64R4 - Corporations: Association and Control.......................182 Brownco Inc. v. R..........................................................................................................196 4. Related Persons.....................................................................................................................197 5. Arms Length...........................................................................................................................199 Interpretation Bulletin IT-419R2 - Meaning of Arm's Length..........................................199 6. Special Rule in ss. 256(1.4)...................................................................................................207 7. Associated by ss. 256(2.1)......................................................................................................209

IV. Investment Income.........................................................................................................210

1. Overview.................................................................................................................................210 2. Dividend Refund - S. 129(1)....................................................................................................212 3. Refundable Dividend Tax on Hand (RDTOH) - Ss. 129(3)......................................................213 4. Meaning of Aggregate Investment Income - Ss. 129(4)..........................................................215 5. Payments between Associated Corporations - Ss. 129(6)......................................................216 6. Taxation of Capital Gains........................................................................................................217 i. The Capital Dividend Account. Definition in ss. 89(1).........................................................217 ii. Capital Dividends ss. 83(2)................................................................................................217 iii. Capital Dividends Paid to Another Corporation.................................................................219

iii iv. Excessive Elections. Part III Tax......................................................................................219 v. Definition of "Taxable Dividend"........................................................................................222 7. Capital Gains..........................................................................................................................222 8. Effect of the RDTOH Account and the CDA ...........................................................................223 9. Inter Corporate Dividends and Part IV - Tax (s. 186)..............................................................225 i. General..............................................................................................................................225 Interpretation Bulletin 269R4........................................................................................226 ii. Connected Corporation ss.186(4)......................................................................................230 iii. Definition of Control ss.186(2)..........................................................................................231

V. Owner-Manager Compensation.....................................................................................233
1. General Rules.........................................................................................................................233 2. Other Matters..........................................................................................................................233 3. Factors to Consider (General reference Material)...................................................................235 4. Bonuses..................................................................................................................................244 5. Management Fees..................................................................................................................248 6. Bonus Payments.....................................................................................................................257 Safety Boss Limited v. R...............................................................................................257

VI. Corporate Distributions.................................................................................................267

1. What is a Dividend?................................................................................................................267 2. Dividends in Kind....................................................................................................................269 i. Amount of Dividend............................................................................................................269 ii. Disposition to Corporation and Acquisition to Shareholder................................................269 3. Stock Dividends......................................................................................................................270 i. Amount of Dividend............................................................................................................270 Interpretation Bulletin IT-88R2 - Stock Dividends.........................................................272 Wong v. R.....................................................................................................................273 ii. Cost to Shareholder...........................................................................................................283 4. Stock Splits and Stock Consolidations....................................................................................283 Interpretation Bulletin IT-65 - Stock Splits and Consolidations......................................283 5. Inter-Corporate Dividend Deduction Under ss. 112(1)............................................................284 i. Purpose..............................................................................................................................284 ii. Section 112(3)...................................................................................................................284 iii. Subsection 112(4), (4.1), (4.2) and (4.3)...........................................................................285 6. Tax Consequences to Corporation Paying Dividends.............................................................285 i. Capital Dividends...............................................................................................................286 Interpretation Bulletin IT-66R6 - Capital Dividends.......................................................286 ii. When Are Dividends Received..........................................................................................290 Horkoff v. R...................................................................................................................290 7. Shareholder Benefits ss. 15(1).............................................................................................292 Arpeg Holdings Ltd. v. R...............................................................................................294

iv Lloyd Youngman v. Her Majesty The Queen, [1990] 2 C.T.C. 10 (FCA).......................296 8. Shareholder Loans..................................................................................................................297 i. Subsection 15(2)................................................................................................................297 ii. Interest-Free and Low-Interest Loans. Subsection 80.4....................................................297 iii. Case Law..........................................................................................................................298 Guiseppe Perlingieri and Roma Construction (Niagara) Ltd. v. Minister of National Revenue.......................................................................................................................298 Sandia Mountain Holdings Inc. v. Canada....................................................................299 Lust v. R.......................................................................................................................309 Davidson v. R...............................................................................................................313 Interpretation Bulletin IT-119R4 - Debts of Shareholders Certain Persons Connected With Shareholders........................................................................................................318 9. Indirect Payments and Benefits ss. 56(2)................................................................................323 Melville Neuman, Appellant v. Her Majesty the Queen, Respondent............................324 Technical Interpretation 2006-0175601E5 -- Discretionary dividends...........................334 Peddle v. Canada.........................................................................................................336 10. Kiddie Tax s. 120.4............................................................................................................346 Kiddie Tax - 1999 Federal Budget Proposed Amendments..........................................347 Demers c. R..................................................................................................................348

VII. Paid-up Capital and the Concept of Deemed Dividends...........................................354

1. General Comments.................................................................................................................354 2. Application of s. 84..................................................................................................................355 3. Definition of Paid-Up Capital. Ss. 89(1)...................................................................................356 4. Adjustments to PUC under the Act..........................................................................................357 5. Operation of Section 84..........................................................................................................357 6. Review of the Concept of Paid Up Capital..............................................................................363 Paid-Up Capital Planning (Canadian Tax Foundation)................................................................363

VIII. Section 85: Tax-Free Transfers of Property to a Corporation.................................380

1. General Rule...........................................................................................................................380 2. Purpose of S. 85(1).................................................................................................................382 3. Who can use S. 85(1)?...........................................................................................................382 4. Assets eligible for Application of S. 85(1)................................................................................382 5. The Requirement to Issue Shares...........................................................................................383 6. Formalities of the Election Requirement..................................................................................383 Deconinck (S.E.) v. Canada..........................................................................................384 7. Examples................................................................................................................................385 8. Rules Governing the Elected Amount.....................................................................................385 9. Tax Consequences.................................................................................................................389 i. to the Transferee Corporation.........................................................................................389

v ii. to the Transferor............................................................................................................389 10. Other Examples....................................................................................................................391 11. Impact of ss. 15(1)................................................................................................................393 12. Subsection 85(2.1)................................................................................................................393 13. Section 84.1..........................................................................................................................394 14. Tax Planning.........................................................................................................................394 15. Case Law..............................................................................................................................396 Peter Dale and Bernard Dale v. Her Majesty The Queen.............................................396 Bugera v. Minister of National Revenue........................................................................401 16. Transfers of Capital Property (Stop Loss Rules)...................................................................401 Cascades Inc. c. R........................................................................................................404 17. Price Adjustment Clauses.....................................................................................................410 Interpretation Bulletin IT-169 - Price Adjustment Clauses.............................................410 18. General Review and technical filing requirements.................................................................411 Interpretation Bulletin IT-291R3 - Transfer of Property to a Corporation under Subsection 85(1) ............................................................................................................................411 85(1) Rollovers Checklist............................................................................................420 i. What types of property can be transferred under ITA ss. 85(1)?...................................420 ii. Consider special characteristics of property proposed to be transferred......................421 iii. Transferee Considerations..........................................................................................422 iv. Transferor Considerations..........................................................................................423 v. Compliance Matters.....................................................................................................424 vi. Other considerations..................................................................................................425 vii. Other Tax Considerations.........................................................................................425 viii. Non-Tax Considerations...........................................................................................426

IX. Tax Avoidance Transactions.........................................................................................428

1. Section 84.1............................................................................................................................428 The Mechanics......................................................................................................................429 Private Company Reorganizations: Common Problem and Pitfalls...............................436 Planning Considerations: Are they at arms length?..............................................................439 2. Capital Gains Strips: Section 55..............................................................................................440 i. Overview............................................................................................................................440 ii. Application: Deemed Proceeds or Capital Gain.................................................................441 iii. Exceptions to s. 55 ..........................................................................................................445 Granite Bay Charters Ltd., Appellant and Her Majesty The Queen, Respondent..........446 Recent Cases of Significance.......................................................................................449

X. Capital Reorganizations..................................................................................................453
1. Share for Share Exchanges s. 85.1......................................................................................453 i. Overview............................................................................................................................453 ii. The Requirements of Subsection 85.1(1)..........................................................................454 Interpretation Bulletin IT-450R - Share for Share Exchange.........................................455 2. Internal Reorganizations: Reorganization of Capital...............................................................459

vi i. Section 86..........................................................................................................................459 a. General Rules.............................................................................................................459 b. PUC Adjustments ss. 86(2.1).....................................................................................462 c. Foreign Spinoffs..........................................................................................................462 Interpretation Bulletin IT-448 - Dispositions - Changes in Terms of Securities..............465 ii. Section 51 Conversion......................................................................................................468 Private Company Reorganizations: Common Problems and Pitfalls.............................468 3. Consolidation of Taxable Canadian Corporations: Section 87................................................470 i. Overview............................................................................................................................470 ii. Mechanics.........................................................................................................................475 4. Dissolution of Corporations: Section 88 Winding-Up...............................................................480 i. Overview............................................................................................................................480 ii. Mechanics Subsection 88(1): Winding-up a 90% Owned Subsidiary..............................490 iii. Mechanics: Subsection 88(2): Winding-Up Canadian Corporations..................................491 Interpretation Bulletin IT-149R4 - Winding-Up Dividend................................................493

I. The Corporate Taxpayer

Is it a Corporation?
Any discussion of corporate tax should begin with an examination of what is considered to be a corporation for Canadian tax purposes. The answer to this question is simple if one is considering a body corporate incorporated under provincial or federal legislation in Canada. It is not as obvious if the entity under scrutiny acquires its legal status in a foreign jurisdiction. Consider the following discussion.

Entity Classification Evolves

A recent internal technical interpretation (TI) (CRA document no. 2008-0266251I7, April 15, 2008) highlights the Canada Revenue Agencys (CRA) evolving methodology for classifying foreign structures. The TI concludes that a Liechtenstein foundation (stiftung) is treated as a trust for Canadian tax purposes. Interpretation Bulletin IT-343R ("Meaning of the Term Corporation," September 26, 1977) sets out the CRA's longstanding position on entity classification: an entity with a separate legal identity and existence was considered to be a corporation. However, the TI and Income Tax Technical News (ITTN) no. 38 (September 22, 2008) acknowledge that separate legal entity status is no longer a distinctive feature of corporations alone. The TI describes the CRA's new two-step approach for classifying foreign entities for the purposes of domestic taxation: (1) determine the characteristics of the foreign entity under the foreign legislation, and (2) compare those characteristics with those of recognized categories under Canadian commercial law. The TI's analysis of the Liechtenstein foundation revolved around whether it was a corporation or a trust for Canadian tax purposes. A stiftung has some features similar to a trust or corporation in common-law jurisdictions, but other features are not present in either structure. Under the relevant foreign legislation, a stiftung's creator (its founder) provides its initial assets. A stiftung is a legal person that owns the assets supplied by the founder, subject to its stated purposes. It is operated by a council or board of directors. It has no shareholders, and no one owns a property interest in the foundation; instead it has "beneficiaries," which "may be named or described in the foundation documentation but customarily are not. The founding (and registered) documents will certainly be silent on the subject." The TI reveals few details of the particular stiftung's structure: its object is to provide support to various families, including "natural and juridical persons outside the family circle," and its beneficiaries are named in separate by-laws. The CRA applied the two-step approach to the stiftung and concluded that, on balance, the entity was more like a trust than a corporation, and thus should be treated as a trust for tax purposes: the founder's endowment that creates a stiftung is similar to a settlor's settlement of property to a trust. A stiftung also has beneficiaries, just like a trust; the beneficiaries, or at least an ascertainable class, are usually named in the stiftung's by-laws at its formation, similar to a trust indenture, and a stiftung's beneficiaries do not pay for their interests and are not entitled to vote. The stiftung board acts in the same way as trustees to protect the stiftung's capital and to follow the founder's wishes; the stiftung's board exercises considerable decision and control powers over the stiftung assets, similar to a trustee's powers over trust assets; a stiftung can be compared to a trust; and the creation of a

2 foundation can be inter-vivos or testamentary. Moreover, a stiftung cannot perform commercial activities unless they serve its non-commercial purpose or unless the type and scope of the participation held requires the facilities of a commercial business. The TI's two-step approach categorizes an entity for Canadian tax purposes according to the type of recognized common-law entity or relationship--corporation, partnership, or trust--that it resembles most, rather than according to whether it has the fundamental characteristics of the entity or relationship. A foreign entity is assumed to be one of a trust, a corporation, or a partnership under Canadian law, and is forced into one of these categories if need be. The CRA's approach is questionable absent a legislative deeming rule that categorizes a foreign entity on the preponderance of its resemblance to one common-law entity or relationship. For example, the SCC in Backman (2001 DTC 5149) unanimously concluded that a partnership created under Texas law was not a partnership for Canadian tax purposes: The term "partnership" is not defined in the Act. Partnership is a legal term derived from common law and equity. . . . As a matter of statutory interpretation, it is presumed that Parliament intended that the term be given its legal meaning for the purposes of the Act. . . . It follows that even in respect of foreign partnerships, for the purposes of s. 96 of the Act, the essential elements of a partnership that exist under Canadian law must be present. Backman suggests that the foreign entity must have the essential elements of the particular commonlaw structure before it can be categorized and taxed as such. A Backman-based two-step approach for classifying foreign entities would require (1) identification of the foreign entity's characteristics and (2) a determination of whether they matched the essential elements of a recognized structure under Canadian commercial law; if no match was found, then the foreign entity would not be subject to the tax rules applicable to the recognized structure. In contrast, the TI based its conclusion on a finding that a stiftung more closely resembled a trust than a corporation, but it did not find that the stiftung had the essential elements of a trust under Canadian law. Arguably, it may be difficult for a Canadian court to find that a stiftung is a trust. Some stiftung attributes are similar to a trust -- in particular, the functions performed by its directors and those performed by a trust's trustees are similar in some respects. But in many of its characteristics -- especially its separate legal personality -- a stiftung differs from a trust, which at common law has no separate legal personality and is merely a relationship between a trustee and beneficiary in respect of property. However, the CRA's approach to foreign entity classification incorporates a purposive interpretation of the Act, and it may be appropriate to extrapolate from categories of entities and relationships -- like trusts -- that are well defined in Canadian law, to capture foreign structures not specifically addressed in the Act. Ever since the SCC's GAAR analysis in Canada Trustco ([2005] 2 SCR 601), the courts have been inclined to apply a purposive interpretation to all of the Act's provisions. An interesting aspect of the CRA's two-step approach is that it appears to permit classification of an entity as a trust in one context and a corporation in another. ITTN no. 38 says that "[the CRA] cannot always reach a general position for a particular foreign entity. In certain situations, we have reached a conclusion after an analysis not only of the foreign legislation under which an entity was formed but also of the agreements like articles of incorporation and contracts between parties that governed it." If a contractual arrangement permitted a stiftung's beneficiaries to select its board of directors, would the CRA conclude that it was a corporation? If the CRA's new approach can lead to different classifications for one type of entity, practitioners will have to go beyond the foreign entity's name and delve into all related legal relationships when advising clients on its Canadian tax effects.

1. Residence
A corporation is an artificial legal entity that is treated as a distinct taxpayer separate and apart from its owners. As a separate taxpayer, a corporation may be a resident or non-resident of Canada for income tax purposes. Unlike human beings however, it is not a simple matter to determine corporate residency and thus liability for Canadian tax. The residence of a corporation is determined by applying statutory rules, common law principles, and tax treaty provisions. There are two distinct tests that have been developed in order to resolve the residency issue. The first test is a deeming provision contained in ss. 250(4). The second is a common law test that looks to where the central management and control of the corporation resides.

Determining the Residence of Members of a Corporate Group

Michael J. McIntyre, (2003), Vol. 51, No. 4 Canadian Tax Journal, 1567-1573. A "corporation" is a set of complex legal relationships that the law has sought to simplify by characterizing the corporation as a "person" in some important contexts. In contrast to a natural person, a corporation has no internal organizational principle or substance. In the terminology of the Aristotelian categories, it has no essence that defines its fundamental nature. To the contrary, it is a collection of accidental relationships that result from the activities conducted in the name of the corporation. Like a computer, it has a soul only through anthropomorphic metaphor. That a corporation has no essence means that it is whatever the law says it is. For example, the law says that a corporation can enter into a contract with other corporations and with natural persons. As a result, it can enter into such contracts. In substance, a contract between a corporation and a natural person specifies a complex relationship between that natural person and the various stakeholders in the corporation. A contract between two corporations specifies the relationships among the stakeholders of both corporations. Some contract doctrines, such as "meeting of the minds," are inapplicable to corporations except by analogy. Sometimes the analogies are fruitful, and sometimes they are downright silly. The starting point of most such analogies is to treat a corporate contract like a contract with a hypothetical natural person who owns the assets held in the name of the corporation. Treating a corporation as a person simplifies the statement of the relationships between persons dealing with the corporation and the stakeholders in the corporation. Those identical relationships could be specified, however, without resort to the metaphor of the corporation as a person. The stakeholders of businesses that operate as partnerships routinely enter into contracts and establish other business relationships without resort to a similar metaphor. In many cases, the law says that a corporation will not be treated like a natural person. For example, corporations are not allowed to vote and are not called for jury duty. In many commercial contexts, the metaphor of corporation as person is so strained that the corporation is treated as a conduit rather than as a person. For example, under tort law, the owner-operators of a corporation may be unable to insulate themselves from liability for a tort simply because their wrongful act was performed in the name of a corporation. When the law treats the stakeholders of a corporation as the owners of the assets held in the name of the corporation, it is sometimes said to have ignored the corporate existence. In fact, the law has simply declined to indulge the fiction that the corporation is a person. It is testament to the power of

4 the corporation-as-person metaphor, however, that a focus on the substance of a set of relationships is commonly described as ignoring that substance. Many countries, including Canada, treat a corporation as a person for purposes of taxation in at least some important cases. That is, the income that is attributed to a corporation under tax accounting rules is subject to taxation as if, in substance, that income were earned by the corporation. The general pattern, however, is to give special relief from the corporate tax in some cases. For example, many countries do not impose a tax on certain owner-operated businesses organized in corporate form. Countries almost always exempt corporations from tax on dividends received from a related corporation, in order to avoid what is referred to, metaphorically, as a double tax on corporate profits. Under the international tax rules followed by Canada and most other countries, the tax treatment of a corporation depends on its status as a resident or a non-resident. A non-resident corporation is taxable only on that portion of its income that has a nexus with the taxing country. In contrast, a resident corporation is taxable, with perhaps some exceptions, on the income it earns from its worldwide operations, without reference to the nexus of its income to its country of residence. The basic problem that arises in ascertaining the residence of a corporation is that a corporation does not have a residence. An individual's residence, according to common parlance, is the place where that person lives and makes a home. A corporation does not live, does not have a home, and is not located anywhere. It can have a "residence," therefore, only if the law assigns it one. Although individuals do reside in particular countries, their residence for tax purposes is usually assigned to them under the tax laws. In some cases, the assignment may have been made under bright-line rules that ignore many of the nuances of the residence concept. For example, the law may provide that an individual is resident in a country if he or she is physically present in the country for more than half of the taxable year. Even these bright-line rules, however, are based on real relationships between the individual and the country. Corporations do not have relationships with a country that are analogous to the relationships used to assign residence status to individuals. For example, a corporation has no physical attributes and therefore cannot be physically present in any country for even a day. The Canadian rules for corporate residence were derived, in significant part, from decisions of the courts of the United Kingdom. The seminal UK case, discussed in detail by Couzin, is De Beers. [De Beers Consolidated Mines, Ltd. v. Howe (1906), 5 TC 198 (HL)]. In that case, the court stated that it would determine corporate residence as nearly as possible by analogy to an individual. "A Company," the court stated, "cannot eat or sleep, but it can keep house and do business. We ought, therefore, to see whether it really keeps house and does business." Determining where a corporation "does business" is similarly problematic. People have become accustomed over the past hundred years to think of corporations as engaging in business. Corporations, however, cannot engage in business, except metaphorically. The business of a corporation is actually conducted by the employees, agents, and other representatives who engage in business activities in the name of the corporation. A corporation engages in business in much the same way that the owner of a baseball team plays baseball. More fundamentally, the residence of an individual is not determined by where he or she engages in businesslocation of business activities is an issue for source jurisdiction, not residence jurisdiction. If the residence of a corporation is to be determined, as the De Beers court argued, by analogy to the

5 residence of individuals, then the place where a corporation metaphorically engages in business is an irrelevancy. In the end, the De Beers court pronounced that the residence of a corporation is the place where "the central management and control actually abides." This place-of-management test owes nothing to an analogy to the way the residence of individuals is determined. Indeed, as Couzin notes, individuals, in general, do not have a place of management. Although this test may be linked to snippets of language from prior UK cases, it appears to be a judicial fabrication. In adopting that test, the De Beers court apparently was attempting to prevent the easy manipulation that everyone understood to be possible under the place-of-incorporation test, which was the test urged on the court by the taxpayer. If the De Beers court was attempting to fashion a corporate residence test that was not subject to easy manipulation by taxpayers, it failed utterly. Corporate taxpayers subject to the place-ofmanagement test are given, in effect, the right to elect their country of residence by performing in that country certain ceremonial events, such as the meeting of the board of directors. Indeed, tax planners seeking to manipulate the residence of a corporation to minimize taxes typically prefer the place-ofmanagement test over the place-of-incorporation test, owing to the ease of changing corporate residence without tax consequences under the former test. What has drained any conceivable substance out of both the place-of-management test and the place-of-incorporation test is the ability of a corporation to avoid residence taxation on its foreign earnings by establishing foreign subsidiaries and earning its foreign profits through those subsidiaries. In principle, that option was available to corporations even at the time of the De Beers case. As a practical matter, however, most multinational companies operated abroad through branches until after the Second World War. Today, multinational companies typically have hundreds, even thousands, of foreign affiliates. Subject only to the modest limitations imposed by anti-avoidance rules, such as Canada's foreign accrual property income rules and the US subpart F rules, a modern multinational enterprise is able to exploit its androgynous nature to make corporate residence ineffective. As discussed above, corporations do not have a residence, as that term is generally understood. It should be no great surprise, therefore, that countries have huge difficulties taxing corporations on the basis of their residence. There are two routes that a country can follow to solve the problem of determining corporate residence. One is to establish a practical system of taxing corporations that does not depend on their residence. The second is to define corporate residence in terms of the function that residence taxation is intended to serve in a corporate income tax. Some of the American states, most importantly California, have developed a practical and effective system of taxing corporations that operates without reference to the residence of a corporation. That system is worldwide combined reporting with formulary apportionment. It can be adapted, with only minor adjustments, by nation-states. (See Michael J. McIntyre, "The Use of Combined Reporting by Nation-States," in Brian J. Arnold, Jacques Sasseville, and Eric M. Zolt, eds., The Taxation of Business Profits Under Tax Treaties (Toronto: Canadian Tax Foundation, forthcoming)). Under that system, each taxing jurisdiction imposes its tax on an apportioned share of the aggregate income of the entire corporate enterprise. No income is apportioned to a tax haven country unless meaningful economic activity is conducted in that country. For example, income from the production and sale of goods is apportioned between the place of production and the place of sale, with no income being apportioned to a jurisdiction simply because intangible assets are being held by a holding company that is resident in that country. In effect, a corporate group is treated as a single corporation operating through branches, and each country taxes its share of the total income fairly attributable to the branches located within its borders.

6 The second route, defining corporate residence functionally, requires some analysis of the functions that residence taxation is intended to serve. In the context of an individual income tax, the main purpose of residence taxation is to tax individuals on their total income, without reference to the source. By taxing its residents without regard to the source of their income, a country bases its tax on ability to pay and avoids creating inefficient tax incentives for foreign investment. The purposes of the corporate tax are similar. The corporate tax is a tax on the income that shareholders have derived through their ownership interests in corporations. By taxing shareholders indirectly on the total income they have earned through those ownership interests, without regard for its source, the corporate tax promotes fairness and efficiency. Fairness is achieved by eliminating artificial distinctions in the measurement of ability to pay based on the source of income. Efficiency is achieved by removing an unwarranted tax incentive for foreign investment. In addition, residence taxation of corporations reduces the opportunities for tax evasion that are endemic in a source-based tax (see Michael J. McIntyre, "How the United States Should Respond to the ETI Dilemma" (2002) vol. 26, no. 7 Tax Notes International 865-72, reprinted in (2002) vol. 95, no. 8 Tax Notes 1251-55). To be successful in imposing and collecting a residence tax on corporations, a country must define "residence" in a way that is not easily avoided. If corporations are free to elect not to be taxed as residents, they will make that election. As currently constituted, the place-of-management test and the place-of-incorporation test are elective to a substantial degree. As a result, the residence tax on corporations is largely elective in tax jurisdictions that employ either or both of those tests.

i. Statutory Test
250(4) For the purposes of this Act, a corporation shall be deemed to have been resident in Canada throughout a taxation year if (a) in the case of a corporation incorporated after April 26, 1965, it was incorporated in Canada; (b) in the case of a corporation that (i) was incorporated before April 9, 1959, (ii) was, on June 18, 1971, a foreign business corporation (within the meaning of section 71 of the Income Tax Act, chapter 148 of the Revised Statutes of Canada, 1952, as it read in its application to the 1971 taxation year) that was controlled by a corporation resident in Canada, (iii) throughout the 10 year period ending on June 18, 1971, carried on business in any one particular country other than Canada, and (iv) during the period referred to in subparagraph 250(4)(b)(iii), paid dividends to its shareholders resident in Canada on which its shareholders paid tax to the government of the country referred to in that subparagraph, it was incorporated in Canada and, at any time in the taxation year or at any time in any preceding taxation year commencing after 1971, it was resident in Canada or carried on business in Canada; and (c) in the case of a corporation incorporated before April 27, 1965 (other than a corporation to which subparagraphs 250(4)(b)(i) to 250(4)(b)(iv) apply), it was incorporated in Canada and, at any time in the taxation year or at any time in any preceding taxation year of the corporation ending after April 26, 1965, it was resident in Canada or carried on business in Canada. 250(5) Notwithstanding any other provision of this Act (other than paragraph 126(1.1)(a)), a person is deemed not to be resident in Canada at a time if, at that time, the person would, but for this subsection and

7
any tax treaty, be resident in Canada for the purposes of this Act but is, under a tax treaty with another country, resident in the other country and not resident in Canada. 250(5.1) Where a corporation is at any time (in this subsection referred to as the time of continuation) granted articles of continuance (or similar constitutional documents) in a particular jurisdiction, the corporation shall (a) for the purposes of applying this Act (other than subsection 250(4)) in respect of all times from the time of continuation until the time, if any, of continuation in a different jurisdiction, be deemed to have been incorporated in the particular jurisdiction and not to have been incorporated in any other jurisdiction; and (b) for the purpose of applying subsection 250(4) in respect of all times from the time of continuation until the time, if any, of continuation in a different jurisdiction, be deemed to have been incorporated in the particular jurisdiction at the time of continuation and not to have been incorporated in any other jurisdiction.

Paragraph 250(4)(a) deems a corporation incorporated in Canada after April 26, 1965 to be resident in Canada throughout a taxation year. Corporations incorporated in Canada before that date are also deemed resident if central management and control is in Canada or if the corporation carried on business in Canada (subject to para. 250(4)(a)). In addition, a corporation may become or cease to become a Canadian resident for tax purposes (section 219.1). A Canadian incorporated corporation may also continue in a new jurisdiction. This is known as corporate migration. Subsection 250(5.1) provides that after continuing into a new jurisdiction that corporation will be treated as having been incorporated there. As a result, a corporation that has been continued abroad will no longer be subject to the deeming rules in subsection 250(4). Conversely, a corporation which migrates (i.e. is incorporated abroad and continued in Canada) to Canada will be treated as though it were incorporated in Canada when it is continued here (subsection 250(5.1)). Notwithstanding these statutory provisions, the common law rules of corporate residency remain relevant and will be determinative for: a. corporations incorporated in Canada prior to April 26, 1965; b. corporations incorporated abroad but which have central management and control in Canada; c. corporations which have migrated or continued into another jurisdiction, but whose central management and control remain in Canada.

ii. The Common Law Position

Both English and Canadian courts have held that corporations are resident where their central management and control is located. In De Beers Consolidated Mines Limited v. Howe, [1906] A.C. 455, at 458 (H.L.), Lord Loreburn, L.C. remarked that: a company resides for the purposes of income tax where its real business is carried on... I regard that as the true rule, and the real business is carried on where central management and control actually abide.

8 Central management and control usually refers to the exercise of power and control by the board of directors of a corporation. Per Unit Construction Co. Ltd. v. Bullock, [1959] 3 All E.R. 831, Viscount Simons said: it is the actual place of management, not that place in which it ought to be managed, which fixes the residence of a company. If it were not so, the result to the Revenue would be serious enough. In how many cases would a limited company register in a foreign country, prescribe by its articles and its business should be carried on by its directors meeting in that country, and then claim that its residence was in that country though every act of importance was directed from the United Kingdom? Note that it is possible for a corporation to be located in two or more jurisdictions, thus the corporation can have more than one residence.

iii. Corporate Continuance and Immigration

Corporations may also choose to continue their corporate existence in Canada and thereby become resident or to emigrate from Canada and cease to be Canadian residents. The tax consequences are outlined below. Excerpt from Corporate Continuance - CRA Explanatory Notes, 1994 Budget Chnages Corporate Continuance s. 250(5.1) In many jurisdictions, a company incorporated elsewhere may be naturalized by submitting to the corporate law of its new home. Such an action is often described as a corporate "continuance" or "continuation". (New) subsection 250(5.1), together with certain concurrent amendments concerning taxpayers' residence, fixes the tax consequences of continuation into a different jurisdiction. The basic principle of subsection 250(5.1) is that the continued corporation will be treated as having been incorporated in the jurisdiction into which it has continued. A corporation, for example, that was originally incorporated in Canada but was subsequently continued abroad will cease to be treated as having been incorporated in Canada, and will therefore no longer for that reason be deemed to be resident in Canada (although it may remain resident by keeping its central management and control in Canada). It should be noted that the continued corporation is treated as having been incorporated in its new home jurisdiction only for the purpose of applying the Act from the time of continuation (and only until continuation into a different jurisdiction). In applying most provisions of the Act, a corporation's deemed incorporation under subsection 250(5.1) will be considered to have taken place as of the date of its original incorporation. Paragraph 250(5.1)(b), however, provides that for the purposes of applying subsection 250(4) the continued corporation will be treated as having been incorporated, in the jurisdiction into which it has continued, as of the date of that continuance.

9 Corporate Emigration s. 219.1

219.1 Where a taxation year of a corporation is deemed by paragraph 128.1(4)(a) to have ended at any time, the corporation shall, on or before its filing-due date for the year, pay a tax under this Part for the year equal to 25% of the amount, if any, by which (a) the fair market value of all the property owned by the corporation immediately before that time exceeds the total of (b) the paid-up capital in respect of all the issued and outstanding shares of the capital stock of the corporation immediately before that time, (c) all amounts (other than amounts payable by the corporation in respect of dividends and amounts payable under this section) each of which is a debt owing by the corporation, or an obligation of the corporation to pay an amount, that is outstanding at that time, and (d) where a tax was payable by the corporation under subsection 219(1) or this section for a preceding taxation year that began before 1996 and after the corporation last became resident in Canada, 4 times the total of all amounts that would, but for sections 219.2 and 219.3 and any agreement or convention between the Government of Canada and the government of any other country that has the force of law in Canada, have been so payable.

Section 219.1 imposes a tax under Part XIV of the Act (commonly known as the "departure tax") where a corporation ceases to be a Canadian corporation. This tax applies to corporations that cease to be resident in Canada. Paragraph 128.1(4)(a) treats an emigrating corporation's taxation year as having ended immediately before the corporation ceased to be resident in Canada. Under section 219.1, such a corporation will be required to pay the 25% departure tax on or before the day it is required to file its income tax return for that taxation year. Under paragraph 128.1(4)(b), the emigrating corporation is also treated as having disposed of all of its property immediately before that deemed year-end for proceeds equal to the property's fair market value. In most cases, the tax under amended section 219.1 is payable on the amount, if any, by which those deemed proceeds, described in paragraph 219.1(a), exceed the total of the paid-up capital in respect of all of the corporation's shares immediately before year-end (paragraph 219.1(b)) and the corporation's debts and obligations, other than amounts payable in respect of dividends and amounts payable under section 219.1 itself (paragraph 219.1(c)).

iv. Corporate Residence Policy

The following excerpts from Arnolds article considers Robert Couzins work- Corporate Residence and International Taxation (Amsterdam: International Bureau of Fiscal Documentation, 2002), providing an excellent outline of the Canadian policy perspective on corporate residence.

A Tax Policy Perspective On Corporate Residence

Brian J. Arnold, (2003), vol. 51, no. 4 Canadian Tax Journal, 1559-1566. The concept of corporate residence is intimately connected with the fundamental proposition that a corporation is a taxable entity separate from its shareholders. It is only because corporations are separate taxable persons that it is necessary to determine their residence. Although the treatment of a corporation as a separate entity for income tax purposes may make sense in a domestic context, it

10 makes little sense in the international context. A resident individual or corporation should not be able to avoid residence-country tax on foreign-source income by the simple expedient of having the income derived by a foreign corporation of which the resident owns all the shares. However, I suspect that in the early days of the income tax, the treatment of domestic corporations as separate taxable entities was extended to foreign corporations without much thought. The death of corporate taxation has been greatly exaggerated. Obviously, if corporations are not taxed, corporate residence becomes largely redundant. However, the reality is that, despite all the pressures that should lead to their demise, corporate taxes not only remain an important component of government revenues, but have grown in importance in recent years. Simply waiting for corporate tax to disappear is not a sensible response to the problems with our corporate residence rules. It is important to keep in mind that the most important (though not the only) purpose of the concept of residence in our system is to distinguish between persons, including corporations, that are taxable on their worldwide income and those that are taxable only on their domestic-source income. Worldwide taxation is most commonly referred to as residence taxation or residence-based taxation. However, worldwide taxation need not hinge on residence in the ordinary or statutory sense; it may, and sometimes does, turn on other factors such as citizenship or place of incorporation. According to Robert Couzin, the basic problem in establishing corporate residence is "how to define a sensible connecting factor for the residence taxation of incorporated companies, and how to choose between potentially competing connecting factors." I would describe the problem a little differently, in terms of the principal purpose of the concept of corporate residence: how to identify those corporations that should pay tax on their worldwide income. For many, probably even most, domestic corporations, the answer is relatively easy. A corporation that is created under and governed by the laws of Canada, that carries on business primarily in Canada, and whose shareholders, directors, and managers are residents of Canada, should clearly be taxable on its worldwide income (unless, as discussed subsequently, taxation of corporations on their worldwide income is abandoned). The determination of which individuals should be subject to worldwide taxation is similarly easy for most individuals. There are, of course, many corporations (and individuals) whose existence is not concentrated exclusively in a single country. Moreover, it is probably safe to say that the number of such corporations (and individuals) is growing as a result of the process of globalization. Nevertheless, in my view, a test that works well in most cases is usually a good one and, while it may need to be tweaked or supplemented, it should not be lightly abandoned. To say that some corporations are subject to tax on their worldwide income and that the function of criteria such as residence and place of incorporation is to identify those corporations is somewhat misleading. It suggests that the distinction between corporations that are taxable on their worldwide income and those that are not (in our system, the distinction between resident and non-resident corporations) is of much greater significance than it really is. Non-resident corporations are generally taxable on any income derived from sources in Canada, and, more important, any Canadian-source business income derived by them is taxable generally in the same way as business income derived by resident corporations. Accordingly, the crucial difference between resident and non-resident corporations has to do with foreign-source income. However, resident corporations can establish nonresident subsidiary corporations to earn any foreign-source income. (This result occurs because, as discussed above, a foreign corporation is a taxable entity separate from the Canadian parent and is not usually resident in Canada on the basis of either a central management and control or a place-ofincorporation test of corporate residence.) If a Canadian-resident corporation earns only Canadiansource income and its foreign subsidiaries earn exclusively foreign-source income, the imposition of Canadian tax on the worldwide income of resident corporations is not nearly as important as it would otherwise appear.

11 In his final chapter, Robert Couzin poses a deceptively simple question: "What is the best test for corporate residence?" Couzin finds both the place-of-incorporation and the central management and control tests vulnerable to manipulation by taxpayers. He suggests that consideration should be given to tests based on the location of executive (day-to-day) management of the corporation or the main business operations of the corporation. My initial reaction is to wonder why, even if these tests are better than the existing tests, it is necessary to have a single test. Our current test is a combination of central management and control and place of incorporation. In principle, I have no difficulty adding other tests so that a corporation might be taxable on its worldwide income if it is incorporated in Canada, its central management and control are in Canada, the executive (day-to-day) control is exercised in Canada, the majority of the corporation's shareholders are resident in Canada, a substantial or controlling shareholder is resident in Canada, or the corporation has substantial business operations in Canada. In practice, however, I suspect that such supplementary tests would have little positive impact on the Canadian tax net. As Couzin emphasizes, in most of these situations, the corporation will also be resident in another country, and the tie-breaker rule in the treaty will often work in favour of the other country. In many cases, therefore, the treaty, in conjunction with subsection 250(5) of the Act, will effectively negate the addition of supplemental residence rules. If the tie-breaker rules do not resolve the dual-residence conflicts, unrelieved double taxation becomes a serious concern. Moreover, the addition of any supplementary tests of corporate residence has implications for the migration rules and for access to tax preferences. (Some tax preferences (for example, the small business deduction) are restricted to corporations resident in Canada. Accordingly, expanding the net of corporations resident in Canada would have the effect of providing these tax preferences to a larger population of corporations, subject to subsection 250(5)). Consider, for example, a supplementary rule deeming corporations to be resident in Canada if they are controlled by a small group of shareholders resident in Canada. The presence of shareholder "control" of a corporation in Canada appears to be a satisfactory connecting factor. Moreover, it is arguable that this type of control is a better test of corporate residence than the current central management and control test because it allows the Canadian tax authorities to look to the controlling shareholders to enforce the tax on the foreign corporation. Although a foreign incorporated company would be deemed to be resident in Canada and taxable on its worldwide income if its controlling shareholders were resident in Canada, the tax authorities might encounter difficulties in enforcing any tax liability against the foreign corporation unless it had assets in Canada. The controlling shareholders resident in Canada could be made liable for any Canadian tax assessed against the foreign corporation. In my view, serious consideration should be given to repealing the central management and control test of corporate residence. That test is subject to manipulation by taxpayers from one year to another. (In contrast, the place-of-incorporation test is subject to manipulation only once, when the corporation is created.) Because of the intensely factual nature of the test and control of the essential information by taxpayers, the tax authorities are in a no-win situation. If it is beneficial for a corporation to be resident in Canada, the necessary information can be marshalled to show that the required decision-making activities took place in Canada. If it is disadvantageous for a corporation to be resident in Canada, the tax authorities have enormous difficulty collecting the necessary information to prove the case. I am not aware of any recent situations where the Canada Customs and Revenue Agency has successfully asserted residence on the basis of central management and control. Therefore, the effect of repealing the test would be simply to remove a tax-planning device.

12

2. Tax Rates for Corporations

A. Tax liability arises for the corporation separate and apart from the tax liability of its shareholders. The shareholder does not become liable for the corporation's taxes. It is a separate liability of the corporation. Potential for double tax: because the corporation is taxed as a separate person, the potential of double taxation arises because the corporation may be taxed on an item of income and the individual is taxed again on the same item when it is distributed in the form of a dividend. This has resulted in the concept of "integration", which we will be discussing in detail later on. Non-consolidation: in Canada, losses of one member of a corporate group cannot be offset against income of another.

B.

C.

i. Basic Rates of Taxation

A. Basic Tax Rate for corporations is set out in para. 123(1)(a) at 38%. The Basic Tax Rate is applied to the taxable income of the corporation. Taxable income is determined by calculating the corporation's income under Division B of the Act, and then adding and subtracting therefrom the additions and deductions from taxable income allowed by Division C. The deductions in Division C consist of loss carryovers, dividends from other taxable Canadian corporations, etc. The addition in Division C relates to the foreign tax credit adjustment under s. 110.5. S. 124 provides for a 10% reduction in the corporate tax rate applicable to the corporation's taxable income earned in the year in a province. The purpose of this is to "make room" for the provinces to levy an income tax. For these purposes, the Yukon Territory and the Northwest Territories are treated as provinces. Surtaxes. From time to time the federal government has levied a surtax calculated as a percentage of Part I tax payable. Formerly s. 123.2 applied a 4% surtax on Part I tax payable. The surtax applied to income of all corporations, including income subject to the small business deduction and income subject to the manufacturing and processing deduction. This surtax was eliminated for all corporations as of Jan 1, 2008. Additional Refundable Tax. Tax otherwise payable under Part I by a corporation throughout a year in which the corporation is a Canadian Controlled Private Corporation (CCPC) is increased by 6% of the corporation's "aggregate investment income" for the year [section 123.3 and subsection 129(4)].
125(7) "Canadian-controlled private corporation" means a private corporation that is a Canadian corporation other than (a) a corporation controlled, directly or indirectly in any manner whatever, by one or more nonresident persons, by one or more public corporations (other than a prescribed venture capital corporation), by one or more corporations described in paragraph (c), or by any combination of them, (b) a corporation that would, if each share of the capital stock of a corporation that is owned by a non-resident person, by a public corporation (other than a prescribed venture capital corporation),

B.

C.

D.

13
or by a corporation described in paragraph (c) were owned by a particular person, be controlled by the particular person, (c) a corporation a class of the shares of the capital stock of which is listed on a designated stock exchange, or (d) in applying subsection (1), paragraphs 87(2)(vv) and (ww) (including, for greater certainty, in applying those paragraphs as provided under paragraph 88(1)(e.2)), the definitions "excessive eligible dividend designation", "general rate income pool" and "low rate income pool" in subsection 89(1) and subsections 89(4) to (6), (8) to (10) and 249(3.1), a corporation that has made an election under subsection 89(11) and that has not revoked the election under subsection 89(12);

E.

The small business deduction (s.125) will be discussed in greater detail later in these materials. However, briefly stated the small business deduction ("SBD") allows for a 17% deduction from tax payable on qualifying income up to a ceiling of $500,000 federal tax payable (under Part 1) as of Jan 1, 2009. For Alberta provincial tax purposes, the small business rate of tax is reduced from 10% to to 3%, and the ceiling was raised to $500,000 on April 1, 2009 (see subsection 22(2.12) of the Alberta Corporate Tax Act). The general corporate income tax rate for Alberta is 10%. Manufacturing and Processing Deduction. S. 125.1 provided for a 7% reduction in the rate of tax applied to Canadian manufacturing and processing profits that did not qualify for the small business deduction under s. 125(1). This was repealed in 2005 due to a general lowering of corporate tax rates. Section 123.4 implemented a "general rate reduction percentage." The rate reduction was applied to the basic rate of 38% (s.123) 38% the application of the provincial abatement of 10% (s.124) and any corporate surtaxes (s.123.1). As a result, the general federal rate (after the application of s.123, 124, 123.1, and 123.4) was lowered in 2008 to 19.5%. Compare this to the rate of 29.12% in 2001. Starting in 2008, the corporate income tax rate continued to decrease to a target rate of 15% as of January 1, 2012. This rate reduction occurred as follows: 19.5% on January 1, 2008; 19% on January 1, 2009; 18% on January 1, 2010; 16.5% on January 1, 2011; and 15% on January 1, 2012. This general rate reduction is not available to corporate income already receiving reduced rates from the "CCPC rate reduction" or otherwise receiving preferential tax treatment (such as investment income, and resource sector income). As will be discussed later in the course, It is also not available to personal services businesses. Capital Tax. Part I.3 of the Act (sections 181 to 181.7) formerly provided for a capital tax levied against corporations equal to 0.225% of the taxable capital employed in Canada by the corporation in excess of $50,000,000. The purpose of the threshold deduction was to levy the tax only against what are considered to be "large corporations". The threshold limit must be shared amongst related corporations. The tax is commonly referred to as the "Large Corporations Tax" (LCT). The Large Corporations Tax can be reduced by the amount of the federal corporate surtax (see s. 181.1(4)). The LCT operated as a minimum tax because it was levied on a corporation's capital and not its income. Therefore, regardless of how much regular Part I tax a corporation was paying, the corporation was subject to the LCT. A corporation that had losses and was not paying any tax was still subject to the LCT. This tax was eliminated of Jan 1 2006, but must still be computed for purposes of determining eligibility for the small business deduction.

F.

G.

H.

14

ii. Provincial Taxation

A. Each province levies its own rate of tax on corporate income. Although the federal government provides "room" for a 10% rate of provincial corporate tax, the provinces are obviously free to set their own rates of tax. The rates set by the provinces vary from a low of 1% for Manitoba on active small business income (Alberta is 3% for active small business income) to a high of 16% for Nova Scotia and PEI on general corporate income. All the provinces except Alberta and Quebec allow the federal government to collect their corporate income tax and to set the rules for calculating taxable income. In these provinces, the federal Income Tax Act applies to determine taxable income and the province merely sets the rate of tax. In Alberta and Quebec, the province sets the rules for determination of taxable income and sets the rate of tax and collects the tax. However, in these two provinces the rules that calculate taxable income essentially parallel the federal Act. Alberta's corporate tax law is found in the Alberta Corporate Income Tax Act. It is 10% effective April 1, 2006. This provincial rate results in a current combined federal-provincial basic corporate tax rate for taxable income earned in the Province of Alberta after January 1, 2012 of 25% [from 38% (federal Basic Tax Rate) - 10% (provincial abatement - 13% (section 123.4 general rate reduction) + 10% (Alberta rate) = 38% - 10% - 13 % + 10% = 25%]. Allocation of Taxable Income amongst Provinces Because a corporation may earn income from more than one province, or from within one or more provinces and also from sources outside Canada, it is necessary to have a method for allocating the taxable income of such a corporation to the various provinces for tax purposes. This is accomplished by way of the formulae contained in Regulation 400 of the Income Tax Regulations, which formulae have been agreed to by the federal government and all the provinces. Under the formulae, corporations are only subject to tax in provinces in which they have a permanent establishment. If a corporation has a permanent establishment in only one province, all of its taxable income will be allocated to that province. lf it has business income from a permanent establishment in more than one province, the income is allocated to the various provinces by means of a formula. Basically, under this formula a corporation's income is allocated among the various provinces in which it has a permanent establishment on the basis of the province's share of the corporation's Canadian payroll and sales. Both these factors are given equal weight in the formula.

B.

C.

15

iii. Combined Rates of Taxation

Federal and Provincial/Territorial Tax Rates for Income Earned by a Non-Canadian Controlled Private Corporation (CCPC) Effective January 1, 2012 [a]:
General M&P Income Federal rates General corporate rate Less federal abatement Surtax Rate reductions Provincial rates British Columbia Alberta Saskatchewan Manitoba Ontario Qubec New Brunswick Nova Scotia Prince Edward Island Newfoundland 38.0% (10.0) 28.0 0.0 28.0 (13) 15 10.0% 10.0 10.0 12.0 10.0 11.9 10.0 16.0 16.0 5.0 Active Business Income 38.0% (10.0) 28.0 0.0 28.0 (13) 15 10.0% 10.0 12.0 12.0 11.5/11.0 11.9 10.0 16.0 16.0 14.0 Investment Income [b]______ 38.0% (10.0) 28.0 0.0 28.0 (13)___________ 15 10.0% 10.0 12.0 12.0 11.5/11.0 11.9 10.0 16.0 16.0 14.0

Notes: a The federal and provincial tax rates shown in the tables apply to income earned by corporations other than Canadian-controlled private corporations (CCPCs). In general, this includes public companies, and their subsidiaries, that are resident in Canada, and Canadian-resident private companies that are controlled by non-residents. b The federal and provincial tax rates shown in the tables apply to investment income earned by non-CCPCs other than gains and dividends received from Canadian corporations. The rates that apply to capital gains are one-half of the rates shown in the table. Dividends received from Canadian corporations are deductible in computing regular Part I tax, but may be subject to Part IV tax, calculated at a rate of 33[1/3]%.

Federal and Provincial/Territorial Income Tax Rates for Income Earned by a CanadianControlled Private Corporation (CCPC) Effective January 1, 2012 [a]
Small Business Income up to $500,000 Federal rates General corporate rate Less federal abatement Surtax Rate reductions Refundable tax[e] 38.0% (10.0) 28.0 0.0 28.0 (17.0) 0.0 11.0 Active Business Income $400,000 to $500,000[b] 38.0% (10.0) 28.0 0.0 28.0 (17.0) 0.0 11.0

General Active Business Income[c] 38.0% (10.0) 28.0 0.0 28.0 (13.0) 0.0 15.0

Investment Income[d] 38.0% (10.0) 28.0 0.0 28.0 0.0 6.7 34.7

16
Provincial rates British Columbia Alberta Saskatchewan Manitoba Ontario Qubec New Brunswick Nova Scotia Prince Edward Island Newfoundland

2.5/0 3.0 2.0 0.0 4.5 8.0 5.0 4.0 1.00 4.0

2.5/0 3.0 2.0 12.0 4.5 8.0 5.0 16.0 1.00 4.0

10.0 10 12.0 12.0 11.5/11.0 11.9 10.0 16.0 16.0 14.0

10.0 10.0 12.0 12.0 11.5/11.0 11.9 10.0 16.0 16.0 14.0

Notes: a The federal and provincial/territorial tax rates shown in the tables apply to income earned by a Canadian-controlled private corporation (CCPC). For tax rates applicable to non-CCPCs, see the first four tables under the Corporations heading above and their related Notes. b The varying rates are due to the fact that some provinces have not increased the small business threshold to $500,000, but rather it is somewhere between $400,000 and $500,000. c For federal purposes, the general corporate tax rate applies to active business income earned in excess of $500,000, and for provincial/territorial purposes the general rates apply to income in excess of the applicable small business income threshold. d The federal and provincial/territorial tax rates shown in the table apply to investment income earned by a CCPC other than capital gains and dividends received from Canadian corporations. The rates that apply to capital gains are onehalf of the rates shown in the table. Dividends received from Canadian corporations are deductible in computing regular Part I tax, but may be subject to Part IV tax, calculated at a rate of 33[1/3]%. e The refundable tax of 6[2/3]% of a CCPC's investment income and capital gains, as well as 20% of such income that is subject to regular Part I tax, is included in the corporation's Refundable Dividend Tax on Hand (RDTOH) account. When taxable dividends are paid out to shareholders, a dividend refund equal to the lesser of 33[1/3]% of the dividends paid or the balance in the RDTOH account is refunded to the corporation.

iv. Resident in a Province

Permanent Establishment of a Corporation in a Province - IT-177R2 (Consolidated) August 25, 1995 (This IT Bulletin still represents the current law as of January 2012) Summary In order for a corporation to have "taxable income earned in the year in a province", it is necessary to determine whether it has a permanent establishment in that province in the year. A corporation will have a permanent establishment in a province if it has a fixed place of business there. It may also have a permanent establishment in certain other circumstances, such as when it carries on business through an employee or agent, or uses substantial machinery or equipment in a province. Where a corporation has a permanent establishment in a province in a year, 10% of its taxable income earned in the year in that province may be deducted from its Part I tax otherwise payable. Discussion and Interpretation Definition 1. The term "permanent establishment" is defined in subsection 400(2) of the Regulations in connection with the determination of "taxable income earned in the year in a province" (as defined in subsection 124(4)) for purposes of the deduction under subsection 124(1).

17 Determination 2. To determine if a corporation has a permanent establishment in a province, it is necessary to see if the corporation meets any of the criteria in subsection 400(2) of the Regulations. This will often involve questions of fact which must be answered by the circumstances of each case. An establishment in a province is not a "permanent establishment" as contemplated in the Regulations unless a business is connected with it. Ownership by the corporation of a farm, timber land, factory or a workshop does not constitute a permanent establishment of the corporation unless it is used in its business. However, if a corporation otherwise has a permanent establishment in Canada and owns land in a province, such land is deemed to be a permanent establishment. For the purpose of determining whether a non-resident corporation has a business in a province, it should be noted that the deeming rules in section 253 apply. Fixed Place of Business 3. If a corporation has a fixed place of business in a province, it has a permanent establishment according to the Regulations. A fixed place of business may include a place, plant or natural resource used in the day-to-day business of the corporation. It does not mean that the place of business must exist for a long time or be located in a durable building; for instance, a temporary field office on a construction site could be a fixed place of business. Examples of fixed places of business are set out in subsection 400(2) of the Regulations but these are not exclusive nor are they absolute. A public warehouse that is used by a corporation, but that is neither owned by it nor under some measure of its control, does not constitute by itself a permanent establishment of that corporation. An office that is maintained and controlled by an employee of the corporation at the employee's choice and expense or an office that is maintained solely to purchase merchandise is not in itself deemed to be a permanent establishment of the corporation. Where a corporation does not have any fixed place of business (in or outside Canada), it will have a permanent establishment in the principal place in which the corporation's business is conducted. Employee or Agent 4. If a corporation does not have a fixed place of business in a province, it may still have a permanent establishment in the province if it satisfies any of the other criteria listed in subsection 400(2) of the Regulations. A corporation is deemed to have a permanent establishment in a particular place if it carries on business through an employee or agent established in that place with a general authority to contract on behalf of the corporation. The fact that a corporation has business dealings in a particular place through a commission agent, broker or other independent agent is not in itself enough to result in a permanent establishment. However, there is nothing in the law which excludes a commission agent, broker or other independent agent from the reference to an "agent" in the abovementioned deeming rule. Therefore, a permanent establishment would be deemed to exist in a particular place where a corporation carries on business through such an agent who is established in that place and has general authority to contract for the corporation. 5. A corporation will also be deemed to have a permanent establishment if an employee or agent, established in a particular place, has a stock of goods owned by the corporation from which the employee or agent regularly fills orders. The orders may be received directly from the corporation or may come from the customers themselves. "Regularly" is taken to mean repeatedly according to an established pattern. A corporation which transacts all its business from a source outside the province through mail order and catalogue sales and does not have a stock of goods in the province will not usually have a permanent establishment in that province. Substantial Usage of Machinery or Equipment

18 6. A corporation that uses substantial machinery or equipment in a particular place in a province will be deemed to have a permanent establishment in that province. The corporation need not own the machinery or equipment that it uses. The size, quantity and dollar value of machinery or equipment used in the particular place are some of the criteria to be considered in the determination of "substantial". A comparison of the total or type of machinery or equipment used by the corporation as a whole with that used in the particular place is not relevant. Another factor that may be taken into account in the determination is whether the said machinery or equipment contributes substantially to the generation of the gross income of the corporation earned at the particular place. The display or demonstration of machinery or equipment by an agent is not a use as contemplated by subsection 400(2) of the Regulations. A permanent establishment will not be considered to exist in a province solely by reason of the fact that a bus or truck travelled through that province. Rental Operation 7. It is a question of fact whether a rental operation constitutes the carrying on of a business or whether rents received constitute income from property. Generally, subject to the comments in the current version of IT-420, Non-Residents - Income Earned in Canada, rental income of a corporation will be considered to constitute income from a business. If a corporation has rental income from real estate that is income from a business, the corporation will have a permanent establishment in each province in which it has a rental property because each property will be considered a fixed place of business. If a corporation has rental income from other business operations, a permanent establishment for those operations may or may not exist in accordance with the rules discussed in this bulletin, depending on the facts of the case. Subsidiary of a Corporation 8. A corporation's subsidiary in a province or a subsidiary engaged in trade or business in a province does not in itself constitute a permanent establishment of the corporation. However, the subsidiary may be an agent of the corporation with general authority to contract on its behalf, in which case the corporation would be deemed to have a permanent establishment in the province (as described in 4).

3. Integration
Because we will be examining the taxation of corporate distributions made to shareholders, we must look at the rates of tax that are paid by individuals. Federally, individuals are taxed on a progressive system of tax rates. For federal tax purposes, in 2012, there are 4 tax rates as follows:

Tax Rates Federal[a] 15.00% 22.00 26.00 29.00

Tax Brackets Up to $42,707 $ 42,707 - $85,414 $85,414 - $132,406 $132,406 and over

The provinces also levy income tax. Alberta has a single rate of tax of 10% on taxable income. (Alberta is the only province or territory with a flat tax rate.) Therefore, the top combined federal-

19 provincial marginal basic rate of tax for residents of the Province of Alberta and for individuals who otherwise have income taxed by the Province of Alberta is 29% + 10% = 39%. It is important to keep in mind that your marginal rate of tax is not the average rate of tax that you pay on total income. For example a person who has taxable income of $133,000 in Alberta is subject to the top marginal rate of 39%. Notwithstanding, he or she will pays an average rate of tax of about 30% on the $133,000. This is because income in the lower brackets is taxed at a lower marginal rate. Only the amount in excess of $132, 406 is subject to the 39% rate. Minimum tax Individuals may also be subject to a minimum tax under Division E.1 of the Act (ss. 127.5 to 127.55). It is determined by applying a federal tax rate of 16% to the individual's "adjusted taxable income" as calculated pursuant to s. 127.52 less the basic minimum tax exemption for the year- currently $40,000. Minimum tax is further reduced by a basic minimum tax credit that allows for a deduction of personal tax credits. "Adjusted taxable income" is calculated by taking the individual's taxable income as calculated under the normal rules and adding back certain deductions thought to be tax shelter or tax preferences items. These include deductions for capital cost allowances on residential property which create tax losses, the portion of capital gains which are not subject to taxation and losses created from the deduction of certain resource expenses. Minimum tax is only payable if the federal tax otherwise calculated is less than the minimum tax. If minimum tax is payable, the difference between the minimum tax and the tax otherwise payable can be carried forward for up to 7 years and used to reduce tax in those years that is in excess of the minimum tax for those years.

Integration & The Tax Treatment of Income

We will be comparing the taxation of income earned by an individual personally with the tax treatment of income earned through a corporation and then distributed to the shareholders as dividends. Corporate income is first subject to corporate tax. The corporate tax rate will vary depending on whether the corporation is eligible for the small business deduction. As we have seen the rate of corporate tax in 2012 varies. The general corporate rate is 25% but that rate is reduced to 14% in Alberta if the corporation is eligible for the small business deduction. The after tax amount retained by the corporation is then distributed to the shareholders. The shareholders are also subject to tax on the taxable dividends they receive. It is easy to understand how these two layers of tax ( corporate and personal) could lead to double taxation of the same income. This issue of double taxation has led to significant reforms to the Canadian tax system over the past decade including the introduction in 2006 of special rules for eligible dividends. (see discussion following the chart.) One of the important factors triggering the reform was the conversion by many corporations to business trusts. The reason for the conversion was that it eliminated the corporate tax and with it the element of double taxation associated with corporate earnings. Because many business decisions are motivated by tax factors it is very important to have a clear idea of how income is taxed if it is earned personally or through a corporate vehicle. This will help to make effective decisions about where the income should be earned. Factors such as tax deferral must also be considered. The following Table provides a summary overview of how ordinary income, capital gains and dividend income will be taxed if earned by an individual personally who is in the top tax bracket. These rates should be kept in mind compared with the applicable corporate tax rates.

20

Top Tax Rates for Individuals on Income, Taxable Capital Gains and Eligible and Ineligible Dividends
Ordinary Income $ $ $ $ $ 100.00 100.00 Taxable Capital gains Eligible Income Earned Directly Dividends From Corporation Less Capital Dividend Dividend Gross Up (38% and 25%) Taxable Income Federal Top Rate DTC (6/11 and 2/3) Total Federal Tax Alberta Basic Rate DTC 10% or 3.5% Total Provincial Tax Total Individual Tax TOTAL TAX After Tax Income $ $ $ $ $ $ 10.00 10.00 39.00 39.00 61.00 # # $ $ $ $ $ $ 5.00 5.00 19.50 19.50 80.50 # # $ $ $ $ $ $ 13.80 (13.80) 0 19.29 19.29 80.71 # # # $ $ $ $ $ $ 12.50 (4.38) 8.12 27.71 27.71 72.29 $ $ $ 29.00 29.00 $ $ $ 14.50 14.50 $ $ $ 40.02 (20.73) 19.29 $ $ $ 36.25 (16.66) 19.59 $ $ $ $ $ 50.00 50.00 $ $ $ $ $ 100.00 38.00 138.00

INDIVIDUAL Tax Rates 2012

Dividends ineligible $ $ $ $ $ 100.00 25.0 125.00

Enhancement to the Dividend Tax Credit (Background Technical Notes: 2006 Federal Budget) Note: This is the explanation for the introduction of the enhanced dividend tax credit for eligible dividends. The actual rates in 2012 are lower as the corporate tax rate has dropped. In an attempt to address the perceived tax burden associated with dividends received by individuals and paid by Canadian corporations out of after-tax dollars, the 2006 Budget introduced an enhanced dividend gross-up and tax credit regime for eligible dividends. The enhanced system aims to level the playing field between income trusts and corporations, by reducing the double taxation that occurs when income is taxed once at the corporate level and again when distributed to shareholders. Dividends paid by taxable Canadian corporations and received by individuals are currently subject to a 25% gross-up, resulting in 125% of the amount of the dividend being included in the income of the recipient. This grossed-up amount is then taxed at a combined federal-provincial rate of approximately 46%. Taking into account the current dividend tax credit of 13%, which allows an individual to claim a credit against tax payable approximately equal to the grossed-up amount, the result is a combined effective rate of tax on such income of approximately 54%. This clearly exceeds the top personal rate in Alberta, which is 39% and the top rate in the other provinces.

21 The Budget increases the gross-up on eligible dividends to 45%, resulting in 145% of the amount of the dividend being included in income. The dividend tax credit is correspondingly increased to 19%, resulting in an effective total rate of federal and provincial tax payable by the corporation and the individual of approximately 46% - the same rate of tax as income distributed by an income trust to an individual in Ontario. The enhanced system will apply to dividends paid after 2005 by public corporations (and other corporations that are not CCPCs) resident in Canada that are subject to the general corporate income tax rate. Dividends paid by CCPCs will only be considered eligible dividends to the extent that such dividends are paid out of business income taxed at the general corporate rate. Dividends paid by a CCPC out of investment income or income that is taxed at preferential rates (which apply to certain types and amounts of income of such corporations) are not eligible for the enhanced tax credit system. The enhanced system will include special rules that would apply where a corporation becomes or ceases to be taxable at the general corporate tax rate, and to ensure that dividends retain their character as eligible dividends or as non-eligible dividends when paid through one or more corporations. For CCPCs, detailed and potentially complex rules may be required in order to trace the source of income and determine the eligibility of dividends for the enhanced gross-up and tax credit regime. In order for these proposals to fully achieve their desired effect, it was expected that the provinces would provide corresponding adjustments in their provincial tax imposed on dividends.

Alberta Dividend Tax Rates Eligible dividends Alberta's enhanced dividend tax credit for eligible dividends is stated as a portion of the Federal gross-up on the dividends. The Federal gross-up was reduced each year until 2012. The Alberta portion of the gross-up is being increased each year, in order to keep the dividend tax credit at 10% of the taxable dividend. The amount included in taxable income is the actual dividend plus the gross-up.

Alberta Dividend Tax Credit Rate on Eligible Dividends

Year 2009 2010 2011 2012 Grossup % 45% 44% 41% 38% Portion of Gross-up 29/90 = 32.222% 18/55 = 32.727% 141/410 = 34.390% 69/190 = 36.316% % of Grossed-up Dividend 10% 10% 10% 10% % of Actual Dividend 14.50% 14.4% 14.1% 13.8%

The provincial tax credit is 6/11 of the gross up amount. The result is that on a $100 taxable dividend the Alberta tax payable is $13.80 if the taxpayer is in the top tax bracket. The gross up and tax credit offset each other. The top combined federal provincial tax rate is 19.29%.

22

Non-eligible, or small business dividends These dividends are grossed-up by 25% to calculate the taxable amount of the dividend. The Alberta Personal Income Tax Act defines the dividend tax credit for these dividends as 7/40ths of the Federal gross-up. For 2009 and later years, the dividend tax credit rate for non-eligible dividends is 3.5% of the grossed-up taxable dividend, and 4.375% of the actual dividend

The following shows the combined corporate and personal tax rates on after tax corporate income distributed to taxpayers in the top tax bracket in 2012. As can be seen active business income earned through a corporation and distributed receives a marginal tax advantage 37.86% tax vs. 39% when income is taxed at the small business tax rate. A capital gain in contrast results in $79.64 in after tax income. If earned directly an individual in the top tax bracket would have $80.50 in after tax income. Investment income is also subject to a higher tax rate when earned through a private corporation and distributed to a shareholder in the top tax bracket.
Combined Corporate and Individual Tax Rates 2012 Non-CCPC Ordinary Income CORPORATE TAX Gross Income Taxable Income Federal Basic Rate Provincial Abatement Small Business Deduction Rate Reduction Federal Surtax CCPC Investment Tax Part IV tax Total Federal Tax Alberta Basic Rate Small Business $ $ 10.00 $ $ 5.00 $ $ $ $ 10.00 $ 5.00 $ $ $ 10.00 (7.00) $ 38.00 $ $ $ $ (13.00) $ $ $ $ 19.00 (5.00) (6.50) 7.50 $ $ $ $ $ $ $ 38.00 $ $ $ $ $ $ $ 3.34 $ $ 17.34 19.00 (5.00) $ $ $ $ $ $ $ $ (17.00) 11.00 38.00 $ $ 100.00 100.00 $ $ 100.00 50.00 $ $ 100.00 100.00 $ $ 100.00 100.00 $ 100.00 $ 50.00 $ $ 100.00 100.00 Capital Gains(public) Portfolio Dividends (private) CCPC Investment Income Capital Gains Eligible for SBD

$ (10.00) $ $ $ $ $ $ 15.00

$ (10.00) $ $ $ $ $ $ 34.67 6.67 -

$ 33.33 $ 33.33

23

Deduction Total Provincial Tax Gross Corporate Tax RDTOH (fully recovered) Total Corporate Tax Available for Distribution INDIVIDUAL TAX Income Earned Directly Dividends From Corporation Less Capital Dividend Dividend Gross Up (38%; 25%) Taxable Income Federal Top Rate DTC Total Federal Tax Alberta Basic Rate DTC (10% of gross-up dividend or 3.5% of gross-up dividend) Total Provincial Tax Total Individual Tax TOTAL TAX After Tax Income $ $ $ $ 14.47 $ $ 39.47 60.53 10.35 (10.35) 0 $ $ $ $ $ $ 12.07 (12.07) 0 16.88 29.38 70.62 $ $ $ $ $ $ 13.80 (13.80) 0 19.03 19.03 80.97 $ 10.25 $ 5.12 $ (1.79) $ 3.33 $ 11.36 $ 20.36 $ 79.64 $ $ $ $ $ $ 10.75 (3.76) 6.99 23.84 37.84 62.16 $ 30.01 $ $ $ 35.01 (18.13) 16.88 $ 40.02 $ 29.72 $ 14.86 $ (6.83) $ 8.03 $ 31.17 $ $ $ $ $ 75.00 28.50 103.50 $ $ $ $ $ 87.50 33.25 120.75 $ $ $ $ $ 100.00 38.00 138.00 $ $ $ $ $ 82.00 20.50 102.50 $ $ 91.00 $ $ $ $ $ 86.00 21.50 107.50 $ 10.00 $ $ $ 25.00 $ 75.00 25.00 $ $ $ $ $ 5.00 12.50 12.50 87.50 $ $ $ $ $ 33.33 (33.33) 100.00 $ 10.00 $ $ 44.67 (26.67) $ 5.00 $ $ $ 9.00 82.00 $ 91.00 22.34 (13.34) $ 3.00 $ $ $ 14.00 $ 86.00 14.00 -

$ 18.00 $

$ (50.00) $ 10.25 $ 51.25

$ (15.54) $ 14.47

$ (20.72) $ 19.03

$ (13.66) $ 16.06

$ (14.32) $ 16.85

$ (3.58) $ 6.67 $ 22.73 $ $ 40.73 59.27

II. Classification of Corporations for Tax Purposes

1. Status of Corporations
The Income Tax Act differentiates between different types of corporations for Canadian tax purposes. Different tax rates will apply depending on whether a corporation is classified as a a public corporation, a private corporation, or a Canadian-controlled private corporation.

24

Interpretation Bulletin IT-391R - Status of Corporations

Summary The tax treatment of corporations depends not only on the type of income earned by a corporation and the method of distribution to shareholders, but also on whether the corporation is classed as private or public. This bulletin discusses the definitions of private corporation and public corporation. The issue of corporate residence is also discussed, since both the definitions of private corporation and public corporation require that the corporation be resident in Canada. Although a corporation is generally either a private corporation or a public corporation, there are circumstances where it may be neither. Discussion and Interpretation 1. A "private corporation" is defined in paragraph 89(1)(f) to be a corporation that is: (a) resident in Canada (see 15 and 16 below); (b) not a public corporation; and (c) not controlled by: (i) one or more public corporations (other than prescribed venture capital corporations after July 13, 1990); (ii) one or more prescribed federal Crown corporations after July 13, 1990; or (iii) any combination of (i) and (ii). For the purposes of (i) and (ii) above, prescribed venture capital corporations are described in section 6700 of the Regulations and prescribed federal Crown corporations are listed in section 7100 of the Regulations. 2. In order for a corporation to be a public corporation it must be resident in Canada at the time of determination. It may then qualify as a public corporation under paragraph 89(1)(g) if it: (a) as a class or classes of shares listed on one of the following prescribed stock exchanges (section 3200 of the Regulations): Alberta, Montreal, Toronto, Vancouver and Winnipeg; [Note that after December 13, 2007, the term prescribed stock exchange was replaced with designated stock exchange but there is no substantive effect from this change.] (b) elects on Form T2073 to be a public corporation (89(1)(g)(ii)(A)); (c) is designated to be a public corporation (89(1)(g)(ii)(B)); or (d) is a public corporation anytime after June 18, 1971 (e.g. it was formerly listed on a prescribed stock exchange) (89(1)(g)(iii)). To qualify as a public corporation by election or designation ((b) and (c) above), the corporation must comply with the prescribed conditions listed in subsection 4800(1) of the Regulations regarding the number of its shareholders, dispersal of ownership of it shares, public trading of its shares and the size of the corporation. A corporation may also elect (Form T2067), or be designated, not to be a public corporation if it meets the prescribed conditions listed in subsection 4800(2) of the Regulations. When filing an election under clause 89(1)(g) (ii)(A) (to be a public corporation) or under clause 89(1)(g)(iii)(A) (not to be a public corporation), the requirements of subsection 4800(4) of the Regulations must be met.

25 6. Sometimes, a public corporation is controlled by a private corporation but, by definition, a private corporation cannot be controlled by a public corporation. However, if the parent of a Canadian resident subsidiary corporation is not resident in Canada, the parent cannot be a public corporation no matter how widely its shares are publicly traded, even if they are also traded on Canadian stock exchanges. Therefore, it is possible for the Canadian resident subsidiary to qualify as a private corporation since it is not controlled by a public corporation. In certain cases, it is possible for a Canadian resident corporation to be neither a private corporation nor a public corporation. For example, a Canadian resident corporation falls into this category if it fails to meet the requirements for qualification as a public corporation under paragraph 89(1)(g) and it is also disqualified as a private corporation because it is controlled by a public corporation. Such a corporation is therefore not entitled to any special treatment that applies to private corporations or to public corporations. The Act contains various deeming provisions regarding the status of corporations. For instance, certain federal Crown corporations are deemed not to be private corporations pursuant to subsection 27(2). However, unless they otherwise qualify as public corporations, the deeming provision does not by itself cause them to be public corporations for tax purposes. Certain non-resident-owned investment corporations are deemed by section 134 not to be private corporations except for the purposes of sections 87, 212.1 and 219 and subsection 88(2). Credit unions, cooperative corporations and general insurers that otherwise would be private corporations are similarly deemed not to be private corporations by subsections 137(7) and 136(1), and section 141.1, respectively, except for certain purposes of the Act including the small business deduction under section 125. Here again, these corporations do not necessarily become public corporations even though they are deemed not to be private corporations. On the other hand, mortgage investment corporations (as defined under subsection 130.1(6)) and life insurers (as defined in subsection 248(1)) that are resident in Canada, are deemed to be public corporations by virtue of subsection 130.1(5) and section 141 respectively. For a corporation to qualify as an investment corporation under subsection 130(3) or as a mutual fund corporation under subsection 131(8) it must be a public corporation. Ordinarily, closed-end mutual fund companies are not public corporations and therefore do not qualify as mutual fund corporations. A corporation that ceases to be a private corporation will no longer be able to elect for the payment of capital dividends under subsection 83(2). In addition, the source of such dividends, the capital dividend account as defined in paragraph 89(1)(b), will be lost for this purpose, to the extent that it was not used up prior to the change of status.

7.

8.

9.

10.

11.

2. The Meaning of "Control"

The concept of control is fundamental to the classification of corporations for Canadian tax purposes. Control is relevant to determining whether or not two corporations are considered associated for purposes of the Act. Association status of corporations is of relevance for the small business deduction, the determination of refundable dividend tax on hand, and other provisions in the Act.

26

i. Common Law Principles

a. b. c. d. e. Buckerfield v. M.N.R. Vineland Quarries and Crushed Stone v. M.N.R. Donald Applicators Ltd. v. M.N.R. Duha Printers Ltd. v. The Queen Transport M.L. Couture Inc.v. R.

Many of the definitions of corporations described in the Act focus on who controls the corporation. In addition, many of the provisions describing whether corporations are related, associated, affiliated or dealing at arm's length also refer to the control issue. Not surprisingly, the common law is well developed in determining when control exists. In addition, and for the purposes of several provisions in the Act, the term "controlled directly or indirectly in any manner whatever" may be found. Review for example the definition of Canadian controlled private corporation in para. 125(7)(b). Clearly this expression has a broader meaning than when the word control alone is used. It is further supplemented by a statutory de facto test (see s. 256(5.1)). There are also special statutory rules to determine "control" in particular situations. For example, a supplemental statutory definition of control is found in the associated corporation rules in s. 256. Still other definitions may be found in the provisions dealing with connected corporations for the purpose of determining liability for Part IV tax (see ss. 186(2) and (4)). The starting point, regardless of which additional statutory provisions are added is the common law definitions of "control". In summary it means legal or "de jure" control, or more simply "ownership of such a number of shares as carries with it the right to a majority of the votes in the election of the Board of Directors". The following decisions discuss the common law meaning of "control". a. De Jure Control

Buckerfields Limited et al. v. M.N.R.

[1964] C.T.C. 504, [1965] 1 Ex. C.R. 299, 64 D.T.C. 5301 One-half of the shares of Buckerfield's belonged to Pioneer Grain Co. Ltd. and one-half to Federal Grain Co. The latter companies also each owned one-half of the shares of Green Valley. These shares were acquired under an agreement in which "Pioneer" and "Federal" would nominate equal numbers to the boards of directors, would co-operate in the management of the companies, and would each have the right of first refusal in respect of the shares owned by the other. The facts relating to "Westland" and "Burrard" were similar, except that there one-third of the shares were owned by each of Pioneer Grain Co., Alberta Pacific Grain Co. (1943) Ltd. and Searle Grain Co. Ltd. It was contended for the appellants that the word "group" did not include any number of persons less than four and that the word in Section 39 (4) implied a group which came together to take advantage of the low rate of tax under Section 39 and not a group which came together for any other purpose. HELD:

27 (i) That "control" within the meaning of Section 39(4)(b) contemplated that right of control that rested in ownership of such number of shares as carried with it the right to a majority of the votes in the election of the board of directors That when a single person did not own sufficient shares to have control in that sense, it became a question of fact whether any "group of persons" did own such number of shares; That "group" could refer to any number of persons from two to infinity and there was nothing in Section 39(4) to suggest any intention to omit any of them; moreover, any such omission of particular numbers would be an obvious gap in the legislative scheme; That "group", as used in Section 39(4), did not imply a group that came together specifically to take advantage of the low rate of tax; That the appeals be dismissed.

(ii) (iii)

(iv) (v)

Jackett, P.: 1. I shall deliver a single set of reasons for judgment in Buckerfield's Limited v. M.N.R., Green Valley Fertilizer & Chemical Co. Ltd. v. M.N.R., Westland Elevators Limited v. M.N.R. and Burrard Terminals Limited v. M.N.R. These four appeals in each case are appeals against the assessments of the respective appellants under the Income Tax Act for the 1961 taxation year. The appellant in each case challenges the assessment on the ground that the Minister erred when, in making the assessment, he assumed that the appellant and another company were "associated with each other" in 1961 within the meaning of these words in subsection (2) of Section 39 of the Income Tax Act. As the Minister's assumption was that Buckerfield's Limited (hereinafter referred to as "Buckerfield's") was associated with Green Valley Fertilizer & Chemical Company Limited (hereinafter referred to as "Green Valley"), the questions in the appeals of those two companies are identical and those appeals were therefore heard together. Similarly, as the Minister's assumption was that Burrard Terminals Limited (hereinafter referred to as "Burrard") was associated with Westland Elevators Limited (hereinafter referred to as "Westland"), the questions in the appeals of those two companies are identical and those appeals were therefore heard together. The argument submitted in support of the appeal is the same in all four cases. In 1961, one-half of the issued shares of Buckerfield's belonged to Pioneer Grain Company Limited (hereinafter referred to as "Pioneer") and one-half belonged to Federal Grain Company (hereinafter referred to as "Federal"). The same two companies each owned onehalf of the issued shares of Green Valley. The shares in Buckerfield's were acquired by Pioneer and Federal under written agreement dated December 24, 1951, under which they agreed in effect, a. b. that their share holdings in Buckerfield's were to be maintained at the same level, that, notwithstanding the number of shares held or controlled by either of them, each of them was to have "an equal voice ... in the control and operation of Buckerfield's",

2.

3.

4. 5.

28

c. d. e.

that each of them was to be entitled to nominate 50 per cent of the board of directors of Buckerfield's, that "the management of Buckerfield's ... shall be such as shall at all times ... be acceptable to both parties", and that each of them should have a right of first refusal in respect of the other's shares in Buckerfield's.

The parties had verbally agreed to the same terms in relation to Green Valley. Buckerfield and Green Valley were controlled in accordance with the respective agreements. 6. The basic facts in respect of Burrard and Westland were in substance the same as the basic facts that I have just recited in relation to Buckerfield's and Green Valley except that, in the case of Burrard, its shares were held one-third by Pioneer, one-third by The Alberta Pacific Grain Company (1943) Limited (a wholly owned subsidiary of Federal hereinafter referred to as "Alberta Pacific") and one-third by Searle Grain Company Limited (hereinafter referred to as "Searle"), and, in the case of Westland, its shares were held one-third by Federal, one-third by Pioneer and one-third by Searle. Buckerfield's and Green Valley were each carrying on a business unrelated to the businesses of their shareholders. They both sold, among other things, fertilizer, and were in active competition with each other. There seems to have been no reason for acquisition of their shares by Pioneer and Federal except that the shares were regarded as a good investment. Burrard and Westland, on the other hand, operated terminal elevators and had facilities which, at certain seasons of the year, were of some considerable importance to the three companies which had acquired their shares. Apart from their mutual interests in the appellant companies, the evidence is that Pioneer, Federal and Searle are vigorous competitors. They are each in the grain business in Western Canada and operate completely independently of each other. The evidence is further that, in three cases at least, the management of the appellants is left to the officers employed for the purpose and that there is, in fact, no control exercised over the management of the appellants by Pioneer, Federal or Searle or by any one or more of them acting in combination. On these facts, the question to be determined in each appeal arises under Section 39 of the Income Tax Act as applicable to the 1961 taxation year. That section reads in part as follows: "39. (1) The tax payable by a corporation under this Part upon its taxable income or taxable income earned in Canada, as the case may be, (in this section referred to as the 'amount taxable') for a taxation year is, except where otherwise provided, a. b. 18% of the amount taxable, if the amount taxable does not exceed $35,000, and $6,300 plus 47% of the amount by which the amount taxable exceeds $35,000, if the amount taxable exceeds $35,000. (2) Where two or more corporations are associated with each other in a taxation year, the tax payable by each of them under this Part for the year is, except where otherwise provided by another section, 47% of the amount taxable for the year.

7.

8.

9.

29 ..... (4) For the purpose of this section, one corporation is associated with another in a taxation year if, at any time in the year, ..... c. both of the corporations were controlled by the same person or group of persons," The question in the one set of appeals is simply whether Buckerfield's and Green Valley are "controlled by the same ... group of persons" within the meaning of those words in Section 39(4)(b) and the question in the other set of appeals is whether Burrard and Westland are "controlled by the same ...group of persons" within the meaning of those words in Section 39(4)(b). 10. Many approaches might conceivably be adopted in applying the word "control" in a statute such as the Income Tax Act to a corporation. It might, for example, refer to control by "management", where management and the board of directors are separate, or it might refer to control by the board of directors. The kind of control exercised by management officials or the board of directors is, however, clearly not intended by Section 39 when it contemplates control of one corporation by another as well as control of a corporation by individuals (see subsection (6) of Section 39). The word "control" might conceivably refer to de facto control by one or more shareholders whether or not they hold a majority of shares. I am of the view, however, that in Section 39 of the Income Tax Act, the word "controlled" contemplates the right of control that rests in ownership of such a number of shares as carries with it the right to a majority of the votes in the election of the board of directors. See British American Tobacco Co. v. C.I.R., [1943] 1 All E.R. 13, where Viscount Simon, L.C., at page 15, says: "The owners of the majority of the voting power in a company are the persons who are in effective control of its affairs and fortunes." See also M.N.R. v. Wrights' Canadian Ropes, Ltd., [1947] A.C. 109; [1947] C.T.C. 1, per Lord Greene, M.R., at pages 118, 6, where it was held that the mere fact that one corporation had less than 50 per cent of the shares of another was "conclusive" that the one corporation was not "controlled" by the other within Section 6 of the Income War Tax Act. 11. Where, in the application of Section 39(4), a single person does not own sufficient shares to have control in the sense to which I have just referred, it becomes a question of fact as to whether any "group of persons" does own such a number of shares. In these appeals, there is no doubt that Pioneer and Federal, in the one pair of appeals, and Pioneer, Federal (including its subsidiary Alberta Pacific) and Searle, in the other pair of appeals, have control of the two appellants. If Pioneer and Federal are, in relation to the ownership of the shares of Buckerfield's and Green Valley, aptly described by the words, "group of persons", Buckerfield's and Green Valley are "associated with each other" within the meaning of those words in Section 39(2). Similarly, if Pioneer, Federal (including its subsidiary Alberta Pacific) and Searle are, in relation to the ownership of the shares of Burrard and Westland, aptly described by the words "group of persons", Burrard and Westland are "associated with each other" within the meaning of those words in Section 39(2). The applicable sense of the word "group" as defined by the Shorter Oxford English Dictionary (1959) is "2. gen. An assemblage of objects standing near together, and forming a collective

12.

13.

30 unity; a knot (of people), a cluster (of things). In early use there is often a notion of confused aggregation." The only other sense that might be applicable is "3. A number of persons or things in a certain relation, or having a certain degree of similarity." 14. Counsel for the appellants referred to other dictionary definitions but I do not find any conflict among them. Apart from the argument on these appeals, the phrase "group of persons" is apt to encompass the companies holding the shares of Buckerfield's and Green Valley or the companies holding the shares of Burrard and Westland, within my understanding of the meaning of that phrase whether or not I seek the aid of dictionaries. Counsel for the appellants, however, put forward two submissions. These two submissions, as I understand them, are a. b. that the word "group" in its ordinary sense does not include any number of persons less than four; and in Section 39(4), the word "group" means a group of persons who come together to take advantage of the low rate of tax under Section 39 and not a group of persons who come together for any other particular common purpose.

15.

16.

In support of the first of these two submissions, as I understand him, counsel submitted that, if Parliament had intended to include two, reference would have been made to a couple or a pair and, if it had intended to include three, reference would have been made to a trio. I cannot accept this submission. The word "group" in its ordinary meaning, as I understand it, can refer to any number of persons from two to infinity. There is nothing in Section 39(4) to suggest that there is any intention to omit any of them. Any omission of particular numbers would be, moreover, an obvious gap in the legislative scheme. I have equal difficulty in appreciating the force of counsel's other submission. It is that, in Section 39(4) "group" means a group of persons who come together to take advantage of the low rates of tax under Section 39. I have difficulty in conceiving of a group of shareholders holding shares in two or more companies having joined together in their share holdings in order to get the benefit of the lower tax rate in Section 39. The course of action that Section 39 has been designed to discourage is the multiplication of corporations carrying on a business in order to get greater advantage from the lower tax rate. If a group were a party to such activity, presumably it would, as a group, have controlled a single company carrying on the business before the business was divided among a number of companies each controlled by the group. In such a case, the group would not have come together for the purpose of getting the low rate under Section 39. Indeed, I can conceive of no case in which the group would have come together for that purpose. In any event, I am unable to appreciate the cogency of the argument in support of the submission that such an artificial limitation should be read into Section 39(4) so as to cut down the ambit of the clear words of that subsection. The appeals are dismissed with costs.

17.

18.

Judgment accordingly. The Buckerfields test is still applicable today. Take for example, Mimetix Pharmaceuticals Inc., [2002] 1 C.T.C. 2188 (TCC) affd [2003] 3 C.T.C. 72 (FCA), where it was held that a US company was

31 the controlling mind of a Canadian corporation despite that the US company only owned 50% of the Canadian corporation. There was a three-person board of directors, but it was found that only the non-resident director exercised any control over the affairs and day-to-day operations of the taxpayer. Therefore the US company was found to exercise de facto control because the US director made or approved all key decisions for the Canadian corporation. In addition, the US corporation was viewed as exerting a form of economic controlling influence over the Canadian corporation. b. Control Through a Corporate Entity The following decision further extends the meaning of "control" under the common law test to include control through a corporate entity.

Vineland Quarries and Crushed Stone Ltd. v. M.N.R.

[1966] C.T.C. 69 , [1966] Ex. C.R. 417, 66 D.T.C. 5092 The appellant was one of a group of three corporations which the Minister regarded as "associated corporations" within the meaning of Section 39 of the Act. The relationship among the three corporations was as indicated by the following schedule showing the ownership of their voting shares: Appellant--50% by S and 50% by corporation controlled by T; S & T --50% by corporation controlled by S and 50% by T; Verben --50% by S and 50% by T.

In the Minister's view all three corporations were controlled by "the same group of persons", namely, the individuals S and T, notwithstanding the interposition of the corporations controlled by one or other of them, as indicated. That is, the appellant was controlled 50-50 by S (directly) and T (indirectly, through his control of the corporation which owned 50% of the appellant's voting shares). The appellant, on the other hand, looked only to the direct share ownership and took the view that the persons who controlled it were not S and T but S and a corporation, who comprised a different "group" from that which controlled the other two corporations, so that "association" was not established. The appellant thus challenged the right of the Minister to "look through" the interposing companies and to impute ultimate control to their shareholders. HELD: (i) That "controlled" in Section 39(4)(b) contemplated and included such a relationship as, in fact, brought about a control by virtue of majority voting power, no matter how that result was effected, that is, either directly or indirectly; That it was inappropriate to end the inquiry after looking at the share registers of the three corporations; it was necessary to look in turn at the share registers of their corporate shareholders to obtain an answer to the inquiry whether the appellant and the two other corporations were controlled by "the same group of persons"; That the Minister was right in assuming that the appellant and the other two corporations were all controlled by the individuals S and T and the corporations were therefore "associated corporations" within the meaning of Section 39;

(ii)

(iii)

32 (iv) That the appeal be dismissed.

Cattanach, J.: 1 2 These appeals are against assessments by the Minister under the Income Tax Act of the incomes of the appellant for its 1961 and 1962 taxation years. Prior to the hearing the parties agreed upon a statement of facts which is reproduced hereunder:
"AGREED STATEMENT OF FACTS The Appellant and the Respondent hereby admit the several facts respectively hereunder specified but these admissions are made for the purpose of this appeal only and may not be used against either party on any other occasion or by any other than the Appellant and the Respondent. The parties reserve the right to object to the admissibility of any or all of the said facts on the ground that they are not relevant or material to any of the issues to be determined in this appeal: 1. In this agreed Statement of Facts the parties will refer to five different corporations and their names will be abbreviated as follows: (a) (b) (c) (d) (e) 2. VINELAND QUARRIES AND CRUSHED STONE LIMITED (hereinafter referred to as 'Vineland'); SAUDER AND THORNBORROW LIMITED (hereinafter referred to as 'S. & T.'); VERBEN TANK LINES LIMITED (hereinafter referred to as 'Verben'); MCMASTER INVESTMENTS LIMITED (hereinafter referred to as 'McMaster'); and BOLD INVESTMENTS (HAMILTON) LIMITED (hereinafter referred to as 'Bold').

Vineland adopted the 31st day of December in each year as the end of its fiscal period, and its taxation years 1961 and 1962 are under appeal herein. All references with respect to the ownership of shares in any or all of the above five corporations will relate to the taxation years of Vineland which are under appeal herein: namely, the calendar years 1961 and 1962. Vineland was incorporated under the laws of the Province of Ontario on the 13th day of December, 1957, having its head office in the City of Hamilton in the Province of Ontario. At all relevant times, there were issued 2,400 preference shares of Vineland and 25,000 common shares of Vineland. The non-voting preference shares were registered in the name of and beneficially owned by Benjamin Sauder as to one-half (1,200) and Vernon Thornborrow as to one-half (1,200). During 1961 and 1962, the voting common shares of Vineland were owned as to one-half (12,500) by or for the benefit of Benjamin Sauder; and the remaining one-half (12,500) were owned by or for the benefit of Bold. Bold was incorporated under the laws of the Province of Ontario on the 28th day of December, 1959 and, throughout 1961 and 1962, Bold was controlled by Vernon Thornborrow through his ownership of more than one-half of its voting share capital. During 1961 and 1962, all of the issued shares of Bold were owned by or for the benefit of Vernon Thornborrow. S. & T. was incorporated under the laws of the Province of Ontario on the 27th day of December, 1950, having its head office in the City of Hamilton in the Province of Ontario. At all relevant times, there were issued 4,000 voting common shares of S. & T. During 1961 and 1962, the voting common shares of S. & T. were owned as to one-half (2,000) by or for the benefit of Vernon Thornborrow; and the remaining one-half (2,000) were owned by or for the benefit of McMaster. McMaster was incorporated under the laws of the Province of Ontario on the 12th day of February, 1959 and, throughout 1961 and 1962, McMaster was controlled by Benjamin Sauder through his ownership of

3. 4.

5.

6. 7.

8.

33
more than one-half of its voting share capital. During 1961 and 1962, all of the issued shares of McMaster were owned by or for the benefit of Benjamin Sauder. 9. 10. Verben was incorporated under the laws of the Province of Ontario on the 9th day of March, 1959, having its head office in the City of Hamilton in the Province of Ontario. At all relevant times, there were issued 1,000 voting common shares of Verben. During 1961 and 1962, the voting common shares of Verben were owned as to one-half (500) by or for the benefit of Benjamin Sauder; and the remaining one-half (500) were owned by or for the benefit of Vernon Thornborrow. Vernon Thornborrow referred to in paragraphs 4, 5, 7 and 10 above is one and the same person. Benjamin Sauder referred to in paragraphs 4, 8 and 10 above is one and the same person. Vernon Thornborrow and Benjamin Sauder are not related in any way and more particularly are not related persons within the meaning of the Income Tax Act, R.S.C. 1952, Chapter 148, as amended. Vineland carries on the business of extracting gravel and crushed stone from quarries in Ontario for processing and sale. S. & T. carries on the business of distribution and sale of fuel oil for domestic and commercial use. Verben carries on the business of leasing tank trucks for the delivery of fuel oil. In terms of gallonage, about 95% of Verben's total business in 1961 and 1962 was derived from the leasing of tank trucks to S. & T. Verben did not employ any individuals in 1961 and 1962 other than Benjamin Sauder and Vernon Thornborrow. By Notices of Assessment dated May 12, 1964, the Minister of National Revenue assessed income tax against Vineland for the 1961 and 1962 taxation years on the basis that Vineland was associated with Verben and S. & T. within the meaning of subsections (2), (3), (4) and (5) of Section 39 of the Income Tax Act, R.S.C. 1952, Chapter 148. Attached hereto as Exhibit 1 and forming part of this Agreed Statement of Facts is a true copy of an agreement made the 15th day of December, 1960, between Benjamin Sauder, Bold and Vernon Thornborrow. The Appellant and the Respondent agree to admit Exhibit 1 as part of the evidence without formal proof upon the hearing of this appeal. Attached hereto as Exhibit 2 and forming part of this Agreed Statement of Facts is a true copy of an agreement made the 15th day of December, 1960, between Vernon Thornborrow, McMaster and Benjamin Sauder. The Appellant and the Respondent agree to admit Exhibit 2 as part of the evidence without formal proof upon the hearing of this appeal. Attached hereto as Exhibit 3 and forming part of this Agreed Statement of Facts is a true copy of an agreement made the 15th day of December, 1960, between Benjamin Sauder and Vernon Thornborrow. The Appellant and the Respondent agree to admit Exhibit 3 as part of the evidence without formal proof upon the hearing of this appeal. Attached hereto as Exhibits 4(a) and 4(b) and forming part of this Agreed Statement of Facts are the financial statements of S. & T. for the taxation years 1961 and 1962 respectively. The Appellant and the Respondent agree to admit Exhibits 4(a) and 4(b) as part of the evidence without formal proof upon the hearing of this appeal. Attached hereto as Exhibits 5(a) and 5(b) and forming part of this Agreed Statement of Facts are the financial statements of Verben for the taxation years 1961 and 1962 respectively. The Appellant and the Respondent agree to admit Exhibits 5(a) and 5(b) as part of the evidence without formal proof upon the hearing of this appeal.

11.

12. 13. 14.

15.

16.

17.

18.

19.

20.

THE PARTIES HERETO reserve the right to call such further and other evidence as Counsel may advise."

3.

Appended to the Agreed Statement of Facts were Exhibits 1, 2 and 3 being agreement between (1) Benjamin Sauder, Bold Investments (Hamilton) Limited and Vernon Thornborrow, (2) Vernon Thornborrow, McMaster Investments Limited and Benjamin Sauder, and (3)

34 Benjamin Sauder and Vernon Thornborrow. Each of the three agreements is dated December 15, 1960. 4. The agreement being Exhibit 1, relates to the appellant company, the agreement being Exhibit 2, relates to Sauder and Thornborrow Limited and the agreement being Exhibit 3, relates to Verben Tank Lines Limited. Also appended to the Agreed Statement of Facts are Exhibits 4(a) and (b) and Exhibits 5(a) and (b) being the financial statements of Sauder and Thornborrow Limited for its 1961 and 1962 fiscal years and the financial statements of Verben Tank Lines Limited for its 1961 and 1962 fiscal years respectively. The three agreements are substantially identical to all intents and purposes. Each agreement contains a clause that no party thereto shall vote or cause to be voted as to cause any resolution to be passed or by-law enacted or business to be transacted by the company to which the agreement relates except with the consent and approval of all parties thereto. If a breach occurs it is provided that the offending party shall be responsible in damages. Each agreement also includes provisions respecting the purchase of shares held by the other natural party and provisions for cross-insurance. The question for determination in respect of each appeal is whether the appellant is "associated" with Sauder and Thornborrow Limited and Verben Tank Lines Limited within the meaning of the word "associated" as used in Section 39 of the Income Tax Act so as to authorize the Minister to assess the appellant by depriving it of the lower income tax rate on its first $35,000 of income in each of the years in question. The pertinent provisions of Section 39 of the Income Tax Act, as applicable to the 1961 and 1962 taxation years, read as follows: "39. (1) The tax payable by a corporation under this Part upon its taxable income for taxable income earned in Canada, as the case may be, (in this section referred to as the 'amount taxable') for a taxation year is, except where otherwise provided, (a) (b) 18% of the amount taxable, if the amount taxable does not exceed $35,000, and $6,300 plus 47% of the amount by which the amount taxable exceeds $35,000, if the amount taxable exceeds $35,000.

5.

6.

7. 8.

9.

(2) Where two or more corporations are associated with each other in a taxation year, the tax payable by each of them under this Part for the year is, except where otherwise provided by another section, 47% of the amount taxable for the year. ..... (4) For the purpose of this section, one corporation is associated with another in a taxation year, if at any time in the year, ..... (b) both of the corporations were controlled by the same person or group of persons.

35 (5) When two corporations are associated, or are deemed by this subsection to be associated, with the same corporation at the same time, they shall, for the purpose of this section, be deemed to be associated with each other." 10. The Minister, in assessing the appellant as he did, acted on the following assumptions: (a) one-half of the voting shares of the appellant company were during 1961 and 1962 owned by or for the benefit of Benjamin Sauder; and the other half of the voting shares of the appellant company were during 1961 and 1962 owned by or for the benefit of Bold Investments (Hamilton) Limited; during 1961 and 1962, more than one-half of the voting shares of Bold Investments (Hamilton) Limited were owned by or for the benefit of Vernon Thornborrow; during 1961 and 1962, the appellant company was controlled by a group of persons consisting of Benjamin Sauder and Vernon Thornborrow; one-half of the voting shares of Sauder and Thornborrow Limited were during 1961 and 1962 owned by or for the benefit of Vernon Thornborrow; and the other half of the voting shares of Sauder and Thornborrow Limited were during 1961 and 1962 owned by or for the benefit of McMaster Investments Limited; during 1961 and 1962, more than one-half of the voting shares of McMaster Investments Limited were owned by or for the benefit of Benjamin Sauder; during 1961 and 1962, Sauder and Thornborrow Limited was controlled by a group of persons consisting of Benjamin and Vernon Thornborrow; the appellant company and Sauder and Thornborrow Limited were associated corporations as contemplated by Section 39(4)(b) of the Income Tax Act because they were both controlled by the same group of persons consisting of Benjamin Sauder and Vernon Thornborrow;. one-half of the voting shares of Verben Tank Lines Limited were during 1961 and 1962 owned by or for the benefit of Benjamin Sauder; and the other half of the voting shares of Verben Tank Lines Limited were during 1961 and 1962 owned by or for the benefit of Vernon Thornborrow; the appellant company and Verben Tank Lines Limited were associated corporations as contemplated by Section 39(4)(b) of the Income Tax Act because they were both controlled by the same group of persons consisting of Benjamin Sauder and Vernon Thornborrow. The Minister contends that: (1) the appellant corporation and Sauder and Thornborrow Limited were associated corporations by virtue of paragraph (b) of subsection (4) of Section 39 of the Income Tax Act because both companies were controlled by the same group of persons consisting of Benjamin Sauder and Vernon Thornborrow;

(b) (c) (d)

(e) (f) (g)

(h)

(i)

36 (2) the appellant corporation and Verben Tank Lines Limited were associated corporations by virtue of paragraph (b) of subsection (4) of Section 39 of the Income Tax Act because both companies were controlled by the same group of persons consisting of Benjamin Sauder and Vernon Thornborrow; Sauder and Thornborrow Limited and Verben Tank Lines Limited were associated corporations by virtue of subsection (5) of Section 39 of the Income Tax Act and by virtue of paragraph (b) of subsection (4) of Section 39 of the Income Tax Act because both companies were controlled by the same group of persons consisting of Benjamin Sauder and Vernon Thornborrow.

(3)

11.

The appellant contends that it is not controlled by the same group of persons that controls Verben Tank Lines Limited and Sauder and Thornborrow Limited. Basically the contention of the appellant is (1) that it is controlled by Benjamin Sauder and Bold Investments (Hamilton) Limited, and not by Benjamin Sauder and Vernon Thornborrow (as alleged by the Minister), even though the shares of Bold Investments (Hamilton) Limited are owned 100% by Vernon Thornborrow, and (2) that Sauder and Thornborrow Limited is controlled by Vernon Thornborrow and McMaster Investments Limited and not by Vernon Thornborrow and Benjamin Sauder (as alleged by the Minister) even though the shares of that company are owned 100% by Benjamin Sauder. There is no question, and it is readily conceded, that Verben Tank Lines Limited is controlled by Vernon Thornborrow and Benjamin Sauder. The narrow question here involved is whether the Court may as a matter of law "look through" Bold Investments (Hamilton) Limited and McMaster Investments Limited and recognize that the voting control capable of being exercised by those two companies over the appellant corporation and Sauder and Thornborrow Limited respectively, is subject to the control of Vernon Thornborrow and Benjamin Sauder, respectively. In order for the Minister to succeed, the facts above recited must establish that the appellant corporation and Sauder and Thornborrow Limited are "controlled" by Benjamin Sauder and Vernon Thornborrow. If such is the case it follows that the three corporations, (1) the appellant, (2) Sauder and Thornborrow Limited and (3) Verben Tank Lines Limited are "associated" within the meaning of Section 39(2) by virtue of subsections (4) and (5) of Section 39. This case turns on the meaning of the words "controlled by the same group of persons" in the context in which they are used in Section 39(4)(b) of the Income Tax Act. The President of this Court had recent occasion to consider the meaning of these very words in Buckerfield's Ltd. v. M.N.R., [1965] 1 Ex. C.R. 299; [1964] C.T.C. 504, where he said at pp. 302, 507: "Many approaches might conceivably be adopted in applying the word 'control' in a statute such as the Income Tax Act to a corporation. It might, for example, refer to control by 'management', where management and the board of directors are separate, or it might refer to control by the board of directors. The kind of control exercised by management officials or the board of directors is, however, clearly not intended by Section 39 when it contemplates control of one corporation by another as well as control of a corporation by individuals (see subsection (6) of Section 39). The word 'control' might conceivably refer to de facto control by one or more shareholders whether or not they hold a majority of shares. I am of the view, however, that, in Section 39 of the Income Tax Act, the word 'controlled' contemplates the right of control that rests in ownership of such a number of shares as carries with it the right to a majority of the votes in the election of the board of directors. See British American Tobacco Co. v. C.I.R., [1943] 1 All E.R. 13, where Viscount Simon, L.C., at page 15, says:

12.

13.

14. 15.

37

'The owners of the majority of the voting power in a company are the persons who are in effective control of its affairs and fortunes.' See also M.N.R. v. Wrights' Canadian Ropes Ltd., [1947] A.C. 109; [1947] C.T.C. 1, per Lord Greene, M.R. at pages 118, 6, where it was held that the mere fact that one corporation had less than 50 per cent of the shares of another was 'conclusive' that the one corporation was not 'controlled' by the other within Section 6 of the Income War Tax Act." 16. 17. In this same decision the President also determined that a "group of persons" can consist of as few as two persons. However, such unequivocal definition of the word "controlled" in its context does not resolve the present issue. I am still faced with the problem of deciding whether control of Bold Investments (Hamilton) Limited by Vernon Thornborrow (the registered and beneficial owner of 100% of the shares in that company) and the control of McMaster Investments Limited by Benjamin Sauder (the registered and beneficial owner of 100% of the shares in that company) vests the control of the appellant and Sauder and Thornborrow Limited in Benjamin Sauder and Vernon Thornborrow or whether the share registers of the appellant company and Sauder and Thornborrow Limited are conclusive in that they show Bold Investments (Hamilton) Limited and McMaster Investments Limited as being the owners of 50% of the shares in the appellant and Sauder and Thornborrow Limited respectively and that therefore, these two companies together with Benjamin Sauder in the one instance and with Vernon Thornborrow in the other instance are the group of persons who have control. I am not here concerned with the proposition that a corporation is a distinct legal entity separate from its shareholders, nor with any question of corporate capacity or power. I readily accept the undisputed proposition that no shareholder, even though he holds all the shares in a corporation, has any property, legal or equitable, in the assets of the corporation and the proposition that a corporation is not, as such, the agent or trustee for its shareholders. The question here is who "controlled" the appellant and Sauder and Thornborrow Limited. Is it Benjamin Sauder and Vernon Thornborrow, or is it Benjamin Sauder and Bold Investments (Hamilton) Limited and Vernon Thornborrow and McMaster Investments Limited. Were it necessary for me to answer this question uninstructed by authorities the solution which commends itself to me, would be to reply that it is Benjamin Sauder and Vernon Thornborrow. This is also the solution which appears to be dictated by the authorities. In British American Tobacco Co. v. C.I.R., [1943] 1 All E.R. 13, the question was whether one body corporate had a "controlling interest" in another body corporate. It was held that Company No. 1 can have a controlling interest in Company No. 3 by owning all the shares in Company No. 2 which in turn owns all the shares in Company No. 3. It was contended that in order that one company (or in this case a natural person) should have a "controlling interest" in another, it must be the beneficial owner of a requisite number of shares in that other company, either in its own name or in the names of its nominees; and that if Company No. 1 owns all the shares in Company No. 2 which in turn owns all shares in Company No. 3, Company No. 1 has no interest, controlling or otherwise, in Company No. 3. These contentions were rejected as unsound by each tribunal which in turn dealt with the matter. In delivering the decision of the House of Lords, Viscount Simon, L.C. said at page 15:

18.

19.

20.

21.

22.

38

"It is true that in such circumstances company No. 1 owns none of the assets of company No. 2, and a fortiori owns none of the assets of company No. 3, and in that sense neither owns, nor has an interest in, company No. 3. But that is to treat the phrase 'controlling interest' as capable of connoting only a proprietary right, that is, an interest in the nature of ownership. The word 'interest', however, as pointed out by Lawrence, J., is a word of wide connotation, and I think the conception of 'controlling interest' may well cover the relationship of one company towards another, the requisite majority of whose shares are, as regards their voting power, subject, whether directly or indirectly, to the will and ordering of the first-mentioned company, If, for example, the appellant company owns one-third of the shares in company X, and the remaining two-thirds are owned by company Y, the appellant company will none the less have a controlling interest in company X if it owns enough shares in company Y to control the latter. In my opinion this is the meaning of the word 'interest' in the enactment under consideration, and, where one company stands in such a relationship to another, the former can properly be said to have a controlling interest in the latter. This view appears to me to agree with the object of the enactment as it appears on the face of the Act. I find it impossible to adopt the view that a person who, by having the requisite voting power in a company subject to his will and ordering, can make the ultimate decision as to where and how the business of the company shall be carried on, and who thus has, in fact, control of the company's affairs, is a person of whom it can be said that he has not in this connection got a controlling interest in the company." 23. It is apparent from the language of Viscount Simon that the words "controlling interest" were interpreted by him as being synonymous with the words "control of a company" and I am unable to attribute any different meaning to the word "controlled" as used in Section 39(4)(b) of the Income Tax Act. In the British American Tobacco case the "person" before Viscount Simon was an incorporated company, the British American Tobacco Co. Ltd., but it seems to me that the language quoted is equally applicable to the case where an individual person was, by having the requisite voting power in a company, able to determine all the ultimate decisions of that company. I was then referred to C.I.R. v. J. Bibby & Sons Ltd., [1945] 1 All E.R. 667, which was also decided by the House of Lords. The words there to be interpreted were "the directors whereof have a controlling interest therein". The relevant facts in the Bibby case were that the directors of the company between them and in their own right held less than 50% of the total voting shares; but three of the directors (who were brothers) in the capacity of trustees of a marriage settlement of their sister were the registered joint holders of further shares in the company. The total of the shares held by the directors in their own right and those held by three of the directors as trustees for their sister was more than a majority of the shares carrying voting rights. In the Bibby case it was in the company's interest to contend that its directors had a controlling interest in it and accordingly it advanced the simple proposition that as the directors were the registered holders of a majority of the voting shares, they therefore, had a controlling interest in the company. For the Crown it was contended that the interest of the three directors who were trustees could not count because they did not have the beneficial interest in those shares and, therefore, could not vote them as they wished but must abide by their trust obligations.

24.

25.

26.

39

27. 28.

The contention of the taxpaying company prevailed in the Court of Appeal and in the House of Lords. Lord Russell of Killowen, said at page 669: "When the section speaks of directors having a controlling interest in a company, what it is immediately concerned with in using the words 'controlling interest' is not the extent to which the individuals are beneficially interested in the profits of the company as a going concern or in the surplus assets in a winding up, but the extent to which they have vested in them the power of controlling by votes the decisions which will bind the company in the shape of resolutions passed by the shareholders in general meeting. In other words, the test which is to exclude a company's business from subsection (9)(a) and include it in (9)(b), is the voting power of its directors, not their beneficial interest in the company. For the purpose of such a test the fact that a vote-carrying share is vested in a director as trustee seems immaterial. The power is there, and though it be exercised in breach of trust or even in breach of an injunction, the vote would be validly cast vis--vis the company, and the resolution until rescinded would be binding on it. The contention that upon the wording of Section 13 the interest must be confined to beneficial interests appears to me to be but a repetition of the argument which was rejected by this House in the case of British American Tobacco Co. v. C.I.R. in relation to National Defence Contribution and the Finance Act, 1937."

29. 30.

It should be noted that Lord Russell states that he was following the principles laid down by the House of Lords in the British American Tobacco case. Lord Simonds in his speech in the Bibby case said at pages 672 and 673: "What, my Lords, constitutes a controlling interest in a company? It is the power by the exercise of voting rights to carry a resolution at a general meeting of the company. Can the directors of the respondent company by the exercise of their voting rights carry such a resolution? Yes: for they are the registered holders of more than half the ordinary shares of the company. Therefore they have a controlling interest in the company. From this result the Crown seeks an escape by the contention that shares held by a director as trustee should not be included for the purpose of computing the controlling interest. In the appellants' argument in this House and in their formal reasons this absolute veto is qualified by the suggestion that, if the director has not only the legal ownership of shares but also a predominating beneficial interest in them, they may be brought into the count. My Lords, in my opinion the Crown's contention cannot be sustained. Those who by their votes can control the company do not the less control it because they may themselves be amenable to some external control. Theirs is the control, though in the exercise of it they may be guilty of some breach of obligation whether of conscience or of law. It is impossible (an impossibility long recognised in company law) to enter into an investigation whether the registered holder of a share is to any and what extent the beneficial owner. A clean cut there must be."

31.

The contention of the appellant in the present case shorn of its refinements essentially amounts to the reasoning in the Bibby case, i.e. that the matter is concluded by reference to the share register; but this would be subject to the reasoning in the British American Tobacco case that where the registered shareholder is a body corporate it is permissible, for certain

40 purposes, to look beyond the register and seek the individuals who themselves control that body corporate. 32. 33. There is no conflict between the British American Tobacco case and the Bibby case in that both reject the test of beneficial shareholding interest. In C.I.R., v. Silverts, Ltd., [1951] 1 All E.R. 703, and S. Berendsen Ltd. v. C.I.R., [1958] 1 Ch. 1, Lord Evershed, M.R., was faced with the problem of reconciling the two decisions of the House of Lords in the British American Tobacco case and the Bibby case, or to put it more accurately a correct appreciation of the scope of those decisions. He had this to say in the Silverts case at page 709: "... In neither case was the question the general one: 'Who controls the company?' In the British American Tobacco case the question was whether (in the ordinary and proper sense of the words) company A held a controlling interest in company C, though the control was exercised, not directly but indirectly through the agency of company B. If the question were raised under some other taxing provision: 'Has company B controlling interest in company C?' an affirmative answer to that question might be given consistently with the affirmative answer to the first question in the British American Tobacco case. So, in the Bibby case and in the present case, the question: 'Have the directors a controlling interest in the company?' falls to be answered, aye or no, without regard to the possible question (if asked) whether some other person or body has (indirectly) a controlling interest in the same company ..." 34. The suggestion in the language of Lord Evershed, above quoted, that company B can have a controlling interest in company C consistent with the finding in the British American Tobacco case that company A has a controlling interest in company C was what was held by Cameron, J. in Vancouver Towing Co., Ltd. v. M.N.R., [1946] Ex. C.R. 623; [1947] C.T.C. 18. He held that regardless of the facts that the managing director, by reason of very extended powers conferred upon him by the articles of association had ultimate control of the appellant company and complete control over its board of directors as well as having an indirect control of the appellant company by owning the shares in a company which in turn held the majority of the shares of the appellant company, nevertheless, the appellant company also had a controlling interest. In my view the word "controlled" in Section 39(4)(b) contemplates and includes such a relationship as, in fact, brings about a control by virtue of majority voting power, no matter how that result is effected, that is, either directly or indirectly. Here the inquiry is directed to whether Benjamin Sauder and Vernon Thornborrow control the appellant and Sauder and Thornborrow Limited. It would seem pointless to me to call a halt on finding in the share register of the appellant company and the share register of Sauder and Thornborrow Limited that in each instance 50% of the shares are held respectively by Bold Investments (Hamilton) Limited and McMaster Investments Limited when an examination of the share register of Bold Investments (Hamilton) Limited and McMaster Investment Limited reveals that all (or nearly all) the shares in those companies are held by Vernon Thornborrow and Benjamin Sauder respectively. On the authority of the British American Tobacco case, I do not think it is appropriate to end the inquiry after looking at the share registers of the appellant and Sauder and Thornborrow Limited. It is proper and necessary to look at the share registers of Bold Investments

35.

36. 37.

38.

41 (Hamilton) Limited and Sauder and Thornborrow Limited to obtain an answer to the inquiry whether the appellant and the two other companies are controlled by the same "group of persons". Where the registered shareholder in the first instance is a body corporate, you must look beyond the share register. 39. It therefore follows that the Minister was right in assuming, as he did when assessing the appellant, that the appellant company was controlled by Benjamin Sauder and Vernon Thornborrow and that Sauder and Thornborrow Limited was controlled by Benjamin Sauder and Vernon Thornborrow as was Verben Tank Lines Limited. Accordingly the appellant company, Sauder and Thornborrow Limited and Verben Tank Lines Limited were associated corporations within the meaning of Section 39(2) by virtue of subsections (4)(b) and (5) of Section 39. The appeals are, therefore, dismissed with costs.

40.

c. Testing the Limits The limits of de jure control were being tested by taxpayers and the courts began seeking creative solutions. Consider the following decision.

Donald Applicators Ltd. Et al. v. M.N.R.

[1969] C.T.C. 98 , [1969] 2 Ex. C.R. 43, Exchequer Court of Canada The ten appellant corporations were admittedly formed for the purpose of ensuring that profits realized from construction supply activities would obtain a maximum benefit from the low tax bracket in Section 39. To achieve this they had to avoid being "associated corporations" within the meaning of that section and in the Minister's view they failed to achieve this objective. In the case of each appellant two Class A shares, out of an authorized 200, were issued and were held by different, unrelated members of a law firm in the Bahamas, and 490 Class B shares, out of an authorized 19,800, were issued and held by an eleventh company, "Saje". The Class A shares carried full voting rights and the Class B shares also carried full voting rights except the right to elect directors. In fact, the only functions carried out by the directors were to appoint a manager for "Saje" and to sign financial statements and minutes of meetings which were prepared and submitted to them. In the appellant's view control of the appellants lay with Class A shareholders, because of their power to elect the directors. The Minister, on the other hand, contended that in the somewhat peculiar setup which obtained, the de jure control of each appellant rested in the Class B shareholder. Alternatively, the Minister contended that in the circumstances de facto control should be held to govern. HELD: It was settled that "control" of a corporation for this purpose rested in de jure control, not de facto control. Here, however, the Class B shareholder had ample voting power to pass or defeat any special resolution or extraordinary resolution that might be proposed and could therefore change the articles of each appellant and remove the directors' authority while reserving all decision-making power for the shareholders as a whole, or for the Class B shareholders, only, in general meeting. In these circumstances it could not be said that the Class B shareholder did not have in the long run de jure control of each appellant. It followed that each appellant was controlled by "Saje" and all were "associated corporations". Appeals dismissed.

42 Thurlow, J.: 1. The issue in each of these appeals, which are from re-assessments of income tax, in some cases for the years 1961 and 1962 and in others for the year 1962 alone, is whether in these years the ten appellant companies were "associated" with each other within the meaning of Section 39 of the Income Tax Act and thus liable to tax at the higher rate prescribed by that section rather than at the lower rate which would otherwise be applicable. The basis relied on for treating the appellant companies as "associated" was that each of them was controlled at the relevant times by another corporation, viz. Saje Management Limited, later renamed MacLab Enterprises Limited, and was thus associated with that corporation, from which it followed from the statutory provisions that all eleven corporations were associated with each other. All ten appellant companies were incorporated in 1961 under The Companies Act, R.S.A. 1955, c. 53, of the Province of Alberta. While their objects, as expressed in their memoranda of association, differed somewhat from company to company all had objects concerned with some phase of the construction or construction supply business. In other relevant respects the memoranda and articles of association of the appellant companies can be treated as alike. Each had two classes of common shares, consisting of 200 Class A shares, each of the par value of $1.00, which carried the right to vote on any question and the exclusive right to vote on the election of directors, a right which could not be altered without the unanimous consent of the Class A shareholders, and 19,800 Class B no par value shares which carried the right to vote on all questions except the election of directors. In each case the memorandum of association further provided that no share or shares might be transferred without the consent of the directors and that the net yearly profits of the company should in each year be divided among the shareholders in dividends payable in cash. Each company adopted Table A of the First Schedule to The Companies Act as its articles of association with certain amendments among which was one providing that no share should be issued to any person without the unanimous consent of the existing shareholders of the company. In each company during the relevant period two Class A shares had been issued and were held by two unrelated persons resident in Nassau in the Bahamas consisting of a solicitor and one of his partners or employees or of two of such persons other than the solicitor himself. In no case, however, did the same two persons hold the shares in more than one of the companies. In each case the Class A shareholders had elected themselves to be the directors of the company. In each case, as well, 498 Class B shares had been issued, at 10 cents per share, to Saje Management Limited. Each company thus had a nominal issued capital of $51.80. The directors of each appellant fixed the registered office of the company at 502 MacLeod Building, Edmonton, Alberta and appointed Mr. James G. Greenough, the controller of Saje Management Limited, as the company's manager. Mr. Greenough was not acquainted with the directors and received no instructions from them but in each case they ultimately approved charges in the company's accounts for management services supplied to the company by Saje Management Limited who paid Mr. Greenough's salary. In fact the only functions carried out by the directors as such were to sign financial statements and minutes of directors' and shareholders' meetings all of which were prepared from time to time in Edmonton and brought to Nassau by Mr. Sandy MacTaggart or his associate Mr. Jean de la Bruyere for the directors' signatures. That these companies were incorporated and these arrangements were made for the purpose of securing that profits realized from the construction and construction supply activities carried out by Saje Management Limited, which carried on its business in Edmonton, Alberta, would

2.

3.

4.

43 be realized by several corporations who were not associated within the meaning of the Act and thus attract less tax was not merely not disputed but was frankly stated by the appellants' counsel in his opening and by Mr. MacTaggart, the principal witness called on behalf of the appellants who, with his associate, Mr. de la Bruyere, were the holders of all the shares of Saje Management Limited. However, no case was made out of any trust or other arrangement by which Saje Management Limited or its shareholders might be said to be in a position to exercise de jure control of the voting rights of the Class A shares of the appellant companies held by the Nassau solicitor or his several partners or employees and the evidence negatives the existence of any such arrangement. Nor was any attempt made to establish the case as one of dummy corporations whose fictitious legal personalities could be ignored. On the contrary, the very foundation of the taxation appealed from is the assumption of the reality of these corporations and of their having made the profits in respect of which they have been assessed. The case therefore falls to be decided, despite the stark unreality of the situation, as disclosed by the evidence, on the basis that these appellants were corporations which it fact engaged in business and thereby realized the profits in question. 5. The question for determination, thus, as I see it, is simply whether Saje Management Limited by reason of its holding of 498 Class B shares, in each case, controlled the corporation. The appellants' position, as I have apprehended it, was basically that the Class A shareholders, by reason of their exclusive right to elect the directors, in each case controlled the corporation from which it followed that Saje Management Limited did not control it. I do not think, however, that it is necessary to reach a conclusion either on the broad question "who controlled the company" or on the narrower question whether the Class A shareholders controlled it since the answer would not necessarily be conclusive in either case. What the appellants require in order to succeed is, as I see it, in each case a determination that Saje Management Limited did not control the corporation. Counsel for the Minister on the other hand took two alternative positions. He submitted first that, notwithstanding the exclusive right of Class A shareholders to elect the directors, in the somewhat peculiar setup of the appellant companies, the de jure control of each of the companies rested in the ownership by Saje Management Limited of its 498 Class B shares. Alternatively, he submitted that even if there was an element of control vested in the Class A shareholders by reason of their exclusive right to elect directors there was also an element of control vested in the Class B shareholder since that shareholder had overwhelming voting power on any other question that might come before a shareholders' meeting and since the directors of the appellant companies did not have all the powers commonly exercised by directors, in that they had no authority to accumulate profits or to issue the unissued shares. He went on to submit that in this situation the Court should take into account the de facto control which, in respect of each of these appellants, was admittedly and undoubtedly exercised entirely by Saje Management Limited through its employee Mr. Greenough under the direction of its two shareholders, and should hold that Saje Management Limited controlled the appellant corporations. I can deal with the alternative submission by saying that in my opinion de facto control is not to be taken into account, that de jure control is what is contemplated by the statute* and that in determining association for the purposes of the statute control itself and not some mere element or fragment of it is required to support a conclusion that corporations are in fact associated. This submission, in my opinion, accordingly fails. The first submission, however, calls for closer examination. In the Dworkin Furs case, [1967] S.C.R. 223; [1967] C.T.C. 50, and other cases and in the Vina-Rug case, [1968] S.C.R. 193;

6.

7.

8.

44 [1968] C.T.C. 1, as well as in the Buckerfield's case, [1965] 1 Ex. C.R. 299; [1964] C.T.C. 504, and the British American Tobacco case, [1943] 1 All E.R. 13, therein referred to the problem presented and considered was essentially one of the quantity of voting power required to afford control of the particular corporation. As the votes in these cases were all exercisable in respect of any question that might arise no question of the quality or characteristics of voting power attaching to different classes of shares was involved. This applied as well in the Aaron's Ladies Apparel Ltd. case, [1967] S.C.R. 223 at 231; [1967] C.T.C. 50 at 53, where unanimity rather than a majority vote was required. Nor was there involved in these cases any question as to the functions and authority of directors when elected, it having been, I think, assumed that the directors had the usual general authority to exercise the powers of the company. It therefore appears to me that while these cases afford principles by which one may be guided they offer no foregone conclusion for a case such as the present. Thus, while in an ordinary situation control may reside in the voting power to elect directors such power to choose directors in my opinion would not afford control of a company in which, by the memorandum and articles, the directors have been shorn of authority to make decisions binding upon the company and such decisions had been reserved for the shareholders in general meeting. If, therefore, in an ordinary situation control of a company rests in the voting power to elect directors but in the suggested situation does not rest in such voting power it seems to me that when the situation is not ordinary the question of de jure control of the company must be resolved as one of fact and degree depending on the voting situation in the particular company and the extent and effect of any restrictions imposed by the memorandum and articles on the decision making powers of the directors. 9. The statement of the President of this Court in Buckerfield's case, [1965] 1 Ex. C.R. 299 at 303; [1964] C.T.C. 504 at 507, when he said, "I am of the view, however, that in Section 39 of the Income Tax Act, the word "controlled" contemplates the right that rests in ownership of such a number of shares as carries with it the right to a majority of the votes in the election of the board of directors" should, I think, be read and understood as applying to a case where the directors when elected have the usual powers of directors to guide the destinies of the company. In the present situation, as I see it, the authority of the directors of the appellant companies has been only slightly restricted or modified from that ordinarily applicable in companies which have adopted Table A of the First Schedule to the Companies Act as their articles and I should not have thought that such restrictions as have been imposed had any serious effect on the authority of the directors to govern the business of the company and generally to direct its affairs.* The directors of these companies, as I see it, had, for example, ample authority to commit them to contracts for the supply of materials or the construction of buildings anywhere in the world or to discharge Mr. Greenough and make other arrangements for the conduct of the companies' businesses whenever they might have seen fit to do so. I would not, therefore, on this account alone conclude either that control of these companies did not rest in the owners of the Class A shares or that control rested in the voting power of the Class B shareholders. There is, however, another aspect of the situation in each of these companies which appears to me to require consideration and which was not involved in any of the cases cited. Here, in the case of each appellant company, Saje Management Limited as the holder of 498 Class B shares had ample voting power, not merely to pass or to defeat any ordinary resolution (other than one electing directors), but to pass or defeat any special resolution or any extraordinary resolution that might be proposed. That shareholder thus had the voting power to change the articles of the company.* As I see it, it had the power to repeal Article 55 and any other article

10.

11.

45 conferring upon the directors authority to bind the company, and thus to reduce the directors to the status of errand boys, while reserving all decision making power not specifically conferred on the directors by the statute or by the memorandum of association for the shareholders as a whole, or of Class B shares only, in general meeting. It had the voting power to remove the directors from office. It had as well the voting power to pass a special resolution to eliminate the need for unanimous consent of all shareholders to the issue of additional shares and to vest in the Class B shareholders authority to issue additional Class A shares in sufficient numbers to outvote the two shares held by the Nassau residents. 12. In these circumstances can it be said that Saje Management Limited did not have de jure control of the appellant companies? So far as I am aware there is no decided case in which such a situation has been considered but there is, I think, some guidance to be found for the decision in the British American Tobacco case, [1943] 1 All E.R. 13 at 15, where Lord Simon, L.C. said: I find it impossible to adopt the view that a person who, by having the requisite voting power in a company subject to his will and ordering, can make the ultimate decision as to where and how the business of the company shall be carried on, and who thus has, in fact, control of the company's affairs, is a person of whom it can be said that he has not in this connection got a controlling interest in the company. As to what may be the requisite proportion of voting power, I think a bare majority is sufficient. The appellant company has, in respect of each of the foreign companies referred to in the case, the control of the majority vote. I agree with the interpretation of "controlling interest" adopted by Rowlatt, J., in Noble v. Commissioners of Inland Revenue, when construing that phrase in the Finance Act, 1920, s. 53(2)(c). He said at p. 926 that the phrase had a wellknown meaning and referred to the situation of a man ... whose shareholding in the company is such that he is more powerful than all the other shareholders put together in general meeting. The owners of the majority of the voting power in a company are the persons who are in effective control of its affairs and fortunes. It is true that for some purposes a 75 per cent majority vote may be required, as, for instance (under some company regulations) for the removal of directors who oppose the wishes of the majority; but the bare majority can always refuse to re-elect and so in the long run get rid of a recalcitrant board. Nor can the articles of association be altered in order to defeat the wishes of the majority, for a bare majority can always prevent the passing of the necessary resolution (italics added). 13. While the present is a converse case in that a particular shareholder has the voting power to pass a special resolution but no immediate right to elect directors, it seems to me that the same guiding principle can be applied. A shareholder who, though lacking immediate voting power to elect directors, has sufficient voting power to pass any ordinary resolution that may come before a meeting of shareholders and to pass as well a special resolution through which he can take away the powers of the directors and reserve decisions to his class of shareholders, dismiss directors from office and ultimately even secure the right to elect the directors is a person of whom I do not think it can correctly be said that he has not in the long run the control of the company. Such a person in my view has the kind of de jure control contemplated by Section 39 of the Act. It follows that Saje Management Limited had control of all ten appellant companies at the material times and that they were all "associated" with one another within the meaning of Section 39.

46 14. The appeals will be dismissed with costs.

d. The Role of Constating Corporate Documents

Duha Printers Ltd. v. Queen

(S.C.C.) 1998 [1998] 3 C.T.C. 303 Supreme Court of Canada The judgment of the court was delivered by Iacobucci J.: 1 In this appeal, this Court is required to examine the definition of "control" for the purposes of s. 111(5) of the Income Tax Act, R.S.C. 1952, c. 148, as amended, in order to determine whether the appellant corporation was entitled to deduct from its 1985 taxable income certain noncapital losses incurred by a predecessor corporation in an amalgamation. In this regard, it will be necessary to consider which of various factors may properly be considered in assessing the de jure control of a corporation, and in particular, whether a unanimous shareholder agreement, as contemplated by the Manitoba Corporations Act, R.S.M. 1987, c. C225[; C.C.S.M., c. C225] (the "Corporations Act") (and by other statutes modelled after the Canada Business Corporations Act, R.S.C., 1985, c. C-44 (the "CBCA")), is to be considered a constating document for the purposes of the de jure control inquiry.

I. Facts 2 This case proceeded on an agreed statement of facts, and therefore the facts are not in dispute. Duha Printers (Western) Ltd. ("Duha No. 1"), incorporated in Manitoba in 1963, carried on business as a specialty printer. Prior to and as at February 7, 1984, all of the voting shares of Duha No. 1 were held either directly or indirectly by Emeric Duha, his wife, Gwendolyn Duha, and their three children. Outdoor Leisureland of Manitoba Ltd. ("Outdoor"), incorporated in Manitoba in 1971, carried on business as a retailer of recreational vehicles. As at February 8, 1984, the shares of Outdoor were held by Marr's Leisure Holdings Inc. ("Marr's"), of which William Marr and his wife, Norah Marr, owned 62.16 percent of the voting shares. On that date, and as early as 1983, Outdoor was inactive and had accumulated non-capital losses in the amount of $541,044. On December 3, 1983, the directors of Duha No. 1 authorized the president of the corporation, Emeric Duha, to proceed at his discretion to acquire the shares of Outdoor in order to attempt to take advantage of the substantial non-capital losses which the latter had accumulated, so long as the losses could be purchased advantageously and if the related costs did not exceed $10,000. This set into motion the chain of events which ultimately gave rise to this litigation. On February 7, 1984, Duha No. 1 amalgamated with 64457 Manitoba Ltd., a wholly owned subsidiary of Duha No. 1, to form Duha Printers Western Ltd. ("Duha No. 2"). This caused a deemed year-end, permitting Duha No. 1 to take advantage of a small business deduction, and the shareholders of Duha No. 2 received the same number of shares as they had previously owned in Duha No. 1. On February 8, 1984, the articles of Duha No. 2 were amended to increase the authorized capital of the company by creating an unlimited number of

47 Class "C" preferred shares. These shares entitled their holders to non-cumulative dividends equal to 9 percent of the redemption price (the stated capital for each share). Each share also carried with it the right to one vote, which was to cease either upon the transfer of the share or upon the death of its holder. The Class "C" shares were redeemable by Duha No. 2 with the consent of the holder, or without the consent of the holder in the event that the shares were transferred. 6 Marr's subscribed for 2,000 Class "C" shares at a price of one dollar each, for a total of $2,000, on February 8, 1984. Consequently, Marr's then held a 55.71 percent majority of the voting shares in Duha No. 2. It is worth noting that, for the period ending December 31, 1983, Duha No. 1 had net income of $182,223 and retained earnings of $296,486. For the period ending January 2, 1985, it had net income of $630,115 and retained earnings of $571,543. Also on February 8, 1984, an agreement was entered into among all of the shareholders of the new corporation, Duha No. 2 (the "Agreement"). Aside from describing itself in Article 3.1 as a "unanimous shareholders' agreement", the Agreement stated that it dealt with the operation and management of the company's business and affairs. According to Article 2 of the Agreement, the affairs of Duha No. 2 were to be managed by a board of directors elected by the shareholders and composed of any three of Emeric Duha, Gwendolyn Duha, William Marr and Paul Quinton. Although Mr. Quinton was a close friend of both Emeric Duha and William Marr, and had served as a director of Duha No. 1 since 1974, it is common ground that he, Emeric Duha, and William Marr were not "related to each other" within the meaning of s. 251 of the Income Tax Act. The Agreement also restricted the transfer of shares so that no shares could be transferred without the consent of the majority of the directors (Article 4.1); prohibited any shareholder from selling, assigning, transferring, or otherwise encumbering its shares in any manner (Article 4.3); and provided that new shares could only be issued with the unanimous consent of the existing shareholders (Article 4.4). Further, in Article 6.1, the Agreement provided that shareholder disputes regarding the business, accounts, or transactions of Duha No. 2 were to be resolved by arbitration. On February 9, 1984, Duha No. 2 purchased all of the outstanding shares of Outdoor from Marr's for $1. On the same date, 64099 Manitoba Ltd., a wholly owned subsidiary of Duha No. 2, purchased from Marr's Leisure Products (1977) Ltd. ("Marr's Leisure"), a wholly owned subsidiary of Marr's, a receivable in the amount of $441,253 owed by Outdoor to Marr's Leisure. Half of the total purchase price of $34,559 was payable on June 1, 1984, and the balance was payable upon the redemption of the 2,000 Class "C" shares of Duha No. 2 held by Marr's. On February 10, 1984, Duha No. 2 and Outdoor effected a statutory amalgamation under the Corporations Act to form Duha Printers (Western) Limited ("Duha No. 3"). The shares of Outdoor were cancelled and the shareholders of Duha No. 3 received the same number and class of shares as they had previously owned in Duha No. 2. On March 12, 1984, the shareholders of Duha No. 3 elected Emeric Duha, Gwendolyn Duha and Paul Quinton as the three directors of Duha No. 3. On January 4, 1985, Duha No. 3, with the consent of Marr's, redeemed the 2,000 Class "C" shares owned by Marr's for a redemption price of $2,000. On February 15, 1985, the Agreement was terminated and Paul Quinton resigned as a director of Duha No. 3.

10

11

48 12 In its corporate tax return filed on June 28, 1985, Duha No. 3 deducted from its income noncapital losses in the amount of $463,820, of which $460,786 had been incurred by Outdoor in previous years. The Minister of National Revenue disallowed the deduction on the basis that Marr's did not control Duha No. 2 prior to its amalgamation with Outdoor, and that the transactions at issue were artificial and a sham. The Tax Court of Canada allowed Duha No. 3's appeal, but this decision was overturned on appeal to the Federal Court of Appeal.

II. Relevant Statutory Provisions 13 Income Tax Act, R.S.C. 1952, c. 148, as amended 87. ... (2.1) Where there has been an amalgamation of two or more corporations, for the purposes only of (a) b) determining the new corporation's non-capital loss, net capital loss, restricted farm loss or farm loss, as the case may be, for any taxation year, and determining the extent to which subsections 111(3) to (5.4) apply to restrict the deductibility by the new corporation of any non-capital loss, net capital loss, restricted farm loss or farm loss, as the case may be, the new corporation shall be deemed to be,

the same corporation as, and a continuation of, each predecessor corporation, except that this subsection shall in no respect affect the determination of (c) (d) (e) the fiscal period of the new corporation or any of its predecessors, the income of the new corporation or any of its predecessors, or the taxable income of, or the tax payable under this Act by, any predecessor corporation.

111. (1) For the purpose of computing the taxable income of a taxpayer for a taxation year, there may be deducted such portion as he may claim of (a) his non-capital losses for the 7 taxation years immediately preceding and the 3 taxation years immediately following the year;

(5) Where, at any time, control of a corporation has been acquired by a person or persons (each of whom is in this subsection referred to as the "purchaser") (a) such portion of the corporation's non-capital loss or farm loss, as the case may be, for a taxation year ending before that time as may reasonably be regarded as its loss from carrying on a business is deductible by the corporation for a particular taxation year ending after that time (i) only if throughout the particular year and after that time that business was carried on by the corporation for profit or with a reasonable expectation of profit...

49

251. ... (2) For the purposes of this Act "related persons", or persons related to each other, are (c) any two corporations (i) 256. ... (7) For the purposes of subsections 66(11) and (11.1), 87(2.1), 88(1.1) and (1.2) and section 111 (a) where shares of a particular corporation have been acquired by a person after March 31, 1977, that person shall be deemed not to have acquired control of the particular corporation by virtue of such share acquisition if that person (i) was, immediately before such share acquisition, related (otherwise than by virtue of a right referred to in paragraph 251(5)(b)) to the particular corporation... if they are controlled by the same person or group of persons...

Corporations Act, R.S.M. 1987, c. C225 6(3) Subject to subsection (4), if the articles or a unanimous shareholder agreement require a greater number of votes of directors or shareholders than that required by this Act to effect any action, the provisions of the articles or of the unanimous shareholder agreement prevail. 6(4) The articles may not require a greater number of votes of shareholders to remove a director than the number required by section 104. 20(1) A corporation shall prepare and maintain, at its registered office and, subject to subsection (5), at any other place in Manitoba designated by the directors, records containing (a) ..... 97(1) Subject to any unanimous shareholder agreement, the directors of a corporation shall (a) (b) exercise the powers of the corporation directly or indirectly through the employees and agents of the corporation; and direct the management of the business and affairs of the corporation. the articles and the by-laws and all amendments thereto, and a copy of any unanimous shareholder agreement;

140(2) An otherwise lawful written agreement among all the shareholders of a corporation, or among all the shareholders and a person who is not a shareholder, that restricts, in whole or in part, the powers of the directors to manage the business and affairs of the corporation is valid. 140(5) A shareholder who is a party to a unanimous shareholder agreement has all the rights, powers and duties and incurs the liabilities of a director of the corporation to which the

50 agreement relates to the extent that the agreement restricts the discretion or powers of the directors to manage the business and affairs of the corporation, and the directors are thereby relieved of their duties and liabilities to the same extent. 240 If a corporation or any director, officer, employee, agent, auditor, trustee, receiver, receiver-manager or liquidator of a corporation does not comply with this Act, the regulations, articles, by-laws, or a unanimous shareholder agreement, a complainant or a creditor of the corporation may, in addition to any other right he has, apply to a court for an order directing any such person to comply with, or restraining any such person from acting in breach of, any provisions thereof, and upon such application the court may so order and make any further order it thinks fit. 14 A few explanatory words regarding this rather complex legislative scheme may be useful at this stage. Under s. 87(2.1) of the Income Tax Act, where there has been an amalgamation of two or more corporations, for the purposes of determining the non-capital loss of the new corporation for any taxation year, the new corporation is deemed to be the same corporation as, and a continuation of, each predecessor corporation. Therefore, for the purposes of s. 111(1), the new corporation is entitled to deduct from its taxable income for a year its noncapital losses for the seven years immediately preceding, and the three years immediately following, the year in question. However, this is subject to at least one important qualification: under s. 111(5), where "control" of a corporation has been acquired by another person (the "purchaser"), that corporation's non-capital losses from the carrying on of a business are only deductible by the purchaser in a subsequent taxation year if, throughout that year and after that time, the business in question was carried on by the corporation with a reasonable expectation of profit -- that is, as a going concern. The foregoing provisions of the Corporations Act are relevant, potentially, as indicators of where "control" of a corporation lay at the material time or times.

III. Judicial History A. 15 Tax Court of Canada, (1994), [1995] 1 C.T.C. 2481 (T.C.C.) Rip J.T.C.C. observed first that, if Marr's acquired control of Duha No. 2 on February 8, 1984, then ss. 251(2) and 256(7)(a)(i) of the Income Tax Act would deem there to have been no change of control when its shares were acquired the next day by Duha No. 2, given that the two companies would have been related to one another. As such, s. 111(5) would not prevent Duha No. 3 from deducting from its income the non-capital losses previously incurred by Outdoor, pursuant to s. 87(2.1), even though the business of Outdoor was not carried on by Duha No. 3 as a going concern. As a preliminary matter, Rip J.T.C.C. noted that, although the parties had referred to the Agreement as a "unanimous shareholders' agreement", the Agreement did not by its terms restrict the powers of the directors of Duha No. 2 to manage the business and affairs of the company, as required by the definition of "unanimous shareholder agreement" in s. 140(2) of the Corporations Act. In his view, the Agreement, while admittedly unanimous, was simply an ordinary shareholders' agreement, not the special type of "unanimous shareholder agreement" contemplated by that statute. Turning to the substantive issues on the appeal, Rip J.T.C.C. began by stating that "control" of a corporation, for the purposes of the Income Tax Act, means de jure control, or the ownership of such a number of shares as carries with it the right to a majority of the votes in the election

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51 of the board of directors, and not de facto control: Buckerfield's Ltd. v. Minister of National Revenue, [1964] C.T.C. 504 (Can. Ex. Ct.) (a definition adopted by this Court in Dworkin Furs (Pembroke) Ltd. v. Minister of National Revenue, [1967] S.C.R. 223 (S.C.C.), inter alia). Rip J. noted also that, in assessing de jure control, the courts may examine the incorporating or constating documents of the company, which are "in effect an agreement between the shareholders and binding upon all the shareholders." 18 The Minister had argued that, although Marr's owned a majority of the voting shares of Duha No. 2, the Agreement "totally neutralized" the ability of Marr's to manage the company, since it effectively prevented Marr's from: electing a majority of its choice to the board of directors, dissenting from corporate transactions and applying to the court for redemption of its shares, or selling its shares. However, after an extensive review of the case law, Rip J. was unable to find authority for the proposition that the Agreement should be taken to vitiate the apparent de jure control of Duha No. 2 by Marr's. At the relevant time, Marr's held more than 50 percent of the voting shares in Duha No. 2 and, in the view of Rip J.T.C.C., nothing in the constating documents prevented Marr's from voting its shares in the normal course, nor was there any evidence that Marr's was not the beneficial owner of the shares and thus unable to decide for itself how the shares were to be voted. Even if Rip J.T.C.C. had accepted that documents other than the constating documents could be considered, he found that nothing in the Agreement obliged Marr's to vote its shares in the manner in which it did, that is, to vote for a majority of directors who were representatives of the Duha family. Marr's was in a position to alter the board of directors, and there was no evidence, in the view of Rip J.T.C.C., that Mr. Quinton was a nominee of the Duha family. Therefore, Marr's was free, by electing to the board Mr. Quinton, either Mr. or Mrs. Duha, and Mr. Marr, to ensure that neither Marr's nor the Duha family would have a majority on the board of directors. Rip J.T.C.C. thus concluded that Marr's, by virtue of its ownership of the majority of the voting shares on February 8, 1984, controlled Duha No. 2 at that time. Turning to whether the transaction was a sham, Rip J.T.C.C. acknowledged that the sole purpose of the chain of events was to enable Duha No. 3 to make use of the losses incurred by Outdoor, that de facto control of Duha No. 2 was never transferred to Marr's, and that Marr's never intended to control the company. However, he could not agree that the transaction was a sham, given that there was no attempt to disguise its true character. The various transactions were binding upon the parties and did precisely what they appeared to do. As for the argument that the transaction was contrary to the "object and spirit" of s. 111, Rip J.T.C.C. simply observed that the purpose of the section was to permit corporations to apply non-capital losses against income earned in subsequent years, that amalgamated corporations are entitled to deduct the losses of predecessor corporations in this manner if the amalgamated corporation is controlled by the same person or group as the predecessor, and that "control" in this sense refers to de jure and not de facto control. In his view, there was nothing in the transaction that violated the "object and spirit" of the provision. Therefore, Rip J.T.C.C. concluded that Marr's did control Duha No. 2 on and immediately prior to February 8, 1984, when Duha No. 2 and Outdoor were amalgamated, and that it controlled Duha No. 3 during the taxation year on appeal. Accordingly, the appeal was allowed.

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B. Federal Court of Appeal, [1996] 3 F.C. 78 (Fed. C.A.) (1) Reasons of Linden J.A. (Isaac C.J. concurring)

52 22 Like the trial judge, Linden J.A. was not persuaded that the transaction was a sham. The legal obligations between the parties were real and accomplished exactly what they purported to do. However, this was not sufficient to achieve the tax results ultimately desired by the parties. It remained to be seen whether the transactions came within the relevant sections of the Income Tax Act. Linden J.A. refused to treat as a distinct issue the "object and spirit" of the provisions in question, stating that, instead, the interpretation of the sections should reflect their objects. The object and spirit of a section will only be practically relevant when the application of that section to factual circumstances admits of doubt, not where the meaning of the section is clear and free of ambiguity or uncertainty: Canada v. Antosko, [1994] 2 S.C.R. 312 (Fed. C.A.). In the view of Linden J.A., the purpose of the provisions at issue on this appeal was "to permit a deduction of a loss if control has not changed hands but to deny it if control has changed hands" (p. 109). Linden J.A. acknowledged that control, for these purposes, means de jure and not de facto control, and that the single most important factor to consider is the voting rights attaching to shares. However, he was equally of the opinion that the scope of scrutiny under the de jure test has been extended "beyond a mere technical reference to the share register" (p. 109). After an exhaustive review of the case law, including cases which he interpreted as relying upon restrictions in the constating documents and "other agreements" as an indicator of de jure control -- and, in particular, Minister of National Revenue v. Consolidated Holding Co., [1974] S.C.R. 419 (S.C.C.)--Linden J.A. concluded (at p. 118) that ...it is important to look to the legal position of the parties as displayed in the wider circumstances of the parties' affairs. ... [T]rue de jure control is just what it is stated to be, control at law. Any binding instrument, therefore, must be reckoned in the analysis if it affects voting rights. 25 Linden J.A. held that, "[i]n determining issues of corporate control, the Court will look to the time in question, to legal documents pertaining to the issue, and to any actual or contingent legal obligations affecting the voting rights of shares" (p. 121). These factors, he held, "are simply facts with legal consequences, so that the distinction between de jure and de facto is not as stark as it once was". In his view, then, "corporate control must be real, effective legal control over the company in question" (p. 121). Such an analysis, he continued, incorporates an appreciation for various considerations which might affect the way in which shares are or could be voted. He concluded that, "if majority ownership does not allow for real legal control over a company, the de jure test of control will not have been met" (p. 124). Applying the law to the facts of the instant appeal, Linden J.A. held that Marr's did not control Duha No. 2 because the Agreement determined that the majority of the Board of Directors would always be nominees of the Duha family. He found that Mr. Quinton was effectively a nominee of the Duha family because he had been a longtime friend of Mr. Duha, had been a director of Duha No. 1 for ten years, and had signed the resolution authorizing the subscription by Marr's of the 2,000 Class "C" shares, the entering into the Agreement by the corporation, and the purchase of Outdoor's shares. On this basis, Linden J.A. concluded that an election of any combination of the directors listed in the Agreement assured the Duha family of control over Duha No. 2. He also noted that Duha No. 2 was worth almost $600,000, and opined that no reasonable person would believe that a $2,000 share purchase would actually yield control of a company of such value. In his view, it was not coincidental that the three Duha family

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53 nominees were in fact elected as directors and that Marr's did not elect its own majority shareholder to the board. 27 Linden J.A. was of the view that the Agreement likely qualified as a unanimous shareholder agreement ("USA") under s. 140(2) of the Corporations Act, given that it operated to restrict the powers of the directors both directly and indirectly. However, he also held that the Agreement did not have to meet this statutory requirement before it could be considered in a de jure control analysis. The Agreement, signed by all the shareholders and by Duha No. 2, was legally binding and had significantly affected how the shareholders could vote their shares. These, in his view, were the minimum conditions to be met before the Agreement could be considered in a de jure control examination, given that "[c]ertain cases of the Supreme Court of Canada explicitly state" (p. 125) that external agreements are not to be considered irrelevant to the issue of de jure control. He distinguished the case of International Iron & Metal Co. v. Minister of National Revenue, [1974] S.C.R. 898 (S.C.C.), aff'g (1969), 69 D.T.C. 5445 (T.C.C.), on the basis that the agreement in that case was "contrived to multiply a tax benefit" (p. 126) and that the parties to whom control was supposedly transferred by the agreement were not parties to it, per se. Moreover, there was other evidence that Marr's did not control Duha No. 2. Linden J.A. noted that the amended articles of Duha No. 2 stated that the company could not issue new voting shares without unanimous shareholder consent and found that this meant that Marr's could not change its restricted choice of directors by using its majority share position. He held that Marr's ability to dissolve Duha No. 2 was not determinative and was little more than "a chimera" because, upon a dissolution, Marr's would receive nothing beyond the stated value of its shares, would forfeit the receivable and would actually suffer a net loss. Linden J.A. concluded that the intentions of the parties had been that Marr's would not control Duha No. 2, that the legal obligations between the parties ensured that the Duha family would retain control over the company, and that this was the legal effect of the transactions. In his view (at p. 129), the appellant had "used the technicalities of revenue law and company law to conjure a legal remedy for restrictions to which it would otherwise be subject. They did not succeed." He concluded, therefore, that Outdoor and Duha No. 2 were not related prior to the amalgamation, that Duha No. 2 never carried on the business of Outdoor as a going concern or with a reasonable expectation of profit, and that the appellant therefore could not make use of Outdoor's non-capital losses. (2) Reasons of Stone J.A. (Isaac C.J. concurring) 30 Like Linden J.A., Stone J.A. would have allowed the appeal, but for different reasons. In his view, the Agreement was to be considered along with the constating documents of the corporation because it was a USA within the meaning of the Corporations Act. Stone J.A. noted that s. 97(1) of the Corporations Act gives directors the power to direct "the business and affairs of the corporation" and that s. 1(1) defines "affairs" as including "the relationships among a body corporate, its affiliates and the shareholders, directors and officers of those bodies corporate but ... not ... the business carried on by those bodies corporate". He further held that, to be a USA for the purposes of s. 140(2) of the Corporations Act, the Agreement had to restrict the powers of the directors to manage the business and affairs of the corporation. Stone J.A. noted that Article 2.1 of the Agreement required the shareholders to "cause the affairs of the Corporation to be managed by a board of three (3) directors" (emphasis added),

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54 and reasoned that this, by exclusion, did not leave the directors with the power to manage the business of Duha No. 2. Further, Article 6.1 of the Agreement provided for the resolution by arbitration of any dispute arising among the shareholders with respect to the "business or accounts or transactions" of the company. Ordinarily, in his view, no dispute as to the "business" of the company would arise between the shareholders, as the business of a corporation is, in the absence of a USA, to be directed by the board of directors. On this basis, he concluded that the Agreement restricted the powers of the directors and was thus a USA within the meaning of the Corporations Act. Thus, in his view, the Agreement had to be considered when examining de jure control. 32 In the circumstances of this case, Stone J.A. concluded that the Agreement prevented Marr's from obtaining the de jure control that it otherwise might have held by virtue of owning 55.71 percent of the voting shares of Duha No. 2. Even though Marr's could in theory determine the composition of the board of directors, its ability to elect a board that could manage only the "affairs" and not the "business" of Duha No. 2 was not de jure control. Stone J.A. also observed that the referral to arbitration of irreconcilable differences between shareholders implied that the unanimous agreement of all shareholders, not simply a majority of votes, was required for business decisions. In this respect, Marr's clearly lacked de jure control over Duha No. 2. Stone J.A. concluded, therefore, that Outdoor and Duha No. 2 had not been related before they amalgamated and that Outdoor's losses could not be utilized by Duha No. 3. While it was not necessary to the manner in which he proposed to dispose of the case, Stone J.A. also held that the transaction was not a sham, as the Minister alleged, given that the requisite element of deceit as to the true nature of the transaction was not present in the circumstances.

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IV. Issues 34 The ultimate issue on this appeal is whether Duha No. 3 should have been entitled to deduct from its 1985 business income non-capital losses incurred in previous years by Outdoor, pursuant to s. 111(5) of the Income Tax Act. To answer this question, it will be necessary to decide whether documents other than the constating documents of a corporation should be considered in determining de jure control of a company for the purposes of ss. 111(5) and 251(2)(c) of the Act, and whether USAs enjoy any special status in this regard. If either or both of these questions are resolved in the affirmative, it will then be necessary to establish whether or not the Agreement was a USA within the meaning of s. 140(2) of the Corporations Act and, if so, whether it in fact deprived Marr's of de jure control over Duha No. 2. On appeal to this Court, the Minister did not pursue the argument that the transaction was a sham.

V. Analysis A. "Control" of a corporation 35 It has been well recognized that, under the Income Tax Act, "control" of a corporation normally refers to de jure control and not de facto control. This Court has repeatedly cited with approval the following test, set out by Jackett P. in Buckerfield's, supra, at p. 507: Many approaches might conceivably be adopted in applying the word "control" in a statute such as the Income Tax Act to a corporation. It might, for example, refer to control by "management", where management and the board of directors are separate, or it might refer to control by the board of directors. ... The word "control" might

55 conceivably refer to de facto control by one or more shareholders, whether or not they hold a majority of shares. I am of the view, however, that in Section 39 of the Income Tax Act [the former section dealing with associated companies], the word "controlled" contemplates the right of control that rests in ownership of such a number of shares as carries with it the right to a majority of the votes in the election of the board of directors. [Emphasis added.] Cases in which this Court has applied the foregoing test have included, inter alia, Dworkin Furs, supra, and Vina-Rug (Can.) Ltd. v. Minister of National Revenue, [1968] S.C.R. 193 (S.C.C.). 36 Thus, de jure control has emerged as the Canadian standard, with the test for such control generally accepted to be whether the controlling party enjoys, by virtue of its shareholdings, the ability to elect the majority of the board of directors. However, it must be recognized at the outset that this test is really an attempt to ascertain who is in effective control of the affairs and fortunes of the corporation. That is, although the directors generally have, by operation of the corporate law statute governing the corporation, the formal right to direct the management of the corporation, the majority shareholder enjoys the indirect exercise of this control through his or her ability to elect the board of directors. Thus, it is in reality the majority shareholder, not the directors per se, who is in effective control of the corporation. This was expressly recognized by Jackett P. when setting out the test in Buckerfield's. Indeed, the very authority cited for the test was the following dictum of Viscount Simon, L.C., in British American Tobacco Co. v. Inland Revenue Commissioners (1942), [1943] 1 All E.R. 13 (U.K. H.L.), at p. 15: The owners of the majority of the voting power in a company are the persons who are in effective control of its affairs and fortunes. [Emphasis added.] 37 Viewed in this light, it becomes apparent that to apply formalistically a test like that set out in Buckerfield's, without paying appropriate heed to the reason for the test, can lead to an unfortunately artificial result. The task before this Court, then, is to determine whether, just prior to the amalgamation, Marr's was in effective control of the affairs and fortunes of Duha No. 2 by virtue of its majority shareholdings. There is no real dispute between the parties that the de jure control test is applicable in the present circumstances. Rather, the dispute is as to which factors may be considered in assessing de jure control. In the submission of the appellant, both Linden and Stone JJ.A. erred in their respective applications of the test: Linden J.A. by holding that this Court has widened the test such that bare contractual agreements between shareholders may be considered, and Stone J.A. by concluding that the agreement here in question was a unanimous shareholder agreement within the definition of that term in the Corporations Act, and that a USA may be considered in assessing de jure control for the purposes of ss. 111(5) and 251(2)(c) of the Income Tax Act. I will examine each of these submissions in turn.

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(1) External agreements 39 In his reasons, after reviewing a number of authorities, Linden J.A. concluded (at p. 118) that ...true de jure control is just what it is stated to be, control at law. Any binding instrument, therefore, must be reckoned in the analysis if it affects voting rights.

56 In the view of Linden J.A. (at p. 118) "it is important to look to the legal position of the parties as displayed in the wider circumstances of the parties' affairs." But while this might seem a sensible approach at first glance, I can find no general support in the extensive authorities cited for Linden J.A.'s application of it. 40 The general approach to the determination of control, as I have already noted, has been to examine the share register of the corporation to ascertain which shareholder, if any, possesses the ability to elect a majority of the board of directors and, therefore, has the type of power contemplated by the Buckerfield's test, supra. The case law seems to point only to limited circumstances in which other documents may be examined, and then only to a narrow range of documents which may be considered. In my view, this is readily apparent even in the case law cited by Linden J.A. in support of the opposite position, which I shall now briefly discuss. The first case in which the Buckerfield's test was applied by this Court was Dworkin Furs, supra. Of the five appeals decided together in Dworkin Furs, the one that is most relevant to the instant case is Aaron's Ladies Apparel Limited, which involved a provision in the articles of association of the corporation which required the unanimous consent of all shareholders or directors, as the case may be, for the successful passage of any resolution. A group of shareholders held two-thirds of the total voting shares of the corporation and the issue before the Court was whether the aforementioned provision deprived this group of de jure control. Hall J., writing for the Court, held that the provision did nullify the shareholders' control of the company (at p. 236): Control of a company within Buckerfield rests with the shareholders as such and not as directors. A contract between shareholders to vote in a given or agreed way is not illegal. The Articles of Association are in effect an agreement between the shareholders and binding upon all shareholders. Article 6 in question here was neither illegal nor ultra vires. 42 In his reasons, Linden J.A. appears to have taken this statement to support the proposition that the court is entitled to consider ordinary contracts between shareholders to assess control. However, the flaw in this interpretation is immediately obvious: in Dworkin, Hall J. was dealing not with an "ordinary" contractual arrangement but with a provision of the company's articles of association, one of its constating documents. It is entirely proper to look beyond the share register when the constating documents provide for something unusual which alters the control of the company. To consider every legally binding arrangement between shareholders as such, however, is another matter entirely. As I will explain in more detail below, the distinction between contractually binding agreements outside the constating documents on the one hand, and legally binding provisions within the constating documents on the other, is crucial. With respect, Linden J.A.'s interpretation of Dworkin Furs cannot be sustained. In fact, Gibson J. in International Iron & Metal Co. v. Minister of National Revenue, [1969] C.T.C. 668 (Can. Ex. Ct.), expressly distinguished the shareholders' agreement there at issue from the "contract" considered in Dworkin Furs, which was "part of the constitution of the Company" (p.674). Attempted analogies to other case cited by Linden J.A. suffer from similar frailties. For example, Linden J.A. cites Donald Applicators Ltd. v. Minister of National Revenue (1969), 69 D.T.C. 5122 (Can. Ex. Ct.), aff'd (1971), 71 D.T.C. 5202 (S.C.C.), as standing for the proposition that de jure control is to be determined in light of the overall voting structure of the company, including "the effect of any restrictions imposed on the decision-making powers of

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57 the directors by the memorandum, the Articles, and by any shareholders agreements" (pp. 115-16). In fact, Thurlow J. (as he then was) made no reference whatsoever in that case to shareholders' agreements as an indicator of de jure control, restricting his analysis and comments, at p. 5125, only to the memorandum and articles of the company. 44 What does emerge, however, from Donald Applicators, is the notion that, in determining de jure control, the court is not limited to a strictly technical and narrow interpretation of the share register and associated share rights of a corporation. Rather, as this Court confirmed in R. v. Imperial General Properties Ltd., [1985] 2 S.C.R. 288 (S.C.C.), at p. 295, "these rights must be assessed in their impact 'over the long run'". However, this view of control, at least as enunciated by Thurlow J. in Donald Applicators, still depends upon the share rights and other powers granted by the corporate constitution, not upon any external shareholders' agreement. Donald Applicators turned on the power of the shareholders to pass any ordinary resolution as well as special resolutions by which they could remove the powers of the directors and reserve decisions to their particular class of shareholders. Given that extensive power, it could not be said that the particular shareholders lacked de jure control "in the long run". However, as shall be seen, the question of control "in the long run" does not arise in the instant case, as the majority shareholder group retained the immediate voting power to elect directors. Similarly, in Imperial General Properties, supra, the issue of control arose following a corporate reorganization which saw the original majority owners of the corporation create nonparticipating preference shares which were issued to another group of shareholders. While each class of shareholders then held 50 percent of voting shares, meaning that neither enjoyed clear majority control, the corporate constitution provided that a 50 percent vote was sufficient to wind up the company, in which case the assets of the corporation would be distributed only among the common shareholders. Therefore, Estey J., writing for the majority of this Court, held that the common shareholders had a clear advantage over the preferred shareholders and thus enjoyed de jure control. While the apparent equality of voting power in this case made it necessary for the majority to resort to the constating documents of the corporation to assess the reality of the situation, Estey J., at p. 298, made clear that this was no extraordinary step in the law: The approach to "control" here taken does not involve any departure from prior judicial pronouncements nor does it involve any "alteration" of the existing statute. The conclusions reached above merely result from applying existing case law and existing legislation to the particular facts of the case at bar. The application of the "control" concept, as earlier enunciated by the courts, to the circumstances now before the court is, in my view, the ordinary progression of the judicial process and in no way amounts to a transgression of the territory of the legislator. 46 With this admonition in mind, I do not believe that Imperial General Properties assists the Minister's case. The approach taken by the majority in deciding the case flows logically from its facts, and, in particular, the voting equality that was apparent on the share register. Indeed, the limitation of this case to the corporate structure and combination of share interests of its particular circumstances was explicitly acknowledged by Estey J. at p. 298. No such parity of shareholding is present in the circumstances of the instant appeal. In addition, in the emphatic words of Wilson J., dissenting (McIntyre J. and Lamer J., as he then was, concurring), at pp. 307-8: Although the scope of scrutiny under the de jure test has been extended beyond a mere examination of the share register in order to determine who really has voting

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58 control, there has been no deviation from the principle that voting control is the proper indicium of control until [Oakfield Developments (Toronto) Ltd. v. Minister of National Revenue, [1971] S.C.R. 1032]. I am of the view, therefore, that the decision in Oakfield is anomalous and should not be followed. For the courts suddenly to change direction in face of well-settled and long-standing authority in our tax jurisprudence is, in my view, quite inappropriate.... I do not think that this is a suitable area for judicial creativity. People plan their personal and business affairs on the basis of the existing law and they are entitled to do so. 47 Apart from whether or not it is good authority in light of the foregoing dictum of Wilson J., Oakfield Developments (Toronto) Ltd. v. Minister of National Revenue. [1971] S.C.R. 1032 (S.C.C.), which was also cited by Linden J.A. in the instant appeal, is, in my view, clearly distinguishable from the case at bar. In that case, as in Imperial General Properties, the Court had recourse to the constating documents of the corporation only because there was no other clear indicator of de jure control, as each of two shareholder groups held 50 percent of the overall voting shares of the company. Therefore, the Court considered the share rights attached to each class of shares and concluded that, because the holders of one class had the power to dissolve the company and to receive all surplus upon its dissolution, that class had de jure control even though its voting power was no greater than that of the other class. Perhaps more importantly, though, there is no indication that the Court in either case looked to any external shareholder agreement as an indicium of control; rather, only the specifics of the constating documents were considered. Equally distinguishable, in my view, are Consolidated Holding, supra, and R. v. Lusita Holdings Ltd. (1984), 84 D.T.C. 6346 (Fed. C.A.), two cases in which the courts considered documents other than the constating documents only because the majority of the shares in the companies in question were held by trustees. It was therefore necessary to examine the trust instruments in order to determine what, if any, limitations existed on the trustees' powers to vote the shares. As it happened, in both cases, the trustees could be constrained in their voting of the shares by the actions of their co-trustees: in Consolidated Holding, the will of the deceased shareholder provided that "the views, discretion or direction of any two of my trustees shall be binding upon the other of my trustees" (p. 422), while in Lusita Holdings it was found as a fact by Stone J.A. that "[t]he right to control the voting rights resided in the cotrustees and not in either of them" (p. 6348). These factors, in my view, clearly demonstrate the distinction between a trust instrument and other external documents for the purposes of assessing de jure control. A trust imposes upon the trustee a fiduciary obligation to act within the terms of the trust instrument and for the benefit of the beneficiary. That is, the trustee is not free to act other than in accordance with the trust document, and if the trust document imposes limitations upon the capacity of the trustee to vote the shares then these must accordingly be taken into account in the de jure control analysis. By contrast, any limitations which might be imposed by an outside agreement are limitations freely agreed to by the shareholders, and not at all inconsistent with their de jure power to control the company. In other words, limitations on the voting powers of trustees must be seen as limitations on their capacity as free actors in the circumstances. No such limitations encumber the ordinary shareholder in his or her exercise of de jure control, even if an outside agreement exists to limit actual or de facto control. In any event, I certainly do not think it can be said that Consolidated Holding supports the very broad proposition gleaned from it by Linden J.A. (at p. 118), that "[a]ny binding instrument ... must be reckoned in the analysis if it affects voting rights". For precisely the reasons

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59 expressed by Wilson J. in the above-quoted passage of her dissent in Imperial General Properties, and in keeping with the approach taken by courts since Buckerfield's, it is clear that the general test for de jure control remains majority voting control over the corporation, as manifested by the ability to elect the directors of the corporation. While this Court has occasionally been willing to examine factors other than the share register of the company, its assessment has been restricted only to the constating documents, not external agreements. The only exception to this rule has been in cases like Consolidated Holding, where the shareholders' very capacity to act has been limited by external documents, but this has to date been manifested only in cases where the shares are held by trustees. 51 Thus, I would conclude that, as a general rule, external agreements are not to be taken into account as determinants of de jure control. This is consistent with the relatively recent decision of the Alberta Court of Queen's Bench in Harvard International Resources Ltd. v. Alberta (Provincial Treasurer) (1992), 93 D.T.C. 5254 (Alta. Q.B.), in which Hutchinson J. declined to interpret the reasons of Estey J. in Imperial General Properties, supra, as inviting the consideration of agreements other than constating documents, other than possibly as an indicium of de facto control. For Linden J.A. to rest his disposition of the instant case on the basis that, in determining issues of corporate control, "the Court will look to the time in question, to legal documents pertaining to the issue, and to any actual or contingent legal obligations affecting the voting rights of shares" (p. 121) was, with respect, inconsistent with the Canadian jurisprudence in this area. Moreover, as Wilson J. correctly observed in her dissent in Imperial General Properties, supra, taxpayers rely heavily on whatever certainty and predictability can be gleaned from the Income Tax Act. As such, a simple test such as that which has been followed since Buckerfield's is most desirable. If the distinction between de jure and de facto control is to be eliminated at this time, this should be left to Parliament, not to the courts. In fact, while it is not directly relevant to the outcome of this appeal, I would observe nonetheless that Parliament has now recognized the distinction between de jure and de facto control, adopting the latter as the new standard for the associated corporation rules by means of s. 256(5.1) of the Income Tax Act, enacted in 1988. In addition, I do not think that the respondent's case is assisted by the decision of the Tax Court of Canada in Alteco Inc. v. R., [1993] 2 C.T.C. 2087 (T.C.C.). Alteco concerned an agreement which provided, inter alia, that no shares in the corporation could be sold or pledged without unanimous shareholder consent, that the five-member board of the company could not be altered without unanimous consent, and that the minority (49 percent) shareholder was entitled to three of the five seats on the board. This agreement was indeed considered in deciding that the minority shareholder enjoyed de jure control over the company. But two significant distinctions separate Alteco from the case at bar. For one, Bell J.T.C.C. found that the agreement at issue in Alteco was a "unanimous shareholder agreement" within the definition of that term in the Saskatchewan Business Corporations Act. While it may be that the agreement in the present case was also a USA, a possibility which I shall consider below, this was not the basis for the reasoning of Linden J.A., and it simply cannot be said that giving effect to a USA as a determinant of de jure control necessarily opens the door to the consideration of all shareholder agreements for this purpose. Secondly, the agreement in Alteco guaranteed the minority shareholder a majority of seats on the board of directors. As I see it, it is not clear in the case at bar that either party enjoyed this type of guaranteed control. While it is true that Marr's could only elect one direct nominee of its own, it would have been possible, as the trial judge found, for it to elect its own nominee, one

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60 Duha nominee, and Paul Quinton, who could not be said to be a nominee of either party. While Mr. Quinton was a longtime friend of the Duha family and a director of Duha No. 1, he was also a friend of William Marr and no actual evidence was adduced to suggest that his loyalties lay with the Duhas. If anything, this assessment must have come down to a question of credibility, and with respect, it was not open to Linden J.A. to interfere with such a finding of the trial judge in the absence of palpable and overriding error. In any event, however, the major concern of the de jure test is to ascertain which shareholder or shareholders have the voting power to elect a majority of the directors. The test neither requires nor permits an inquiry into whether a given director is the nominee of any shareholder, or any relationship or allegiance between the directors and the shareholders. 55 Therefore, as I have indicated, I conclude that Linden J.A. erred in considering the Agreement for the purposes of ascertaining de jure control, even assuming, for the sake of argument only, that he was correct in treating it as an ordinary shareholders' agreement. This determination is generally to be restricted to the share register of the company, as is clear from Buckerfield's and the related case law. However, as I have already mentioned, it would be unduly artificial to restrict the analysis in this way if something exists in the corporate constitution of the company to alter the picture of de jure control. Thus, to ensure an accurate result, the share register should be read in light of the relevant corporate law legislation (in this case, the Corporations Act) and the constating documents of the corporation. External agreements, however, have no place in this analysis; they are relevant only to de facto control. Of course, all of this begs the question of the status of the unanimous shareholder agreement, in its statutory form, as a determinant of de jure control. It is to this question that I now turn. (2) (a) 57 Unanimous shareholder agreements The nature and significance of the USA for the purposes of de jure control

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Stone J.A. based his concurring reasons on the characterization of the agreement in question as a USA. Important references to such agreements in the Corporations Act are to be found in ss. 97(1) and 140(2). Section 97(1)(b) contemplates the abrogation, by a USA, of the power of the directors to "direct the management of the business and affairs of the corporation", while s. 140(2) confirms the validity of such agreements for the purpose of restricting the powers of the directors to manage said business and affairs. The legal status of the USA, which is a unique species of agreement given its statutory origin and recognition, has nonetheless been a matter of some uncertainty. At the outset, it is important to bear in mind the distinction between the tests of de jure and de facto control developed by the courts. In my view, the de jure standard was chosen because in some respects it is a relevant and relatively certain and predictable concept to employ in determining control. In general terms, de jure refers to those legal sources that determine control: namely, the corporation's governing statute and its constitutional documents, including the articles of incorporation and by-laws. The de facto concept was rejected because it involves ascertaining control in fact, which can lead to myriad of indicators which may exist apart from these sources. See, for example, F. Iacobucci and D.L. Johnston, "The Private or Closely-held Corporation", in J.S. Ziegel, ed., Studies in Canadian Company Law (1973), vol. 2, 68, at pp. 108-12. As I have already indicated, agreements among shareholders, voting agreements, and the like are, as a general matter, arrangements that are not examined by courts to ascertain control. In

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61 my view, this is because they give rise to obligations that are contractual and not legal or constitutional in nature. Thus, to my mind, the issue comes down to whether the USA is to be characterized as constitutional or contractual in nature. If it is the former, then its provisions are to be examined under the de jure control analysis; if it is the latter, then its provisions are beyond the scope of that test. For a discussion of the origin of the USA in Canadian corporate law, see, generally, R.W.V. Dickerson, J.L. Howard and L. Getz, Proposals for a New Business Corporations Law for Canada (1971), at paras. 298-299. 60 Fortunately, the instant case provides ample opportunity to put this debate to rest. In my view, for the reasons that follow, the USA is to be considered a constating document for the purposes of determining de jure control of a corporation. The argument for treating a USA as part of the corporate constitution, along with and equivalent to the articles of incorporation and the by-laws, is strong, given the role of such an agreement in the overall context of corporate governance. As Professor Welling points out in Corporate Law in Canada (2nd ed. 1991), at p. 481 et seq., prior to statutory provision for USAs, the ability of shareholders to control a corporation incorporated in Canadian jurisdictions (and which, I would add, did not follow the English memorandum and articles of association system of incorporation) was in reality limited to the power to elect and dismiss directors. Directors generally owe a duty not to the shareholders but to the corporation, and shareholders could not, therefore, control the day-to-day business decisions made by the directors and their appointed officers. In other words, although the shareholders could elect the individuals who would make up the board, the board members, once elected, wielded virtually all the decision-making power, subject to the ability of the shareholders to remove or fail to re-elect unsatisfactory directors. However, in a private or closely held corporation, it may generally be assumed that the dominant interests to be served by decision-making are the expectations and needs of the shareholders, as opposed to the corporation in the abstract. These corporations were modelled to some extent on incorporated partnerships, and the underlying economic policy was thought to be best met by enabling the shareholders to arrange the organization of their enterprise as they choose: see Iacobucci and Johnston, supra. Because, at common law, shareholders could not agree to fetter or interfere with the discretion of the directors, even unanimously (see Motherwell v. Schoof, [1949] 4 D.L.R. 812 (Alta. T.D.), and Atlas Development Co. v. Calof (1963), 41 W.W.R. 575 (Man. Q.B.), legislative intervention was needed to allow shareholders to choose their corporate control and management structure. See Iacobucci, "Canadian Corporation Law: Some Recent Shareholder Developments", in The Cambridge Lectures 1981 (1982), 88 at p. 92 et seq. The advent of the USA, first in the CBCA and then in other statutes modelled after it, materially altered this situation by providing a mechanism by which the shareholders, through a unanimous agreement, could strip the directors of some or all of their managerial powers as desired by the shareholders. Rather than removing the directors from their positions, a USA simply relieves them of their powers, rights, duties, and associated responsibilities. This may be accomplished without specific formality; all that is required appears to be some unanimous written expression of shareholder will. The result, however, amounts to a fundamental change in the management of the company, as s. 140(5) of the Corporations Act provides that the shareholders who are parties to the USA assume all the rights, powers, duties and liabilities of the directors which are removed by the agreement, and that the directors are relieved of their

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62 duties and liabilities to the same extent. As I have already intimated, what is in effect created is an "incorporated partnership" with statutory force. 65 Stone J.A. opined that, if an agreement can be viewed as a USA within the definition in the Corporations Act, it is to be read alongside the corporation's constating documents in determining the issue of de jure control. I agree. The fact that the USA has supplanted the long-standing principle of shareholder non-interference with the directors' powers to manage the corporation, an exclusive right which is granted by the statute and the corporate constitution, clearly indicates that it is at least as important as the "traditional" constating documents in assessing de jure control. It would be truly artificial to conclude, only on the basis of the share register, the articles of incorporation, and the by-laws, that one shareholder has de jure control over the corporation by virtue of its apparent power to elect the majority of the board of directors, if a USA exists which limits substantially the power of the board itself. In other words, the USA is a corporate law hybrid, part contractual and part constitutional in nature. The contractual element is immediately apparent from a reading of s. 140(2): to be valid, a USA must be an "otherwise lawful written agreement among all the shareholders of a corporation, or among all the shareholders and a person who is not a shareholder". It seems to me that this indicates not only that the USA must take the form of a written contract, but also that it must accord with the other, general requirements for a lawful and valid contract. More generally, the USA is by its nature able to govern both the procedure for running the corporation and the personal or individual rights of the shareholders: see Iacobucci, supra. The constitutional element of the USA is even more potent than its contractual features. Numerous provisions of the Corporations Act that govern fundamental aspects of the running of the corporation, including the management of its business and affairs (s. 97(1)), the issuing of shares (s. 25(1)), the passing of by-laws (s. 98(1)), the appointment of officers (s. 116), and the situations in which a dissenting shareholder can request dissolution of the company (s. 207(1)(b)), are expressly made subject to the USA. More generally, s. 6(3) reads as follows: 6(3) Subject to subsection (4), if the articles or a unanimous shareholder agreement require a greater number of votes of directors or shareholders than that required by this Act to effect any action, the provisions of the articles or of the unanimous shareholder agreement prevail. [Emphasis added.] Subsection (4) stipulates only that the articles may not require a greater number of votes to remove a director than that required elsewhere in the Act, but does not place any such limitation on a USA. This denotes the equivalent constitutional status of the USA vis--vis the articles of incorporation. 68 This status is greatly reinforced by s.20(1) of the Corporations Act, which requires that a copy of any USA, along with the articles and by-laws of the corporation, be contained in the corporate records required by that section to be maintained at the registered office of the corporation. This is cogent evidence that the legislator has treated the corporation's constating documents and the USA in pari materia. It is also significant that s. 240 of the Corporations Act includes USAs along with the Act, the regulations promulgated thereunder, and the articles and by-laws of a corporation as documents the breach of which entitle a complainant or a creditor to seek a compliance order or other remedy deemed appropriate by the court. As well, the provisions of a USA may be enforced against the corporation and its officers and directors although they need not be parties to the agreement. This stands as a further indication of the constitutional character of the USA.

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63 69 Thus, a USA can play a vital role in the de jure control analysis. If the Buckerfield's test were to be followed slavishly and the inquiry limited only to the share register of the corporation, or even extended to the articles of incorporation and by-laws but not to USAs, then a company could circumvent the test or obfuscate the picture of corporate control simply by confining to a USA provisions that substantially alter the way in which corporate decisions are made. If, by a USA, the board of directors is deprived of the power to manage the business and affairs of the corporation, this is more than simply an issue of de facto control. It would defy logic to treat de jure control as remaining unaltered by an agreement which, by the very statute which governs the incorporation of the company and the governance thereof by its articles and by-laws, is given the same power as the articles to supersede the statutory provisions for corporate control. Not only is this a distinction without a difference, but it is also one without any principled foundation. As I have said, the essential purpose of the Buckerfield's test is to determine the locus of effective control of the corporation. To my mind, it is impossible to say that a shareholder can be seen as enjoying such control simply by virtue of his or her ability to elect a majority of a board of directors, when that board may not even have the actual authority to make a single material decision on behalf of the corporation. The de jure control of a corporation by a shareholder is dependent in a very real way on the control enjoyed by the majority of directors, whose election lies within the control of that shareholder. When a constating document such as a USA provides that the legal authority to manage the corporation lies other than with the board, the reality of de jure control is necessarily altered and the court must acknowledge that alteration. Therefore, I would conclude that, while "ordinary" shareholder agreements and other external documents generally should not be considered in assessing de jure control, in keeping with the long line of jurisprudence to this effect, the USA is a constating document and as such must be considered for the purposes of this analysis. To this end, I must add that, to the extent that it held that a USA is not one of the constating documents of a corporation. Alteco, supra, was wrongly decided. It is true that, at common law, a unanimous agreement between or among shareholders would have been considered only as part of the de facto analysis. However, in my view, the unique status of the statutory form of USA in corporate law, when compared to other shareholder agreements, provides a complete answer to the appellant's concern that the consideration of the USA for the present purpose would open the door to the consideration of all agreements between shareholders. Unlike an "ordinary" shareholder agreement, which cannot interfere with the exercise of the directors' powers, a USA can and must do so. Moreover, as we have seen, a USA can in fact incorporate provisions that would otherwise be contained in the articles. Viewed in this light, I fail to see how the USA can be ignored as a vital determinant of de jure control. The appellant correctly points out that to recognize the USA as affecting de jure control begs the question of how much power must be removed from the directors before one may safely conclude that the majority voting shareholder no longer has de jure control. Certainly, the existence of a USA does not necessarily imply the loss of de jure control. But I cannot agree that there is no rational basis for determining when a majority shareholder loses de jure control on the basis of a restriction of the directors' powers. As I will discuss in more detail below, this issue comes down to a question of fact, turning on the extent to which the powers of the directors to manage are restricted, to what extent these powers have devolved to the shareholders, and to what extent the majority shareholders are thereby able to control the exercise of the governing powers.

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64 73 Accordingly, two questions remain to be answered: whether the Agreement in this case was a USA, and, if so, whether it in fact deprived Marr's of de jure control over Duha No.2. (b) Was the Agreement a USA? Section 1(1) of the Corporations Act defines a USA as, inter alia, an agreement of the type described in s. 140(2). Stone J.A. recognized that this section discloses a number of requirements for a valid USA: the agreement must be "otherwise lawful", must be among all the shareholders of the corporation (as well as, possibly, a non-shareholder), and must restrict, in whole or in part, the powers of the directors to manage "the business and affairs of the corporation". There is really no room for debate as to whether the Agreement satisfied the first two criteria. To the extent that the status of the Agreement is in question, the issue is whether it satisfied the third. In the view of Stone J.A., the Agreement satisfied those requirements and was therefore a USA. He based this conclusion on a technical analysis of the Agreement, and especially Article 2.1, which provided that the "affairs" of the corporation were to be managed by the board of directors, and Article 6.1, which provided for the settlement by arbitration of disputes between shareholders on matters concerning the "business" of the corporation. From these provisions, Stone J.A. inferred that the Agreement deprived the directors of Duha No. 2 of the power to manage the "business" of the corporation, leaving them with control only over its "affairs". Because s. 1(1) of the Corporations Act defines "business" as a concept separate from and exclusive of "affairs", Stone J.A. concluded that the Agreement restricted the s. 97(1) management power of the directors and was therefore a USA within the meaning of s. 140(2). For my part, I find this conclusion difficult to accept. To provide that the directors shall have the power to manage the "affairs" of the corporation cannot, without more, be taken to exclude them from the management of the "business". Despite the separate definitions of the two concepts in s. 1(1), it seems to me that clearer language would be required to remove such a fundamental power from the directors. Moreover, it is not at all clear that "affairs" must be defined, for the purposes of the Agreement, by reference to its statutory definition -- especially, as I will discuss below, when to so define this term could lead to a rather awkward result. Indeed, the Concise Oxford Dictionary (9th ed. 1995) defines "affairs" as including "business dealings". Considering this linguistic ambiguity in addition to the foregoing concerns, I do not think it safe to conclude that the intention of Article 2.1 was to deprive the directors of their power to manage the business of Duha No. 2. I take a similar view of the effect of Article 6.1. The presence of this arbitration clause to resolve disputes among shareholders does not lead to the conclusion that all business of the corporation was to be transacted by unanimous shareholder resolution, as the Minister contends. Again, clearer language would be required to achieve this end, particularly when it is considered that the result of such an arrangement would be that the entire corporation could be paralyzed by the dissent of a single shareholder on a very minor issue. A better interpretation, as contended for by the appellant, is that the word "business" in Article 6.1 was used to refer to corporate business that is ordinarily transacted among shareholders, rather than business of the corporation which is within the power of the directors to manage. In fact, this is consistent with s. 129(5) of the Corporations Act, which makes specific reference to "business" transacted by shareholders at an annual or special meeting of shareholders. Generally speaking, USAs exist to deal with major issues facing a corporation: corporate structure, issuance of shares, declaration of dividends, election of directors, appointment of officers, and the like. General business decisions are not ordinarily touched by such

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65 arrangements, and with good reason: it would not be efficient, for business purposes, to remit every decision, however minor, to a shareholder vote, let alone to require unanimous agreement among the shareholders on such decisions. Fundamental disagreements among shareholders are ordinarily dealt with by different means, such as, for example, buy-sell arrangements or other methods of dispute resolution. In exceptional cases, a USA may provide that an aggrieved shareholder may apply to the court for dissolution of the corporation and the return of his or her share capital. But these are long-term solutions which are agreed upon with a view to facilitating the ongoing operation of the business, undisturbed by the dayto-day wrangling and disagreements that often characterize the relationships among shareholders in closely-held companies, while permitting insurmountable disputes to be resolved by special measures. This is vastly different from requiring unanimous consent to every action taken in furtherance of the business of a corporation. Such an extraordinary corporate policy would require specific expression in the constating documents. In my view, the provisions cited by the Minister do not qualify as such. 79 However, this is not to say that the Agreement does not affect the powers of the directors at all and, as such, is not a USA. On the contrary, Article 4.4, which prevented the corporation from issuing further shares "without the written consent of all of the Shareholders", imposed a clear restriction upon the directors' power to manage. According to s.25(1) of the Corporations Act, Subject to the articles, the by-laws and any unanimous shareholder agreement ... shares may be issued at such times and to such persons and for such consideration as the directors may determine. [Emphasis added.] Thus, by reserving to themselves one of the powers of management which the Act expressly grants to the directors, the shareholders obviously restricted in part the ability of the directors to manage the corporation. Additionally, the language of s. 25(1) makes clear that, in the absence of a specific provision in the constating documents, such can only be accomplished by means of a USA. To my mind, there is no doubt that this brings the Agreement within the terms of s. 140(2). 80 To summarize my conclusions on this point, I agree with Stone J.A. that the Agreement constituted a USA, within the meaning of s. 140(2) of the Corporations Act, but for different reasons. While the provisions of Articles 2.2 and 6.1 did not, to my mind, pose any restrictions on the power of the directors to manage the business and affairs of the corporation, Article 4.4 surely did. The next question, therefore, is whether this particular USA had the effect of depriving Marr's of de jure control over Duha No. 2. (c) The effect of the USA 81 As I have already said, the simple fact that the shareholders of a corporation have entered into a USA does not have the automatic effect of removing de jure control from a shareholder who enjoys the majority of the votes in the election of the board of directors. Rather, the specific provisions of the USA must alter such control as a matter of law. But to what extent must these powers be compromised before the majority shareholder can be said to have lost de jure control over the company? In my view, it is possible to determine whether de jure control has been lost as a result of a USA by asking whether the USA leaves any way for the majority shareholder to exercise effective control over the affairs and fortunes of the corporation in a way analogous or equivalent to the power to elect the majority of the board of directors (as contemplated by the

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66 Buckerfield's test). There need be no concern that the consideration of USAs in the de jure analysis will lead either to uncertainty or to a situation where every USA would automatically imply a loss of de jure control by the majority shareholder. It will in every case be necessary to establish this result by examining the specific provisions of the USA in question. 83 In my view, the provisions in the Agreement at issue in this case did not in fact result in the loss of de jure control by Marr's. The inability to issue new shares without unanimous shareholder approval, while surely a restriction on the powers of the directors to manage the business and affairs of Duha No. 2, was not so severe a restriction that Marr's can be said to have lost the ability to exercise effective control over the affairs and fortunes of the company through its majority shareholdings. In fact, Thurlow J. expressly found in Donald Applicators, supra, at p. 5125, that "the authority of the directors of the appellant companies [was] only slightly restricted or modified" from their statutory powers by their inability to issue new shares, and that this restriction did not have "any serious effect on the authority of the directors to govern the business of the company and generally to direct its affairs". These holdings, along with the balance of the reasons in Donald Applicators, were affirmed by this Court. Thus, I would conclude that, in the circumstances of this case, the general rule holds. Marr's, by virtue of its ability to elect the majority of the board of directors, enjoyed de jure control over Duha No. 2 immediately prior to its amalgamation with Outdoor. Nothing in the constating documents, including the USA, served to alter this state of affairs. Accordingly, there was no change in control occasioned by the amalgamation, which means that s. 111(5) of the Income Tax Act did not prevent Duha No. 3 from deducting from its 1985 taxable income the noncapital losses accumulated in previous years by Outdoor, regardless of whether or not the business of Outdoor was intended to be or was actually carried on by Duha No. 3 as a going concern. (3) Summary of principles and conclusion as to control 85 It may be useful at this stage to summarize the principles of corporate and taxation law considered in this appeal, in light of their importance. They are as follows: (1) (2) Section 111(5) of the Income Tax Act contemplates de jure, not de facto, control. The general test for de jure control is that enunciated in Buckerfield's, supra: whether the majority shareholder enjoys "effective control" over the "affairs and fortunes" of the corporation, as manifested in "ownership of such a number of shares as carries with it the right to a majority of the votes in the election of the board of directors". To determine whether such "effective control" exists, one must consider: (a) the corporation's governing statute; (b) the share register of the corporation; and (c) any specific or unique limitation on either the majority shareholder's power to control the election of the board or the board's power to manage the business and affairs of the company, as manifested in either: (i) the constating documents of the corporation; or (ii) any unanimous shareholder agreement. Documents other than the share register, the constating documents, and any unanimous shareholder agreement are not generally to be considered for this purpose.

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67 (5) If there exists any such limitation as contemplated by item 3(c), the majority shareholder may nonetheless possess de jure control, unless there remains no other way for that shareholder to exercise "effective control" over the affairs and fortunes of the corporation in a manner analogous or equivalent to the Buckerfield's test.

B. Object and spirit 86 In light of the foregoing conclusions, it is not necessary to consider whether the Federal Court of Appeal erred in considering the object and spirit of the Income Tax Act provisions, the intentions of the parties, and the commercial reality of the transactions, given that the relevant provisions of the Act are clear and unambiguous. However, I would like to comment briefly on the suggestion by the appellant that Linden J.A. would have denied the taxpayer the benefit of the provisions of the Act "simply because the transaction was motivated solely for tax planning purposes". It is well established in the jurisprudence of this Court that no "business purpose" is required for a transaction to be considered valid under the Income Tax Act, and that a taxpayer is entitled to take advantage of the Act even where a transaction is motivated solely by the minimization of tax: Stubart Investments Ltd. v. R., [1984] 1 S.C.R. 536 (S.C.C.). Moreover, this Court emphasized in Antosko, supra, at p. 327 that, although various techniques may be employed in interpreting the Act, "such techniques cannot alter the result where the words of the statute are clear and plain and where the legal and practical effect of the transaction is undisputed". Although Linden J.A. cites these principles in his reasons, he appears not to have adhered to them in his analysis. At various junctures, he comments broadly about the apparent structuring of transactions, including the one at issue in this appeal, solely for tax purposes, and seems to imply, particularly in his analysis of the International Iron and Buckerfield's cases, supra, that the courts will not permit shareholders to attain tax benefits by means of "contrived" transactions. To the extent that this analytical approach may have affected his ultimate decision, Linden J.A. was, with respect, in error. It was entirely open to the parties to use what Linden J.A. referred to as "technicalities of revenue law" to achieve their desired end: to transfer de jure control of Duha No. 2 to Marr's while preventing Marr's from exercising actual or de facto control over the business of the corporation. Indeed, this is what they accomplished, and nothing in the "object and spirit" of any of the various provisions can serve to displace this result. That is, while the general purpose of s. 111(5) may be to prevent the transfer of non-capital losses from one corporation to another, the parties successfully excepted themselves from the general rule by bringing the two companies under common control prior to their amalgamation.

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VI. Disposition 89 For these reasons, I would allow the appeal, set aside the judgment of the Federal Court of Appeal, and restore the judgment of the Tax Court of Canada, with costs to the appellant throughout.

Appeal allowed.

Other Documents Affecting Voting Control? (De Jure vs. De Facto Control?)

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M.N.R. v. Dworkin Furs (Pembroke) Ltd. et al., [1967] C.T.C. 50 (S.C.C.). The Buckerfield's concept of de jure control is again approved by the Supreme Court of Canada. Vineland Quarries also adopted the Buckerfield's concept but the Supreme Court in that case only dismissed the appeal without reasons whereas in the Dworkin Furs case the Court gave written reasons confirming adoption of the Buckerfield's test. The case deals with the concept of a casting vote. Articles of a corporation provided that at meetings of shareholders and of directors of the corporation, the chairman of the meeting had a second or casting vote. Mr. Aaron owned 50% of the issued and voting shares of Allied Business Supervisions Limited, and as chairman of meetings of shareholders, had a second or casting vote. It was therefore argued that he had control of the corporation. The Court held that the casting vote was an adjunct of the office of chairman of the particular meeting and was not a vote arising from a shareholding and therefore did not give Mr. Aaron control. In Avotus Corp. v. R., 2006 TCC 505, [2007] 2 C.T.C. 2001, Justice Paris held that the chairmans power to cast the deciding vote at a directors meeting gave the chairman control. What is interesting is that the chairman claims to have been unaware of this provision found in the corporations bylaws and had not used this provision to actually control the company. Here it appears the written documents are taking precedence over the day-to-day situation in existence. In contrast, in Plomberie J.C. Langlois Inc. c. R., [2007] 3 C.T.C. 148 (FCA), the actual facts appear to take precedence over the written agreements. The corporation was owned by two shareholders, each with 50% control, one had a decision making role while the other had an operation role. The shareholder with the decision making role was considered in de facto control of the company since he was the sole director and effectively ran the companys administration and finances. There was a unanimous shareholder agreement in place but it was not being enforced so the Court disregarded this agreement when determining whether de facto control existed. The Tax Court in Brownco Inc., 2008 TCC 58, held that 50% ownership plus a casting vote on the board given by a unanimous shareholder agreement created de facto control. e. The Role of Other Factors in Determining Control Consider the following case and note the additional factors considered in determining de facto control.

Transport M.L. Couture Inc. c. R.

9044-2807 Qubec Inc., Appellant and Her Majesty the Queen, Respondent APPEAL by trucking and haulage corporation from judgment reported at 2003 CarswellNat 1199 (T.C.C. [General Procedure]), where its appeal, along with appeal of associated corporation, from assessments refusing small business deductions for 1995 to 1997 taxation years were both dismissed.

Nol J.A.: This is one of two appeals from a decision by Judge Archambault on January 16, 2003 (2003 D.T.C. 817, [2003] 3 C.T.C. 2882 (T.C.C. [General Procedure])). Both appeals (the other being listed as case A-81-03) were consolidated on May 2, 2003, and this appeal designated the [TRANSLATION] "principal appeal".
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69 The issue is whether 9044-2807 Qubec inc. (the appellant or ML1) and the appellant in the related case Transport M.L. Couture inc. (ML2) were associated with Transport Couture et Fils inc. (Transport Couture) and 1864-5333 Qubec inc. (1864 Qubec) within the meaning of subsection 256(1) of the Income Tax Act when read with subsection 256(5.1). If so, the Tax Court judge was right to deny the appellant the full amount of the small business deduction mentioned in subsection 125(1) of the Act, and the parties agree that the appeal should be dismissed.
2

Facts The trial judge's reasons set out in detail the development of the trucking business founded by Louis-Marie Couture in the 1950s, which is the subject of the case at bar. Since the parties did not dispute the account of the facts given by the trial judge at paragraphs 2 to 14 of his reasons, I rely on that account and feel no need to set it out again.
3

I need only note, to explain the background to the case, that in the relevant period (the taxation years ending August 31, 1995, August 31, 1996 and December 9, 1996, in the case of ML1 and August 31, 1997, in the case of ML2), Transport Couture, ML1 and ML2 were under the control of separate persons according to the list of the holders of their respective capital stock.
4

Thus, Transport Couture's shares were held by a holding company (1864 Qubec) in which LouisMarie Couture's five sons each held 20% of the capital stock.
5 6

Louis-Marie Couture was the sole shareholder in ML1. Ninety per cent of ML2's shares were held by his wife, Fleurette Couture. The other 10% was held by Claude Rodrigue, Louis-Marie Couture's former accountant, who became the internal comptroller of Transport Couture and secretary of ML1 in 1995 and who was still occupying those positions during the period at issue. At the same time, ML1 and ML2 had no separate employees or premises. Transport Couture was their sole client and it was that company which provided the management services and obtained for ML1 and ML2 the drivers who carried out their transport operations. Fleurette Couture and LouisMarie Couture had little or no involvement in their respective companies. It was Transport Couture which ensured that things worked smoothly.
7

It was on the basis of these facts that the trial judge concluded that ML1 and ML2 were under the controlling influence of Transport Couture and subject to its de facto control.
8

[statutory provisions deleted]

Decision a quo The trial judge came to the conclusion that Transport Couture exercised de facto control over ML1 and ML2 during the relevant period and that they were therefore associated within the meaning of section 256. Accordingly, ML1, ML2 and Transport Couture had to share the $200,000 "business limit" mentioned in section 125(2) of the Act.
11

In the course of his reasons the judge indicated that before 1988, the Act did not define what control of a corporation was. In the absence of any legislative guidance, the courts have concluded over the years that only de jure control is decisive (that is, the power to elect a majority of the directors of a corporation).
12

70 In this regard, the trial judge cited the classic decision on the matter (Buckerfield's Ltd. v. Minister of National Revenue (1964), 64 D.T.C. 5301 (Can. Ex. Ct.), at 5303:
13 Many approaches might conceivably be adopted in applying the word 'control' in a statute such as the Income Tax Act to a corporation. It might, for example, refer to control by 'management', where management and the Board of Directors are separate, or it might refer to control by the Board of Directors. The kind of control exercised by management officials or the Board of Directors is, however, clearly not intended by section 39 when it contemplates control of one corporation by another as well as control of a corporation by individuals (see subsection (6) of section 39). The word 'control' might conceivably refer to de facto control by one or more shareholders whether or not they hold a majority of shares. I am of the view, however, that, in section 39 of the Income Tax Act, the word 'controlled' contemplates the right of control that rests in ownership of such a number of shares as carries with it the right to a majority of the votes in the election of the Board of Directors. See British American Tobacco Co. v. I.R.C., [1943] 1 A. E. R. 13, where Viscount Simon L. C., at page 15, says: The owners of the majority of the voting power in a company are the persons who are in effective control of its affairs and fortunes.

He explained that subsection 256(5.1) was adopted in 1988 to incorporate the concept of de facto control in the Act, together with the concept of de jure control. To avoid any conflict between these two concepts, the Act now provides in subparagraph 256(1.2)(b)(ii) that a corporation may be controlled by a person notwithstanding that the corporation is also controlled or deemed to be controlled by another person. Accordingly, Transport Couture could exercise de facto control over ML1 and ML2 although the de jure control lay elsewhere.
14

After a lengthy analysis of the facts surrounding the operations of the corporations in question, and relying principally on their economic dependence on Transport Couture, the operational control exercised over each of them by Transport Couture and the family connection between the shareholders of the three corporations the trial judge concluded there was such control by Transport Couture over ML1 and ML2 (reasons, paragraphs 34 to 38).
15

Alleged errors in judgment a quo In support of its appeal, the appellant challenged the trial judge's conclusion regarding the operational control allegedly exercised by Transport Couture and the economic interrelationship between that corporation and ML2. On the evidence, ML1 and ML2 could issue subcontracts at any time or act as "brokers" for other businesses.
16

Additionally, in the appellant's submission, there is nothing to show that the five Couture brothers benefited economically from the fact that ML1 and ML2 were entitled to the full small business deduction, and conversely nothing indicated that Louis-Marie Couture in the case of ML1, or Fleurette Hamel Couture and Claude Rodrigue in the case of ML2, benefited economically from the fact that Transport Couture and 1864 Qubec were entitled to that full deduction. Thus, the appellant submitted, the very spirit of the application of subsection 256(5.1) was not met.
17

Finally, the appellant submitted that the trial judge made an error of law in the interpretation of subparagraph 256(1.2)(b)(ii), which provides that "a corporation may be controlled by a person or a particular group of persons notwithstanding that the corporation is also controlled or deemed to be controlled by another person or group of persons".
18

In the appellant's submission, the wording of subsection 256(1.2) clearly limits its application to subsections (1), (1.1) and (1.3) to (5). If Parliament had intended a broader application covering subsection (5.1), it would have used wording similar to subsections 256(6.1) and 256(6.2), which deal
19

71 with simultaneous control. Thus, according to the appellant, in the case at bar de jure control and de facto control cannot coexist. Analysis and decision In my view, the trial judge gave a complete answer to this last argument at paragraph 40 of his reasons:
20 As for the alternative argument raised by counsel for the appellants, namely, that there could be no control in fact of ML1 and ML2 where there was control de jure of these corporations, I will note here, as I concluded in the Rosario Poirier inc. decision [17] (supra), that subparagraph 256(1.2)(b)(ii) of the Act expressly provides that one person may control a corporation even if another controls it also. The fact that subsection 256(1.2) does not refer to subsection 256(5.1) of the Act does not preclude the simultaneous existence of de jure control by one person and de facto control by another. These two concepts are found in subsection 256(1) of the Act. In other words, subsection 256(1.2) of the Act does not have to refer to subsection 256(5.1). The reference to subsection 256(1) suffices.

Subsection 256(1), referred to by subsection 256(1.2), is a provision of general application the effect of which is to associate one corporation with another wherever one controls the other, and subparagraph 256(1.2)(b)(ii) states that for this purpose the existence of one of these two forms of control does not exclude the other. The fact that subsection 256(1.2) makes no reference to subsection 256(5.1) does not in any way impair the effect sought.
21

As to the argument that the application of the concept of de facto control is contrary to the spirit of subsection 256(5.1), on the ground that the claiming of the full deduction by one of the corporations in question does not economically benefit the shareholders of the other, I note as did the trial judge that it is members of the same family who were shareholders of ML1, ML2 and Transport Couture. In any case, nothing in subsection 256(5.1) requires that there be such a benefit.
22

This leads us to the question of whether the trial judge could conclude that there was control of ML1 and ML2 by Transport Couture within the meaning of subsection 256(5.1). This is essentially a question of fact, and the Court clearly should not intervene unless there was palpable and overriding error (Housen v. Nikolaisen, [2002] 2 S.C.R. 235 (S.C.C.)).
23

It is not possible to list all the factors which may be useful in determining whether a corporation is subject to de facto control (Duha Printers (Western) Ltd. v. R., [1998] 1 S.C.R. 795 (S.C.C.), para. [38]). However, whatever factors are considered, they must show that a person or group of persons has the clear right and ability to change the board of directors of the corporation in question or to influence in a very direct way the shareholders who would otherwise have the ability to elect the board of directors (Silicon Graphics Ltd. v. R., 2002 FCA 260 (Fed. C.A.), para. [67]). In other words, the evidence must show that the decision-making power of the corporation in question in fact lies elsewhere than with those who have de jure control.
24

The trial judge relied primarily on the operational control exercised by Transport Couture, the economic dependence on it of ML1 and ML2 and the family relations between the shareholders as a basis for concluding that Transport Couture in fact controlled ML1 and ML2. The appellant did not challenge the relevance of the factors considered by the trial judge. However, it argued that the evidence did not allow the trial judge to conclude that operational control of ML1 and ML2 was in the hands of Transport Couture or that ML1 and ML2 were economically dependent on Transport Couture.
25

In my view, the evidence amply supports the trial judge's decision. As he indicated at paragraph 36 of his reasons, if Transport Couture had decided not to renew its management contract and no
26

72 longer to retain the services of ML1 and ML2, neither Louis-Marie Couture in the case of ML1 nor his wife in the case of ML2 would have been in a position to pursue the activities of those corporations. The appellant challenged the trial judge's assertion that Louis-Marie Couture was suffering from the unfortunate effects of Alzheimer's disease during the relevant period, and had ceased to control the operations of ML1. However, the evidence was that Mr. Couture never went to the office and that his interest was limited to [TRANSLATION] "looking after his trucks".
27

On the question of operational control, the evidence showed that it was the Couture brothers and Claude Rodrigue, manager of Transport Couture, who took all the important decisions and who negotiated truck purchases, loans and financing. Louis-Marie Couture's involvement was nil and that of his wife was limited to one information session a month.
28

The appellant stated that it and ML2 could have stayed in business even if they had cut all ties to Transport Couture, citing the fact that the market was expanding. However, it did not show how the opposite conclusion drawn by the trial judge was unreasonable or invalid.
29

On the last factor considered by the trial judge (the family relationship between shareholders), the following passage from the reasons indicates the relevance and force of that factor in the context of the case at bar (paragraph 38):
30 ... it is reasonable to believe that Mr. and Ms. Couture counted on their children to take sufficient care of their investments in these two companies. Given their situation as retired persons and Mr. Couture's health, it is reasonable to conclude that they were under the influence of their five sons, who together held all of the shares of Transport Couture ...

Ultimately, the evidence was that, motivated by the relationship of trust which they had with their five sons, Louis-Marie Couture and his wife relied on Transport Couture and relegated to it all the decision-making powers they held as shareholders of ML1 and ML2.
31

In my opinion, therefore, the trial judge properly concluded that Transport Couture was in a position to exercise de facto control over ML1 and ML2 during the relevant period and that ML1, ML2, Transport Couture and 1864 Qubec inc. were therefore associated companies within the meaning of subsection 256(1).
32

33 For these reasons, I would dismiss the appeal with costs and in accordance with the order of May 2, 2003 I would ask that a copy of these reasons be entered in case A-81-03 to stand as the reasons in that case. Only one set of costs will be awarded.

Judgment accordingly.

Corpor-Air Inc., [2006] 5 C.T.C. 2525 (TCC), followed suit. In this case there were two corporations: one corporation was owned by the husband and the other corporation was owned by the wife. The Tax Court held that the husband had de facto control over the wifes company as she was not involved in her companys day-to-day decisions and her company was economically dependent on the husbands company.

73

ii. Simultaneous Control (Ultimate Control)

a. The Common Law Position The question of who ultimately controlled a corporation in a chain of corporations was raised in the following case.

Parthenon Investments Ltd.

1997 CarswellNat 817, [1997] 3 C.T.C. 152, (Federal Court of Appeal) Income Tax Federal Income Tax Act, S.C. 1970-71-72, c. 63 20(1)(c), 20(1)(c)(i), 20(1)(c)(ii), 125(1), 125(7)(b) Interest Loan to non-arm's length company Canadian-controlled private corporation Taxpayer issued promissory note to parent in order to pay dividend Parent gave note to other subsidiary Taxpayer was unable to claim interest deduction for interest paid on note Taxpayer was owned by Canadian parent which was owned by American grandparent which was in turn owned by two Canadian great-grandparent companies Taxpayer was Canadian-controlled since ultimate control rested with Canadian great-grandparent companies Fact that ownership chain included American grandparent did not prevent taxpayer from being Canadian company Debt was not used for taxpayer's business operations and no borrower-lender relationship existed between taxpayer and subsidiary. The taxpayer and O Ltd. were both wholly-owned subsidiaries of the parent. The parent's voting shares were in turn allowed by an American grandparent company which was in turn owned by two Canadian great-grandparent companies. In its 1985 taxation year, the taxpayer declared a dividend to the parent. Instead of paying the dividend, the taxpayer issued a promissory note, for the amount of the dividend, bearing interest at the rate of 12 per cent per annum. The parent assigned the promissory note to O Ltd. In the 1985, 1986 and 1987 taxation years, interest was accrued as payable by the taxpayer to O Ltd. In filing its returns for the 1985, 1986 and 1987 taxation years, the taxpayer deducted the interest from its income. The Minister of National Revenue disallowed the deductions. This decision was affirmed by the Tax Court of Canada. The court found the amounts were not deductible under para. 20(1)(c) of the Income Tax Act since no money was borrowed by the taxpayer, the debt was not borrowed money that was used for the taxpayer's own business and the debt was not incurred for the purpose of earning income from a business or property. The taxpayer argued that the interest was deductible. The taxpayer further argued that it was a Canadian controlled private corporation and was therefore entitled to deduct certain deductions given only to small Canadian businesses. The taxpayer appealed to the Federal Court of Appeal. Held: The appeal was allowed in part. The Tax Court was correct in finding that the taxpayer did not borrow money on which it could deduct interest as required by subpara. 20(1)(c)(i). There was a debtor-creditor relationship between the taxpayer and O Ltd. but there was not a borrower-lender relationship. Nor was the interest deductible under subpara. 20(1)(c)(ii) since the promissory note was issued to pay a dividend rather than to acquire property. The test for determining whether a company was Canadian-controlled for the purposes of para. 125(7)(b) was de jure control. The taxpayer was Canadian-controlled. The fact that the taxpayer was indirectly owned by the American parent did not constitute a weak link in the chain of control which would make it ineligible under para. 125(7)(b), since ultimate control was in the hands of the two Canadian great-grandparent companies.

74 [The Tax Review Board in] Les Produits Alimentaires Anco (1961) Inc. v. The Minister of National Revenue (1979), 79 D.T.C. 573 came to the conclusion that, because the text of the [definition of Canadian-controlled private corporation in s. 125(7)(b) of the Income Tax Act, R.S.C. 1985, c. 1 (5th Supp.)] was written negatively and because of the breadth of the phrase "in any manner whatever," it was enough to exclude a Canadian corporation that it was controlled at any stage by a non-resident corporation. In keeping with this approach, the respondent argued that the appellant was controlled indirectly both by an American-resident and by a Canadian-resident corporation. It seems to us that one cannot thus divide up the notion of de jure control. Control has about it a character of exclusivity, of finality, and cannot allow for two masters simultaneously. In the case at bar control rests, ultimately, in the hands of Canadian residents. We do not see an interpretation in terms of ultimate control as an addition of the word "ultimately" to what would otherwise be a rule of plain meaning, but rather as emphasizing that the concept of control has necessarily latent within it the notion of ultimate control. Appeal from decision of Tax Court of Canada reported at [1993] 2 C.T.C. 2872 dismissing appeal by taxpayer from income tax assessment by Minister of National Revenue. b. The Legislative Response The Legislative Response to Parthenon Investments was swift. Amendments to section 256 in the form of sections 256(6.1), (6.2) were added in June 14, 2001, by S.C. 2001, c. 17, ss. 194(1), applicable after November 1999. 256(6.1) Simultaneous control For the purposes of this Act and for greater certainty, (a) where a corporation (in this paragraph referred to as the "subsidiary") would be controlled by another corporation (in this paragraph referred to as the "parent") if the parent were not controlled by any person or group of persons, the subsidiary is controlled by (i) the parent, and (ii) any person or group of persons by whom the parent is controlled; and (b) where a corporation (in this paragraph referred to as the "subject corporation") would be controlled by a group of persons (in this paragraph referred to as the "first-tier group") if no corporation that is a member of the first-tier group were controlled by any person or group of persons, the subject corporation is controlled by (i) the first-tier group, and (ii) any group of one or more persons comprised of, in respect of every member of the first-tier group, either the member, or a person or group of persons by whom the member is controlled. 256(6.2) Application to control in fact In its application to subsection (5.1), subsection (6.1) shall be read as if the references in subsection (6.1) to "controlled" were references to "controlled, directly or indirectly in any manner whatever,". Application: The June 5, 2000 Notice of Ways and Means Motion, s. 118, will add subsecs. 256(6.1) and (6.2), applicable after November 1999. Technical Notes: Section 256 of the Act provides rules relevant to the determination, for the purposes of the Act, of whether corporations are associated, whether a corporation is controlled by a person or group of persons, and whether control of a corporation has been acquired.

75

New subsection 256(6.1) of the Act specifies that a corporation may be controlled simultaneously by persons or groups at more than one level above it in a corporate chain. Paragraph 256(6.1)(a) specifies that, where a subsidiary would be controlled by its parent if the parent were not itself controlled by any other person or group, the subsidiary is considered to be controlled both by the parent and by the person or group that controls the parent. Paragraph 256(6.1)(b) is a rule of similar effect that applies where the subject corporation would be controlled by a group (the "first-tier group") if no member of the first-tier group were itself controlled by a third party. In that case, the subject corporation is considered to be controlled both by the first-tier group, and by any higher-tier group which includes, in respect of each member of the first-tier group, either the member or a person or group by whom the member is controlled. If one person controls all members of the first-tier group, that person would constitute a higher-tier group. The operation of paragraph (b) is illustrated by the following example, in which the percentages represent ownership of voting shares, and the various groups identified are assumed to act in concert in voting their shares.

X 100% 50%

Z 50%

X co

YZ co

50%

50%

XYZ co

In this example, XYZco is considered to be simultaneously controlled by: (i) the first-tier group comprised of Xco and YZco, (ii) the higher-tier group comprised of X, Y and Z, (iii) the higher-tier comprised of Xco, Y and Z, and (iv) the higher-tier group comprised of X and YZco. While the concepts set out in subsection 256(6.1) deal directly only with a corporation and persons in the two levels of ownership immediately above it, application of the provision sequentially from the top of a chain makes it applicable to corporate chains with three or more levels.

76 New subsection 256(6.2) of the Act specifies that the rule regarding simultaneous control in new subsection 256(6.1) also applies to the concept of de facto control, which is set out in subsection 256(5.1) of the Act.

c. More on Control How do you determine who controls?

Silicon Graphics v. R.
2002 Carswell Nat 1377, 2002 FCA 260 Introduction 1 The issue in this case is whether a company is controlled by non-residents for the purposes of paragraph 125(7)(a) of the Income Tax Act, R.S.C. 1985, c. 1 (5[th] Supp.), by reason solely of the fact that more than 50% of the shares are held by non-resident persons where there is no evidence of any common connection among them. Facts 2 The appellant is the successor corporation to Alias Research Inc. ("Alias"). Alias was incorporated in 1985 under the Ontario Business Corporations Act, R.S.O. 1990, c. B-16, and was at all material times in the business of creating and marketing advanced computer graphics software products. From 1986 to 1993 Alias employed a significant and increasing number of people doing scientific research and experimental development ("SR & ED") in Canada. Alias's principal place of business was in Toronto, Ontario. 3 From February 13, 1985 until July 17, 1990, Alias was not a publicly traded corporation. The majority of outstanding shares of Alias during this time were held by Canadian residents. In those years Alias was recognized by Revenue Canada as a "Canadian-controlled private corporation" ("CCPC") as defined in the Income Tax Act. It was therefore eligible for investment tax credits on its qualified SR & ED expenditures at the rate of 35% on the first $2,000,000 of such expenditures pursuant to subsection 127(10.1) of the Income Tax Act and for refundable income tax credits under subsection 127.1(1) of the Income Tax Act. 4 On July 17, 1990, during Alias's 1991 taxation year, Alias made an initial public offering ("IPO") of common shares through the NASDAQ stock exchange in the United States. A total of 5, 049,836 common shares were issued following the public offering. No shares other than common shares were outstanding after the IPO. 5 Alias subsequently issued common shares as a result of private placements, exercise of employee share options, consideration paid for corporate acquisitions and fees for services rendered by third parties, from November of 1990 through the end of Alias's 1993 taxation year. By January 31, 1993, there were approximately 8,187,241 issued and outstanding common shares of Alias. 6 Following the IPO and thereafter, including to the end of Alias's 1993 taxation year, more than half of the common shares were held by non-residents of Canada. At the end of the 1992 and 1993 taxation years, non-residents held 89% and 74% of the common shares respectively.

77

7 It should be noted, as well, that Alias was not only publicly traded but relatively widely held. During the relevant times no shareholder held more than 13% of the shares. On September 10, 1991, there were 136 shareholders, 78 of whom were non-residents. On May 6, 1992, there were 305 shareholders, 233 of whom were non-resident. 8 There was no evidence of any agreement or common connection among the shareholders that would influence the manner in which they would vote their shares and indeed it appears there was no easily available mechanism for shareholders to learn the identity of the other shareholders. 9 During this time, the majority of the board of directors and the entire management team were residents of Canada and Alias's principal place of business was in Toronto, Ontario. 10 The Toronto management team annually prepared a slate of people to be elected to the board of directors, which slate was always accepted by the shareholders. 11 In assessing Alias for its 1992 and 1993 taxation years, the Minister concluded that, because more than 50% of the shareholders of Alias were non-resident, Alias no longer met the statutory definition of a CCPC. As a result, the claims by Alias in respect of SR & ED were disallowed. Decision of the Tax Court 12 The issue before the Tax Court was whether Alias was a CCPC. A CCPC was defined in subsection 125(7) of the Income Tax Act which at the relevant times read as follows: "Canadian-controlled private corporation" means a private corporation that is a Canadian corporation other than a corporation controlled, directly or indirectly in any manner whatever, by one or more nonresident persons, by one or more public corporations (other than a prescribed venture capital corporation) or by any combination thereof. Insofar as it applies to the present case, this definition breaks down into three elements: to be a CCPC, a corporation (1) must be a Canadian corporation, (2) must be a private corporation, and (3) must not be controlled by one or more non-resident persons. 13 A "Canadian corporation" was defined in subsection 89(1) of the Income Tax Act as follows: "Canadian corporation" at any time means a corporation that was resident in Canada at that time and was ... incorporated in Canada, ... Alias was incorporated in Canada and was resident in Canada and therefore was a "Canadian corporation". 14 The definition of a "private corporation" in the Income Tax Act as contained in sub-paragraph 89(1)(f)(i) provided: "private corporation" at any particular time means a corporation that, at the particular time, was resident in Canada, was not a public corporation and was not controlled by one or more public corporations ... or prescribed federal Crown corporations or by any combination thereof ... 15 In the relevant taxation years, "public corporation" was restrictively defined in paragraph 89(1) (g) of the Income Tax Act: "public corporation" at any particular time means a corporation that was resident in Canada at the particular time, if ... at the particular time, a class or classes of shares of the capital stock of the corporation were listed on a prescribed stock exchange in Canada ...

78

The relevant portion of the definition provided that a "public corporation" means a corporation which has a class of shares "listed on a prescribed stock exchange in Canada". Section 3200 of the Income Tax Regulations, C.R.C., c. 945, lists which exchanges are "prescribed" for the purposes of section 89. The NASDAQ was not a stock exchange in Canada and, during the relevant taxation period, was not a prescribed stock exchange under Section 3200. Therefore, subsequent to the IPO, Alias was not a "public corporation", given the manner in which "private corporation" was defined and, as it was resident in Canada, Alias was, by default, a "private corporation" and a "Canadian corporation". Therefore, the sole issue before the Tax Court Judge was whether Alias was "controlled directly or indirectly in any manner whatever by one or more non-resident persons". 16 The Tax Court Judge dismissed the appeal and held that de jure control existed by reason of the simple fact that a majority of the outstanding shares of Alias were held by non-residents. As a result, the Tax Court Judge found it unnecessary to consider the issue of de facto control raised by the respondent in its pleading. 17 The Tax Court Judge concluded: Once the number of non-resident shareholders reaches 50 percent plus one, the control and right to elect the Board of Directors has passed to those non-resident shareholders and a common connection between those non-resident shareholders is not a requirement. Issues on Appeal 18 The main issue is whether Alias was a CCPC in its 1992 and 1993 taxation years. Specifically, the issue is whether Alias was controlled by non-residents during its 1992 and 1993 taxation years. 19 This main issue breaks down into two sub-issues: 1) Was Alias subject to de jure control by non-residents? 2) Was Alias subject to de facto control by non-residents?

De Jure Control 20 Where the issue of the definition of "control" has arisen in the past, a distinction has been made between de jure control and de facto control. These will each be considered in turn. Case Law 21 The general test for de jure control has been described in a number of cases as the majority voting control of the corporation, as manifested by the ability to elect the directors of the corporation. The classic description of de jure control was articulated by Jackett P. in Buckerfield's Ltd. v. Minister of National Revenue (1964), 64 D.T.C. 5301 at 5303, where he defined de jure control as, the right of control that rests in ownership of such a number of shares as carries with it the right to a majority of the votes in the election of the board of directors. 22 This statement has been quoted with approval by the Supreme Court of Canada in a succession of cases: M.N.R. v. Dworkin Furs (Pembroke) Ltd. (1967), 67 D.T.C. 5035 at 5036; VinaRug, (Canada) Limited v. M.N.R., [1968] S.C.R. 193 at 197; International Iron & Metal Company Limited v. M.N.R. (1972), 72 D.T.C. 6205 at 6207; The Queen v. Imperial General Properties Limited (1985), 85 D.T.C. 5500 at 5502; and Duha Printers (Western) Ltd. v. Canada, [1998] 1 S.C.R. 795 at 815. It should be noted, however, that in none of these cases did the Supreme Court of Canada determine that de jure control comprised a simple majority of shares in a widely-held company. In

79 every case, the controlling interest was owned by one shareholder or a handful of shareholders that were connected in some way. 23 The most recent pronouncement by the Supreme Court of Canada on the concept of de jure control is that contained in Duha Printers, supra, relied upon heavily by the respondent. In that case, Duha Printers (Western) Ltd. ("Duha") decided to acquire the shares of an inactive company, Outdoor Leisureland of Manitoba, from Marr's Leisure Holdings in order to take advantage of Outdoor's noncapital losses. 24 Subsection 111(5) of the Income Tax Act restricted the claiming of losses by a corporation in circumstances where "control of the corporation has been acquired by a person or group of persons" that did not control the corporation when the losses were incurred. Therefore, in order for Duha to deduct Outdoor's non-capital losses, Duha had to purchase Outdoor and yet Marr's had to retain control of Outdoor. To accomplish this, it was arranged that Marr's would buy a controlling interest in Duha and then Duha would buy the shares of Outdoor. 25 The issue in Duha Printers was whether Marr's acquisition of 56% of the shares of Duha, which Marr's held for a period of one day, amounted to acquisition of control of Duha. The Minister argued that Marr's brief ownership of Duha meant that Marr's did not control Duha. Nevertheless, the Supreme Court found that Marr's had acquired control of Duha (and therefore Outdoor) for the purposes of the Income Tax Act. 26 Dealing with the issue of control of a corporation, Iacobucci J. in Duha Printers said at 815: Thus, de jure control has emerged as the Canadian standard, with the test for such control generally accepted to be whether the controlling party enjoys, by virtue of its shareholdings, the ability to elect the majority of the board of directors. However, it must be recognized at the outset that this test is really an attempt to ascertain who is in effective control of the affairs and fortunes of the corporation. That is, although the directors generally have, by operation of the corporate law statute governing the corporation, the formal right to direct the management of the corporation, the majority shareholder enjoys the indirect exercise of this control through his or her ability to elect the board of directors. Thus, it is in reality the majority shareholder, not the directors per se, who is in effective control of the corporation. This was expressly recognized by Jackett P. when setting out the test in Buckerfield's. 30 Thus, Duha Printers stands for the proposition that where one shareholder controls in excess of 50% of the voting shares of a corporation that shareholder will be deemed to have de jure control unless the other constating documents of the corporation, including such things as a USA, derogate from this position of control. 31 However, Duha Printers was not concerned with the way in which one can determine control of a company where more than one shareholder is said to be in control. In the case of companies whose shares are widely held, an examination of the shareholders register in and of itself will not normally reveal whether any particular shareholders are in control. Therefore, I am of the view that the Duha Printers case does not assist the respondent's position. 32 Most cases that address the issue of control involve situations where one or a few persons held a controlling interest. However, the critical issue here is whether a simple majority of shares held by non-residents leads to an inference of de jure control by those non-residents or whether some common connection or nexus must exist amongst those shareholders to support such an inference. 33 A few cases have suggested that a common connection must exist amongst the majority shareholders in order for them to compose a "group of persons" for the purposes of the Income Tax

80 Act. In Yardley Plastics of Canada Ltd. v. M.N.R. (1966), 66 D.T.C. 5183 (Exch. Ct.), the court stated that one cannot simply select an aggregation of shareholders holding more than half the voting power to be the controlling group. Justice N wrote at 5188: I do not believe, as submitted by counsel for the Minister, that the latter is allowed to choose out of several possible groups any aggregation holding more than 50% of the voting power, even if the members of the group are common shareholders in both corporations and that such a group then becomes irrefutably deemed to be the controlling group for the purposes of section 39(4) of the Act as this could lead to an absurd situation where no two large corporations in this country would be safe from being held to be associated. 34 Again, in Regal Wholesale Ltd. v. The Queen (1976), 76 D.T.C. 6146 (FCTD), Dub J. also found that the members of a "group of persons" must have a "community of interest". Justice Dub wrote at 6152: [A]s defined by the Oxford and Webster dictionaries, the word "group" connotes "collective unity", "segregation from others", "having a community of interest". 35 The most authoritative case dealing with control by more than one shareholder is the decision of the Supreme Court of Canada in Vina-Rug, supra. In that case, the issue was whether a company controlled by a father and his two sons was associated with a second company, more than 50% of the shares of which were held by the two sons and an unrelated party. The Court held that the second corporation was controlled by the two sons and the unrelated party because there existed between the shareholders a "sufficient common connection as to be in a position to exercise control" of the second corporation. The Court said at 196: The learned trial judge held that John Stradwick, Jr., W.L. Stradwick and H.D. McGilvery, who collectively owned more than 50 per cent of the shares of Stradwick's Limited, had at all material times a sufficient common connection as to be in a position to exercise control over Stradwick's Limited and therefore constituted a "group of persons" within the meaning of subs. (4) of s. 39 of the Income Tax Act. I am in agreement with that finding. (underlining mine) 36 Based on these cases, I agree with the appellant's submission that simple ownership of a mathematical majority of shares by a random aggregation of shareholders in a widely held corporation with some common identifying feature (e.g. place of residence) but without a common connection does not constitute de jure control as that term has been defined in the case law. I also agree with the appellant's submission that in order for more than one person to be in a position to exercise control it is necessary that there be a sufficient common connection between the individual shareholders. The common connection might include, inter alia, a voting agreement, an agreement to act in concert, or business or family relationships. 37 In the present case, no evidence was adduced that would suggest the non-resident shareholders will vote as a block in the election of the directors of Alias or in other important matters relating to control of that company. The residence of shareholders alone provides no indication as to whether or not they are in agreement on the major issues relating to control of a company. The fact that there are in excess of 50% of the shareholders of Alias residing in the United States where there is no evidence that they have any common connection or indeed even know each other's identity provides no indication as to whether or not they could or would agree on any issue relating to control of the company. Statutory Arguments

81

38 It was the respondent's position that for the purposes of the definition of CCPC in subsection 125(7), it is the residency of the shareholders that is decisive. The respondent argued that the issue of the residence of shareholders is fundamental to the determination of a CCPC, the focus being not whether the shareholders form a controlling group but rather on the residency of those holding the power to elect the board of directors. 39 It seems to me that the respondent in advancing these propositions has failed to focus on the importance of the word "control" in the definition of CCPC in subsection 125(7). Residency of a crosssection of shareholders surely cannot indicate whether or not they have any power to control the corporation. Indeed, the respondent's submissions really amount to saying that if a majority of the shares of a corporation are owned by non-residents then control lies with those non-residents. The difficulty I have with this submission is that no word connoting mere ownership is used in the subsection 125(7) definition of CCPC. 40 The drafter of the definition of CCPC in subsection 125(7) could have used the concept of ownership rather than the concept of control if that was intended. The words "ownership" and "owned" have been used in other parts of the Income Tax Act. For example, subsection 139A(1), which was in the pre-1972 Income Tax Act and thus predated the CCPC definition, stated: 139A. (1) For the purposes of this Act a corporation has a degree of Canadian ownership in a taxation year if throughout the sixty-day period immediately preceding that year ... not less than 25% of the issued shares of the corporation having full voting rights under all circumstances were owned by one or more individuals resident in Canada, one or more corporations controlled in Canada or a combination thereof, ... Subsections 88(1) and (1.1) of the Income Tax Act deal with winding-up a corporation into its parent, and still provide in their opening words: Where a taxable Canadian corporation (in this subsection referred to as the "subsidiary") has been wound up ... and not less than 90% of the issued shares of each class of the capital stock of the subsidiary were, immediately before the winding-up, owned by another taxable Canadian corporation ... 41 It is worthy of note as well that by S.C. 1998, c. 19, subsections 145(2) and 145(5), subsection 125(7) was changed for taxation years commencing after 1995 by adding a paragraph to the definition of CCPC that emphasizes ownership. The original section remains unchanged as paragraph (a) of the definition, except for the addition of a reference to a new paragraph (c). In the context of the facts of this case, the change in paragraph (b) provides that all the shares held by each non-resident person shall be deemed to be held by a single non-resident individual. If that hypothetical non-resident individual would control the corporation then the corporation is not a CCPC. The wording of the CCPC definition provided by S.C. 1998, c. 19, subsection 145(2) is as follows: "Canadian-controlled private corporation" means a private corporation that is a Canadian corporation other than a corporation (a) controlled, directly or indirectly in any manner whatever, by one or more non-resident persons, by one or more public corporations (other than a prescribed venture capital corporation), or by any combination thereof, (b) that would, if each share of the capital stock of a corporation that is owned by a non-resident person or a public corporation (other than a prescribed venture capital corporation) were owned by a particular person, be controlled by the particular person, or

82 (c) a class of the shares of the capital stock of which is listed on a prescribed stock exchange; (underlining mine) The definition was further amended for taxation years commencing after 1999 by S.C. 2001, c. 17, subsections 113(2) and 113(4) but not in any way material to the issue dealt with here.

42 The respondent argues that it is impermissible for the Court to give any consideration to subsequent changes to the definition of CCPC in subsection 125(7) and relies on subsection 45(2) of the Interpretation Act, R.S.C. 1985, c. I-21, which reads: 45. (2) The amendment of an enactment shall not be deemed to be or to involve a declaration that the law under that enactment was or was considered by Parliament or other body or person by whom the enactment was enacted to have been different from the law as it is under the enactment as amended. 43 However, the Interpretation Act does not preclude the Court from drawing an inference that amendments to legislation are intended to change the legislation where the internal and external evidence warrants such a conclusion. It has been suggested that there is a presumption that changes to the wording of legislation are purposeful and that the provisions of the Interpretation Act referred to above do not preclude the Court from acknowledging that, in principle at least, the foremost purpose of amendments is to bring about a substantive change in the law. See R. Sullivan, ed., Driedger On The Construction of Statutes, 3d ed. (London: Butterworths, 1994) at page 451. 44 In the present case, it seems to me that when Parliament intends that mere ownership of shares be significant in the determination of control, it uses the words "owned" or "ownership". Thus, I conclude that the word "control" in the unamended version of the definition of CCPC in subsection 125(7) did not connote mere ownership. 45 I am of the view that this is a circumstance where it is obvious that a substantive change was made to the statutory provision. The change was that mere ownership of shares by a majority of nonresidents would be sufficient to constitute non-resident control. This substantiates my view that the definition of CCPC in subsection 125(7) in its unamended form requires that there be a common connection among shareholders in order to show that a group of shareholders is in control. 46 It should also be mentioned that the wording of the definition of CCPC in subsection 125(7) is different from other provisions of the Income Tax Act that refer to control of a corporation. For instance, subsection 39(4), the provision considered in Buckerfield's, supra, Dworkin Furs, supra, and Vina-Rug, supra, states: For the purpose of this section, one corporation is associated with another in a taxation year, if, at any time in the year, ... (b) both of the corporations were controlled by the same person or group of persons.)

47 The definition of CCPC in subsection 125(7) does not mention the phrase, "group of persons" as does subsection 39(4) but only states: "Canadian-controlled private corporation" means a private corporation that is a Canadian corporation other than a corporation controlled, directly or indirectly in any manner whatever, by one or more non-

83 resident persons, by one or more public corporations (other than a prescribed venture capital corporation) or by any combination thereof. (underlining mine) The respondent argued that the absence of the words "group of persons" in the definition of CCPC distinguishes it from other provisions and that cases such as Yardley Plastics, supra, and Regal Wholesale, supra do not apply (Yardley Plastics and Regal Wholesale suggest that some common connection must exist among the shareholders in order to find that de jure control exists). 48 An inconsistency in the position now taken by the Minister is revealed by the view expressed by Revenue Canada at the time that the acquisition-of-control rules contained in the statute used the phrase "person or persons". Prior to 1987, subsections 111(4) and 111(5) of the Income Tax Act restricted the claiming of losses by a corporation in circumstances where "control of the corporation has been acquired by a person or persons" that did not control the corporation when the losses were incurred. In the Revenue Canada Roundtable, 1984 Conference Report (Toronto: Canadian Tax Foundation, 1985) at 816-17, the following answers were given by departmental officials responding to the following questions: Question 42 What is the Department's position concerning the acquisition of control of a loss corporation by a person or persons within the meaning of subsections 111(4) and 111(5) in the following examples? (1) More than 50 per cent of a widely held public corporation that has losses is held by another widely held public corporation. The controlling corporation disposes of a sufficient number of shares of the loss corporation to the public so that it no longer controls the loss corporation ... Department's Position (1) If persons can be identified after the sale who own in the aggregate more than 50 per cent of the shares of the loss corporation and who also act together to control it, we would consider control to have been acquired as a result of the sale ... Comments The test of control is de jure control as established by the courts. There is no jurisprudence with respect to "control ... has been acquired by a person or persons". It is our view that "persons" will be considered as having collectively acquired control where there is evidence that they have a common link or interest or they act together to control the corporation. (underlining mine) 49 This is further illustrated by the Technical Notes to subsection 111(5), released when the amendment was made in 1987: The words "person or persons" at the beginning of subsection 111(5) are changed to read "person or group of persons". This makes the terminology consistent with that used elsewhere in the Act relating to control and is not intended to cause any change in meaning. 50 Of course, Technical Notes are not binding on the courts, but they are entitled to consideration. See Canada v. Ast Estate (C.A.), [1997] F.C.J. No. 267 (C.A.), para. 27: Administrative interpretations such as technical notes are not binding on the courts, but they are entitled to weight, and may constitute an important factor in the interpretation of statutes. Technical Notes are widely accepted by the courts as aids to statutory interpretation. The interpretive weight of

84 technical notes is particularly great where, at the time an amendment was before it, the legislature was aware of a particular administrative interpretation of the amendment, and nonetheless enacted it. 51 A similar position was put forward at the 1995 Tax Foundation Conference, Revenue Canada Roundtable, 1995 Conference Report (Toronto: Canadian Tax Foundation, 1996) at 52:10, where the position of the department was clarified as follows: It remains our view that it is a question of fact whether persons who own the majority of voting power in a corporation constitute a group that has de jure control of the corporation. Two or more persons who become the owners of a majority of the voting shares of a corporation will generally be considered to have acquired control of the corporation where there is an agreement amongst them to vote their shares jointly, where there is evidence that they act in concert to control the corporation, or where there is evidence of their intention to act in concert to control the corporation. A group of persons would be regarded as acting in concert when the group acts with considerable interdependence in transactions involving a common purpose. A common link or interest between members of a group is required to ensure that an acquisition of control is the result of a jointly decided action, rather than a mere fortuitous event. 52 Of course, statements by Revenue Canada officials are not declarative of the law. However, in the recent case of Canadian Occidental (U.S.) Petroleum Ltd. v. The Queen, [2001] D.T.C. 295 (T.C.C.), Bowman A.C.J. noted that while the administrative position of Revenue Canada is not declarative of the law, it is nonetheless of assistance in circumstances where the Minister seeks to reassess the taxpayer in a manner inconsistent with its own administrative position. Associate Chief Justice Bowman wrote at 299: The Court is not bound by departmental practice although it is not uncommon to look at it if it can be of any assistance in resolving a doubt: Nowegijick v. The Queen et al., 83 D.T.C. 5041 at 5044. I might add as a corollary to this that departmental practice may be of assistance in resolving a doubt in favour of a taxpayer. There can be no justification for using it as a means of resolving a doubt in favour of the very department that formulated the practice. 53 Quite apart from the statements of the departmental officials, I have considerable doubt that a difference exists between the meaning of the phrase "controlled by one or more ... persons" and the phrase "controlled by a person or group of persons". 54 In Buckerfield's, supra at page 5303, Jackett P. said:

The word "group" in its ordinary meaning, as I understand it can refer to any number of persons from two to infinity. In the context of control, the phrase "one or more persons" surely must mean the same thing and I am therefore of the view that the concept of "a group of persons" and the case law attendant thereon is applicable when interpreting the definition of CCPC in subsection 125(7). The significant word is "control" and in my view "control" necessitates that there be a sufficient common connection between the several persons referred to in that definition in order for there to be control by those several persons. It should be noted as well that the respondent's assertion that there is an intentional distinction in the Income Tax Act between the phrase "control by a group of persons" and the phrase "control by one or more persons" is inconsistent with published comments with Revenue Canada and the Department of Finance. 55 In conclusion, it is my view that the phrase "control by one or more persons" which remains in the CCPC definition has no different meaning from the phrase "control by a person or group of persons". Hence, the case law arising from the construction of the phrase "control by a person or

85 group of persons" is applicable. Therefore, there must be a common link or interest between members of a group, or evidence that they act together in order for control to be demonstrated. There is no such evidence here. Policy Arguments 56 The respondent further advanced an argument to the effect that the main purpose of the underlying tax advantages given to CCPCs is to encourage economic growth and increase employment in Canada. It was said that the tax advantages are restricted to CCPCs so that the tax system subsidizes the growth of primarily Canadian owned small business rather than primarily foreign owned business. 57 In this connection, it should be noted that the majority of Alias's board of directors and the entire management team were residents of Canada, that Alias' principal place of business was in Canada and that product development occurred in Canada, thus suggesting that indeed economic growth and increases in employment in Canada are taking place. Conclusion 58 From the foregoing analysis, I am persuaded that the concept of de jure control as developed by Buckerfield's, Yardley Plastics, Vina-Rug, and Duha Printers applies fully to the definition of CCPC in subsection 125(7). In particular, de jure control includes a requirement that a sufficient common link or interest exist amongst the shareholders that compose the "group of persons", or there must be evidence that those shareholders act together to exert control over the corporation. 59 In the present case, there is no such evidence. To the contrary, Alias was widely held and there is no evidence that the non-resident shareholders even knew one another. Therefore, I find that the Tax Court Judge erred in finding that the non-resident shareholders possessed de jure control of Alias. 60 Having concluded that the non-resident shareholders did not possess de jure control of Alias, I will now turn to the question of whether the non-resident shareholder possessed de facto control. In Silicon Graphics the meaning of de facto control was also examined. 61 The Trial Judge found it unnecessary to make any finding with respect to de facto control. Nevertheless, on appeal, the respondent advanced essentially the same argument as had been advanced at trial, and because I have concluded that the non-resident shareholders did not have de jure control, it is necessary to consider whether the non-resident shareholders had de facto control. 62 The respondent in its amended reply alleged that non-residents were in de facto control of Alias because, throughout the taxation years of Alias ending January 31, 1992 and January 31, 1993, one or more non-resident persons had direct or indirect influence that, if exercised, would result in control in fact in the years. 63 The respondent argued that Silicon Graphics Inc. ("Silicon US"), a U.S. public corporation whose shares are listed on the New York Stock Exchange, was in de facto control of Alias because of a loan Silicon US made to Alias. The argument was as follows: In December 1991, Silicon US agreed to advance up to $5,000,000 US to Alias in consideration of a security interest in all the assets of Alias and the issuance of warrants to acquire common shares of

86 Alias. During the period in which the loan was outstanding, Silicon US determined which creditors would be paid and the amount of that payment. Alias was required to prepare a daily cash forecast to submit to Silicon US for approval. In effect, Silicon US was in control of Alias's finances. As a consequence of this indebtedness, Silicon US held de facto control of Alias at a minimum during the period in which the loan was outstanding. 64 In addition, the respondent submitted that the actions and involvement of Silicon US extended beyond that necessary for the safeguarding of its rights and interests in respect of the loan. The respondent argued that other evidence pointed to the ongoing significant influence of Silicon US over Alias: The founder of Silicon US was a director of Alias; The president, chief operating officer and chief executive officer during the years under appeal was previously a senior officer of Silicon US; Silicon US made financial contributions to Alias for software development and marketing; and Alias was dependent on Silicon US given the fact that Alias software only operated on Silicon Hardware during the years under appeal; 65 Because the assumption of de facto control was withdrawn by the Minister, the onus is on the respondent to establish the facts necessary to uphold this alternative basis for the assessment. See The Queen v. Bowens (1996), 96 D.T.C. 6128 at 6129 (F.C.A.); and Pollock v. The Queen (1994), 94 D.T.C. 6050 at 6053 (F.C.A.). 66 The case law suggests that in determining whether de facto control exists it is necessary to examine external agreements (Duha Printers, supra at 825); shareholder resolutions (Socit Foncire d'Investissement Inc. v. Canada, [1996] T.C.J. No. 1568, para. 10 (T.C.C.)); and whether any party can change the board of directors or whether any shareholders' agreement gives any party the ability to influence the composition of the board of directors (International Mercantile Factors Ltd. v. The Queen (1990), 90 D.T.C. 6390 at 6399 (F.C.T.D.), aff'd (1994), 94 DTC 6365 (F.C.A.); and Multiview Inc. v. The Queen (1997), 97 D.T.C. 1489 at 1492-93 (T.C.C.)). 67 It is therefore my view that in order for there to be a finding of de facto control, a person or group of persons must have the clear right and ability to effect a significant change in the board of directors or the powers of the board of directors or to influence in a very direct way the shareholders who would otherwise have the ability to elect the board of directors. 68 The Respondent has adduced no evidence which would satisfy these criteria. There is no evidence that Silicon US as a creditor ever exercised operational control of Alias. It simply loaned money to Alias and took steps to make sure that money was only spent with a view to protecting its position as a lender. Further, the $5,000,000 bridge financing agreement lasted for only seven weeks and was repaid by the end of Alias' 1992 taxation year. Additionally, there is evidence that Silicon US did not want to be in control of Alias because it did not want to be viewed as partisan to other customers who were competitors of Alias. Silicon US never tried to install a person in management or as a director. 69 The fact that the founder of Silicon US was a director of Alias out of a board of four directors is not compelling. The suggestion that the president, chief operating officer, and chief executive officer during the years under appeal was previously a senior officer of Silicon US ignores the fact that Alias itself suggested that that person assume this position. In other words, it was not something which was forced upon Alias by Silicon US.

87 70 Further, the fact that Silicon US made financial contributions to Alias for software development and marketing and that Alias software only operated on Silicon Hardware hardly demonstrates the sort of control necessary in order to amount to de facto control. 71 It would appear that the facts alleged by the respondent in relation to the loan by Silicon US simply demonstrate that Silicon US was protecting its interests as a lender to Alias. Subsection 256(6) of the Income Tax Act provides that where a party has control in fact for a period of time in order to safeguard its rights or interest, that party is deemed not to have control in fact. 72 In any event, it would appear that de facto control always remained in Canada by reason of the following findings of fact made at Trial: (e) The majority of the Board of Directors and the entire management team were residents of Canada; (f) Alias's principal place of business was in Toronto, Ontario; (g) The Toronto management team annually prepared a slate of people to be elected to the Board of Directors, which slate was always accepted by the shareholders. Conclusion 73 I conclude that Alias was a CCPC through its 1992 and 1993 years because it was not controlled directly or indirectly in any manner whatever by one or more non-resident persons. 74 I therefore would allow the appeal with costs in the Tax Court of Canada and in this Court, set aside the judgment of the Tax Court of Canada dated March 28, 2001 and order that the determination of loss made pursuant to the Income Tax Act for the taxation years of Alias Research Inc. ending January 31, 1992 and January 31, 1993 be referred back to the Minister of National Revenue for reassessment on the basis that Alias Research Inc. was throughout its 1992 and 1993 taxation years a Canadian Controlled Private Corporation within the meaning of subsection 125(7) of the Income Tax Act. A.J. Stone J.A.: I agree Marshall Rothstein J.A.: I agree ASSOCIATED CORPORATIONS - SELECTED TAX ISSUES by Marc E. Marion Prairie Provinces Tax Conference, Canadian Tax Foundation 2008. De Jure Control In Duha Printers (Western) Ltd. v. R., the Supreme Court of Canada confirmed the basic Canadian tax principle that where the term "control" is used in the Act, without the qualifier "directly or indirectly in any manner whatever," the term means de jure control and not de facto control. The test for determining de jure control and the intent underlying this test is stated in the following terms: Thus, de jure control has emerged as the Canadian standard, with the test for such control generally accepted to be whether the controlling party enjoys, by virtue of its shareholdings, the ability to elect the majority of the board of directors. However, it must be recognized at the outset that this test is really an attempt to ascertain who is in effective control of the affairs and fortunes of the corporation. That is, although the directors generally have, by operation of the

88 corporate law stature governing the corporation, the formal right to direct the management of the corporation, the majority shareholder enjoys the indirect exercise of this control through his or her ability to elect the board of directors. Thus, it is in reality the majority shareholder, not the directors per se, who is in effective control of the corporation. The Supreme Court's decision in Duha Printers endorsed the de jure control test set out in the seminal decision of Buckerfield's Ltd. et al. v. MNR, and affirmed that the purpose of this test is to determine who is ultimately in effective control of the affairs and fortunes of the corporation. Although the directors of a corporation have the power to manage and supervise the business and affairs of the corporation under the corporate law statute governing the corporation, it is those persons holding a majority of the voting shares of the corporation that effectively control the corporation as they have the legal right to determine the composition of the board of directors and to restrict its power to manage and supervise the corporation's business and affairs. The ambiguity in subsection of 256(5.1) is compounded by the absence of any definition of "direct or indirect influence" and, more importantly, "control in fact." The absence of any definition of "direct or indirect influence" leads one to query as to what kind of influence will be subject to subsection 256(5.1), and on who, or on what, must the hypothetical influence be effected. While the source of influence resulting in de jure control derives from the ownership of such number of shares as carries with it the right to a majority of the votes in the election of the board of directors, the source of influence resulting in de facto control could presumably derive from any agreement, arrangement, relationship or other circumstance. In Socit Foncire d'Investissement Inc. v. R., the first case to consider the scope of subsection 256(5.1), the court suggested that a controlling influence can be economic, contractual or moral in nature. The more significant question is influence on who, or on what. The issue here is whether the influence must be effected on those who hold legal control of a corporation (i.e. those who enjoy, by virtue of their shareholdings, the ability to elect the majority of the directors of a corporation), or whether it may also be effected on the corporation's board of directors who have the responsibility of managing and supervising the business and affairs of the corporation. In Silicon Graphics Ltd. v. R., the first case at the appellate level to consider the application of subsection 256(5.1) , the Federal Court of Appeal suggested that, in order for there to be a finding of de facto control, the influence must be effected on "the shareholders who would otherwise have the ability to elect the board of directors." In some of the subsequent cases, including some decisions issued by the same court, it is suggested that the influence in question may also be effected on the corporation's board of directors, thereby expanding the scope of this provision. The answer to the question posed above is largely dependent on the ultimate interpretation of the expression "control in fact." While subsection 256(5.1) was enacted to introduce the concept of de facto control wherever the expression "controlled, directly or indirectly in any manner whatever" is used, it does not actually define the expression "control in fact." It does, however, make reference to control in fact of the corporation just as other provisions in section 256 make reference to control of a corporation, either in an active form or a passive form. In other words, it does not make any reference to control of the business and affairs of a corporation. This distinction between control of a corporation and control of its business and affairs has been acknowledged by the CRA. Jurisprudence

89 Without any clear statutory guidance on the meaning of "direct or indirect influence" and "control in fact," taxpayers and their advisors must seek guidance in decisions of the courts issued in recent years. To date, two lines of cases have developed as to the nature of de facto control resulting in two tests that may be applied in determining whether a corporation is factually controlled by a person or group of persons. Current Judicial Tests The first line of cases has applied the narrower test enunciated by the Federal Court of Appeal in Silicon Graphics. In that case, the court explained what is required for a finding of de facto control under subsection 256(5.1) as follows: [66] The case law suggests that in determining whether de facto control exists it is necessary to examine external agreements (Duha Printers, supra at 825); shareholder resolutions (Socit Foncire d'Investissement Inc. v. Canada, [1996] T.C.J. No. 1568, para. 10 (TCC)); and whether any party can change the board of directors or whether any shareholders' agreement gives any party the ability to influence the composition of the board of directors (International Mercantile Factors Ltd. v. The Queen (1990), 90 DTC 6390 at 6399 (FCTD), | aff'd (1994), 94 DTC 6365 (F.CA); and Multiview Inc. v. The Queen (1997), 97 DTC 1489 at 1492-93 (TCC)). [67] It is therefore my view that in order for there to be a finding of de facto control, a person or group of persons must have the clear right and ability to effect a significant change in the board of directors or the powers of the board of directors or to influence in a very direct way the shareholders who would otherwise have the ability to elect the board of directors [emphasis added]. According to the Federal Court of Appeal, a finding of control in fact requires identifying those forms of influence that, if exercised, would enable a person or group of persons to change or control the composition of a corporation's board of directors (what has been called "board control"). This formulation of de facto control is similar to de jure control in that both look to the relationship between the composition or powers of a corporation's board of directors (i.e. the decision-makers) and the person or group of persons believed to control the board's composition or its powers. By linking de facto control with de jure control, the court narrowed the scope of subsection 256(5.1) and introduced some degree of certainty and predictability in its application. In addition, the use of the expressions "clear right and ability," "significant," and "very direct way" suggests a high threshold for there to be a finding of de facto control. A divergent line of cases quickly emerged applying a broader test in determining whether a person or group of persons have control in fact of a corporation. In this line of cases, the existence of de facto control is equated with identifying those forms of influence that, if exercised, would enable a person or group of persons to control the corporation's business and affairs (what has been called "operational control"). This broader formulation of de facto control looks to the relationship between the power to manage and supervise the business and affairs of the corporation (i.e. the decision-making power) and the person or group of persons believed to control that decision-making power. Over a year after issuing its decision in Silicon Graphics, the Federal Court of Appeal in Transport M.L. Couture Inc. v. R. reiterated the narrower test of board control, but then appeared to adopt the broader test of operational control relied upon by the court of first instance. The Federal Court of Appeal stated:

90 [24] It is not possible to list all the factors which may be useful in determining whether a corporation is subject to de facto control (Duha Printers, [1998] 1 SCR. 795, para. [38]). However, whatever factors are considered, they must show that a person or group of persons has the clear right and ability to change the board of directors of the corporation in question or to influence in a very direct way the shareholders who would otherwise have the ability to elect the board of directors (Silicon Graphics, [2002] FCA 260, para. [67]). In other words, the evidence must show that the decision-making power of the corporation in question in fact lies elsewhere than with those who have de jure control. [25] The trial judge relied primarily on the operational control exercised by Transport Couture, the economic dependence on it of ML1 and ML2 and the family relations between the shareholders as a basis for concluding that Transport Couture in fact controlled ML1 and ML2. The appellant did not challenge the | relevance of the factors considered by the trial judge. However, it argued that the evidence did not allow the trial judge to conclude that operational control of ML1 and ML2 was in the hands of Transport Couture or that ML1 and ML2 were economically dependent on Transport Couture. [26] In my view, the evidence amply supports the trial judge's decision. As he indicated at paragraph 36 of his reasons, if Transport Couture had decided not to renew its management contract and no longer to retain the services of ML1 and ML2, neither Louis-Marie Couture in the case of ML1 nor his wife in the case of ML2 would have been in a position to pursue the activities of those corporations [emphasis added]. The existence of two tests used to determine whether a corporation is controlled in fact by a person or group of persons was expressly acknowledged by the Federal Court of Appeal in Lenester Sales Ltd. v. R.,22 which did not express a preference of one test over the other. Summary The foregoing review of recent cases serves to highlight that there is growing uncertainty and debate as to the proper test to be applied in determining whether a corporation is "controlled, directly or indirectly in any manner whatever," by a person or group of persons within the meaning of subsection 256(5.1) . While some cases continue to apply the narrow test set out by the Federal Court of Appeal in Silicon Graphics, other cases apply the broader test suggested by the same court in Transport M.L. Couture. Until the issue of which is the correct test to be applied is resolved, either by statutory amendment or judicial clarification, the scope and application of subsection 256(5.1) will continue to be, as initially submitted by the CBA-CICA joint committee on taxation, "a major source of complexity and frustration for the tax administration and taxpayer." iv. De Facto Control Group Control Excerpt from Tax for the Owner-Manager, Canadian Tax Foundation, Volume 6, Number 3, July 2006 In Crystal Beach Park Limited (2006 TCC 183), the issue was whether the appellant was entitled to deduct non-capital losses from 1989 in its 1993 and 1994 tax returns. The deductions had been disallowed by the CRA on the basis that there had been an acquisition of control under subsection 111(5) of the Act by two unrelated individuals, T and G. The CRA also argued that the appellant was not carrying on the business in which the loss was sustained. Both arguments were rejected and the

91 appeal was allowed. The case is of particular interest for its discussion of the meaning of the phrase group of persons in subsection 111(5). The CRA took the position that T and G were a group of persons that acquired control of the appellant by purchasing all of the companys shares. T and G held 50 percent of the common shares and all of a class of non-voting special shares that were convertible into voting common shares, provided that all of the holders agreed to convert them. In the CRAs view, T and G acting together could have converted their special shares and thereby had control of the appellant as a group of persons. The shareholders register indicated that all of the voting common shares (not just 50 percent) and the nonvoting special shares were in the names of T and G. The register had a notation indicating that one-half of the common shares were held in trust for a corporation controlled by a third party; the notation was in accordance with a trust agreement between T and G and that corporation. T and G maintained that they were not the beneficial owners of this 50 percent of the issued common shares. Sheridan J found as a fact that T and G held 50 percent of the common shares in trust for another company and that each was the beneficial and legal owner of only 25 percent of the common shares. Because T and G (either individually or together) did not acquire in excess of 50 percent of the voting shares of the appellant on November 22, 1989, Sheridan J held that they did not have de jure control of the appellant; accordingly, they did not acquire control of the appellant under subsection 111(5). Apparently because of the terms of the trust agreement, and relying on Duha Printers (Western) Ltd. ([1998] SCR 795), Sheridan J did not include the shares held in trust in deciding the de jure control issue. Relying on Silicon Graphics (2002 FCA 260) and Lenester Sales Ltd. (2003 TCC 531; 2004 FCA 217), Sheridan J found that there was not a sufficient common connection between T and G to constitute a group of persons and therefore T and G did not have de jure or de facto control. (It should be noted that de facto control is not relevant to the issue of an acquisition of control.) The Silicon Graphics case dealt with de jure and de facto control of a corporation by non-resident shareholders. To reach his decision, Sheridan J used the criteria suggested by the FCA in that case to determine whether individual shareholders constituted a group of persons. He considered the family relationship (there was none) and the business relationship of T and G and whether there was an agreement between T and G to act in concert or a voting agreement between them with respect to acting in concert. He also found that the existence of the trust agreement was another factor militating against T and Gs agreeing to vote together to exercise their conversion rights. In Lenester Sales, Bowman ACJ, as he then was, rejected the notion that the fact that two independent business persons in pursuit of their own business interests worked together to achieve a mutually beneficial commercial objective meant that they were acting in concert. Sheridan J relied on those comments to reject the CRAs position that T and Gs shared desire to make a success of the business was sufficient to establish that T and G had acted in concert. In Lenester Sales, the issue was whether a franchiser had de facto control of its franchisees under subsection 256(5.1). Bowman ACJs comments regarding acting in concert were in respect of the issue of arms length. Sheridan J applied those comments in determining whether two individuals constituted a group of persons for the purposes of subsection 111(5). As an alternative position, the CRA argued that after T and G purchased their shares, the appellant carried on a real estate development business that was not the business in which the losses were

92 sustainednamely, an amusement park business. On this issue, Sheridan J held on the facts that the essence of the business both before and after the amalgamation was the exploitation of a recreational site; therefore, the same business was carried on before and after November 22, 1989. Philip Friedlan, Friedlan Law, Toronto and Markham, Ontario

3. Canadian-controlled private corporation (CCPC) IT-458R2 Canadian-Controlled Private Corporation

May 31, 2000 (content still represents current law as of January 2012) Summary This bulletin explains the meaning of a Canadian-controlled private corporation (CCPC) and the requirements that must be met for a corporation to be a CCPC. The appendix to this bulletin provides examples of situations which illustrate whether corporations meet the requirements to be considered a CCPC. A CCPC is a special type of private corporation that is also a Canadian corporation. In order to qualify as a CCPC it must not be controlled, directly or indirectly in any manner whatever, by public corporations, non-residents or a combination of the two. In many respects, it is advantageous for a corporation and its shareholders that the corporation qualify as a CCPC. Some of these advantages, which are primarily designed to assist small businesses, include: access to the small business deduction; an additional month to pay the balance of taxes payable under Parts I, I.3, VI and VI.1 for the year; enhanced investment tax credits, which may be fully refundable, for their qualified expenditures on scientific research and experimental development; shareholder entitlement to the capital gains exemption on the disposition of qualified small business corporation shares; and deferral of an employee's taxable benefit arising from the exercise of stock options granted by a CCPC. In many of these situations it is necessary that the corporation be a CCPC throughout the particular taxation year. Consequently, the advantages of CCPC status may not be available in the year a corporation becomes or ceases to be a CCPC. Furthermore, certain of these advantages may be restricted or unavailable if the CCPC is part of an associated group (see IT-64R4 CONSOLID, Corporations: Association and Control). Discussion and Interpretation 1. A CCPC is defined in subsection 125(7). Under the opening words of this definition, a corporation must be a Canadian corporation and a private corporation as those terms are defined under subsection 89(1). A corporation resident in Canada that has a class of shares listed on a prescribed stock exchange in Canada is not considered to be a private corporation and, therefore, cannot be considered to be a CCPC. In addition, under paragraph (c) of the definition of a CCPC, a corporation that has a class of shares listed on a foreign stock exchange listed in section 3201 of the Regulations, will be prevented from qualifying as a CCPC after 1995. The current version of IT-391 (IT-391R), Status of Corporations, discusses the meaning of private and public corporations for the purposes of the Act. Paragraph (a) of the definition of a CCPC provides that the corporation must not

93 be "controlled, directly or indirectly in any manner whatever" (see 8) by one or more non-resident persons (non-residents), one or more public corporations (other than a prescribed venture capital corporation within the meaning of section 6700 of the Regulations), or any combination of nonresidents and public corporations. The control test referred to in the definition of CCPC envisages situations where over 50% of the shares of a corporation are owned by one or more non-residents or by one or more public corporations regardless of whether or not a controlling group can be identified. To that end, paragraph (b) of the definition of a CCPC clarifies that, after 1995, a corporation is prevented from being a CCPC if the corporation would, if each share of the capital stock of a corporation that is owned by a non-resident person or a public corporation (other than a prescribed venture capital corporation) were owned by a particular person, be controlled by that particular person. 2. It is not necessary that a corporation be controlled by Canadian residents, private corporations or a combination thereof, in order to qualify as a CCPC. For example, if an individual resident in Canada controls 50% of the voting rights of the shares of a Canadian corporation that is a private corporation, normally, no other person or group of persons (i.e. public corporations and/or nonresidents) would control the corporation for purposes of the definition of a CCPC under subsection 125(7). However, this would not be the case if control by non-residents or public corporations exists as a result of holding a right as described in paragraph 251(5)(b) and discussed in s 5 or 6, or because of the existence of de facto control by non-residents or public corporations as described in subsection 256(5.1) and discussed in 8. See Example 1. 3. If a Canadian corporation is controlled by another corporation resident in Canada, which is itself controlled by a non-resident or by a public corporation, the Canadian corporation cannot qualify as a CCPC because it is indirectly controlled by a non-resident or a public corporation. Also, if the corporation is controlled by a non-resident corporation that is itself controlled by a CCPC, it will not qualify as a CCPC because it is directly controlled by a non-resident corporation. See Examples 2, 3 and 4. Subsection 256(6.1) of the Act -- introduced in response to the decision of the Federal Court of Appeal in Parthenon Investments Ltd. v. The Queen, 97 D.T.C. 5343, [1997] 3 C.T.C. 152 -- specifies, for greater certainty, that a corporation may be controlled simultaneously by persons or groups at more than one level above it in a corporate chain. 256(6.1)(a) specifies that, where a subsidiary would be controlled by its parent if the parent were not itself controlled by any other person or group, the subsidiary is considered to be controlled both by the parent and by the person or group that controls the parent. Paragraph 256(6.1)(b) is a rule of similar effect that applies where the subject corporation would be controlled by a group (the "first-tier group") if no member of the first-tier group were itself controlled by a third party. In that case, the subject corporation is considered to be controlled both by the first-tier group, and by any higher-tier group, either the member or a person or group by whom the member is controlled. If one person controls all members of the first-tier group, that person would constitute a higher-tier group. Proposed 256(6.2) of the Act specifies that the rule regarding simultaneous control in new subsection 256(6.1) also applies to the concept of de facto control. [Note that subsection 256(6.2) was enacted in 2001 and applies after November 1999]. 4. A corporation can become, or cease to be, a CCPC if control changes or the status of the parties who control the corporation changes. For example, a Canadian corporation that would be a CCPC (except for the fact that it is controlled by non-residents) will become a CCPC if a sufficient number of shareholders become residents of Canada so that not more than 50% of the voting rights of the shares are controlled by non-residents. This is so, whether the shareholders actually become residents of Canada or are deemed under paragraph 250(1)(a) to have been resident in Canada throughout the year. Similarly, if a sufficient number of Canadian resident shareholders of a CCPC become non-residents so that non-residents control more than 50% of the voting rights of the shares, the corporation will cease to be a CCPC.

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5. Paragraph 251(5)(b) provides special rules in determining whether or not a corporation qualifies as a CCPC. Subparagraph 251(5)(b)(i) provides that if, at any time, a person has a right under a contract, in equity or otherwise, either immediately or in the future and either absolutely or contingently, to, or to acquire, shares of the capital stock of a corporation, or to control the voting rights of such shares, that person is deemed to have the same position in relation to the control of the corporation as if that person owned the shares at that time. For example, if a public corporation or non-resident acquires an option to purchase more than 50% of the voting shares of what would otherwise be a CCPC, the public corporation or non-resident is deemed, by virtue of subparagraph 251(5)(b)(i), to control the corporation. This would cause the corporation to lose its status as a CCPC. See Example 5. 6. Subparagraph 251(5)(b)(ii) provides that if, at any time, a person has a right under a contract, in equity or otherwise, either immediately or in the future and either absolutely or contingently, to cause a corporation to redeem, acquire, or cancel any shares of its capital stock owned by other shareholders, that person is deemed to have the same position in relation to control of the corporation as if the shares were redeemed, acquired, or cancelled by the corporation at that time. Thus, this subparagraph may also apply to deny status as a CCPC if a public corporation or non-resident has a "right" pursuant to subparagraph 251(5)(b)(ii). Under subparagraph 251(5)(b)(iii), if, at any time after April 26, 1995, a person has a right under a contract, in equity or otherwise, either immediately or in the future and either absolutely or contingently, to, or to acquire or control, voting rights in respect of shares of the capital stock of a corporation, that person is deemed to have the same position in relation to the control of the corporation as if that person could exercise the voting rights at that time. Subparagraph 251(5)(b)(iv) provides that if, at any time after April 26, 1995, a person has a right under a contract, in equity or otherwise, either immediately or in the future and either absolutely or contingently, to cause the reduction of voting rights in respect of shares of the capital stock of a corporation that are owned by other shareholders, that person would be deemed to have the same position in relation to the control of the corporation as if the voting rights were so reduced at that time. 7. There are exceptions to the rules in paragraph 251(5)(b). The provisions of paragraph 251(5)(b) will not apply if one or more of the rights described therein are not exercisable until the death, bankruptcy or permanent disability of an individual. Thus, paragraph 251(5) (b) does not apply if a person has a right, for example, to acquire shares under a survivorship agreement.

8. The concept of control of a corporation is paramount in determining whether the corporation is a CCPC. The word "control" is not defined in the Act. The term control usually contemplates the right of control that rests in ownership of such a number of shares as carries with it the right to a majority of the votes in the election of the board of directors. Such control is commonly referred to as de jure control. However, the expression "controlled, directly or indirectly in any manner whatever" (see 1) that is found in the definition of a CCPC has an extended meaning for purposes of the Act by virtue of subsection 256(5.1). Under subsection 256(5.1), a corporation is considered to be controlled, directly or indirectly in any manner whatever, by another corporation, a person or a group of persons (the "controller") if the controller has any direct or indirect influence that, if exercised, would result in control in fact of the corporation (de facto control). In order to determine whether or not there exists such influence that, if exercised, would result in control of a corporation, it would be necessary to review all of the facts in each situation. An example of de facto control might be a situation in which a person held a significant portion, but less than 50%, of the voting control of a corporation and the balance was widely dispersed among many employees of the corporation or was held by persons who could reasonably be considered to act in respect of the corporation in accordance with his or her

95 wishes. An exception to the rules in subsection 256(5.1) is provided when the corporation and the controller are dealing at arm's length and the controller's influence is derived from an agreement or arrangement such as a franchise, license, lease, distribution, supply or management agreement, the main purpose of which is to govern the relationship between the parties regarding the manner in which a business carried on by the corporation is to be conducted. 9. If the provisions of subsection 256(6) are met, a corporation that controls, directly or indirectly in any manner whatever another corporation at a particular time will be deemed not to control that corporation at that time. This particular provision may have application when, for example, a manufacturing corporation which is a public corporation or a corporation controlled by non-residents, establishes distributorships in Canada. This is usually effected by creating a corporation in such a manner that the Canadian operator or distributor will not acquire actual control of it until certain financial obligations to the manufacturer are met. When all of the provisions of subsection 256(6) are met, the newly created corporation will be a CCPC from the time of incorporation if the other conditions of the definition of a CCPC under subsection 125(7) are met. Appendix The purpose of the following examples is to indicate when a corporation is controlled, directly or indirectly in any manner whatever, by one or more non-resident persons, one or more public corporations (other than prescribed venture capital corporations) or by a combination thereof. It is assumed that the other criteria of the definition of a CCPC under subsection 125(7) are met. Unless otherwise indicated, percentages shown indicate the percentage of the voting shares held in the corporation by the particular person or group of persons.

1. Public corporations and/or non-residents 50%

Residents 50%

Corporation A

Corporation A is a CCPC because it is not controlled by non-residents, public corporations or a combination of non-residents and public corporations. The above result assumes that control does not exist by virtue of the holding of a right under paragraph 251(5)(b) or by the existence of de facto control under subsection 256(5.1).

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2. Corporation A is not a CCPC because it is indirectly controlled by non-residents and/or public corporations. . Canadian corporation that is a private corporation 51% Non-resident corporation 51% Corporation A

Corporation A is not a CCPC because it is directly controlled by a non-resident corporation. The fact that the non-resident corporation is itself directly controlled by a Canadian corporation that is a private corporation is not relevant.

4. Canadian corporation that is a private corporation 51% Non-resident corporation 51% Canadian corporation that is a private corporation 51% Corporation A

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Corporation A is not a CCPC because it is indirectly controlled by a non-resident corporation. The fact that Corporation A is controlled both directly and indirectly by Canadian corporations that are private corporations does not negate the fact that it is also indirectly controlled by a non-resident corporation for purposes of the definition of a CCPC. 5. Public corporation and/or Non-residents (Pubco)

Residents 50% common shares 50% common shares

100% preferred shares (non-voting), convertible into common shares at any time

Corporation A (A Co.) A Co. is not a CCPC because of the "right" of Pubco to convert its preferred shares to common shares. This right places Pubco in the same position, in relation to control of A Co., as if it owned the A Co. common shares to which the preferred shares are convertible by reason of subparagraph 251(5)(b)(i). Therefore, since Pubco owns 50% of the common shares and has the right to acquire additional common shares that, when taken together with the common shares it already owns, aggregate more than 50% of the total common shares issued and outstanding of A Co., Pubco is considered to control A Co. 6. Public corporations 30% common shares 30% common shares Non-Residents Residents 40% common shares

Corporation A (A Co.)

Although the shares of A Co. are widely dispersed among public corporations and non-residents that are likely not acting together to exercise control of A Co., A Co. is not a CCPC due to the hypothetical shareholder rule in (c) of the definition of CCPC. This is because if the shares of A Co.'s capital stock

98 that are owned by the non-residents and by the public corporation were owned by the same person, A Co. would be controlled by that person.

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7 Public corporations 33.33% common shares 100% common shares Non-Residents Residents 33.33% common shares

Canadian corporation 33.33% common shares Corporation A (A Co.)

A Co. is not a CCPC because if the shares of its capital stock and of the capital stock of Canadian corporation that are owned by non-residents were owned by the same person, that person would control A Co.

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Mimetix Pharmaceuticals Inc. v. Canada

[2001] T.C.J. No. 749
REASONS FOR JUDGMENT 1 LAMARRE T.C.J.:-- This is an appeal from an assessment made by the Minister of National Revenue ("Minister") under the Income Tax Act ("Act") with respect to the appellant's 1996 taxation year. In assessing the appellant, the Minister: (a) revised the qualified expenditures for the purposes of investment tax credits from $1,964,600 as claimed by the appellant 1 down to $1,755,573, the difference of $209,027 having been disallowed as a qualified expenditure; (b) calculated investment tax credits at a rate of 20 per cent instead of the 35 per cent rate used by the appellant;2 and (c) denied refundable investment tax credits in the amount of $600,599 claimed by the appellant. 2 With respect to paragraph 1(a) above, it is my understanding that the qualified expenditures were reduced by an amount of $209,027 with respect to a piece of equipment, the "Collette mixer", that the appellant had leased prior to its acquisition thereof. The respondent submits that the Collette mixer had been used by the appellant before its acquisition and consequently that the expenditure for its acquisition was a prescribed expenditure within the meaning of paragraph 2902(b) of the Income Tax Regulations ("Regulations"). Therefore, the expenditure was not a qualified expenditure within the meaning of subsection 127(9) of the Act for purposes of the investment tax credit provided for in subsection 127(5) of the Act. 3 With respect to paragraph 1(b) above, the respondent submits that under subsections 127(5) and 127(9) of the Act the appellant was only entitled to deduct as investment tax credits from tax otherwise payable 20 per cent of qualified expenditures and not the 35 per cent claimed by the appellant, which, if I understand correctly, tried to take advantage of an additional investment tax credit under subsection 127(10.1) of the Act. The respondent took the position that the appellant was not a Canadian-controlled private corporation ("CCPC") within the meaning of subsection 125(7) of the Act during the 1996 taxation year, and therefore was not allowed to deduct more than 20 per cent of qualified expenditures as investment tax credits. 4 Finally, with respect to paragraph 1(c) above, the respondent submits that for the same reason, i.e. that it was not a CCPC in 1996, the appellant did not meet the definition of "qualifying corporation" set out in subsection 127.1(2) of the Act and was therefore not entitled to a refundable scientific research and experimental development ("SR&ED") tax credit for that year pursuant to subsection 127.1(1) of the Act.3 [Statutory provisions deleted] Issues

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6 The parties agree that this appeal can be narrowed down to two issues. The first is whether the appellant was a CCPC in its 1996 taxation year. The second is whether the acquisition of the Collette mixer was a prescribed expenditure within the meaning of subparagraph 2902(b)(iii) of the Regulations. I. First issue: Was the appellant a CCPC in its 1996 taxation year? 7 The appellant will be considered a CCPC in 1996 if it can be shown that it was not in that year a corporation controlled, directly or indirectly in any manner whatever, by one or more non-resident persons, as required by subsection 125(7) of the Act. Both parties agreed that no one had de jure control over the appellant. The issue is rather whether the appellant was controlled in fact, directly or indirectly in any manner whatever, by a non-resident. In other words, it has to be determined whether the non-resident corporation Mimetix Inc. ("Mimetix"), which owned 50 per cent of the voting shares of the appellant in 1996, exercised de facto control over the latter corporation within the meaning of subsection 256(5.1) of the Act which reads as follows: 256(5.1) (5.1) Control in fact. For the purposes of this Act, where the expression "controlled, directly or indirectly in any manner whatever," is used, a corporation shall be considered to be so controlled by another corporation, person or group of persons (in this subsection referred to as the "controller") at any time where, at that time, the controller has any direct or indirect influence that, if exercised, would result in control in fact of the corporation, except that, where the corporation and the controller are dealing with each other at arm's length and the influence is derived from a franchise, licence, lease, distribution, supply or management agreement or other similar agreement or arrangement, the main purpose of which is to govern the relationship between the corporation and the controller regarding the manner in which a business carried on by the corporation is to be conducted, the corporation shall not be considered to be controlled, directly or indirectly in any manner whatever, by the controller by reason only of that agreement or arrangement. Facts 8 The appellant was incorporated in Canada in 1994 to carry out research and development with respect to a pharmaceutical product known as DIAC, a powdered form of diatomic iodine devised as an effective treatment for women with fibrocystic breast disease. The original patent for the DIAC formula was registered by the late Dr. Ghent, who resided in Kingston, Ontario, at that time. In 1993, Dr. Ghent's estate negotiated with Mimetix, an American company, a licensing arrangement with respect to DIAC under which Mimetix would own an exclusive licence for that product. Mimetix paid a licence fee of US$100,000. In January 1995, Mimetix sub-licensed to the appellant, for no consideration, the non-exclusive right to conduct in Canada the clinical trials and other investigations involving the licensed product and to manufacture and proceed with the development of the product with a view to obtaining approval for commercial sale in Canada. 9 Under the sub-licence agreement, the appellant had the right to utilize third party contractors, subject to prior approval by Mimetix, to perform or to conduct certain aspects of such development. The appellant thus hired contractors or consultants to carry out the clinical trials, both in Canada and in the U.S. The appellant also hired a firm named Custom Pharmaceuticals ("Custom"), a wholly-owned subsidiary of a Canadian company named Patheon Inc. (which had invested in Mimetix in 1994), located in Fort Erie, Ontario, to look

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after the day-to-day manufacturing of the product. The appellant used land owned by Custom to build a plant in Fort Erie. The appellant invested approximately $600,000 in that plant according to its balance sheet as of December 31, 1996. 10 The administration of the appellant was carried out from San Francisco in the U.S. by Mimetix because, as James Wooder, the only director of the appellant to testify explained, that was a lot cheaper for the appellant. It is not clear from his testimony whether Mimetix charged the appellant any fee for the administration services provided, although it appears from the appellant's financial statements for the 1996 taxation year that the appellant did pay someone administration fees totalling $12,000 in that year. However, at his examination for discovery, Mr. Wooder testified that no payments were made for those services. 11 At the time of its incorporation in November 1994 the appellant issued 100 common voting shares at $1.00 each, of which 50 were subscribed for by Mimetix, and the other 50 by Robert Tedford, a Canadian resident and a senior director at Patheon. At that time, there were three directors elected to the appellant's board of directors: Robert Tedford, Donald Eaton, an American resident who was the chairman and chief executive officer of Mimetix, and a third person, Nick DiPietro, a Canadian resident. 12 On June 20, 1995, Nick DiPietro and Robert Tedford tendered their resignations as directors of the appellant. On the same date, Dr. Marie-Madeleine Bernard, a Canadian resident who apparently was employed by the appellant as its Canadian medical director, and Ewart Budgell, also a Canadian resident, who is apparently an accountant and an occasional consultant for Patheon, were elected to fill the vacancies created on the appellant's board of directors. Robert Tedford, however, remained an officer of the appellant, along with Donald Eaton. On January 31, 1996, Dr. Marie-Madeleine Bernard tendered her resignation as a director of the appellant and she was replaced on the same day by James Wooder,4 a Canadian resident who is vice-president of Helix Investments, Canada, a Canadian venture capital firm investing in early-stage technology companies, that had just invested $3 million in Mimetix. On the same date, Robert Tedford transferred 25 common shares to James Wooder.5 Messrs. Wooder, Eaton and Tedford were also appointed as officers of the appellant: Mr. Wooder as president, Mr. Eaton as vice-president and secretary/treasurer, and Mr. Tedford also as a vice-president. 13 To summarize, from January 31, 1996 and during the balance of that year, Mimetix owned 50 common shares in the capital stock of the appellant, and Robert Tedford and James Wooder owned 25 common shares each. There were three directors elected to the board of directors, namely Donald Eaton, James Wooder and Ewart Budgell. In addition, Donald Eaton, James Wooder and Robert Tedford were appointed as officers of the appellant. 14 According to Mr. Wooder's testimony, he became a shareholder and was elected as a director of the appellant when Helix (the corporation for which he was acting as vicepresident) invested $3 million in Mimetix. If Helix had not invested in Mimetix, he would not have become a shareholder and director of the appellant. As a matter of fact, he was elected at the same time to Mimetix's board of directors. 15 In his testimony, Mr. Wooder said that he never met or talked to the appellant's other Canadian director, Mr. Budgell. Although they both signed the resolutions of the board of directors, they signed them separately and never discussed anything together, as they did not know each other. Mr. Wooder also said that he occasionally met Mr. Eaton or Mr. Tedford in San Francisco in the U.S. or in Toronto, Canada, to "get an update on what was happening in both companies [the appellant and Mimetix]".6 Although every director was an authorized signing officer for the appellant, it appears that in June 1995, Mr. Eaton unilaterally added an authorized signing officer Sam Teichman, M.D., an American cardiologist hired as president

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and chief operating officer for Mimetix.7 This was done without any resolution of the appellant's board of directors. Apparently Dr. Teichman was appointed for his expertise in clinical trials and in the pharmaceutical industry. From then on, it was Dr. Teichman who approved and signed all the appellant's invoices, entered into contracts with different contractors, signed agreements for the conduct of clinical trials and generally took care of the appellant's business administration. In fact, it appears that the reason for Dr. MarieMadeleine Bernard's departure in January 1996 was a conflict in views between her and Dr. Teichman. According to a letter sent by the appellant's counsel, Mark L. Siegel, to Revenue Canada on April 21, 1999,8 "[f]ollowing [Dr. Bernard's] departure from the [appellant] Corporation, [the appellant] made the decision that, since the [appellant] Corporation had established a structure which could rely upon the medical expertise and research planning and management provided by persons employed by the research companies retained by the [appellant] Corporation, it would make economic sense to eliminate the cost of having a separate medical director in Canada... . Dr. Teichman signed the contracts with the research companies since, given his medical expertise, he was in a position to provide the professional knowledge necessary to ensure that the contracts would meet the needs of the Canadian [appellant] corporation". 16 Mr. Wooder testified that he had met Dr. Teichman either in San Francisco or in Toronto. However, In Mr. Wooder's own words, Mr. Eaton was the sole director who had been involved with the appellant since its creation. Apart from Dr. Teichman, it seems that only Mr. Eaton signed cheques and other documents for the appellant. Moreover, it was Mr. Eaton who signed the sub-licence agreement on behalf of Mimetix and the appellant. As a matter of fact, Mimetix had been investing in redeemable and retractable preferred shares of the appellant since December 1994. By the end of 1996 Mimetix had invested $3 million in the appellant, and close to $4,5 million by the end of 1997.9 Mimetix had also loaned the appellant an amount of $1,1 million, interest free, as per the appellant's 1996 financial statements. No other shareholder owned preferred shares in 1996 or loaned money to the appellant in that year. 17 Mr. Wooder, who is experienced in the field of venture capital and who sat on the boards of directors of many different companies, explained that he agreed to become a director and officer of the appellant solely because he viewed the appellant as a virtual corporation, i.e. a corporation with virtually no employees that utilized the services of several major pharmaceutical research companies in Canada to carry out its day-to-day research activities, rather than having its own employees. Those companies, using their expertise in the relevant area, would provide the management and planning functions with respect to the research studies. In Mr. Wooder's view, the directors and officers of a virtual corporation have little to do and it is not necessary for them to have real knowledge of its operations or to be involved in day-to-day management functions. As a matter of fact, it was demonstrated in cross-examination that Mr. Wooder had very little knowledge not only of the appellant's business operations but also of its board of directors, even though he was the president of the appellant. 18 Mr. Wooder's vision of his role as a director of the appellant is in direct contradiction of the remarks made by Mr. Eaton in a letter sent to Revenue Canada on May 20, 1998.10 In that letter, Mr. Eaton stated that "[t]he overall responsibility for the [appellant's] day to day operations during 1996, rested with the [appellant's] Board of Directors, who, from time to time were assisted by Sam Teichman, M.D., Marie-Madeleine Bernard, M.D. (for a portion of 1996), Cato Pharma Canada [the Custom Pharmaceuticals division of Patheon Inc. in Toronto], Alison Ghent [Dr. Ghent's wife], and Custom Pharmaceuticals (Patheon)". Mr. Eaton also said in that letter that "[d]uring 1996, the [appellant's] Directors performed the

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normal functions of a board of directors, which included management of the day to day operations of the business, plus approving corporate policies and resolutions". 19 Mr. Wooder disagreed with Mr. Eaton's statement that the board of directors was responsible for day-to-day operations. He tried to explain that Mr. Eaton probably meant to say that the board of directors was responsible for day-to-day administration. Mr. Wooder explained that in fact Mr. Eaton was heavily involved in administration, for he was signing the cheques and contracts and was working closely with Dr. Teichman. Also, all documentation went through Mimetix in San Francisco (including the appellant's tax return, which showed Mimetix's address, and the bank statements). 20 In 1997 the clinical trials were completed and the licensed product did not prove to be effective. Mr. Wooder testified that just prior to the completion of the trials the appellant raised US$3 million from a Canadian company by the name of Working Ventures Canadian Fund Inc. ("Working Ventures") in consideration of 800,000 preferred shares of the appellant. At that time, Working Venture had one of its representatives elected to the appellant's board of directors and a resolution of the board was apparently passed requiring at least two signatures for transactions involving the bank account (this resolution was not, however, filed in evidence). From then on, Mr. Eaton apparently could not unilaterally transfer funds to Mimetix and he eventually resigned as a director. Appellant's Arguments 21 Counsel for the appellant submits that the appellant was at all times a CCPC within the meaning of subsections 125(7) and 256(5.1) of the Act. The appellant was not in the taxation year at issue directly controlled by one or more non-resident persons. Indeed, 50 per cent of the voting shares were owned by residents of Canada. Furthermore, counsel submits that the appellant was not indirectly controlled by one or more non-resident persons, since its board of directors was controlled by residents of Canada (two directors out of three were Canadian residents). In his view, the fact that administrative personnel of Mimetix was performing bookkeeping, banking and contract-signing functions for the appellant did not mean that the board of directors' control of the appellant had been usurped, since that administrative personnel was acting under the authority of the board of directors. 22 Furthermore, counsel submits that many other factors are present which enable one to conclude that control was exercised in Canada. The DIAC product was invented in Canada and approved by the Health Protection Branch of Health Canada. All the pharmaceutical activities took place in Canada out of a plant built by the appellant in Fort Erie, Ontario. The research was done in Canada through different Canadian contractors hired by the appellant, and the manufacturing of the product was done by Custom, a Canadian company located in Fort Erie. The majority of the board of directors were Canadian residents and included Mr. Wooder, who had extensive knowledge as a venture capitalist and as a director of corporations. The majority of the officers of the appellant were Canadian residents, including Mr. Tedford, who was vice-president of the appellant, a major investor through Patheon and the owner of Custom, both of which companies are Canadian. Mr. Tedford had knowledge of the pharmaceutical field and there was therefore no need for the board of directors to take an active role in the day-to-day operations of the appellant. 23 In counsel's view, the fact that Mimetix owned a significant number of non-voting retractable preferred shares in the appellant, or that the appellant was indebted to its nonresident shareholder Mimetix, does not mean that Mimetix had effective control of the appellant. He submits that the preferred shares were acquired by Mimetix as part of its longterm investment in the appellant. The mere fact that a type of share would allow a shareholder to call for the redemption of such shares does not in itself result in that

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shareholder being in a position to control the corporation in which it holds those shares. Indeed, under the Canada Business Corporations Act ("CBC Act"), shares cannot be redeemed if that would render the company insolvent (see subsection 36(2) of the CBC Act). 24 With respect to the intercompany debt owed to Mimetix, it related to the acquisition of equipment by the appellant for use in its business activities in Canada. In counsel's view, the loan was made for commercial purposes and did not result in the appellant being made subject to financial pressure or control by Mimetix. 25 Counsel referred to the decision by the Federal Court of Appeal in Robson Leather Co. Ltd. v. M.N.R., 77 D.T.C. 5106, in stating that those factors (a debt relationship existing between a shareholder and a corporation, or a shareholder holding retractable preferred shares in the corporation) can only be considered to give control to a shareholder where the corporation is in financial difficulty and the other shareholders are not in as financially secure a position as the shareholder holding the debt or the retractable shares. In the present case, the appellant was not in financial difficulty, as evidenced by the financial statements showing that the appellant spent millions of dollars in Canada on scientific research relating to the development of a pharmaceutical product. In addition, the resident shareholders of the appellant and its directors were financially stable and would not be subject to economic pressure from the non-resident shareholder, Mimetix. 26 Counsel also referred to this Court's decision in Zinkhofer et al. v. M.N.R., 91 D.T.C. 643, in which Judge Sobier, as he then was, held that the existence of a debt relationship or of retractable preferred shares could not result in control since one consequence of that would be that major creditors who are not shareholders of the corporation would be considered to control the corporation. 27 Counsel also referred to Birmount Holdings Ltd. v. The Queen, 78 D.T.C. 6254 (F.C.A.), in emphasizing that the control and central management of a corporation is a factor to be considered in determining who controls the corporation. In his view, the fact that the appellant was incorporated in Canada, that it carried on all its business activities in Canada, that it filed Canadian income tax returns and that Mimetix did not overrule the Canadian directors of the appellant in terms of their decisions with respect to the operations of the appellant, demonstrates that the central management and control was in Canada. 28 Counsel finally concludes that if the evidence has not shown to the Court's satisfaction that control of the appellant was exercised by Canadian residents (which he does not believe to be the case), it certainly has demonstrated that control was not exercised in the U.S. by the non-resident shareholder Mimetix, and that is sufficient to be able to declare that the appellant was a CCPC in 1996. The best illustration of that is that in 1997 Mr. Eaton was blocked by the appellant's board of directors in his attempt to transfer money from the appellant to Mimetix. Respondent's Argument 29 Counsel for the respondent submits that the meaning of control, as defined in Buckerfield's Ltd. et al. v. M.N.R., 64 D.T.C. 5301 (Ex. Ct. of Canada), has changed, at least since the addition of subsection 256(5.1), in defining the concept of control in the Act by including de facto control. (See Socit Foncire d'Investissement Inc. v. Canada, [1995] T.C.J. No. 1568 (T.C.C.) (Q.L.).) 30 Counsel for the respondent submits that the appellant was controlled in fact by a nonresident person in 1996. In his view, the appellant was indeed controlled by Mimetix, the American shareholder, in 1996. The fact that Mimetix had invested $3 million in preferred

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shares and made an interest-free loan of $1,1 million to the appellant is, in his view, very relevant to the present matter, especially if we take into account that the other shareholders had only invested $25 each in common shares. How can one say that with an investment of $25 each the Canadian shareholders had control over the appellant when the non-resident shareholder had invested over $4 million in the appellant? Indeed, the evidence disclosed that Mimetix, through Mr. Eaton, kept a very close eye on the appellant's affairs. All the exhibits show that the documents relating to the appellant's business went through Mimetix or through Dr. Teichman, the expert in the pharmaceutical industry who was hired on Mimetix's own decision. 31 Counsel submits that where the research is done is not relevant nor is it relevant that the equipment used in the appellant's business was located in Canada. What is relevant for the purpose of determining whether the appellant was a CCPC is to find out who in 1996 controlled that corporation in fact within the meaning of subsection 256(5.1) of the Act, regardless of whether it was a virtual corporation, as argued by counsel for the appellant, or not. 32 In counsel's view, it is abundantly clear from the evidence that the two Canadian directors, who, according to the appellant's argument, were supposed to control the appellant, in fact knew almost nothing about the appellant (for example, Mr. Wooder did not know at the time of his examination for discovery how many employees were working for the appellant, who had signing authority for the appellant, etc.). 33 Counsel is of the opinion that Mimetix had financial control over the appellant and had a controlling influence over the appellant's affairs. This is best illustrated, in his view, by the fact that Dr. Marie-Madeleine Bernard, who was a Canadian director of the appellant, had to leave following a conflict with Dr. Teichman, who was not even a shareholder, director or officer of the appellant, but was hired by Mr. Eaton on his own decision, without any resolution of the board of directors. Counsel submits that it is difficult to argue in the circumstances that the board of directors in Canada had control over the appellant's affairs. In his view, the situation might have changed in 1997 with the arrival of a new shareholder, Working Venture. But things were different in 1996 and this Court is called upon to deal with the 1996 taxation year only. 34 For these reasons, counsel submits that the appellant was controlled by the nonresident corporation Mimetix in 1996 and therefore did not qualify as a CCPC. Analysis 35 The appellant has to show that it was a CCPC throughout its 1996 taxation year in order to benefit from a higher rate of investment tax credit and from a refundable investment tax credit (see subsection 127(10.1) and section 127.1 of the Act). 36 In order for a corporation to qualify as a CCPC, it must be shown among other things that that corporation was not in the year at issue controlled, directly or indirectly in any manner whatever, by non-residents. That is the issue here. 37 The term "control" is not defined in the Act. Control usually means the right of control that rests on ownership of such a number of shares as carries with it the right to a majority of the votes in the election of the board of directors (see Buckerfield's, supra). Such control is referred to as de jure control. In other words, the owners of the majority of the voting power in a company are de jure the persons who are in effective control of its affairs and fortunes (which statement has been approved by the Supreme Court of Canada in M.N.R. v. Dworkin

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Furs (Pembroke) Ltd. et al., 67 D.T.C. 5035 and more recently in Duha Printers (Western) Ltd. v. The Queen, 98 D.T.C. 6334). 38 However, subsection 256(5.1) has incorporated a de facto control concept for the purposes of the Act. As Iacobucci J. observed in Duha Printers, supra, at p. 6344: 52... . Parliament has now recognized the distinction between de jure and de facto control, adopting the latter as the new standard for the associated corporation rules by means of s. 256(5.1) of the Income Tax Act, enacted in 1988. 39 Under subsection 256(5.1), a corporation is considered to be controlled, directly or indirectly in any manner whatever, by another person (the "controller") if the controller has any direct or indirect influence that, if exercised, would result in control in fact of the corporation. This is de facto control, and determining its existence necessitates a review of all the facts in each particular situation. Subsection 256(5.1) provides an exception to the above rule where the corporation and the controller are dealing at arm's length and the controller's influence is derived from an agreement or similar arrangement, the main purpose of which is to govern the relationship between the parties regarding the manner in which a business carried on by the corporation is to be conducted. This exception has not been argued in the present case. 43 In my view, the evidence discloses that not only did Mr. Eaton and Dr. Teichman control the day-to-day operations of the appellant from San Francisco but they also controlled its fortune by making all the decisions. Counsel for the appellant argued that all decisions were nevertheless taken under the authority of its board of directors. The board of directors was composed of three people, namely Messrs. Wooder, Eaton and Budgell. No evidence was adduced as to Mr. Budgell's role in the appellant. The only thing we know is that he is Canadian, that he was an accountant working occasionally for Custom and that he never met the other Canadian director, Mr. Wooder. As for Mr. Wooder, he was a director and the president of the appellant. One would assume that, holding these positions, he would be relatively well informed about the appellant. This assumption is reinforced by the duties of the president as stated in the "Organizational and General Administrative Resolutions of the Board of Directors of [the appellant] ...". Those duties are described as follows in Exhibit A-2, Tab 44, pp. 8-9: (a) PRESIDENT. The President shall be the chief operating officer and shall have the powers and duties conferred upon him by the by-laws of the Corporation and by this resolution and such other powers and duties as the Board of Directors may determine. The President shall exercise a general control of and supervision over the affairs and business of the Corporation, except to the extent that the Board of Directors shall otherwise determine. 44 It is obvious from the evidence that Mr. Wooder did not exercise such control and supervision over the affairs and business of the appellant. With respect to the administrative services provided by Mimetix to the appellant, Mr. Wooder testified that the sole reason for having the services provided by Mimetix was that they were thereby obtained at a lesser cost than if they were provided in Canada. Mr. Wooder did not know if any monies were paid for the administrative services but assumed that the $12,000 shown for the year on the appellant's financial statements represented the consideration for those services. In addition, Mr. Wooder did not even know who the authorized signing officers for the appellant were, and he never met the other Canadian director, Mr. Budgell. Furthermore, with the exception of the acquisition of the Collette mixer, he was not aware of any of the contracts signed by

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the appellant in the operation of its business. It seems quite unusual for a director and president of a company to be uninformed to such a degree. Mr. Wooder admitted that if Helix had not invested $3 million in Mimetix, he would not have been appointed to the appellant's board of directors. It is therefore erroneous to assert, as does counsel for the appellant, that the administrative personnel in the U.S. was acting under the authority and supervision of the appellant's board of directors. Mr. Eaton alone was not the board of directors. 45 Indeed the evidence discloses that the only director that exercised such control and supervision was Mr. Eaton, the non-resident director. He was the one who took or approved all of the decisions, the main one being the hiring of Dr. Teichman, who replaced the Canadian medical doctor, Dr. Bernard. That decision was taken without the approval of the board of directors. It does not appear that either Mr. Wooder or Mr. Budgell was consulted at that time; at least the evidence does not show that to have been the case. 46 Dr. Teichman was authorized by Mr. Eaton to sign all agreements, invoices and cheques with respect to the appellant's business operations. All work contracted out to third parties was authorized and approved not by the board of directors but by Mr. Eaton and Dr. Teichman. What all this shows is that Mimetix in fact had control over the appellant. Indeed, the non-resident corporation Mimetix was, through Dr. Teichman and Mr. Eaton, both nonresidents of Canada, the controlling mind of the appellant. Furthermore, no evidence was brought forward as to the role played by Mr. Tedford, one Canadian officer of the appellant. The only thing we know is that Patheon, for which Mr. Tedford was working, invested in Mimetix in 1994, not in the appellant. I will not therefore give any weight to the appellant's counsel's submission that Mr. Tedford had influence over the appellant in 1996. At least, the documentary evidence does not reveal that to have been the case. 47 To explain Mr. Wooder's lack of knowledge and authority, the appellant's counsel submitted that the appellant was a virtual corporation and as such would employ individuals possessing the requisite expertise to carry out work on a contract basis. These contractors would not only perform the required task but would also look after the management aspect of that task. Therefore, the directors and officers would have little knowledge of the activities of the appellant. This explanation is however inconsistent with the role played by Mr. Eaton in the 1996 taxation year. He, as a director, was the only one who was at all times aware of the expertise that the appellant required and he acted appropriately to meet those requirements. 48 Furthermore, even though the appellant was not in as bad a financial situation as existed in Robson, supra (although I note that the appellant suffered a $1,6 million loss in 1996 and a $2,5 million loss in 1997), I would nevertheless conclude that Mimetix, being the only investor in the appellant's business in 1996, was in a position to exert the kind of pressure that enabled it to have its will prevail with respect to that business. This conclusion is reinforced, in my view, by other instances in which the appellant has not dealt with Mimetix on a commercial basis. Indeed, it was seen that even though Mimetix paid US$100,000 to acquire the licence for DIAC, a sub-licence was granted to the appellant for no consideration. As well, when Mimetix loaned $1,1 million to the appellant, there was no interest charged. With respect to the administrative services, the evidence is unclear as to the cost to the appellant of such services but if there were any costs they would have been minimal. All this, in my view, certainly constitutes a form of economic controlling influence exercised by Mimetix over the appellant in 1996, and that is precisely what is covered by the definition of de facto control in subsection 256(5.1) of the Act. 49 That being so, and since the concept of control has been broadened with the addition of subsection 256(5.1), I do not find that the appellant can rely on the Zinkhofer decision, supra, which had to do with capital losses suffered in taxation years preceding that

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amendment to the Act. Indeed, economic controlling influence does not have any bearing on de jure control, which was, in my view, the basis of Judge Sobier's decision in Zinkhofer. 50 Furthermore, de facto control of a corporation may shift from one shareholder to another based on external factors, as is recognized in the following terms in one academic commentary referred to by counsel for the appellant (D.S. Ewens and S.J. Hugo, "The Effect of Bill C-139 on Certain Corporate Reorganizations." 88 Canadian Tax Journal 1021 at pp. 1032-33): ... With the new factual control test, a shareholder may find himself considered to be in control of a corporation because of changes in economic conditions, either external or internal to the corporation. Such could have been the case here in 1997, with the injection of new funds by a new shareholder, Working Ventures, but that is not at issue here. 51 Finally, I do not find that the decision of the Federal Court of Appeal in Birmount Holdings Ltd., supra, referred to by counsel for the appellant has any relevance in the present case. In Birmount, the Federal Court of Appeal had to examine whether the central management and control of a corporation was in Canada in order to determine whether that corporation was a Canadian resident. That case did not deal with the issue of who was controlling the corporation but rather had to do with where the central management and control was exercised for residency purposes. In any matter, I certainly do not agree with counsel for the appellant's assertion that Mimetix did not overrule the Canadian directors of the appellant in terms of their decisions with respect to the operations of the appellant. To the contrary, the evidence rather supports the position that the Canadian directors made no decisions regarding the appellant's operations at all. Conclusion 52 I therefore conclude from all the facts that the appellant was in fact controlled by Mimetix, the non-resident shareholder, in 1996, and consequently was not a CCPC in that year, within the meaning of subsections 125(7) and 256(5.1) of the Act. Decision 73 From the foregoing, the appeal is dismissed, with costs.

This case was affirmed by the Federal Court of Appeal with brief reasons, 2003 FCA 106.

Paragraph 125(7)(b): Interaction with 251(5)(b)

Who is The Hypothetical Shareholder? Sedona Networks Corporation and Her Majesty the Queen 2007 CarswellNat 991, 2007 FCA 169, [2007] 3 C.T.C. 237, 2007 D.T.C. 5359 (Eng.), 362 N.R. 61, 35 B.L.R. (4th) 283 (FCA) ;: affirming Sedona Networks Corp. v. R. (2006), 2006 TCC 80, 2006 CarswellNat 573, [2006] 3 C.T.C. 2159, 2006 D.T.C. 2486 (Eng.) (T.C.C. [General Procedure]) B. Malone J.A.:

110 I. Introduction The issue in this appeal is whether Sedona Networks Corporation ( Sedona ) was, throughout its 1999 taxation year, a Canadian-controlled private corporation (CCPC) as defined in subsection 125(7) of the Income Tax Act, R.S.C. 1985, c. 1 (5th Supp) (Act). In a judgment dated March 2, 2006, a judge of the Tax Court of Canada (2006 TCC 80 (T.C.C. [General Procedure])) dismissed an income tax appeal by Sedona for 1999 on the basis that Sedona was not a CCPC throughout that year. Sedona now appeals to this Court.
1

A CCPC is generally defined by subsection 125(7) of the Act as a Canadian corporation that is not controlled by disqualifying shareholders, such as non-residents and certain public corporations. Under paragraph (b) of the statutory definition, shares owned by disqualifying shareholders are attributed, for the purposes of the definition of CCPC, to a mythical "particular person". If the result of that attribution is that the particular person controls the corporation at any time during the relevant taxation year, the corporation is not a CCPC for that taxation year. The focus of present appeal, therefore, is the number of votes exercised by non-resident persons and public corporations.
2 3

The relevant parts of the definition of CCPC reads as follows: Section 125(7): "Canadian-controlled private Section 125(7): socit prive sous corporation" means a private corporation that contrle canadien Socit prive qui est is a Canadian corporation other than une socit canadienne, l'exception des socits suivantes: ... (b) a corporation that would, if each share of the capital stock of a corporation that is owned by a non-resident person, by a public corporation (other than a prescribed venture capital corporation), or by a corporation described in paragraph (c) were owned by a particular person, be controlled by the particular person [Emphasis added] ... b) si chaque action du capital-actions d'une socit appartenant une personne nonrsidente, une socit publique (sauf une socit capital de risque vise par rglement) ou une socit vise l'alina c) appartenait une personne donne, la socit qui serait contrle par cette dernire; [Je souligne]

II. Factual Background Sedona was incorporated in 1998 under the Canada Business Corporations Act, R.S.C. 1985, c. C-44 (CBCA), and went into bankruptcy on March 30, 2001. It was in the business of developing, manufacturing and distributing products that enable network service providers to deliver bundled voice data services. During its 1999 taxation year, Sedona incurred $2,929,361 in scientific research and experimental development expenditures. Sedona claimed a refundable tax credit of $927,785 in respect of those expenditures pursuant to sections 127(10.1), 127.1(2) and 127.1(2.01) of the Act. Sedona is entitled to that credit only if it was a CCPC throughout 1999.
4

A number of issues have been raised in determining control of Sedona . "Control" in this context means de jure control, which is the control manifested in the ownership of the number of shares required to cast a majority of the votes in the election of the board of directors. However, an exception arises where the corporate constitution or a unanimous shareholder agreement deprives the directors of the authority to manage the business and affairs of the corporation (see Duha Printers (Western) Ltd. v. R., [1998] 1 S.C.R. 795 (S.C.C.) [Duha Printers] at paragraph 50; Buckerfield's Ltd. v. Minister of National Revenue (1964), [1965] 1 Ex. C.R. 299 (Can. Ex. Ct.)).
5

111 III. Analysis (1) Issued and Outstanding Shares without Options Counted The first issue relates to 438,597 class B preferred shares of Sedona owned by Bank of Montreal Capital Corporation (BMCC), a wholly owned subsidiary of Bank of Montreal (BMO). BMO is a taxable Canadian corporation and a public corporation for the purposes of the Act. (A second issue arises in relation to options granted by Sedona to employees and others to acquire its treasury shares; that issue is discussed separately in the next section.)
6

Excluding the BMCC Shares, the following chart represents the distribution of all Sedona 's issued voting shares between, in one column, residents and non-public corporations, and in the other column, non-residents and public corporations:
7

SHARES

RESIDENTS/NON-PUBLIC

NON-RESIDENTS/PUBLIC 9 419 931 50.4%

Common and Preferred 9 281 789 Shares Percentage of Control

8

49.6%

Shares in the 'non-residents/public' column are attributed to the "particular person" under paragraph (b) of the definition of CCPC in subsection 125(7). According to Sedona , the BMCC shares should be included in the 'residents/non-public' column. If Sedona is correct, then residents would have controlled Sedona throughout its 1999 taxation year and it would have been a CCPC (assuming all options are ignored in the calculation). According to the Minister, however, these shares are properly to be included in the 'non-residents/public' total because BMCC was controlled by a public corporation (BMO). If the Minister is correct, then the "particular person" would control Sedona (assuming all options are ignored in the calculation), and Sedona would not be a CCPC throughout its 1999 taxation year. The Minister, relying on Vineland Quarries & Crushed Stone Ltd. v. Minister of National Revenue, [1966] Ex. C.R. 417 (Can. Ex. Ct.), argues that, in determining who controls the votes attached to the BMCC Shares, it is necessary to look though BMCC to its wholly owning parent corporation, BMO. It argues that, because BMO is a public corporation, the BMCC Shares must be treated for purpose of paragraph 125(7)(b) as though they were owned by the 'particular person' referred to in that paragraph.
9

However, Sedona argues that on the facts of this case, the applicable principle cannot be found in Vineland Quarries, because the voting rights attached to the BMCC Shares rest with a Canadian resident private corporation named Ventures West Management TIP Inc. (Ventures).
10

Ventures carries on the business of providing venture capital management services. Throughout Sedona 's 1999 taxation year, BMCC Shares were the subject of a Management Agreement between BMCC and Ventures. The Management Agreement permitted Ventures to organize and operate three venture capital related programs on behalf of BMO. It gave Ventures the right to exercise, at its sole discretion, the voting rights with respect to the BMCC Shares, as well as the right to acquire those shares in the case where BMCC terminated the agreement without proper cause. A general power of attorney was also executed in order to allow Ventures to carry out these management services on BMCC's behalf.
11

112 In my analysis, the correctness of Sedona 's argument turns on the principles stated in Duha Printers at paragraph 85, where Iacobucci J. provided a comprehensive list of principles for determining de jure control:
12 (1) Section 111(5) of the Income Tax Act contemplates de jure, not de facto, control. (2) The general test for de jure control is that enunciated in Buckerfield's, supra: whether the majority shareholder enjoys "effective control" over the "affairs and fortunes" of the corporation, as manifested in "ownership of such a number of shares as carries with it the right to a majority of the votes in the election of the board of directors". (3) To determine whether such "effective control" exists, one must consider: (a) the corporation's governing statute; (b) the share register of the corporation; (c) any specific or unique limitation on either the majority shareholder's power to control the election of the board of the board's power to manage the business and affairs of the company, as manifested in either: i. the constating documents of the corporation; or ii. any unanimous shareholder agreement [Emphasis added]. (4) Documents other than the share register, the constating documents, and any unanimous shareholder agreement are not generally to be considered for this purpose.

The Judge concluded that the Management Agreement was not to be taken as determinative of de jure control because it was not a constating document within the meaning of corporate law, or a unanimous shareholder agreement. At para. 24 he stated:
13 The management agreement is an "ordinary" contractual arrangement between BMCC and Ventures which gives the latter wide powers in managing the technology portfolio of BMCC. It is just an external document and, as a general rule, this kind of document is not to be taken into account as determinative of de jure control. It does not affect the corporate constitution of BMCC. For instance, it is not a constating document limiting the powers of the BMCC's board of directors to manage its affairs. Nor does it modify the ownership rights of BMCC in the Sedona shares, although such rights may be exercised by Ventures in the course of the provision of its management services.

In my analysis, the Judge was correct to characterize the Management Agreement as he did. It is well established that the owner of voting shares who is obliged by contract to exercise them in a certain way does not thereby divest himself of those rights (see Duha Printers at paragraph 81). I see no reason why the same principle should not apply where the owner of voting shares enters into a contract with another person that grants that person a contractual right to vote the shares but not the other incidents of share ownership.
14

Sedona also argues that the Management Agreement was a unanimous shareholder agreement, which had the effect of restricting the powers of BMCC directors to manage its business and affairs. The Judge did not accept that argument, primarily because BMO was not a party to that agreement. At para. 25 he stated:
15 The management agreement cannot be considered to be a USA entered into by BMCC's shareholder either. BMO is not a party to this management agreement. Under subsection 146(3) [of the] CBCA, a

113
person who is the beneficial owner of all the issued shares of a corporation can make a written declaration that restricts in whole or in part the powers of the directors to manage the business and affairs of the corporation, and this declaration is deemed to be a USA. Here, there is no evidence that BMO made such a written declaration. If BMO had the intention of removing or altering directors' powers to manage the business and affairs of BMCC, it would have at the very least intervened in the management agreement and made its intention clear.

Pursuant to subsection 146(1) of the Canada Business Corporations Act a unanimous shareholder agreement is defined in the following way:
16

146(1) An otherwise lawful written agreement among all the shareholders of a corporation, or among all the shareholders and one or more persons who are not shareholders, that restricts, in whole or in part, the powers of the directors to manage, or supervise the management of, the business and affairs of the corporation is valid [Emphasis added].
17

146. (1) Est valide, si elle est par ailleurs licite, la convention crite conclue par tous les actionnaires d'une socit soit entre eux, soit avec des tiers, qui restreint, en tout ou en partie, les pouvoirs des administrateurs de grer les activits commerciales et les affaires internes de la socit ou d'en surveiller la gestion [Je souligne].

Sedona relies on Duha Printers at para. 64 for the proposition that a unanimous shareholder agreement may be brought into existence without specific formality and that all that is required is some written expression of shareholder will. It argues that the Management Agreement meets the description of a unanimous shareholder agreement in relation to BMCC for the following reasons: * Subsection 1.1(t) provides that a representative be chosen, who is a BMO senior executive, to be the primary point of contact between the Manager and BMO; * Section 2.5 requires the transfer of BMO assets to be managed by Ventures; * Ventures is also required to provide services to BMO-TIP (the BMO program of investments) that Ventures, via the Management Agreement, will manage; * Section 4.2 provides for the secondment of BMO employees to Ventures; and * Various provisions contained in the Management Agreement provide contractual obligations of Ventures, BMCC and/or BMO. In essence, Sedona argues that it is through the agency of BMCC, both express and implied, that BMO is made a party to the Management Agreement. As such, the Management Agreement can be construed as a unanimous shareholder agreement between the shareholder of BMCC, BMCC itself and Ventures, which restricts the powers of the directors of BMCC to manage the business and affairs.
18

In my view, the Judge was correct to find that BMO is not a party to the Management Agreement. The items listed in paragraph 19 are simply provisions that enhanced Ventures' ability to perform its management function.
19

Even if BMO were a party to the Management Agreement, there is no basis for concluding that the Management Agreement restricted the powers of BMCC's board of directors to manage its business and affairs. Without this restriction, the statutory requirements for a unanimous shareholder agreement are not met.
20

114 In summary, Sedona cannot point to any constating document or unanimous shareholder agreement that would have the effect of attributing the BMCC Shares to Ventures, a private corporation. It follows that the BMCC shares fall into the 'non-resident/public' column and must be attributed to the mythical "particular person" under paragraph (b) of the definition of CCPC in subsection 125(7). The result would be that Sedona was not a CCPC during its 1999 taxation year:
21

SHARES

RESIDENTS/NON-PUBLIC

NON-RESIDENTS/PUBLIC 9 419 931 438 597

Common and Preferred 9 281 789 Shares BMCC shares Total 9 281 789

9 858 528 51.5%

Percentage of Control 48% (ignoring options) (2) Taking the options into account

In June of 1999, Sedona adopted a share option plan under which certain of its employees and consultants could be granted options to subscribe for common shares of Sedona . During Sedona 's 1999 taxation year, options to acquire 733,500 shares were granted to employees or consultants who were resident in Canada, and options to acquire 342,000 shares were granted to employees and consultants who were not resident in Canada.
22

On July 22, 1999, Manouch Khezri, a non-resident, was hired by Sedona to begin employment on August 2, 1999. On that date, Sedona 's board of directors authorized the grant to Mr. Khezri, on October 15, 1999, of options to acquire 458,000 common shares. The date of the granting of that option was deliberately chosen to fall outside of Sedona 's 1999 taxation year, which ended on September 30, 1999, in the hope that the status of Sedona as a CCPC in that taxation year would not be jeopardized.
23

Options to acquire shares are relevant to determination of the status of Sedona as a CCPC because of paragraph 251(5)(b), the relevant portion of which reads as follows:
24

Section 251(5): For the purposes of (5) Pour l'application du paragraphe (2) et de subsection 251(2) and the definition la dfinition de "socit prive sous contrle "Canadian-controlled private corporation" in canadien" au paragraphe 125(7): subsection 125(7), ... (b) where at any time a person has a right under a contract, in equity or otherwise, either immediately or in the future and either absolutely or contingently, (i) to, or to acquire, shares of the capital stock of a corporation or to control the voting rights of such shares, the person shall, except where the right is not exercisable at that time because the exercise thereof is contingent on the death, bankruptcy or permanent disability of an individual, be ... b) la personne qui, un moment donn, en vertu d'un contrat, en equity ou autrement, a un droit, immdiat ou futur, conditionnel ou non: (i) des actions du capital-actions d'une socit ou de les acqurir ou d'en contrler les droits de vote, est rpute occuper la mme position relativement au contrle de la socit que si elle tait propritaire des actions ce moment, sauf si le droit ne peut tre exerc ce moment du fait que son

115 deemed to have the same position in relation exercice est conditionnel au dcs, la to the control of the corporation as if the faillite ou l'invalidit permanente d'un person owned the shares at that time particulier, [Emphasis added].
25

[Je souligne]

In essence, subparagraph 251(5)(b)(i) deems a person who has a contractual right to acquire shares at some future date to have the same position in relation to the control of the corporation as if the person already owned the shares. An option to acquire a share is a right that fits within the scope of paragraph 251(5)(b). It is not clear whether whatever right Mr. Khezri was granted on July 22, 1999 fell within paragraph 251(5)(b) at any time during Sedona 's 1999 taxation year. Because of that uncertainty, it is convenient to conduct the analysis first without taking the Khezri options into account. The Judge made two key findings in relation to the options issue. First, he held that the option rights contemplated by paragraph 251(5)(b) could never be attributed to the particular person under paragraph (b) of the definition of CCPC in subsection 125(7). His reasoning was that paragraph 251(5)(b) does not deem anyone to own shares; it only creates a legal fiction of control of a corporation (see Reasons at para. 13). Secondly, the Judge chose not to decide whether Mr. Khezri's rights should be included in determining whether Sedona was a CCPC in its 1999 taxation year because he found that consideration to be irrelevant in light of his other conclusions.
26

In my analysis, the legal fiction created by the paragraph 251(5)(b) is directed at the concept of ownership, not control. Once it is determined that a person has a right that falls within the scope of paragraph 251(5)(b), it is necessary to assume that the right is exercised and the related shares are actually acquired by the holder of the right. Then, it is necessary to determine how many votes are attached to the shares actually issued and the shares that would be issued if the options were exercised. Finally, answering the question asked by paragraph (b) of the definition of CCPC in subsection 125(7), it is necessary to determine how many votes should be attributed to the mythical "particular person". As this was not the approach adopted by the Judge, I am compelled to conclude that the Judge made a legal error in his interpretation of subparagraph 251(5)(b)(i). In my view, the correct interpretation of these provisions requires them to be applied as follows. If it is assumed that all of the non-Khezri options were exercised in 1999, the control calculation would be as follows:
28

SHARES

RESIDENTS/NON-PUBLIC

NON-RESIDENTS/PUBLIC 9 858 528

Common and Preferred 9 281 789 Shares (including BMCC Shares) Options Total Percentage of Control
28

733 500 10 015 289 49.55%

342 000 10 200 528 50.45%

If all of the votes attached to the shares in the 'non-resident/public' column are attributed to the "particular person" referred to in paragraph (b) of the definition of CCPC in subsection 125(7), the particular person would control Sedona in its 1999 taxation year. It follows that Sedona did not qualify as a CCPC in that year. This conclusion makes it unnecessary to determine whether or not the right granted to Mr. Khezri fall within paragraph 251(5)(b) during Sedona 's 1999 taxation year. IV. Conclusion

116 As the Judge correctly determined that Sedona was not a CCPC during its 1999 taxation year, there is no basis for reversing his decision. I would dismiss this appeal with costs.
29

M. Nadon J.A.: I agree K. Sharlow J.A.: I agree Appeal dismissed. 1 A corrigendum issued by the Court on June 11, 2007 has been incorporated.

4. The Small Business Deduction

As previously noted, below is an additional example of how the small business deduction (SBD) works. The SBD is contained in subsection 125(1) of the Act. It is available to Canadian-controlled private corporations. Such a corporation may deduct from basic federal tax an amount equal to 17% of its income from an active business carried on in Canada (up to $500,000 on a federal basis after January 1, 2009). For our purposes, you should know that where a corporation is entitled to the deduction, the federal tax rate on active business income is 11%. A corporation entitled to this deduction is also entitled to a reduced tax rate at the provincial level on qualifying active business income. In Alberta, such corporations are taxed at 3% as of April 1, 2008. Therefore, the effective combined federal and provincial corporate tax rate in Alberta for the 2012 calendar year is 14% calculated as follows:

s.123 s.124

basic federal rate less federal abatement Surtax base

38.00% (10.00%) 28.00% 0% 28.00% (17.00%) 11% 3% 14.00%

s.123.2

surtax (0%) on federal tax payable Federal Tax before small business deduction

s.125(1)

less small business deduction Federal tax Provincial Tax Combined Federal and Provincial rate:

The reduction in the applicable tax rate is pro-rated for those corporations with taxation years that do not coincide with the calendar year.

117

i. The Concept of Active Business Income

S. 125(1) allows a 17% rate reduction on income of a corporation for the year from an active business carried on in Canada provided the corporation is a CCPC throughout the year. What does "income of the corporation for the year from an active business carried on in Canada" mean? Prior to 1980, section 125 contained no definition of what constituted an active business or income from an active business. There were a great number of cases that dealt with these two issues. Section 125 now defines active business and income from an active business. (a) "Active business carried on by a corporation" is defined in s. 125(7) of the Act. "active business carried on by a corporation" means any business carried on by the corporation other than a specified investment business or a personal services business and includes an adventure or concern in the nature of trade. It means any business carried on by the corporation, including an adventure in the nature of trade, but excluding a specified investment business or a personal services business. S. 248(1) defines "business" to mean "business" includes a profession, calling, trade, manufacture or undertaking of any kind whatever and, except for the purposes of paragraph 18(2)(c), section 54.2 and paragraph 110.6(14)(f), an adventure or concern in the nature of trade but does not include an office or employment. Hence, every type of business activity carried on qualifies as an active business except those activities falling within the category of a specified investment business or a personal services business. (b) "Income of the corporation for the year from an active business" is defined in subsection 125(7) of the Act. "Income of the corporation for the year from an active business" means the total of: (a) the income of the corporation for the year from an active business carried on by it including any income for the year pertaining to or incident to that business, other than income for the year from a source in Canada that is a property (within the meaning assigned by s. 129(4), and the amount, if any, included under s. 12(10.2) in computing the income of the corporation for the year.

(b)

Income from an active business means the income of the corporation for the year from an active business carried on by it (within the definition of "active business" in ss. 125(7)) including ancillary income. That is to say, income that is pertaining to or incident to an active business is included as part of active business income. Income from property is specifically excluded. There is a cross-reference to the concept of "income from property" in ss. 129(4).

118 For the purposes of the definition "aggregate investment income" in ss. 129(4) and ss. 129(6), "income" or "loss" of a corporation for a year from a source in Canada that is a property includes the income or loss from a specified investment business carried on by it in Canada other than income or loss from a source outside Canada but does not include income or loss (a) (b) (c) from any property that is incident to or pertains to an active business carried on by it, or from any property used or held principally for the purpose of gaining or producing income from an active business carried on by it. Subsection 129(6) operates to prevent the conversion of active business income within an associated group to income from property. Subsection 129(6) provides that when an amount is paid or payable to one corporation (the "recipient corporation") by another corporation (the "associated corporation") with which the first corporation is associated, and the amount would otherwise be income from property to the recipient corporation, if the amount was deductible in, computing the income of the associated corporation (that is, the one paying the amount) from an active business carried on by it in Canada, then it is not treated as income of the recipient corporation from a source that is property, and it is deemed to be income of the recipient corporation from an active business carried on by it in Canada. For example, Corporation A and Corporation B are associated. Corporation B carries on an active business in Canada and earns income from that active business. Corporation A lends Corporation B money at a rate of interest which money is used by Corporation B in the course of carrying on its active business. Corporation B deducts the interest expense in determining its income from the active business. Normally such interest income would constitute income of Corporation A from a source that is property, but s. 129(6) deems the income to be income of the recipient from an active business carried on by it in Canada, and hence the interest income would be eligible for the small business deduction in Corporation A, subject to the other rules in s. 125. But for this provision, payments amongst associated corporations could result in the re-characterizing of active business income to non-active business income. [Another example: Corporation A leases office premises or a factory to Corporation B.] (d) The result of this is that income of a CCPC for a year from an active business means income from any business carried on by the corporation including an adventure in the nature of trade and including income pertaining to or incident to that business, but excluding (e) income from a specified investment business, income from a personal services business, and income from property, including any income that is income from property by s.129(4). Remember that to qualify for the small business deduction, the income must be from an active business carried on in Canada and the corporation must be a CCPC throughout the particular taxation year. Whether or not a business is carried on in Canada is a question of fact. See paragraph 10 of Interpretation Bulletin IT-73R6 for some very general comments.

119 (f) There have been a number of cases dealing with the concept of income ancillary to an active business. The classic example is a corporation has excess funds derived from an active business which funds are invested on a short-term basis and produce income. Is this income from property or is it income that is pertaining to or incident to the active business?

The distinction can be very important if the income qualifies as active business income, it is eligible for the significantly lower rate of tax. If the corporation has too much active business income, it may prefer the special treatment provided to property income, as will be discussed later on. Consider the following decisions. Canadian Marconi Company v. The Queen [1986] 2 C.T.C. 465, [1986] 2 S.C.R. 522, 70 N.R. 174, 33 D.L.R. (4th) 481, 86 D.T.C. 6526 (S.C.C.) The appellant's business was the manufacturing of electronic equipment and prior to 1973 it also owned a broadcasting division. In 1971 the Canadian Radio-Television Commission directed that the appellant's broadcasting licence not be renewed because it was foreign controlled. In 1972 the appellant sold its broadcasting division for $18 million which it invested in short-term securities from 1973 to 1976. It intended to use the funds to purchase another business similar to its manufacturing business when the opportunity arose. About 20 per cent of the time of a senior officer was taken up in the day-to-day management of the investments and as many as 12 other employees were also involved. The invested funds amounted to about 50 per cent of the corporation's assets. The appellant contended that the income from the investments formed part of its Canadian manufacturing and processing profits for the purpose of the tax credit provided by section 125.1 as being income from an active business. The Minister assessed the appellant on the basis that the income from the investments was income from property and not income from an active business. Both the Federal Court Trial Division and Federal Court of Appeal dismissed the corporation's appeals. HELD: In the case of a corporate taxpayer there is a rebuttable presumption that income received from an object set out in the corporation's constating documents is income from a business. In this case the evidence tended to support the presumption. Whether particular income is income from a business or property is a question of fact to be determined by an examination of the taxpayer's whole course of conduct. The appellant was compelled to enter the investment business. The fact that the appellant would have preferred to be in the manufacturing business and not in the investment business was irrelevant. The extent of the appellant's investment activity, although only intended to be temporary, was such as to constitute the investment earnings as income from an active business. The definition of "Canadian manufacturing or processing profits" in paragraph 125.1(3)(a) includes all amounts of income from an active business and is not restricted to income from manufacturing or processing. Appeal allowed. Editorial Comment/Summary The appellant was a manufacturer of electronic equipment and, prior to 1973, it also owned a broadcasting division which it was compelled to sell in 1972 because its broadcasting licence had not been renewed. The proceeds of sale, $18 million, were invested in short-term securities pending the purchase of another business similar to its manufacturing business. The issue in the case was whether the appellant's income in its 1973 to 1976 taxation years from the short-term investments was income from an "active business" within the meaning of paragraph 125.1(3)(a) which defined "Canadian manufacturing and processing profits" for the purpose of determining the amount of

120 corporate tax deduction under subsection 125.1(1). It was held that the income in question was income from an active business. In coming to its conclusions the Court held: (1) there is a rebuttable conclusion that income received from or generated by an activity done in pursuit of an object set out in the corporation's constating documents is income from a business; (2) the question whether a particular income is income from business or property is a question of fact to be made from an examination of the taxpayer's whole course of conduct; (3) the evidence in this case supported the presumption that the income was from a business; (4) the fact that the taxpayer would have preferred to be in the manufacturing business and not in the investment business was irrelevant; and (5) the term "active business" in paragraph 125.1(3)(a) is not restricted to a manufacturing business. Situations like those in this case were probably not contemplated when the definition of Canadian manufacturing profits was drafted. The judgment of the Court was delivered by Wilson, J.: 3. The Issue 7 The distinction between income from a business and income from property is a difficult one to draw but it is one which the Act compels us to make. There are two reasons for the difficulty. First, the terms "business" and "property" are broadly and loosely defined in subsection 248(1) of the Income Tax Act. As a consequence the definitions on a fair reading can be construed in such a way as to overlap. Second, persons or corporations generally engaged in trading-type activity often use property as a means of earning income. On first reflection this sort of income could realistically be considered either business income or property income. The observation of Thurlow, J. (as he then was) in Wertman v. M.N.R., [1964] C.T.C. 252 at 266; 64 D.T.C. 5158 at 5167 (Ex. Ct.), that cases are "readily conceivable where particular income may be accurately described as income from property and just as accurately regarded as income from a business" is frequently apposite. The courts have handled the difficult task of deciding whether a particular receipt is business income or property income by applying certain set criteria or indicia of trading activity and, in the case of a corporate taxpayer, by applying a presumption in favour of the characterization of its income as income from a business. I shall examine these in reverse order. 8 It is frequently stated in both the English and Canadian case law that there is in the case of a corporate taxpayer a rebuttable presumption that income received from or generated by an activity done in pursuit of an object set out in the corporation's constating documents is income from a business. This presumption appears to have originated in a comment made by Jessel, M.R. in Smith v. Anderson (1880), 15 Ch. D. 247. There, the Master of the Rolls said at 260 61; You cannot acquire gain by means of a company except by carrying on some business or other, and I have no doubt if any one formed a company or association for the purpose of acquiring gain, he must form it for the purpose of carrying on a business by which gain is to be obtained. ..... When you come to an association or company formed for a purpose, you say at once that it is a business, because there you have that from which you would infer continuity; it is formed to do that and nothing else, and, therefore, at once you would say that the company carried on a business. So in the ordinary case of investments, a man who has money to invest, invests his money and he may occasionally sell the investments and buy others, but he is not carrying on a business. But when you have an association formed, or where an individual makes it his continuous occupation the business of his life to buy and sell securities he is called a stock-jobber or share-jobber, and nobody doubts for a moment that he is carrying on business. So, if a company is formed for doing the very same thing, that is for investing money belonging to persons in the purchase of stocks and shares, and changing

121 them from time to time, either with limited or unlimited powers, I should say there can be no question that they are carrying on a business, whether you call it a business of investment or business of dealing in securities, or, as in the case before me, both the business of investment and the business of dealing in securities. The presumption was applied again for the purpose of distinguishing between business and other income in C.I.R. v. Korean Syndicate, Ltd., [1921] 3 K.B. 258; 12 T.C. 181 (C.A.). The Court of Appeal considered that the fact that the taxpayer was a company in existence for some particular purpose "is a matter to be considered when you come to decide whether doing that is carrying on a business or not" (p. 273; 202). Most recently, in England, the presumption appears to have been extended to corporations with a profit-making purpose and not just corporations whose precise objects are set out in their constating documents. In American Leaf Blending Co. v. Director-General of Inland Revenue, [1979] A.C. 676; [1978] 3 All E.R. 1185 (P.C.), Lord Diplock stated that "in the case of a company incorporated for the purpose of making profits for its shareholders any gainful use to which it puts any of its assets prima facie amounts to the carrying on of a business" (p. 684; 1189). 9 In Canada, the presumption was employed by Duff, J. (as he then was) in the case of Anderson Logging Co. v. The King, [1925] S.C.R. 45; [1917 27] C.T.C. 198; Duff, J., in a passage often cited by subsequent authority, said at 56 (C.T.C. 207): The sole raison d'tre of a public company is to have a business and to carry it on. If the transaction in question belongs to a class of profit-making operations contemplated by the memorandum of association, prima facie, at all events, the profit derived from it is a profit derived from the business of the company. The existence of the presumption was also noted by Locke, J. in Western Leaseholds Ltd. v. M.N.R., [1960] S.C.R. 10; [1959] C.T.C. 531 and it has been applied in many subsequent cases: see, for example, Queen & Metcalfe Carpark Ltd. v. M.N.R., [1973] C.T.C. 810; 74 D.T.C. 6007 (F.C.T.D.), aff'd [1976] C.T.C. xvi (F.C.A.); Fontaine Watch Co. Ltd. v. M.N.R., 25 Tax A.B.C. 146; 60 D.T.C. 535 (T.A.B.); M.R.T. Investments Ltd. v. The Queen, [1976] 1 F..C. 126; [1975] C.T.C. 354; 75 D.T.C. 5224 (T.D.), aff'd. [1976] C.T.C. 294; 76 D.T.C. 6158 (F.C.A.). Indeed, although strictly speaking not relevant to the disposition of this appeal, it is interesting to note that Revenue Canada itself affirms the existence of the rebuttable presumption: see Interpretation Bulletin IT-73R3, paragraph 2. The case law thus provides ample support for the existence of the presumption and, in my view, rightly so. An inference that income is from a business seems to be an eminently logical one to draw when a company derives income from a business activity in which it is expressly empowered to engage. 10 The traditional expression of the presumption restricts its application to corporations whose corporate objects are expressly set out in their constating documents. Corporations formed under the Canada Business Corporations Act, S.C. 1974 75 76, c. 33, the Ontario Business Corporations Act, 1982, S.O. 1982, c. 4, and similar legislation do not need to list their corporate objects. These statutes have simply provided that corporations have the capacity and the rights, powers and privileges of a natural person (Canadian Act, s. 15; Ontario Act, s. 15). Accordingly, an issue may be raised some day as to whether the presumption applies to such corporations (or, more particularly, whether the scope of the presumption should be extended as Lord Diplock has done in the American Leaf Blending Co. case, supra) but this issue does not arise for consideration in this appeal since CMC, being incorporated in 1902 under The Ontario Companies Act, R.S.O. 1897, c. 191, and continued in 1903 under a special federal statute (An Act to incorporate the Marconi Wireless Telegraph Company of Canada, Limited, S.C. 1903, c. 149) was required to state its objects. Section 21 of this federal statute was amended (by An Act respecting Canadian Marconi Company, S.C. 1935, c. 70, s. 3) to provide that CMC:

122 ... may take or otherwise acquire and hold shares, debentures or other securities of any other company having objects altogether or in part similar to those of the Company, or carrying on any business capable of being conducted so as, directly or indirectly, to benefit the Company, and to sell or otherwise deal with the same. Thus, CMC had a specific "investment business" object and the traditional rebuttable presumption, in my view, applies in favour of its investment income being characterized as income from a business. Indeed, even if CMC's investment objects were not expressed, I believe that a broader form of the presumption should apply. In a general sense CMC was incorporated to earn income by doing business. There is no reason why any income earned by it should not be considered as prima facie income from a business so long as it is recognized that the presumption is a rebuttable one. This approach has commended itself to courts even where no express object was contained in the constating documents: see, for example, Supreme Theatres Ltd. v. The Queen, [1981] C.T.C. 190; 81 D.T.C. 5136 (F.C.T.D.) and Fontaine Watch Co. v. M.N.R., supra. 11 As I have indicated, the presumption that income earned by a corporate taxpayer in the exercise of its duly authorized objects is income from a business is rebuttable. For example, in Sutton Lumber and Trading Co. v. M.N.R., [1953] 2 S.C.R. 77; [1953] C.T.C. 237 the appellant successfully rebutted the presumption and in Burri v. The Queen, [1985] 2 C.T.C. 42; 85 D.T.C. 5287 (F.C.T.D.), Strayer, J., although questioning the existence of the presumption (pages 46 47; D.T.C.; 5289 90), held that if such existed it was rebutted on the facts before him. The question whether particular income is income from business or property remains a question of fact in every case. However, the fact that a particular taxpayer is a corporation is a very relevant matter to be considered because of the existence of the presumption and its implications in terms of the evidentiary burden resting on the appellant. The Federal Court of Appeal does not appear to me to have given adequate consideration to this aspect of the case, namely that CMC was a company with an investment object in its constating document. 12 The evidence at trial was far from offsetting the effect of the presumption; indeed, if anything, it tended to support it. It is trite law that the characterization of income as income from a business or income from property must be made from an examination of the taxpayer's whole course of conduct viewed in the light of surrounding circumstances: see Cragg v. M.N.R., [1952] Ex. C.R. 40; [1951] C.T.C. 322 per Thorson, P. at 46 (C.T.C. 327). In following this method courts have examined the number of transactions, their volume, their frequency, the turnover of the investments and the nature of the investments themselves. In this case the Federal Court of Appeal noted the extensive activities of CMC's employees in purchasing short-term investments, the large number and high value of those transactions, the high proportion which the interest earned bore to the total income of the company and the high proportion which the total value of the investments bore to the total value of CMC's assets. But it perceived a number of considerations which it thought were "overriding", namely: (1) the funds were derived from the sale of the broadcasting division and were set aside for the purchase of new capital assets; (2) the considerable activity involved in purchasing the investments were "a necessary consequence of the need to hold investments in liquid form, in the form of paper that could be quickly converted into cash"; and (3) few employees were involved and not a great deal of staff time was expended. 13 I shall deal with the first two together since they are both premised on the relevance of the taxpayer's business strategy. The assertion is, as I understand it, that the taxpayer's business strategy was to hold these funds as a temporary investment and that any investment activity was necessarily a result of that business strategy. But is the taxpayer's business strategy relevant to the issue before us? It seems to me that it is not.

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14 The commercial reality in this case is that the taxpayer, perhaps unwillingly and contrary to its business strategy, has been compelled to enter the investment business rather than the electronic manufacturing or broadcasting business. The fact that the taxpayer might prefer or hope to be in the manufacturing business and not the investment business does not, however, appear to me to be relevant. The relevant inquiry is whether in fact he is in the investment business. 15 In Western Leaseholds Ltd. v. M.N.R., supra, the issue was whether the proceeds from sales of mineral rights by the taxpaying corporation were business income. The Crown argued that the proceeds were not business income and in support of its position cited the fact that the corporation intended at the outset that its main business should be in the production and sale of oil, not transactions in mineral rights. The plan was to use the proceeds of the transactions in mineral rights to finance the production of oil. Locke, J. for the Court held that this intention was an "irrelevant circumstance in determining whether what was done was in truth the carrying on of a business for the purpose of making profit" (page 24; C.T.C. 549). Similarly, the fact that the taxpayer here wanted his investments to be kept as liquid as possible so that, if the right opportunity arose, it could wind up its investment business and put its funds into that new business opportunity, does not alter the fact that the extent of the taxpayer's investment activity in the meantime was such as to constitute the earnings from it income from a business. In Gunnar Mining Ltd. v. M.N.R., [1968] S.C.R. 226; [1968] C.T.C. 22 where the characterization of interest receipts from short-term investments was in issue, Spence, J. clearly thought that the taxpayer's objective of maintaining liquidity was irrelevant. At 233 (C.T.C. 27) he stated: ... during the tax exempt period the appellant was operating two businesses firstly, a mining business, and secondly, an investment business, and the fact that its purpose in operating the second business was so that it might accumulate funds in a readily realizable form with which it could pay off the 5 per cent sinking fund debentures if they became due makes it nonetheless the operation of a second business. I would respectfully adopt the reasoning of Locke, J. and Spence, J. in these two cases. 16 The Federal Court of Appeal was also influenced by its finding that few employees were involved in the company's investment activity and not a great deal of staff time was expended. While these are undoubtedly relevant considerations, it is important not to give them inordinate weight. In M.R.T. Investments Ltd. v. The Queen, supra, two of the three corporate taxpayers who were engaged in lending money by way of mortgages on real estate were held to be earning income from a business, despite the fact that the three companies were not paying salaries or rent for office space and despite the fact that they did not even have employees working for them. The presumption which I have discussed above and the day-to-day intervention of the officers and directors of the company in the company's business were enough to characterize the income as business income. It has also been repeatedly stressed that a large organization is not required for an "adventure or concern in the nature of trade": see, for example, M.N.R. v. Taylor, [1956 60] Ex. C.R. 3; [1956] C.T.C. 189. 17 It seems to me, therefore, that two of the "over-riding considerations" cited by the Court of Appeal are not relevant considerations in law. The third, while relevant, is not of sufficient weight to offset the effect of the presumption and the large scale investment activity of CMC during the years in question. 18 Counsel for the Crown submitted that the effect of allowing CMC's appeal would be that a tax credit intended to reduce the tax imposed on manufacturing and processing profits would be granted on income earned by means which in no way involved manufacturing or processing. But, as I read the Act, this is clearly permitted. Under subsection 125.1(3) "Canadian manufacturing and processing profits" are defined as including a portion of "all amounts, each of which is the income of the

124 corporation for the year from an active business ..." as is determined by rules prescribed by regulation. The regulation (section 5200 of the Income Tax Regulations, S.O.R. Cons. 1955, 1872, as amended by S.O.R./73 495) defines that portion as being a portion of the corporation's "adjusted business income", defined in section 5202 of the regulations as the amount by which income from an active business carried on in Canada exceeds the loss from an active business carried on in Canada. "Active business" is nowhere restricted to a manufacturing or processing business. If Parliament intended such a restriction, it must express itself clearly to that effect. In Morguard Properties Ltd. v. City of Winnipeg, [1983] 2 S.C.R. 493; 3 D.L.R. (4th) 1 Estey J., for the Court, stated at 509 (D.L.R. 13): ... the courts require that, in order to adversely affect a citizen's right, whether as a taxpayer or otherwise, the Legislature must do so expressly. Truncation of such rights may be legislatively unintended or even accidental, but the courts must look for express language in the statute before concluding that these rights have been reduced. I would adopt and apply this same principle of construction to this case. 4. Disposition: 19 For these reasons I would allow the appeal and refer the matter back to the Minister of National Revenue for the appropriate reassessments for the 1973, 1974, 1975 and 1976 taxation years. I would allow the appellant its costs throughout. Appeal allowed. McCutcheon Farms Ltd. v. The Queen [1991] 1 C.T.C. 50, 40 F.T.R. 180, 91 D.T.C. 5047 (F.C.T.D.) During the years in question, 1981 to 1983, the taxpayer had large sums of money on deposit with several institutions that it claimed were necessary for maintaining its credit standing and for emergency needs of its farming business. It claimed that the interest income generated by these deposits was active business income and includable in its small business income. The Minister assessed the amount as Canadian investment income. HELD: The amounts in the deposits were far larger than any reasonably foreseeable emergency would require. There was nothing to suggest that the taxpayer's credit rating required the maintenance of such amounts. Save for $14,000 spent before this period on expenses, the deposits were never used for business purposes. No planning for reserves or a relationship between the total funds and possible needs from them was produced. In fact, while they were not drawn on, surpluses from the business were put into the deposits. The deposits were not incident to or pertaining to the business nor were they property held principally for producing income from an active business. There was no doubt that the business was an active one and successful. A portion of the deposits might reasonably have been justifiable to cover short-term cash shortages (though no such use occurred) but a substantial relationship of financial dependence was not found. The interest from the deposits was Canadian investment income. Appeal dismissed. Relief Requested

125 1 The plaintiff appeals, in respect of taxation years 1981, 1982, 1983 the reassessments of the Minister of National Revenue in which he reassessed certain interest income of the plaintiff as Canadian investment income. The plaintiff seeks a judgment of this Court referring such reassessments back to the Minister with the direction that the amounts in question be reassessed as active business income of the plaintiff. The context of the specific issue in the present case is the interrelationship of Sections 125 and 129 of the Act, the former permitting a deduction from tax otherwise payable on income from an active business carried on by a Canadian-controlled private corporation to a specific amount of income and income over that specific amount being taxed at the full rate (i.e. $150,000.00 until 1982 and $200,000.00 thereafter) and the latter enabling a private company that has paid income tax at the full corporate rate on Canadian investment income to recover a portion of that tax by virtue of the payment of taxable dividends to its shareholders. The structure of Sections 125 and 129 requires a distinction to be drawn between two general sources of income from an active business and income from property. 3 The reassessments in question have already been unsuccessfully appealed to the Tax Court of Canada, the appeal having been dismissed in a judgment of Sarchuk, T.C.J. of February 22, 1988 [[1988] 1 C.T.C. 2349; 88 D.T.C. 1208]. 4 The interest income in question during the relevant taxation years arose out of three sources. The plaintiff kept on demand deposit with the Cargill Company substantial sums of money, starting with $117,000 provided by Mr. McCutcheon at the time of incorporation. By 1982 this had grown to some $245,000 and Cargill declined to keep such large sums. It paid to the plaintiff all amounts over $100,000 which the plaintiff then deposited with the Saskatchewan Wheat Pool in a similar demand deposit. The interest earned from each of these deposit accounts was automatically redeposited with these respective companies and in turn earned more interest. The evidence is that neither of these accounts, nor the interest therefrom, have ever actually been drawn from for the farm or business operations. The other source of the contested interest income was, during the years in question, term deposits with the Canadian Imperial Bank of Commerce in Saskatoon. These have been generally short-term deposits, most of them for 60 days or less and only one for as long as 180 days. The interest earned from these term deposits was paid into the plaintiff corporation's current account at the bank from which operating expenses were paid. It is also true that certain amounts surplus to current needs have been drawn from the current account from time to time and put into further term deposits. On only one occasion has any principal amount been withdrawn from the term deposits to meet farming and business expenses and that was the sum of $20,000, drawn out in 1977 well before the taxation years in question. The evidence indicated that only $14,000 of this was spent on operating expenses. 5 The general magnitude of these capital sums can be seen in the following table which also shows the interest income in each of the years in question as compared to the gross income from the farm and business and the relationship which the interest income bore to the gross income. As I understand it, the "Cash Holdings" item includes the amounts held in the demand deposits at Cargill and the Saskatchewan Wheat Pool, as well as the current operating account at the Canadian Imperial Bank of Commerce.
1981 Income: 1982 1983

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Interest Income Gross Income Percentage of Interest to Gross Income Total Expenses Income Before Taxes Net Income Cash Holdings Term Deposits

$ 43,863.00 275,490.00 15.92 $189,257.00 86,233.00 62,641.00 $262,113.00 100,000.00

$ 68,213.00 342,109.00 19.94 $233,239.00 108,870.00 80,402.00 $260,619.00 200,000.00

$ 47,418.85 235,915.85 20.10 $158,558.00 77,357.85 57,217.89 $309,152.00 200,000.00

The evidence indicates that interest rates earned generally followed money market changes. 6 It appears to me that if this interest income can be brought within paragraph 129(4.1)(b) as being from property "that is incident to or pertains to an active business" then it would also meet the general definition of income from an active business set out in paragraph 125(6)(e) as "income pertaining to or incident to that business ...". There have been several decisions of the Tax Court of Canada in respect of the meaning of paragraph 129(4.1)(b) since its adoption in 1979 (S.C. 1979, c. 5). I am advised by counsel that several such decisions are on appeal to this Court but no such appeals have yet been decided. In my respectful view, the paragraph has been properly interpreted by Christie, A.C.J.T.C. in Atlas Industries Ltd. v. M.N.R., [1986] 2 C.T.C. 2392; 86 D.T.C. 1756. In that case a corporation carrying on a custom fabrication sheet metal business and a roofing business put surplus funds on hand in short-term deposits, the balance of its funds being retained in a non-interest bearing current account in amounts regarded as sufficient for operating purposes. In that case the taxpayer sought to establish that the interest earned on the short-term deposits was "Canadian investment income" whereas the Minister sought to establish that it was active business income within the meaning of paragraph 129(4.1)(b). Christie, A.C.J.T.C. allowed the appeal from the Minister's reassessment, holding that such interest income was not income from an active business. He gave the following interpretation of paragraph 129(4.1)(b) at page 2404 (D.T.C. 1764-65). Giving the words "incident to or pertains to an active business" their grammatical and ordinary sense, and bearing in mind their context, there must I think be a financial relationship of dependence of some substance between the property and the active business before the exclusion in paragraph 129(4.1)(b) comes into play. The operation of the business ought to have some reliance on the property in the sense that recourse is had to it regularly or from time to time or that it exists as a back-up asset to be called on in support of those operations when the need arises. This I regard to be the basic approach to paragraph 129(4.1)(b). Whether income-producing property has crossed the dividing line into the paragraph will depend on the facts of each case. I am satisfied that the facts under consideration do not place the relevant property within it. The relationship between the debts created by the term deposits and the appellant's businesses was tangential at best. The debts were never resorted to in aid of the appellant's businesses nor was there any real expectation that they would be. The fundamental purpose of these term deposits was unrelated to sustaining the appellant's businesses, but it was to direct the profits therefrom into the hands of the shareholders, primarily by way of bonuses. 7 Counsel have not relied on recent jurisprudence with respect to the meaning of paragraph 129(4.1)(c) also added in 1979. It appears to be common ground, however, that the approach to this paragraph should be similar to that employed in interpreting former paragraph 129(4)(a) where there was excluded, from "Canadian investment income", income from a property "used or held by the corporation in the year in the course of carrying on a business". In the decision of the Federal Court of Appeal in The Queen v. Marsh & McLennan, Ltd., [1983] C.T.C. 231; 83 D.T.C. 5180 at 243 (D.T.C.

127 5190) Le Dain, J., in referring to a fund of an insurance broker into which there were paid premiums received from insured parties and out of which the broker paid the company, the broker earning interest in the meantime on surplus amounts in the fund not yet due to the insurer, applied the following as the proper test under subparagraph 129(4)(a)(ii): "... was the fund employed and risked in the business?" [Emphasis added.] He held that it was because an amount equivalent to the fund "was committed to the carrying on of the business in order to meet the company's obligations to the insurers". This test was approved by Wilson, J. writing for the majority of the Supreme Court of Canada in Ensite Ltd. v. The Queen, [1986] 2 C.T.C. 459; 86 D.T.C. 6521. In elaborating on the test of "risk" and on this test generally, she said (at page 464 65 (D.T.C. 6525-26)): But "risked" means more than a remote risk. A business purpose for the use of the property is not enough. The threshold of the test is met when the withdrawal of the property would "have a decidedly destabilizing effect on the corporate operations themselves": March Shipping Ltd. v. M.N.R., supra, at 2531 (D.T.C. 374). This would distinguish the investment of profits from trade in order to achieve some collateral purpose such as the replacement of a capital asset in the long term (see, for example, Bank Line Ltd. v. Commissioner of Inland Revenue (1974), 49 T.C. 307 (Scot. Ct. of Session) from an investment made in order to fulfill a mandatory condition precedent to trade (see, for example, Liverpool and London and Globe Insurance Co. v. Bennett, [1913] A.C. 610 (H.L.) and Owen v. Sassoon (1951), 32 T.C. 101 (Eng. H.C.J.). Only in the latter case would the withdrawal of the property from that use significantly affect the operation of the business. The same can be said for a condition that is not mandatory but is nevertheless vitally associated with that trade such as the need to meet certain recurring claims from that trade: see, for example, The Queen v. Marsh & McLennan, Ltd., supra, and The Queen v. Brown Boveri Howden Inc., [1983] C.T.C. 301; 83 D.T.C. 5319 (F.C.A.). It is true that in this case the taxpayer could have done business and fulfilled the Philippine requirement that foreign currency be brought into the country by a means not involving the use of property. It could have borrowed the U.S. currency abroad and brought it into the Philippines. But this consideration is irrelevant to our inquiry. The test is not whether the taxpayer was forced to use a particular property to do business; the test is whether the property was used to fulfill a requirement which had to be met in order to do business. Such property is then truly employed and risked in the business. 8 With these tests in mind I shall deal briefly with the various claims of the plaintiff that the income in question was from property "that is incident to or pertains to an active business" or is "used or held principally for the purpose of gaining or producing income from an active business". 9 It was contended that these large capital sums are required by the plaintiff in case of emergencies or crop failures, failures which would not only drastically reduce or eliminate farm income but would badly affect sales of seed grain, fertilizer, and chemicals. But the evidence indicates that these capital sums were not drawn on for such purposes, not just in the years in question but never since the incorporation of the farm in 1976. While both the evidence and common knowledge indicate that there are many risks in farming, the risk that sums in the amount of the principal sums in question here would be required must, in the absence of more precise evidence, be regarded as "remote" and this, according to the Ensite decision, is not sufficient. One can readily understand, and admire, the position taken by Mr. McCutcheon, the president of the plaintiff company, that he would not want to farm without cash reserves, having seen many farm failures in the past by those who had inadequate reserves. But there is a basic problem in that the plaintiff has not shown clearly what would be a reasonable reserve nor does the evidence indicate any rational relationship between the principal sums accumulated and the reserves required. Mr. McCutcheon spoke of wanting the equivalent of two years' expenses available in cash reserves. But the principal sums in question here have simply been allowed to grow by reinvestment of interest and by transfers from the current account without any indication of a rational plan or any evidence that such a plan was being followed. (See, e.g., Newton Ready-Mix Ltd. v. M.N.R., [1989] 2 C.T.C. 2369; 89 D.T.C. 595 at 2375 (D.T.C. 599) (T.C.C.).)

128

10 It was argued that the plaintiff carried no insurance of any kind during the years in question either on buildings, crops, or equipment and therefore required these large capital sums as a form of "selfinsurance". But the day-to-day operations of the business would not be dependent on the existence of such a fund nor, indeed, would the corporation necessarily draw on the fund in case of loss. There is no evidence, not only in respect of the three years in question, but over the whole period since the plaintiff was incorporated in 1976, that these principal amounts have ever been drawn on to pay for any loss by hail, or even theft, for example. The prospect of a widespread disaster to a value represented by these capital amounts again must be regarded as remote. The investment of surplus funds in these interest-bearing deposits is no different from any other investment the corporation might make in order to ensure that it was solvent enough, in the face of some disaster, to either resume this business or undertake some other business. 11 It was suggested that such capital sums were required to establish a proper credit rating with Cargill and Cominco, wholesale suppliers of chemicals and fertilizers to the plaintiff. But there was little evidence to indicate what the credit requirements of these companies are and certainly nothing to suggest that they required liquidity in the order of several hundred thousand dollars. The evidence indicated that the plaintiff's credit limit with Cargill was $30,000, an amount which has obviously allowed the plaintiff to carry on its fertilizer and chemical business without difficulty. Assuming Cargill would want to be assured of liquid assets held by the plaintiff in this amount, this has no relationship to the principal sums actually held. 12 Again it was argued that this interest income was important to the overall profitability of the company. It will be noted in the table quoted above that interest income ranged from 15.92 per cent to 20.10 per cent of the gross income of the company and over 50 per cent of the net income before its taxes. But the more critical question is, was this income somehow necessary to the farming and agribusiness? It is clear that they would have been profitable without the income. It is also true that, with the exception of the interest income from term deposits which was paid into the company's current account, the money was not employed in the business in any way. If the interest from the term deposits had simply been automatically accumulated in more term deposits the company could still have met its expenses and produced a profit. Further, there is evidence that from time to time surplus funds were drawn from the current account to augment the term deposits. As was pointed out in the case of Ben Barbary Co. v. M.N.R., [1989] 1 C.T.C. 2364; 89 D.T.C. 242 (T.C.C.) such income and the asset from which it is earned is no different from any other investment which the taxpayer might make even if it chose to use the income from such investment to help support its business. This does not make the capital asset "incident to or pertain to" the business. Nor in my view does it make it properly "used ... principally for the purpose of ... producing income from an active business". 13 It was suggested that the capital sums might have to be used from time to time to pay expenses. As noted earlier, there is only one instance of this having happened, and that was in 1977 when $20,000 was withdrawn from term deposits of which $14,000 was actually used for expenses. In fact, the only formal arrangement with the bank, in case of overdrafts on the current account from which operating expenses were paid, was that the bank could automatically have recourse to Mr. McCutcheon's personal account. There might well be some justification for having liquid assets such as a portion of the term deposits available to cover short-term cash shortages. But it is difficult to see that in these particular facts there was a relationship of financial dependence on them "of some substance" as referred to in the Atlas Industries Ltd. case, supra. As was said in that case, the relationship between the term deposits and the appellant's businesses "was tangential at best". Or in the language of Ensite, supra, the risk of such sums being needed was "remote". If some reasonable amount of reserves was in fact required, this amount was not demonstrated by the evidence.

129 14 It was argued that such liquid sums were required to provide for replacement of what is undoubtedly very expensive farm machinery. Yet again there is no evidence that any of these capital sums were ever resorted to for such purpose. In the Ensite case Wilson, J. said that a "business purpose for the use of property" is not enough and regarded profits held by a business "... in order to achieve some collateral purpose such as the replacement of a capital asset in the long term ..." as not being "employed or risked in the business" and therefore not "properly used or held ... in the course of carrying on a business". 15 Finally, it was argued that these large capital sums were required in order for the plaintiff to be in a position to purchase land and pay all or substantial amounts of the purchase price in cash. First, it should be observed that since 1976 down to the present the corporation has never bought any additional land and although it has made a few offers none of these have been accepted. Secondly, I do not accept that money accumulated to expand a business, if that was really in contemplation here, creates any "financial relationship of dependence" (Atlas Industries, page 2404 (D.T.C. 1764-65)) between that sum and the existing business or that it involves money "employed" or "risked" (Ensite, pages 464 65 (D.T.C. 6525-26)) in the existing business. 16 Looking at all of these putative purposes of the liquid capital sums involved, I cannot find a "financial relationship of dependence of some substance" between those sums and the ongoing existing business. The money was generated by the business but it was not, in the years in question, employed in the business except in a limited way through the use of term deposit earnings for current expenses. As noted, this was not a one-way street, as surplus funds from the current account were also used to purchase term deposits from time to time. The possibilities of these funds being drawn upon to sustain the business in any important way was remote and in fact did not happen during the years in question. I therefore do not think that these capital sums can be seen as "property that is incident to or pertains to an active business" within the meaning of paragraph 129(4.1)(b). Using the tests employed respectively in analogous provisions under consideration in cases such as Ensite, I am unable to conclude that these sums amounted to "property used or held principally for the purpose of gaining or producing income" from the business, as referred to in paragraph 129(4.1)(c). These sums were not truly "employed and risked" in the business. One test referred to in the Ensite case was to consider whether the withdrawal of the property would have a "decidedly destabilizing effect" on the business (pages 464 65 (D.T.C. 6525-26)). Looking at all the facts, I am unable to conclude that such withdrawal would have that effect. 17 Counsel for the plaintiff invited me to consider in the alternative, if I was not prepared to direct that all of this income be regarded as coming from property which is incident to the business or held principally for the purpose of the business, to conclude that certain of the funds in question were of this nature and others were not. From what I have said, it is clear that I am unable to make such a distinction because I do not find that any of the capital sums were truly committed to the business and necessary to its good operation. It should also be noted that the burden is always on the taxpayer to show that the assessment is wrong and it would have been open to the taxpayer to produce much more precise evidence as to the extent of liquid capital reserves which the business could reasonably be said to require and upon which the business was financially dependent. That has not been done. 18 I am therefore dismissing the appeal with costs. Appeal dismissed. Shamita Inc. v. R.

130 1996 CarswellNat 2759, (sub nom. Shamita Inc. v. R.) [1998] 2 C.T.C. 2974 (Tax Court of Canada) The Minister of National Revenue disallowed the taxpayer's claims for the small business deduction, finding that the active business income of the taxpayer was negative since its investment income exceeded its other income. The taxpayer appealed, arguing that it actively carried on a business and did not carry on a specified investment business, as defined by para. 125(7)(e) of the Income Tax Act, because the principal purpose of its business was not to derive income from property. Held: The appeal was dismissed. The fact that the taxpayer carried on a business and was not a specified investment business did not mean that it could not receive income from property. It did not follow that, because the taxpayer did not receive income from a specified investment business, that all its income was from an active business. "Income from a property" in subsec. 129(4.1) includes more than just income from a specified investment business. The taxpayer's interest income was derived from a Canadian source which was an asset, and was not accessory to the active business of the taxpayer, although the income was shown to be used in part to fund the business. The relationship between this income from property and the activities carried on by the business was not close enough to conclude that this income was income from an active business. As the interest income was "income from a property" and as this income was greater than the taxpayer's business income, the taxpayer had no remaining income from an active business which was eligible for the small business deduction. The appellant's representative . . . argued that, as it was not a specified investment business . . . it does not have income from a property within the meaning of subsection 129(4.1) [of the Income Tax Act, S.C. 1970-71-72, c. 63]. It would appear that the argument made by the appellants representative does not take into account the word "includes" used in subsection 129(4.1). The word gives a completely different meaning to the provision, in that income "from a source in Canada that is a property" is not limited to income "from a specified investment business". Appeal from income tax assessment disallowing deduction of small business deduction.

ii. Specified Partnership Income

Corporate Partnerships (a) In calculating the income of the CCPC from an active business carried on in Canada para. 125(1)(a) requires that income of the corporation from a business carried on by it as a member of a partnership be separated out. Instead, the corporation's active business income is then increased by its "specified partnership income" for the year. That is to say, if a corporation carries on an active business directly and through a partnership, its active business income carried on directly is separated from its income carried on through the partnership and then a separate calculation is made of its "specified partnership income". The two are then added together, losses from those two sources are deducted, and the result is the amount referred to in para. 125(1)(a). "Specified partnership income" is defined in ss. 125(7).

(b)

131 (c) What is the purpose of this? Suppose four unrelated individuals want to establish a business which will earn active business income. If they incorporate a CCPC, the first $500,000 will be eligible for the small business deduction. Instead, however, suppose each individual incorporates his own CCPC and the four corporation enter into a partnership agreement to carry on the business. If they are all equal partners, each company would be allocated 1/4 of the income from the partnership and, because a partner is considered to carry on the same business that the partnership carries on and to have earned income from the same source as is the source of the income of the partnership, then each partner would be allocated 1/4 of the income of the partnership which would be treated as active business income. Without special rules, each company would then be entitled to the small business deduction and accordingly a total of $2,000,000 (4 x $500,000) would be eligible for the small business deduction. To prevent this from occurring, the definition of "specified partnership income" found in ss. 125(7) essentially ensures that the total amount of active business income earned through a partnership that is eligible for the small business deduction is limited to a total of $500,000. Item A of the definition of "specified partnership income" determines the corporate partner's specified partnership income as being the lesser of: the corporation's share of the partnership's income from an active business carried on in Canada less deductions of the corporation at the corporate level in earning the partnership income (paragraph (a) of item A in the definition), and that proportion of $500,000 that is the corporation's share in the partnership (paragraph (b) of item A in the definition). For example, if a partnership had three equal corporate partners and the partnership's income from an active business carried on in Canada was $150,000, each corporate partner's specified partnership income from that partnership would be the lesser of $50,000 and $166,666 (1/3 of $500,000). If the partnership's income from the active business was $290,000, each corporate partner's specified partnership income from that partnership would be the lesser of $96,667 and $166,666 (1/3 of $500,000). Each corporate partner would add its specified partnership income from each partnership of which it was a member to the amounts determined under subpara. 125(1)(a)(i) to get the amount determined under para. 125(1)(a). If the partnership's fiscal period is less than 365 days, the definition requires that the $500,000 be reduced to the proportion thereof that the number of days in the fiscal period is to 365 (subparagraph (ii) of item M in the definition). Item B in the definition provides that, in the event the corporation also has a loss in the particular taxation year from an active business carried on in Canada, either by it directly or through a partnership, as well as income in that year from an active business carried on by it in Canada through a partnership, the losses are to be first offset against the active business income of the partnership that is not eligible for the small business deduction. This provision would only apply if the corporation had suffered losses from an active business and it had earned active business income through a partnership which would not otherwise qualify as "specified partnership income" because the corporation's share of such active business income exceeds its share of the $500,000 limit. That is to say, the amount in, paragraph (a) of item A in the definition exceeds the amount determined in paragraph (b) of item A in the definition. This is accomplished by adding to the corporation's specified partnership income the lesser of

(d)

132 `(b) of item B in the definition). For example, if a corporation had a loss of $100,000 from an active business carried on in Canada, either directly or through another partnership, and also had active business income of $1 M from a partnership of which it is a 1/3 equal partner, the specified partnership income of the corporation would be the lesser of $166,666 (1/3 of $500,000) or $333,333 (1/3 of $1 M) before taking into account the loss because this would represent the corporation's share of the $500,000 limit. However, because it has also suffered a loss of $100,000 it is permitted to add to its specified partnership income the lesser of $100,000 and $166,667 ($333,333 166,666). Therefore the specified partnership income would be $166,666 + $100,000 = $266,666. In applying para. 125(1)(a), the specified partnership income referred to in subpara. 125(1)(a) (ii) would be $266,666 but there would be a reduction in either of subpara. 125(1)(a)(ii) or (iv) of $100,000, resulting in a net addition to para. 125(1)(a) of $100,000. The point is that the $100,000 loss did not reduce the small business deduction when there was a considerable excess amount of active business income in the partnership which would not be eligible for the small business deduction. (e) Suppose the relationship between the four CCPCs referred to in the example above was not that of partnership but was instead a joint venture. The total amount of active business income which could be eligible for the small business deduction would then be $2 M. Ss. 125(6) is designed to prevent a corporation from avoiding the limitation resulting from the specified partnership income concept by simply becoming a member of a number of different partnerships. If it may reasonably be considered that one of the main reasons for the separate existence of the partnerships is to increase the small business deduction, then the corporation's "specified partnership income" is to be computed as if all the partnerships were ignored except for the one with the largest amount of active business income. "Specified partnership loss" of a corporation is defined in ss. 125(7) to be the corporation's share of a loss from an active business realized by it through a partnership. This amount must be deducted under s. 125(1)(a)(iv) in determining the amount calculated under ss. 125(1)(a). Ss. 125(6.1) provides that a corporation that is a member of a partnership which in turn is a member of another partnership will be deemed to be a member of the second partnership and the corporation's share of the income of the second partnership will be the amount that it is directly or indirectly entitled through the first partnership. This provides that one must effectively "look through" tiers of partnerships. Ss. 125(6.2) provides that the income of a partnership that is controlled, directly or indirectly in any manner whatever, by any combination of non-resident persons or public corporations cannot qualify for the small business deduction. The purpose of this rule is to ensure that the income of such a partnership is treated in the same way as if the business were carried on by a corporation, in which case the corporation would not qualify for the small business deduction because it would not qualify as a CCPC. The rule operates by deeming the income of the partnership, for the purposes of computing the specified partnership income of a corporation that was a member of the partnership as being nil. [Is this rule really necessary? Without the rule, the non-resident corporation's share of income from the partnership would not be subject to the small business deduction. Furthermore, the rule is avoided if the non-resident and the resident Canadian corporation conduct their business by way of a joint venture instead of through a partnership.]

(f)

(g) (h)

(i)

133 (j) Ss. 125(6.3) provides that for the purposes of ss. 125(6.2), a partnership will be deemed to be controlled by one or more persons if the aggregate of the shares of the income of the partnership of that person or persons for the fiscal period of the partnership is greater than one-half of the income of the partnership from that source for that period. Nevertheless, a person or persons may be considered to control, directly or indirectly in any manner whatever, a partnership where ss. 125(6.3) is not applicable. That is to say, ss. 125(6.3) is not exhaustive: a person or persons may have de facto control depending upon the relevant facts and circumstances. Note that the rule in ss. 256(5.1) would not apply because it only refers to direct or indirect control of the corporation. Furthermore, there are no cases dealing with the concept of direct or indirect control of a partnership and the Buckerfield and other cases are restricted to the concept of "control" of a corporation.

iii. Specified Investment Business

A "Specified Investment Business" (SIB) is excluded from the definition of "active business" under para. 125(7)(a). This may operate to either the advantage or disadvantage of the taxpayer depending on the particular tax circumstances. As you will recall, the active business income date is limited to the first $500,000 of taxable income earned each year. Active business income in excess of that amount is taxed at top corporate rates. Income from a SIB is subject to the integration system afforded to private corporations, and would be subject to a lessor overall tax rate than ABI in excess of $500,000. Thus, if total corporate income is less than $500,000 the taxpayer would prefer to have it all taxed as ABI, but where corporate income exceeds $500,000, the characterization of income as SIB may offer a better overall tax result. As you may expect there are both overlapping and grey areas in characterizing this income. A specified investment business is defined in para. 125(7)(e) to mean a business (other than the business of a credit union or of leasing property other than real property) the principle purpose of which is to derive income from property (including interest, dividends, rents or royalties) unless the corporation employs in the year more than five full-time employees. A further exception is made in subpara. 125(7)(3)(ii) if the corporation would have employed more than five full-time employees but does not because another corporation associated with it provides managerial, administrative, financial, maintenance or other similar services that would otherwise have been performed by its own employees. Consider the following decisions. a. Meaning of Specified Investment Business

Temax Investments Inc. & Mayon Investments Inc. v. M.N.R.

[1991] 1 C.T.C. 2245, 91 D.T.C. 364 (T.C.C.) The appellants carried on the business of mortgage brokers. Mr. and Mrs. Bick were the only full-time employees. Both companies had premises and employed a number of people (about 11) on a parttime basis. Both companies were reassessed by the respondent, treating mortgage interest income as investment income rather than active business income and by disallowing the small business deduction in computing taxable income in each company. The Minister argued that the appellants each carried on a specified investment business, thereby preventing them from taking advantage of the small business deduction.

134 HELD: Although there was sufficient activity to conclude that the appellants were deriving income from business, the source of revenues was principally interest income, and it would seem that this is what is meant by "the principal purpose of which is to derive income from property" used by the legislators in paragraph 125(7)(2) of the Income Tax Act. The intention of defining "specified investment business," as was done in paragraph 125(7)(e), was to bring within its scope businesses such as the appellants'. Appeal dismissed. Analysis 26 The appellants' arguments are centred around the interpretation given by the courts. The principles enunciated by the case law were described above and one can conclude that much support for the appellants is found therein. The appellants submit that the corporations at issue are not specified investment businesses because their "principal purpose" is to derive income from business. Interest income can be either income from business or income from property. The working of paragraph 125(6)(h) does not change that basic proposition. The principle that interest income can be either income from business or income from property is dependent upon the level of activity associated with acquiring it. This principle is illustrated in Marconi, supra. The phrase "income from property", the appellants submit, contemplates a distinction from income from business based on the level of activity of the taxpayer in addition to the presumption of business. The evidence indicates intensive business-like intervention. The appellants then conclude that the income earned by the companies was income from business. 27 The respondent's argument is centred around a complete departure from past jurisprudence. The new provision was enacted to disqualify from the small business deduction corporations which would otherwise qualify under the criteria of section 125. The principal purpose of the corporations at issue was to derive income from interest, meeting thereby the criteria set out in paragraph 125(6)(h). The respondent submits that the level of activity is irrelevant, what is important is the nature of the income. Since over 96 per cent of the income generated by the said corporations is interest income from mortgages, one must conclude that they are from a "specified investment business". 28 The legislative purpose of the small business deduction is to limit the application of a lower rate of corporate tax (designed as an incentive to small business) to income the source of which is an active business, and to prevent it from extending to investment income. It is also aimed to achieve an integration in respect of investment income derived by a corporation and thereby to maintain approximate neutrality in the taxation of investment income, neither penalizing nor benefitting individuals who choose to make their investments through a corporation rather than by direct personal ownership. Prior to the amendment of 1979, the meaning of section 125 was by way of reference to its presumed antonym the "Canadian investment income" in section 129. Investment income generates refundable tax on hand under subsection 129(3). A distinction was made between active business and one that was not; such a distinction was based on the quantum of activity. It would seem that the purpose of the amendment was to distinguish a "specified investment business" from any other business. Any other business would simply be labelled "active" and fall into the residual category in respect of which the lower rate of corporate tax is enjoyed. 29 In the 1981 Canadian Tax Conference, David C. Nathanson contributed an article entitled "Active Versus Passive Once Again: Active Business Income and Investment Income of Canadian Controlled Private Corporations". At page 913 he says: Because of the "specified investment business" concept, the fine distinction between propertytype income that is from an active business, on the one hand, and property-type income that is not, on the other, for the future has been made largely irrelevant. Most property-type income

135 that, but for the "specified investment business" definition, could pass for business income will now effectively be treated as property-type income unless the five-employee limit is exceeded. 30 This passage lends support to the respondent's position in the present appeals.

31 Interpretation Bulletin IT-73R4 illustrates the position of the respondent on the proper definition and analysis of paragraph 125(6)(h), now paragraph 125(7)(e), and more particularly the words "principal purpose". Paragraphs 11 and 13 of that bulletin read as follows: 11. "Principal purpose" is not a defined term in the Act for the purposes of paragraph 125(7) (e), but it is considered to be the main or chief objective for which the business is carried on. 13. The principal purpose of a corporation's business must be determined annually after all the facts relating to that business carried on by that corporation in that year have been considered and analyzed. Included in this evaluation should be such things as (a) the purpose for which the business was originally commenced, (b) the history and evolution of its operations, including changes in its mode of operation and purpose of existence and (c) the manner in which the business is conducted. 32 No cases have yet dealt directly with the issue, except for Porter Land Ltd., supra. However, I do not think that this case can assist in any way in the proper interpretation of paragraph 125(6)(h) especially when we are, as in the present case, confronted with a more nebulous situation where income from property and income from business seem to overlap. This case is of no assistance since the Court made a conclusion based on facts which demonstrated income from property, the income from leases, which would meet the general criteria developed by the courts in distinguishing income from business from income from property. 33 The difficulty with the interpretation of the section at issue is that the legislator has used both the terms "business" and "income from property" which seem at first glance contradictory. The courts have usually concluded on the presence of income from property when there was an absence of business. The proper interpretation must therefore reconcile these two apparently contradictory notions found in paragraph 125(6)(h). In the past, the courts have been very liberal in defining the scope of the small business deduction. It would seem that the amendment was made to restrict this trend. A "specified investment business" as then defined in section 125(6)(h) is, it says it in express terms, a business. The general opposition between income from business as opposed to income from property, as defined for instance in Hollinger, supra, seems to have been circumvented. Furthermore, the presumption of business income from a corporation cannot again be of assistance. 34 The appellants are deriving income from business. This seems quite apparent from the evidence presented as one can see the presence of, at least, a large enough level of activity to warrant such a conclusion. The case of MRT Investments Ltd., supra, dealt with very similar facts, and had it not been for the amendments enacted in 1979, that case would be directly on point. 35 The legislator, however, has intervened. Even if there is no presumption that an amendment of law means a change of past interpretation, it seems that such a change has been enacted. The legislator has used the words "principal purpose". These words have not been interpreted before. I would tend to think that the purpose of defining "specified investment business", as it was done, was to bring in its scope businesses such as the appellants'. Although there is, in the case of the appellants, sufficient activity to conclude that they are indeed deriving income from business, since

136 the source of revenues is principally interest income, it would seem that this is what is meant by "the principal purpose of which is to derive income from property". That is when the source of revenue, the nature of the assets held, and the purpose of the corporation are to derive income from property, such as interest income. The appellants are not generating the major portion of their income from the services that they provide but rather from the interest from mortgages. 36 The appeals are dismissed.

Langille v. Canada
2009 TCC 139 Appeal from an income tax assessment for the 2000 taxation year. The appellant claimed a business investment loss of $111,540 in respect to monies loaned to Alland Developments Inc., a company for which the appellant was the sole director, officer and employee, and considered unrecoverable. The notice of reassessment denied $62,889 as an ineligible allowable business investment loss on the grounds that Alland was carrying on a specified investment business. Instead, the Minister allowed the loss of $111,540 as a net capital loss. The issue was whether Alland was carrying on a specified investment business. The respondent assumed Alland was carrying on a business but that the principal business activity was the investment of funds. Alland participated in approximately 43 trades involving the purchase and sale of liquidated goods during the period Feb. 1999 to May 2000. Each of the trades were characterized by Alland advancing funds to Trev-Cor Trading Inc. so that Trev-Cor could purchase liquidation, bankruptcy and overstocked items and then re-sell the goods at a profit. Upon completion of a deal, Alland's advance would be returned, plus a share of the net gain from the inventory trade. According to the respondent, the return of the investment was income from property for the purposes of the definition of specified investment business. The issue was whether Alland was carrying on a specified investment business. The respondent argued that Alland's participation consisted of passive investments or "... a series of high=-risk loans with variable returns based on the outcome of Trev-Cor's tradings..." HELD: Appeal allowed with costs. The assessment was referred back to the Minister for reconsideration and reassessment. The court did not accept that the business of Trev-Cor, which was the only business with activity outside Canada, could be attributed to Alland. There was scant evidence that any transactions actually occurred either inside or outside Canada. Most of the deals belonged to the deceptive hoax that Mr. Leard was perpetrating on the appellant and other individuals. Alland could not be in the business of defrauding itself. The court took the dual approach of (1) assuming the arrangements between Alland and Trev-Cor created the legal rights and economic relationships the appellant believed them to be at that time, or (2) recognizing the arrangements were part of an elaborate fraud that Leard and Trev-Cor were perpetrating on the appellant and Alland. Under either approach, any income arising from the trades could not be characterized as income from property. It followed that Alland was not engaged in a specified investment business as alleged. Since the respondent assumed Alland was engaged in a business, this conclusion implied Alland was a small business corporation and entitled the appellant to treat his unrecoverable loans to Alland as business investment losses. Assuming the trades were bona fide, the return to Alland was not income from property because Alland was a co-venturer with Trev-Cor and thus the income retained the character of the underlying inventory trades. If the trades were part of an elaborate fraud, even if the principal purpose of Alland could be considered to be deriving income when the principal source of such income is designed to ultimately fail, acknowledging the fraud suggested that the source of any income would be the re-shuffling of advances from other participants within the pyramid scheme. Therefore in reality it was not income at all or at least not from sales of inventory. If a genuine transaction would not give rise to income from property, the same

137 transaction would not through alchemy give rise to income from property when the intention of one of the parties participating in those transactions is to defraud the other.

138

b.

More than Five Full Time Employees i) Generally

489599 B.C. Ltd. v. R.

Between 489599 B.C. Ltd., Appellant, and Her Majesty the Queen, Respondent

2008 D.T.C. 4107 (Tax Court of Canada) Appeal by the taxpayer, 489599 B.C. Ltd., from reassessment made by the Minister of National Revenue. The appellant's two shareholders were husband and wife. The appellant provided management, purchasing and administrative services to Anglo, a forestry company. The husband was the president and director of both Anglo, and the appellant. The appellant employed five full-time employees and one part-time employee. It filed its income tax returns on the basis that it was not a personal services business. It claimed the small business deduction, and deducted the full amount of its business expenses from income. The Minister reassessed the appellant and found otherwise, denying the small business deduction and restricting the claim for business expenses. The appellant challenged the Minister's finding that one of its workers was a part-time employee rather than a fulltime employee. The appellant further challenged the finding that its staffing did not fit within the exception to the definition of a personal services business under s. 125(7) (c) of the Income Tax Act. The Minister submitted that the exception's requirement of more than five full-time employees required the appellant to employ at least six full-time workers, rather than five plus a part-time worker. HELD: Appeal allowed. The Minister's interpretation was not in keeping with the spirit and intent of the Act. Had Parliament meant at least six full-time employees, as contended by the Minister, it would have stated as much. The exception, as worded, recognized that workplaces were comprised of both full-time and part-time employees. Therefore, the appellant employed more than five full-time employees in the reassessment years. Thus the definition of personal services business did not apply by virtue of the exception contained in s. 125(7)(c) of the Act. Ambiguity in the jurisprudence was resolved in the taxpayer's favour. JUDGMENT:-- The appeals from the assessments made under the Income Tax Act for the 2003 and 2004 taxation years are allowed, with costs, and the assessments are referred back to the Minister of National Revenue for reconsideration and reassessment in accordance with the attached Reasons for Judgment. REASONS FOR JUDGMENT 1 CAMPBELL T.C.J.:-- These appeals are from the reassessments in respect to the Appellant's 2003 and 2004 taxation years. The Appellant filed its income tax returns in those taxation years on the basis that it was not a personal services business and claimed the small business deduction under subsection 125(1) of the Income Tax Act (the "Act") and also claimed the full amount of its business expenses as a deduction from income for those years. The Minister of National Revenue (the "Minister") reassessed the Appellant, concluding that it was a personal services business and denying the small business deduction and restricting the claim for the business expenses, pursuant to paragraph 18(1)(p) of the Act. 2 The parties filed the following Agreed Statement of Facts and Definition of Issues:

AGREED STATEMENT OF FACTS AND DEFINITION OF ISSUES

139 A. FACTS: 1. Throughout its 2003 and 2004 taxation years, 489599 B.C. Ltd. ("489") was a duly incorporated company resident in Canada. The taxation years of 489 ended January 31, 2003 and January 31, 2004 respectively. 2. Throughout 489's 2003 and 2004 taxation years, Gerald Clark and Barbara Clark were married to each other, and were the only shareholders of 489, each holding 50% of the issued shares. 3. During its 2003 and 2004 taxation years, 489 provided management consulting, purchasing and administrative services to Anglo American Cedar Products Ltd. ("Anglo"), a duly incorporated company resident in Canada, pursuant to an agreement entered into between 489 and Anglo on January 1, 2000. The services provided by 489 to Anglo included production, sales support, purchasing, financial, legal and miscellaneous services. 4. In order to provide these services to Anglo throughout each of its 2003 and 2004 taxation years, 489 employed in its business five employees who regularly worked 5 days per week, 7.5 hours per day. 5. In addition, for its 2003 and 2004 taxation years, 489 employed in its business two further employees. The first employee, Barbara Clark, throughout each taxation year worked 15 hours per week. Attached as Schedule A hereto is a table outlining the hours worked by the second employee, Sunny Donatelli, in 489's 2003 and 2004 taxation years. Sunny Donatelli was paid on an hourly basis. All other employees of 489 were paid an annual salary. 6. Throughout 489's 2003 and 2004 taxation years, Gerald Clark was the President and a director of Anglo, for which he was paid a fee of $10,000 per annum. He was also the President and a director of 489. 7. For its 2003 and 2004 taxation years, 489 filed and computed its income on the basis that it was not carrying on a "personal services business" as defined in subsection 125(7) of the Income Tax Act (Canada) (the "Act"). 8. By Notices of Reassessment dated August 17, 2005, the Minister of National Revenue (the "Minister") reassessed 489 for its 2003 and 2004 taxation years, and disallowed as a deduction all of 489's business expenses other than those which could be properly claimed by a "personal services business" pursuant to paragraph 18(1)(p) of the Act. The reassessments and their confirmation were based on the Minister concluding that in those years 489 was a "personal services business" within the meaning of subsection 125(7) of the Act. This conclusion in turn was based on the Minister concluding that: (a) Gerald Clark provided the services to Anglo on behalf of 489 and was therefore an "incorporated employee" of 489 for the purposes of the Act; (b) Gerald Clark and Barbara Clark were "specified shareholders" for the purposes of the Act, and Gerald Clark "would reasonably be regarded as an officer or employee of Anglo but for the existence of 489"; (c) 489 and Anglo were not "associated corporations" within the meaning of subsection 256(1) of the Act; (d) The 5 employees who regularly worked 5 days per week, 7.5 hours per day, as described in paragraph 4 above, were "full-time employees" for the purposes of the Act; (e) Sunny Donatelli was a "part-time employee" and not a "full-time employee" for the purposes of the Act; and

140 (f) 5 full-time and 1 or more part-time employees employed throughout these years did not constitute "more than five full-time employees" for the purposes of the definition of "personal services business" in subsection 125(7) of the Act. 9. The Appellant does not dispute the conclusions reached by the Minister in paragraphs 8(a) through (d) of this Statement of Agreed Facts and Definition of Issues. The Appellant disputes the conclusions reached by the Minister in paragraphs 8(e) and (f) of this Statement of Agreed Facts and Definition of Issues. B. ISSUES: 10. The Appellant agrees that the $5,000 and $17,507 amounts set forth in paragraph 8(p) of the Respondent's Reply are not deductible. 11. The issues to be decided are therefore: (a) in its 2003 taxation year, did 489 employ in its business throughout the year "more than five fulltime employees" such that the definition of "personal services business" in subsection 125(7) of the Act does not apply by virtue of paragraph (c) of that definition; and (b) in its 2004 taxation year, did 489 employ in its business throughout the year "more than five fulltime employees" such that the definition of "personal services business" in subsection 125(7) of the Act does not apply by virtue of paragraph (c) of that definition. C. DISPOSITION: 12. If paragraph 11(a) is answered in the affirmative, the Appeal for the 2003 taxation year should be allowed, other than the adjustments for the $5,000 amount described in paragraph 10 above. 13. If paragraph 11(a) is answered in the negative, the Appeal for the 2003 taxation year should be dismissed. 14. If paragraph 11(b) is answered in the affirmative, the Appeal for the 2004 taxation year should be allowed, other than the adjustments for the $17,507 amount described in paragraph 10 above. 15. If paragraph 11(b) is answered in the negative, the Appeal for the 2004 taxation year should be dismissed. This Statement of Agreed Facts and Definition of Issues is agreed to by the parties for the purpose of this action and any appeal therefrom but shall not bind the parties in any other action. No evidence inconsistent with this Statement of Agreed Facts may be adduced at the hearing of this action or any appeal therefrom except through further agreement by the parties. DATED at the City of Vancouver, in the Province of British Columbia, this 9th day of April, 2008. "Gordon S. Funt" Gordon S. Funt Counsel for the Appellant DATED at the City of Vancouver, in the Province of British Columbia this 9th day of April, 2008. "Karen A Truscott" Karen A. Truscott Counsel for the Respondent ---------------------------------------------------------

141

SCHEDULE A Sunny Donatelli worked the following hours as an employee of 489 during its 2003 taxation year (ending January 31, 2003): Pay Period End1 Hours Worked 2002-02-08 2002-02-22 2002-03-08 2002-03-22 2002-04-05 2002-04-19 2002-05-03 2002-05-17 2002-05-31 2002-06-14 2002-06-28 2002-07-12 2002-07-26 2002-08-09 2002-08-23 2002-09-06 2002-09-20 2002-10-04 2002-10-18 2002-11-01 2002-11-15 2002-11-29 2002-12-13 2002-12-27 2003-01-10 2003-01-24 2003-02-07 Notes: 1Each pay period is two weeks in duration. 2Sunny Donatelli was temporarily laid off by 489 on September 6, 2002. 3On October 1, 2002 Sunny Donatelli resumed working for 489. 4This pay period overlaps 489's 2003 and 2004 taxation years, and is therefore indicated on the chart for each year. 64.00 66.00 60.50 61.00 59.50 57.00 61.00 45.50 64.00 62.00 54.50 23.00 50.50 48.00 70.50 6802 0.00 6.003 0.00 9.00 0.00 12.00 15.00 12.00 42.50 56.50 63.004

142 Sunny Donatelli worked the following hours as an employee of 489 during its 2004 taxation year (ending January 31, 2004): Period End Hours Worked 2003-02-07 63.004 2003-02-21 50.50 2003-03-07 62.50 2003-03-21 60.00 2003-04-04 60.50 2003-04-18 60.00 2003-05-02 680 2003-05-16 60.00 2003-05-30 60.00 2003-06-13 61.00 2003-06-27 60.00 2003-07-11 60.00 2003-07-25 60.00 2003-08-08 60.00 2003-08-22 60.00 2003-09-05 61.50 2003-09-19 0.00 2003-10-03 60.00 2003-10-17 60.50 2003-10-31 60.00 2003-11-14 60.00 2003-11-28 60.00 2003-12-12 60.00 2003-12-26 75.00 2004-01-09 60.00 2004-01-23 60.00 2004-02-06 60.00 Notes: 4This pay period overlaps 489's 2003 and 2004 taxation years, and is therefore indicated on the chart for each year.

3 This appeal involves the interpretation of the definition of "personal services business" as contained in subsection 125(7) of the Act. The only matter in dispute with respect to the criteria that must be satisfied, before the statutory definition of personal services business will be applied, is whether the Appellant employed "more than five full-time employees" in each of the relevant taxation years. If the Appellant employed more than five full-time employees in each of these years then the definition of personal services business contained in subsection 125(7) will not apply because of the exception contained in paragraph 125(7)(c). The importance of this finding for the Appellant will determine whether its activities fall within the definition of personal services business and, if they do, the Appellant will not be carrying on an active business in those years. Therefore, if the Appellant is

143 not carrying on an active business then, of course, it is not entitled to claim the small business deduction or to claim its full business expenses, because its claim will be restricted by paragraph 18(1)(p) of the Act. 4 The definition of "personal services business" contained in subsection 125(7) of the Act states:

"personal services business" carried on by a corporation in a taxation year means a business of providing services where (a) an individual who performs services on behalf of the corporation (in this definition and paragraph 18(1)(p) referred to as an "incorporated employee"), or (b) any person related to the incorporated employee is a specified shareholder of the corporation and the incorporated employee would reasonably be regarded as an officer or employee of the person or partnership to whom or to which the services were provided but for the existence of the corporation, unless (c) the corporation employs in the business throughout the year more than five full-time employees, or (d) the amount paid or payable to the corporation in the year for the services is received or receivable by it from a corporation with which it was associated in the year; ... The focus in this appeal is on paragraph 125(7)(c) and more particularly the wording "more than five full-time employees". 5 The Appellant's position is that it is not a personal services business because it satisfies the wording contained in paragraph 125(7)(c) by employing five full-time employees and at least one parttime employee throughout 2003 and 2004 taxation years (Appellant's Written Argument, paragraph 3). 6 The Respondent's position is that the Appellant was a personal services business because it did not employ more than five full-time employees as required by the provision since the wording of the statute requires that there be "at least six full-time employees". Therefore the employment of part-time employees can not satisfy this provision. The Respondent contends that a full-time employee must be defined as an individual that is regularly employed working regular working hours of each working day throughout the taxation years in question. Since neither of the Appellant's part-time employees satisfies this requirement, the Appellant, although it had five full-time employees, was carrying on a personal services business within the meaning of subsection 125(7) because it did not employ "at least six full-time employees" in each of the taxation years (Respondent's Written Submissions, paragraphs 7 and 8). 7 The consequences attached to a conclusion that a corporation is earning its income as a "personal services business" is explained in the Federal Court of Appeal decision, Dynamic Industries Ltd. v. The Queen, 2005 D.T.C. 5293 at paragraphs 45-48: [45] A corporation's income from a personal services business does not qualify for the small business deduction, which means that it is taxed at a higher rate than other business income of a corporation. [46] Also, in computing the income of a corporation from a personal services business, no deductions are permitted except remuneration paid to the corporation's "incorporated employee" (the person referred to in paragraph (a) of the definition of "personal services business"), certain expenses relating to the incorporated employee, and certain legal expenses. These restrictions on the deductibility of business expenses are set out in paragraph 18(1)(p) ...

144 [47] In the most common situation involving paragraph 18(1)(p) of the Income Tax Act, no deduction is permitted for such ordinary business expenses as rent, telephone costs, administration and office costs, and remuneration to any employee other than the "incorporated employee". In this case, for example, most of the disallowed expenses over the three years under appeal represent remuneration paid to Ms. Shkwarok for administrative services. That expense was disallowed only because the Crown considered Dynamic to be carrying on a personal services business. There is no allegation that Ms. Shkwarok did not perform administrative services for Dynamic, or that her remuneration for those services was unreasonable. [48] Nothing in the Income Tax Act provides offsetting relief to the application of paragraph 18(1)(p). Thus, for example, Ms. Shkwarok would have been taxed on the remuneration she received from Dynamic, even though Dynamic was not permitted to deduct it. Consequently, if I determine that the Appellant is a personal services business, it will be restricted to a claim of those expenses listed in 18(1)(p) and will not be eligible for the small business deduction because it will not be considered an "active business". 8 My decision is dependent upon my interpretation of the expression "more than five full-time employees". Put another way, does the provision require at least six full-time employees, as the Respondent contends, or will it be satisfied by five full-time employees plus one or more part-time employees, as the Appellant argues. In the alternative, the Appellant contends, that if I agree with the Respondent and find that the provision requires six full-time employees, then Sunny Donatelli, one of the employees classified as part-time, who generally worked 30 hours per week except for vacation, sick leave and a lay-off period, occasioned by a fire, was working in a full-time capacity for the Appellant in the relevant years. 9 The rules of interpretation were recently reiterated by the Supreme Court of Canada in Imperial Oil Ltd. v. Canada, [2006] 2 S.C.R. No. 447, 2006 SCC 46: 24 This Court has produced a considerable body of case law on the interpretation of tax statutes. I neither intend nor need to fully review it. I will focus on a few key principles which appear to flow from it, and on their development. 25 The jurisprudence of this Court is grounded in the modern approach to statutory interpretation. Since Stubart Investments Ltd. v. The Queen, 1984 CanLII 20 (S.C.C.), [1984] 1 S.C.R. 536, the Court has held that the strict approach to the interpretation of tax statutes is no longer appropriate and that the modern approach should also apply to such statutes: [T]he words of an Act are to be read in their entire context and in their grammatical and ordinary sense harmoniously with the scheme of the Act ... . (E. A. Driedger, Construction of Statutes (2nd ed. 1983), at p. 87; Stubart, at p. 578, per Estey J.; Ludco Enterprises Ltd. v. Canada, 2001 SCC 62 (CanLII), [2001] 2 S.C.R. 1082, 2001 SCC 62, at para. 36, per Iacobucci J.) 26 Despite this endorsement of the modern approach, the particular nature of tax statutes and the peculiarities of their often complex structures explain a continuing emphasis on the need to carefully consider the actual words of the ITA, so that taxpayers can safely rely on them when conducting business and arranging their tax affairs. Broad considerations of statutory purpose should not be allowed to displace the specific language used by Parliament (Ludco, at paras. 38-39). 27 The Court recently reasserted the key principles governing the interpretation of tax statutes -although in the context of the "general anti-avoidance rule", or "GAAR" -- in its judgments in

145 Canada Trustco Mortgage Co. v. Canada, 2005 SCC 54 (CanLII), [2005] 2 S.C.R. 601, 2005 SCC 54, and Mathew v. Canada, 2005 SCC 55 (CanLII), [2005] 2 S.C.R. 643, 2005 SCC 55. On the one hand, the Court acknowledged the continuing relevance of a textual interpretation of such statutes. On the other hand, it emphasized the importance of reading their provisions in context, that is, within the overall scheme of the legislation, as required by the modern approach. 28 In their joint reasons in Canada Trustco, the Chief Justice and Major J. stated at the outset that the modern approach applies to the interpretation of tax statutes. Words are to be read in context, in light of the statute as a whole, that is, always keeping in mind the words of its other provisions: It has been long established as a matter of statutory interpretation that "the words of an Act are to be read in their entire context and in their grammatical and ordinary sense harmoniously with the scheme of the Act, the object of the Act, and the intention of Parliament": see 65302 British Columbia Ltd. v. Canada, 1999 CanLII 639 (S.C.C.), [1999] 3 S.C.R. 804, at para. 50. The interpretation of a statutory provision must be made according to a textual, contextual and purposive analysis to find a meaning that is harmonious with the Act as a whole. When the words of a provision are precise and unequivocal, the ordinary meaning of the words play a dominant role in the interpretive process. On the other hand, where the words can support more than one reasonable meaning, the ordinary meaning of the words plays a lesser role. The relative effects of ordinary meaning, context and purpose on the interpretive process may vary, but in all cases the court must seek to read the provisions of an Act as a harmonious whole. [para. 10] 29 The Chief Justice and Major J. then addressed the underlying tension between textual interpretation, taxpayers' expectations as to the reliability of their tax and business arrangements, the legislature's objectives and the purposes of specific provisions or of the statute as a whole: As a result of the Duke of Westminster principle (Commissioners of Inland Revenue v. Duke of Westminster, [1936] A.C. 1 (H.L.)) that taxpayers are entitled to arrange their affairs to minimize the amount of tax payable, Canadian tax legislation received a strict interpretation in an era of more literal statutory interpretation than the present. There is no doubt today that all statutes, including the Income Tax Act, must be interpreted in a textual, contextual and purposive way. However, the particularity and detail of many tax provisions have often led to an emphasis on textual interpretation. Where Parliament has specified precisely what conditions must be satisfied to achieve a particular result, it is reasonable to assume that Parliament intended that taxpayers would rely on such provisions to achieve the result they prescribe. [para. 11] (See also Mathew, at paras. 42-43.) 10 Both the Federal Court of Appeal and the Federal Court -- Trial Division have dealt with this same wording in discussing the definition of "specified investment business", the sister provision of paragraph 125(7)(c). The definition of "specified investment services", also contained in subsection 125(7), has the same exception as in the definition of "personal services business". The Respondent relied on the decision of Muldoon, J. in The Queen v. Hughes & Co. Holdings Limited, 94 D.T.C. 6511, where the Trial Court considered whether a specified investment business required "at least six full-time employees" or "five full-time employees plus one or more part-time employees". At page 6518 of that decision, Muldoon, J. states:

146 39 The statutory provision prescribes that "the corporation employs in the business throughout the year more than five full-time employees". The defendant's view of this is that Parliament really meant to express the notion of "employment" in a fluid-measure sense, like "more water", "more wheat", or indeed "less water" or "less wheat, oats, barley" and so on, instead of meaning individual employees. The defendant's view seemed to be that one could have "more than five full-time employees" by supplementing, complementing or "topping up" the five with a few parttimers. That might well produce more employment than that needed for more than five full-time employees, but that is not what Parliament meant as this Court construes subparagraph 125(7) (e)(i). The statutory phrase yields its (quite transparent) meaning by keeping all the words and introducing no new ones, but by re-arranging the word order, thus "full-time employees, more than five". It means more full-time employees than five [full-time employees]. The subject matter bears no reference to any employees other than full-time employees: it does not even contemplate part-time employees. 40 A most telling judicial interpretation of the same construction, but in a different subject matter, was performed by Mr. Justice Dysart in the Shenowski case supra cited by the defendant. He was construing the 1931 version of section 750 of the Criminal Code, which provided that: (a) if a conviction or order is made more than fourteen days before a sittings of the court to which an appeal is given, such appeal shall be made to that sittings; but if ... Now, it having been established in this case that subparagraph 125(7)(e)(i) does not even contemplate a part-time employee, much less a part or fraction of an employee, it is instructive to note how Dysart, J. construed the above-recited section 750(a) of the Code: The phrase 'more than fourteen days before' has been held by Supreme Court of Nova Scotia to mean at least 15 clear days: Rex v. Johnston (1908) 13 C.C.C. 179; and there is no authority cited to me, or known to me, which is at variance with that decision. It follows that the phrase 'fourteen days before the sitting' means 14 whole days exclusive of any part of the day of the sittings; and that, because there are no fractions of days 'more than fourteen days' must mean at least 15 whole days. (Emphasis added) ([1932] 1 W.W.R. pp. 19394) 11 With respect, I believe Muldoon, J.'s conclusions are incorrect. First, it is clear that in paragraph 39 of his reasons, he rearranged the words used in the Act in order to support his conclusions by stating that the word "more" modified "full-time employees". This goes directly against the rules of interpretation to which I refer in paragraph [9] of my Reasons. Second, he relied on a criminal case to support his conclusion that "more than five" meant "at least six". The decision in Shenowski (Rex v. Shenowski, [1932] 1 W.W.R. 192), in considering the 1931 version of section 750(a) of the Criminal Code, determined that "more than fourteen days" used in that section meant "at least fifteen clear days". Muldoon, J., in the Hughes case, cited the paragraph (as referenced in my quote from his decision) where the Court in Shenowski explained that there existed at the time a well established legal practice regarding time computation. However, Muldoon, J. neglected to include the most relevant portion of that decision in Shenowski as it relates to this issue, where Dysart, J. states: 9 In reckoning the number of days elapsing between two events, the days on which those events themselves occur are not, as a general rule, to be included. The reason is that in law days are regarded as points or short periods of time exactly coinciding in duration with the events themselves, so that there is no possible fraction of a day either before or after the event itself to be included in the reckoning: Lester v. Garland (1808) 15 Ves. Jun. 248, at 257, 33 E.R. 748; Pugh v. Leeds (Duke) (1777) 2 Cowp. 714, at 720, 98 E.R. 1323; In re Railway Sleepers Supply Co. (1885) 29 Ch. D. 204, 54 L.J. Ch. 720.

147 While there is the legal practice for computation of time that existed in the criminal case of Shenowski, there is no similar practice I know of respecting people and more particularly employees. Therefore Muldoon, J.'s reliance upon the principles in Shenowski is misplaced. Third, the intent of Parliament in using the phrase "more than five" in paragraph 125(7)(c) cannot mean "at least six full-time employees" as Muldoon, J. has concluded. The expression "more than" is used over 200 times in the Act and has been considered by this Court on several occasions. For example, in Burton v. Canada, [2005] T.C.J. No. 596, 2005 TCC 762, the Court found that an assessment completed "more than" two years after the Appellant ceased to be a director was statute barred. The assessment was dated April 26, 2004 but the Appellant had resigned in February 2002. As we can see "more than two years" used in subsection 227.1(4) was not interpreted to mean "at least three years". The phrase "more than" is also used in other sections of the Act, such as section 122.3, which deals with the overseas employment tax credit, applicable to residents of Canada working abroad for a specified employer throughout a period of "more than 6 consecutive months". At paragraph 9 of Interpretation Bulletin IT497R4, the position adopted by Canada Revenue Agency (the "CRA") is that this period means 6 consecutive months "plus one day" and not "at least seven consecutive months". Fourth, Muldoon, J. had effectively disposed of the appeal when he determined that the employee in question was not a full-time employee of the taxpayer and therefore the taxpayer corporation employed only four full-time employees and not five full-time employees. However, he went on to address the possibility of an appellate court finding against him and concluding that the employee was a full-time employee, bringing the number to five full-time employees and necessitating the need to then address the issue of a number of part-time employees which is the issue in the present appeal. I am of the view that his comments in regard to part-time employees can be considered obiter. 12 Although I believe that Muldoon, J. incorrectly re-arranged the wording of the provision to justify his conclusion, even if this did not affect his end result, equating the phrase "more than five" to mean "at least six" cannot be supported when one looks at the overall scheme of the Act and the intent of Parliament. I agree with the Appellant's submissions that, if Parliament meant "at least six" employees, it simply would have stated it. There are many other provisions within the Act where the phrase "at least" is employed by Parliament. Some of those are contained in section 19, paragraph 110.6(1.2)(a), subsection 127.1(2.2), paragraph 147(2)(g) and paragraph 248(1)(e) of the definition of automobile. Consequently, the presumption of consistent expression as described in Driedger on the Construction of Statutes (3rd ed.) (Markham: Butterworths Canada Ltd., 1994) at page 163, has to be applied in this appeal. It seems to be Parliament's intent to carefully, consistently and accurately delineate between the use of the phrases "more than" and "at least" within the Act. I do not believe that it was Parliament's intention that these terms be used interchangeably in this provision. If Parliament had intended "at least six full-time employees" within the context of this provision, it would have used those words. I believe the fact that Parliament chose the words "more than five full-time employees", supports Parliament's obvious recognition that Canada's workplace today is comprised of both full-time and part-time employees. 13 Before leaving my discussion of Muldoon, J.'s decision in Hughes, there are several cases which have referenced Hughes regarding the expression "more than five full-time employees. Margeson, J. in the Ben Raedarc Holdings Limited et al. v. The Queen, 98 D.T.C. 1218, case approved Muldoon, J.'s comments in Hughes stating at page 1225 that "... to avoid "specified investment business status", a taxpayer must have "more than five full-time employees". This clearly means at least six full-time employees." With respect, I do not agree with Margeson J.'s comments. However, they are obiter because the Court did not have to conclude on that issue as it had decided that there were only four full-time employees. 14 Beaubier, J. in Woessner et al. v. The Queen, 99 D.T.C. 1039, quoted Muldoon, J. in Hughes and simply concluded that he had the same situation before him. Beaubier, J. was deciding whether

148 residential building managers were full-time employees of the corporation such that, in addition to the three full-time employees, the corporation would have more than five full-time employees. However, he did not consider the issue of part-time employees which is before me. 15 In Lerric Investments Corp. v. The Queen, 2001 D.T.C. 5169, Rothstein, J. at paragraph 18 made the following comments concerning the Hughes decision: 18 I am not convinced of the correctness of the view expressed in The Queen v. Hughes & Co. Holdings Limited (1994), 94 D.T.C. 6511, at 6518, that the "more than five full-time employees" requirement means at least six full-time employees and could not be met by a single corporation employing five full-time employees and one part-time employee. All that is necessary is that the employer employs more than five full-time employees. However, I think that an approach which allocates fractions of full-time employees of co-ownerships or joint ventures to a co-owning or joint venturing corporation to satisfy the "more than five full-time employees" requirement would involve reading words into the provision that were not placed there by Parliament. In Lerric, the Court was deciding whether the Appellant fulfilled the requirement of "more than five fulltime employees" by employing two full-time employees and sharing the expenses of fifteen others. Since the Court was not considering the question of whether a part-time employee fulfills the requirement of "more than five full-time employees", Rothstein, J.'s comments are obiter. However, these remarks suggest that there is no uniform consensus on the approach to be taken and that ambiguity exists regarding the meaning to be assigned to this expression. 16 In the case of Baker et al. v. The Queen, 2005 D.T.C. 5266, in considering whether six individuals were part-time or full-time, the Court at paragraph 14 stated: 14 In my view, the conclusion by Muldoon J. in Hughes and Co., supra, at page 6517, that the term "full-time" employment in the definition of "specified investment business" is used in contradistinction with "part-time" employment, is correct. This distinction reflects the broad consideration which Parliament had in mind when it provided for a minimum of five full-time employment throughout the year. Only full-time employment, as opposed to part-time employment, qualifies. I do not believe the Court was commenting on what will constitute "more than five full-time employees". It made no statement on the requirement that the additional employee should be a fulltime or a part-time employee. It states only that the five employees referenced in the provision are all required to be full-time employees. My conclusion here is supported by the following passage at paragraph 11 of that decision: 11 The requirement that the taxpayer employ five full-time employees, as embodied in the definition of "specified investment business", must be analysed in the light of the object and purpose of this definition. ... I view the decision in Baker as confirmation only, that it is not possible to replace the requirement of five full-time employees by numerous part-time employees and with that I agree. 17 The dictionary definitions of "full-time" certainly assist in a determination of whether a corporation employs the minimum of "five full-time employees" but beyond that they are not useful because I do not believe that the provision requires a sixth full-time employee. The Respondent's position is that "more than five" means "at least six". At paragraph 15, Bowman, J. in Lerric Investments Corp. v. The Queen, 99 D.T.C. 755, in commenting on the Crown's contention that "more than five means at least six": ... As a pure matter of mathematics this is not correct. Five point two is more than five.

149 In this regard the presumption of consistent expression must apply. Where Parliament has not used the term "at least" in the provision, I do not believe an interpretation should be applied that would elevate the phrase "more than five" to mean "at least six". In this respect, I am mindful of Bowman J.'s comments in Lerric Investments, regarding the object and spirit of the Legislation, which were quoted with approval in the Federal Court decision in Lerric Investments. I believe that Parliament meant to establish a test that a corporation must meet of "more than five full-time employees" in order to be considered an active business that would qualify it for the deduction. But beyond establishing this requirement, Parliament did not go further, as it could have done, because it was cognizant of the very real possibility of part-time employees. Therefore I believe that my interpretation is in keeping with the spirit and intent of the Legislation and what Parliament had in mind when enacting this provision. Common sense dictates that Parliament would have used entirely different wording if it had meant that, for a corporation to be an active business, it had to employ "at least six full-time employees". It did not use this wording for a reason and, that is, Parliament intended that employment of part-time employees throughout the year could tip the scales in favour of a corporation being an active business where it employed five full-time employees. I believe this simply reflects Parliament's recognition of the existence of part-time as well as full-time employees within the landscape of the Canadian workforce. 18 In the particular facts of this case, the parties agreed that the Appellant employed five full-time individuals [paragraph 8(d), Agreed Statement of Facts]. The Agreed Statement of Facts also refers to the employment of two further employees, Barbara Clark and Sunny Donatelli (paragraph 5). Barbara Clark worked throughout each taxation year for 15 hours weekly. It was also agreed at paragraph 8(e) that Sunny Donatelli was a part-time employee. I have concluded that "more than five full-time employees" did not require the Appellant to employ six full-time individuals throughout the 2003 and 2004 taxation years to be excluded from the definition of personal services business. Parliament's use of the expression "more than" is consistent with Parliament's use of this expression in other sections of the Act. The Appellant fulfilled the requirement of hiring "throughout the year more than five fulltime employees" by employing "part-timers". The issue of what constitutes part-time employment need not be addressed here as admissions have been made in the Agreed Statement of Facts. That is left for another day. 19 There is certainly ambiguity within the case law regarding the interpretation of the expression "more than five full-time employees". The principle affirmed in Johns-Manville Canada Inc. v. The Queen, 85 D.T.C. 5373 that such ambiguity should be resolved in favour of the taxpayer has application here. This principle has been narrowed in Corporation Notre-Dame de Bon-Secours v. Communaute Urbaine de Qubec et al., 95 D.T.C. 5017. This rule of statutory interpretation was also recently reaffirmed by Chief Justice Bowman in 943372 Ontario Inc. v. The Queen., [2007] T.C.J. No. 208, 2007 TCC 294. Where such ambiguity exists within the case law the taxpayer must be given the benefit. However I believe Parliament employed the expressions "more than five" and "throughout the year" to distinguish between a corporation for which the definition of personal services business applies and one to which it does not. Alternate wording could have been chosen ("at least six fulltime") but Parliament did not do so. In my view, although the case law contains ambiguity, the provision is capable of only one interpretation. 20 Accordingly the appeals are allowed, with costs, to the Appellant.

In Baker v. R., [2005] 3 C.T.C. 135, the Federal Court of Appeal held that employees who worked 20 hours per week were not full-time employees despite the fact that the employees worked five days a week. It was unsuccessfully argued that the 20 hours per week was full-time according to industry standards for cleaning personnel.

150 ii) Specified investment business: partnership issues

Lerric Investments Corp. v. R.

2001 CarswellNat 290, 2001 FCA 14, 2001 D.T.C. 5169, [2001] 2 C.T.C. 84, 267 N.R. 118, [2001] 2 F.C. 608, 2001 CarswellNat 1725, 2 F.C. 608 APPEAL by taxpayer from judgment reported at (1999), 99 D.T.C. 755, [1999] 2 C.T.C. 2714 (T.C.C.) disallowing small business deduction. The judgment of the court was delivered by Rothstein J.A.: 1 This is an appeal from a judgment of Bowman J.T.C.C. (as he then was) dismissing the appellant's appeal with respect to its 1990, 1991 and 1992 taxation years. The sole issue is whether the appellant's business is a "specified investment business" within the meaning of paragraph 125(7) (e ) of the Income Tax Act . If it is a specified investment business, it is excluded from the definition of "active business" in paragraph 125(7)(a ) and is not entitled to the small business deduction provided by subsection 125(1). 2 At the relevant time, subparagraph 125(7)(e )(i) read:

(e) "Specified investment business ". - "specified investment business" carried on by a corporation in a taxation year means a business (other than a business carried on by a credit union or a business of leasing property other than real property) the principal purpose of which is to derive income from property (including interest, dividends, rents or royalties), unless (i) the corporation employs in the business throughout the year more than five full-time employees, or [...] Facts 3 I cannot improve upon the concise statement of relevant facts of the learned Trial Judge and I reproduce them here: [3] It is admitted that the principal purpose of the appellant's business was to derive income from property in the form of rents. The sole issue is whether the appellant throughout each of the three years in question employed more than five full-time employee. [4] The appellant had interests in eight apartment projects, which it owned with other co-owners or joint venturers. In none of the projects was it a partner. [5] The following schedule sets out the number of full-time employees employed at each project by the joint ventures in which the appellant had an interest, and its percentage of ownership:

Joint Venture Sheridan Twins The Diplomat Apartments Humber Park Apartments Lyon Manor 839 Roselawn Ivory Towers

# of Full Time Employees 4 2 2 1 1 1

% Ownership 16.67 20.00 15.00 25.00 50.00 17.50

151 Joint Venture Hyland Park Apartments Rhona Towers # of Full Time Employees % Ownership 1 15.00 3 20.00

[6] The above schedule is for 1990. For 1991 and 1992 the percentages remain the same, and the only difference is that in 1991 Humber Park Apartments had three employees and in 1992 it had four employees. [7] If one applies the percentage of ownership in each project to the number of employees at each project, the result will be a notional attribution of a fraction of a full-time employee to Lerric. [8] For 1990 the calculation made by the appellant looks like this: Joint Venture Sheridan Twins The Diplomat Apartments Humber Park Apartments Lyon Manor 839 Roselawn Ivory Towers Hyland Park Apartments Rhona Towers Lerric Total Number of full Employees # of Full Time % Ownership Employees 4 16.67 2 20.00 2 15.00 1 25.00 1 50.00 1 17.50 1 15.00 3 20.00 2 100.00 Time 5.05 Allocated Lerric 0.67 0.40 0.30 0.25 0.50 0.18 0.15 0.60 2.00 to

[9] For 1991 and 1992, the percentage changes slightly because Humber Park Apartments had three employees in 1991 and four in 1992. This meant that the allocation to Lerric in respect of Humber Park in those years was 0.45 and 0.60 respectively, and the total rose to 5.20 and 5.35. [10] The appellant had two full-time employees in addition to those employed at the various apartments. 4 In the Tax Court, the appellant relied on Interpretation Bulletin IT73R5, paragraph 16. 16. If, for example, two corporations carry on a business in partnership as equal partners with the partnership business employing more than five full-time employees, each partner would, for the purpose of paragraph (a) of the definition of "specified investment business" in subsection 125(7), be considered to employ more than five full-time employees. However, if the business is carried out by corporations in a joint venture or other form of co-ownership, the total number of full time employees who work jointly for all the co-owners must be allocated to each co-owner in accordance with the co-owner's percentage of interest in the property. Issue 5 On the facts of this appeal, the question is whether the words in subparagraph 125(7)(e)(i)

The corporation employs in the business throughout the year more than five full-time employees

152 include employees of joint ventures or co-ownerships in which a corporation is a joint venturer or coowner. Reasons of the Trial Judge 6 The Trial Judge accepted that it is difficult to ascertain whether and how that provision applies in circumstances such as this. He therefore turned to the scheme of the legislation. At paragraphs 23 and 24 of his reasons, he sets out the object and purpose of the provision. I agree with his explanation. [23] [...] The concept of specified investment business seems to have been a response to certain decisions of the courts which treated virtually any commercial activity of a corporation, however passive, even where it was carried [sic] under contract by independent contractors who were not employees, as an active business (see, for example, The Queen v. Cadboro Bay Holdings Ltd., 77 D.T.C. 5115 (F.C.T.D.) ; The Queen v. Rockmore Investments Ltd., 76 D.T.C. 6157 ; E.S.G. Holdings Limited v. The Queen, 76 D.T.C. 6158 ; The Queen v. M.R.T. Investments Ltd., 76 D.T.C. 6158 ). [24] The result was the introduction of the concept of specified investment business the purpose of which [sic] to ensure that "active" meant truly active and that the word not be, in effect, judicially written out of the Act. Therefore the object of the new legislation was to ensure that the business of a corporation that invested in rental properties would not be considered "active" unless there was sufficient activity in the corporation's business to justify the employment of over five full-time employees. 7 He then found that the appellant employed two full-time employees and shared the expenses of fifteen others. He rejected the approach of IT73R5 because: [26] [...] To allocate fractions of employees (.15 to .67) to a joint venturer or co-owner strikes me as outside the realm of reality and I would be surprised if whoever wrote the bulletin considered the situation with which we are concerned here. 8 His final conclusion was that each case was fact dependent and that real-estate investment companies who invest through co-ownerships or joint ventures may not be excluded from subparagraph 125(7)(e )(i) in all cases. However, he was of the opinion that it was necessary to "draw the line where one's good sense tells one to draw it". He dismissed the appellant's appeal. Analysis 9 Section 125 distinguishes between active and inactive corporations, only the former being eligible for the small business deduction. Ordinarily, a business whose income is primarily derived from property is treated as inactive and therefore ineligible for the deduction. Subparagraph 125(7)(e )(i) provides an exception to this rule and allows the small business deduction to a corporation that derives income from property where that corporation is sufficiently active - employment being the indicia of activity. As Bowman J.T.C.C. explained, the requirement that the corporation employ more than five full-time employees simply operates as a test to ensure that a corporation is sufficiently active such that it should qualify for the deduction. 10 Employing the words of the learned trial judge found at paragraph 16 of his decision, the fundamental question posed by subparagraph 125(7)(e )(i) is whether a corporation's business is sufficiently active that it uses more than five employees. However, before the question of sufficient activity can be raised, it is first necessary to ask who is it that the corporation employs in its business.

153 11 Subparagraph 125(7)(e )(i) is straightforward when a corporation is carrying on business on its own. If the corporation employs more than five full-time employees throughout the year in its business, the requirement of subparagraph 125(7)(e )(i) will have been met. 12 However, the question here is whether it is possible to construe the words of subparagraph 125(7)(e )(i) to apply if a corporation's business is carried on through co-ownerships or joint ventures and the employees work for the co-ownership or joint venture rather than directly for the corporation. 13 There are two approaches under which the corporation could be considered to employ more than five full-time employees for purposes of subparagraph 125(7)(e )(i). The first approach reasons that, because a co-ownership or joint venture is not a legal entity separate and distinct from its coowners or joint venturers, each employee can be said to be employed by each co-owner or joint venturer. Put another way, this argument implies that the same employee can be a full-time employee of each and every co-owner or joint venturer. In the relevant taxation years, this approach would attribute 15 to 17 full-time employees to Lerric, depending upon the taxation year in question. I do not think such an approach is consistent with the words of subparagraph 125(7)(e )(i) in their context. 14 The words of the provision that are determinative are: "the corporation employs". In my opinion, having regard to the context of paragraph 125(7)(e ), that it is a measure of business activity, this crucial phrase connotes a direct relationship between the corporation as employer and the specified employees. If a corporation employs a full-time employee, I do not see how, in the context of paragraph 125(7)(e ), the same employee, providing a single service, can be simultaneously employed full time by another employer to whom that employee provides exactly the same service. This approach involves double, triple, or even multiple counting of the same employee. To attribute more than five employees to a corporation simply because it has a fractional interest in a coownership or joint venture that employs more than five employees ignores the context in which the words "the corporation employs" are used in paragraph 125(7)(e ). 15 The other approach in which full-time employees could be said to be employees of a co-owner or joint venturer individually is if their employment is allocated to each co-owner or joint venturer in accordance with an allocation formula, e.g. one based on the co-owner's or joint venturer's interest in the property. In the relevant taxation years, this approach would attribute 5.05 to 5.35 full-time employees to Lerric, depending upon the taxation years in question. 16 This allocation approach does not suffer from the same impediment as the first approach, i.e. double or multiple counting of the same employees, such that the same employee is considered to be employed full-time by more than one employer. Also, as the Trial Judge found, mathematically, it meets the numerical test of subparagraph 125(7)(e )(i), i.e. more than five. 17 However, I do not think the allocation approach is envisaged by the words of subparagraph 125(7)(e )(i). As I have stated, the provision simply conceives of a single corporation employing more than five full-time employees. There are no words in the provision that imply that a proportional or sharing approach of the same employee by different employers is contemplated. 18 I am not convinced of the correctness of the view expressed in R. v. Hughes & Co. Holdings Ltd. (1994), 94 D.T.C. 6511 (Fed. T.D.) , at 6518, that the "more than five full-time employees" requirement means at least six full-time employees and could not be met by a single corporation employing five full-time employees and one part-time employee. All that is necessary is that the employer employs more than five full-time employees. However, I think that an approach which allocates fractions of full-time employees of co-ownerships or joint ventures to a co-owning or joint venturing corporation to satisfy the "more than five full-time employees" requirement would involve reading words into the provision that were not placed there by Parliament.

154 19 The appellant, with some justification, asks who employs the employees working in the coownership or joint venture if the employer is not each co-owner or joint venturer. The appellant's view is that the co-ownership or joint venture is not a separate legal entity and, therefore, the employees must be employed by each co-owner or joint venturer. 20 The Minister's answer, and it is one that I must accept, is that it is the co-owners or joint venturers together, but not independently, who employ the employees. No co-owner or joint venturer can say that it individually employs the employees or portions of the employees. They can say that, in accordance with the co-ownership or joint venture agreement, they are responsible for a percentage of each employee's wages. However, this does not give rise to the allocation of fractional employees and the aggregation of these fractions to meet the "more than five full-time employees" test in subparagraph 125(7)(e )(i). 21 The Minister says the provision is an arbitrary proxy for an active business and it may not accommodate every deserving situation. I am forced to agree with the Minister. It is not difficult to construct anomalies which demonstrate that either the application or non-application of subparagraph 125(7)(e )(i) to co-ownerships or joint ventures leads to illogical results. However, applying an arbitrary rule to situations not contemplated by the rule will have that effect because it is arbitrary. Be that as it may, it is the duty of the Court to take the statute as it finds it. 22 The appeal will be dismissed with costs.

Appeal dismissed.

iv. Personal Service Business

The definition of active business income also excludes a "personal services business". This term is defined in paragraph 125(7)(d) and requires some guess work on the part of those attempting to apply it. The technical part of the definition states that a personal services business means: A business of providing services where (i) (ii) an individual who performs services on behalf of the corporation ("incorporated employee"), or any person related to the incorporated employee is a specified shareholder (defined in subsection 248(1) to mean, in part, an owner, directly or indirectly, of 10% or more of the shares with all non-arm's length shareholders being deemed to be one such shareholder) of the corporation; and the incorporated employee would reasonably be regarded as an officer or employee of the entity to which services are provided. The difficult question is determining whether or not the incorporated employee could reasonably be regarded as an officer or employee of the entity to which the services are provided. The situation which the legislation was attempting to address was employees (commonly professional athletes) replaced their personal contract of employment with a new contract with their corporation, which

155 promised that the corporation would provide the services of the former employee. Typically the new corporation would have one major client, i.e., the former employee, and few, if any, employees other than the former employee and now owner of the new corporation. Even where it appears a personal service business is being carried on, the restrictions otherwise placed on such a business will not apply if: (i) (ii) the corporation employs throughout the year more than five full time employees, or the services are provided to an associated corporation.

A corporation carrying on a personal services business is not eligible for a small business deduction with respect to that income. Furthermore, such a corporation is denied any deductions other than salary, wages and other benefits provided to the individual who performed the services or amounts that would have been deductible to an employee as costs incurred in selling property or negotiating contracts or legal expenses incurred in collecting amounts owing for services. This limitation on the deductions of a personal services business is found in paragraph 18(1)(p).

Dynamic Industries Ltd. v. R.

2005 FCA 211, 2005 D.T.C. 5293, [2005] 3 C.T.C. 225, 337 N.R. 174 Sharlow J.A.: 2 The central question in this case is whether paragraph 18(1)(p) applies to Dynamic in the years under appeal. If the answer is yes, the appeal must fail. If the answer is no, the appeal must succeed. Facts 3 Dynamic is a British Columbia corporation, incorporated on August 11, 1983. Its head office is in Cranbook, British Columbia. Since its incorporation, Dynamic has carried on the business of providing steel work services in Alberta and British Columbia. At all material times, the shares of Dynamic have been owned by Mr. Steven Martindale or his spouse, Ms. Shkwarok. 4 Mr. Martindale and Ms. Shkwarok have been employees of Dynamic from the outset. Mr. Martindale provided the services of an iron worker and a construction manager, as needed. Ms. Shkwarok provided administrative services. 16 Dynamic began by providing welding services, fabrication and erection services to various general contractors. As Mr. Martindale gained further experience, Dynamic undertook construction management projects and provided subcontracting services to a variety of companies between 1988 and 1995. Depending on the demands of a particular job, Dynamic would employ other workers in addition to Mr. Martindale. The number of workers varied between one and eight at any given time. 17 One of the contractors Dynamic worked for beginning in 1990 was Southern Interior Maintenance Installation Ltd., a corporation owned by Mr. Jim Larson and his spouse, Ms. Gail Larson, neither of whom are related to Mr. Martindale or Ms. Shkwarok. Dynamic billed Southern Interior on a cost-plus project at $38 per hour. In 1993, Dynamic negotiated a fixed-price contract for a small job with Southern Interior and in late 1993 Dynamic also negotiated another cost-plus contract at $45 per hour plus living-out expenses.

156

18 Dynamic later provided services to S.I.I.L. Maintenance Ltd. (SIIL), a corporation owned by Ms. Larson alone. Ms. Larson's husband, Mr. Jim Larson, was a member of the Ironworkers Union and a full time employee of SIIL. SIIL provided mostly maintenance work in coal mines. 21 The contract between SIIL and Dynamic was not written. However, it is common ground that Dynamic was paid on a cost-plus basis for the work performed by Mr. Martindale at the rate of $45 per hour, with overtime rates of $63 per hour or $82 per hour, depending upon the circumstances, plus a living-out allowance, and GST. The living out allowance was based on a specified rate for each day worked by Mr. Martindale, rather than the seven day living-out allowance that the union members working through Local 97 would have been entitled to. These rate were first set in 1993 and remained unchanged until 1999. The rate was calculated so that SIIL made a 10% profit over what it charged to Fording. 22 Dynamic also charged SIIL $1000 per month for use of a truck, until SIIL purchased its own truck in 1997. 23 If Dynamic had to fix an error it had made, the work was treated as "warranty work" by Dynamic. SIIL had no obligation to compensate Dynamic for the time or costs entailed in such warranty work. Overhead costs incurred to operate Dynamic were also not compensated by SIIL. 29 The contracts between Dynamic and SIIL did not require Mr. Martindale to keep regular hours of work, and he received no direction as to where he would work at any particular time. Mr. Martindale used his discretion as to when and where he was needed. There were no regular reporting sessions between Dynamic and SIIL. Mr. Martindale would keep SIIL informed on an ad hoc basis frequently, often daily, but there were no formal reporting requirements. 30 Dynamic invoiced SIIL for its project management work and the truck rental at various intervals. In the years under appeal, Dynamic issued 33 invoices to SIIL. The invoiced amounts for services ranged from slightly over $1,300 to over $15,000, with the most typical amounts falling within a range of approximately $8,000 to $10,000. There was no regular schedule on which the invoices were submitted or paid. Dynamic would sometimes accept partial payment and wait for the balance of the payment to be made at a later date. 35 During the years under appeal, Dynamic was providing unique services in southeastern B.C. and Mr. Martindale was integral to the success of the business of Dynamic. Mr. Martindale testified that there would be other people he could have hired or did in fact hire in later years to replace him should he have been unable to provide his services because of sickness or other leave. The Law 39 The provisions of the Income Tax Act relating to personal services businesses were enacted to deny certain tax advantages that may be obtained by providing services through a corporation, rather than personally. These provisions are directed primarily at the situation exemplified by Sazio v.

157 Minister of National Revenue (1968), [1969] 1 Ex. C.R. 373, [1968] C.T.C. 579, 69 D.T.C. 5001 (Can. Ex. Ct.). 40 Ralph Sazio was employed as the head coach of a professional football club for a three year period ending on December 9, 1965. In 1964, he resigned from that position. The football club instead retained a corporation, Ralph J. Sazio Limited, to provide coaching services. It was understood that those services would be provided personally by Mr. Sazio, and that he would not perform similar services for a competing football club. The corporation was owned by Mr. Sazio and his wife. Mr. Sazio was an officer and director of the corporation, and received remuneration from the corporation. 41 The Crown's position in Sazio and similar cases was (and still is) that the interposition of a corporation between the recipient of a service and the individual who personally performs the service could result in unreasonable tax advantages, resulting in part from a corporate income tax rate that is significantly lower than the personal tax rate, and in part from opportunities for income splitting. Mr. Sazio was reassessed for 1965 on the basis that the contractual arrangements between the football club and Mr. Sazio's corporation should be ignored because there was no bona fide business purpose for them, that Mr. Sazio should have been taxed as though he were still an employee of the football club, and that the money paid to Mr. Sazio's corporation should be taxed in Mr. Sazio's hands because it was in substance his salary. 42 Mr. Sazio's appeal was allowed by Cattanach J. His decision foreshadowed what has become a well-established proposition, that a tax motivation does not affect the validity of a transaction for tax purposes: Walls v. R., [2002] 2 S.C.R. 684 (S.C.C.); Backman v. R., [2001] 1 S.C.R. 367 (S.C.C.); Shell Canada Ltd. v. R., [1999] 3 S.C.R. 622 (S.C.C.); Antosko v. Minister of National Revenue, [1994] 2 S.C.R. 312 (S.C.C.); Stubart Investments Ltd. v. R., [1984] 1 S.C.R. 536 (S.C.C.). 43 Cattanach J. based his conclusion on the following considerations. First, there is no reason in law why a corporation cannot provide football coaching services. Second, the use of a corporation to provide the services of a single person is well recognized and accepted. Third, absent proof of sham, the separate legal existence of a corporation, and its legal rights and obligations, must be respected for income tax purposes. 44 The rejection of the business purpose test appeared to make it easier for a person to provide services through a Sazio -type arrangement, rather than personally, thus obtaining the related tax advantages. The government still believed that such a result was not reasonable. The enactment of the definition of "personal services business", and related provisions such as paragraph 18(1)(p), was intended to deny, in part, the tax advantages of such arrangements. (references to ITA s. 125 removed) 45 A corporation's income from a personal services business does not qualify for the small business deduction, which means that it is taxed at a higher rate than other business income of a corporation. 46 Also, in computing the income of a corporation from a personal services business, no deductions are permitted except remuneration paid to the corporation's "incorporated employee" (the person referred to in paragraph (a) of the definition of "personal services business"), certain expenses relating to the incorporated employee, and certain legal expenses. These restrictions on the deductibility of business expenses are set out in paragraph 18(1)(p).

158 (reference to 18(1)(p) removed) 47 In the most common situation involving paragraph 18(1)(p) of the Income Tax Act, no deduction is permitted for such ordinary business expenses as rent, telephone costs, administration and office costs, and remuneration to any employee other than the "incorporated employee". In this case, for example, most of the disallowed expenses over the three years under appeal represent remuneration paid to Ms. Shkwarok for administrative services. That expense was disallowed only because the Crown considered Dynamic to be carrying on a personal services business. There is no allegation that Ms. Shkwarok did not perform administrative services for Dynamic, or that her remuneration for those services was unreasonable. 48 Nothing in the Income Tax Act provides offsetting relief to the application of paragraph 18(1)(p). Thus, for example, Ms. Shkwarok would have been taxed on the remuneration she received from Dynamic, even though Dynamic was not permitted to deduct it. Applying the Law to The Facts 49 It is agreed that paragraph 18(1)(p) of the Income Tax Act applies in this case only if Dynamic carried on a "personal services business", as defined in subsection125(7) of the Income Tax Act, during the years under appeal. Dynamic will have met that definition during any period in which Mr. Martindale (who the Crown say is the "incorporated employee" of Dynamic), would reasonably be regarded as an employee of SIIL, but for the existence of Dynamic. This hypothetical question arises from the words between paragraphs (b) and (c) of the definition of "personal services business", in what legislative drafters have been known to call the "mid-amble" 50 This case requires consideration of Wiebe Door Services Ltd. v. Minister of National Revenue, [1986] 3 F.C. 553, [1986] 2 C.T.C. 200, 87 D.T.C. 5025 (Fed. C.A.) and 671122 Ontario Ltd. v. Sagaz Industries Canada Inc., [2001] 2 S.C.R. 983 (S.C.C.), the leading cases in which the central question is whether an individual is providing services to another person as an employee, or as a person in business on his or her own account. I refer to this as the "Sagaz question" (Sagaz, paragraph 47). The factors to be taken into account in determining the Sagaz question will depend upon the particular case, but normally they will include the level of control the employer has over the worker's activities, whether the worker provides his or her own equipment, whether the worker hires his or her own helpers, the degree of financial risk taken by the worker, the degree of responsibility for investment and management undertaken by the worker, and the worker's opportunity for profit in the performance of his or her tasks. 51 The Judge dealt with the Sagaz factors under three headings, "ownership of tools", "chance of profit and risk of loss", and "integration". Counsel for the appellant has taken issue with a number of the conclusions the Judge reached with respect to these specific factors, and has also submitted that the Judge failed to consider the control factor. 52 The position of the Crown with respect to these issues is that the determination of whether Dynamic carried on a "personal services business" is one of fact, not to be disturbed by this Court in the absence of a palpable and overriding error. I do not agree with this characterization of the issue. The evidence is substantially uncontradicted and the facts are undisputed. What is in issue is whether the Judge correctly applied the law to those facts. That is a question of mixed law and fact: Canada (Director of Investigation & Research) v. Southam Inc., [1997] 1 S.C.R. 748 (S.C.C.), at para. 35. Appellate intervention in such a case is justified if the application of the law to the facts discloses an error in principle: Housen v. Nikolaisen, [2002] 2 S.C.R. 235 (S.C.C.), at paragraph 37.

159 1. Ownership of tools 53 The Judge found that the "ownership of tools" factor favoured the position of the Crown because SIIL provided Mr. Martindale with office space, parking facilities, administrative facilities, and technical and maintenance services. The difficulty with this conclusion is that it is speculative. The record discloses no evidence to support this conclusion. 2. Chance of profit and risk of loss 54 The Judge concluded that the evidence relating to the chance of profit and risk of loss also supported the Crown's position. In reaching this conclusion, the Judge appeared to focus on the fact that Mr. Martindale did not stand to share in the profits or losses of SIIL. With respect, that misses the point. The "chance of profit and risk of loss" factor is intended to reveal whether the activities of Mr. Martindale entail the kind of risks that are more typical of those borne by a business enterprise than an employee. The business enterprise is not that of SIIL, but that of Mr. Martindale himself. To quote Sagaz (at paragraph 47), it is "the worker's opportunity for profit in the performance of his or her tasks". 55 Mr. Martindale was remunerated for the services he provided to SIIL on a basis that in certain respects resembled that of an hourly employee. The remuneration was based on an hourly rate, with higher rates for overtime, and additional amounts to cover certain direct costs of the work. Also, at one point Mr. Martindale received a gratuitous bonus. 56 On the other hand, the manner in which the remuneration in this case was determined is also consistent with the kind of cost-plus contract that is commonly used by a subcontractor carrying on a business like that of Mr. Martindale. As well, there are three significant aspects of Mr. Martindale's remuneration that were not typical of an employment relationship. First, Mr. Martindale was not compensated for the time spent on working on estimates for SIIL if the estimate did not result in a contract. Second, Mr. Martindale was not remunerated on a regular or timely basis, with the result that he was compelled to provide his own financing to compensate for the delays. Third, the costs of "warranty work" (work required to correct Mr. Martindale's errors) were required to be borne by Mr. Martindale, rather than SIIL. 57 On balance, the manner in which Mr. Martindale was remunerated point away from the existence of an employment relationship. I conclude that the Judge erred in finding the contrary. 3. Integration 58 The Judge found that Mr. Martindale's contribution to SIIL during the years under appeal made him an integral part of the operation of that corporation, and thus more like an employee rather than a person carrying on business on his own account. However, in reaching that conclusion, the Judge failed to consider the substantial body of evidence that the construction management business was carried on for a number of years before the years under appeal, and also afterward. 59 In the years under appeal, there was no change in the method in which the construction management business was conducted. In fact, the only thing that was unique about the years under appeal was that SIIL monopolized the services of Mr. Martindale because of the demands of their own contracts with Fording. In my view, the Judge was wrong to consider those years in isolation from the entire history of the business built up by Mr. Martindale, in which services were provided to numerous enterprises apart from SIIL.

160 60 From 1988 and into the early part of the 1990s, Mr. Martindale was seeking to avoid the limitations of being an ironworker employed solely through the union hall. He was developing the skills of an entrepreneur and a construction manager, which resulted in more and better opportunities for him than he could have achieved as an ironworker obtaining work through Local 97. This would suggest that if Dynamic did not exist, Mr. Martindale might have chosen, once he had learned the skills of project management in the early 1990s, to pursue various opportunities as a project manager through his own business, rather than as an employee of anyone. In that event, it would be reasonable to conclude that, during 1997, 1998 and 1999, the services he provided to SIIL would have been provided as an independent contractor, rather than an employee. 61 The fact that most favours the Crown's position is that during the years in question and in the two prior years, Mr. Martindale provided services only to SIIL. However, the monopolization of Mr. Martindale during that period did not arise because SIIL and Mr. Martindale were forging a relationship resembling that of employer and employee. Rather, it arose because SIIL was particularly successful during that period in obtaining work from Fording. There was no reason to believe that SIIL could reasonably expect that situation to continue, and in fact it did not continue after 1999. 4. Control 62 The Judge did not mention the factor of control, that is, the degree to which SIIL controlled Mr. Martindale's activities as construction manager. In the context of this case, this was a significant factor, and it should have been addressed. The evidence on this point favours the position of Mr. Martindale. It establishes that Mr. Martindale was substantially independent, and that SIIL exercised no meaningful control over his activities. Conclusion 63 Overall, the Judge failed to correctly apply all of the Sagaz factors to the facts in this case. It is my view, based on the considerations discussed above, that it would not be reasonable to conclude that, but for the existence of Dynamic, Mr. Martindale would have provided his services to SIIL as an employee in 1997, 1998 and 1999. 64 I would allow this appeal with costs in this Court and in the Tax Court. I would set aside the judgment of the Tax Court, and make an order referring this matter back to the Minister for reassessment on the basis that paragraph 18(1)(p) of the Income Tax Act does not apply to the appellant in 1997, 1998 or 1999. In Criterion Capital Corp., [2001] 4 C.T.C. 2844, the Tax Court held that a President/CEO of a company was an independent contractor for the additional services he provided outside the scope of his duties as President/CEO, therefore there was not a personal service business. In W.B. Pletch Co., [2006] 1 C.T.C. 2582, a personal service business was found as the owner was a senior executive who basically continued to provide management services to his former employer and this was his only client.

161

609309 Alberta Ltd., Appellant and Her Majesty the Queen, Respondent 2010

CarswellNat 681, 2010 TCC 166

APPEAL by taxpayer and numbered corporation from assessment by Minister of National Revenue, regarding business expenses. Patrick Boyle J.: 1 These appeals were heard together on common evidence. Mr. Nance and his former commonlaw spouse were the sole shareholders of the corporate appellant in the relevant years, 1998 and 1999. I. Issues 2 The issues in this case involve (i) whether 609309 Alberta Ltd. (609309) was a personal services business and Mr. Nance its incorporated employee under subsection 125(7) of the Income Tax Act (the Act); (ii) whether some of 609309's expenditures were properly disallowed because of the personal services business restrictions in paragraph 18(1)(p), because they were not laid out to earn income as required by paragraph 18(1)(a), because they were personal or living expenses described in paragraph 18(1)(h), or because they were unreasonable; (iii) whether Mr. Nance received an amount as a tax-free special worksite board and lodging allowance described in subsection 6(6); and (iv) whether management fees accrued by 609309 in 1999 were incurred as deductible business expenses and, if so, whether they were caught by the 180-day requirements of subsection 78(4). II. Facts 3 Mr. Nance is an experienced and successful ironworker. In his early years he was involved in a number of structural steel projects including high rises, bridges, oil sands plants and heavy machinery. He had worked in Alberta, Saskatchewan, British Columbia and Hawaii on significant projects. By the years in question he was largely involved in a supervisory role in construction management and through the 1990's had worked in this capacity on several major projects of Canada's large petroleum and chemical companies. 4 In 1993 and 1994 he was employed by Spantec Constructors Ltd. (Spantec), a Canadian industrial contractor, to work on the Genesee power plant west of Edmonton. In early 1994 Spantec decided to close its Calgary office. Spantec sent Mr. Nance a letter in April 1994 confirming it would no longer be providing him with full-time employment. The letter went on that Spantec intended to continue to have Mr. Nance working for it on an hourly basis and would also cover his associated employment expenses. The letter closes with a further reference to providing him with employment in the future. 5 Mr. Nance testified that he had a related conversation with the Spantec officer who signed the letter at about the same time in which he was told Spantec wanted to continue to use him on a contract basis.

162 6 Based upon the letter and the conversation, Mr. Nance testified that he decided it would make sense to work through a corporation. He then formed 609309 with himself and his then common-law spouse as equal shareholders and continued working as a contractor from there. 7 For contracts booked through 609309, Mr. Nance provided all of the revenue generating services to clients. His then common-law spouse attended to the necessary books, payroll, banking, liaising with accountants and running errands. 609309 did not have any other employees. 609309 provided the services of Mr. Nance for construction management as well as some building construction work. Mr. Nance did not do all of his work through the corporation and he continued to be employed directly when working through his union. 8 Mr. Nance and his spouse lived in Eckville. His spouse ran a hair salon in town. They also jointly owned three modest rental properties and a quarter section of land. 9 In November 1997, Spantec and 609309 entered into a contract titled Personal Services Contract which provided that 609309 would provide the personal services of Mr. Nance as Steel Superintendent to Spantec. The work was at the Nova Chemicals Cogeneration Plant in Joffre Alberta. Joffre is near the city of Red Deer which has a population of 90,000 and is Alberta's third largest city. According to the evidence of both sides, Joffre is less than an hour's drive from Eckville. Surprisingly, no one could or would tell me or agree on the driving distance and no one asked Mr. Nance either how far the Joffre worksite was from his home or how long it took him to drive even though he drove it regularly in the years in question. 10 The Personal Services Contract provided that 609309 would receive forty-four dollars per hour worked by Mr. Nance and there were no overtime rates. Spantec was obligated to provide professional liability insurance coverage as well as comprehensive general liability insurance coverage for the services of Mr. Nance provided by 609309. The contract included an express agreement by Spantec and 609309 that they were independent contractors and required that Mr. Nance be an employee of 609309. Under the terms of the Personal Services Contract Spantec provided a pickup truck for Mr. Nance's work and reimbursed all related fuel and maintenance charges. He was also allowed to use the pickup truck to drive to and from work whether he was staying at his Eckville home or at his summer trailer. 11 In November 1998, the 1997 Personal Services Contract was either replaced or extended with an unsigned one page Project/Agreement Contract because, in Mr. Nance's words, the prior purchase order ran out. This document provided that 609309 would provide Mr. Nance's supervisory services on the same project at the same hourly rates. This document provided that the billed hours were to match the crew hours and that additional hours to complete paperwork etc. was not to be billed. It also set the work hours as Monday to Thursday, 10 hours per day. It provided that expenses would be paid to Mr. Nance not 609309, and would be billed on Spantec's expense claim paper. It further provided that the living out allowance and expenses, or LOA, was also to be submitted on Spantec expense claim forms. It is clear from the evidence that Spantec's employee expense claim forms were used for these purposes by Mr. Nance and Spantec. 12 While neither agreement provided for the terms of the LOA, Mr. Nance received a seventy-fivedollar per day allowance directly from Spantec as a LOA. Mr. Spantec said he was only entitled to receive it for days worked, however as detailed below, I find that, and it is clear from the documentary evidence submitted by the Crown that, he put in signed Spantec employee expense claims and received LOAs for many more days than he worked. This is evidenced by the 609309 invoices to Spantec and corroborating daily timesheets submitted at the same time.

163 13 14 Neither Mr. Nance nor 609309 reported the LOA amounts for income tax purposes. I must begin by commenting on the quantity and quality of the appellants' evidence.

15 I received extremely little corroborating evidence to support Mr. Nance's testimony. Neither his former common-law spouse nor anyone from Spantec testified. There were no supporting documents of any kind entered to justify any of the expenses deducted as having been incurred nor confirming the property or services acquired. There was no evidence of any nature led by the appellants to explain, much less substantiate, the accrued management fees. There was no corroborating evidence of Mr. Nance's testimony that 609309 had other clients than Spantec during the period 1998 and 1999 and whether or not 609309 reported the income. I heard no evidence of what was done in the home office, no details of what Mr. Nance's supervisory services involved, or what the numerous motor vehicles other than the one provided by Spantec were used for. Similarly I did not hear any evidence if or how expenses for his Eckville home, such as cleaning services, utilities, and the home computer, were allocated to the home office. 16 Mr. Nance testified in a most general fashion. There is certainly nothing wrong with being a man of few words. However, I found Mr. Nance to be, at critical times, evasive and not forthcoming. Specifically, when he was challenged in cross-examination about his testimony that he really did not report to anyone conflicting greatly with his answers on discovery that he reported on a regular or daily basis to a named Project Manager, he retorted simply Well, everybody has to report to somebody. Another example was when in cross-examination he was asked about the express reference to employment with Spantec in its April 1994 letter to him and that it did not suggest the use of a consulting corporation but spoke of working on an hourly contract basis, he replied to the effect that I guess you can read it anyway you want. In the circumstances, absent clear corroborating uncontradicted written evidence, I cannot accept Mr. Nance's testimony alone on any of the issues in dispute as sufficient to discharge the onus on the appellants to satisfy me on a balance of probabilities. 17 Specifically, I find that the only client 609309 had in the period in question was Spantec. I accept the evidence put in by the respondent that substantially all of the reported revenues of 609309 were accounted for by amounts billed to and received from Spantec. Mr. Nance's evidence to the contrary was wishful. 18 I also find Mr. Nance's decision to establish 609309 and provide his services through it was neither at the request nor suggestion of Spantec. 19 Mr. Nance's testimony was most inconsistent as to when he worked and as to when he commuted daily to and from his Eckville home to Joffre or to and from his holiday trailer by the river during the summer months. Mr. Nance did not have a place to stay at the Joffre worksite where he was only provided a work cubicle and a pickup truck. He testified he could remember staying on occasion at a motel or hotel in Blackfalds near Joffre though I was not given a name of an establishment, a reason for the occasion, much less an invoice or credit card statement. The evidence is such that there was nowhere else for me to think Mr. Nance could have slept most every night but in his own bed in Eckville or in his summer trailer by the river. Specifically, I find that Mr. Nance did in fact commute daily from either his home or trailer to his worksite in Joffre and did not incur any board or lodging expenses in Joffre or thereabouts on all but the rarest occasions. I further find that Mr. Nance did not work at the Joffre worksite everyday including most weekends. I find he worked his contracted forty hours per week or thereabouts consistent with the written agreement, and the invoice and timesheet in evidence. I find that he nonetheless put in for and received a seventy-five-dollar daily LOA for each day of the year whether he worked it or not except for an approximately two-week

164 period over Christmas and New Years. I assume this reflected the understanding he and 609309 had with Spantec regarding the LOA . III. Personal Services Business 20 A personal services business is defined in subsection 125(7) of the Act and, in a case such as this, requires me to determine if, but for the existence of 609309, Mr. Nance would reasonably be regarded as an employee of Spantec. 21 The determination of whether an individual is an employee or independent contractor includes considerations of (i) the intent of the parties; (ii) control over the work; (iii) ownership of tools; (iv) chance of profit/risk of loss; and (v) the business integration, association or entrepreneur criteria. None of these considerations govern, and the relative weight and relevance of each will depend upon the facts of a particular case and the context of the issue involved. Leading authorities on this include 671122 Ontario Ltd. v. Sagaz Industries Canada Inc., 2001 SCC 59, [2001] 2 S.C.R. 983 (S.C.C.), in the Supreme Court of Canada, Wiebe Door Services Ltd. v. Minister of National Revenue (1986), 87 D.T.C. 5025 (Fed. C.A.), and Royal Winnipeg Ballet v. Minister of National Revenue, 2006 FCA 87, 2006 D.T.C. 6323 (Eng.) (F.C.A.), in the Federal Court of Appeal and Lang v. Minister of National Revenue, 2007 TCC 547, 2007 D.T.C. 1754 (T.C.C. [Employment Insurance]), in this Court. 22 Appellants' counsel relies strongly upon the intention of the parties in this case as evidenced by the terms of the Personal Services Contract entered into between 609309 and Spantec. He points out that several judgments of this Court have focused on the importance of this consideration since the Federal Court of Appeal's decision in Royal Winnipeg Ballet. 23 In the context of a personal services business determination, the intention of the parties is not a helpful or relevant test for at least three reasons. Firstly, the section is an anti-avoidance provision aimed at denying the reduced small business corporate tax rate and associated tax deferral to certain corporations' businesses. The sought-after reduced rate and tax deferral could not be achieved to begin with unless the parties intended an independent contractor relationship. The anti-avoidance nature of the personal services business restrictions are discussed at length by Sharlow J.A. in Dynamic Industries Ltd. v. R., 2005 FCA 211, 2005 D.T.C. 5293 (F.C.A.). Since the service provider in a personal services business is by definition a corporation, there is no employment alternative. Thirdly, the wording of subsection 125(7) definition requires a court to ignore the actual relationship and reasonably guess what the parties would have done had they done otherwise. Both of these considerations cause me to conclude that a subsection 125(7) personal services business determination is quite different from the ordinary Employment Insurance, Canada Pension Plan and income tax determination of whether the known, real and actual relationship between a worker and a payor constitutes employment or an independent contractor relationship. In this regard, I agree with the V.A. Miller J. when she said in 1166787 Ontario Ltd. v. R., 2008 TCC 93, 2008 D.T.C. 2722 (T.C.C. [General Procedure]), that she did not think intent is a relevant consideration in a case involving a personal services business determination under subsection 125(7). I also note that McArthur J. did not consider the parties' intentions in making his personal services business determination in 758997 Alberta Ltd. v. R., 2004 TCC 755, 2004 D.T.C. 3669 (T.C.C. [General Procedure]), against the taxpayer in a case involving an industrial piping designer and drafter working at the same Nova Chemicals Cogeneration site in Joffre. The Federal Court of Appeal in Dynamic Industries did not consider the parties' intentions in making its personal services business determination. 24 In any event, there is little helpful evidence in this case to assist me in determining what Spantec and Mr. Nance would have intended had they decided to contract directly. Mr. Nance's testimony was

165 that he believed Spantec wanted to deal with a corporation not with him directly. No one from Spantec testified. The Personal Services Contract makes it clear that Spantec required Mr. Nance to be an employee of 609309; it would not be acceptable to Spantec for Mr. Nance to be an independent contractor of 609309, he had to be an employee. I can infer that each of Spantec and 609309 intended the relationship between them to be an independent contractor relationship but than there was little alternative since a corporation cannot be an employee. Both prior to the years in question and after the years in question, Spantec obtained Mr. Nance's services directly as an employee for similar supervisory construction management work. There may well have been real business considerations for Spantec requiring Mr. Nance to be an employee of 609309 if not an employee of theirs in order to ensure appropriate workers' compensation was obtained and was paid for only once and by the appropriate party, that Spantec's insurance for general liability as well as professional liability extended to Mr. Nance as an unnamed insured, and similar reasons. In the face of the ambiguous direction in which what little helpful evidence I have of intention in this case leads, I conclude that the parties' intentions are not helpful in making a determination one way or the other in this case. 25 With respect to the ownership of tools, 609309 provided the laptop used by Mr. Nance in his work and Spantec provided the pickup truck and workspace. No other tools were needed. I note Mr. Nance used the Spantec provided truck for driving to and from work. This consideration does not lead me in one direction over the other and is therefore not particularly helpful in this case. 26 The opportunity for profit of Mr. Nance and 609309 was limited to forty-four dollars per hour worked by Mr. Nance plus the additional seventy-five-dollar daily LOA. All related expenses, including insurance, were borne by Spantec except for workers' compensation. The only risk of loss to Mr. Nance and 609309 was getting caught up in a potential insolvency of Spantec or its client Nova Chemicals, neither of which were possibilities according to the evidence. 27 With respect to control, I must find that the extent of control that Spantec had and needed over the services provided by Mr. Nance were such that a proper characterization of his services, had he contracted directly with Spantec, would have been one of employment. There is a significant degree of control evidenced by what documents were in evidence. However, I make this finding primarily based upon Mr. Nance's entirely inconsistent testimony on this very issue at trial compared with his answers under oath on discovery. 28 It is inconceivable that even Spantec's most senior representative on the site would not be reporting regularly, directly or indirectly, to an overall project overseer. The structural steel work is but one component of a working cogeneration plant. I infer from Mr. Nance's nonsensical denial of his earlier answer on discovery that, if truth were told, the degree of reporting required was, at least in Mr. Nance's mind, sufficient to cause him at the very least a significant risk of being an employee. 29 Overall, it is simply hard to see how a worker on these contracted financial terms with Spantec could be said to be truly in business for himself. 30 I am not satisfied on the evidence put forward that it is more likely than not that, had Mr. Nance and Spantec contracted directly for his services, the contract would have been such as to characterize Mr. Nance as an independent contractor of Spantec. Thus, the reassessments do not have to be amended to characterize the business of 609309 as other than a personal services business. IV. Disallowed Expenses

166 31 I am not satisfied that any of the disallowed expenses should be allowed. The allowable expenses of a personal services business are subject to the restrictions of paragraph 18(1)(p) and, as discussed by the Federal Court of Appeal in Dynamic Industries, this can result in otherwise deductible business expenses not being deductible at the corporate level notwithstanding that the denied deduction may also be included in a shareholder's income. 32 In any event, the evidence in this case is insufficient to satisfy me on a balance of probabilities that the expenses claimed were actually incurred by 609309 and related to its business. There was a lack of documentary evidence and a complete absence of explanatory testimony. Mr. Nance's testimony is that he honestly did not know how the business expenses were compiled. 33 Appellants' counsel relies on the fact that most of the amount of expenses in question was added to Mr. Nance's income as a shareholder benefit. In his submission only one-half should have been so included since Mr. Nance's former common-law spouse was also a fifty-percent shareholder. I do not have sufficient credible evidence to allow me to conclude that it is likely that the expenses benefited Mr. Nance's former spouse as much as they benefited him or that it is incorrect to have otherwise allocated all of the benefit to him. 34 Appellants' counsel also points out that all of the disallowed expenses reflected as shareholder benefit amounts could have been payable by 609309 to Mr. Nance as additional remuneration and employee benefits and therefore deductible under the restrictive personal services business provisions of paragraph 18(1)(p). He refers to 758997 Alberta in support of such an outcome. I do not need to even consider the approach taken by McArthur J. in that case since it is clear that, while he was dealing with a somewhat similar personal services business arrangement, the quality of the oral and evidentiary record for him was markedly different. I should add that it is not clear to me that a proper consideration of the Federal Court of Appeal's comments in Dynamic Industries would allow me to follow the result in the earlier 758997 Alberta decision in any event. V. LOA/Special Worksite 35 The LOA amounts received by Mr. Nance directly from Spantec are not eligible for the subsection 6(6) tax-free treatment of reasonable board and lodging allowance and benefits at special worksites or remote worksites. 36 Subsection 6(6) only applies to an allowance received by an employee. Mr. Nance was not an employee of Spantec; he was an employee of 609309. Spantec paid the LOA directly to Mr. Nance. Neither 609309 nor Mr. Nance accounted for the LOA for bookkeeping, accounting, tax or other purposes. It is not clear that subsection 6(6) could apply to the LOA paid by Spantec to Mr. Nance. 37 Subsection 6(6) requires that a qualifying allowance be in respect of expenses the taxpayer has incurred for board and lodging at the special worksite and that it be reasonable. In this case Mr. Nance was sleeping in his own bed almost every night. He did not use the LOA amounts for board and lodging at or near the worksite. Also, he was paid the LOA for days he neither worked at the Joffre site nor stayed there or nearby. This went well beyond a checkout allowance for those weekends where an employee returns home occasionally for family or other personal reasons when not working. Neither of the two requirements is met. 38 A special worksite must be such as the taxpayer could not reasonably be expected to have returned home daily because of the distance. In this case, Mr. Nance did return home almost daily, not on occasion for family or other reasons. This requirement therefore is not met.

167 39 Subsection 6(6) only applies if the taxpayer was required by his duties to be away from home or at a special worksite or remote location for 36 hours or longer. In this case, Mr. Nance worked tenhour shifts at a site less than an hour's drive from his home. It cannot be said that this required him to be away 36 hours. 40 I have great difficulty seeing that a fifty-four-minute drive over public roads through the city of Red Deer or its outskirts could be sufficiently distant to meet either of these last two requirements. VI. Management Fees 41 The evidence with respect to the disallowed management fees deducted by 609309 is no better than the evidence with respect to its other disallowed expenses. I have no evidence that it was in fact ever payable or paid, to whom it was paid, or what if any services were provided. There was no agreement, invoice, cancelled cheque or anything else. Mr. Nance's testimony was that he was only made aware of the issue in the last few days and does not know to whom it was paid. The evidence is not sufficient to satisfy me on a balance of probabilities that the expense was incurred for purposes of 609309's business. 42 I can add that since the business of 609309 was a personal services business, it would not be deductible under paragraph 18(1)(p) unless it was remuneration paid to Mr. Nance. In that case, there is no evidence that it was in fact paid within the 180-day period mandated by subsection 78(4). 43 The taxpayers' appeals are dismissed. The Crown is entitled to costs in each appeal in accordance with the Tariff. Since the hearing of the appeals was joined on common evidence, there will be only one set of costs for the hearing date. Since the hearing went past 6:00 p.m. in the evening at the request of the parties and with the gracious consent of Court staff, costs for the hearing shall be computed as if it were a hearing of one and a half days. Appeal dismissed.

Professional Incorporation
Canadian Tax Highlights, Canadian Tax Foundation, Volume 14, Number 5, May 2006 A CRA 2005 opinion letter (2005-0156741E5, issued January 30, 2006) considers whether, in the context of incorporating a professional practice, a professional corporation carries on a personal services business (PSB) if it and the professional are prohibited from competing with the corporation to which the professional services are provided. In a 2004 advance tax ruling (2004-0084311R3), a professional service partnership transfers its business to a corporation (Newco); the former partners provide services to Newco directly as employees or independent contractors or through professional corporations formed by them. Compensation paid to independent contractors and professional corporations is negotiated case by case and evidenced by a written contract. Newcos net income is expected to be less than the business limit; any amounts exceeding the limit are likely to be distributed by Newco as fees, bonuses, or similar payments. On the facts, the former partners and the professional corporations are not prohibited from competing with Newco, provided that they fully discharge their contractual obligations with Newco. The CRA ruled that the professional corporations did not carry on a PSB.

168 After the 2004 ruling was issued, the CRA was asked in a separate letter to opine on similar facts, except that the former partners and the professional corporations were subject to certain competition restrictions. In such a case, was the professional corporation carrying on a PSB? In the 2005 opinion letter, the CRA responded that it could not conclude whether a PSB existed, but noted that whether a company carries on a PSB is a question of fact. One factor in the determination is whether the professional corporation and the incorporated employees are allowed to compete with Newco. The CRA commented that the existence of a non-competition agreement might indicate that the incorporated employee could be regarded as an officer or employee of Newco, and thus the professional corporation would be carrying on a PSB. The CRA also referred to RC4110Employee or Self-Employed?which discusses the factors to be considered when determining whether an individual is an employee or self-employed. The CRAs comments indicate that members of professional service partnerships who are considering incorporating their practices may want to forgo implementing non-competition agreements. The existence of such an agreement may imply that the professional corporation carries on a PSB. In that case, the corporations income will not qualify for the small business deduction and its shares will not qualify for the capital gains exemption for qualifying small business corporation shares.

2009-0315011E5 - Professional corporation's entitlement to the small business deduction

Date: May 27, 2009 Reference: 125(7), 256(2.1)

SUMMARY: Professional corporation's entitlement to the small business deduction -- ITA-125(7), 256(2.1) -- Tax implications where there is a restriction on a professional's right to compete and whether CRA would provide an advance income tax ruling. Please note that the following document, although believed to be correct at the time of issue, may not represent the current position of the CRA. Prenez note que ce document, bien qu'exact au moment mis, peut ne pas reprsenter la position actuelle de l'ARC. PRINCIPAL ISSUES: Tax implications where there is a restriction on a professional's right to compete and whether the CRA would provide an advance income tax ruling. POSITION: Terms or arrangements that bring into question the independent status of the professional could deny or restrict access to the SBD. The CRA is unable to provide assurances in an advance ruling where such conditions exist. REASONS: An evaluation could only be made on an after-the-fact basis. Re: Small Business Deduction We are writing in reply to your correspondence of March 23, 2009, with respect to a partnership reorganization under which a professional's right to provide professional services are restricted. You have asked for our views as to the potential tax implications to a professional corporation's ("PC") eligibility to claim a small business deduction ("SBD") where a restriction is placed on the professional's right to compete.

169 Our Comments: Professionals may provide their services through professional corporations, if provincial legislation and governing bodies permit this. In some cases, professionals that carry on business as partnerships may provide their professional services to the partnership as employees of their PC, which in turn are independent contractors to the partnership. The professionals, in the capacity as partners, would continue to provide non-professional services (i.e., promotional, administrative and other services) to the partnership. Under an alternative reorganization structure, the assets of the partnership may be acquired by a newly formed central corporation ("Newco"). Similarly, the professionals may provide their professional services as employees of the PC, which in turn are independent contractors to Newco. The CRA accepts that professionals can provide services through a PC and may access the small business deduction ("SBD"). We would not challenge the transactions simply because that result is obtained, however, it is important that the parties genuinely create and maintain the structure that meets the requirements of the Income Tax Act. A corporation that falls within the definition of a personal services business ("PSB") is not entitled to claim the SBD. A PC may be considered a PSB if the professional could reasonably be regarded as an officer or employee of the entity for whom the professional services are provided. The SBD may also be required to be shared among the PCs if they are carrying on business in partnership or if they are considered to be associated corporations under section 256. For example, two or more corporations are deemed to be associated under subsection 256(2.1) where it may reasonably be considered that one of the main reasons for the separate existence of those corporations in a taxation year is to reduce the amount of taxes that would otherwise be payable. We would therefore look to whether the arrangement is conducted on an arm's length basis in which the fees and services would be of a kind and amount that would be agreed to between a partnership or Newco and a professional who is not a partner or an employee. In other words, consideration is given to whether the PCs and the professionals are providing services as independent contractors and the reasons that may exist for providing the services through the PCs. The CRA is often requested to provide advanced income tax rulings with respect to such arrangements. Since the purpose of a ruling is to provide certainty of interpretation, the CRA would be unable to give assurance in an advance ruling where there are terms within the arrangements that bring into question the independent status of the professional. This is because where such conditions exist, that determination depends on the actual conduct of the parties and their future relationships, which can only be evaluated on an after-the-fact basis. The following are examples of some factors and conditions we would expect before providing an advance income tax ruling: * There are no restrictions (oral or otherwise) on the PC's or the professional's right to compete with the partnership, Newco or other PCs. * Fees are based on the value of professional services rendered. For example, there would be no inclusion of fringe benefits, vacation, sabbatical or large fixed fees (i.e., guaranteed amounts). * Fees earned and paid to the particular PC are not based on the success of collecting the revenue billed to the clients of the partnership or Newco in respect of the professional services provided by the PC.

170 * The professional is responsible for his or her own administrative services, library, and supplies. If the partnership or Newco were to provide such items to the professional, it would expect to be recompensed.

v. The Small Business Deduction Interpretation Bulletin IT-73R6 - The Small Business Deduction
March 25, 2002 (the information in this publication is still relevant as of January 2012) This bulletin deals with the rules concerning the small business deduction that may be claimed by a Canadian-controlled private corporation (CCPC) in respect of its income from carrying on an active business in Canada. The corporation must be a CCPC throughout the year to qualify for the small business deduction for that year. The special low rate of tax provided by the small business deduction recognizes the special financing difficulties and higher cost of capital faced by small businesses and is intended to provide these corporations with more after-tax income for reinvestment and expansion. As the small business deduction is intended to benefit only small corporations, a large corporation's access to the deduction is restricted on the basis of its taxable capital employed in Canada. This bulletin also discusses the impact of the small business deduction on the accelerated tax reduction for CCPCs and on any general tax reduction claimed by a CCPC. 5 The courts have found that, in interpreting the meaning of "pertains to" or "incident to" in context, there has to be a financial relationship of dependence of some substance between the property in question and the active business before the property is considered to be incident to or to pertain to the active business carried on by the corporation. In addition, the operations of the business have to have some reliance on the property such that the property is a back-up asset that could support the business operations either on a regular basis or from time to time. If, for example, a corporation carrying on an active business holds term deposits that are not used or connected to its business operations, the term deposits are not property that is incident to or pertains to an active business carried on by the corporation, nor are the term deposits used or held principally for the purpose of gaining or producing income from an active business by the corporation. Accordingly, a determination is required of whether the source of income (e.g., term deposits) is a separable activity, apart from the corporation's main business activities. The courts have held that when a corporation derived income from an activity that was inseparable from its normal active business, such income was properly classified as active business income. If the income is part of the normal business activity of the corporation, and it is inextricably linked with an active business, it is considered active business income. For example, in the 1981 case of Supreme Theatres Ltd. v. The Queen, [1981] C.T.C. 190, 81 D.T.C. 5136, it was held by the Federal Court Trial Division that rental income from hiring out the part of a building that was a motion picture theatre auditorium constituted active business income derived from the company's normal business activity of operating motion picture theatres, while the rental income from hiring out a portion of a parking lot was not. 6. As indicated in 4, for the purpose of the small business deduction, income from property does not include income "from any property that is incident to or pertains to an active business carried on by the corporation" or "from any property that is used or held principally for the purpose of gaining or producing income from an active business carried on by the corporation." Income from property that is

171 employed or risked in a corporation's business operations is considered to be active business income. This must be distinguished from income from property, which is not connected to or is not necessary to sustain a corporation's business operations. It is a question of fact whether a property is used principally in an active business. Factors to be considered in determining whether a property is used in an active business include the actual use to which the asset is put in the course of the business, the nature of the business involved and the practice in the particular industry. The issue of whether property was used or held by a corporation in the course of carrying on a business was considered by the Supreme Court of Canada in Ensite Limited v. Her Majesty the Queen, [1986] 2 C.T.C. 459, 86 D.T.C. 6521. The court held that the holding or using of property must be linked to some definite obligation or liability of the business and that a business purpose test for the use of the property was not sufficient. The property had to be employed and risked in the business to fulfill a requirement which had to be met in order to do business. In this context, risk means more than a remote risk. If the withdrawal of the property would have a decidedly destabilizing effect on the corporate operations, the property would generally be considered to be used in the course of carrying on a business. In other words, the property has to be an integral part of the financing of the business or necessary to the overall business operations in order for income from the property to be part of the "income of the corporation ... from an active business." For example, although a mortgage receivable is an asset whose existence may be relevant to the equity of a corporation, it is not generally an asset used in an active business because the funds tied up in the mortgage are not available for the active business use of a corporation. However, if the corporation could establish that the mortgages are employed and risked in the business such that the mortgages are inextricably tied to or vitally connected with the business, they could be considered to be used in an active business carried on by the corporation. 7. A corporation may derive income from holding property in Canada (e.g., income in the form of real estate rentals, interest, or royalties). If such income is received or receivable from an associated company and the amount is or may be deductible in determining the associated company's income from an active business carried on by it in Canada, then paragraph 129(6)(b) deems the income in the recipient's hands to be income from an active business carried on by it in Canada. If subsection 129(6) deems rental income to be active business income and capital cost allowance on the rented building was deducted in calculating active business income, any recapture of capital cost allowance on the disposition of the building would also be considered to be active business income. 8. If a corporation is incorporated to earn income by doing business, there is a general presumption that profits arising from its activities are derived from a business (or from separate businesses as discussed in the current version of IT-206 [IT-206R], Separate Businesses). Thus, from the time that the activities contemplated commence (see the current version of IT-364, Commencement of Business Operations) until they permanently cease, most corporations carry on or will have carried on one or more businesses. However, in some circumstances, a corporation's entire profits can be characterized as income from property, as might be the case where the corporation is formed for the sole purpose of holding shares of a second corporation or holding a property to be rented with limited landlord responsibilities. It is, of course, quite possible that a corporation will earn income from property as well as income from a business carried on, if such property income is not income from another separate business. Meaning of "Carried On in Canada" 10. Whether or not a particular business is carried on in whole or in part in Canada is a question of fact. However, as a general rule, a business that involves the sale or leasing of goods is usually

172 carried on in the country where the corporation is resident, unless the business (or a part of it) is conducted by a virtually autonomous branch operation outside Canada. When a corporation's business involves the rendering of services, that business is carried on in Canada only to the extent that services are rendered in Canada, necessitating an apportionment of net business income on a reasonable basis. Income derived from property, ancillary to the activities involved in carrying on a business, that is categorized as income from an active business may also have to be apportioned on a reasonable basis having regard to the place where the related business is carried on. Specified Investment Business 11. A "specified investment business" carried on by a corporation in a taxation year is defined in subsection 125(7) to be a business the principal purpose (see s 12 to 14) of which is to derive income from property. Such income includes interest, dividends, rentals from real estate (including subrentals) and royalties. Specifically excluded from the definition is any business carried on by a credit union or a business of leasing property other than real property. However, the business of the corporation will generally be considered to be an active business rather than a specified investment business when either: (a) the corporation employs in the business throughout the taxation year more than five full-time employees (see s15 to 17); or (b) an associated corporation, in the course of carrying on an active business, provides managerial, administrative, financial, maintenance or other similar services to the corporation in the year and it is reasonable to assume that the corporation would have required more than five full-time employees in its business if those services had not been provided. The exceptions in (a) and (b) above do not apply to a business carried on by a prescribed laboursponsored venture capital corporation where the principal purpose of the business is to derive income from property. Section 6701 of the Regulations contains the meaning of "prescribed labour-sponsored venture capital corporation" for the purposes of this rule in the definition of "specified investment business" in subsection 125(7). Investment activities of a corporation cannot constitute a "specified investment business" if such activities are not the main business of the corporation, or a separate business of the corporation (see the current version of IT-206 [IT-206R], Separate Businesses). 12. "Principal purpose" is not a defined term in the Act for the purposes of the definition of "specified investment business" in subsection 125(7), but it is considered to be the main or chief objective for which the business is carried on. 13. A corporation that operates a business may buy real property for the purpose of using the site in the future as a business premise. In the interim, if rental income is derived, such income would probably be considered to be active business income rather than income from a specified investment business. In such cases, it is presumed that the principal purpose test referred to in the definition of "specified investment business" in subsection 125(7) would not be met for as long as the corporation's principal purpose in owning the site is not to derive rental income from it. A corporation that operates a hotel is generally considered to be in the business of providing services and not in the business of renting real property. Accordingly, the business is normally considered to be an active business rather than a specified investment business. 14. The principal purpose of a corporation's business must be determined annually after all the facts relating to that business carried on by that corporation in that year have been considered and analyzed. Included in this evaluation should be such things as:

173 (a) the purpose for which the business was originally commenced; (b) the history and evolution of its operations, including changes in its mode of operation and purpose of existence; and (c) the manner in which the business is conducted. Personal Services Business 18. Pursuant to the definition of "personal services business" in subsection 125(7), a corporation is carrying on a "personal services business" in a taxation year if it is in the business of providing services and: (a) an individual who performs the services provided to another person or partnership (the entity) on behalf of the corporation (referred to as an "incorporated employee") would, if it were not for the existence of the corporation, reasonably be regarded as an officer or employee of the entity to which the services were provided; (b) the incorporated employee or any person related to the incorporated employee is a "specified shareholder" of the corporation (see below); (c) the corporation employs in the business in the year (subject to the comments in 15) fewer than six full-time employees (see s 15 to 17) including incorporated employees and other employees; and (d) the fee for the services is not received or receivable by the corporation from a corporation with which it was associated in the year. A personal services business does not qualify for the small business deduction and is therefore subject to tax at full corporate rates. In addition, paragraph 18(1)(p) limits the deductions permitted in computing a corporation's income for a taxation year from a personal services business. Subject to various deeming provisions in the definition of "specified shareholder" in subsection 248(1), a "specified shareholder" of a corporation in a taxation year is a taxpayer who owns directly or indirectly at any time in the year not less than 10% of the issued shares of any class of the capital stock of the corporation or of any other corporation that is related to the corporation. Specified Partnership Income 20. As noted in 2, one of the amounts that enters into the calculation of a corporation's small business deduction is its "specified partnership income" (if any) for the year. This term is defined in subsection 125(7). A corporation's specified partnership income is the aggregate of two components, which are identified as variables A and B. In general terms, variable A represents the corporation's eligible share of income from partnerships from active businesses carried on in Canada. More precisely, variable A is the total of separate amounts, each of which is an amount with respect to a particular partnership of which the corporation was a member in the year. With respect to each partnership, this amount is the lesser of two amounts: (i) The first amount is the total of separate amounts, each of which is an amount (if positive) with respect to a particular active business which the corporation carried on in Canada as a member of the partnership. With respect to each business, this amount is equal to the corporation's share of the income (if any) of the partnership from the business for the fiscal period (or fiscal periods) ending in the year plus any amount included in the corporation's income for the year from the business because of subsection 34.2(5) minus all amounts deducted at the partner level in computing the corporation's income for the year from the business (other than amounts deducted in computing the income of the partnership from the business).

174 (ii) The second amount with respect to each partnership is determined by dividing the corporation's share of all the amounts of income of the partnership from active businesses carried on in Canada for fiscal periods ending in the year by the total of all such amounts of income of the partnership for such fiscal periods, and multiplying the result by $200,000 [now $500,000] (or a proportionately smaller amount when the number of days in any such fiscal period is less than 365). The second component, variable B, of a corporation's specified partnership income is an additional amount to ensure that any losses of the corporation for the year from active businesses carried on by it in Canada are offset first against business income that is not eligible for the small business deduction before reducing the income that would otherwise qualify for the small business deduction. Variable B is the lesser of two amounts: (i) the total of all amounts each of which is the corporation's loss for the year from an active business carried on by it (other than as a member of a partnership) in Canada plus the corporation's "specified partnership loss" for the year (see 21); and (ii) the total of all amounts each of which is any positive amount for the year that results when amount (ii) for variable A above with respect to any partnership of which the corporation was a member in the year is subtracted from amount (i) for variable A with respect to that partnership. Variable B is relevant only if the corporation has both losses for the year from an active business carried on by it in Canada (whether as a member of a partnership or otherwise) and income for the year from an active business carried on by it in Canada as a member of a partnership. For purposes of determining whether a corporation has carried on an active business as a member of a partnership, as referred to in the subsection 125(7) definitions of "specified partnership income" and "specified partnership loss" (see 21), the following rules should be taken into consideration: the subsection 125(7) definition of "active business carried on by a corporation" (see 3); the subsection 125(7) definition of "income of the corporation for the year from an active business" (see s 4 to 6); the meaning, in subsection 129(4), of "income" or "loss" of a corporation for a taxation year from a source that is property (see s 4 to 6); and the subsection 125(7) definition of "specified investment business" (see s 11 to 15 and 17) and the exclusion of a business from that definition if there are more than five full-time employees throughout the year (as discussed in s 11, 15 and 17). A business carried on by a corporation as a member of a partnership is not a "specified investment business" if the partnership employs more than five full-time employees. In other words, the corporation's share of income from the business can be included in the calculation of its "specified partnership income". Specified Partnership Loss 21. If a corporation has a "specified partnership loss" for a taxation year, it is used in the calculations in s 2 and 20. The term "specified partnership loss" is defined in subsection 125(7). A corporation's specified partnership loss consists of the following: the corporation's share of all the losses from partnerships of which the corporation was a member in the year, for fiscal periods ending in the year, from active businesses carried on in Canada by the corporation as a partnership member; plus

175 the total of all amounts each of which is any positive amount with respect any particular business carried on by the corporation in Canada as a member of a partnership that results when the amounts deducted at the partner level in computing the corporation's income for the year from that particular business (other than any amount deducted in computing the income of a partnership) are reduced by the corporation's share of the income from that business for the fiscal period or periods ending in the year and by any amount included in the corporation's income for the year from that business because of subsection 34.2(5). Taxable Income Limit Paragraph 125(1)(b) 22. In computing the small business deduction of a CCPC, paragraph 125(1)(b) requires the determination of the corporation's taxable income for the taxation year in excess of the total of: 10/3 of the corporation's foreign tax credit deductible under subsection 126(1) for the year without reference to sections 123.3 and 123.4; 10/4 of the corporation's foreign tax credit deductible under subsection 126(2) for the year without reference to section 123.4; and any portion of the corporation's taxable income for the year that is exempt from tax under Part I because of an Act of Parliament. The amounts deducted from the corporation's taxable income represent income on which no Canadian income tax was paid because the income is exempt from tax or because of the foreign tax credit.

vi. Special Provisions

a. Qualified Small Business Shares Section 110.6 was introduced to individuals residing in Canada with a lifetime exemption from tax on qualifying net taxable capital gains. The exemption is $750,000 in capital gains or $375,000 taxable capital gains. The exemption applies to qualified small business corporation shares and to qualified farm and fishing property. Qualified small business corporation shares are described in subsection 110.6 in para. (a). The corporation must be a Canadian-controlled private corporation using substantially all of its assets in carrying on an active business in Canada (see the definition of "small business corporation" in ss. 248(1), and Canadian-controlled private corporation" in ss. 125(7)) and for the 2-year period preceding the disposition more than 50% of the corporation's assets were used in carrying on an active business in Canada. For both tests, shares or debt of other corporations that meet the test can qualify as such assets. Under para. (b) of the definition, shares must generally have been held by the taxpayer or a person related to the taxpayer for 2 years to qualify for the exemption. See para. 110.6(14)(f), which deems new treasury shares to have been held by an unrelated person (and thus not to qualify) unless certain conditions are met. An agreement to sell the shares to a public corporation or non-resident will not invalidate the shares' eligibility for the exemption (para. 110.6(14)(b)).

176 Where a corporation owns an interest in a limited partnership that carries on an active business in Canada, CRA will consider that the corporate partner uses its proportionate share of each asset of the partnership for purposes of this definition. The CRA takes the position that "all or substantially all," used in the opening words of para. (d), means 90% or more. b. Capital Gains Deferral - Eligible Small Business Investments

Section 44.1 provides a rollover on a disposition of common shares of certain small business corporations, to the extent that the proceeds are reinvested in shares of another such corporation or corporations. The apparent purpose of the provision is to provide small businesses with greater access to venture capital. The rollover is available in respect of "qualifying dispositions" made by individuals, other than trusts, after February 27, 2000 (paragraph 44.1(2)(a)). Where the conditions are satisfied the rollover applies automatically. A partial rollover is available if less than the full proceeds are reinvested in eligible investments. Only capital gains realized by individuals are eligible for the rollover an the shares must be held on capital account. There is no relief for shares that are held on ordinary income account by an individual who is considered a trader or dealer or whose holding constitutes an adventure or concern in the nature of trade within the definition of a "business" in subsection 248(1). For shares to qualify as Eligible Small Business Corporation shares (ESBCS), the following tests must be met: (1) The shares must be common shares, acquired from treasury or from certain related individuals. (2) At the time the shares are issued, the corporation must be an eligible small business corporation (ESBC)--that is, a Canadian-controlled private corporation, all or substantially all of the assets of which (measured by fair market value) are used in an active business carried on primarily in Canada, and/or shares or debt of other related ESBCs. (3) The total carrying value of the assets of the corporation and related corporations immediately before and immediately after the issuance of the shares must not exceed $50 million. Professional corporations, specified financial institutions, and real estate corporations are excluded, as is any corporation where real estate represents more than 50 percent of total asset value. Two further tests apply when the ESBCSs are sold: (1) The shares must have been owned by the individual for at least 185 days prior to the sale. (2) Throughout the time the individual owned the shares, the corporation must have been an active business corporation. To qualify as such, it must have continuously met the tests for an ESBC, with only two exceptions: it is not necessary that it remain private, and the requirement to carry on business primarily in Canada is lifted, in effect, after two years.

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III. Associated Corporations

1. Purpose of Rules
The small business deduction only applies to the first $500,000 of active business income. Obviously, without anti-avoidance legislation, the $500,000 limitation could easily be circumvented through the incorporation of a number of corporations with each one having a $500,000 active business income limit. That is to say, individual A could incorporate Corporation A, Corporation B, and Corporation C and, in the absence of specific legislation to the contrary, each corporation would be entitled to earn up to $500,000 of active business income eligible for the small business deduction. Mr. A would have succeeded in having $1,500,000 taxed at the low rate through the use of three corporate entities. The associated corporation rules in the Income Tax Act are designed to restrict the small business deduction to $500,000 for all corporations that are treated as being "associated" with each other. Subsection 125(2) sets the business limit of corporations that are associated as being nil, but ss. 125(3) provides that, notwithstanding ss. 125(2), associated corporations may allocate the $500,000 business limit amongst themselves in any manner they see fit as long as the total of the allocations for any given year does not exceed $500,000. If associated corporations fail to make the allocation, the Minister may do so in accordance with ss. 125(4). There are two ways by which corporations can be considered to be associated for purposes of the Income Tax Act. First, ss. 256(1) sets out a number of rules which determine when corporations will be considered to be associated based on the concept of control. That is to say, the rules in ss. 256(1) which consider a corporation to be associated with another corporation are all based on the concept of common control. Second, in addition to the rules in ss. 256(1), ss. 256(2.1) provides that two or more corporations will be deemed to be associated if it may reasonably be considered that one of the main reasons for their separate existence was primarily for tax avoidance purposes. The rules that treat corporations as being associated, whether by virtue of ss. 256(1) or ss. 256(2.1), are applicable for purposes of the whole Act. While the main purpose of the associated corporation rules is to prevent multiplication of the small business deduction, there are a number of other places in the statute where reference is made to associated corporations. For example, we have already seen that ss. 129(6) treats what would otherwise be investment income to a Canadian-controlled private corporation as being active business income if the amount is paid by an associated corporation and is deductible in calculating the payor's income from an active business.

2. Subsection 256(1)
A corporation will be associated with another corporation in a taxation year for purposes of the Act if, at any time in the year, (a) (b) (c) one of the corporations controlled, directly or indirectly in any manner whatever, the other, both of the corporations were controlled, directly or indirectly in any manner whatever, by the same person or group of persons, each of the corporations was controlled, directly or indirectly in any manner whatever, by a person and the person who so controlled one of the corporations was related to

178 the person who so controlled the other, and either of those persons owned, in respect of each corporation, not less than 25% of the issued shares of any class, other than a specified class, of the capital stock thereof, (d) one of the corporations was controlled, directly or indirectly in any manner whatever, by a person and that person was related to each member of a group of persons that so controlled the other corporation, and that person owned, in respect of the other corporation, not less than 25% of the issued shares of any class, other than a specified class, of the capital stock thereof, or each of the corporations was controlled, directly or indirectly in any manner whatever, by a related group and each of the members of one of the related groups was related to all of the members of the other related group, and one or more persons who were members of both related groups, either alone or together, owned, in respect of each corporation, not less than 25% of the issued shares of any class, other than a specified class, of the capital stock thereof.

(e)

The essential test under ss. 256(1) which determines association is the test of control. However, ss. 256(1) extends the concept of control to de facto control through use of the words "controlled, directly or indirectly in any manner whatever", which is defined in ss. 256(5.1). By virtue of ss. 256(5.1), in addition to control of a corporation existing by reason of the ability of the controlling party to elect a majority of the directors of the corporation, corporations will also be associated where control is exercised in any manner whatever, including circumstances where control in fact exists by reason of a person having any direct or indirect influence. Ss. 256(1.1) defines a class of shares to be a "specified class" for the purposes of ss. 256(1) if: (a) (b) (c) (d) the shares are neither convertible nor exchangeable, the shares are non-voting, dividends payable on the shares are fixed in amount or rate, the annual rate of the dividend on the shares, expressed as a percentage of the fair market value of the consideration for which the shares were issued, does not exceed the prescribed rate of interest at the time the shares were issued, and the amount that a holder of the shares is entitled to receive on their redemption, cancellation or acquisition by the corporation or by a person with whom the corporation does not deal at arm's-length does not exceed the fair market value of the consideration for which the shares were issued plus any unpaid dividends.

(e)

The purpose of this provision is to permit a person that controls a corporation to invest funds in another corporation controlled by a related person, such as a spouse or child, without associating both corporations provided that the investment in the other corporation takes the form of fixed-rate, non-voting, non-convertible preferred shares. S. 256(1.2) provides a series of special rules to be applied for the purposes of determining whether a corporation will be considered to be controlled for purposes of s. 256(1). These rules apply only for the purposes of s. 256(1) to (5) and not for other purposes of the Act.

179 (a) In determining whether a corporation is controlled by a group of persons, a group, in respect of that corporation, means any two or more persons each of whom owns shares of the capital stock of the corporation. There is no need for there to be any commonality of interest in order to form a group of persons for the purposes of s. 256(1). (S. 256(1.2)(a)), This means then that two large corporations could be associated if a common group out of happenstance owned over 50% of the voting shares of each. A corporation can be considered to be controlled by a person or a particular group of persons notwithstanding that the corporation is also controlled by another person or group of persons. This ensures that a corporation can be considered to be controlled at the same time by several persons or groups of persons. In addition, where a group of persons owns shares of the capital stock of a corporation, the fact that an individual member of the group owns, by himself, enough shares to control the corporation will not alter the fact that the group also controls the corporation. This is a legislative reversal of the decision in Southside Car Market Ltd. et al. v. The Queen, [1982] CTC 214 (F.C.T.D.), (para. 256(1.2)(b)). A person or group of persons will be treated as controlling a corporation where the person or group owns shares of any class representing more than 50 % of the fair market value of all of the issued and outstanding shares of the corporation, or owns common shares representing more than 50 % of the fair market value of all the issued and outstanding common shares of the corporation. For purposes of making this valuation, para. 256(1.2)(g) provides that voting rights of shares are to be disregarded in determining the fair market value of the shares (para. 256(1.2)(c)). A shareholder of a corporation that holds shares of another corporation is treated as owning such of those shares of the other corporation as is proportionate to the value of his holdings in the first corporation. Again, para. 256(1.2)(g) would provide that in determining that proportion, voting rights of shares are to be disregarded (para. 256(1.2)(d)). There is a similar "look-through" rule for shares that are property of a partnership. A member of a partnership that holds shares of a corporation is treated as owning such of those shares as is proportionate to his income interest in the partnership (para. 256(1.2)(e)). A similar look-through rule is provided where shares are held by a trust (para. 256(1.2) (f). For the purposes of the rules in ss. 256(1.2), a share of a corporation that is in financial difficulty (as described in paragraph (e) of the definition of "term preferred share" in ss. 248(1)) and a share of a specified class of shares are to be disregarded for purposes of making the fair market valuations required in ss. 256(1.2) (ss. 256(1.6)).

(b)

(c)

(d)

(e)

(f) (g)

Ss. 256(1.3) provides that shares of a corporation that are owned by a child who is under 18 years of age will be deemed to be owned by the child's parent for the purposes of determining if the corporation is associated with a corporation controlled, directly or indirectly in any manner whatever, by the parent or by a group of persons of which the parent is a member, unless it is reasonable to consider that the child manages the business and affairs of the corporation without a significant degree of influence by the parent.

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Ss. 256(2) provides that when two corporations are associated with a third corporation at the same time, they will be deemed to be associated with each other. The rule does not apply for purposes of the small business deduction in s. 125 where the third corporation does not claim the small business deduction either because it is not a CCPC or elects not to claim the deduction. This rule ensures that two corporations will not be considered to be associated for purposes of the small business deduction if they are associated with a corporation that, for example, is a non-resident and not entitled to the small business deduction. This overrules the decision in Holiday Luggage Mfg, Co. v. The Queen, [1987] 1 CTC 23 (F.C.T.D.). Control. The foundation of the rules set out in ss. 256(1) is the concept of "control". In each of paragraphs (a) to (e) of the associated corporation rules in ss. 256(1) the basis of the nexus between corporations is the concept of common control. "Controlled" is not defined for these purposes; accordingly, a body of jurisprudence has arisen as to the meaning of the concept of control of a corporation. In addition, paragraphs (a) to (e) employ the concept of direct or indirect control.

Association and Control

In general, one corporation is associated with another corporation if it meets one of the following six conditions at any time in the tax year. For the purpose of this provision controlled means directly or indirectly in any manner. Condition 1 The corporations are associated if one corporation controls the other. Example X Co. Limited owns 100% of the voting shares of Y Co. Limited. Y Co. Limited owns 51% of the voting shares of Z Co. Inc. X Co. Limited is associated with Y Co. Limited, because it has direct control of it. X Co. Limited is associated with Z Co. Inc., because it has indirect control of it. Condition 2 Two corporations are associated if both corporations are controlled by the same person or group of persons. Corporations may be associated because the same group of persons controls both corporations, even if the members of this group do not act together and have no other connection to each other. Example Rob owns 40% of the voting shares of ABC Company Ltd. and 30% of the voting shares of XYZ Limited. Mike owns 20% of the voting shares of ABC Company Ltd. and 40% of the voting shares of XYZ Limited.

181
As a group, Rob and Mike control both companies. ABC Company Ltd. and XYZ Limited are associated. Condition 3 The corporations are associated if: * each corporation is controlled by one person; * that person is related to the person controlling the other corporation; and * one of those persons owns at least 25% of the issued shares of any class, other than shares of a specified class, of the capital stock of each corporation. Example AB Co. owns 100% of the issued share capital of CD Co. It also owns 25% of the Class A shares (other than shares of a specified class) of XY Co, whose controlling shareholder is Willy. Willy's brother Fred controls AB Co. AB Co., CD Co., and XY Co. are associated. Condition 4 The corporations are associated if: * one corporation is controlled by one person; * that person is related to each member of a group of persons who controls the other corporation; and * that person owns at least 25% of the issued shares of any class, other than shares of a specified class, of the capital stock of the other corporation. Example Sally controls AY Limited. Her two daughters control AZ Inc. Sally also owns 50% of the Class A preferred shares of AZ Inc. AY Limited and AZ Inc. are associated. Condition 5 The corporations are associated if: * each corporation is controlled by a related group; * each of the members of one of the related groups is related to all members of the other related group; and * one or more persons who are members of both related groups, either alone or together, own at least 25% of the issued shares of any class, other than shares of a specified class, of the capital stock of each corporation. Example Ron and his two daughters control A Co. Sally and her two daughters control B Co. Ron owns 33% of the common shares in each corporation.

182
A Co. and B Co. are associated. Condition 6 Two corporations that are not associated with each other will be considered associated under subsection 256 (2) if they are associated with the same corporation (the third corporation). See Schedule 28, Election not to be an Associated Corporation.

Interpretation Bulletin IT-64R4 - Corporations: Association and Control

August 14, 2001 (This bulletin is still of relevance as of January 2012) Summary This bulletin discusses provisions in the Income Tax Act that contain rules with respect to the association of corporations (the "association rules"). There are a number of provisions in the Act for which the association rules are relevant (e.g., those pertaining to the small business deduction); however, a discussion of such provisions is outside the scope of this bulletin. Section 256 contains the association rules. Subsections 256(1) and (2) provide the general rules with respect to whether one corporation is associated with another. Subsections 256(3), (4), (5) and (6) provide for certain exceptional circumstances under which the association of one corporation with another does not occur. The essential test in determining whether a corporation is associated with another relies on the control of the corporation that is exercised "directly or indirectly in any manner whatever." This expression encompasses: de jure control (i.e., control in law), the meaning of which has been determined by case law; and de facto control (i.e., control in fact), as determined under subsection 256(5.1). There are a number of additional rules in section 256, including rules which: provide or extend the meaning of certain terms and concepts, such as a "group of persons" and "control by a group of persons"; can result in deemed control by means of a fair market value test; can result in deemed ownership of shares by means of "look-through" rules; can deem the shares of a child under 18 to be owned by the child's parent; can result in deemed ownership of shares or control by means of options or rights; and allow for simultaneous control by two or more persons or groups of persons. Any statement in this bulletin with respect to the question of whether corporations are associated with each other, or with respect to any rule that relates to that question, should implicitly be taken as meaning that such question or rule is being considered at a particular point in time, unless otherwise stated. Discussion and Interpretation Some Basic Rules

183 Control of One Corporation by Another Corporation Paragraph 256(1)(a) 1. Under paragraph 256(1)(a), two corporations are associated with each other if one of them is controlled, directly or indirectly in any manner whatever, by the other. (For a discussion of the meaning of "controlled" and the meaning of "controlled, directly or indirectly in any manner whatever," see s 13 to 18 and s 19 to 23, respectively.) Control of Two Corporations by Same Person or Group of Persons Paragraph 256(1)(b) 2. Under paragraph 256(1)(b), two corporations are associated with each other if they are both controlled, directly or indirectly in any manner whatever, by the same person or group of persons. (The meaning of "group of persons" is discussed in 24.) Anti-Avoidance Provision Subsection 256(2.1) 3. Subsection 256(2.1) contains an anti-avoidance rule which deems two or more corporations to be associated with each other if one of the main reasons for the separate existence of those corporations is to reduce the amount of income taxes otherwise payable (or to increase the amount of refundable investment tax credits available under section 127.1). Subsection 256(2.1) could apply, for example, where two parts of what could reasonably be considered to be one business, such as the manufacturing and sales activities of a single business, are carried on by two corporations each of which is controlled by different persons. In such a case, if it is reasonable to conclude that the separate existence of the corporations is mainly tax-motivated, the corporations will be deemed to be associated with each other. Bankrupt Corporation Not Associated Paragraph 128(1)(f) 4. Paragraph 128(1)(f) deems a corporation not to be associated with any other corporation in a taxation year ending in the period when it is bankrupt. Corporations Can Be Related but Not Associated 5. Two corporations can be "related persons" as defined in subsection 251(2) and still not be associated with each other under subsection 256(1). As an example, if 65 per cent of the voting shares of Corporation A are owned by Mr. A and 60 per cent of the voting shares of Corporation B are owned by his brother, Mr. B, the corporations are "related persons" pursuant to subparagraph 251(2) (c)(ii); however, the two corporations would not be associated with each other unless the crossownership test in paragraph 256(1)(c), as discussed in 27, were met. Dealings Between Corporations Not Required for Association 6. Two corporations may be associated with each other even if those corporations and their shareholders do not have any dealings with each other. Association depends solely upon the fulfillment of the control and share ownership requirements set out in subsection 256(1). Corporations With Different Taxation Years 7. If two corporations have taxation years ending at different times in the calendar year, such corporations are not associated with each other in a particular taxation year unless, on some day which is within that particular taxation year for each of them, they are associated with each other. For example, assume that Corporation A and Corporation B have year-ends of March 31 and September 30, respectively. If, on July 31, 2000, Corporation A acquires all the issued common shares of Corporation B, the two corporations would not be associated with each other in their respective 2000

184 taxation years. This is the case because the date when they first became associated with each other, although within the 2000 taxation year of Corporation B (assuming it retains its September 30 yearend after the acquisition of control), is not within the 2000 taxation year of Corporation A. If, however, the date when Corporation A acquired the shares of Corporation B was February 28, 2000, the two corporations would be associated with each other in their respective 2000 taxation years since that date is within the 2000 taxation year of each of them. Two Corporations Associated With the Same Corporation Subsection 256(2) 8. If two otherwise unassociated corporations are associated with the same third corporation, subsection 256(2) deems the two corporations to be associated with each other. (There are exceptions -- where subsection 256(2) will not apply for the purposes of the small business deduction. For further particulars, see subsection 256(2).) Exceptions Situations Involving an Indebtedness or Redeemable Shares Where Association Is Deemed Not to Occur -- Subsection 256(3) 9. Subsection 256(3) provides an exception, in particular circumstances, to the general rules that two corporations will be associated with each other when: one corporation controls, directly or indirectly in any manner whatever, the other corporation (see 1); or the two corporations are controlled, directly or indirectly in any manner whatever, by the same person (see 2). Pursuant to subsection 256(3), the two corporations will be deemed not to be associated with each other when such control exists for the purpose of safeguarding the rights or interests of the corporation that controls the other corporation or the person who controls the two corporations (referred to in this paragraph as the "controller") in respect of: (a) any indebtedness owing to the controller; or (b) any redeemable shares owned by the controller in the controlled corporation (in this paragraph and in 12, "redeemable shares" means shares to be redeemed by the controlled corporation or shares to be purchased by a person or group of persons with whom the controller deals at arm's length). There must also be an enforceable agreement in place providing that control will pass, upon the occurrence of an event that is likely to occur, to a person or group with whom the controller was dealing at arm's length. An example of a situation where subsection 256(3) applies might be one involving a manufacturing corporation that has financed a dealer corporation and has retained control, directly or indirectly in any manner whatever, of that dealer corporation, until the manufacturing corporation has recovered its advances. Another example might be where a corporation lends money to another corporation or to a chief shareholder thereof and holds control, directly or indirectly in any manner whatever, of the corporation as security. Two Corporations Controlled by Same Executor, Liquidator of a Succession or Trustee -- Subsection 256(4) 10. Subsection 256(4) ensures that when two or more corporations, not previously associated with each other, have come under the control of the same executor, liquidator of a succession or trustee (either a corporation or an individual) through the deaths of their respective controlling shareholders, the corporations will not, for that reason alone, become associated with each other. This relieving

185 provision does not apply if the executor, liquidator or trustee acquired control of the corporations as a result of one or more estates or trusts created by the same individual or two or more individuals not dealing with each other at arm's length. Corporation Controlled by Corporate Trustee Subsection 256(5) 11. Subsection 256(5) provides that, if one corporation acting as a trustee controls another corporation through a trust, the two corporations are deemed not to be associated with each other. This does not apply if a settlor of the trust controls or is a member of a related group that controls the corporation that is the trustee. (The term "related group" is defined in subsection 251(4) see 27.) Situations Involving an Indebtedness or Redeemable Shares Where Control Is Deemed Not to Occur Subsection 256(6) 12. As is the case with subsection 256(3) (see 9), subsection 256(6) deals with certain situations involving an indebtedness or redeemable shares. The rules in subsection 256(6) are similar to the rules in subsection 256(3), except that the controlled corporation is deemed not to be controlled by the person or partnership which controls, directly or indirectly in any manner whatever, the corporation (referred to in this paragraph as "the controller") rather than deemed not to be associated (as is the case in subsection 256(3)) with the controller. Subsection 256(6) could apply, for example, where a manufacturing corporation establishes a dealership in another corporation and, under the terms of the financing arrangement, the operator or dealer will not acquire active control of the dealership corporation until certain financial obligations to the manufacturing corporation are met. In these circumstances, and assuming that the other requirements of subsection 256(6) are met, this subsection deems the dealership corporation not to be controlled by the manufacturing corporation, which results in the corporations not being associated with each other by reason of the arrangement. Group of Persons Definition -- Paragraph 256(1.2)(a) 24. By virtue of paragraph 256(1.2)(a), the expression "group of persons" used in subsection 256(1) refers to any two or more persons each of whom owns shares of the capital stock of the corporation. Once it is established that a group of persons owns a majority of the voting shares of a corporation (even though one person in the group may alone control the corporation as discussed in 26) and that the same group also owns a majority of the voting shares of a second corporation, that fact is sufficient to make the two corporations associated with each other. This is the case whether or not other combinations of shareholders also could own a majority of voting shares in either corporation (see the Supreme Court of Canada's decision in Vina-Rug (Canada) Limited v. MNR, 68 D.T.C. 5021, [1968] C.T.C. 1). Therefore, for the purposes of applying the provisions of subsection 256(1), any two or more persons, related or unrelated, may be identified as a group of persons, without considering whether the members of the group act in concert to control the corporation. Application of Paragraph 256(1.2)(a) 25. The existence of de facto control under subsection 256(5.1), as discussed in s 19-23, does not require that the controller own any shares in the corporation being considered. Therefore, the definition of "group of persons" in paragraph 256(1.2)(a) is restricted in its application to subsections 256(1) to (5) and does not apply for the purposes of subsection 256(5.1). Simultaneous Control of a Corporation Paragraph 256(1.2)(b)

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26. Paragraph 256(1.2)(b) provides that a corporation can be considered to be controlled by a person or particular group of persons notwithstanding that the corporation is also controlled or deemed to be controlled by another person or group of persons. Thus, if Mr. X controls a corporation de jure and Mr. Y controls the same corporation de facto, the corporation is considered, by virtue of paragraph 256(1.2)(b), to be controlled by each of Mr. X and Mr. Y. Paragraph 256(1.2)(b) also provides that if a group of persons owns shares of the capital stock of a corporation, the fact that an individual member of the group, alone, owns enough shares to control the corporation will not alter the fact that the group also controls the corporation. Example

Mr. A 49% 51% 49%

Mr. B

51%

Corporation A

Corporation B

Mr. A and Mr. B constitute a group that controls both Corporation A and Corporation B by virtue of paragraph 256(1.2)(b), even though each corporation is also controlled by one person. Therefore, the corporations are associated with each other under paragraph 256(1)(b) because they are controlled by the same group of persons. Control of Two Corporations by Related Persons or Related Groups of Persons Paragraphs 256(1)(c), (d) and (e) 27. Paragraphs 256(1)(c), (d), and (e) contain rules that cause corporations to be associated with each other if they are controlled, directly or indirectly in any manner whatever, by related persons or related groups of persons and certain cross-ownership tests are met. For the meaning of "related persons", see subsection 251(2). The term "related group" is defined in subsection 251(4) to mean a group of persons each member of which is related to every other member of the group. Two corporations are associated with each other under paragraph 256(1)(c) if the following conditions exist: Each corporation is controlled, directly or indirectly in any manner whatever, by a person. The person controlling one of the corporations is related to the person controlling the other corporation. Either of those two persons owns at least 25 per cent of the issued shares of any class -- other than a "specified class" (this term is discussed immediately after the final example in this paragraph) -- of the capital stock of each corporation.

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Example

Mr. X 25% 100%

Mr. Y (Mr. Xs brother)

75%

Corporation X

Corporation Y

Paragraph 256(1)(d) provides a rule that is similar to the above-mentioned rule under paragraph 256(1)(c). Under paragraph 256(1)(d), two corporations are associated with each other if the following conditions exist: One of the corporations is controlled, directly or indirectly in any manner whatever, by a person. That person: is related to each member of a group of persons which controls, directly or indirectly in any manner whatever, the other corporation; and owns at least 25 per cent of the issued shares of any class other than a "specified class" (discussed below after the final example)-of the capital stock of that other corporation. Example

Mr. X

Mr. Y (Xs brother) 25%

Mrs. Z (Xs sister) 25% 25%

Mrs. X (Xs Spouse) 25%

100%

Corporation X

Corporation Y

Paragraph 256(1)(e) provides another similar rule to those discussed above. Under paragraph 256(1) (e), two corporations are associated with each other if the following conditions exist: Each corporation is controlled, directly or indirectly in any manner whatever, by a related group. Each member of one related group is related to all the members of the other related group.

188 One or more persons who are members of both related groups own, in total, at least 25 per cent of the issued shares of any class-other than a "specified class" (discussed below after the example) -- of the capital stock of each corporation.

Example

Mrs. X (Xs Spouse) 50%

Mr. X 50% 25%

Mr. Y (Xs brother) 25%

Mrs. Z (Xs sister) 50%

Corporation X

Corporation Y

Shares of a "specified class" as discussed above are defined in subsection 256(1.1) and must have all the following characteristics: (a) The shares are not convertible or exchangeable. (b) The shares are non-voting. (c) The dividends are calculated as a fixed amount or by reference to a fixed percentage of the fair market value of the consideration for which the shares were issued. (d) The annual dividend rate cannot in any event exceed the following: (i) where the shares were issued after 1983, the prescribed rate of interest at the time the shares were issued; and (ii) where the shares were issued before 1984, the rate of interest prescribed for the purposes of subsection 161(1) at the time the shares were issued. (e) The shares cannot be redeemed, cancelled or acquired for more than the fair market value of the consideration for which the shares were issued plus any unpaid dividends on such shares. The dividends on shares of a specified class need not be cumulative. Furthermore, if the dividends are cumulative, the fact that the shareholders forfeit their entitlement to a particular dividend e.g., because of corporate law constraints or because of insufficient profits or cash flow will not prevent the shares from qualifying as a specified class of shares. Since a share that is issued as a stock dividend is issued for no consideration, it cannot qualify as a share of a specified class because it cannot satisfy characteristic (e) above.

189 Additional Rules That Can Determine Ownership of Shares, or Control, of a Corporation Deemed Control by the Fair Market Value Test Paragraph 256(1.2)(c) 28. For the purposes of the association rules in subsections 256(1) to (5), paragraph 256(1.2)(c) deems a person or group of persons to control a corporation where the person or group: (a) owns shares representing more than 50 per cent of the fair market value of all the issued and outstanding shares of the capital stock of a corporation; or (b) owns common shares representing more than 50 per cent of the fair market value of all the issued and outstanding common shares of the capital stock of the corporation. For purposes of making this valuation, paragraph 256(1.2)(g) provides that voting rights shall be ignored. As well, subsection 256(1.6) provides that shares described (and during the applicable time referred to) in paragraph (e) of the definition of "term preferred shares" in subsection 248(1), and shares of a "specified class" as defined in subsection 256(1.1) (see 27), shall be disregarded. Deemed Ownership of Shares by the "Look-Through" Rules Paragraphs 256(1.2)(d) to (f) Introduction 29. Paragraphs 256(1.2)(d), (e), and (f) provide rules that apply to "look through" corporations, partnerships and trusts. The rules deem shares owned by a corporation, partnership or trust to be owned by the shareholders of the corporation (see 30), the members of the partnership (see 31) or beneficiaries of the trust (see 32), respectively. Looking through a corporation Paragraph 256(1.2)(d) 30. Where a corporation owns (or is deemed by subsection 256(1.2) to own) shares of a second corporation, paragraph 256(1.2)(d) deems those shares to be owned by any shareholder of the first corporation in proportion to the fair market value of their shareholding in the first corporation. In determining the fair market value of shares of a corporation for purposes of applying the look-through rules, all issued and outstanding shares of the capital stock of the corporation are deemed by paragraph 256(1.2)(g) to be non-voting. Example

Mr. A 100%

Mrs. A 75%

Holdco

25%

Opco

190 Paragraph 256(1.2)(d) deems Mr. A to own 25 per cent of Opco 2. As a result, Opco 1 and Opco 2 are associated with each other under paragraph 256(1)(c) (see 27). Looking through a partnership Paragraph 256(1.2)(e) 31. Similarly, where shares of a corporation are the property of (or are deemed by subsection 256(1.2) to be owned by) a partnership, paragraph 256(1.2)(e) looks through the partnership and deems the shares to be owned by the partnership's members in proportion to their respective income interests in the partnership. If both the income and loss of the partnership in a fiscal period are nil, so that a member's income interest cannot be determined, paragraph 256(1.2)(e) further provides that the member's proportionate income interest is to be determined as if the partnership had income of $1,000,000 in that period. Example

Mr. A 45% 100%

ABCD Partnership
40% Mr. E 15%

Corporation A

Corporation B

Assuming Mr. A, B, C and D are equal partners in ABCD Partnership, each will be deemed by paragraph 256(1.2)(e) to own 10 per cent of the shares of Corporation B. Therefore, Corporation A and Corporation B will be associated with each other under paragraph 256(1)(b) because both corporations are controlled by Mr. A. Looking through a trust Paragraph 256(1.2)(f) 32. Paragraph 256(1.2)(f) provides the look-through rule for shares of a corporation that are owned (or deemed by subsection 256(1.2) to be owned) by a trust. It deems the shares to be owned by beneficiaries of the trust (and possibly also by a person from whom property was received by the trust). The percentage of the shares that a particular beneficiary is deemed to own depends on the type of trust. The general rules are as follows: (a) Where a beneficiary's share of income or capital of the trust is subject to any discretionary power (such a trust being referred to hereafter as a "discretionary" trust), each such beneficiary is deemed to own all the shares held by the trust. (b) Where the trust is not a discretionary trust, each beneficiary is deemed to own shares in proportion to the fair market value of that beneficiary's beneficial interest in the trust. (c) An exception to the rules in (a) and (b) occurs where: the trust is a testamentary trust; one or more of its beneficiaries (referred to hereafter as the "initial income beneficiaries") are entitled to receive all the income of the trust before the date on which the death of one or all of them has occurred (the "distribution date"); and

191 prior to that date no other person (e.g., a beneficiary who is solely a capital beneficiary, or a person who will become an income beneficiary only upon the occurrence of the distribution date) can receive or obtain the use of the income or capital of the trust. If all these conditions exist, shares held by the trust are deemed to be owned only by the initial income beneficiaries before the distribution date. Whether any particular initial income beneficiary is deemed to own all, or only a proportion of, the shares will depend on whether the trust is discretionary or not discretionary as described in (a) and (b), respectively. After the distribution date, the rule in (a) or (b), as the case may be, applies with respect to all the beneficiaries, including those that are solely capital beneficiaries. Where a trust is one referred to in subsection 75(2) of the Act, such as a "reversionary" trust, the person from whom property of the trust was received is also deemed to own the shares.

(d)

The result of the application of paragraph 256(1.2)(f) is that more than one person can be deemed to own the same shares at the same time. In addition, paragraph 256(1.2)(f) does not negate the fact that the shares are actually held by the trustees of the trust. Thus, control of a corporation, the majority of whose voting shares are owned by a trust, will rest with the trustee or group of trustees that can bind the trust (see MNR v Consolidated Holding Company Limited, 72 D.T.C. 6007, [1972] C.T.C. 18 (SCC)). Example

Xs Children (all over 18 years) Beneficiarie s Mr. X 25% 100 % Corporation A Xs Uncle

Sole Trustee

Discretionar y Trust 75% Corporation B Corporation C

100 %

Since X's children are the beneficiaries of the discretionary trust, they are each deemed by subparagraph 256(1.2)(f)(ii) to own all of the shares of Corporation B that are owned by the trust. Therefore, since each one of X's children controls Corporation B, Corporation A and Corporation B are associated with each other under paragraph 256(1)(c) (see 27). Also, since X's uncle is the sole trustee of the trust, he will control Corporation B. Therefore, Corporation B and Corporation C will be associated with each other under paragraph 256(1)(b). Corporation A and Corporation C will also be associated with each other by virtue of subsection 256(2) (assuming one of the two exceptions described in 8 does not apply). Looking through a chain

192 33. A person at the top of a chain can be deemed to own a proportion of the shares of a corporation at the bottom of the chain, by applying the rules in subsection 256(1.2) sequentially from one level of the chain to the next. Furthermore, there will be simultaneous ownership or deemed ownership of some shares (or some percentage of shares) of the corporation at the bottom of the chain by different individuals, corporations, partnerships or trusts at different levels of the chain. Example Corporation Y has only common shares, 95% of which are owned by Corporation X. Corporation X has only common shares, 95% of which are owned by Partnership AB. Under paragraph 256(1.2)(d), Partnership AB is deemed to own 90.25% (i.e., 95% x 95%) of the shares of Corporation Y. Trust A is a member of Partnership AB and is entitled to 90% of its income. Under paragraph 256(1.2)(e), Trust A is deemed to own 81.225% (i.e., 90% x 90.25%) of the shares of Corporation Y. Corporation A is the sole beneficiary of Trust A. Under paragraph 256(1.2)(f), Corporation A is deemed to own 81.225% (i.e., 100% x 81.225%) of the shares of Corporation Y. Corporation A has only common shares, 75% of which are owned by Mr. A. Under paragraph 256(1.2)(d), Mr. A is deemed to own 60.91875% (i.e., 75% x 81.225%) of the shares of Corporation Y. Therefore, in accordance with the principle discussed in 17, Mr. A has de jure control of Corporation Y. Parent Deemed to Own Shares of Child Subsection 256(1.3) 34. Subsection 256(1.3) provides that shares of a corporation owned by a child under the age of 18 shall be deemed to be owned by a parent of the child for the purposes of determining whether the corporation is associated with any other corporation that is controlled, directly or indirectly in any manner whatever, by that parent or a group that includes that parent. An exception to subsection 256(1.3) is provided where the child manages the business and affairs of the corporation without a significant degree of influence by the parent. The following example illustrates the operation of the look-through rules in paragraph 256(1.2)(f) (see 32) in conjunction with the rules in subsection 256(1.3). Example Corporation A is controlled by Mr. X and Corporation B is controlled by an inter vivos trust for the benefit of his two children who are under 18 years of age. The children are income and capital beneficiaries of the trust. The provisions of paragraph 256(1.2)(f) will apply to deem the children to own the shares of Corporation B. Since the provisions of paragraph 256(1.2)(f) are applicable for the purposes of subsections 256(1) to (5), subsection 256(1.3) would then apply to deem Mr. X to own those shares deemed to be owned by the children and thus Corporation A and Corporation B would be associated with each other under paragraph 256(1)(b) because they are controlled by the same person, Mr. X.

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Options or Rights Subsection 256(1.4) Effect of Option 35. Subsection 256(1.4) provides two special rules, for the purposes of the association rules, which deem a person, or a partnership in which the person has an interest (the "partnership"), to own shares of a corporation in which the person or partnership holds certain options or rights. Under the first rule -- which is in paragraph 256(1.4)(a) -- if the person or partnership has a right, under a contract, in equity or otherwise, to acquire shares in a corporation or to control the voting rights of shares in a corporation, the shares are deemed to be issued and outstanding and to be owned by the person or partnership. Under the second rule -- which is in paragraph 256(1.4)(b) -- if the person or partnership has a right to cause a corporation to redeem, acquire or cancel shares of its capital stock owned by other shareholders, the person or partnership is deemed to have the same position in relation to control of the corporation and ownership of shares of its capital stock as if the shares were redeemed, acquired or cancelled by the corporation. Neither paragraph 256(1.4)(a) nor 256(1.4)(b) applies, however, with respect to a right that is not exercisable until the death, bankruptcy or permanent disability of an individual. For example, paragraph 256(1.4)(a) would not apply to a right that the person or partnership has under a survivorship agreement to acquire shares of a corporation. Convertible Securities 36. If bonds, debentures or preferred stock of a corporation are convertible into voting shares, subsection 256(1.4) may apply because of the "right" of the owners of those securities to make the conversion. However, whether it will be applied can depend upon their distribution. Thus, if such securities have been issued to the general public and have wide distribution, they may usually be ignored. However, if large numbers of them are concentrated in the hands of, say, four or five persons, the situation will be examined because they may be used as a device so that the real control of the corporation will not be apparent simply from an examination of the shareholdings. A similar situation can exist, also, when a person has a right in some other form to subscribe for voting shares. Buy-Sell Agreements 37. Although the wording in subsection 256(1.4) may be broad enough to include almost any "buysell" agreement, this subsection will not be applied unless both (or all) parties clearly have either a right or an obligation to buy or sell, as the case may be. Accordingly, subsection 256(1.4) would not be applied solely as a result of the existence of either of the following: a "right of first refusal"; or a "shotgun arrangement" under which, if a shareholder offers to purchase the shares of another shareholder, the latter must either accept the offer or purchase the shares owned by the offering party. Simultaneous Control and Deemed Control 38. If subsection 256(1.4) does apply, it is possible for each of two separate and unrelated persons to be regarded, for the purposes of the Act, as having control of the same corporation at the

194 same time. For example, one person could have control by means of direct ownership of shares and the other could have control as a result of the application of one of the rules in subsection 256(1.4). This provision prevents a person who really controls a corporation from giving the appearance of divesting control by "selling" the controlling shares to some other person while retaining an option to repurchase them. Subsection 256(1.4) does not deny that actual control is held by the person who holds it. If it did so, it would be possible for a person or other entity which controls a corporation to give the appearance of divesting itself of control by giving to some other person or other entity an option that will never be exercised. Example Mr. S has actual control of Corporations A and X. Mr. J, who controls Corporation Y, has an option to purchase from Mr. S, during his lifetime or from his estate, the controlling shares in Corporation A. In these circumstances, subsection 256(1.4) deems Mr. J to have control of Corporation A but does not deny Mr. S the actual control of it. As a result: Corporations A and X are related (see subparagraph 251(2)(c)(i)) and are deemed not to deal with each other at arm's length (see paragraph 251(1)(a)); Corporations A and Y are related (see subparagraph 251(2)(c)(i)) and are deemed not to deal with each other at arm's length (see paragraph 251(1)(a)); Corporations X and Y are related (see subsection 251(3)) and are deemed not to deal with each other at arm's length (see paragraph 251(1)(a)); and all three corporations are associated with each other under the provisions of section 256 (see s 2 and 8). If, however, Mr. J's option had been exercisable only after Mr. S's death, bankruptcy or permanent disability, Mr. J would not be deemed to have control of Corporation A, because of the exceptions in subsection 256(1.4), in which case only Corporations A and X would be associated with each other. Simultaneous Control at Different Levels of a Corporate Chain Subsections 256(6.1) and (6.2) 39. It is possible for there to be simultaneous ownership of the same shares of a corporation, or simultaneous control of the corporation, by different persons or groups of persons in the manner described in 26, 34 or 38. In addition, in a situation involving a corporate chain (e.g., where the shares of a corporation are held by one or more other corporations the shares of which, in turn, are held by one or more other corporations), there can be simultaneous ownership of the same shares of the corporation at the bottom of the chain by different entities at different levels of the chain in the manner described in 33. Furthermore, de jure control can exist at the top of the chain (see 17 and the reference therein to the Vineland Quarries case). However, in Parthenon Investments Limited v. MNR, 97 D.T.C. 5343, [1997] 3 C.T.C. 152, the Federal Court of Appeal held that a particular corporation at the bottom of a corporate chain was controlled by the corporation at the top of the chain and not by any intermediate

195 corporation for the purposes of determining whether the particular corporation was a Canadiancontrolled private corporation. *Note that in CRA Views 2007-0243211C6, the CRA stated that it may apply subsection 256(1.4) to a shotgun arrangement which allows one of the parties to increase the price of the offer of the other party until the time when one of the parties gives in. *Also note that the CRA does not view comments made in Sedona Networks to alter their position that where paragraph 256(1.4)(a) is applicable with respect to acquiring shares owned by other shareholders, control of the corporation is determined as though the rights are exercised simultaneously. See CRA Views 2006-0192291C6.

196

Brownco Inc. v. R. Excerpt from Tax Hypersion Volume 5 Number 3, March 2008 Article Written by Bruce Russell, QC of McInnes Cooper
In the recent Tax Court decision of Brownco Inc. v. R., the Court considered whether the taxpayer corporation and another corporation, Bost Investments Inc. (Bost) were or were not associated within the meaning of paragraph 256(1)(a) of the Income Tax Act (Canada) (Act). Bost held 50% of the shares of the taxpayer corporation and both were involved in residential home construction in and around Barrie, Ontario. The taxpayer had filed on the basis that the two corporations were not associated and thus the taxpayer claimed the full small business deduction under subsection 125(1). The Minister of National Revenue considered that the two corporations were associated on the basis that Bost controlled the taxpayer corporation directly or indirectly in some manner, resulting in the taxpayer corporation not being entitled to the small business deduction. The decision, per Paris, J., reflects several significant legal considerations relevant to the matter of association between corporations. The first consideration was the fact that Bost and the other shareholder of the taxpayer each had the right to nominate a member to the two-person board of directors of the taxpayer, however the Bost-nominated director had the right of casting vote. That is, if the two directors disagreed on any matter, the Bost-nominated director had the right to cast a second and tie-breaking vote The taxpayer's other argument against de facto control was that due and proper observance of the fiduciary duties statutorily imposed on directors would be inconsistent with exercise of de facto control. These fiduciary duties included that the directors manage assets of the corporation in pursuit of realization of the objects of that corporation. Also, they must avoid conflicts of interest with the corporation and must avoid abusing their position to gain personal benefit. They must maintain confidentiality of information acquired by virtue of their position. Directors and officers are to serve the corporation selflessly, honestly and loyally. In response to this argument, however, the Court held without elaboration that fiduciary duties of directors were not relevant for the purpose of determining control of a corporation under the Act. This was "because control can be held and exercised without breaching these fiduciary duties". Having found de facto control by Bost over the taxpayer, the Court considered the exception provided by subsection 256(5.1). This exception is that if nevertheless the taxpayer and the controller are dealing with each other at arm's length and the control influence is derived from a franchise, license, lease, distribution, supply or management agreement, the main purpose of which is to govern the relationship between the two companies regarding the manner in which the controlled company carries on business, then this is excepted from a finding of direct or indirect control in any manner whatever. The first question therefore was whether Bost and the taxpayer were dealing with each other at arm's length. This turned on three factors, one being de facto control (as already found). The other two were: did there exist a common mind that directed the bargaining for both parties and did the parties act in concert with separate interests. In applying these tests, the sticking point for the Court was that the taxpayer's directors had guaranteed a credit facility of Bost that was in excess of the taxpayer's own credit needs. The taxpayer had provided no evidence or argument to explain why the taxpayer would guarantee credit in excess of its own needs. The Court concluded that this was evidence of a

197 common mind directing the bargaining for both parties, and therefore they were not operating at arm's length. Accordingly, the subsection 256(5.1) exception did not apply. The Court went on to find that in any event the unanimous shareholders agreement between the two corporations did not constitute a management agreement, the main purpose of which was to govern the business relationship between the two corporations. This was a further reason for the subsection 256(5.1) exception not applying. This was sufficient to conclude the matter in the Crown's favour. However, for additional completeness the Court also addressed subsection 256(2.1) of the Act. It is an anti-avoidance avoidance provision which deems association of two corporations if "it may reasonably be considered that one of the main reasons for the separate existence of those corporations. . . is to reduce the amount of taxes that would otherwise be payable . . . " Of course seeking to pay the small business tax rate would constitute a reduction of the amount of taxes otherwise payable. The Court found in accordance with this provision that indeed a main reason for the existence of the taxpayer in addition to Bost was reduction of tax. Several factors for this conclusion were cited, including the lack of a formal written franchise agreement, and the fact that all agreements and legal documents pertaining to the taxpayer had been prepared by Bost lawyers without the taxpayer's signatory obtaining any independent legal advice. The unrestricted nature of the Bost -- nominee's casting vote -- i.e., "veto power" -- not being restricted to management matters, was a further factor indicating tax motivation. In conclusion, this decision provides helpful guidance as to circumstances in which two corporations will be found to be associated, resulting in denial of separate small business deduction claims. The Court's findings on these various points are essentially factual in nature. Thus, the prospects for successful appeal would be challenging, requiring establishment of palpable and overriding error in respect of evidentiary findings by the Tax Court.

4. Related Persons
Associated corporations are in some cases defined by reference to "related persons". This definition is found in s. 251. Related persons include 'relationships' 1. 2. 3. between individuals; between individuals and corporations; between corporations.

The critical key in each of these relationships is usually whether the individuals involved are connected by blood, marriage, or adoption.

198 The following diagram outlines the individuals you are related to for tax purposes.

OLDER GENERATION Parents & Grandparents In-law (252(2)(d))

Parents and Grandparents (256(6) (a) . Brothers & Sisters (251(6)(a) . Their Spouses (252(2)(b)(c)) . Their Spouses Brothers & Sisters (251(6)(b))

CURRENT GENERATION Spouse** (251(6)(b)) . Brothers & Sisters of your Spouse (252(2)(c)) . Their Spouses (251(6)(b))

YOU*

YOUNGER GENERATION

Children (251(6)(a), including: . Adopted (251(6)(c) & (252(1)(d)) . Born out of Marriages (252(1)(a)) . Wholly Dependent and under custody of (252(1) (b) . Children of Spouse (252(1)(c)) . Daughter or Son-in-Law (252(1)(e)) . Other descendants

*You are related to yourself for certain purposes (para. 251(5)(c) and 256(1.5)) Generally, subsection 252(4) defines "spouse" for purposes of the Act to include a person of the opposite sex to whom the taxpayer is legally married. In addition a common-law partner including a same sex partner who cohabits with the taxpayer in a conjugal relationship will be considered related. 1 In addition, either: a) the two individuals must have cohabited throughout a 12-month period ending before the relevant time; or b) both individuals must have a child2 in common. The definition of "spouse" was repealed throughout a wide range of federal statutes effective January 1, 2001 and replaced with a new definition of "common-law partner". The new definition essentially extends the current definition of opposite sex common-law partners to include same sex partners. The new definition is effective only for 2001 and subsequent taxation years, but it is possible to file a retroactive election to have the new common-law partner definition apply to 1998, 1999 and 2000.

The amendment to include common-law partners of the same sex was introduced in 2001. Whether two people are in a conjugal relationship is a question of fact. In our self-assessing system, individuals are expected to declare their status truthfully. The definition of conjugal relationship has previously been considered largely in the context of inheritance and family law matters. See, for example M. v. H., [1999] 2 SCR 3 and Molodowich v. Penttinen (1980), 17 RFL (2d) 376 (Ont. Dist. Ct.). Accepted characteristics of a conjugal relationship include shared shelter, sexual and personal behavior, services, social activities, economic support and children and societal perception of the couple. The relevance given to these various factors must be determined on a case by case basis. It is not clear when a conjugal relationship is considered to be severed. Presumably with the new meaning of common-law partner, the commencement and cessation of a conjugal relationship will take on more importance for income tax matters. 2 A child is specifically defined in subsection 252(1) and, for these purposes, means a natural child, adopted child or a person who is wholly dependent on the taxpayer for support and of whom the taxpayer has, in law or in fact, custody and control.

199 Two corporations may be related but not associated for income tax purposes; for example, Husband's 100 percent owned corporation is related to, but is not associated with, Wife's 100 percent owned corporation. Two corporations may also be associated but not related.

Assume that two Canadian-controlled private corporations, A Co and B Co, are owned by two unrelated individuals, X and Y. X owns 60 percent of A Co and 50 percent of B Co, while Y owns 40 percent of A Co and 50 percent of B Co. According to para. 256(1.2)(a), X and Y constitute a group vis--vis each of A Co and B Co for associated-corporation purposes. According to subpara. 256(1.2) (b)(i)), A Co and B Co are controlled by the same group and are therefore associated. Are A Co and B Co also related? Subpara 251(2)(c)(i) provides that A Co and B Co are related if they are both controlled by the group made up of X and Y. Because there is no definition of the term "group" for purposes of the relatedcorporation provisions, one must look to the jurisprudence to determine whether X and Y are indeed a group that controls each of A Co and B Co. Southside Car Market Ltd. (FCTD 1982) held that if one member of a group controls a corporation, that person and not the group is considered to control. Therefore, X (not the group X and Y) controls A Co and the group X and Y controls B Co. Thus, A Co and B Co are not related corporations.

5. Arms Length Interpretation Bulletin IT-419R2 - Meaning of Arm's Length

June 8, 2004 (The information in this bulletin is still current as of January 2012) Reference: Section 251 (and s. 252) Summary This bulletin discusses the criteria used to determine whether or not persons deal with each other at arm's length under the Act. Although the term at arm's length is used throughout the Act, the Act does not contain any precise definition of the term. Section 251, which is the statutory provision for determining arm's length relationships, refers to three categories of persons. This bulletin deals with each category separately. The first category of persons is related persons, the second category involves personal trusts and their beneficiaries, while the third category includes persons not related to each other. Persons described in the second and third categories are referred to as unrelated persons in this bulletin. Discussion and Interpretation Related Persons 1. Paragraph 251(1)(a) deems that related persons do not deal with each other at arm's length. This is the case regardless of how they actually conduct their mutual business transactions. Subsection 251(2) defines related persons for the purposes of the Act. Subsections 251(3) to 251(6) clarify and expand on the definitions in subsection 251(2).

200 Related Individuals 2. According to paragraph 251(2)(a), individuals connected by blood relationship, marriage, common-law partnership (see 7) or adoption are related persons. Blood relationship 3. Paragraph 251(6)(a) refers to a blood relationship as being that of a parent and a child (or other descendant, such as a grandchild or a great-grandchild) or that of a brother and a sister. Section 252 extends the meaning of those terms to encompass other individuals who might otherwise not be considered to fit the normal use of the term. 4. In addition to a natural child and an adopted child, subsection 252(1) provides that a child of an individual includes: (a) a person who is wholly dependant on that individual for support if the person is or was, before reaching 19 years of age, in law or in fact, under the individual's custody and control; (b) a child of the individual's spouse, (e.g., a stepchild) or common-law partner (see 7); and (c) a spouse or common-law partner of the individual's child, e.g., a son-in-law or a daughter-in-law, as well as the spouse or common-law partner of a stepchild, of an adopted child or of an individual considered to be the taxpayer's child as described in (a) above. On the divorce of an individual's child (whether a natural child, an adopted child, a stepchild, or an individual considered to be a child by reason of paragraph (a) above), the child's former spouse ceases to be the child's spouse and is no longer a child of the individual. 5. Paragraph 252(2)(b) provides that an individual's brother includes the brother of the individual's spouse or common-law partner and the spouse or common-law partner of the individual's sister. It does not include the spouse or common-law partner of the sister or of the brother of the individual's spouse or common-law partner. Similarly, paragraph 252(2)(c) provides that an individual's sister includes the sister of the individual's spouse or common-law partner and the spouse or common-law partner of the individual's brother. It does not include the spouse or common-law partner of the brother or sister of the individual's spouse or common-law partner. Therefore, if Mr. A and Mr. B are otherwise unrelated, and they have each married one of two sisters, they are not related by blood according to paragraph 251(6)(a). Similarly, if Mr. X and Mrs. Y are brother and sister, Mrs. X and Mr. Y are not related by blood. However, Mr. A and Mr. B, and Mrs. X and Mr. Y, in the respective examples, are connected by marriage according to paragraph 251(6)(b). Marriage 6. According to paragraph 251(6)(b), two persons are connected by marriage if one person is married to the other person or to an individual who is connected by blood relationship to that other person. For example, an individual will be connected by marriage to the parents and any siblings of the individual's spouse. However, where an individual's marriage is dissolved by either divorce or the death of the individual's spouse, the individual will cease to be connected by marriage or to be connected by blood relationship to the parents and any siblings of the individual's former spouse. Common-law partnership 7. Paragraph 251(6)(b.1) provides that two individuals are connected by common-law partnership if one individual is in a common-law partnership with the other or with a person who is connected by blood relationship to that other person. Subsection 248(1) defines a common-law partnership as the relationship between two persons who are common-law partners of each other. The expression

201 common-law partner is also defined in subsection 248(1) and means a person of the opposite or same sex who, at that time, lives with and has a conjugal relationship with the individual. In addition, one of the following conditions must be satisfied: (a) the person has been living in a conjugal relationship with the individual for a continuous period of at least one year; or (b) the person is the natural or adoptive parent (whether legally or in fact) of the individual's child (see 4). Where an individual and another person have been living together in a conjugal relationship, they will be considered, at any time thereafter, to be living together in a conjugal relationship unless the couple have been living apart for a period of at least 90 days that includes the particular time because of a breakdown of their conjugal relationship. Once a common-law partnership has been established, it will continue to exist unless the parties are living apart and have been doing so for a continuous period of 90 days due to a breakdown in the relationship. For example, Ms X and Mr. Y have been living together in a conjugal relationship beginning in 1997. On January 15, 2001, they begin to live separate and apart as a result of a breakdown in their relationship. On June 30, 2002, they reconcile and resume living together in a conjugal relationship. Ms X and Mr. Y will be common-law partners beginning June 30, 2002 because they have previously lived together in a conjugal relationship for a continuous period of one year. Subsection 248(1) [provides] that an individual will be considered a common-law partner of another person at a particular time only where they have lived together in a conjugal relationship throughout the 12-month period that ends at the particular time. In the example referred to above, the effect of this is that Ms X and Mr. Y will not be considered common-law partners until June 30, 2003. [The definition of common-law partner] applies for the 2001 and subsequent taxation years. 8. In determining whether an individual is a parent of their partner's child, paragraph (b) of the definition of common-law partner does not restrict such a determination to the natural child of the partner. Consequently, subsection 252(1) characterizes each individual as a parent of a child when there is a legal or factual adoption of that child. When the facts substantiate that an individual is the adoptive (see 10) parent of the child of an individual with whom the individual is living together in a conjugal relationship, both individuals would be considered to be the parents of the child and a common-law partnership will be considered to have begun at that time, which could be at the time that the couple began to live together conjugally, or it could be after that time. For the purposes of paragraph (b) of the definition of common-law partner, a child does not generally include a son in law or a daughter in law. Therefore, for example, a woman who begins to live together in a conjugal relationship with her son-in-law's father would not be the common law partner of her son in law's father until they have lived together for a continuous 12-month period. Other relatives 9. For purposes of the Act, an individual's niece, nephew, aunt, or uncle is not related by blood, marriage, common-law partnership or adoption to the individual unless such person is also the individual's child or parent because of the extended meaning of child as described in 4. Cousins are not related by blood unless one is the child of the other because of the extended meaning of child (as described in 4), or is the spouse or common-law partner of the other one's brother or sister. However, under certain circumstances, cousins may be related by marriage, common law partnership, or adoption.

202 Adoption 10. According to paragraph 251(6)(c), two individuals are connected by adoption if one individual is the adopted child of the other. Adoption includes a legal adoption and an adoption in fact. In addition, an individual who is related by blood (except a brother or sister) to another individual will be related by adoption to that person's adopted child. Therefore, individuals are connected by adoption to their adoptive children, parents and grandparents. Whether a factual adoption has occurred at a particular time is a question of fact and has to be determined based on a consideration of the particular circumstances. The fact that an individual is appointed guardian of a child does not, in and of itself, constitute adoption in fact. For a de facto adoption to exist, generally the adoptive parent must exercise parental care and guidance on a continuing basis. The factors to look for in determining whether a certain relationship between an individual person and a child constitutes an adoption in fact are actual control and custody, an exercise of parental care and responsibility on a continuing basis, dependency, and proximity to each other. Corporations and Other Persons 11. Paragraphs 251(2)(b) and (c) set out the statutory rules for determining when a corporation and another person will be considered to be related persons (or persons related to each other) for purposes of the Act. Under paragraph 251(2)(b), a corporation will be related to another person (including another corporation) where: (a) that person controls the corporation; (b) that person is a member of a related group that controls the corporation; or (c) that person is a person who is related to a person described in (a) or (b) above. In addition, paragraph 251(2)(c) provides that two corporations will be related if: (i) the two corporations are controlled by the same person or group of persons; (ii) each of the corporations is controlled by one person and the person who controls one corporation is related to the person who controls the other corporation; (iii) one of the corporations is controlled by one person and that person is related to any member of a related group that controls the other corporation; (iv) one of the corporations is controlled by one person and that person is related to each member of an unrelated group that controls the other corporation (see Example 1 below); (v) any member of a related group that controls one of the corporations is related to each member of an unrelated group that controls the other corporation (see Example 2 below); or (vi) each member of an unrelated group that controls one of the corporations is related to at least one member of an unrelated group that controls the other corporation (see Example 3 below). For the purposes of subsection 251(2), control means de jure control, which generally means the right of control that rests in ownership of such number of shares as carries with it the right to a majority of the votes in the election of the board of directors of the corporation. For a detailed discussion of de jure control of a corporation, see the current version of IT 64, Corporations: Association and Control. Example 1 A has two adult children, C and D. C has two children, X and Y, and D has one child, Z. A owns all of the issued and outstanding shares of Aco, consequently, A controls Aco. Each of Y and Z owns 50% of the common shares of Opco. Since Y and Z are cousins, they will, for purposes of the Act, be an unrelated group that controls Opco. As A is related to each of Y and Z (i.e. A is their grandparent), Aco and Opco will be related pursuant to subparagraph 251(2)(c)(iv).

203 Example 2 Same facts as in Example 1, except that each of A, C and D owns 33 1/3% of the common shares of Bco. A, C and D are a related group that controls Bco. Since A is related to each of Y and Z (i.e. A is their grandparent), Bco and Opco will be related pursuant to subparagraph 251(2)(c)(v). Example 3 Mr. X, Mr. Y and Mr. Z are an unrelated group that controls XYZ Co. Their spouses, Mrs. X, Mrs. Y and Mrs. Z are an unrelated group that controls ZYX Co. As Mr. X is related to Mrs. X, Mr. Y is related to Mrs. Y and Mr. Z is related to Mrs. Z, XYZ Co will be related to ZYX Co pursuant to subparagraph 251(2)(c)(vi). 12. The expression related group is defined in subsection 251(4) and means a group of persons each member of which is related to every other member of the group. For example, a group consisting of two common-law partners and their children would be a related group. An unrelated group refers to a group of persons that is not a related group. For a group of unrelated persons to constitute a group of persons which controls a corporation, there must be a common link or interest between the persons (which must involve more than their mere status as shareholders) or there must be evidence that those shareholders act together to exert control over the corporation. In the case of a closely-held corporation (i.e. where there are two or three unrelated shareholders, none of which individually controls the corporation) the CRA considers that there is a presumption that the shareholders of such a closely-held corporation will act together to control the corporation. In order to rebut this presumption, it would be necessary to show that no one is controlling the corporation and that the decision-making process in the corporation is effectively deadlocked. 13. Subsection 251(3) provides that where two corporations are each related to a third corporation, they will be considered to be related to each other for the purposes of subsections 251(1) and (2). For example, A and B are sisters and each has an adult child, being C and D, respectively. Each of A, B, C and D owns all of the issued shares of a corporation, Aco, Bco, Cco and Dco, respectively. In this situation, Aco and Bco are related to each other by virtue of subparagraph 251(2)(c)(ii). Also, Aco and Cco are related to each other and Bco and Dco are related to each other by virtue of subparagraph 251(2)(c)(ii). Therefore, Aco and Dco will be related to each other by virtue of subsection 251(3) because each of them is related to Bco. Similarly, Bco and Cco will be related under subsection 251(3) because each of them is related to Aco. However, since subsection 251(3) does not apply for the purposes of a subsequent application of subsection 251(3), Cco will not be related to Dco. Special Rules 14. The provisions of paragraphs 251(5)(a), (b), and (c) apply in the determination of control of a corporation for the purposes of identifying related persons within the meaning assigned by subsection 251(2) and for the purpose of the definition of a Canadian-controlled private corporation in subsection 125(7). When a related group is in a position to control a corporation, paragraph 251(5)(a) deems the corporation to be controlled by the related group even though it may be part of a larger group that in fact controls the corporation. In determining whether two corporations are related, paragraph 251(5) (c) provides that a person who owns shares of more than one corporation shall be deemed, as shareholder of the corporations to be related to himself, herself, or itself. Options and Rights Effect of option

204 15. Paragraph 251(5)(b) deems a person to be in the same position, relative to the control of a corporation when, under a contract, in equity or otherwise, that person has the right: (a) to acquire shares (or control voting rights of shares) as if that person actually owned the shares; (b) to cause the corporation to redeem, acquire, or cancel any shares of its capital stock owned by other shareholders as if the shares were redeemed, acquired, or cancelled by the corporation; (c) to (or to acquire or control) voting rights of a corporation's shares as if that person could exercise those voting rights at that time; or (d) to cause the reduction of voting rights of a corporation's shares owned by other shareholders as if the voting rights were reduced at that time. However, the provisions of paragraph 251(5)(b) will not apply to the extent that one or more of the rights described above is not exercisable at that time because the exercise of the right is contingent on: the death, the bankruptcy, or permanent disability, of an individual. Convertible securities 16. If bonds, debentures or non-voting shares of a corporation are convertible into voting shares, paragraph 251(5)(b) may apply because of the right of the owners of those securities to make the conversion. However, whether it will be applicable can depend upon the distribution of such convertible securities. If such securities have been issued to the general public and have wide distribution, they may usually be ignored since it is unlikely that the exercise of such rights will result in any person or group of persons acquiring control of the corporation as a result of the conversion of such securities. However, if large numbers of such securities are concentrated in the hands of a small group of people, their impact will need to be considered. A similar situation can exist, also, when a person has a right in some other form to subscribe for voting shares of a corporation. Buy-sell agreements 17. Although the wording in paragraph 251(5)(b) may be broad enough to include almost any buysell agreement, this paragraph will not normally be applied solely because of: (a) a right of first refusal; or (b) a shotgun arrangement (i.e. an arrangement under which a shareholder offers to purchase the shares of another shareholder and the other shareholder must either accept the offer or purchase the shares owned by the offering party) contained in a shareholder agreement. Simultaneous control and deemed control 18. If paragraph 251(5)(b) does apply, it is possible for each of two unrelated persons to be regarded, for the purposes of subsection 251(2), as having control of the same corporation at the same time. For example, one person could have control by means of direct ownership of shares and the other could have control as a result of the application of one of the rules in paragraph 251(5)(b). This provision prevents a person who really controls a corporation from giving the appearance of divesting control by selling the controlling shares to some other person while retaining an option to repurchase them. Paragraph 251(5)(b) does not deny that actual control is held by the person who holds it. If it did so, it would be possible for a person or other entity which controls a corporation to give the appearance of divesting itself of control by giving to some other person an option that will never be exercised.

205 Example S owns a majority of the voting shares in each of Corporations A and B and, therefore, has actual control of Corporations A and B. J, who controls Corporation C, has an option to purchase from S or from S's estate, the controlling shares in Corporation A. S and J are not related. In these circumstances, paragraph 251(5)(b) deems J to have control of Corporation A, but does not deny that S has the actual control of it. As a result: Corporations A and B are related (see subparagraph 251(2)(c)(i)) and are deemed not to deal with each other at arm's length (see paragraph 251(1)(a)); Corporations A and B are each related to S (see subparagraph 251(2)(b)(i)) and are deemed not to deal with S at arm's length (see paragraph 251(1)(a)); Corporations A and C are related (see subparagraph 251(2)(c)(i)) and are deemed not to deal with each other at arm's length (see paragraph 251(1)(a)); Corporations A and C are each related to J (see subparagraph 251(2)(b)(i)) and are deemed not to deal with J at arm's length (see paragraph 251(1)(a)); and Corporations B and C are related (see subsection 251(3)) and are deemed not to deal with each other at arm's length (see paragraph 251(1)(a)). If, however, J's option had been exercisable only after the death, bankruptcy or permanent disability of S, J would not be deemed to have control of Corporation A, because of the exceptions in paragraph 251(5)(b), in which case Corporations A and B would not be related to Corporation C and J would not be related to Corporation A. Unrelated Persons 22. Paragraph 251(1)(c) provides that, at a particular time, it is a question of fact whether unrelated persons (other than persons described in s 19 and 20) are dealing with each other at arm's length. Sometimes unrelated persons may deal with each other at arm's length, sometimes they may not, depending on all the circumstances. By providing general criteria to determine whether there is an arm's length relationship between unrelated persons for a given transaction, it must be recognized that all-encompassing guidelines to cover every situation cannot be supplied. Each particular transaction or series of transactions must be examined on its own merits. The following paragraphs set forth the CRA's general guidelines with some specific comments about certain relationships. 23. The following criteria have generally been used by the courts in determining whether parties to a transaction are not dealing at arm's length: was there a common mind which directs the bargaining for both parties to a transaction; were the parties to a transaction acting in concert without separate interests; and was there de facto control. 24. The courts have held that when one person (or a group of persons) is, in fact, the bargaining agent, or the mind by which the bargaining is directed, on behalf of both (or all) parties to a transaction, then the parties cannot be dealing at arm's length. The courts have expanded this principle to include the concept of acting in concert with respect to an element of common interest. Therefore, even when there are two distinct parties (or minds) to a transaction, but these parties act in a highly interdependent manner (in respect of a transaction of mutual interest), then it can be assumed that the parties are acting in concert and therefore are not dealing with each other at arm's length. When a common purpose exists, a transaction is not necessarily a non arm's-length one when

206 different interests (or independent parties) are also present. In this context, different interests are considered to exist when each party has an independent interest from the other parties to a transaction, notwithstanding the fact that each party may have the same purpose, such as economic gain. 26. Failure to carry out a transaction at fair market value may be indicative of a non arm's length transaction. However, such failure is not conclusive and, conversely, a transaction between unrelated persons at fair market value does not necessarily indicate an arm's length situation. The key factor is whether there are separate economic interests which reflect ordinary commercial dealing between parties acting in their separate interests. The situation where one party to a transaction is merely accommodating the other party in an attempt to obtain a certain tax result may be a situation where the parties are not dealing at arm's length because they do not have separate economic interests which reflect ordinary commercial dealings between parties acting in their own separate interests. Partnerships 27. In circumstances where a partnership owns a majority of the issued voting shares of a corporation, the partnership will not be considered to deal at arm's length with the corporation. In situations when one partner is in a position to control a partnership, either through ownership of a controlling interest or through a mandate vested in that partner by the other partners, that partner is not considered to be dealing at arm's length with the partnership. However, when a partner is not in a position to control a partnership in which the partner has an interest, and that partner has little or no say in directing the operations of the partnership, it is generally recognized that the partner is dealing at arm's length with the partnership. Where a related group of partners owns a controlling interest in a partnership, each member of that related group will not be considered to deal at arm's length with the partnership. 28. As a general rule, it is presumed that partners, who are not related persons, deal with each other on an arm's length basis in transactions outside of their partnership activity, although their partnership in business would be a factor to be considered in any other transaction between them. Trusts 29. In the situation where a trust owns a majority of the voting shares of a corporation such that the trustees of the trust control the corporation, the trust and the corporation will be related persons by virtue of subparagraph 251(2)(b)(i) and will, pursuant to paragraph 251(1)(a) be considered not to be dealing at arm's length. Also, as discussed in s 19 and 20, a specified personal trust will be deemed not to deal at arm's length with its beneficiaries or with any person who does not deal at arm's length with any such beneficiary. In any other case, it is a question of fact whether or not a trust and a particular person or group of persons are dealing at arm's length. 30. Unless the facts indicate otherwise, a trust is considered not to be dealing at arm's length with its settlor; however, unless the settlor has maintained some degree of influence over the trustee this general presumption may be ignored when the trustee of the trust is a professional trustee, (e.g., a public trust company); or if property is settled on a trust and, as a result, the settlor has transferred all of the usual rights of ownership of the property, the settlor might be considered to deal at arm's length with the trust provided that the trustee of the trust is free of any influence exercised by the settlor. However, the CRA generally considers that a transfer of property from a deceased to the estate of the deceased or to a trust created by the will of the deceased is not an arm's length transaction.

207 31. According to subsection 104(2), a trust is deemed to be an individual in respect of trust property and, pursuant to the definition in subsection 248(1), an individual is a person. Therefore, in section 251, a reference to the word person includes a trust. Shareholders and Corporations 32. If, by the rules in paragraph 251(2)(b), a shareholder does not control a corporation or is not otherwise related to the corporation, there is a general presumption that the shareholder deals at arm's length with the corporation in which the shareholder holds shares. However, if a sufficient number of minority shareholders act in concert in order to direct the affairs of a corporation, they may be considered not to be dealing at arm's length with the corporation. Acting in concert generally means a predetermined agreement to act in a certain manner. In a widely held corporation, the fact that a majority of shareholders vote collectively to take some business action will not, by itself, indicate that those shareholders are acting in concert and therefore not dealing at arm's length with each other and the corporation. Also, the direct management voice of any minority shareholder who holds an officer's position with a corporation may be relevant in assessing that shareholder's relationship with that corporation.

6. Special Rule in ss. 256(1.4)

(Excerpt from Canadian Tax Highlights, Canadian Tax Foundation, Volume 12, Number 4, April 2004) For the purposes of determining control of a corporation, paragraph 251(5)(b) (for the purposes of the definition of "related persons" in subsection 251(2) and of "CCPC" in subsection 125(7)) and paragraph 256(1.4)(a) (for the purposes of the association rules) both provide that a person is deemed to own all the shares that he has an option or a right to acquire. It is not clear whether control is tested for as if all rights outstanding have been exercised, or only the particular shareholder's rights. For example, assume that a Canco has two shareholders: Mr. A, a Canadian resident, who owns 1,000 common shares and an option to acquire 400 more, and Publico, a public corporation, which owns 600 common shares and has an option to acquire another 500. There is only one class of shares, and each carries one vote. No agreements or other documents affect Canco's control, nor is there any de facto control. Common shares owned Additional common shares owned if options exercised Ownership excluding options Ownership if options exercised separately Ownership if all options exercised simultaneously Mr. A 1,000 400 62.5% 70% 56% Publico 600 500 37.5% 52% 44%

If only Publico is deemed to exercise its options, it controls Canco with 52 percent ownership, and Canco is not a CCPC. But if Mr. A's options are also deemed exercised, Publico has only 44 percent ownership and does not control; thus, Canco is not a CCPC. The CRA says that for the purposes of the CCPC definition in paragraph 251(5)(b), only the particular taxpayer's rights are deemed exercised. In contrast, on the basis of the different wording in the association rules in paragraph 256(1.4)(a), the CRA says that a corporation's control is determined once, taking into account all shares that all persons with a right are deemed to own and that are deemed to be issued and

208 outstanding. The surprising result is that Canco is not a CCPC because of the control implicit in the options held by Publico; yet Canco is not associated with Publico. Tax Executive Institute, 2003 Question 16. Control Paragraph 251(5)(b) (for the purposes of subsection 251(2) and the definition of Canadian controlled private corporation (CCPC)) and paragraph 256(1.4)(a) (for purposes of the association rules) both provide that, for purposes of determining "control" of a corporation, a person is deemed to own all the shares that the person has a right to acquire. In other words, for such purposes the underlying shares that each shareholder has a right to acquire are deemed issued and outstanding. The Act is unclear, however, whether the determination of "control" is made assuming that (1) all the rights owned by all persons are deemed "exercised" jointly at a single time and tested together or (2) the individual shareholder's rights are deemed exercised separately and tested separately for control. To illustrate the difference in result, consider the following example for determining CCPC status. A corporation has two shareholders. Shareholder A, a Canadian resident individual, owns 1,000 common shares of the corporation and has an option to acquire 400 additional common shares. Shareholder B, a public corporation, owns 600 common shares of the corporation and has an option to acquire an additional 500 common shares. Question: If only shareholder B, the public corporation, is deemed to have exercised its option, then shareholder B controls 52 percent and the subsidiary will not be considered a CCPC. If all the options owned by shareholder A and shareholder B are deemed exercised at the same time, however, shareholder B will be considered as controlling only a 44-percent interest in the subsidiary and the subsidiary will be a CCPC. Would the CRA provide its interpretation of the application of paragraph 251(5)(b) and subsection 256(1.4) to the example? CRA Response: When a number of persons have a right that meets the conditions in subparagraph 251(5)(b)(i), it is CRA's view that, for each person that has a right, a distinct determination of "control" of the corporation must be made on the assumption that that person owned the shares of the corporation which the person has the right to, or the right to acquire, or the right to control the voting rights of such shares. For the purpose of determining whether a corporation is associated with another corporation, with which it is not otherwise associated, in a situation where a number of persons have a right described under paragraph 256(1.4)(a), it is CRA's view that the "control" of a corporation must be determined once, taking into account all the shares that all the persons with a right are deemed to own and that are deemed to be issued and outstanding. Our opinion is based on the fact that the presumptions under paragraph 251(5)(b) and under paragraph 256(1.4)(a) are different, in that, under paragraph 251(5)(b), "... the person shall, ..., be deemed to have the same position in relation to the control of the corporation as if the person owned the shares ..." and, under paragraph 256(1.4)(a), "... the person or partnership shall, ..., be deemed to own the shares at that time, and the shares shall be deemed to be issued and outstanding at that time;" In the situation described above, the application of paragraph 251(5)(b) results in shareholder B, the public corporation, controlling the subsidiary, and, therefore, the subsidiary not being a

209 CCPC, as defined under subsection 125(7). In this situation, absent de facto control, shareholder B, the public corporation, is not associated with the subsidiary as shareholder B does not control the subsidiary whether control is determined with or without applying paragraph 256(1.4)(a).

7. Associated by ss. 256(2.1)

Subsection 256(2.1) was at issue in Hughes Homes Inc. v. R., [1998] 1 C.T.C. 2367. Mr. and Mrs. Hughes each owned 50% of Hughes Home Limited which was a management company for Mr. Hughes homes building business. Mrs. Hughes incorporated Lopa Enterprises Ltd. to provide design and decorating services to Hughes. The Tax Court held that Lopa had a sufficient business purpose and existed as a distinct and separate business from that of Hughes. The taxpayer also argued that Lopa was created to protect the assets of Mrs. Hughes from the inherent risks of the construction business, and this evidence was accepted by the Court.

Excerpt from Tax for the Owner-Manager, Canadian Tax Foundation, Volume 4, Number 2, April 2004 Under subsection 256(2.1) of the Income Tax Act, two or more corporations are deemed to be associated if it may reasonably be considered that one of the main reasons for their separate existence is to reduce the taxes otherwise payable under the Act. LJP Sales (TCC 2003) addressed the meaning of the phrase "one of the main purposes" in the subsection. The case illustrates the practical difficulties associated with the application of a statutory test that turns on the state of mind of the taxpayer, and reminds taxpayers that the anti-avoidance rule in subsection 256(2.1), which can result in the denial of separate small business deductions, should be considered when closely held corporations are restructured and taxes are reduced or refundable investment tax credits are thereby increased. In LJP Sales, Mr. and Mrs. P had built up a successful locksmith business. Two companies were involved in the business. Jo-Van Distributors carried on the operations and was 91 percent owned by Mrs. P. VMP Properties provided the premises in which Jo-Van carried on business and was owned by Mr. P. Mrs. P ran the locksmith business; Mr. P assisted with sales. The locksmith side of the operations prospered. Mr. and Mrs. P experienced relationship difficulties, especially with respect to their two children. A divorce was discussed, and Mr. P considered disinheriting the children. Mrs. P did not wish to abandon them. There were discussions regarding the business and the fact that Mrs. P's equity was growing at a faster rate than Mr. P's. On the advice of their accountant, they decided to reorganize the business. Mr. P incorporated LJP Sales Agency to take over the marketing and sales functions for Jo-Van for a fee of 5 percent of sales. It was thought that this arrangement would allow Mr. P, through LJP, to participate in the growth of the locksmith business. It would also allow the spouses to deal separately with their respective estates. Shortly thereafter the couple divorced, but they continued the new business arrangement. Mr. P changed his will to disinherit his children. Mrs. P left her estate to them. The CRA deemed LJP Sales to be associated with Jo-Van under subsection 256(2.1). At trial, Mr. and Mrs. P testified that they undertook the reorganization in an attempt to save their marriage and so that they could pursue separate estate-planning strategies. They denied that LJP Sales was incorporated for tax reasons. The accountant confirmed their testimony and said that he developed the business plan to accomplish their objectives in a tax-efficient manner. In argument, counsel for the Crown suggested that even if the court accepted the evidence, it should find that the

210 couple had an "unconscious motive" to reduce tax, citing the decision in Levitt-Safety (FCTD 1973). Miller J allowed the appeal. He said, "[I]t is unusual that a court might rely on an unconscious reason of an individual especially where an individual's testimony is so adamantly to the contrary."

IV. Investment Income

1. Overview
Investment income is given special treatment in the Income Tax Act when it is earned by a private corporation in order to attempt tax neutrality between investment income earned by a private corporation and distributed to its shareholders, and the same income being earned directly by the shareholder. This is the concept of integration which we have looked at before. However, there are two main exceptions to the principle that the corporate tax and shareholder tax on the same amount of investment income ought to be integrated. The first exception is that this does not apply to public corporations. Public corporations pay the basic corporate rate of tax on investment income. For investment income considered earned in Alberta pursuant to Regulation 400 of the Income Tax Regulations, this will be 38% - 10% - 13% + 10% = 25 % after January 2012. Second, the integration rules on investment income apply only to Canadian-controlled private corporations, with the exception of the integration rules applicable to dividends received from other corporations. That is to say, the integration rules that apply to dividends received from other corporations are applicable to private corporations, but the integration rules that apply to other forms of investment income are applicable only to private corporations that qualify as Canadian-controlled private corporations. We have seen that income from an active business carried on in Canada is given special treatment when earned by a Canadian-controlled private corporation in an attempt to achieve neutrality in respect of income earned and distributed by such a corporation to an individual shareholder compared to such income earned directly by the shareholder. The Act has a somewhat similar goal with respect to investment income earned by a Canadian-controlled private corporation. Investment income earned by a corporation that is not a Canadian-controlled private corporation is initially taxed like any other income under the general rules, with the exception of dividend income received by a private corporation. CCPCs pay an additional Part 1 tax of 6 2/3%. This was intended to remove any benefit of deferral due to a lower corporate tax rate. At the time it was added to the Act, the Alberta rate was 46% and in many provinces exceeded 50%. Given that the top personal rate in Alberta is now 39.00% there appears little incentive to earn investment income through a corporate vehicle. Therefore the tax on a CCPC earning this type of income in Alberta is, without factoring in refundable taxes (i.e. 28 + 6 2/3 + 10) 44.7% after April 1, 2006. For the 2012 calendar year, investment income is taxed as follows: (a) All corporations are not taxed at the basic rate of corporate tax on their investment income. Non-CCPCs are eligible for the 10% rate reduction reducing the federal tax rate to 15% in 2012. CCPCs are subject to the 28% federal tax rate.

211

(a.1)

CCPC's pay an additional Part 1 tax of 6 2/3% of their aggregate investment income. The total Part 1 tax on investment income paid by CCPCs in 2012 is, thus, 28% + 6 2/3% + 10% Alberta tax for a total of 44.7%. The purpose of the 6 2/3% tax is to ensure that corporations pay approximately 50% total tax on investment income up front. As can be seen the rate is less than 50% in Alberta. Private corporations can set up a notional account called the "Refundable Dividend Tax on Hand" account, or the RDTOH account. However, only private corporations that qualify as Canadian-controlled private corporations can include a portion of their investment income in the RDTOH account. Into this account, the corporation adds 26 2/3 % of its "aggregate investment income". These two terms are defined in subsections 129(3) and (4) respectively. Taxable dividends received by a corporation from a taxable Canadian corporation or from a corporation resident in Canada and controlled by it are exempt from Part I tax. They are included in income under para. 82(1)(a) and para. 12(1)(j) but are deducted in calculating taxable income under ss. 112(1). As we discussed in the portion of the course dealing with integration and double taxation, it is necessary to ensure that dividends between corporations are not taxable so that double or multiple taxation does not occur (dividends are not deductible by the distributing corporation.) This is commonly referred to as the inter-corporate tax-free dividend rule. However, it is necessary to tax dividends received by private corporations in order to avoid an individual from deferring tax by incorporating a holding company to receive all of her dividend income. Therefore, a special Part IV tax applies to dividends received by a private corporation (and certain types of public corporations) and that are exempt from the normal Part I tax as a result of s. 112. Generally, the tax only applies to private corporations. Presumably public corporations will not be established to be used as tax deferral vehicles. There is an exception to this rule which we will discuss later. The point is that the Part IV tax is designed to put a tax on dividend income received by a private corporation which would not otherwise bear any tax. The rate of Part IV tax on dividends received by such a corporation was 25 % in respect of dividends received prior to January 1, 1995 and was increased to 33 1/3 % in respect of dividends received on or after January 1, 1995. The Part IV tax is designed to prevent the deferral of taxation on dividends otherwise received by an individual by the individual simply transferring the relevant shares to a wholly-owned corporation and having the corporation receive the dividends free of Part I tax as a result of s. 112. However, the 25 % rate was lower than the top marginal tax rates applicable to dividend income received by individuals which resulted in a significant deferral of tax. For this reason, the Part IV tax rate was increased to 33 1/3% effective January 1, 1995. Given that the top marginal rate on ineligible dividends in Alberta is 27.71%, the increase from 25% to 33 1/3% would not be as necessary for Alberta as it is for other provinces to prevent deferral. To allow for integration, this Part IV tax ought to be refunded when the corporation pays a dividend to the individual shareholder since she will then be subject to the gross-up and dividend tax credit on the amount of the dividend. Accordingly, the full amount of Part IV tax payable is also added to the corporation's RDTOH. This is applicable to all private corporations, whether or not they are CCPCs. In other words, all private corporations can have an RDTOH account into which they add their Part IV taxes payable but only private

(b)

(c)

212 corporations qualifying as CCPCs can also add to their RDTOH 26 2/3 % of their aggregate investment income. (d) When taxable dividends are paid out by the private corporation, a tax refund is given to the corporation equal to the lesser of its RDTOH at the end of the taxation year and 1/3 of the taxable dividends paid by it in the taxation year. This is called the "dividend refund" of the corporation and the rules that set out how the dividend refund works are known as the refundable dividend tax rules. Hence, by paying out dividends equal to three times the RDTOH account, a tax refund equal to the RDTOH account can be received which, in the case of a CCPC, is equal to 33 1/3% of investment income plus all of the Part IV tax on taxable dividends received in the year. In the case of a private corporation that is not a CCPC, a full refund of the RDTOH account means a refund of all of its Part IV tax. Where the investment income is earned by and fully distributed out of a CCPC, after the individual shareholder pays tax on the dividend, applying the gross-up and dividend tax credit rules, the effect is, in theory, full integration. As we shall see, a slight degree of underintegration results instead of complete and neutral integration. When the income is earned by and distributed out of a private corporation that is not a CCPC, integration clearly does not work since a non-CCPC cannot include investment income in its RDTOH. There is, instead, the usual measure of double taxation that occurs when income earned and taxed in a corporation is distributed to its shareholders. The result of the RDTOH provisions is that we now have the following rates of corporate taxation for the calendar year of 2012. 14% (Alberta) on active income of a CCPC eligible for the small business deduction up to $500,000. 44.7% on "aggregate investment income" of a CCPC (including the Part 1 tax of 6 2/3% in s. 123.1), of which up to 26.66 % is potentially refundable. 25% on investment income of corporations other than CCPCs. 25 % on everything else. This would include all income of a public corporation, all income of a private corporation that is not a CCPC, active business income of a CCPC that exceeds the annual business limit, and any other business income of a CCPC that is not included in its RDTOH account.

(e)

(f)

2. Dividend Refund - S. 129(1)

The dividend refund of a private corporation is set out in ss. 129(1). As ss. 129(1) presently reads, where a return of a corporation's income is filed within 3 years after the end of the year, the Minister must refund an amount equal to the lesser of: (i) (ii) one-third of all taxable dividends paid by the corporation in the year and at a time when it was a private corporation on shares of its capital stock, and its refundable dividend tax on hand at the end of the year.

213

Note that the corporation need not be a private corporation at the end of the year to be entitled to the dividend refund, but rather must have been a private corporation at the time it paid the dividend in the year. Note further that the provision says that the Minister may make the refund without application at the same time that he mails the notice of assessment for the year. However, if the Minister for some reason does not make the refund, para. 129(1)(b) requires the Minister to make the refund after mailing the notice of assessment if the corporation has made an application in writing for the refund within the time periods set out in paras. 152(4)(b) and (c). Ss. 129(2) provides that instead of making a refund that might otherwise be made under ss. 129(1), the Minister may apply the amount of the refund against any amount that the corporation is liable or is about to become liable in respect of any taxes payable under the Act. Essentially what happens is that on the income tax return the amount of dividend refund is treated as a credit towards taxes payable. If this credit results in a refund, then the Minister only refunds the excess. The amount of the refund determined under para. 129(1)(a) is referred to in the Act as the corporation's "dividend refund" for the year. For taxation years commencing after 1991, ss. 129(2.1) provides that the Minister is required to pay interest on dividend refunds at the prescribed rate. The period during which interest is payable starts on the later of (a) the 120th day following the end of the taxation year to which the dividend refund relates and (b) the date on which the corporation files its tax return for that year. The period ends on the date on which the dividend is paid or credited to the corporation.

3. Refundable Dividend Tax on Hand (RDTOH) - Ss. 129(3)

The amount of a dividend refund of a private corporation is equal to the lesser 1/3, of its taxable dividends paid in the year and its RDTOH at the end of the year. The amount of a corporation's RDTOH at the end of a year is determined under ss. 129(3). The RDTOH account is a cumulative account. It is composed of additions which comprise (i) a percentage of aggregate investment income and (ii) 100% of all of the corporation's Part IV taxes. These additions are made in respect of all taxation years that have ended since the corporation last became a private corporation. The account is reduced by the amount of all dividend refunds the corporation has ever had since it last became a private corporation. The RDTOH calculation is divided into three parts. The first part deals with the addition to RDTOH of amounts in respect of aggregate investment income for the particular taxation year and all prior taxation years. This is found in para. 129(3)(a). Secondly, para. 129(3)(b) adds to RDTOH the amount of Part IV tax payable by the corporation for the particular taxation year and all prior taxation years. Thirdly, para. 129(3)(c) reduces the RDTOH account by the amount of the corporation's dividend refunds for all prior taxation years.

214 Note that the RDTOH calculation is always made at the end of a particular taxation year. It is a yearend calculation, and is compared 1/3 of all taxable dividends paid by the corporation in the year in order to determine the amount of the dividend refund for the year. (a) Determination of RDTOH in respect of aggregate investment income.

The RDTOH account will be increased 26 2/3 % of aggregate investment income, except that the amount that can be added is restricted to Canadian tax paid on the investment income. In other words, if losses or charitable deductions have reduced taxable income to an amount below the amount of investment income, if foreign tax credits have reduced the amount of federal tax payable on foreign investment income, or if investment tax credits have reduced Part I tax, then the amount that can be added to the RDTOH is limited to the federal tax paid on such income. (i) Subpara. 129(3)(a)(i). The RDTOH account is increased by 26 2/3 % of the total of (A) aggregate investment income earned by a CCPC calculated after deducting losses from such property sources, and (B) net capital loss carryovers from other years and allowable capital losses from capital gains. In other words, take aggregate investment income and reduce it by losses. Then deduct capital loss carryovers from other years. This gives you 26 2/3 % of net investment income after losses and capital loss carryovers. (ii) It is also possible that foreign investment income will have borne a foreign tax such as a withholding tax and that Canada will have given a federal foreign tax credit under ss. 126(1). Therefore, the Act does not want to include in RDTOH any amounts on which Canada did not collect federal taxes. So, subpara. 129(3)(a)(i) attempts to limit the foreign investment income to the actual federal tax payable thereon less foreign tax credits given. The limitation in subpara. 129(3)(a)(i) is intended to reduce the refundable portion of a corporation's Part I tax if foreign tax credits reduce the effective rate of Canadian tax to below 26 2/3 %. The Canadian tax rate for this purpose is 36 %; if a corporation's "foreign investment income" has borne foreign tax at rates not exceeding 9.34 %t, (36 per cent minus 26.66 per cent) there will be no grind under subpara. 129(3)(a)(i). If the rate at which foreign source income has born tax increases above 9 1/3 %, the effective Canadian tax rate will fall below 26 2/3 % and so will the refundable portion of Part I tax. Subpara. 129(3)(a)(ii) limits the refundable portion of Part I tax to a corporation's taxable income that has borne Canadian tax at full rates. The amount determined under subpara. 129(3)(a)(ii) is 26 2/3 % of a corporation's taxable income for the year, less any amounts that were subject to the lower small-business tax rate under ss. 125(1) or that supported a foreign tax credit. These amounts are specified in clauses 129(3)(a)(ii)(A), (B), and (C). Clause (A) requires a deduction of the least of the amounts determined under paras. 125(1)(a) to (c) in respect of the corporation for the year (i.e., the corporation's income that was eligible for the small business deduction). Clauses (B) and (C) require the deduction of amounts that are calculated by assuming that foreign tax paid were Canadian tax and determining the amount of income reflected by that tax. The fractions in clauses (B) and (C) reflect assumptions that foreign-source non-business income is taxable at a total federal rate of 36 per cent and foreign-source business income at a rate of 40 %.

(iii)

215

(iv)

Subpara. 129(3)(a)(iii). The addition to RDTOH is limited to the Part I tax payable in the year, other than the surtax. Because Part I tax payable could be reduced by investment tax credits or other carryover losses, it is necessary to limit the RDTOH addition to net Part I tax payable. Calculated without reference to the surtax of 4%.

(b)

Determination of RDTOH in respect of Part IV tax payable.

Para. 129(3)(b) adds to RDTOH the amount of Part IV taxes payable by the corporation for the particular taxation year and all prior taxation years. Note that the amount of the Part IV tax that is added to RDTOH is 100% of the Part IV tax, not 26 2/3 % of the Part IV tax. (c) Reduction by Prior Dividend Refunds.

Para. 129(3)(c) reduces the RDTOH by the corporation's dividend refunds for prior taxation years. A dividend refund for a particular year does not reduce the RDTOH account for that year but instead reduces it for the subsequent year.

4. Meaning of Aggregate Investment Income - Ss. 129(4)

"Aggregate investment income" is defined in ss. 129(4). Essentially, it means the corporation's net taxable capital gains plus its income from property, in both cases to the extent the capital gain or income from property is from sources in Canada. (a) Capital Gains. Item (a) of the formula in the definition of "aggregate investment income". The taxable portion of capital gains in a year from dispositions of property. Hence, for calendar years after 2000, 1/2 of a capital gain will be considered to be aggregate investment income. If the corporation was once not a CCPC but then became one, the portion of the taxable capital gain that accrued prior to the corporation becoming a CCPC must be excluded. This does not apply to property owned by the corporation on November 12, 1981 (see definition of "designated property"). From this amount is deducted the corporation's allowable capital losses in a year from dispositions of property. Again, losses (otherwise than from "designated property") accruing prior to the corporation becoming a CCPC are excluded. Finally, deduct carryover losses from other years. (b) Investment Income. Item B of the definition formula. The corporation's income in a year from sources that are property, net of all related outlays and expenses deducted in the year which were made or incurred for the purpose of earning income from property, is also considered to be aggregate investment income. Excluded, however, are dividends deductible in computing taxable income, such as taxable dividends deductible under ss. 112(1). Also excluded are payments under a NISA Fund which are deemed to be active business income, and certain payments from a trust. The corporation's losses in a year from investments deducted from aggregate investment income. Ss. 129(4). For the purposes of the definition of "aggregate investment income", income or loss of a corporation that is a property is specifically defined to include income or loss from a specified investment business carried on in Canada. As we saw earlier, income from a

(c)

216 specified investment business is not subject to the small business deduction as it is specifically excluded from the definition of "active business" in para. 125(7)(a). A "specified investment business" is defined in para. 125(7)(e) to mean a business the principal purpose of which is to derive income from property, specifically including interest, dividends, rents or royalties, unless the corporation employs in the business throughout the year more than five full-time employees, or in the course of carrying on an active business, any other corporation associated with it provides managerial, administrative, financial, maintenance or other similar services to the corporation in the year and the corporation could reasonably be required to require more than five full-time employees if those services had not been provided. Ss. 129(4) also specifically excludes from income or loss from property any income or loss from any property that is incident to or pertains to an active business carried on by it, or from any property used or held principally for the purpose of gaining or producing income from an active business carried on by it.

This raises the same issues that arise in determining whether or not income is from an active business. That is to say, income or loss from a property that is incident to or pertains to an active business will not qualify as aggregate investment income and presumably will qualify as income from an active business pursuant to ss. 125(7).

5. Payments between Associated Corporations - Ss. 129(6)

As noted under the discussion relating to the small business deduction, ss. 129(6) operates to prevent the conversion of active business income within an associated group to income from property which would be included in Canadian investment income. Ss. 129(6) says that when an amount is paid or payable to one corporation (the "recipient corporation") by another corporation (the "associated corporation") with which the first corporation is associated, and the amount would otherwise be income from property to the recipient corporation, if the amount was deductible in computing the income of the associated corporation (that is, the one paying the amount) from an active business carried on by it in Canada, then it is not treated as income of the recipient corporation from a source that is property, and it is deemed to be income of the recipient corporation from an active business carried on by it in Canada.

Definition of Refundable Dividend Tax on Hand of a CCPC in ss. 129(3) (a) Assuming no foreign source income is earned will equal the least of (i) (ii) (iii) 26 2/3% of the corporation's "Aggregate investment income", defined in ss. 129(4); 26 2/3% of the amount by which the corporation's taxable income for the year exceeds the amount eligible for the small business deduction in ss. 125(1); the corporation's tax payable under Part I for the year.

217

PLUS (b) PLUS (c) MINUS (d) All dividend refunds that have been received for prior taxation years. Prior Year balances Part IV Taxes Payable for the Year

6. Taxation of Capital Gains i. The Capital Dividend Account. Definition in ss. 89(1).
We have seen that taxable capital gains of a CCPC are included in aggregate investment income for purposes of the refundable dividend tax provisions. Hence, one-half of a capital gain is a taxable capital gain. If a capital gain is realized by a private corporation, whether or not a CCPC, the portion of the capital gain not taxed is included in the corporation's "capital dividend account". The "capital dividend account" is defined in ss. 89(1). It is comprised of 1/2 of all capital gains less capital losses realized by the corporation while it has been a private corporation and prior to 1988, 1/3 of all capital gains less capital losses realized by the corporation after 1987 and prior to 1990, and 1/4 of all capital gains less capital losses realized by the corporation after 1989 and prior to February 28, 2000, 1/3 of all capital gains less capital losses realized by the corporation from February 28, 2000 and prior to October 18, 2000, and 1/2 of all capital gains less capital losses realized by the corporation after October 17, 2000. If the corporation was once not a private corporation but then becomes one, the portion of any capital gain that accrued prior to the corporation becoming a private corporation must be excluded. This does not apply to property owned by the corporation on November 12, 1981 (see definition of "designated property"). The capital dividend account is a cumulative account. The account is not calculated on a yearend basis like the RDTOH account. It is calculated at any time since the definition refers to the capital dividend account "at any particular time". The purpose of the capital dividend account is to allow private corporations to distribute the tax-free portion of their capital gains to their shareholders on a tax-free basis.

ii. Capital Dividends ss. 83(2).

Ss. 83(2) provides that a private corporation, whether or not a CCPC, that declares a dividend may elect that the dividend be deemed to be a capital dividend, meaning that the dividend is deemed to be paid out of the corporation's capital dividend account. If the corporation so elects, then no part of the dividend is included in computing the income of the shareholder to whom it is paid.

218 Specifically, ss. 83(2) provides that where a dividend becomes payable by a private corporation to shareholders of any class of its shares, and the corporation makes the proper election in respect of the full amount of the dividend, then the dividend is deemed to be a capital dividend to the extent of the corporation's capital dividend account, calculated as of the time immediately prior to the time the dividend becomes payable, and no part of the dividend is to be included in computing the income of any shareholder.

To make the election properly, it must be completed on a prescribed form (Form T2054) and must be filed on or before the time the dividend is payable, or the first day on which any part of the dividend was paid, whichever is earlier. The CRA considers a dividend to become payable on the day stipulated by the directors' resolution that declared the dividend (Interpretation Bulletin IT-66R6, paragraph 2). Note that the election must be made in respect of the full amount of the dividend. The corporation cannot declare a dividend of $100 and elect that $60 of the $100 be a capital dividend payable out of its capital dividend account. It must elect on the whole $100 or not elect at all. If an election to have a dividend treated as a capital dividend out of the capital dividend account is not filed on time, then ss. 83(3) allows the election to be filed late provided a penalty is paid. The penalty is provided for in ss. 83(4) and is 1% per annum of the amount of the dividend referred to in the election for each month or part of a month during the period commencing with the time that the dividend became payable, or the first day on which any part of the dividend was paid if that day is earlier, and ending with the day the election is made, up to a maximum of $41.67 per month or part of a month. The effect of this is that if a private corporation realizes a capital gain from the disposition of property, whether that property is located within or without Canada, 1/2 of the capital gain net of any capital losses will be added to the corporation's capital dividend account out of which it is able to pay dividends that will not be taxable. The reason for this is that because capital gains are only taxable as to 1/2, there would be a tremendous disadvantage to an individual holding investments through a private corporation since if he held the investments directly, only 1/2 of capital gains would be included in his income. Accordingly, through the use of the capital dividend account, the tax-free 1/2 of the capital gain is preserved since this 1/2 can be added to the capital dividend account and taxfree dividends paid out to the shareholder from that account. The capital dividend account and the ability to pay capital dividends out of the capital dividend account only apply to private corporations. Capital gains realized by public corporations will be subject to double taxation in the sense that when the tax-free one-half of the gain is distributed, it will be distributed by way of a taxable dividend. If a private corporation becomes a public corporation at a time when it still has a balance in its CDA, the ability to distribute that balance as a capital dividend is lost forever. Note, however, that the capital dividend account and capital dividend rules in ss. 83(2) apply to private corporations whether or not they are Canadian-controlled private corporations. This is to be contrasted with the fact that 26 2/3% of 1/2 of the capital gain can be added to the RDTOH account only if the private corporation is a CCPC.

219

iii. Capital Dividends Paid to Another Corporation

Paragraph (b) in the definition of "capital dividend account" in ss. 89(1) also includes dividends received by the corporation out of the capital dividend account of another corporation. That is to say, if Corporation A pays a capital dividend to its shareholders, one of which is Corporation B, Corporation B will include in its capital dividend account the amount of the capital dividend paid by Corporation A. This, obviously, is to prevent the conversion of capital dividends to ordinary surplus where the dividends are paid by one corporation to another. Naturally, Corporation B can only include the capital dividend in its capital dividend account if it is a private corporation since, although corporations other than private corporations may have a capital dividend account, only private corporations can pay capital dividends out of their capital dividend account. Note that capital losses of a private corporation reduce capital gains included in the CDA but do not reduce the amount of the CDA account composed of capital dividends received from other private corporations. For example, if a corporation has $100 of taxable capital gains, $120 of allowable capital losses and $10 of capital dividends received from other private corporations, the CDA balance is $10.

iv. Excessive Elections. Part III Tax

What happens if the full amount of a dividend that the corporation elects to have treated as a capital dividend is greater than the amount in the capital dividend account? This could arise due to a miscalculation of the balance in the account. More importantly, it could arise as a result of a reassessment by the CRA whereby a gain which was treated by the corporation as a capital gain is reassessed as an item of ordinary income because the CRA has treated the transaction as an adventure in the nature of trade. Meantime, the corporation has paid a dividend and elected that it be paid as a capital dividend out of the capital dividend account. The first thing to note is that there is no tax consequence to the recipient shareholder. Examine ss. 83(2) again. It says that if the corporation elects in respect of a dividend, the dividend is deemed to be a capital dividend to the extent of the corporation's CDA account. It also says that no part of the dividend is to be included in the income of any shareholder. This is the effect of para. 83(2)(b) and you will note that it does not say that the dividend is not included in income to the extent it is a capital dividend. It simply says that no part of the dividend is to be included in income. Hence, the fact that an election is made on a dividend the amount of which exceeds the balance in the CDA account is of no concern to the recipient. Note however that ss. 185(4) makes the shareholder jointly and severely liable with the corporation to pay a proportion of the corporations tax payable under Part III because of the election. Instead, it is the corporation that pays the penalty for an excessive election. The penalty is a special tax provided for in Part III of the Act. Ss. 184(2) provides that where a corporation has elected under ss. 83(2) in respect of a dividend, and the full amount of that dividend exceeds the portion deemed by ss. 83(2) to be a capital dividend, i.e. the full amount of the dividend exceeds the CDA account determined immediately prior to the time when the dividend is declared to be payable, the corporation must pay a tax of 75 % of the excess. The liability for the tax arises as of the time the excessive election was made, not as of the time the election was determined to be excessive and interest will apply on the 75 % penalty from the time of the election until the time the penalty is paid.

220 As an alternative to paying the tax under Part III of the Act, the corporation may, provided it meets certain requirements, make an election under ss. 184(3) to treat the excess of the dividend over the corporation's CDA account as a separate taxable dividend which will be included in the income of the shareholders who received such dividend. Ss. 184(4) provides that this election is not valid unless (a) it is made with the concurrence of the corporation and all of the shareholders entitled to receive a portion of the dividend, (b) the address of each such shareholder is known to the corporation and either (c) the election is made within 30 months of the dividend becoming payable or (d) each shareholder concurs with the election such that the Minister can reassess each shareholder to account for the taxable portion of the dividend notwithstanding that the normal reassessment period may have expired. It should be noted that unexpected tax consequences can arise if an excess election is made under ss. 184(3). Consider the following excerpts from Stuart Hoegners article The Best Things in Life are (Tax-) Free, Canadian Tax Journal, Volume 50, Number 4, 2002. This section explores several planning strategies that can help private corporations and their shareholders to make the most effective use of the CDA. Circulating the CDA Because a corporation's CDA can be reduced by certain transactions, it may be efficient for the corporation to distribute positive amounts out of the CDA, to the extent that it is permissible to do so, before those amounts are eroded. This | strategy may be called "circulating" the CDA. The objective is to distribute amounts credited to the CDA when they become available, in order to exploit the CDA's full potential to the benefit of the corporation's shareholders. The discussion that follows first reviews the considerations that may influence the decision to circulate the CDA of a private corporation, then examines two structures that may be used for effecting the circulation, and concludes with a brief comment on how circulation might assist in addressing the particular concerns of shareholders holding high-low shares. It is important to note that, as defined by the Act, a CDA cannot have a negative balance. Several paragraphs of the definition in subsection 89(1) provide that the CDA consists only of the excess, if any, of certain amounts over certain other amounts. In other words, a corporation's CDA cannot dip below zero. For example, with respect to dispositions of capital property, paragraph (a) of the definition states that, generally, the CDA of a corporation at any particular time is the amount, if any, by which the non-taxable portions of capital gains exceed the non-deductible portions of capital losses. As it is only the amount of any excess that falls within the ambit of the definition in paragraph (a), the amount generated by that paragraph cannot be negative. However, as noted above, certain events or transactions may lead to recognition of a negative amount that will grind down an existing positive CDA balance. Accordingly, shareholders may favour the distribution of positive amounts as they accumulate, instead of risking erosion of the funds if they are retained for a longer term. Of course, tax planning is never quite so simple. While the CDA cannot have a negative balance, the computation of the CDA is a point-in-time calculation covering the entire period during which a private corporation can accumulate amounts in the account. A distribution of capital dividends will have consequences for the computation of the CDA in the future. For example, assume the following facts: Immediately after incorporation at the beginning of 2001, a private corporation has a nontaxable portion of capital gain in its CDA in the amount of $100,000. During its 2001 taxation year, the corporation elects and pays out a capital dividend of $100,000. The corporation's year-end is December 31.

221 Before the 2001 year-end, but after the election and payment of the capital dividend, the corporation recognizes a non-deductible portion of a capital loss of $100,000. On January 1, 2002, the corporation has another non-taxable portion of capital gain to add to its CDA in the amount of $50,000. On February 1, 2002, the corporation has yet another non-taxable portion of capital gain to add to its CDA in the amount of $50,000. The following table shows the computation of the corporation's CDA at both January 2, 2002 and February 2, 2002. Circulating the Capital Dividend Account (CDA): Calculation of CDA Balance January 2, 2002 Non-taxable portion of capital gain received in 2001 $100,000 Capital dividend distributed in 2001 ($100,000) Non-deductible portion of capital loss recognized in 2001 ($100,000) Non-taxable portion of capital gain received on January 1, 2002 $ 50,000 Non-taxable portion of capital gain received on February 1, 2002 n/a Subtotal ($ 50,000) Amount in CDA pursuant to subsection 89(1) paragraph (a) of the definition of CDA $ 0 February 2, 2002 $100,000 ($100,000) ($100,000) $ 50,000 $ 50,000 $ 0 $ 0

Even though, on both dates, the amount in the corporation's CDA is at zero, the negative $50,000 "remains" throughout January 2002 and "follows" the corporation until enough non-taxable capital gains are received into the CDA to offset it. Accordingly, while the circulation of amounts out of the CDA may be useful to certain shareholders, it may result in less long-term flexibility for the corporation and its shareholders, to the extent that capital dividends paid out will still be part of the CDA calculation at later dates. One factor that may affect the decision to circulate amounts out of a private corporation's CDA is the presence of refundable dividend tax on hand (RDTOH) in the corporation. A private corporation may obtain a "dividend refund" from the minister equal to the lesser of one-third of its taxable dividends paid to shareholders in the year and its RDTOH at the end of the year. Assuming that the taxable dividends paid to shareholders in the year do not exceed three times the total RDTOH, some shareholders may prefer to receive taxable dividends from the corporation instead of a capital dividend distribution. For example, in several provinces (such as Ontario, Alberta, and British Columbia), the effective tax rate on dividends, at the top marginal income tax rate for individuals, is less (at 31.34 percent, 24.08 percent, and 31.58 percent, respectively) than the one-third of tax refunded on the payment of taxable dividends by private corporations with RDTOH. Where a private corporation with RDTOH has only one individual shareholder, and that shareholder resides in a province with such a favourable tax rate on dividends, the payment of taxable dividends by the corporation will create a personal tax liability for the shareholder in respect of the dividends received but will entitle the corporation to recover more than that amount as a dividend refund on taxable dividends paid. The combined effect, for the corporation and the shareholder taken together, is to convert the net tax cost of paying a taxable dividend into a net benefit. Life-Insurance-Funded Redemptions or Purchases for Cancellation

222 The inclusion of proceeds of a life insurance policy in the CDA (less the cost basis of the policy) can be a valuable tool for tax planners. A CDA funded by life insurance can be used to help fund the redemption or purchase for cancellation of part or all of a deceased shareholder's capital stock. By providing at least part of the funds necessary for the redemption or purchase for cancellation, life insurance of a corporate beneficiary can provide a measure of security for the shareholder's estate. It can contribute to the smooth transition of the ownership of a business, thereby satisfying the needs of employees and creditors, if any. Also, on the death of a key shareholder, a life-insurance-funded CDA can help maintain the value of the company for the surviving shareholders.

v. Definition of "Taxable Dividend"

We have referred to taxable dividends before as being dividends in respect of which, if received by an individual from taxable Canadian corporations, are subject to the gross-up and dividend tax credit rules and if received by a corporation are deducted out from taxable income under ss. 112(1). The definition of taxable dividends is contained in ss. 89(1) and essentially means any dividend other than a dividend which the corporation has elected to have treated as a capital dividend.

7. Capital Gains
Comparison of Corporate Tax Assume a $100 capital gain is realized in 2012. Because a private corporation can pay a dividend out of its CDA account, the example will examine a CCPC, a non-CCPC private corporation, and a public corporation. Assume the recipient shareholder is in the top tax bracket in Alberta. Assume the Alberta corporate tax rate is 10%.

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CCPC $ Capital Gain Capital Dividend Account Taxable Capital Gain Less: Corporate Tax 28% Plus: Rate reduction (13%) Less: Federal Surtax of 6 2/3% Less: Provincial Tax (10%) Total Tax After-Tax Retained Earnings Dividend RDTOH (assume full refund) Dividend to Shareholder after Dividend Refund Less Personal Tax at 27.71% or 19.29% After Tax Cash Add: Capital Dividend Total After Tax Cash Total Tax Paid 100.00 50.00 50.00 (14.00) N/A (3.33) (5.00) 22.33 27.67 27.67 13.33 41.00 (11.36) 29.64 50.00 79.64 20.36

Non-CCPC $ 100.00 50.00 50.00 (14.00) 6.50 N/A (5.00) 12.50 37.50 37.50 N/A 36.75 (7.08) 29.67 50.00 79.67 20.33

Public $ 100.00 N/A 100.00 (14.00) 6.50 N/A (5.00) 12.50 87.50 87.50 N/A 86.75 (16.73) 70.02 N/A 70.02 29.98

* RDTOH account ($50 x 26 2/3%). If the shareholder had earned the $100 capital gain directly, she would have paid tax of $19.50, being 1/2 of the 2012 top personal rate of 39.00%, and would have $80.50 remaining. Hence, when a CCPC is used, there is under-integration (meaning more tax is paid when using a corporation as a conduit) in the amount of $1.04 on the $100 capital gain. Why does this result? First, because the gross-up and dividend tax credit systems and the refundable dividend tax credit system for ineligible dividends assumes a corporate rate of tax of 20%. Here the rate is 28% (federal rate) + 6 2/3 % (123.3 tax) + 10.00% (Alberta rate) - (RDTOH refund) = 19.85%. Second, integration is affected by the fact that the Alberta personal rate of tax is 10% of taxable income, not 50% of the federal rate. Note that the untaxed portion of the capital gain (50%) can be subject to the Alternative Minimum Tax.

8. Effect of the RDTOH Account and the CDA

The purpose of the RDTOH and CDA accounts is to provide integration with respect to investment income. How successful is it? Examples:

224 (a) Assume $100 of Canadian investment income (interest) is earned for the calendar year of 2012. Assume a top bracket Alberta individual shareholder. In the example below, a comparison is made between $100 of investment income is earned by a CCPC and $100 of investment income received by a non-CCPC. The non-CCPC could be a private corporation or a public corporation.

CCPC $. Interest Income Less: Basic Corporate Tax (net of abatement) Less: Federal Surtax @ 0% Plus: Tax reduction Less: Federal Refundable tax @ 6 2/3% Less: Provincial Tax After-Tax Retained Earnings RDTOH (Dividend refund)** Total Corporate Tax Dividend to Shareholder Gross-Up of 25% or 38% Total Income of Shareholder from Dividend Federal Tax @ 29% Less: Dividend Tax Credit (13.33 % or 15.02%) grossed-up dividend) Basic Federal Tax Payable Add: Alberta Flat Tax of 10% Less: Dividend tax credit (3.5% or 10% of grossed- up dividend) Total Personal Tax on Dividend Net Cash Position Dividend Less: Personal Tax Paid After Tax Cash Initial investment income to corporation Combined corporate and personal tax rate 82.00 (22.76) 59.24 100.00 40.76 N/A (6.67) (10.00) 55.33 26.67 18.00 82.00 20.50 102.50 29.72 (13.63) 16.09 10.25 (3.58) 22.76 100.00 (28.00)

Non-CCPC $ 100.00 (28.00) 13.00 (10.00) N/A 25.00 75.00 28.5 103.5 30.01 (15.54) 14.47 10.35 (10.35) 14.47

75.00 (14.47) 60.53 100.00 39.47

NOTE: *As per the subpara.123.4(b)(iii) definition of "full rate taxable income". ** $78.81 must be paid out in taxable dividends to get refund of $26.27 on $80.

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Assume now that the interest is earned personally by an Alberta resident individual. shareholder had earned the $100 directly, he would have paid tax as follows.
Taxable Income Basic Federal Tax @ 29% Add: Alberta Tax @ 10% Total Tax After Tax Cash $100.00 29.00 10.00 39.00 61.00

If the

From the above analysis, the most tax efficient way to earn interest is through an individual at a tax rate of 39%. If the interest income is earned through a corporation that is also a CCPC and distributed to a shareholder in the top tax bracket, more tax will be paid (40.76%). If the interest income earned by a non-CCPC and distributed to a shareholder, more tax will be paid (39.47%). One should also consider the deferral potential if the income is retained and reinvested by the corporation as opposed to being distributed as a dividend to the shareholder. If the shareholder earned and reinvested the money, he would have $61 to invest, if the CCPC reinvested it would have $55.33 to reinvest as a result of the 44.67% corporate tax that it must pay. Therefore, on both a tax savings and deferral level, it is most efficient for an Albertan individual in the highest tax bracket to earn interest income personally rather than through a corporation.

9. Inter Corporate Dividends and Part IV - Tax (s. 186) i. General

As originally conceived, Part IV tax was only payable by private corporations. Public corporations were not subject to the tax even if such corporations received dividends on portfolio investments in other corporations. The exemption for public corporations was justified on the basis that the Part IV tax was intended to deter high rate bracket individuals from deferring tax on portfolio investments by holding those investments in a private corporation. In theory, public corporations were widely held and would not present opportunities for deferral of this kind. In practice, it was found that a number of large private corporations with substantial portfolio investments avoided the Part IV tax by arranging to list a class of shares on a prescribed stock exchange in Canada, thereby acquiring public corporation status. In extreme cases, the publiclytraded shares represented a small fraction of the total equity of the corporation and in some cases carried no voting rights whatever. From a practical point of view, the now public company was still directly and effectively controlled by the small group of individuals that owned 100% of the company before the public issue. The preamble in s. 186 now addresses this situation with the concept of a "subject corporation". In general terms, this is any corporation that is not a private corporation and that is controlled directly by an individual or a related group of individuals. A subject corporation is liable to pay Part IV tax on assessable dividends received from corporations with which it is not connected. Part IV tax is payable by: 1. a corporation that is a private corporation at any time during the year;

226 2. certain public corporations that are controlled by an individual, or related group of individuals.

Rate of tax is 33.3% of assessable dividends received. Taxable dividends subject to Part IV tax are: 1. 2. 3. assessable dividends [para.186(1)(a)(i)]; received from non-connected Canadian corporations

assessable dividends from non-connected foreign corporations (you may ignore this) [para.186(1)(a)(ii)]; assessable dividends from connected private corporations if payor corporation is entitled to a dividend refund [s.186(1)(b)].

Interpretation Bulletin 269R4

April 24, 2006 (Information is current as of January 2012) Part IV Tax on Taxable Dividends Received by a Private Corporation or a Subject Corporation Summary The purpose of Part IV is to prevent the deferral of tax on portfolio dividend income through the use of private or other closely held corporations. Since corporations are generally permitted to deduct dividend income in calculating their taxable income, Part IV imposes a tax on dividends received by private corporations or closely-held corporations in order to eliminate the incentive for an individual to obtain a significant deferral of tax on dividend income by transferring investments in shares to such corporations. Part IV tax is intended to approximate the tax that would be paid by an individual taxable at the highest marginal tax rate had the dividends been received by that individual. Generally, this tax is fully refundable as a dividend refund to the corporation when the corporation pays dividends to its shareholders, since the shareholders will then be subject to tax at their marginal rates on the dividends. Discussion and Interpretation General 1. Taxable dividends are included in the income of corporations by virtue of paragraph 12(1)(j) or 12(1)(k). Where a corporation which is resident in Canada has received a taxable dividend from (a) a taxable Canadian corporation, or (b) a corporation resident in Canada (other than a non-resident-owned investment corporation or a corporation exempt from Part I tax) and controlled by the recipient, section 112 permits the receiving corporation to deduct from income an amount equal to the dividend for the purpose of computing its taxable income. Where the corporation has received a dividend from a foreign affiliate, an amount, as calculated under section 113, may be deducted from the corporation's income for the purpose of computing its taxable income. Although Part I tax is not exigible on taxable dividends received by a corporation resident in Canada to the extent that such

227 dividends are deductible pursuant to sections 112 or 113, section 186 may impose a Part IV tax on such dividends as discussed below. 2. The Part IV tax applies to assessable dividends received by a corporation that was at any time in a taxation year a private corporation or a subject corporation. Subsection 186(3) defines an assessable dividend as an amount received by a corporation at a time when it is either a private corporation or a subject corporation as, on account of, in lieu of payment of or in satisfaction of, a taxable dividend from a corporation to the extent of the amount in respect of the dividend that is deductible under section 112, paragraph 113(1)(a), (b) or (d) or subsection 113(2) in computing the recipient corporation's taxable income for the year. A private corporation is defined in subsection 89(1). Refer to the current version of IT-391 [IT-391R], Status of Corporations, for a discussion of what constitutes a private corporation. Subsection 186(3) defines a subject corporation as a corporation (other than a private corporation) resident in Canada that is controlled, whether by reason of a beneficial interest in one or more trusts or otherwise, by or for the benefit of an individual (other than a trust) or a related group of individuals (other than trusts). For greater certainty, a corporation may be controlled by or for the benefit of an individual or a related group of individuals even where such control or benefit is derived indirectly through one or more intermediary corporations, partnerships or trusts. Exemptions from Part IV Tax 3. Pursuant to section 186.1, Part IV tax is not payable for a taxation year by a corporation (a) that was a bankrupt at any time in the taxation year, or (b) that was, throughout the year, (i) a bank, (ii) a corporation licensed or authorized under the laws of Canada or a province to carry on in Canada the business of offering to the public its services as a trustee, (iii) an insurance corporation, (iv) a prescribed labour-sponsored venture capital corporation, (v) a prescribed investment contract corporation, (vi) a non-resident-owned investment corporation (note that a corporation cannot be a non-residentowned investment corporation after 2003 according to paragraph (i) of the definition of non-residentowned investment corporation in subsection 133(8)) or (vii) a registered securities dealer that was throughout the year a member of a prescribed stock exchange in Canada. 5. Pursuant to subsection 227(14), Part IV tax does not apply to any corporation for any period throughout which it is exempt from tax because of section 149. Such corporations include registered charities and pension corporations. Application of Part IV Tax Calculation of Part IV tax subsection 186(1) 6. The tax payable under Part IV for a year by a particular private corporation or subject corporation is equal to the amount by which the total of (a) 1/3 of all assessable dividends (see 2) received in the year by a recipient corporation from payer corporations with which it is not connected (see 11), and (b) the total of each amount in respect of an assessable dividend received in the year by a recipient corporation from a private corporation or a subject corporation that was a payer corporation connected with the recipient corporation (see 11), equal to the proportion of the payer corporation's dividend refund (see 7) for its taxation year in which it paid the dividend that

228 (i) the amount of the dividend received by the recipient corporation is of (ii) the total of all taxable dividends paid by the payer corporation in its taxation year in which it paid the dividend and at a time when it was a private corporation or a subject corporation exceeds 1/3 of the total of (c) such part of the recipient corporation's non-capital loss and farm loss for the year as it claims, and (d) such part of the recipient corporation's (i) non-capital loss for any of its 10 taxation years immediately preceding or 3 taxation years immediately following the year, and (ii) farm loss for any of its 10 taxation years immediately preceding or 3 taxation years immediately following the year as it claims to the extent that such amount would be deductible under section 111 if the corporation had sufficient income for the year. The expression farm loss as defined in subsection 111(8) includes a loss for the year from a fishing business. To the extent that the deduction of a non-capital loss is subject to the restrictions of subsection 111(5), such loss can not be applied to reduce the corporation's Part IV tax. 7. For the purpose of the calculation described in 6(b), a payer corporation's dividend refund is defined in paragraph 129(1)(a) to be the lesser of (a) 1/3 of all taxable dividends paid by the corporation in its taxation year and at a time when it was a private corporation, and (b) its refundable dividend tax on hand (RDTOH) (see 18 below) at the end of its taxation year. 8. For purposes of 6, the determination of whether an assessable dividend was received from a connected corporation must be made at the time that the dividend was received by the recipient corporation. If the assessable dividend was received from the payer corporation at a time when that corporation was not connected to the recipient corporation (see 11), then the dividend is subject to Part IV tax as described in 6(a), notwithstanding that the payer corporation may have been connected to, or might subsequently become connected to, the recipient corporation at some other time during the taxation year. Use of non-capital or farm losses to reduce Part IV tax 9. Generally, it is more advantageous for a corporation to use its non-capital loss or farm loss to reduce its taxable income rather than to reduce its Part IV tax as described in s 6(c) and (d), because the Part IV tax rate is normally lower than the combined federal and provincial tax rate applicable to investment income (i.e. non-active business income). A corporation might decide to use a non-capital loss or farm loss to reduce or eliminate its Part IV tax base for a particular year where, for example: the corporation is a Canadian-controlled private corporation and all of its income is eligible for the small business deduction (i.e. the effective combined tax rate on its taxable income is lower than the Part IV tax rate), or the corporation might not otherwise be able to use all of its non-capital loss or farm loss before the end of the applicable carry-forward period. Assessable dividends subject to Part IV.1 tax 10. Where a corporation receives an assessable dividend that is subject to tax under Part IV.1, subsection 186(1.1) reduces the Part IV tax as follows: (a) where the assessable dividend is one described in 6(a), by 10% of the assessable dividend, and (b) where the assessable dividend is one described in 6(b), by 30% of the amount determined under that paragraph for the assessable dividend.

229 Part IV.1 levies a tax on certain dividends received on taxable preferred shares (defined in subsection 248(1)). Generally, a taxable preferred share will include most preferred shares issued after June 18, 1987. Connected Corporations Definition of connected 11. Pursuant to subsection 186(4), a payer corporation is connected with the recipient corporation at a particular time where (a) the recipient corporation controls (see 12) the payer corporation (otherwise than by virtue of a right referred to in paragraph 251(5)(b)) at that time, or (b) the recipient corporation owns, at the particular time, (i) more than 10% of the issued share capital (having full voting rights under all circumstances) of the payer corporation, and (ii) shares of the payer corporation having a fair market value greater than 10% of the fair market value of all the issued shares of the payer corporation. 12. For the purpose of determining whether a payer corporation is connected with a recipient corporation (see 11(a)), subsection 186(2) expands the normal concept of control and provides that one corporation is considered to be controlled by another corporation if more than 50% of its issued share capital having full voting rights belongs to (a) the other corporation, (b) persons not dealing at arms' length with the other corporation, or (c) the other corporation and persons not dealing at arms' length with the other corporation. For example, consider the situation where the issued share capital of Corporation A consists solely of 100 common shares of which 90 are owned by Mr. X. The remaining 10 common shares are owned by Corporation B, a corporation that is controlled by the spouse of Mr. X. For the purposes of Part IV, Corporation A would, by virtue of subsection 186(2), be controlled by Corporation B because more than 50% of the issued share capital of Corporation A is owned by Mr. X who is related to and, therefore, deemed not to deal at arm's length with Corporation B. As noted in 11(a), control of the corporation is determined by considering the actual ownership of shares, without taking into account any rights referred to in paragraph 251(5)(b). 13. Due to fluctuations in the fair market value of different classes of the shares of the payer corporation referred to in 11(b), the recipient corporation's percentage interest of the fair market value of all the issued shares of the payer corporation may vary from time to time, which may result in the payer corporation becoming or ceasing to be connected with the recipient corporation. Where a corporation is controlled (as discussed in 12) by one or more persons and the recipient corporation does not control, and is not a member of the group that controls, the corporation, a discount from the pro-rata value would normally be applied to determine the fair market value of the shares held by the recipient corporation to reflect the recipient corporation's minority interest status. Similarly, where restrictions on the marketability of shares exist, a discount will normally be applied in determining the fair market value of such shares to reflect those restrictions. 14. For the purposes of 11(b), shares which have full voting rights do not cease to have such rights even if the holder of such shares limits their voting rights by entering into a shareholder agreement or a voting trust which dictates how the shares are to be voted. Deemed dividends under subsection 84(3)

230 17. For purposes of 11, where a payer corporation redeems shares owned by a recipient corporation resulting in a deemed dividend under subsection 84(3), the recipient corporation is considered to be the owner of the shares of the payer corporation at the time that the deemed dividend arises, notwithstanding that the shares were redeemed at that time. Thus, if the payer corporation was connected with the recipient corporation immediately before the redemption of the shares, the payer corporation would be connected with the recipient corporation at the time of the deemed dividend. Consequently, the recipient corporation will not be subject to Part IV tax under the general provisions of paragraph 186(1)(a) for such taxable dividend (see 6(a)). However, where the payer corporation receives a dividend refund as a result of the deemed dividend under subsection 84(3), the recipient corporation will be liable to Part IV tax to the extent provided by paragraph 186(1) (b), as discussed in 6(b), since the payer corporation is connected with the recipient corporation. Refundable dividend tax on hand 18. The tax payable for the year under Part IV is added to the recipient corporation's refundable dividend tax on hand at the end of its taxation year under paragraph 129(3)(b). Provided that the recipient corporation is a private corporation when it subsequently pays taxable dividends to its shareholders, all or a portion of such Part IV tax will be refunded to the recipient corporation as explained in the current version of IT-243, Dividend Refund to Private Corporations. By virtue of subsection 186(5), a subject corporation is deemed to be a private corporation for the purpose of the dividend refund under section 129; however, the amount of a subject corporation's RDTOH is limited to the total of all taxes payable under Part IV that have not previously been refunded whereas the RDTOH of certain private corporations (for example, a Canadian-controlled private corporation) may include other amounts. Circularity of Part IV Tax 20. In certain divisive reorganizations, a corporation may be both a payer and a recipient of a taxable dividend as a result of the cross-redemption of shares which generally occurs in such reorganizations. Consequently, where either of the transferee corporation or the distributing corporation has, or will have, a balance in its RDTOH account at the end of the taxation year in which the cross-shareholdings are redeemed, the resulting deemed dividends can lead to a circular calculation of the Part IV tax and dividend refund that each corporation is entitled to receive in circumstances where the corporations are connected with each other. Several techniques are available to address this circularity problem, including the use of a subsidiary of the transferee corporation or the staggering of the cross-redemptions to occur in different taxation years of one of the corporations.

ii. Connected Corporation ss.186(4)

Payer Corporation is connected with a particular corporation if Payer Corporation is controlled by the particular corporation at that time (s.186(2) control definition) other than by virtue of a right referred to in paragraph 251(5)(b) [options etc.] or

231

the particular corporation owned at that time: a. and b. shares of Payer Corporation had a fair market value greater than 10% of the fair market of all the issued shares of Payer Corporation more than 10% of the issued voting shares of Payer Corporation

iii. Definition of Control ss.186(2)

Separately defined for purposes of s. 186: Control exists if more than 50% of voting shares owned by the corporation or persons with whom the Corporation does not deal at arm's length or the corporation and person with whom the corporation does not deal at arm's length.

232 Part IV: Examples of Control s.186(2)

Mr. AB 100% 5% Co. X

Son of AB 95%

Co. Y

Son of AB is related to Co. X (subpara. 251(2)(b)(iii)).

General Concept

Co. X 80% 5% Co. Z 60% Co. Y

Common Law Co. X controls Co. Y Co. Y controls Co. Z Therefore, Co. X considered to control Co. Z (Vineland Quarries)

Subsection 186(2) Co. X. controls Co. Y, i.e. more than 50% of the issued voting shares in Co. Y belong to a person who does not deal at arm's length with Co. X - ss.186(2). Co. X connected with Co. Y Co. X connected with Co. Z No part IV tax payable on dividend paid by Z Co. to X Co.

233

V. Owner-Manager Compensation
1. General Rules
(a) If the corporation is a CCPC earning active business income, with low levels of cash requirements, the shareholder/manager should take all salary. He should continue to take all salary until his marginal rate on the next dollar of salary will exceed 14% (for the calendar year of 2012). This is because up to that point, each dollar of income is taxed more cheaply to the shareholder/manager than in the corporation because he/she will have personal tax credits. As soon as the shareholder achieves the position where the next dollar of salary paid to him will cost more than the value of the deduction to the corporation, the shareholder should commence taking dividends as well as salary. As the dividends will produce dividend tax credit, always ensure that there is no dividend tax credit in excess of federal tax payable. Mix the salary and the dividends so that cash required is taxed at the corporate and individual level at the lowest total tax cost. Example $10,882 salary plus $5,000 dividend results in no tax for a taxpayer supporting a spouse. Taxpayer is also at poverty level. (c) At a certain point, it will be optimum to pay only dividends. This is because the tax cost of additional salary to the shareholder will exceed the value of the deduction to the corporation and the dividend tax credit is equal to or less than the federal tax payable. If the corporation is not entitled to the small business deduction, pay salary until the shareholder's marginal rate on the next dollar of salary will exceed the marginal corporate rate of tax. Thereafter, pay salary or defer. If the corporation has RDTOH, pay dividends to obtain a dividend refund. The shareholder's marginal rate on dividends is less than the dividend refund. In any event, do not pay dividends to access a dividend refund until (a) has been achieved. Consider paying tax-free dividends from the capital dividend account. Again, this should not be done until the combination of salary and taxable dividends has been achieved such that the cost to the shareholder of the next dollar of salary or taxable dividend exceeds the value of the deduction to the corporation for the payment of the salary.

(b)

(d)

(e)

(f)

2. Other Matters
(a) Withholding Requirement. Payments of salary require withholding of a portion of the salary pursuant to Part I of the Income Tax Regulations which are made pursuant to ss. 153(1). This will affect the timing of cash flow. Reasonableness of Deduction to Corporation. All expenses of a taxpayer that are otherwise deductible are limited to a reasonable requirement pursuant to s. 67. This is rarely a problem

(b)

234 for an owner manager but one must be aware of the point should extremely large salaries be paid to family members or to holding corporations. (c) The number of shareholders and employees. The optimum mix of salary and dividend will change dramatically if more than one shareholder and/or employee is involved in the corporation. With more than one shareholder, the exercise would include the determination of the optimum salary and dividend mix for each shareholder, then a negotiation of the optimum salary and dividend payments that will be made out of the corporation when considering the tax costs to each shareholder. It is very unlikely that an optimum salary and dividend mix for one shareholder will be the optimum for other shareholders. Even if the shareholders each have an interest in the company, their personal exemptions, deductions, and so forth would differ and one may prefer more salary than the other. "Earned Income" for RRSP contributions. Canada Pension Plan and RRSP contributions may require additional salary income to maximize the taxpayer's RRSP deduction limit for the purpose of ss. 146(5). Multiple classes of shares. The issuance of differing classes of shares to different types of shareholders, generally non-income earning spouses, can be done provided that it is clear that the shares held by such persons are indeed shares of a separate class. Attribution Rules Any plan that involves a transfer of property from a parent to children or between spouses must be carefully structured in order to avoid the application of the income attribution rules in section 74.1 through 74.5 and section 75. The rules are designed to discourage incomesplitting arrangements in many circumstances. Income or loss from property transferred or loaned by an individual, either directly or indirectly, to or for the benefit of that individuals spouse, common law partner or to certain minors is attributed to the individual and not included in the income of the spouse, common law partner or minor, by virtue of ss. 74.1(1) and (2). Taxable capital gains or allowable capital losses realized on the disposition of property transferred or loaned by an individual to the individuals spouse or common law partner, but not to a minor, are also attributed to the individual, and not included in the computation of the income of the spouse or common law partner, by virtue of section 74.2. In each case, attribution applies to income, gains or losses from the original property or property substituted for it. There is no attribution once the transferor or lender ceases to be a resident of Canada or is no longer alive. Attribution may be avoided by ensuring that a spouse or minor pays fair market value (FMV) for the shares acquired with funds that are obtained independently. The CRA agrees that subsection 74.1(2) will generally not apply to attribute, to a freezor, dividends paid on shares held by a trust for minor children as part of a typical estate freeze, provided that the shares held by the trust are issued for an amount equal to their FMV and are paid for with funds that are not obtained from the freezor. In Romkey et al. v. The Queen, 2000 D.T.C. 6047 (FCA) (leave to appeal to SCC denied) the court found that FMV had not been paid for shares issued to a trust as part of an estate freeze. The court attributed dividends paid on the shares back to the original shareholders. In causing shares to be issued to trusts for the children, "the appellants had already effected a transfer of

(d)

(e)

(f)

235 property to their respective children, i.e. divesting themselves of the right to receive a measure of future dividends." Another area to consider when planning an income-splitting arrangement is subsection 74.4(2) corporate attribution rules. This subsection applies where an individual has transferred property, either directly or indirectly by means of a trust or by any other means whatever, to a corporation and one of the main purposes of the transfer... may reasonably be considered to be to reduce the income of the individual and to benefit, either directly or indirectly, by means of a trust or by any other means whatever, a person who is a designated person in respect of the individual. (The term "designated person" includes a spouse of the individual or a child of the individual who is under 18 years of age). The corporate attribution rules will not apply as long as the corporation is a small business corporation. Advisers should also consider the "kiddie tax" rules with respect to dividends and other investment income paid to minor children. Split income received by the child from a non-arm'slength corporation will be taxed at the highest marginal rate. One must consider the potential application of the attribution rules in cases where the capital gains exemption is being claimed. A certain amount of due diligence may be required to ensure that the capital gain on the shares on which the exemption is claimed has not been attributed to someone other than the intended shareholder. The attribution rules can apply to attribute both capital gains and income when shares of a corporation are transferred to a taxpayer's spouse.

3. Factors to Consider (General reference Material)

The following excerpts are taken from Donald E. Carsons Tax Rate Changes for the Period 2007 Through 2012 (Canadian Tax Foundation, Ontario Tax Conference, 2008) Key concepts associated with integration include the notions of a tax deferral or tax prepayment. A tax deferral exists when the amount of tax payable on corporately-taxed income is less than the amount of tax that would arise if the income was otherwise received directly or through the payment of a reasonable (and deductible) bonus by the corporation. Conversely, a tax prepayment occurs when the amount of tax payable on corporately-taxed income exceeds the amount of tax that would arise if the income was either received directly or through the payment of a reasonable bonus by the corporation. While some individuals associate the tax deferral as being the personal income tax on the ultimate distribution of the corporation's after-tax earnings, such analogy may not be appropriate to the extent that such funds could be used in ways that neither gives rise to a taxable dividend for the shareholder nor a taxable benefit for the owner-manager. For example, such funds could be used to pay for the corporate tax that would otherwise arise for certain non-deductible corporate outlays (i.e., corporateowned life insurance policies and/or the non-deductible portions of business-related meals and entertainment expenditures or corporately-leased automobile expenses) or be used to fund provincial political contributions. A tax deferral generally represents the additional amount that is available to invest by the related group. For owner-managers who are subject to tax at top marginal rates, a tax deferral exists when

236 active business income is taxed inside the corporation rather than directly. Assuming that the ownermanager has sufficient personal income and/or assets to meet personal expenditure needs or commitments, to the extent that the company's internal rate of return exceeds that available through general passive investments, the deferral could be invested back into the business and thereby affording any new income generated on such deferral to be taxed at lower rates than if the ownermanager had directly received the second-generation income. While many benefits are associated with a tax deferral, such benefits must be weighed against the costs, if any, of distributing the ultimate proceeds to the owner-manager. Generally, with federal corporate tax rates decreasing in recent years, an owner-manager's strategy of paying a reasonable bonus to reduce the corporately taxed income to the small business limit warrants reexamination. From an integration perspective, the concepts of a tax savings or tax cost relate to corporately-taxed income. Imperfect integration exists when tax savings or tax costs are present. A tax savings exists when the aggregate amount of tax paid firstly at the corporate level and secondly on the distribution of the after-tax corporate income to the owner-manager or shareholder is less than the tax that would be otherwise payable had the income been either earned directly or distributed by the corporation to the owner-manager through the payment of a reasonable bonus. Conversely, a tax cost exists when the total amount of corporate and personal tax exceeds the tax that would otherwise be payable had the income been either earned directly or distributed by the corporation to the owner-manager through the payment of a reasonable bonus. Generally, under the current dividend gross-up and tax credit regime for non-eligible dividends, a tax cost will exist with respect to ABI when the combined federal and provincial net corporate tax rate exceeds 20%. In addition, under the dividend gross-up and tax credit regime for eligible dividends, a tax cost will exist for corporately-taxed ABI that does not qualify for the federal SBD when the combined federal and provincial corporate tax rate exceeds approximately 31.0% for 2008 and 2009, 30.5% for 2010, 29.0% for 2011 and 27.5% for 2012 and subsequent years One such alternative involves the distribution of ABI retained earnings as a corporately-taxed capital gain. Given that 50% of capital gains are subject to tax, the effective integrated tax rate on a corporately-taxed capital gain is substantially lower then the current top marginal tax rate for Canadian non-eligible dividends received by individuals. Accordingly, valuable tax savings can be realized if distributions to the owner-manager are a combination of efficient non-eligible taxable dividends (i.e., non-eligible dividends that are just sufficient to generate a full dividend refund for the payer corporation) and capital dividends rather than taxable non-eligible dividends that do not generate any dividend refund for the payer corporation. With respect to M&P income, a tax cost exists until 2009, when the combined federal and provincial net corporate tax rate of 31.00% is slightly lower than the implicit 31.03% corporate tax rate associated with a 45% eligible dividend gross-up. A tax savings of less than 1.00% exists for 2009 through 2012. With respect to non-M&P income, a tax cost will continue to exist in 2012 (although the cost will be reduced in each subsequent year after 2008), because the combined federal and provincial net tax rate will exceed the implicit combined federal and provincial corporate rate associated with the applicable eligible dividend gross-up. Ontario's reduced personal income taxes on eligible dividends means the top marginal tax rate for Canadian eligible dividends received by individuals will be only slightly higher (with the difference decreasing each year from 2006 to 2009) than the personal income top rate on capital gains for 2006

237 through 2008 and slightly lower in 2009. Reductions to the federal dividend gross-up and federal tax credit rate will subsequently increase the marginal tax rate on eligible dividends each year from 2010 to 2012, causing the combined federal and Ontario top marginal tax rate on eligible dividends to exceed its top personal rate on capital gains after 2009 (with the difference increasing each year from 2010 to 2012). By taxing ABI eligible for the federal and provincial SBD's in the corporation, a significant income tax deferral is available. An ultimate tax savings results from the subsequent distribution of such ABI as taxable dividends. Tax deferral benefits are available for other types of ABI taxed in the corporation; however, ultimate tax costs exist when the after-tax corporate proceeds are distributed as taxable dividends. Such tax costs are generally the result of the combined federal and provincial corporate income tax rates on such type of ABI being higher than the tax impact of the combined federal and Ontario DTC's for individuals. Since distributions of pre-tax corporate income as deductible salaries attract provincial EHT, the ultimate tax cost of having such income taxed corporately with the after-tax proceeds distributed as a dividend is lower than it would otherwise be. It is important to note that the tax deferral benefit of having ABI that is not eligible for the federal and provincial SBD's corporately taxed may outweigh the ultimate tax cost if the dividend distribution can be deferred for a sufficient period of time. The amount of time required to eliminate the ultimate tax cost depends on a variety of factors including the pre-tax rate of return inside the corporation and the differential between corporate and personal income tax rates. Advantages of Distributing Income as Dividends Whereas the distribution of income in the form of salaries is based on services rendered, the distribution of income in the form of dividends is based on share ownership. Accordingly, this noticeable distinction may be an issue to consider when the CCPC has more than one ownermanager. Corporate Advantages The advantages to the CCPC of taxing income within the corporation and subsequently distributing the income as dividends include the following: Loss Carry Back Having income taxed corporately provides owner-managers flexibility to utilize future losses to recover previously paid income taxes. Non-capital losses incurred may be carried back and deducted against taxable income in the three preceding taxation years in order to recover the income tax paid in those years. However, the benefits of any loss carry back opportunity should be weighed against the ability to reduce the corporation's future income taxes. Specific issues, among others, for consideration relating to a loss carry back include: whether the loss carry back will impact the corporation's dividend refund for a preceding year, whether the corporation's net LCT liability will be impacted by the loss carry back due to the reduction of its taxable income and corresponding reduction to its surtax liability, whether future federal or provincial corporate tax rates will be higher or lower than that applicable in the loss year, whether any non-refundable federal or provincial investment tax credits will have to be repaid, and whether a provincial loss carry back will create a corporate minimum tax ("CMT") liability? To the extent that a corporation's taxable income has been substantially reduced through the payment of reasonable salaries or bonuses, the amount of losses incurred by a corporation in a subsequent year that can be converted into an income tax refund vis--vis a loss carry back, will also be substantially reduced. While taxes paid on salaries and bonuses may be recovered if an individual

238 incurs personal losses, it is unlikely that personal losses, if any, will exceed losses that may be incurred by the corporation carrying on the business. RDTOH Income retained in the corporation and distributed as dividends may recover RDTOH. As previously discussed, a CCPC may accumulate a RDTOH balance through the payment of Part IV tax on assessable dividends received and / or if it has earned investment income subject to refundable tax treatment. Also previously discussed, a corporation is entitled to recover $1 for every $3 of taxable dividends paid to the extent of the corporation's RDTOH balance. Canada Pension Plan ("CPP") Premiums An owner-manager may view the requirement to remit CPP premiums as an additional cost (or tax) associated with the payment of reasonable salaries rather than dividends. CPP rates increased significantly during the past several years. In addition, the range of pensionable earnings on which CPP premiums are exigible has increased. Whereas in 1993, the maximum CPP premium to be paid by each of the employee and employer was $752.50 or $1,505.00 in aggregate, for 2008, the amount had increased to $2,049.30 or $4,098.60 in aggregate. CPP rates for employees and employers for 2006 and subsequent years are currently legislated at 4.95%. The annual basic pensionable earnings exemption has been frozen at $3,500. For 2008, the maximum CPP premium is reached at a salary level of $44,900. Accordingly, salary paid by a corporation to the owner-manager in excess of $44,900 will not be subject to additional CPP premiums. To the extent that an owner-manager is being paid a salary from more than one corporation, there is an increase to net cost of paying CPP premiums. This cost increase occurs because every corporation paying salaries has an obligation to withhold and remit CPP up to the maximum level of CPP premiums. Although the owner-manager may recover excess premiums paid at the individual level when filing his or her individual income tax return, excess CPP premiums paid at the corporate level are not refundable. Therefore, if a salary is to be paid to an individual it is | prudent to pay the entire salary from one corporation. If the salary is to be charged to another associated corporation, GST should be considered. Employment Insurance ("EI") Premiums Similar to CPP premiums, an owner-manager may view the requirement to remit EI premiums as an additional cost (or tax) associated with the payment of reasonable salaries rather than dividends. In 2008, the combined cost of EI premiums of an employee and employer is $1,706.47 on maximum insurable earnings of $41,100. EI premiums are not exigible in certain circumstances. While a comprehensive analysis of the EI exemption rules is beyond the scope of this paper, generally, when the employee and employer are not dealing at arm's length or where the employee controls more than 40% of the voting shares of the employer corporation, the employee is not eligible to receive EI benefits and for that reason, the corporation and the employee are exempt from paying EI premiums regarding the employee's salary. Charitable Donations Deciding to have income taxed inside the corporation rather than the payment of a reasonable salary increases the deductible amount of charitable donations that may be contributed by the corporation. Further, the subsequent distribution of corporately-taxed income may increase the tax creditable amount of donations for the owner-manager. A deduction, in the case of a corporation, or nonrefundable tax credit, in the case of the owner-manager, for charitable donations (other than cultural gifts and ecological gifts) is limited to 75% of the corporation's or owner-manager's net income.

239 The taxation of income within a corporation provides the corporation with the net income necessary to make deductible charitable donations. When the income is distributed to the owner-manager as a dividend, the owner-manager will also have net income so that charitable donations may be eligible for tax credits. In fact, the amount of creditable donations to the owner-manager is actually increased by receiving dividends since the dividend gross-up (25% for non-eligible dividends and 45% for eligible dividends) qualifies as income for purposes of the 75% limitation. Investment Tax Credits ("ITCs") Taxing income within the corporation not only promotes the ability to use non-refundable ITCs for the corporation's current taxation year, but also provides the flexibility to utilize ITCs earned in the three subsequent taxation years since ITCs may be carried back to the three preceding taxation years. Individual Advantages The advantages to the owner-manager of taxing income in the CCPC and subsequently distributing the income as dividends include the following: Cumulative Net Investment Losses ("CNIL") While the $100,000 general capital gains exemption ("CGE") was eliminated in the 1994 federal budget, the enhanced exemptions ("ECGE's") for qualified small business corporation shares and qualified farm property remain and provide certain individuals the opportunity to shelter up to a maximum of $750,000 of capital gains resulting from the dispositions of said assets. This is also the case for capital gains arising on a disposition of qualified fishing property because of the $750,000 lifetime capital gains exemption for such property introduced in the 2006 federal budget. The availability to utilize the ECGE, however, is restricted to the extent of the individual's CNIL balance. A CNIL balance will exist for an individual to the extent that the cumulative amount of the individual's investment expenses (such as interest, rental losses, limited partnership losses) claimed after 1987 exceeds the cumulative amount of the individual's investment income (such as dividends, interest, rental income, limited partnership income) received after 1987. Accordingly, a strategy that pays dividends rather than salary to the owner manager will reduce an individual's CNIL balance and may increase the individual's allowable CGE claim. Income Splitting Subject to the application of various attribution provisions and the tax on split income ("kiddie tax") provisions, dividend distribution strategies may facilitate income splitting among family members. Generally, an adult with no other income and claiming only the basic personal | non-refundable tax credit may receive in 2008 a non-eligible dividend of up to approximately $37,568 (or a taxable noneligible dividend of $46,960) free of federal income tax. At this level of dividend income, the aggregate of the federal basic personal non-refundable tax credit and the federal DTC on non-eligible dividends is equal to the tax liability payable on the dividend received. Income tax of approximately $6,230 (inclusive of an Ontario Health Tax of approximately $400), however, would be payable by the same individual in receipt of $37,568 of salary. Instead, if the same adult individual were to receive in 2008 an eligible dividend of approximately $69,834 (or a taxable eligible dividend of approximately $101,260), no regular federal income tax would be exigible. However, a federal AMT liability of approximately $3,035 would be applicable. ECGE Dividend Test An individual may be denied the ECGE on the disposition of any shares of a corporation if a significant portion of the capital gain may be attributable to the fact that the corporation failed to pay sufficient dividends on non-prescribed shares (generally shares other than common shares).

240 Therefore, the payment of dividends to shareholders of non-prescribed shares may avoid the denial of the ECGE. Old Age Security ("OAS") Clawback OAS received by an individual is required to be repaid at a rate of 15% of net income in excess of $64,718. The maximum OAS paid in 2008 is approximately $6,050. To the extent that the ownermanager has sufficient funds for personal expenditure needs, the retention of income within a corporation may reduce or eliminate the OAS to be clawed back. In years when dividends are paid, the amount of the OAS clawback may be greater, however, than if the income were distributed as salary since the amount of the dividend gross-up is included in arriving at the OAS clawback income threshold. Because a gross-up of 45% applies to eligible dividends, the receipt of these dividends means that the OAS net income threshold will be reached with a smaller amount of dividends after 2005 than previously when a 25% dividend gross up applied to all dividends. However, the lower tax rate on eligible dividends will likely offset any additional clawback. Safe Income on Hand (SIOH) To the extent that there may be a future sale of the corporation's shares owned by the ownermanager, the retention of corporately-taxed income either within the operating company or at the holding company level may provide opportunity for a future tax deferral. Personal Tax Installments A bi-annual distribution of dividends from the corporation can avoid or reduce the obligation for the owner-manager to pay quarterly personal tax installments on such dividend income. However, to the extent that an owner-manager is not a top marginal-rate taxpayer and an OAS recipient, the benefits associated with graduated personal income and / or surtax brackets should be considered as the tax savings afforded from a set of graduated tax rates and brackets may exceed the income that can be generated on a deferral of personal tax installments. In addition, personal tax installments for 2008 that are based on the estimated tax liability for that year should take into account any anticipated change in the salary dividend mix and the reduced tax rate on eligible dividends. Creditor Proofing If a corporation defaults on its debts, certain assets that are retained by the corporation may be seized by the creditors. The extraction of funds from the corporation may prevent such funds from being seized by creditors. A simple and common method to reduce an operating company's exposure to creditors is through the establishment of a holding company to which excess funds can be distributed as tax-free inter-corporate dividends. Clearly, this method assumes that there are no restrictions by creditors that preclude the distribution of dividends. To the extent that funds are required in the business, monies can be advanced by the holding company to the operating company on a securitized basis. However, before establishing a holding company, various issues must be considered including the impact the holding company may have on an individual's access to the ECGE on a future sale of the shares of the operating company. Advantages of Distributing Income as Salaries An owner-manager's remuneration package generally includes the payment of a periodic salary and bonuses. Bonuses are frequently used to adjust the amount of the corporation's taxable income to a desired level. To achieve such a taxable income level, significant bonuses may be paid by the corporation. The deductibility of salaries and bonuses paid to an owner-manager has been thoroughly addressed in previous articles and CRA access letters and therefore will not be reexamined other than to highlight that the CRA is generally fairly lenient regarding the deductibility of salaries and bonuses paid to active owner-managers provided the following three tests are satisfied:

241 i) ii) and iii) The amount of the salary or bonus is reasonable; The corporation has a legal obligation to pay the salary or bonus at the end of its taxation year; The salary or bonus is paid within 180 days of the end of the taxation year.

Corporate Advantages Advantages to the CCPC by distributing its income as salaries include the following: Scientific Research and Experimental Development ("SR&ED") ITCs and Other Benefits The federal and Ontario governments offer generous incentives to corporations carrying on SR&ED activities in Canada. The 2008 federal budget extends the federal SR&ED ITC to certain salary and wages incurred in respect of SR&ED carried on outside Canada after February 25, 2008. Subject to certain limitations, qualified expenditures include salaries (but not bonuses paid to owner-managers) paid to individuals engaged in SR&ED activities. Paying sufficient salaries or bonuses reduces a corporation's taxable income and will thereby afford the corporation the ability to maximize its ITC and related provincial benefits from SR&ED expenditures. A qualifying corporation is entitled to a federal ITC on its first $3 million of annual SR&ED expenditures. Generally, qualifying corporations are CCPC's whose taxable income, combined with the taxable income of any associated corporations, did not exceed the SBD limit in the preceding year (i.e., $400,000 for 2008 taxation years) and whose taxable capital, combined with the taxable capital of any associated corporation, did not exceed $10 million. A qualifying CCPC is entitled to receive a refund of 100% of federal ITCs earned on the first $3 million of current SR&ED expenditures (dropping to 40% for current SR&ED expenditures in excess of $3 million) and 40% of capital SR&ED expenditures. Special rules apply to the extent that the associated group's taxable income exceeds its business limit. Generally, SR&ED expenditures eligible for the higher ITC rate and corresponding refundable treatment are gradually reduced if the associated group's taxable income exceeds its federal SBD limit. For each dollar of the associated group's taxable income in excess of the SBD limit, the maximum SR&ED expenditures ($3 million) eligible for the enhanced benefits is reduced by $10. Consequently, once the associated group's taxable income reaches $700,000, no SR&ED expenditures will be eligible for the higher ITC rate or refundable treatment. The associated group's annual $3 million expenditure limit is also reduced when the associated group's aggregate amount of taxable capital exceeds $10 million. The $3 million expenditure limit for the 35% federal ITC rate and related 100% current or 40% capital refund rates is reduced by $0.75120 for every $10 by which the associated group's aggregate taxable capital amount exceeds $10 million. Therefore, the annual $3 million expenditure limit is eliminated once the associated group's taxable capital amount exceeds $50 million. The associated group's taxable income level is a determining factor in calculating the amount of applicable provincial SR&ED incentives. It has been standard planning practice to reduce a CCPC's taxable income by way of bonus to the SBD limit in order to preserve the higher ITC rate and refundable treatment. Income Tax Installments The distribution of corporate income as a reasonable salary, within 180 days following the end of the corporation's taxation year in which the salary was accrued, reduces the corporation's taxable income thereby possibly reducing its corporate income tax installments for the current and the two immediately following taxation years. As outlined in Regulation 108, source deductions | related to the salary must be remitted to the Receiver General as early as 3 days after the date of payment to as

242 late as 45 days after the date of payment depending on the date the salary is paid and on the average monthly payroll withholding of the corporation for the first or second preceding calendar year. Therefore, distributing income as salary may achieve a significant cash flow advantage as a result of reduced corporate income tax installments and although a payroll withholding liability arises, it may be remitted as late as 224 days after the taxation year-end. Distributing income as dividends will not reduce the corporation's current taxable income and therefore will generally not reduce its corporate income tax installments obligation. Dividends may also increase the owner-manager's personal income tax installment liability for the current and the two immediately following calendar years. Capital Tax Corporations carrying on business in Ontario may be subject to provincial capital tax127 at a rate of 0.225%128 of the corporation's taxable capital. As mentioned, before 2006 LCT also applied. Taxable capital includes retained earnings for the purposes of capital tax (and before 2006, LCT). Distributing income as salaries or dividends reduces retained earnings and therefore reduces the corporation's current and future capital tax (and before 2006, LCT) liability. The corporation's taxable capital base will increase to the extent that the funds are loaned back to the corporation. Salaries need only be accrued at the end of the year to reduce taxable capital provided that they are paid within 180 days of the end of the taxation year. Distributing income in the form of a future dividend will not reduce the corporation's current capital tax liability. However, dividends that are declared and remain payable at year-end may yield provincial capital tax savings even though such dividends will not be subject to tax for the individual until they are received. Individual Advantages The advantages to the owner-manager of distributing income as salaries include the following: Registered Retirement Savings Plan ("RRSP") An individual's contribution to a RRSP and ultimate deduction is limited by the individual's earned income for the preceding year. Earned income includes salary, net rental and business income and certain other amounts. An owner-manager's 2007 earned income must be at least $111,112 ($116,667 in 2009) for the owner-manager to be eligible to make the maximum 2008 RRSP contribution of $20,000 ($21,000 in 2009). Canada Pension Plan ("CPP") It is debatable whether the payment of a salary to the owner-manager merely to be eligible to make CPP contributions is a wise investment decision. Nevertheless, an owner-manager's salary in 2008 must be at least $44,900 in order to be eligible to make the maximum combined employee-employer CPP contribution of $4,098.60. Individual Pension Plans ("IPP") IPPs may offer an owner-manager an effective method of deferring income and providing for retirement. It is common for an IPP to base the pension income to be received by the owner-manager on the average salary earned over a number of years preceding retirement. Contributions to an IPP on the owner-manager's behalf may, however, limit the owner-manager's RRSP contribution room. Retirement Compensation Arrangement ("RCA") A full discussion of the various tax aspects of and financing capabilities associated with an RCA is beyond the scope of this paper. However, certain tax advantages may be available for owner-

243 managers that choose to establish an RCA. Contributions made by a corporation to an RCA are deductible under paragraph 20(1)(r) of the Act provided that the contributions are reasonable and are in respect of services rendered by the employee or former employee. Generally, pursuant to subsection 207.7(1), such RCA contributions are subject to a 50% refundable tax which is to be withheld at source. Income earned in the RCA is also subject to a 50% refundable tax. A refund of the refundable tax paid by the RCA is triggered on distributions to the RCA plan's beneficiaries. Given that the 50% refundable tax is higher than the combined federal and Ontario tax rates currently applicable to Ontario-resident individual and corporations, contributions to an RCA do not afford an owner-manager with a tax deferral (in fact, a tax prepayment currently exists). However, because contributions to an RCA plan are not subject to EHT, an ultimate tax savings may be realized by making tax deductible contributions to an RCA plan, rather than the payment of salaries to the ownermanager. In addition, to the extent that the owner-manager's future marginal tax rates will be lower than those currently applicable or the owner-manager is planning to retire in another jurisdiction having lower marginal tax rates (albeit in another province, territory or emigrate from Canada), the ultimate tax liability for the owner-manager beneficiary relating to the RCA plan's distributions may be significantly less than if a salary and/or bonus is received directly by the owner-manager. Child Care Expenses Subject to certain conditions and restrictions, child care expenses are only deductible to the extent that an individual has received earned income. The payment of a salary to the owner-manager, as opposed to dividends only, may provide a tax subsidy for child care expenses. Alternative Minimum Tax ("AMT") While dividends are given preferential treatment for regular income tax purposes, the receipt of noneligible dividends by a top marginal tax rate owner-manager should not give rise to an AMT liability as the effective marginal tax rate for regular income tax purposes (being approximately 19.5833%) exceeds the effective marginal tax rate applicable for AMT purposes. In the event that an ownermanager has incurred an AMT liability either currently or within the previous 7 taxation years, the receipt of salaries, as opposed to dividends, will allow a faster reduction to the AMT liability otherwise owing or ensure a more timely use of the owner-manager's AMT carry forward credit. The top federal marginal income tax rate on eligible dividends for 2008 and 2009 is 14.55%, yet the AMT tax rate for both years is 15.00%. As a result, AMT likely will apply to many individual taxpayers (in all income brackets) who receive eligible dividends and have little other income. Double Taxation Distributing income as salaries or dividends may reduce the value of the corporation and accordingly, the amount of the capital gain arising on an actual or deemed disposition of the shares of the corporation. The 50% capital gain inclusion rate creates the situation whereby Ontario top marginal tax rate individuals would prefer to realize a capital gain rather than receive non-eligible or eligible dividends in 2008. This preference exists since in 2008 capital gains are taxed at a lower rate than dividends. However, to the extent that the CCPC will receive a dividend refund equal to 1/3 of the amount of taxable dividends distributed, the distribution of a dividend to the owner-manager can occur with no net tax cost to the related group. In fact, if the payer corporation's effective dividend refund rate is greater than the current top marginal tax rate applicable to Canadian non-eligible dividends received by an individual, a tax savings will result for the related group. In 2009 Ontario top marginal tax rate individuals will still prefer to realize a capital gain rather than receive non-eligible dividends, but they will have a slight preference for eligible dividends over capital

244 gains. Commencing 2010, their preference will return to capital gains rather than either non-eligible or eligible dividends. Double taxation may arise when there is (i) a capital gain to the individual on an actual or deemed disposition of the shares, and (ii) a capital gain to the corporation upon a subsequent disposition of assets and ultimate distribution of the funds as a non-eligible dividend. In the case of a deemed disposition on death, double taxation may be avoided by redeeming the shares held by the estate of the deceased individual. The redemption of the shares will generally result in a deemed dividend and a capital loss which may be used to offset the capital gain realized by the individual on death. While the net effect of such planning may result in the conversion of a capital gain realized on death to a dividend (which, as discussed, is taxed at a higher rate assuming the ECGE is not available and the dividend is non-eligible), a tax savings may be realized if all or a portion of the deemed dividend arising from the redemption of the shares is a capital dividend or generates a dividend refund for the payer corporation. Another alternative to avoid double taxation involves the use of a "wind-up" and the "bump" provisions of section 88. A discussion of the circumstances for which double tax minimization alternative would be preferable is beyond the scope of this paper.

4. Bonuses
Excerpt from Recent Developments in Small Business Taxation by Matthew T. Clark, Prairie Provinces Tax Conference, Canadian Tax Foundation 2006. Section 67 Reasonableness of Salaries and Bonuses The Canadian tax system is designed to place a shareholder receiving dividends in essentially the same tax position as if the shareholder had earned the income directly, without the intervention of the corporation. This concept is referred to as integration. Historically, integration has only applied to active business income eligible for the small business deduction. Integration is not achieved for corporate income that is not eligible for the small business deduction. Thus, a common tax planning objective is to reduce or eliminate corporate income above the small business deduction limit. This is often done by paying deductible remuneration sufficient to reduce corporate income to that limit. However, salaries, bonuses and other remuneration paid to employees and independent contractors are subject the limitations in section 67 of the Income Tax Act, which reads as follows: In computing income, no deduction shall be made in respect of an outlay or expense in respect of which any amount is otherwise deductible under this Act, except to the extent that the outlay or expense was reasonable in the circumstances. As a result, if the remuneration is not reasonable, it is not deductible by the payer corporation and may be subject to double taxation. In order to eliminate much of the uncertainty created by section 67, CRA has adopted an administrative policy that creates a safe harbor for salaries and bonuses, provided they meet certain criteria. CRA's "bonus policy" has been the subject of much commentary, which will not be duplicated here. However, it is important to note that section 67 has continued to be relevant with regard to remuneration given the fact that the "bonus policy" does not always apply.

245 The leading case on section 67 is Gabco Ltd. v. MNR. In that case, the Court stated the following test for the application of the predecessor to section 67: It is not a question of the Minister or this Court substituting its judgment for what is a reasonable amount to pay, but rather a case of the Minister or the Court coming to the conclusion that no reasonable business man would have contracted to pay such an amount having only the business consideration of the appellant in mind. The purpose of this part of the paper is to discuss some of the recent developments in the interpretation and application of section 67. Recent cases The application of section 67 can be seen in a number of recent cases. In the 2005 case of Manchester Chivers & Associates Insurance Brokers Ltd., the shareholders of a corporation appointed their adult children to act as directors. The children did not participate in day-to-day operations and management of business, and did little more than to sign documents requiring signature of directors. Directors' fees were paid to the children and deducted by the corporation. CRA disallowed the directors' fees as an expense on the basis that they were not incurred to earn income from a business or, in the alternative, on the basis that the expenses claimed were not reasonable pursuant to section 67. At trial, the Tax Court held that the fees were incurred to earn income, but that the quantum of the fees was unreasonable given the minimal contributions made by the directors. The Court allowed deductible fees of $1,500 per director. The result in this case can be contrasted with that in the 2004 case of Ambulances B.G.R. Inc. v. R., where the sole shareholder of a corporation employed his children. Little or no salary was paid to the children, but they each received substantial annual bonus payments. CRA reassessed to deny deductions for the bonus payments under section 67. On appeal, the Tax Court held that the bonuses were not unreasonable, since the services provided by the children were real, the performance of the children player a material role in the corporation's financial success, and the salaries the children received were not fair value remuneration. Thus, these cases reaffirm that the section 67 analysis is always highly fact specific and that the substance of the services provided by the recipient is always a central fact. Technical Interpretation 2005-0146001E5 In a recent technical interpretation, CRA was asked whether a plan that would interpose a holding company between an individual shareholder and a corporation earning specified investment income could be used to convert the specified investment income into active business income. Specifically, the holding company would charge a management fee to the investment company equal to the annual profit of the investment company, thereby leaving no income in the investment company for each taxation year. The management fee would be considered to be active business income. CRA stated that it might apply the General Anti-Avoidance Rule to such a transaction, but more likely would apply section 67 to the management fee. This is consistent with CRA's published position in Income Tax Technical News no. 22, where CRA reserved the right to challenge the reasonableness of inter-corporate management fees. However, CRA went on to give some insight on what it would consider to be a reasonable management fee. CRA stated that it would consider it inappropriate for the investment company to

246 pay the holding company a management fee that included amounts earned from the capital employed by the investment company in its investment business: it is our view that a reasonable management fee should not exceed the income that [the investment company] earned in a taxation year that was in excess of that which would have been earned where its mortgage capital was employed without the benefit of [the shareholder's] active management. Thus, CRA seems to suggest that the payment of a management fee out of investment profits is reasonable to the extent that the active management generates returns in excess of returns that would have been generated without active management. However, what this means in practice is unclear. Does this mean that management fees can be paid out of profits in excess of those that would have been generated by the return generated by a GIC or some other riskless rate of return? Perhaps time will tell. Can section 67 deny the entire amount of an expense? The Federal Court of Appeal's 2005 decision in Hammill v. R. explores an interesting facet of the operation of section 67 can section 67 deny the entirety of an expense that has otherwise been incurred for the purpose of earning income within the meaning of paragraph 18(1)(a)? The taxpayer in this case, who was the victim of a fraud, claimed as deductible losses the amounts paid to the fraudster. At trial, the Tax Court of Canada disallowed the deduction under paragraph 18(1)(a) on the basis that no business existed, since the purported business was a fraud from its inception and there was never any possibility of earning a profit. Additionally, the Court found that even if there were a business, the expenses were unreasonable under section 67 since the taxpayer did not act as a prudent or reasonable businessman. On appeal, the Federal Court of Appeal upheld the decision of the Tax Court of Canada, finding that the Tax Court Judge properly ignored the transactions in concluding that the appellant was the subject of a scam from start to finish. The Court held that this finding precluded the existence of a business and was sufficient to dispose of the appeal. Nevertheless, the Court then went on to comment on the scope of section 67: The appellant points out that [section 67] contemplates an outlay or expense that has been incurred for the purpose of earning income within the meaning of paragraph 18(1)(a), and allows the Minister to disallow that part of the expenditure which can be shown to be unreasonable. In other words, the provision does not allow for a qualitative review of the expenditure since the expenditure must have been made to earn income to begin with. What is contemplated is a quantitative review of the expenditure. The Court agreed with the taxpayer that the case law on section 67 had to date treated the issue arising under that provision as one of magnitude or quantum. The Court agreed that the following statement of Vern Krishna properly illustrated the scope and purpose of section 67: The word "reasonable" [in section 67] would appear to relate primarily to the size or the amount of the deductions claimed or quantified and not to the type of the expense. "The purpose of the rule is to prevent taxpayers from artificially reducing income by deducting inordinately high expenses" However, while acknowledging this precedent for the application of section 67, the Court argued that the Supreme Court of Canada's 2002 decision in Stewart broadened the scope of section 67.

247

It may be remembered that the Supreme Court of Canada in Stewart did away with the "reasonable expectation of profit" test. The Federal Court of Appeal held that, in Stewart: The Supreme Court identified section 67 as the statutory means of controlling excessive or unwarranted expenditures once a source of income is found to exist. It said at paragraph 57: ...If the deductibility of a particular expense is in question, then it is not the existence of a source of income which ought to be questioned, but the relationship between that expense and the source to which it is purported to relate. The fact that an expense is found to be a personal or living expense does not affect the characterization of the source of income to which the taxpayer attempts to allocate the expense, it simply means that the expense cannot be attributed to the source of income in question. As well, if, in the circumstances, the expense is unreasonable in relation to the source of income, then s.67 of the Act provides a mechanism to reduce or eliminate the amount of the expense. Again, however, excessive or unreasonable expenses have no bearing on the characterization of a particular activity as a source of income. The choice of words (reduce or eliminate) is not accidental. The Supreme Court was setting-up section 67 as the proper means of testing the reasonableness of an expense once a business has been found to exist. It was doing so after having explained that at the first level of inquiry (i.e. the existence of a source of income and the relationship between an expense and that source) courts ought not to second guess the business judgment of the taxpayer (Stewart, supra, paragraphs 55, 56 and 57). Section 67 was identified as the statutory authority pursuant to which an inquiry could be made as to the reasonableness of an expense. In my view, the Supreme Court in Stewart acknowledged that there is no inherent limit to the application of section 67, and that in the appropriate circumstances, it can be used to deny the whole of an expense, if it is shown to be unreasonable. Thus, it now appears that the potency of section 67 as a tool in CRA's arsenal has been enhanced. Paying more than fair market value is not necessarily unreasonable Another potentially significant principle in the application of section 67 has emerged from two recent seismic tax shelter cases. In both McLarty and Petro-Canada, the appellants purchased interests in seismic data and added the purchase prices to their Cumulative Canadian Exploration Expense ("CEE") pools, thereby creating deductions against income. In both cases, the taxpayers were reassessed by CRA on the basis that, among other grounds, the fair market value of the seismic data was significantly less than the amount added to their CEE pools. At trial, the Crown argued that the fact that the purchase price of the seismic data exceeded its fair market value is sufficient to limit the addition to the CEE pools to that fair market value on the basis of section 67. In Petro-Canada, the Federal Court of Appeal held that even though the purchase price ($46,751,752) was far in excess of the fair market value of the seismic data ($4,759,464), section 67 did not apply: While it may be true, as suggested in Mohammad, that paying fair market value for something is prima facie reasonable, I am unable to agree with the Crown that it necessarily follows that paying more than fair market value is unreasonable. There may be circumstances in which a decision to pay more than fair market value for something is a reasonable decision.

248 Considering the test stated in Gabco, I am not persuaded that this is an appropriate case for the application of section 67. In McLarty, the Tax Court of Canada held that given the highly speculative nature of the oil and gas exploration industry and the fact that seismic data is very difficult to value this was not a situation where paying more than the fair market value would be unreasonable. Unfortunately, neither case provides any guidance regarding the circumstances where it might be reasonable to pay more than fair market value for something outside of the seismic context. As a result, it remains to be seen whether this principle can be extended to other contexts. For example, see the Tax Court of Canada's decision in Fransyl, where the Tax Court of Canada held that rent paid to a related company was unreasonable pursuant to section 67 as it was three times the fair market value rent. Is section 67 relevant any longer? Perhaps the most important recent development with regard to the reasonability of remuneration was the November 23, 2005 announcement by the Minister of Finance that legislation would be introduced to enhance the gross-up and dividend tax credit mechanism in an effort to extend integration to all corporate income, whether subject to the small business deduction or not. A detailed analysis will be presented later at this conference comparing the bonus down strategy with the simple payment of dividends subject to the new enhanced dividend tax credit. If the provinces follow the federal government's lead, it is likely that something approaching full integration may be achieved. If that objective is realized, then taxpayers will no longer need to run the risk of paying bonuses and salaries that may be subject to section 67. On May 2, 2006, the Federal Government confirmed in its Budget that legislation giving effect to the enhanced dividend tax credit regime would be enacted. To date, only Quebec has introduced tax changes to its taxation of eligible dividends, increasing its tax rate on such dividends to 17.6% (from 16.5%). British Columbia and Manitoba have confirmed that they will follow the federal lead and reduce their tax rate on eligible dividends. Most other provinces have said they will wait for details of the federal changes before deciding on their plans in this area.

5. Management Fees
Excerpt from Recent Issues in Owner-Manager Remuneration Planning by Kim G.C. Moody, Canadian Tax Foundation Conference Report, 2004 For years, taxpayers and their advisers have attempted to use management fees as a flexible form of remuneration. Payments or accruals of management fees often take the form of payments or accruals to related corporations. Often, the recipient corporation will have a different taxation year-end from that of the payer corporation. Accordingly, the objective of such a payment may be income tax deferral. Assume, for example, that Mr. Apple owns all of the issued shares of a related corporation, Holdco. Holdco enters into a contractual arrangement with Opco to provide management services to Opco. Opco has a December 31 taxation year-end and Holdco has a November 30 taxation year-end. In practice, advisers may sometimes recommend that the accrual of a lump-sum management fee be made by Opco to Holdco at Opco's December 31 year-end. The argument is that Holdco will need to report the receipt of the management fee in its November 30 taxation year, thereby affording a significant deferral since Holdco would not report such income until approximately 11 months later.

249 However, this simple plan is fraught with problems. Upon audit, the CRA will often argue that the management fee reported by Holdco was earned proportionately throughout its taxation year, thereby trying to tax a significant portion of the accrued management fee in its prior taxation year and resulting in the elimination of the deferral. Management fees are sometimes used by taxpayers and their advisers in a simple but crude attempt to multiply access to the small business limit. Consider again the situation of Mr. Apple. Assume that Mrs. Apple owns 100 percent of the shares of Holdco. Holdco and Opco enter into a contractual arrangement whereby Holdco provides administrative and management services to Opco. Holdco receives amounts from Opco and takes the position that it is not associated with Opco. To the extent that Holdco and Opco were associated, the small business limit would have to be shared by Holdco and Opco. In this example, Holdco and Opco must carefully consider the possibility of deemed association. Practitioners and their advisers sometimes also use management fees to try to avoid the withholding requirements under the Act. Assume that over the year, Mr. Apple withdrew $100,000 from Opco and did not characterize the amounts as salary (thereby avoiding the withholding requirements that Opco would otherwise have had to fulfill) or dividends. Accordingly, Mr. Apple's shareholder loan account is in a debit position of $100,000. In order to avoid a subsection 15(2) inclusion, Mr. Apple enters into a contractual arrangement with Opco and takes the position that the $100,000 amount was paid to Mr. Apple at the end of Opco's taxation year as "management fees." Accordingly, the corporation makes a journal entry in its accounting records to offset the shareholder debit amount and expenses the $100,000 as management fees. Mr. Apple then reports the $100,000 as business income on his personal return in the taxation year in which the shareholder debit was offset. Such a plan is also fraught with problems. For example, it is debatable whether the subsection 153(1) withholding requirements are escaped. Under paragraph 153(1)(g), any person paying fees or other amounts for services must withhold from the payment the amount determined under regulations. However, given that the regulations do not contemplate a withholding requirement regarding payments to independent contractors, there is no withholding under paragraph 153(1)(g) on such payments. This was confirmed in R.K. Liu v. The Queen. It is this aspect upon which some plans base an attempt to avoid the withholding requirement. In other words, Mr. Apple would have to argue that he was an independent contractor when he received the management fees. The GST considerations would also have to be considered in such a plan. All of the foregoing management fee examples raise numerous issues that must be considered: 1) Are the management fees a sham? 2) Are the management fees reasonable? Were they incurred for the purpose of earning income from a business or property? If not, section 67 or paragraph 18(1)(a) could deny the deduction of the payment of the management | fees by the payer. As stated earlier, the CRA has confirmed recently that its administrative policy as outlined in Income Tax Technical News no. 22 does not apply to management fees. 3) The CRA takes the position that management fees paid to a related corporation will have to be reported under the "earned method" or, for greater certainty, the "receivable method." Accordingly, to the extent that the CRA's position is correct, the deferral opportunities that might have otherwise been enjoyed by the payment of management fees to a related corporation with a differing taxation year will be eliminated. 4) In the example given above, wherein a shareholder debit is eliminated by the payment of management fees in an attempt to escape the withholding requirements, one must argue that Mr. Apple is truly providing management services (as opposed to employment services) and that the amounts received are management fees. There is very little case law on what the term "management

250 fees" means. In addition, there is no statutory definition of "management fees." The CRA sets out its views on the meaning of the phrase "management or administration fee" in Interpretation Bulletin IT468R: A management or administration fee or charge is not defined in the Act. For the purposes of paragraph 212(1)(a) the Department considers that the term "management or administration" generally includes the functions of planning, direction, control, co-ordination, systems or other functions at a managerial level. These functions may involve services for various departments of a business such as accounting, financial, legal, electronic data processing, employee relations, management consultation, labour negotiations, taxation, etc. relating to the management or administration. It is not possible to provide an all-inclusive definition of management fees in an interpretation bulletin, and it is suggested that the above comments be read together with the comments below in order to determine whether an amount paid or credited to a non-resident in a particular set of circumstances constitutes a management fee that is subject to a non-resident tax under paragraph 212(1)(a). Accordingly, to the extent that a payment is to be referred to as a "management fee," it is important to ensure that the appropriate factual situation exists. In addition, it is highly advisable to ensure that such a payment is contractually documented. 5) As mentioned above, GST issues must be considered. In certain provinces, the applicable provincial sales tax legislation should also be reviewed for possible application. In Fillion, a recent case involving management fees, a husband, his wife, and their two sons formed a general partnership. Each member of the partnership invested $100. It appears that the purpose of the general partnership was to | develop business, seek out clients, do public relations work, and sell financial products. During the taxation years at issue, the husband was the only partner who held an insurance broker's licence and the only partner who was authorized to manage the general partnership. The children were full-time students and did no work for the partnership. At court, it was also found that the spouse did very little work for the partnership. The income from the partnership appears to have been derived almost exclusively from a corporation of which the husband was the sole shareholder. The corporation sold insurance products. During 1994, it appears that the corporation paid management fees of $19,100 to the husband. To justify the expenditure, the corporation submitted two invoices dated December 31, 1994. The minister disallowed the deduction of $19,100 claimed by the corporation for its 1994 taxation year on the basis that the outlay was not incurred to produce business income in accordance with paragraph 18(1)(a) of the Act. The court made the following comments, which were reproduced by the Federal Court of Appeal in finding for the minister: In order to claim an expense, it is not enough to make an accounting entry backed by a vague invoice. In order to deduct an expense from income, it must be established that the evidence was real, fully supported and justified and, moreover, that the expenditure was incurred in order to produce business income in accordance with paragraph 18(1)(a) of the Act. As was the case with the other aspects of the appeal, the appellant was unable or simply unwilling to explain the relevance of the nonetheless significant expense of $19,100. He simply stated that to earn money he had to spend money, a statement that in itself is not necessarily false, but is certainly not sufficient to establish that this was a genuine expenditure. If the appellant had provided certain details, explained why and how he arrived at this amount and, at the same time, had connected it in some way to his income, the Court might have been able to make certain corrections but the evidence was so deficient that it is not possible to make any correction, if only to confirm that it was appropriate to disallow the management fees expense established by the appellant at $19,100.

251 Taxpayers and their advisers should be aware that considerations of formality, reasonableness, and appropriateness apply when dealing with management fee planning. Although management fees can be an appropriate and powerful tool in the right circumstances, practitioners should exercise caution when dealing with management fees as a form of remuneration for their owner-manager clients. The recent informal procedure case of Lecerf is another example of the risks involved with management fee planning. Mr. Lecerf was the sole shareholder of 774638 Alberta Ltd., which owned a real estate property in Rocky Mountain House, Alberta. The corporation rented the property to Mr. Lecerf in the 2000 taxation year for $8,470. Mr. Lecerf sublet the property to another business during the 2000 taxation year and received $5,350 in rent. The business that Mr. Lecerf sublet the property to was owned and operated by Ms. Smith. Mr. Lecerf deducted a "management fee" of $34,000 that was paid to Ms. Smith on December 29, 2000. The management fee increased the rental losses that were incurred by Mr. Lecerf. The minister, upon review of the rental losses, denied the deduction of the management fee paid to Ms. Smith, asserting that such fees were not reasonable pursuant to section 67. After reviewing the evidence, the court found that the management fees were "incredibly" high for a property that was purchased for $75,000 in a small rural town. The court found that a normal rental property management fee, to the general knowledge of the public, is a contingency fee of around 5 percent of rent collected. The court also found that the alleged management contracts were not in writing, and they did not appear to represent ordinary or customary market terms. Accordingly, the court found that the management fee in question was not reasonable, and it therefore denied the deduction. In order to preserve integration and ensure that remuneration to owner-managers is deductible, it is important to ensure that the Canada Revenue Agency (CRA) | agrees that such remuneration is reasonable. The CRA has been asked many times about its administrative position with respect to reasonable remuneration for owner-managers. As mentioned above, in order to ensure that integration is maintained, it will often make sense for owner-managers to receive their remuneration in the form of bonuses paid out of ABI in order to reduce the CCPC's income to the small business limit. Since 1981, the CRA's position has been that it will not challenge the reasonableness of salaries and bonuses paid to the principal shareholder-managers of a corporation when a) the general practice of the corporation is to distribute the profits of the company to its shareholders-managers in the form of bonuses or additional salaries; or b) the company has adopted a policy of declaring bonuses to the shareholders to remunerate them for the profits the company has earned that are, in fact, attributable to the special know-how, connections, or entrepreneurial skills of the shareholders. The CRA further stated that bonuses paid to shareholders other than principal shareholder-managers will be subject to the normal test of reasonableness. Over the years, the CRA has been asked many times to clarify its position on bonuses paid to shareholders, and many court cases have dealt with the reasonableness of remuneration paid from a corporation to owner-managers and their family members. In 2000 and 2001, the CRA released three technical interpretations concerning the reasonableness of owner-manager remuneration. In addition, the court in Safety Boss found that a bonus paid to the corporation's non-resident president and fees paid to a non-resident corporation were reasonable. Together, the three technical interpretations and the Safety Boss decision created great uncertainty with respect to whether or not the administrative position set out in the 1981 round table would still apply in certain cases.

252 In response to that uncertainty, the CRA outlined the criteria that the remuneration must meet in order to be found reasonable. These criteria were subsequently set out by the CRA in Income Tax Technical News no. 22, which was released on January 11, 2002, and can be summarized as follows: 1) the salaries and/or bonuses are paid to managers who are shareholders (either directly or indirectly) of a CCPC; 2) the shareholder-managers are Canadian residents; and 3) the shareholder-managers are actively involved in the day-to-day operations of the business and contribute to the income-producing activities from which the remuneration is paid. The CRA also clarified that the ownership structure of a corporation does not matter with respect to its administrative policy as long as the criteria referred to above are met. In addition, the CRA clarified that it would continue to challenge the reasonableness of intercorporate management fees. This topic will be discussed in more depth later in the paper. However, in a somewhat surprising commentary in Income Tax Technical News no. 22, the CRA stated that it would not challenge the reasonableness of salaries and bonuses paid out of "non-active business income" as long as the criteria set out above were met. In a technical interpretation, the CRA explained that the term "non-active business income," which is not defined in the Act, is meant to encompass all business income, active or otherwise. In general terms, this could include income incidental to an active business and income of a "specified investment business." The CRA stated in the technical interpretation that if a corporation's only source of income is stocks and interest-bearing investments, the income will be considered "non-active business income." The CRA was asked how much activity is required of a shareholder-manager in order for him or her to be considered active in the day-to-day operations of the company when the company generates non-active business income. The CRA responded by stating that whether or not managing a portfolio is sufficient to qualify a shareholder-manager as being active in the day-to-day operations of the business will be a question of fact. However, the CRA is of the view that when a corporation's only business activity is investments, which are managed through a third party, the shareholder is not considered active in the day-to-day operations of the business. In another technical interpretation, the CRA clarified its position in Income Tax Technical News no. 22 with respect to "non-active business income." The CRA was asked whether a corporation can pay a bonus to an active shareholder to offset the taxable portion of a capital gain and not have the reasonableness assertion challenged by the CRA. The CRA concluded that salaries and bonuses are not deductible in computing a capital gain; accordingly, the policy in Income Tax Technical News no. 22 will not apply. The CRA arrived at its conclusion on the basis that outlays or expenses may be deducted in computing a taxable capital gain pursuant to subparagraph 40(1)(a)(i) of the Act only to the extent that "they were made or incurred by the taxpayer for the purpose of making the disposition." The CRA stated that the words "for the purpose of" mean "for the immediate or initial purpose of,"36 not the eventual or final goal that the taxpayer may have in mind. The CRA said that to give the words the latter meaning would permit the most indirect or most distantly related outlay or expense to reduce the amount of a gain. The CRA believes that this could not have been Parliament's intent. However, one can question whether or not such an interpretation is consistent with the Act. For example, presumably it is the work effort of the owner-manager that has contributed to the capital gain. Perhaps it was previous years' forgone bonuses that yielded a greater capital gain. If the bonus was negotiated between the corporation and the owner-manager before the business assets were sold, and if such a negotiation was documented by a binding contract, is the bonus deductible against the capital gain? It is conceivable that such a bonus would meet the conditions of subparagraph 40(1) (a)(i). Accordingly, the CRA's administrative policy should not be to categorically deny the deduction of bonuses in the computation of taxable capital gains.

253 In 2003, the CRA once again commented on the reasonableness of owner-manager remuneration. The CRA subsequently documented its comments in Income Tax Technical News no. 30, dated May 21, 2004. Some of the comments therein are of interest to practitioners. The CRA noted that the intent of the policy documented in Income Tax Technical News no. 22 is to provide flexibility to CCPCs and their active shareholder-managers and allow tax planning so that taxpayers can take full advantage of marginal corporate and personal income tax rates and any integration provided for under the law. In addition, the CRA stated that it would consider ruling on the reasonableness of shareholder-manager remuneration in order to provide certainty to taxpayers concerning the taxable status of transactions that are within the intent of the policy outlined in Income Tax Technical News no. 22. The CRA also clarified that the following items are beyond the intent of the policy outlined in Income Tax Technical News no. 22: 1) remuneration paid out of the proceeds generated from a major sale of business assets, including the sale of the entire business's assets or those of a large division; 2) all sources of income triggered by the proceeds, including capital gains, recapture of capital cost allowance, and income arising from the disposition of eligible capital properties (unless such a sale of assets is incidental to the normal business operations); 3) remuneration paid from the income of a CCPC when such income is derived from management fees; and 4) remuneration paid from a CCPC when the income of the CCPC is derived from dividends that have flowed through a complex corporate structure. In Income Tax Technical News no. 30, the CRA suggests that its administrative policy will not apply when recapture of capital cost allowance and/or eligible capital property is the source of income from which the bonus is paid. In a technical interpretation, the CRA commented that, in light of its response in Income Tax Technical News no. 30, recapture of capital cost allowance and the income arising from the disposition of an eligible capital property generated from a major sale of business assets is not earned during the normal course of business operations but rather is an indication of the cessation of business operations, notwithstanding that such income may be ABI. The CRA noted that remuneration paid from the proceeds of a major sale of business assets will not necessarily be considered unreasonable for the purposes of section 67 of the Act. However, it stated that it reserves the right to review the reasonableness of the amount. A number of advance tax rulings on the reasonableness of owner-manager remuneration have recently been released. Interestingly, two such rulings deal with situations in which remuneration is paid out of income triggered from the proceeds of a sale of business assets. In one ruling, the assets of a CCPCland, buildings, other fixed assets, working capital, franchise rights, and goodwill | were sold, generating taxable amounts, including amounts taxable under subsection 14(1) of the Act. The CCPC had six shareholders, three of whom were active in the day-to-day management of the operations of the business prior to its sale. Subsequent to the sale, the corporation declared a bonus payable to the three active shareholders. The bonus was unanimously authorized by the corporation's board of directors and approved by its shareholders in a meeting. Subsequent to that meeting, the corporation and the owner-managers became aware that the CRA had clarified its policy on when such remuneration would be considered reasonable for the purposes of section 67 of the Act; as a result, they decided that the bonus would not be paid until a favourable advance income tax ruling could be obtained on the income tax status of the bonus. Accordingly, the purpose of the subject ruling was to ensure, prior to payment, that the CRA would not invoke section 67 to deny the deductibility of the bonus by the payer corporation. In the ruling, it was stated that the purpose of the payment of the bonus was to remunerate the owner-managers for their contribution to the successful management of the corporation. On the basis of the facts at hand, the CRA ruled that section 67 and paragraphs 18(1)(a) and 18(1)(e) of the Act would not apply to prohibit the corporation from deducting the amount of the bonus in computing its business income for the applicable taxation year. Although

254 this ruling is not thoroughly enlightening, it is interesting: it is one of the first advance tax rulings on the reasonableness of remuneration, and it provides a taxpayer with certainty in a situation where such income is generated from the disposition of business assets. Another ruling also concluded that paragraph 18(1)(a) and section 67 would not apply in a situation where the disposition of business assets resulted in recaptured depreciation under subsection 13(1) of the Act. An additional ruling dealt with the payment of a bonus that would create a non-capital loss for the corporation, and whether or not such a payment would be reasonable in light of the CRA's policy. In the subject ruling, the bonus was paid from cash reserves arising from the corporation's profitable activities in prior years and was to be payable to its active owner-manager. However, the proposed payment would create a non-capital loss for the corporation, and therefore the corporation would request a carryback of the non-capital loss to reduce its taxable income for prior taxation years. The carryback of the losses would result in the reduction of the corporation's prior years' taxable income to approximate the small business deduction limit in those years. Again, after a review of the facts, the CRA ruled positively that section 67 and paragraph 18(1)(a) would not apply to deny the deductibility of the bonus. In addition, it ruled that the non-capital loss could be carried back to the corporation's prior taxation years, subject to the limits of paragraph 111(1)(a). Given the general principles outlined by the CRA in Income Tax Technical News nos. 22 and 30 and in subsequently released technical interpretations, many creative techniques are available to remunerate owner-managers. For example, would a bonus from a corporation to a trust shareholder of a CCPC resident in Canada be subject to the reasonableness provisions under section 67? A careful reading of the criteria outlined in Income Tax Technical News no. 22 seems to indicate that such a payment to a trust from a CCPC would be subject to section 67, in the CRA's opinion. This was confirmed in a technical interpretation. Ignoring the CRA's comments, one would also need to ensure that any payments to a trust shareholder are properly characterized; a salary or a bonus payment to a trust could be problematic, given that a trust cannot likely be an employee. What about payments to an employee profit-sharing plan trust? This subject is reviewed in more detail later in the paper, but a strict reading of the CRA's administrative policy suggests that such a payment would not be captured. There have been many court cases on the reasonableness of shareholder remuneration. Mpalex is one example. In that case, the taxpayer was the majority shareholder of one corporation (Agridanax) and his wife was the majority shareholder of another corporation (Mpalex). From 1995 to 1997, Agridanax and Mpalex paid various amountsranging from a low of $19,185 to a high of $50,835 to each of the taxpayer's two children, aged 17 and 13. Those amounts were deducted by the various corporations as "bonus" amounts and therefore treated as salary amounts to the children. The parents explained that their children assisted in the business activities of the two corporations, including catalogue preparation, Web site maintenance, secretarial assistance, and sales assistance. The CRA argued that the salaries paid to the children were not reasonable given the ages of the children, the fact that the children attended school on a full-time basis, and the fact that one of the children also had a part-time job at Wal-Mart. Interestingly, the parents agreed that the salary payments to the children were not reasonable; they argued that the salary payments would have been reasonable, however, had they been directed to the parents themselves. Therefore, they argued, such amounts should be taxed in their own hands pursuant to the provisions of subsection 56(2) or subsection 74.1(2) of the Act. Obviously, such arguments were made in order to prevent the double taxing effect that section 67 would create to the extent that the deduction for the unreasonable salary payments would be denied. The court found that subsection 56(2) did not apply (in addition to subsection 74.1(2)). Instead, the court found that the bonuses or salaries paid to the children were unreasonable:

255 The appellants were reassessed because the bonuses or salaries paid to the managers' children were unreasonable, and it is those assessments that are in appeal here. The Minister was entitled to find those bonuses unreasonable. Even the appellants agreed with him, but they are asking that the salaries paid to the parents and children be amended by increasing the salaries of the parents and reducing those of the children. The court cannot restructure what has been done. However, the court found that some of the services rendered by the children might deserve remuneration. It appears that the CRA auditor had already performed | an analysis of what might be reasonable in the circumstances, and the court agreed with that analysis. Accordingly, section 67 applied to deny the unreasonable portion of the payments by the corporation. Mpalex illustrates the need for taxpayers to be cautious and reasonable with payments made to children who might perform nominal services in the business activities of the CCPC. In Petrovic, the reasonableness of a "management fee" paid to a spouse was called into question. Although the court in Petrovic did not rely on section 67 to determine the outcome (rather, it relied on the "reasonable expectation of profit" doctrine,) Petrovic is nevertheless an interesting review. The case involved a husband who financed a home-based jewellery-manufacturing business that was operated by the wife. The business struggled throughout its formative years and was not profitable. "Management fees" were paid by the proprietor husband to the wife to compensate her for her efforts. However, the management fees drove the business into a further loss. Such losses were then deducted by the taxpayer husband, and taxes that were paid on his normal employment income were recovered. The taxpayer used those refunds to continue to finance the business. Given that the deduction of the management fees either eliminated all of the marginal profits or increased the already existing losses, the CRA argued that there was no business and that the "business" was really personal in nature. The court agreed. Accordingly, practitioners should be aware of such issues when recommending income-splitting opportunities between family members, notwithstanding that the case was decided outside the provisions of section 67 and before Stewart and Walls. The Tax Court of Canada has heard a number of informal procedure cases that deal with the reasonableness of shareholder and owner-manager remuneration. Prefontaine, for example, addressed the issue of whether certain expenses claimed by Mrs. Prefontaine in her property rental business were deductible. Mrs. Prefontaine had full-time employment outside of her property rental business. The property rental business generated profits. Mrs. Prefontaine paid approximately $3,000 in "salary" to her two daughters aged 17 and 12. The minister was not satisfied that such payments were reasonable and therefore denied the deduction against the rental profits. The judge found that the wages of $1,925 paid to the 17-year-old daughter were unreasonable given that one of the rental units was vacant for several months during the applicable taxation year, the daughter was in full-time attendance at school, and the daughter also gave music lessons for $20 an hour. However, the judge found that the daughter had done some cleanup and yard work and therefore estimated that a reasonable amount would be $500. The judge also found that the salary amounts paid to the 12-yearold were not justifiable given insufficient evidence presented at trial. Aessie is another example of an informal procedure case that dealt with the reasonableness of ownermanager remuneration. Aessie involved a self-employed chartered accountant who provided public accounting services from his residence. The appellant's spouse provided assistance in the business (through a corporation, "Mayday," the shares of which were equally owned by the spouse and her | sister) in the form of administrative duties. In the computation of his income for the 1999 and 2000 taxation years, the appellant deducted "fees" in respect of services provided by his spouse in the amount of $34,500 for the 1999 taxation year and $38,000 for the 2000 taxation year. In reassessing the taxpayer, the minister denied the deduction of $25,650 in management fees for 1999 and $29,150

256 for 2000, asserting that such amounts were not reasonable pursuant to section 67 of the Act. The administrative services provided by the taxpayer's spouse in respect of the taxpayer's accounting business included reception, typing, tax return assembly, proofing, mailing, dealing with mail, photocopying, filing, etc. After the management fees were deducted, the profit from the accounting business was nominal. Finding in favour of the taxpayer, the judge made the following noteworthy comments: Finally, it should be pointed out that many professionals and businessmen make less money from their businesses than their secretaries do. Often that occurs occasionally. Sometimes it occurs frequently. The deal with Mayday is a common and reasonable business deal that is not unusual or untoward in the business world. It is not appropriate for the Court to interfere in such a transaction. Therefore the appeal respecting this matter is allowed. Aessie is interesting because the taxpayer's facts appear consistent with the pattern that the CRA finds disturbing; nevertheless, the taxpayer was successful at trial. Muhammedi is another informal procedure decision that involved the reasonableness of ownermanager remuneration. Mr. Muhammedi reported net business income in the amounts of $332 and $346 for the 1999 and 2000 taxation years, respectively. In computing his net business income, Mr. Muhammedi claimed deductions for "casual labour" in the amounts of $12,000 and $3,500 for the 1999 and 2000 taxation years, respectively. In 1999, a "management fee" of $3,500 was paid to the spouse of Mr. Muhammedi; for 2000, no management fee was paid to the spouse. The balance of the "casual labour" payments for the 1999 and 2000 taxation years appeared to have been paid to the taxpayer's two children, aged 17 and 12. It appears that cheques were issued to the children, but the funds were deposited back into the bank account of either the taxpayer's business or the personal account of the taxpayer and the spouse. None of the cheques issued to the children were endorsed by them. In addition, there was no formal written loan agreement between the appellant and the children in regard to the amounts deposited back into the bank accounts of the business or the taxpayer. In reassessing Mr. Muhammedi, the minister relied on paragraph 18(1)(a) and section 67 of the Act, submitting that Mr. Muhammedi was not entitled to deduct the amounts of $12,000 and $3,500 in computing the income for the 1999 and 2000 taxation years because Mr. Muhammedi had not shown that the amounts were incurred for the purpose of gaining or producing income. The minister further submitted that Mr. Muhammedi and the children were not engaged in a bona fide business arrangement and that, to the extent that the Tax Court found that the amounts paid constituted salaries to the children, such payments were not reasonable pursuant to section 67 on the basis of the children's ages, the dates the payments were made, and the amounts of the payments in comparison with the amounts paid to the spouse during the same period. After reviewing the facts and finding (1) that the cheques issued to the children either were not paid to them or, upon being paid to them, were immediately deposited into the bank accounts of the business or one or both of the parents, (2) that there was no loan documentation, and (3) that the children did not declare the "casual labour" amounts on their personal income tax returns, the judge stated the following: One is left with the impression that what was involved was tax planning designed to reduce, as much as possible, the overall tax burden of the family. This is not necessarily the end of the matter but when the operations are carried out in the fashion that they were it smacks of a sham and does not meet the requirements of paragraph 18(1)(a) and section 67 of the Income Tax Act. The judge dismissed the taxpayer's appeal and denied the deduction of the casual labour amounts. Although Prefontaine, Aessie, and Muhammedi were informal procedure decisions, they should serve as a reminder to practitioners that formality and reasonableness are critically important in ensuring that section 67 and paragraph 18(1)(a) do not apply to remuneration planning.

257 Given the continuing uncertainty regarding the reasonableness of owner-manager remuneration, one questions whether it is finally time for the Department of Finance to legislate the criteria (perhaps as outlined in Income Tax Technical News no. 22) in order to provide taxpayers with certainty about when owner-manager remuneration will not be subject to the provisions of section 67 or paragraph 18(1)(a).

6. Bonus Payments Safety Boss Limited v. R.

[2000] 3 C.T.C. 2497 APPEALS by taxpayer from Minister's disallowance of portion of bonus paid to president and of fee paid to company. Bowman T.C.J.: 1 These appeals concern two assessments under Part I of the Income Tax Act for the 1991 and 1992 taxation years as well as an assessment under Part XIII of non-resident withholding tax and penalties. 2 In 1991, the appellant paid a bonus to its president and 99% shareholder, Mr. Michael Miller, who at the time was a non-resident of Canada. In 1992, it paid a fee to Mr. Miller's non-resident company. The Minister of National Revenue disallowed a portion of the bonus paid to Mr. Miller and of the fee paid to his company on the basis that these amounts were in excess of the amounts that would have been reasonable had the parties been dealing at arm's length. In addition, the Minister treated the amount disallowed as a benefit conferred on Mr. Miller and accordingly imposed nonresident withholding tax and a penalty. The issue is whether the Minister was right in doing so. 3 The appellant carries on the business of oilfield firefighting and the capping of blow-out oil and gas wells. Its fiscal period is August 31. 4 Michael Miller is an oilfield firefighter. At the time of the trial he was 55 years old. During the years in question he was the president and chief executive officer of the appellant, as well as the owner of 99% of the shares. He bought the company from his father in 1979. It had been a family company since 1956. He has had many years of experience in the oil and gas business and in fighting oil well fires throughout the world. One example of a large fire that he worked on was the blow-out at Lodge Pole which burned for 67 days. In 1983, he fought two fires on offshore rigs off the coast of Iran. 5 After Mr. Miller's acquisition of Safety Boss in 1979, the company went through a period of extreme financial difficulty for about 10 years, probably as the result of the National Energy Program, which had a devastating effect on the oil and gas industry in western Canada. Mr. Miller was forced to sell all of his oil and gas reserves and borrow money simply to keep the business afloat. 6 The business of fighting oil and gas well fires is dangerous in the extreme. It requires extraordinary skill, endurance and courage. Mr. Miller is the one person who predominantly contributed to the success of the company. 7 The following paragraphs in the notice of appeal are admitted by the respondent:

258 6. Miller had over 30 years of oilfield experience including significant experience outside Canada and in particular, in the Middle East. 7. Miller had developed skills and a personal reputation worldwide as a person capable of dealing with the most adverse oil and gas fires. His reputation was particularly strong in the Middle East because of work he had done in that region. 8. At all relevant times, Miller's duties in connection with the Business included undertaking all strategic planning, direct responsibility for negotiating all contracts with customers and for maintaining good relationships with suppliers, responsibility to ensure that the contracts of the Business were completed to an appropriate standard, responsibility for management of day to day operations for all oilfield firefighting activities, recruitment of all personnel, purchasing of all supplies necessary to carry out contracts, and arranging for all financial aspects pertaining to the Business. 9. Any goodwill of the Appellant in relation to the Business was attributable to the personal reputation and capabilities of Miller. 8 In addition to the above admissions, the following allegations in the notice of appeal are substantially admitted by the respondent and, to the extent that they are not admitted, they have been amply proved in the viva voce evidence: 10. At the end of the 1991 war between Iraq and Kuwait ("Gulf War") the retreating Iraqi troops exploded and ignited 731 oil wells in Kuwait, creating an ecological disaster of a magnitude several times greater than anything previously experienced by mankind. 11. This carnage created by the retreating Iraqi troops had been anticipated by the Kuwaiti government. By virtue of Miller's prior personal contact with officials of the Kuwait Oil Company, his reputation and the work previously undertaken by him, on February 28, 1991, the Government of Kuwait entered into an agreement with Miller's company, the Appellant, to extinguish oil well fires which were expected to be ignited by the retreating Iraqi troops. Shortly after the termination of the Gulf war, the Appellant began performing its contractual duties in Kuwait. 12. The work undertaken by the Appellant and its staff in Kuwait was incredibly difficult and dangerous. Miller provided the extraordinary motivational leadership which sustained the employees of the Appellant and enabled the Appellant to perform and complete its contract in Kuwait. 13. The unique hazardous circumstances of the work provided Miller an opportunity to apply certain original concepts he had devised for battling oil well fires. This innovation allowed the Appellant to extinguish more fires than any other team active in the Kuwait operation. 9 Part of the evidence of devastation created by the retreating Iraqi troops by their blowing up and igniting oil wells was adduced by means of photographs and videos. It is difficult to describe the magnitude of the disaster, or of the task that was undertaken by the appellant under the leadership of Mr. Miller. 10 Three other oilfield firefighting companies, all Texas based were involved: the famous Red Adair's company, Boots & Coots and Wild Well Control. In addition to all of the other difficulties that he encountered, Mr. Miller had to put up with the arrogance and bullying of the Texans, who resented the intrusion of a Canadian company on what they regarded as their exclusive bailiwick. 11 There is no doubt that the contract with Kuwait was obtained through Mr. Miller's initiative and contacts, as well as his reputation and skill. There is equally no doubt that his innovations contributed substantially to the success of the company. Some of these innovations included mobile monitoring sheds, huge fire trucks, the use of foam or water as opposed to explosives, a crane attached to mobile vehicles for use in inserting a "stinger" into a burning oil well, the purpose of which was to draw

259 off and ultimately extinguish the burning oil, and the design of a wide tracked vehicle, the purpose of which was to separate burning wells from those that had been extinguished. It was in part as the result of Mr. Miller's innovations that the appellant capped 180 wells more than anyone else, including the three Texas companies, even though the appellant arrived several weeks after the Texans. Mr. Miller's operation was fundamentally different from that of the Texas companies and this may account for his success, as well as for the fact that, after the fires were all put out, the appellant was asked to remain in Kuwait to do cleanup work, whereas the Texans were not. In fact, the fires were put out in a matter of months, not, as anticipated originally, years. 12 It is clear on the facts that the substantial earnings of the appellant from this work in Kuwait was the direct result of Mr. Miller's leadership, initiative, intelligence and business acumen. In saying this, I do not in any way mean to minimize the skill and courage of the men whom he hired to work under him. The heat, danger, and grueling conditions under which they all worked were indescribable. It was however, Mr. Miller who inspired them to do so. For this he was awarded the Order of Canada and was named Oilman of the year by Oilweek magazine. 13 So much then for the somewhat dramatic background to this income tax appeal.

14 On June 28, 1991 Safety Boss International Limited ("SBIL") was incorporated under the laws of Bermuda. Mr. Miller acquired 11,996 of the 12,000 issued shares. On August 2, 1991 he moved to Bermuda. It is admitted that he became a non-resident of Canada and became a resident of Bermuda. 15 On August 30, 1991, the appellant declared a bonus to Mr. Miller of $3,000,000, and deducted it in computing its income. 16 The resolutions of the sole director of the appellant read as follows: WHEREAS the Company has benefited greatly through the efforts of Michael J. Miller, its President, in obtaining, negotiating and performing the contract with the Government of Kuwait. AND WHEREAS without the expertise and efforts of its President the Company would not have acquired the contract or have been in a position to benefit from it. AND WHEREAS the Company wishes to recognize in a tangible way the significant contribution of its President. NOW THEREFORE BE IT RESOLVED that a bonus in the amount of $3,000,000.00 be declared to Michael J. Miller effective August 30, 1991. RESOLVED FURTHER that the bonus be paid within 180 days of the fiscal year end of the Corporation. RESOLVED FURTHER that the bonus be deemed to have been earned by Mr. Miller pro rata from February 28, 1991 to August 30, 1991. RESOLVED that the officers and directors of the Corporation be and they are hereby authorized to execute and deliver all necessary documents, agreements and other papers which may be requisite or necessary to fulfill the full intent and meaning of this resolution. Dated at Al Ahmadi, Kuwait, this 30th day of August, 1991.

17 The recitals are fully supported by the facts. 18 The bonus was paid to Mr. Miller before the end of December 1991. He declared $2,513,513 as income earned in Canada and subject to Canadian tax, and excluded $486,487. The portion of the bonus declared by him was arrived at as follows: 155 X $3,000,000 = $2,513,513

260 19 The precise rationale for this particular method of allocation was not made particularly clear. The denominator (185) is roughly the number of days between February 28 and August 30. The numerator (155) is roughly the number of days in 1991 between the February 28 and August 2, the day Mr. Miller became a non-resident. The exact basis of the figure is not particularly germane to this case, but it is noteworthy that the appellant, on the advice of his accountant, Mr. Duncan Moodie, adopted a most conservative position and, notwithstanding his residency in Bermuda when the bonus was received, declared as subject to Canadian tax almost 84% of the bonus. 20 The Minister did not seek to tax Mr. Miller on the $486,487. Rather, he disallowed a portion of it, $418,987, on the theory that only $67,500 was a reasonable amount within the meaning of subsection 69(2) of the Income Tax Act. 21 The second issue has to do with a fee of $800,000 per month paid by the appellant to SBIL. On August 30, 1991 Mr. Miller resigned as president and director of the appellant and commenced an exclusive employment contract with SBIL, under which SBIL was to pay him $800,000 per month. On September 1, 1991, the appellant and SBIL entered into an agreement under which SBIL was to render services to the appellant for a consideration of $800,000 per month. As a term of that contract SBIL agreed to make the services of Mr. Miller available to the appellant. 22 By November 14, 1991 the fires in Kuwait had been put out and the appellant's contract with Kuwait came to an end and the appellant stopped paying SBIL the amounts specified in the contract. The appellant paid SBIL $800,000 for each of the months of September and October, 1991 and $373,333 for the 14 days in November, for a total of $1,973,333. 23 Of this amount, the Minister allowed as a deduction in computing the appellant's income for the taxation year ending August 31, 1992 only $126,000, on the basis that any amount in excess of this figure that was paid for Mr. Miller's services was unreasonable. 24 The Minister treated the amounts of $418,987 and $1,847,333 disallowed in 1991 and 1992 as benefits conferred by the appellant on Mr. Miller and subject to withholding tax. He also imposed a penalty under Part XIII of the Act. 25 The provision of the Act that is central to the Crown's position is subsection 69(2) which reads: (2) Unreasonable consideration. Where a taxpayer has paid or agreed to pay to a nonresident person with whom he was not dealing at arm's length as price, rental, royalty or other payment for or for the use or reproduction of any property or as consideration for the carriage of goods or passengers or for other services, an amount greater than the amount (in this subsection referred to as "the reasonable amount") that would have been reasonable in the circumstances if the non-resident person and the taxpayer had been dealing at arm's length, the reasonable amount shall, for the purpose of computing the taxpayer's income under this Part, be deemed to have been the amount that was paid or is payable therefore.

26 It is interesting, although perhaps not significant, that the Minister relied upon subsection 69(2), but not on section 67. Section 67 allows as a deduction of an outlay or expense only "to the extent that the outlay or expense was reasonable in the circumstances." 27 "Reasonable" in section 67 is a somewhat open-ended concept requiring the judgment and common sense of an objective and knowledgeable observer. "Reasonable amount" in subsection 69(2) as between non-arm's length persons, is essentially defined as an amount that would have been reasonable in the circumstances had the non-resident and the taxpayer been dealing at arm's length.

261

28

If there is a difference between the concepts in the two provisions it is not readily apparent.

29 If the amounts paid by the appellant to Mr. Miller and SBIL are not "reasonable amounts" within subsection 69(2), the disallowance of the excessive payments follows inevitably. 30 The other two consequences the withholding tax and the penalties are less clear. In light of the conclusion that I have reached on the main issue it is unnecessary that I deal with these subsidiary issues, but out of deference to the submissions made by both counsel, I shall touch briefly on them. 31 If the amounts paid are unreasonable the excessive amount, on the Minister's view, is a benefit conferred by the appellant on Mr. Miller, a shareholder within subsection 15(1). I should think this argument would be difficult to resist in the case of the bonus if it is unreasonable. If it is a benefit under subsection 15(1), subsection 214(3) would deem it to be a dividend paid by a corporation resident in Canada where it is a benefit conferred on a non-resident shareholder, taxable under subsection 212(2) and subject to the requirement of withholding by the resident payor under subsection 215(1). 32 However, in the case of the disallowed fee of $1,847,333 paid to SBIL in the 1992 taxation year, counsel argues that the benefit, if any, was conferred not on the shareholder, Mr. Miller, but on his company, SBIL. He contends that to treat an unreasonable or excessive payment to SBIL as a benefit conferred on its sole shareholder would constitute an unwarranted piercing of the corporate veil. While I express no concluded view on the matter, because I do not need to, I should have thought as a matter of common sense that the conferral of a benefit on a corporation, all of the shares of which are owned by a taxpayer, would constitute a benefit conferred on the taxpayer. It increases the value of the taxpayer's shareholding in the corporation that receives the benefit and allows the corporation to make payments to the shareholder that it could not otherwise do. 33 The second subsidiary issue touched on by counsel for the appellant is the matter of penalty. Subsection 227(8) reads: (8) Subject to subsection (8), every person who in a calendar year has failed to deduct or withhold any amount as required by subsection 153(1) or section 215 is liable to a penalty of (a) 10% of the amount that should have been deducted or withheld; or (b) where the person had at the time of the failure been assessed a penalty under this subsection in respect of an amount that should have been deducted or withheld during the year, 20% of the amount that should have been deducted or withheld. Paragraph (b) was amended in 1994, applicable after 1992 to read: (b) where at the time of the failure a penalty under this subsection was payable by the person in respect of an amount that should have been deducted or withheld during the year and the failure was made knowingly or under circumstances amounting to gross negligence, 20% of that amount. 34 Counsel for the appellant contends that the 10% penalty which was imposed in this case under paragraph 227(8)(a) is one of strict as opposed to absolute liability and he relies upon Consolidated Canadian Contractors Inc. v. R., [1998] G.S.T.C. 91 (Fed. C.A.) and Pillar Oilfield Projects Ltd. v. R., [1993] G.S.T.C. 49 (T.C.C.). 35 Counsel for the respondent submits that in light of paragraph 227(8)(b), which imposes a higher penalty where a failure to withhold was made knowingly or under circumstances amounting to gross negligence, the inference to be drawn is that the penalty under 227(8)(a) is automatic and absolute and that no defense of due diligence is available. While I need not decide the point in this

262 case, I question the correctness of this proposition, even if the amended version of paragraph 227(8) (b) applied. I do not think it is supported by Consolidated Canadian Contractors. Section 285 of the Excise Tax Act contains a more severe penalty where false statements are made knowingly or under circumstances amounting to gross negligence and this did not displace the existence of a defense of due diligence under section 280. 36 I turn now to the principal issue whether the bonus paid to Mr. Miller or the fees paid to SBIL were "greater than the amount that would have been reasonable in the circumstances if the nonresident person and the taxpayer had been dealing at arm's length" within the meaning of subsection 69(2). 37 I begin by observing that it is passing strange that so long as Mr. Miller was a resident of Canada, the Minister did not question the reasonableness of remuneration paid to him. The 84% of the bonus allocated by Mr. Miller and his accountant to Mr. Miller's income taxable in Canada was evidently quite reasonable in the eyes of the Minister. It was only the 16% portion, $486,487, allocated to him as a resident of Bermuda, that caught the Minister's attention. No doubt there is a practical rationale for what must appear to be a somewhat anomalous and inconsistent approach by the Minister. The justification is presumably that so long as the remuneration was fully taxable in Mr. Miller's hands the deduction by the company did not result in any loss to the fisc. This position is understandable but it must be emphasized that the reasonableness of an expense is not affected by the question whether the amount is taxable in the hands of the recipient. 38 The assessment is based on the view that Mr. Miller's remuneration, whether in the form of the bonus in 1991 or through the fees paid to SBIL in 1992, should not exceed $2,250 per day when he was in Kuwait and $750 per day when he was not. The $2,250 figure was simply $1,500 per day that was paid to another employee who acted as team leader plus an additional $750 per day for any managerial duties performed by Mr. Miller. 39 The premises that form the foundation of the assessments and the assessments themselves are flawed for a number of reasons: (a) They fail to take into account the fact that the existence of the contract with Kuwait and its fulfillment were attributable to Mr. Miller. However competent the other employee may have been he was nonetheless an employee of Mr. Miller's company whom Mr. Miller hired and directed. That employee did not, to put it colloquially, bring in the business. He participated in performing the work that Mr. Miller brought in. To relegate Mr. Miller to the position of just another employee, when he was the driving force behind the company without which neither the company nor its contract with Kuwait would have existed, is both demeaning to Mr. Miller and commercially unrealistic. (b) The assessments fail to take into account the years in which Mr. Miller struggled to keep the company afloat during the lean years, and in which he accepted no or reduced remuneration. Indeed, the Minister sought to justify the assessments for 1991 and 1992 by referring to the remuneration Mr. Miller received in the earlier lean years. I should have thought that precisely the opposite inference ought to be drawn. (c) The justification advanced for ignoring the fact that Mr. Miller was the person who singlehandedly brought in the business is that when he was paid the bonus in 1991 and when his company was paid a fee of $800,000 per month for about 2 months in 1992, the contract was already in place, and therefore what he did in the past to bring about the company's profits was simply past history and could have no bearing on what he was to be paid when, as the result of his efforts, the company was in a position to pay him amounts that were commensurate with his contributions to its profits. This theory is not sustainable, either as a matter of commercial practice or of common sense. It is quite common to reward valued

263 employees in profitable years in recognition of services rendered in prior years. In any event, the contract with Kuwait was entered into in 1991. (d) What seems obvious to me and it was evidently not obvious to the departmental officials is that the substantial amounts paid by Kuwait to the Appellant were paid because of Mr. Miller. It was he who predominantly contributed to the appellant's profits. He was the rainmaker. 40 It is interesting to note that in a memorandum dated December 12, 1994 to the Calgary office of the Department of National Revenue from the head office, it was accepted that a withholding tax on the fees under paragraph 212(1)(a) (management or administration fee or charge) could not be sustained because of paragraph 212(4). 41 The memorandum of December 12, 1994 reads in part as follows: You have asked for our comments on two possible approaches. Your first approach would be to apply a 25% withholding tax to the management fees paid by SBL to Safety Boss International Ltd. (SBIL). You feel that paragraph 212(4)(b) is not applicable using the same logic as in the Peter Cundill & Associates Ltd. case [reported Peter Cundill & Associates Ltd. v. R., [1991] 2 C.T.C. 221 (Fed. C.A.)]. I have reviewed this case it deals with a paragraph 212(4)(a) exclusion and not a paragraph 212(4)(b) exclusion. Thus it is our opinion that the Peter Cundill case does not deal with the same issue as your case. It appears that the taxpayer has clearly shown that the paragraph 212(4)(b) exclusion is appropriate and thus no Part XIII tax should be assessed. The only situation that paragraph 212(4)(b) would not be appropriate is if the management fee was not reasonable in the circumstances in which case the 25% withholding tax would be applicable. With regards to your second approach, we make the following comments: The facts are well laid out in Felesky Flynn's letters of July 18, 1994 and October 24, 1994. SBL made two separate types of payments for services rendered to it for work on the Kuwait fire contract. I will deal with each separately. 1. SBL declared a bonus for its fiscal year ended August 31, 1991 in favour of Mr. Miller in the amount of $3,000,000. It was in connection with Mr. Miller's efforts on the Kuwait project. Mr. Miller was a resident of Canada for most of this time and all but $486,587 was reported by Mr. Miller on his 1991 T1. For this reason, I do not feel it is worth while to pursue the reasonableness of this payment. 2. On September 1, 1991 SBL and SBIL entered into an agreement whereby SBIL agreed to render services, including Mr. Miller's services, to SBL in respect of SBL's contract with the Government of Kuwait. SBL agreed to pay to SBIL, a fixed fee of $800,000 per month based upon SBIL's obligation to pay Mr. Miller remuneration of $800,000 per month. SBL expensed $1,973,333 which covered the 2 month period ending November 14, 1991. SBL does not deal at arm's length with SBIL and thus the management fee must be the reasonable amount as per subsection 69(2). In order to determine the reasonable management fee, we suggest that the following steps be taken. 42 I shall not reproduce the remainder of the memorandum. It contains a number of suggestions, all of which were ignored by the Calgary office. 43 Paragraph 212(4) reads: (4) For the purpose of paragraph (1)(a), "management or administration fee or charge" does not include any amount paid or credited or deemed by Part I to have been paid or credited to a non-resident person as, on account or in lieu of payment of, or in satisfaction of, (a) a service performed by the non-resident person if, at the time he performed the service (i) the service was performed in the ordinary course of a business carried on by him that included the performance of such a service for a fee, and

264 (ii) the non-resident person and the payer were dealing with each other at arm's length, or (b) a specific expense incurred by the non-resident person for the performance of a service that was for the benefit of the payer, to the extent that the amount so paid or credited was reasonable in the circumstances. 44 Paragraph 212(4)(b) is not restricted to arm's length transactions. All that is required to exclude a fee paid to non-residents from the ambit of paragraph 212(1)(a) is that it be in satisfaction of a specific expense incurred by the non-resident for the performance of a service that was for the benefit of the payor and that the amount paid be "reasonable in the circumstances". 45 Counsel for the appellant asks in effect: If the Minister accepts that the fees paid to SBIL are reasonable for the purpose of subsection 212(4), why do they become unreasonable for the purpose of subsection 69(2)? I agree there is an inconsistency here. Income tax appeals are not, however, won solely by demonstrating inconsistencies in the reasoning of the departmental officials. They are won by demonstrating that an assessment is objectively wrong, whether factually or legally. 46 Counsel also suggests that subsection 212(4) is more specific than subsection 69(2), and that therefore subsection 212(4) would exclude the application of section 69(2) on the principle of generalia specialibus non derogant and that if the department accepts that 212(4) does not apply, it cannot then apply subsection 69(2). In light of the conclusion I have reached, I need not express a concluded view on this point, but I should have thought that the argument pushes the generalia specialibus non derogant well beyond its purpose as an aid to construction. 47 Subsection 69(2) is aimed at denying under Part I the deduction of unreasonable payments to non-arm's length non-residents. Subsection 212(4) is intended to exclude certain payments from paragraph 212(1)(a). The purpose of the two provisions is so fundamentally different that it would be pointless to try to ascribe predominance to one of them. Moreover, the principle embodied in the Latin maxim is simply that general words in a later statute should not be construed as repealing the specific provisions of earlier statutes. 48 While departmental practice is not determinative it is sometimes useful to look at it, particularly where the assessment in question is a departure from a beneficial and sensible practice. In the 1981 Revenue Canada Round Table, the following answer was given in response to a question relating to the reasonableness of salaries and bonuses: In general, the Department will not challenge the reasonableness of salaries and bonuses paid to the principal shareholders-managers of a corporation when (a) the general practice of the corporation is to distribute the profits of the company to its shareholders-managers in the form of bonuses or additional salaries; or (b) the company has adopted a policy of declaring bonuses to the shareholders to remunerate them for the profits the company has earned that are, in fact, attributable to the special knowhow, connections, or entrepreneurial skills of the shareholders. 49 Mr. Miller, as noted above, falls squarely within paragraph (b) of the response.

50 The determination of the amount of the bonus, the allocation of 84% to Canada, and the amount of the fee were not arbitrary decisions. Mr. Moodie, the accountant, made a conscious effort to leave money in the company for future needs, and to compensate Mr. Miller for his contribution to the profits. 51 I revert to the question: Would it have been unreasonable for an arm's length person to pay to Mr. Miller or SBIL the amounts that the appellant in fact paid to them? One must not ignore the fact

265 that Kuwait clearly at arm's length with the appellant in fact paid substantially more for what were essentially Mr. Miller's services, including his expertise, experience, know-how, reputation and managerial skills. The appellant is essentially a one-man company, and, although it had employees and equipment, it was in many ways a one-man operation. Had Mr. Miller operated as a sole proprietorship and received fees from Kuwait out of which he paid salaries, wages and expenses, his income from the arm's length source, Kuwait, would have been significantly greater. Yet it could not have been suggested that Kuwait was paying an unreasonable fee for his services. 52 There have been numerous cases on the question of the reasonableness of expenses. Essentially the determination is one of fact. I shall refer to only one that sets out the principle and that has been frequently cited: Gabco Ltd. v. Minister of National Revenue (1968), 68 D.T.C. 5210 (Can. Ex. Ct.). At page 5216 Cattanach J. said: It is not a question of the Minister or this Court substituting its judgment for what is a reasonable amount to pay, but rather a case of the Minister or the Court coming to the conclusion that no reasonable business man would have contracted to pay such an amount having only the business consideration of the appellant in mind. I do not think that in making the arrangement he did with his brother Robert that Jules would be restricted to the consideration of the service of Robert to the appellant in his first three months of employment being strictly commensurate with the pay he would receive. I do think that Jules was entitled to have other considerations present in his mind at the time of Robert's engagement such as future benefits to the appellant which he obviously did. 53 It has in my view been overwhelmingly established that the bonus paid to Mr. Miller in 1991 and the fees paid in 1992 to his company SBIL were fully commensurate with the services rendered by Mr. Miller and were not in excess of the amounts that it would have been reasonable to pay had the parties been at arm's length.* 54 The appeals for the 1991 and 1992 taxation years are allowed and the assessments under Part I of the Income Tax Act are referred back to the Minister of National Revenue for reconsideration and reassessment to permit the deduction in computing the appellant's income of the bonus paid to Mr. Miller and the fees paid to Safety Boss International Ltd. 55 The appeal from the assessment of non-resident withholding tax under Part XIII of the Income Tax Act made on October 1, 1998 is allowed and the assessment of tax, interest and penalties is vacated. 56 The appellant is entitled to its costs.

Appeals allowed. Bonus payments to family members Excerpts from Canadian Tax Highlights, Canadian tax Foundation Volume 5, Number 3, July 2005 The CRAs longstanding position has been that it will not challenge the reasonableness of salaries and bonuses paid by a Canadian-controlled private corporation (CCPC) to an individual who is a shareholder of the corporation, provided that the individual is active in the business operations and is resident in Canada. On the other hand, the CRA has made it clear that bonuses paid to individuals other than principal shareholder-managers will be subject to the normal test of reasonableness. Ambulances B.G.R. Inc. (2004 TCC 168) is one of the most recent cases to address the reasonableness of such bonuses. At

266 issue was whether the bonuses paid by the taxpayer to its sole shareholders two children could be deducted in calculating its income for its 1995, 1996, and 1997 taxation years. The Tax Court of Canada found in favour of the taxpayer. The facts are rather interesting. Neither of the children was a shareholder of the taxpayer. The sole shareholders daughter was the taxpayers controller and worked 50 to 70 hours a week. Her bonus was challenged by the CRA as unreasonable because it was in excess of the bonus paid to the taxpayers sole shareholder. The sole shareholders son was the taxpayers equipment manager. The CRA appears to have challenged his bonus because he spent only 50 percent of his efforts on the taxpayers business. The minister also argued that the bonuses were paid to reduce the taxpayers income only to take maximum advantage of the small business deduction; that the children were not shareholders of the taxpayer; that the taxpayer paid no bonuses to any of its other employees, apart from the members of the sole shareholders family; and that the bonuses were not paid to earn income and were not of a reasonable amount. The ministers approach was rejected by the Tax Court. The court said that the taxpayer received genuine services from the children in return for the bonuses paid to them. The children played a material role in the taxpayers financial success. The remuneration that they received during the years under appeal did not take into account their exceptional contribution to the taxpayer. Their bonuses represented well-deserved remuneration that had been expected but not paid during prior years, and the court found that they were reasonable and therefore deductible. Note: The CRA administrative policy to not challenge the reasonableness of bonuses paid to Canadian resident owner-managers who are active in the business does not apply to non-CCPCs. Once a corporation ceases to be a CCPC, a deduction to the corporation for such bonus would be subject to section 67. Excerpt From Bonus from Goodwill Proceeds by Wayne Tunney, Canadian Tax Highlights, (2006) vol. 14, no. 4 A recent advance tax ruling (2005-0163741R3) allowed a Canadian-controlled private corporation (CCPC) a deduction for bonuses paid to several shareholder-managers even though a portion of the underlying income came from the sale of its goodwill and other business assets rather than from the company's regular business activities. The CRA's longstanding position is generally not to challenge the reasonableness of a salary or bonus paid to a CCPC's Canadian-resident shareholder-manager if he or she is active in the operating business and the remuneration is paid out of income from the CCPC's normal business activities. The CCPC may deduct the salary or bonus to reduce its income to the threshold for the small business tax rate; on several occasions the CRA has confirmed this general policy on bonusing down to the small business threshold. In the ruling, three holdcos-A Co, B Co, and C Co-owned equal numbers of Opco shares. Each holdco was owned in turn by Mr. A, Mr. B, or Mr. C and a corresponding spousal trust. Mr. A, Mr. B, and Mr. C and their spouses (the shareholder-managers) were all Opco directors and were therefore responsible for the strategic direction of the company. Mr. A, Mr. B, and Mr. C managed Opco's dayto-day activities.

267 Opco had a history and general practice of paying bonuses to its shareholders in years when its taxable income exceeded the small business threshold. During the current year, Opco sold its goodwill and other business assets to an arm's-length purchaser for significant proceeds. The current year's assets, salaries, and bonuses were already higher than in prior years because the company retired bank financing whose loan covenants had restricted the remuneration payable to the shareholder-managers. Opco proposed to pay bonuses to the six shareholder-managers to compensate them for their contribution to the successful management of Opco and to distribute to them the proceeds from the sale of the business assets in a tax-effective manner. The CRA ruled that paragraph 18(1)(a), section 67, and subsection 78(4) did not prohibit Opco from deducting the amount of the bonuses. This ruling accords with previous rulings (see 2004-0092931R3 and 2005-0146031R3). However, the ruling seems to contradict the CRA's statement at the Canadian Tax Foundation's 2003 annual conference round table that its administrative policy of not challenging the deductibility of bonuses to shareholder-managers does not apply to bonuses paid as part of the sale of the payer corporation's business assets.

VI. Corporate Distributions

1. What is a Dividend?
The Act includes in income, for the purposes of calculating Part I tax, taxable dividends received from corporations resident in Canada. This provision applies to all taxpayers, whether individuals or corporations. In addition, where the corporation paying the dividend is a taxable Canadian corporation and the recipient is an individual, para. 82(1)(b) requires that an additional 25% of the dividend be included in the individual's income in the case of ineligible dividends and 45% otherwise. As an offset to the inclusion in income of a corporation of dividends from other corporations that are resident in Canada, we have seen that the recipient corporation is entitled to a deduction under ss. 112(1) in respect of taxable dividends received from a taxable Canadian corporation or from a corporation resident in Canada and controlled by it. The deduction is a 100% deduction and results in the recipient corporation not being required to pay Part I tax on dividends that meet the requirements of ss. 112(1). Note that ss. 112(1) is contained in Division C and therefore is a deduction from income for the purpose of calculating taxable income. That is to say, the dividends are first included in income under para. 82(1)(a) and then subsequently deducted out when calculating taxable income. As we have seen, individuals are also entitled to special tax treatment in respect of dividends received by them in the form of the dividend tax credit found in s. 121. It provides a deduction against federal tax payable of 2/3 of the amount of the gross-up under para. 82(1)(b) (2/3 of 25%) in the case of ineligible dividends and 6/11 for eligible dividends 6/11 of 38%). With respect to dividends received from corporations that are not resident in Canada, s. 90 requires all taxpayers, whether individuals or corporations, to include in income all dividends received by the taxpayer on shares of the capital stock of a corporation not resident in Canada. Finally, as we have seen, there can be a Part IV tax payable by private corporations (and certain kinds of public corporations) on taxable dividends received from other corporations.

268 The question arises: what is a dividend? Does it refer to any and all distributions of cash or property from a corporation to its shareholders? The word "dividend" is defined in ss. 248(1) as follows: "dividend" -- "dividend" includes a "stock dividend" (other than a stock dividend that is paid to a corporation or a mutual fund trust by a nonresident corporation); As an inclusive and not an exhaustive definition, it is of little help. Hence, resort must be had to the case law. In R.A. Hill v. Permanent Trustee Company of New South Wales, Ltd., [1930] A.C. 720 (P.C.), the Privy Council was faced with a question of whether a trustee should treat a corporate distribution as income or capital for trust purposes since the testator had directed that capital of the trust was to go to one group of beneficiaries and income of the trust was to go to another group. Their Lordships drew upon several propositions under corporate law in making their decision and in the course of their decision made the following comments: "A limited company not in liquidation can make no payment by way of return of capital to its shareholders except as a step in an authorized reduction of capital. Any other payment made by it by means of which it parts with moneys to its shareholders must and can only he made by way of dividing profits. Whether the payment is called "dividend" or "bonus", or any other name, it still must remain a payment on division of profits." [Emphasis added] The Exchequer Court has adopted the position in the Hill decision. In Northern Securities Co. v. The King, (1935) 1 DTC 282, the Court said that the Privy Council's decision meant that any distribution of money, except on a reduction of capital, by which assets are released to shareholders can only be a distribution of profits by way of dividend. Subsequent decisions have established that even where the source of the dividend is a capital surplus account or a paid-in surplus account, the distribution is by way of dividend. It is therefore commonly said that distributions of property by a corporation pro rata amongst its shareholders, other than upon a statutory reduction of capital or a liquidation are dividends. The point is that it is not necessary to find retained earnings or accounting profits in order to determine whether or not there is a dividend. The presence of undistributed profits in the company is not a prerequisite to characterization of the distribution as a dividend. What is the Department's position? In paragraph 2 of Interpretation Bulletin IT-67R3, the Department gives a definition of a dividend as follows: "Because there is no specific meaning given to the word "dividend" in the Act, it must be given its generally accepted meaning. Accordingly, any distribution by a corporation of its income or capital gains made pro rata among its shareholders may properly be described as a dividend unless the corporation can show that it is another type of payment. The fact that a distribution of this kind may not be called a dividend does not affect the nature of the distribution. Also, any interest received on an income bond is deemed under subsection 15(3) to be a dividend where the payer corporation is not entitled to deduct such payment in computing its income. Where an amount is transferred from an unclaimed dividend account of a corporate broker or dealer in securities to a capital or surplus account and is subsequently distributed to the company's shareholders, the shareholders are in receipt of a taxable dividend." The ABCA is also not helpful. It is more concerned with when a corporation shall not pay a dividend than with what a dividend is. Section 40 prevents a corporation from declaring a dividend when it fails

269 the insolvency test set out therein. Section 41 allows the dividend to be paid in money, property or shares. Accordingly, when a distribution qualifies as a dividend under this analysis, the rules in Part I and Part IV that we have studied become applicable.

2. Dividends in Kind i. Amount of Dividend

Where a dividend is declared to be payable by the distribution of property, other than additional shares of the corporation paying the dividend, the dividend is referred to as a dividend in kind. Ss. 248(1) defines "amount" as meaning "money, rights or things expressed in terms of the amount of money or the value in terms of money of the right or thing." Therefore, the "amount" of a dividend in kind is the value in terms of money of the property so distributed. Accordingly, if a dividend is declared by the distribution of property such as bricks of gold, or shares of a corporation other than the corporation paying the dividend, the amount of the dividend for the purposes of Part I and Part IV is the value of the property so distributed--in this case the value of the bricks of gold or the shares of the other corporation. This value will be the amount included, for example, in para. 82(1)(a) and, in the case of an individual, 1/4 of this amount will be included in para. 82(1)(b). The amount of the dividend is the value of the distributed property, not the amount that might be set out by the directors, in the resolution declaring the dividend, as being the amount of the dividend. Note that the effect of this can be that the shareholder is required to pay tax on the receipt of property which may require the taxpayer to access other sources of funds to pay the tax on the dividend.

ii. Disposition to Corporation and Acquisition to Shareholder

In addition to being a taxable event in the sense that the dividend will be included in the income of the recipient pursuant to s. 82(1), the dividend in kind also constitutes a taxable event to the paying corporation since it is treated as having disposed of the property for proceeds of disposition equal to the fair market value of the property. This is the effect of s. 52(2) of the Act: "Where any property has, after 1971, been received by a shareholder of a corporation at any time as, on account or in lieu of payment of, or in satisfaction of, a dividend payable in kind (other than a stock dividend) in respect of a share owned by the shareholder of the capital stock of the corporation, the shareholder shall be deemed to have acquired the property at a cost to the shareholder equal to its fair market value at that time, and the corporation shall be deemed to have disposed of the property at that time for proceeds equal to that fair market value." If the property distributed is capital property to the paying corporation and it has a fair market value greater than its adjusted cost base, then a capital gain will be recognized by the corporation equal to the excess. If the fair market value is less than the adjusted cost base, a capital loss will be realized. If the property is inventory, then the paying corporation will recognize income or loss in accordance with the rules governing the determination of income or loss from sales of inventory. If the property is

270 depreciable property, there may be recapture of previously claimed capital cost allowance or a terminal loss. At the same time, the shareholder is treated as having acquired the property at a cost equal to that same fair market value. This is important as it determines the starting point for the determination of future gain or loss on the property to the shareholder.

3. Stock Dividends i. Amount of Dividend

A "stock dividend" is defined in ss. 248(1) as including any dividend paid by a corporation to the extent that it is paid by the issuance of shares of any class of the capital stock of the payer corporation. It is different from a dividend in kind because a dividend in kind involves a distribution of assets of the corporation whereas the stock dividend is a distribution of additional shares of the capital stock of the paying corporation. The "amount" of a stock dividend is dealt with in the definition of "amount" in ss. 248(1). "Amount" means money, rights or things expressed in terms of the amount of money or the value in terms of money of the right or thing, except that, (a) notwithstanding paragraph (b), in any case where subsection 112(2.1), (2.2) or (2.4), or section 187.2 or 187.3 or subsection 258(3) or (5) applies to a stock dividend, the "amount" of the stock dividend is the greater of (i) (ii) (b) the amount by which the paid-up capital of the corporation that paid the dividend is increased by reason of the payment of the dividend, and the fair market value of the share or shares paid as a stock dividend at the time of payment,

in any case where section 191.1 applies to a stock dividend, the 'amount' of the stock dividend for the purposes of Part VI.1 is the greater of (i) (ii) the amount by which the paid-up capital of the corporation that paid the dividend is increased by reason of the payment of the dividend, and the fair market value of the share or shares paid as a stock dividend at the time of payment,

and for any other purpose the amount referred to subparagraph (i), and (c) in any other case, the "amount" of any stock dividend is the amount by which the paid-up capital of the corporation that paid the dividend is increased by reason of the payment of the dividend;"

Putting aside paragraphs (a) and (b) of the definition, the provision provides that the amount of a stock dividend is the amount by which the paid-up capital of the corporation is increased as a result of the issuance of the share. What is paid-up capital? "Paid-up capital" is defined in ss. 89(1) as follows:

271

'paid-up capital' at any particular time means, (a) in respect of a share of any class of the capital stock of a corporation, an amount equal to the paid-up capital at that time, in respect of the class of shares of the capital stock of the corporation to which that share belongs, divided by the number of issued shares of that class outstanding at that time, in respect of a class of shares of the capital stock of a corporation, (i) where the particular time is before May 7, 1974, an amount equal to the paid-up capital in respect of that class of shares at the particular time, computed without reference to the provisions of this Act, where the particular time is after May 6, 1974, and before April 1, 1977, an amount equal to the paid-up capital in respect of that class of shares at the particular time, computed in accordance with [this Act] as it read on March 31, 1977, and where the particular time is after March 31, 1977, an amount equal to the paid-up capital in respect of that class of shares at the particular time, computed without reference to the provisions of this Act except subsections 51(3) and 66.3(2) and (4), sections 84.1 and 84.2, subsections 85(2.1), 85.1(2.1), 86(2.1), 87(3) and (9), 128.1(2) and (3), 138(11.7), 192(4.1) and 194(4.1) and section 212.1 [except... special rules for cooperatives and credit unions], and in respect of all the shares of the capital stock of a corporation, an amount equal to the total of all amounts each of which is an amount equal to the paid-up capital in respect of any class of shares of the capital stock of the corporation at the particular time."

(b)

(ii)

(iii)

(iii)

The relevant portion of the definition is subparagraph (b)(iii) which essentially refers to the corporate law definition of paid-up capital subject to adjustment under the provisions set out therein. We will be spending some time dealing with the concept of paid-up capital, but for now accept that there will be no adjustment to corporate PUC when determining the amount by which the PUC of a corporation is increased on the payment of a stock dividend. Therefore, the amount of the stock dividend is the amount by which the PUC of the corporation is increased as a result of the issuance of the share, as determined under corporate law. What does corporate law say? S. 41 of the ABCA provides as follows. "41(1) A corporation may pay a dividend by issuing fully paid shares of the corporation and, subject to section 40, a corporation may pay a dividend in money or property. (2) If shares of a corporation are issued in payment of a dividend, the declared amount of the dividend stated as an amount of money shall be added to the stated capital account maintained or to be maintained for the shares of the class or series issued in payment of the dividend." It would appear that the directors are free to set a stated amount of the 'dividend and this stated amount will be added to the stated capital of that class of shares issued on the payment of the stock dividend. Pursuant to subparagraph (b)(iii) and paragraph (c) of the definition of "paid up capital" in s.

272 89(1), the amount of the stock dividend will equal the amount of the increase in corporate stated capital being the amount set by the directors in their resolution. Once the amount of the stock dividend has been determined, it is this amount that is included in income under s. 82(1)(a) and, in the case of an individual shareholder, the normal gross-up and dividend tax credit rules apply. Note that although no cash has been distributed, there is still a tax liability to the shareholder.

Interpretation Bulletin IT-88R2 - Stock Dividends

May 31, 1991 (This bulletin is still relevant as of January 2012) This bulletin discusses the tax implications of receiving a stock dividend. It discusses what constitutes a stock dividend, how to determine the amount of the stock dividend and the cost to the recipient of the shares received. A stock dividend is a dividend paid by the issuance of shares of the capital stock of the payer corporation. For stock dividends paid by Canadian resident corporations, the "amount" of a stock dividend is generally equal to the increase in the paid-up capital of the corporation by virtue of the payment of the dividend. This "amount" is included in the shareholder's income as an ordinary taxable dividend and is subject to the gross-up and dividend tax credit provisions. Shares received as a result of a stock dividend are deemed to have been acquired at a cost equal to the "amount" of the stock dividend. An exception to these general rules applied to certain stock dividends paid by public corporations between April 1, 1977 and May 23, 1985. These stock dividends did not constitute dividends and therefore were not required to be included in the shareholders' income. The shares so received were deemed to have been acquired at a cost of nil. Meaning of Stock Dividend 1. In subsection 248(1), "stock dividend" is defined as including any dividend paid by a corporation to the extent that it is paid by the issuance of shares of any class of the capital stock of the payer corporation. 2. A dividend which is paid in the form of shares of another corporation is a dividend "in kind" and not a stock dividend for income tax purposes. For a discussion of dividends "in kind", refer to the current version of IT-67 entitled Taxable Dividends from Canadian Resident Corporations. 3. A stock dividend must also be distinguished from a stock split. The fact that a corporation may refer to a transaction as a stock split does not prevent the Department from looking behind the language used to determine its true nature. In a stock split, there is an increase in the number of shares accompanied by a proportional decrease in the legal paid-up capital per share so that neither the total amount of legal paid-up capital nor the total amount of surplus available for distribution as a dividend is altered. In a stock dividend, there is a distribution of shares accompanied by a capitalization of retained earnings or any other surplus account available for distribution as a dividend. For a discussion of the tax implications of a stock split, refer to the current version of IT-65 entitled, Stock Splits and Consolidations. 4. In certain jurisdictions it is permissible for a corporation to acquire previously issued shares in its capital stock, without cancelling them or restoring them to authorized but unissued shares, and to subsequently resell such shares. Whether or not a pro rata distribution of such shares constitutes a stock dividend depends on the corporate law to which the payer corporation is subject. In some

273 jurisdictions, such a distribution of shares is a stock dividend only if it involves the "issuance" of shares of the corporation and a distribution of previously issued shares would not constitute an issuance. 5. The rules governing the cost of shares received as a stock dividend and the amount of a stock dividend are found in subsections 52(3) and 95(7) and in paragraph (c) of the definition of "amount" in subsection 248(1). These rules have been amended several times since 1972. The definition of "amount" depends on the definition of "paid-up capital" in paragraph 89(1)(c) which has also been amended several times since 1972. Therefore, special attention should be given to the relevant definition of "paid-up capital" in the Act when computing the "amount" of a stock dividend as described in the paragraphs below.

Wong v. R.
Citation: 1999 CarswellNat 31, 99 D.T.C. 458, [1999] 2 C.T.C. 2173

Rowe D.J.T.C.: Counsel agreed these four appeals would be heard on common evidence. The facts are applicable to all the appeals. The issue - common to all appeals - is whether subsection 15(1.1) of the Income Tax Act (the "Act") applies to stock dividends received by the appellants in their 1989 and 1991 taxation years. A Book of Documents was filed as Exhibit A-1, Tabs 1-12 inclusive and any reference to a Tab number will be in relation to a document found in Exhibit A-1.
1

The Minister of National Revenue (the "Minister") issued assessments of income tax against all appellants in February, 1994 and added the sum of $24,975 to each appellant's income in each of the 1989 and 1991 taxation years. The Minister's position was that each appellant in 1989 and in 1991 had received stock dividends that should have been included in computing income in accordance with subsection 15(1.1) of the Act.
2

The corporation redeemed certain Class "C" preferred shares held by Lauren Lee, Andrew Lee and Jordan Lee and by virtue of subsection 84(3) of the Act the appellants reported income on the basis they were deemed to have received dividends of $14,985 in the 1989 taxation year, $9,990 in the 1990 taxation year and $9,900 in the 1991 taxation year. As a result, Lauren Lee, Andrew Lee and Jordan Lee take the position that the amounts were duly included in their income under subsection 82(1) of the Act as a taxable dividend for the respective taxation years and no reassessment is required. There was never any redemption of any Class "C" shares held by Judy Wong.
3

Hilary Pui Kay Lee testified he is a resident of Vancouver, British Columbia and is a physician. He is the husband of the appellant, Judy Wong , and the father of the appellants, Lauren - 12 - Jordan 13 - and Andrew - 15. At Tab 1, he referred to a copy of the Certificate of Incorporation, dated November 14, 1985, pertaining to Dr. H. Pui Kay Lee Inc. and, at Tab 2, to the Memorandum and Articles. The corporation provided medical services, serving as a vehicle for his personal medical practice which was transferred to the corporation. Dr. Lee referred to a letter - dated March 21, 1986 Tab 4 - sent to his solicitor (with a copy directed to him) by his accountant, Vanesse Ling. The letter also attached an Appendix setting forth the assets transferred by him to the corporation at fair market value. The corporation, in consideration for the transfer of assets, issued him a promissory note in the sum of $89,226 and 156 Class "C" preferred shares with a par value of $1 per share and redeemable and retractable at $1,000 per share. Later, he received 25 Class "B" shares along with all of the appellants. As required by the British Columbia College of Physicians and Surgeons, he held all of the Class "A" voting shares. The corporation also issued Class "C" shares to the appellants. Dr. Lee
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274 explained that, by 1989, he had acquired 45 Class "C" shares in addition to 156 of those shares he had been issued in 1985. Dr. Lee stated the value of his medical practice had not increased between 1985 and 1989. He was the sole Director of the corporation and referred to a resolution - Tab 5 - of the Directors of the corporation, dated December 5, 1989, wherein the corporation declared a dividend of one Class "C" preferred share for each Class "B" non-voting common share held. As a result, Dr. Lee, his wife, Judy Wong and their children, Andrew, Jordan and Lauren each received 25 Class "C" preferred shares. On October 14, 1991 a resolution - Tab 7 - was consented to in writing by the Directors of the corporation by which the corporation issued 25 Class "C" preferred shares - as a dividend - to Dr. Lee and to each of the appellants by virtue of each holding 25 Class "B" non-voting common shares. At this point, Dr. Lee stated he now held 251 Class "C" shares and his wife, Judy Wong, held 95 Class "C" shares. As the sole Director, he made all decisions whether or not dividends would be paid. He stated that, in the fall of 1985, he had discovered physicians in British Columbia were permitted to incorporate and to carry on a practice through the vehicle of a corporation. He understood there were some tax advantages to this mechanism and he went to the accounting firm of Price Waterhouse for some advice. Dr. Lee stated he spoke to John Robinson, Chartered Accountant, and to others, including Vanesse Ling, working in the firm under his supervision. A letter - Tab 3 dated October 30, 1985 was sent to him by the accounting firm setting out details of incorporating a professional corporation and referring to potential advantages from the standpoint of reducing income tax by being able to defer tax on earnings retained in the corporation for investment or other purposes and to split income with family members. He decided to accept the advice and a solicitor was retained, on his behalf, by Price Waterhouse to proceed with the incorporation and related matters. In accordance with the mechanism established by the method of incorporation, he relied on accounting advice when the resolutions of December 5, 1989 - Tab 5 - and October 14, 1991 - Tab 7 - were passed in order to issue the dividend of one Class "C" preferred share for each Class "B" share held. He stated it was clear to him that the purpose of declaring the dividends in this manner was to "share income of the corporation with the shareholders". He had received advice from Price Waterhouse that the stock dividend method allowed greater flexibility for redemption by shareholders in return for cash. As to whether he ever considered the effect these dividends would have on his interest in the corporation or on his capital gain position, Dr. Lee stated: "the thought never crossed my mind". He explained the corporation would be of value only to another physician who was licensed to practise in British Columbia and the possibility of any sale would be "very, very remote". The matter of the effect, if any, on the value of his own shares, as a result of issuing dividends in the particular manner after having received advice from his accountants, was never raised by him or with him at any time. On December 30, 1990, as a result of a resolution - Tab 6 - the company was authorized to redeem 25 of the issued and outstanding Class "C" preferred shares for the sum of $1,000 per share from each of Andrew Lee, Jordan Lee and Lauren Lee. On December 30, 1993, as a result of a resolution - Tab 8 the company was authorized to redeem 25 of the issued and outstanding Class "C" preferred shares from each of Andrew Lee, Jordan Lee and Lauren Lee. Upon each redemption the relevant share certificates were cancelled. On behalf of the corporation, he issued a cheque dated December 15, 1989 - Exhibit A-2 - in the sum of $45,000 to Judy Wong in trust for Andrew, Jordan and Lauren representing payment for redemption of 15 Class "C" shares held by each child. Dr. Lee stated he prepared income tax returns for each of the children. The return of Andrew Lee - Tab 9 - indicates the sum of $18,790.67 was reported as the taxable amount of dividend received from a taxable Canadian corporation. The income tax returns for Jordan and Lauren were completed in the same manner to record the redemption. The resolution - Tab 8 - dated December 30, 1993 reflected that all Class "C" shares previously owned by the children had been redeemed by the corporation. The amount of $24,975 which was included in the income, by the Minister, of each appellant in respect of each of the 1989 and 1991 taxation years represented the total redemption amount of the Class "C" preferred shares issued to each child appellant (Judy Wong's shares were never redeemed) in each of the taxation years under appeal less the amount of $25 which had been included in each appellant's return of income for those years in respect of such stock dividends. Of the stock dividends received by

275 the appellants in their 1989 and 1991 taxation years the following stock was redeemed on the following dates for the amounts specified:
15 Class "C" preferred shares were redeemed for $15,000 from each of Andrew Lee, Jordan Lee and Lauren Lee in 1989; 10 Class "C" preferred shares were redeemed for $10,000 from each of Andrew Lee, Jordan Lee and Lauren Lee in 1990; 10 Class "C" preferred shares were redeemed for $10,000 from each of Andrew Lee, Jordan Lee and Lauren Lee in 1991; 15 Class "C" shares were redeemed for $15,000 from each of Andrew Lee, Jordan Lee and Lauren Lee in 1993.

Dr. Lee stated he would discuss his year-end financial position with his accountants and then receive advice from them on the appropriate dividend to be issued by the corporation. In cross-examination, Dr. Lee stated he relied on the advice contained in the letter dated October 30, 1985 - Tab 3 - received from Vanesse Ling of Price Waterhouse with a view to splitting income with family members and - to a lesser degree - deferring some tax and taking advantage of the lower tax rate for small business corporations. In 1985, his income from his medical practice was approximately $175,000 and it remained at about the same level thereafter. He drew out $60,000 a year in salary and left the remainder in the corporation since that was the only way to benefit from the lower tax rate applying to corporations as opposed to individuals. Subsequent to incorporation, he intended to use the corporation to pay dividends to holders of Class "B" shares and then to redeem them on behalf of his children based on advice from his accountants. Relying on advice from that source, his wife, Judy Wong , who earned a salary from the corporation, chose not to redeem her Class "C" shares. He understood that, as a physician, he had to hold all the voting shares in the professional corporation but he was not as clear on the matter of Class "B" and Class "C" shares except he knew these share classes could be used to facilitate splitting of income. He understood that the corporation would pay dividends only on Class "B" shares. He was unable to explain the reason for having been issued the specific amount of 1,000 Class "A" shares but he knew he had to own all of the voting shares. He stated he was not aware he held over 90% of the issued shares in the corporation and the extent of his ownership was never discussed with any of the accountants at Price Waterhouse. The income of the corporation was earned as a result of him carrying on a medical practice. His aim was to split income with family members and to take advantage of the fact they were in a lower tax bracket. He never considered any effect on his own shareholding position as a result of issuing dividends to his wife and children. At the end of each fiscal year, tax advice became more relevant and he understood the advice he had received from Price Waterhouse and used the vehicle of issuing Class "C" shares as a means by which to pay dividends on Class "B" common shares.
5

John Robinson testified he is a Chartered Accountant practising at Price Waterhouse Coopers, successor to the firm of Price Waterhouse. In 1985, he was working as a supervisor of tax in the Burnaby office and met Dr. Lee. Medical doctors had recently been granted permission to carry on practice through a professional corporation and Dr. Lee was seeking advice about various aspects of incorporation. At Tab 3, Robinson identified the letter dated October 30, 1985 sent to Dr. Lee as a letter generated by the Price Waterhouse office as a generic letter offering advice to doctors and dentists. Robinson stated he handled tax matters arising from any incorporation by their clients. The letter dated March 21, 1986 - Tab 4 - signed by Vanesse Ling and directed to Frank Baily, Barrister and Solicitor contained advice which was commonly offered to physicians and dentists. The assets of Dr. Lee were transferred to the corporation at fair market value and in a manner which would avoid incurring any additional tax. Dr. Lee received a promissory note and 156 Class "C" preferred shares at
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276 $1.00 per share redeemable at $1,000 per share which then accounted for the total value of his medical practice. The amount of $12,000 for goodwill was based on certain factors but was, basically, an estimate of value. The Class "B" shares were worth $1.00 each. Robinson stated that in 1985, the Tax Court of Canada had issued a decision in the McClurg case (McClurg v. Minister of National Revenue (1984), 84 D.T.C. 1379 (T.C.C.)) in which it had been held the taxpayer had conferred a benefit on his wife by issuing a cash dividend on non-voting shares. The decision was appealed and, while waiting for it to be heard, the firm of Price Waterhouse considered the most conservative method by which the result in McClurg could be avoided was to use a "two-step" process. This method was premised on not paying cash dividends but, instead, to issue stock as a dividend which would be redeemed later. One of the advantages of incorporating the professional practice was that the physician could draw out sufficient funds to support a lifestyle and retain surplus funds in the corporation. The precise number of shares to be declared to Dr. Lee's family members by way of dividend - to be redeemed later - was probably not the subject of specific advice from Price Waterhouse but Dr. Lee was provided with a general overview of the procedure. Robinson stated the only purpose of setting up the payment of dividends in this fashion was to avoid the effect of the Tax Court of Canada decision in McClurg . He stated there was never any discussion with Dr. Lee on the subject of capital gains on shares and no conversations about the shares of the corporation ever being sold to anyone. Robinson estimated he had acted for 20 or 30 physicians and none had ever sold shares in a professional corporation that was used to carry on a medical practice. There was never any consideration of the matter whether issuance of dividends would alter Dr. Lee's interest in the corporation. The issue as to whether or not subsection 15(1.1) of the Act might apply was raised by an auditor from Revenue Canada. As a result, Robinson stated he spoke to other accountants in his firm who conceded the auditor may have a point. However, it had never been considered at any time in the course of offering tax advice to Dr. Lee which had included offering up a suggested effective range of dividend to any shareholder without any additional income, with the maximum at $20,000. After the reassessments, the appellants whose shares had been redeemed and the dividends declared on income tax returns would be worse off than before because the Minister's position was that the operation of subsection 15(1.1) of the Act did not permit recognition of the income which had been reported earlier by way of taxable dividend. In cross-examination, John Robinson repeated the primary objective of incorporation by Dr. Lee was to reduce the amount of tax payable. The letter - Tab 3 - referred only to income tax advantages by deferral and/or income splitting - by means of issuing dividends to minor children who would be taxed at a lower rate. Dr. Lee received a salary of $60,000 per year from the corporation. Any payment of dividends had to come from retained earnings of the corporation after paying salary to Dr. Lee and the amount of corporation tax owing for that fiscal year. The corporation owned a medical practice - carried on by Dr. Lee - and had other assets which could enure to the benefit of the shareholders. Since 1,025 out of a total of 1,125 shares issued by the corporation were owned by Dr. Lee, counsel for the respondent suggested Dr. Lee would be entitled to 91.11% of the retained earnings of the corporation but had actually received only 20% of that amount by way of dividends issued on his Class "B" shares in the form of Class "C" shares and then redeeming the latter shares. Robinson did not quarrel with the calculations offered by counsel and agreed that payment of dividends on any class of share reduces the value available to participating shareholders. Similarly, if a corporation is wound up, then the Articles of Association dictate the manner in which that will be undertaken and, on winding up, Dr. Lee would be entitled to 91.11% of the net assets. Robinson agreed that the payment of dividends on the Class "B" shares would affect the amount of money in the corporation which would otherwise be available to Dr. Lee as the sole shareholder of Class "A" voting shares. Robinson acknowledged that only the Lee children received cash from the corporation upon redeeming their Class "C" shares because they did not have any other significant amounts of income, if any, and would be taxed at a lesser rate. Pursuant to the Articles of Association - Tab 2 - by virtue of subparagraph 27.1(c) - the declaration of dividend was at the sole discretion of Dr. Lee.
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277 Counsel for the appellants submitted the legislative purpose of subsection 15(1.1) of the Act found in the Technical Notes of the Department of Finance published when this section was introduced - indicates that it was an anti-avoidance provision directed against the use of stock dividends to effect a change in the interests of significant shareholders in a corporation and thereby shift the capital gain on a subsequent sale of shares from one person to another. This amendment was consequential on the introduction of the new lifetime capital gains exemption. Counsel submitted the evidence clearly established that none of the purposes of payment of stock dividends in the within appeals was to significantly alter the value of the interest of any specified shareholder in the corporation and that the purpose of the transactions was adequately explained by the evidence adduced on behalf of the appellants.
8

Counsel for the respondent submitted there was no need to look beyond the actual wording of subsection 15(1.1) of the Act as there was no ambiguity requiring referral to external sources. Counsel pointed out Dr. Lee was a specified shareholder for purposes of the subsection and, while income splitting with members of the Lee family may have been a motivating factor in setting up the method of payment of stock dividends, the mechanism chosen inherently shifted the value in the corporation from Dr. Lee to his wife and children. In counsel's submission, it was an inescapable result that the income-splitting mechanism would significantly alter the value of Dr. Lee's interest in the corporation and, therefore, the procedure to accomplish the income-splitting may reasonably be considered as one of the purposes of paying the dividends.
9 10

The relevant provision of the Act is subsection 15(1.1) as follows:

Notwithstanding subsection (1), where in a taxation year a corporation has paid a stock dividend to a person and it may reasonably be considered that one of the purposes of that payment was to significantly alter the value of the interest of any specified shareholder of the corporation, the fair market value of the stock dividend shall, except to the extent that it is otherwise included in computing that person's income under paragraph 82(1)(a), be included in computing the income of that person for the year.

The Federal Court of Appeal dealt with this subsection in the case of Wu v. R. (1997), 98 D.T.C. 6004 (Fed. C.A.). The decision of Strayer J.A. (orally for the Court) is brief and I quote the entire judgment as follows:
11 This is an application for judicial review of a decision of the Tax Court of Canada dated September 3, 1996, in which the Court allowed an appeal by Mr. Wu with respect to his 1990, 1991 and 1992 taxation years. The provision of the Income Tax Act at issue is subsection 15(1.1) which provides as follows: (1.1) Notwithstanding subsection (1), where in a taxation year a corporation has paid a stock dividend to a person and it may reasonably be considered that one of the purposes of that payment was to significantly alter the value of the interest of any specified shareholder of the corporation, the fair market value of the stock dividend shall, except to the extent that it is otherwise included in computing that person's income under paragraph 82(1)(a), be included in computing the income of that person for the year. We should first note that we are satisfied that the Trial Judge correctly found that the stock dividends paid to Mr. Wu in the years in question had the effect of significantly altering the value of the class A common share of his wife, Dr. Ng. The remaining issue is whether the Trial Judge made a reviewable error in concluding that it was not established that this was one of the purposes of that payment. In addressing the proper interpretation of subsection 15(1.1) and in reaching his conclusions on the facts the learned Trial Judge stated:

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Although subsection 15(1.1) is capable of a broader interpretation, I do not believe that it goes so far to allow one to equate words there set forth with words such as "he knew or ought to have known" that it would significantly alter the value of the shares. There must be some evidence which would permit one to place the purpose in the mind of the Appellant other than conjecture or speculation. We understand this passage to mean that to establish the relevant purpose of a payment under subsection 15(1.1) that purpose must be demonstrated to have been in the conscious intent of the taxpayer: that is, a subjective test must be applied to "place the purpose in the mind" of the taxpayer. We do not believe that this is correct as a matter of law. The words "it may reasonably be considered" in subsection 15(1.1) clearly indicate that the evidence of necessary intent can be established if in the circumstances it is reasonable to consider that this was one of the purposes of the payment. In this connection we refer to the decision of this Court in H.M. v. Placer Dome Inc., decided after the trial judgment in the present case. The provision in question in that case, subsection 55(2) of the Income Tax Act, required for its application that "one of the purposes" be to support a significant reduction in capital gain realized. It did not contain the words "may reasonably be considered that...". This Court, for purposes of decision, assumed, without finding, that the test was subjective. But it was held that in the face of the Minister's presumption that this was one of the purposes: the taxpayer must offer an explanation which reveals the purposes underlying the transaction. That explanation must be neither improbable nor unreasonable ... the taxpayer must offer a persuasive explanation that establishes that none of the purposes was to effect a significant reduction in capital gain. In our view, with the additional words in subsection 15(1.1) allowing for its application where "it may reasonably be considered" that one of the purposes of payment is alteration of the value of the interest of a shareholder, the onus is even greater on a taxpayer to produce some explanation which is objectively reasonable that none of the purposes was to alter the value of a shareholder's interest. The learned Trial Judge appears not to have applied this legal standard to the facts before him. He concluded his decision with the following statements: The only evidence before the Court was that of Mr. Wu. At best, with respect to the fourth purpose Mr. Wu states that he cannot recall any discussions with anyone concerning the effect of declaring and paying stock dividends. I was not impressed with Mr. Wu's evidence. At times, he was evasive and at other times he was forgetful. But the fact remains that unimpressive as it was, his testimony was the only evidence before the Court on this subject. The share structure, according to Mr. Wu came forth full blown in the manner it did because that was what the solicitor drafted. This drafting came about on the instructions of Mr. Wu to incorporate the "usual" company to carry on a portion of a medical practice and nothing more. However, I am not on the whole satisfied that one of the purposes of paying the stock dividends was to significantly alter the value of Dr. Ng's class A common shares. Therefore, the appeal is allowed with costs. The learned judge appears not to have taken into account the onus placed on the taxpayer by the Minister's assumption that this was one of the purposes of the payment of the stock dividends to the taxpayer. In other words, the onus here was on the taxpayer to prove that this was not one of the purposes of the payment. Yet, after treating the taxpayer's evidence as unsatisfactory, in the passage quoted above, he held that as this was the only evidence he had to accept it. He should instead have considered whether the evidence met the standard of objective reasonability which was required to overcome the onus on the taxpayer of proving that none of the purposes of the payment was a significant alteration of Dr. Ng's interest within the meaning of subsection 15(1.1).

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In the circumstances we have concluded that the decision of the Tax Court should be set aside and the matter remitted for a new trial and disposition in accordance with these reasons. At that time, the Trial Judge should also adopt in his or her judgment the terms consented to by the parties at trial and not dealt with by the Tax Court in the decision under appeal. Reasonable and proper costs are awarded to the respondent.

The appeal was from the decision of The Honourable Judge Sobier, Tax Court of Canada, unreported, (Wu v. R. 96-7(IT)I ), [reported, [1996] 3 C.T.C. 2879 (T.C.C.)]. In the course of his analysis, at p. 4 of his judgment Judge Sobier stated:
12 Subsection 15(1.1) of the Act states: (1.1) Notwithstanding subsection (1), where in a taxation year a corporation has paid a stock dividend to a person and it may reasonably be considered that one of the purposes of that payment was to significantly alter the value of the interest of any specified shareholder of the corporation, the fair market value of the stock dividend shall, except to the extent that it is otherwise included in computing that person's income under paragraph 82(1)(a), be included in computing the income of that person for the year. It is the redemption price which has been added to Mr. Wu's income. An examination of subsection 15(1.1) shows that the appropriate language used in determining whether the subsection applies reads as follows: ...where in a taxation year a corporation has paid a stock dividend to a person and it may reasonably be considered that one of the purposes of that payment was to significantly alter the value of the interest of any specified shareholder of the corporation ... This language differs somewhat from what is contained in subsection 55(2) of the Act which subsection was dealt with by Judge Bell of this Court in the unreported case of Placer Dome Inc. v. The Queen. The relevant portion of subsection 55(2) (edited by me) reads as follows: Where a corporation resident in Canada has received ... a taxable dividend in respect of which it is entitled to a deduction under subsection 112(1) or 138(6) as part of a transaction or events ... one of the purposes of which ... was to effect a significant reduction in the portion of the capital gain that, but for the dividend, would have been realized ... In Placer Dome, the question was whether one of the purposes of the transaction was to effect a significant reduction in the capital gain but for the dividend. At page 12 of his reasons, Judge Bell said: The next question is whether one of the purposes of the transactions (assuming a transaction can have a purpose) was to effect a significant reduction in the portion of the capital gain that, but for the dividend, would have been realized by the Appellant on the sale at fair market value of the shares of Falconbridge and McIntyre. It is my conclusion that neither the Appellant nor Falconbridge had such purpose. Respondent's counsel submitted that under subsection 55(2) the Appellant need only have a purpose, not a main purpose, of effecting a significant capital gain reduction. He referred to definitions of "purpose" such as from Black's Law Dictionary That which one sets before him to accomplish or attain; an end, intention, or aim, object, plan, project. Term is synonymous with ends sought, an object to be attained, an intention etc. and

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from Shorter Oxford English Dictionary 1. The object which one has in view 2. The action or fact of intending or meaning to do something: mention, resolution, determination. He then submitted that a person is presumed to intend the natural consequences of his actions and that in the Appellant's case one of the consequences was the significant reduction of capital gain. This approach seems to employ hindsight. The receipt of a dividend which may be free of tax does not mean that one of the purposes of the transactions was the payment or receipt of a tax free dividend. That approach looks at the transactions completed rather than examining all evidence in order to determine whether that particular result was an objective of any party to the transactions.

In my view the addition of the words "it may reasonably be considered" in subsection 15(1.1) does not detract from the validity of examining the definition of "purpose" as it pertains to the intention, end, aim, object, plan, project or goal to be accomplished or achieved. The additional words make it clear that an objective standard is to be applied to the evidence offered up by a taxpayer and fanciful, outrageous or otherwise unreliable testimony on the issue of purpose does not have to be accepted at face value any more than any other portion of testimony or piece of evidence even though it is forcefully expressed in a manner consistent with a deeply-held belief. It is apparent the standard to be applied against the taxpayer is much more stringent than where the language of the legislation used the word, "desired" as in subsection 56(2) of the Act as considered by the Federal Court of Appeal in Ascot Enterprises Ltd. v. R. (1995), [1996] 1 C.T.C. 384 (Fed. C.A.). Using the latter report, I quote from the judgment of Dcary, J.A. - writing for the Court - at p. 388 as follows:
13 Once it is recognized that the purpose of subsection 56(2), as summed up by Dickson C.J. in McClurg v. Canada, [1990] 3 S.C.R. 1020, [1991] 1 C.T.C. 169, 91 D.T.C. 5001, at pages 1052-53 (C.T.C. 184, D.T.C. 5012), is to: ...ensure that payments which otherwise would have been received by the taxpayer are not diverted to a third party as an anti-avoidance technique... and that one should be careful when interpreting that provision not to ...violate fundamental principles of corporate law and the realities of commercial practice and... "overshoot" the legislative purpose of the section. It becomes evident that the "desire" to confer a benefit is a key element of the provision. On a plain reading, the section will not be applicable where there exists no intention by the taxpayer to avoid receipt of funds in his hands by arranging payments to be made without adequate consideration to third persons. The use of the word "desire" in the Income Tax Act is exceptional. Its use in subsection 56(2) introduces a requirement of purpose. It carries a step further the requirement that the taxpayer participate in a leading way ("pursuant to the direction of") or in a more passive way ("with the concurrence of") in the decision to make the payment or transfer of property. This Court, in Smith v. Minister of National Revenue, [1993] 2 C.T.C. 257, 93 D.T.C. 5351 at page 261, (D.T.C. 5355) (F.C.A.) referred to "the taxpayer's motive...". It is indeed remarkable that in the other provisions where the phrase "as a benefit that the taxpayer desired to have conferred" is found, i.e. in paragraphs 51(2)(c), 85(1)(e.2) and 86(2)(b), it is preceded by the words "it is reasonable to regard any part [or portion] of such excess as ...", which indicates, in my view, that the test to be applied under these paragraphs is different from, and less subjective than, that applicable under subsection 56(2). The Court has, therefore, to direct its attention to what it is that the taxpayer wanted to achieve. The test is subjective, but as always when assessing a subjective state of mind after the fact one may resort to inferences. It is not what the taxpayer says now but what he did then that

281
counts. As noted in Smith, at page 262 (D.T.C. 5356), a judge most certainly can conclude that, on a balance of probabilities, a taxpayer has not disproved the assumptions upon which the Minister assessed him when the taxpayer relied solely on his ignorance. It is up to the taxpayer to explain why the transactions were made and why they have been handled as they were. There will be cases -- some were enumerated in Smith, at page 261 (D.T.C. 5355) -- where the nature of the benefit conferred or the circumstances of a transaction will speak for themselves and be such as to render obvious the purpose of the taxpayer.

Turning to the evidence before me, it is clear, Dr. Lee was extremely interested in obtaining advice about using a professional corporation to carry on the practice of medicine. The permission to use the vehicle of the professional corporation was newly granted in 1985 and he sought advice from the accounting firm of Price Waterhouse. The advice he received was consistent with what he wanted to achieve, namely, the ability to defer income under certain circumstances and, most important, to be in a position whereby he could split his income with his wife and children to reduce the overall amount of tax paid on the earnings derived from his efforts as a medical practitioner. By using the professional corporation, he could draw out a salary of approximately $60,000 per year and retain earnings in the corporation after paying the appropriate amount of corporate income tax at the lower rate applying to corporations. The particular method chosen to issue dividends was in response to the judgment of the Tax Court of Canada in McClurg , (supra). While the case was under appeal by the taxpayer (allowed by the Federal Court - Trial Division -- McClurg v. Minister of National Revenue (1986), 86 D.T.C. 6128 (Fed. T.D.) - and upheld by the Federal Court of Appeal -- (1988), 88 D.T.C. 6047 (Fed. C.A.)), the advice given to Dr. Lee and acted on by him was to utilize the method of paying dividends on Class "B" shares by issuing Class "C" shares redeemable for the sum of $1,000 per share. When the Class "C" shares issued - as dividends - to the children were redeemed by the corporation, the amounts received by the children were reported on each of their income tax returns pursuant to the provisions of subsection 82(1) of the Act. Dr. Lee testified he never considered any effect these dividends paid to the children would have on his interest in the corporation or on his capital gain position. He stated "the thought never crossed my mind". It is obvious it never was considered by John Robinson, C.A. who was the person offering income tax advice to Dr. Lee. In fact, it was not until the auditor from Revenue Canada raised the matter of potential applicability of subsection 15(1.1) of the Act to the particular facts of the Wong and Lee income tax returns that Robinson consulted with colleagues in his firm to examine the matter further. Until that time, I accept that this effect - even as a downstream or potential consequence - was never contemplated by either Dr. Lee or any of his professional advisors. From the standpoint of Dr. Lee, his corporation was a professional corporation specially permitted by law in British Columbia and, more important, finally approved by the British Columbia College of Physicians and Surgeons as a business vehicle suitable for carrying on a medical practice under certain conditions. One of the conditions was that Dr. Lee, in his capacity as a licensed medical practitioner, had to hold all of the voting shares in the corporation. Pursuant to subparagraph 27.1(b) of the Articles of Association of the corporation, the Class "B" non-voting common shares and the Class "C" preferred shares "may only be held by a Member of the College of Physicians and Surgeons holding the Class "A" common shares or the Member's spouse or child". Dr. Lee considered any possibility of selling the corporation to any other practising physician as being extremely remote. Prior to being permitted to practise medicine by means of the professional corporation, Dr. Lee's annual income was about $175,000 and, for the most part, would be taxable. Following incorporation, the revenue from the medical practice remained consistent but he was able to draw only $60,000 per year from the corporation and then take advantages accruing from retained earnings in the corporation - which paid tax at a lower rate than an individual - and then to split income with his wife and children to lower the overall tax extracted on the earned income of the corporation. His wife, Judy Wong , worked for the corporation in the medical practice and earned about $24,000 per year.
14

282 It is obvious that the effect of the manner of issuing the stock dividends in the form of Class "C" preferred shares redeemable at $1,000 per share was to significantly alter the interest of Dr. Lee in the corporation. Whether or not he or his advisors ever turned their minds to that aspect of their taxplanning procedures, that was the result.
15 16

The Minister wishes that subsection 15(1.1) read this way:

...where in a taxation year a corporation has paid a stock dividend to a person and it may reasonably be considered that one of the effects of that payment, notwithstanding the purpose for which it was made, was to significantly alter the value of the interest of any specified shareholder of the corporation ... shall be included in computing the income of that person for the year.

Although the language of the desired provision - set forth in italics - has not been approved by Parliament, Counsel for the Respondent submitted I could interpret it as though it had been drafted in that manner on the basis that purpose can be divined by examining the inevitable result. On the evidence before me, there is no reason to reject the testimony of Dr. Lee explaining the reasons for setting up the corporation and - later - for using the particular method of paying stock dividends to his wife and children. The testimony of John Robinson, Dr. Lee's accountant, supports the proposition that the sole purpose of the incorporation and the payment of stock dividends in the manner chosen was to split income with the family members so as to reduce the amount of income tax otherwise payable and to take advantage of a lower corporate tax rate on retained earnings. Because the ability to use a professional corporation to carry on a medical practice in British Columbia was granted in 1985, after Dr. Lee had been in practice for some years, it is reasonable to accept that the narrow structure of the professional corporation would not lead anyone to consider it as having any marketable value to any outsider.
17

I do not find that one of the purposes of the payment of stock dividends was to significantly alter the value of the interest of Dr. Lee in the company. To hold otherwise on the evidence would be to embrace the procedures of certain tribunals in medieval times which were prone to convict persons of the specific crime of "having unlawfully imagined the death of Our Sovereign" despite vociferous denials - under oath - by those unfortunate accused coupled with heartfelt affirmations of constant, undying fealty. Unmoved, and despite any other evidence, the verdicts were based on the supposition that those various and sundry felons must have - at some point in their miserable lives contemplated, however fleeting, the possibility, however remote, of the Sovereign's demise. The Minister continues to see tax avoidance nearly everywhere in various shapes and forms - all deliberate and crafty disguises - and wishes the Courts would be more open to embracing nonstatutory anti-avoidance doctrines even in the face of clear language in the particular legislation under consideration. That crusade is based, apparently, on the vague concept that, sometimes, a particular result "just isn't fair" or that there could never have been any real intent by Parliament to allow any "wiggle room" when enacting a particular provision.
18

Counsel for the appellant and counsel for the respondent made helpful submissions to me on what their positions would be in the event I found subsection 15(1.1) of the Act applied and it would have required further analysis as to whether recognition could be extended to the income already reported by the Lee children who had received payment for redemption of the Class "C" preferred shares. The corporation did not redeem any of the Class "C" preferred shares issued to Judy Wong. I do not see any reason to consider any alternative result in light of the clear finding I have made and the facts upon which the alternative submissions are based are evident and need no specific factfinding by me to assist any appellate court should it be determined that I am incorrect in holding subsection 15(1.1) of the Act is not applicable to the within appeals.
19

283 The appeal of each appellant is hereby allowed with one set of costs on a party-party basis. I find the Minister should not have included any amounts into the income of any appellant for either the 1989 or 1991 taxation year because subsection 15(1.1) of the Act does not apply and the assessments against each appellant are hereby vacated.
20

Appeals allowed.

ii. Cost to Shareholder

Unlike a dividend in kind, there is no disposition of property to the paying corporation. For capital gain purposes, the definition of "disposition" found in ss. 248(1) of the Act makes it clear that the issue by a corporation of a share of its capital stock is not considered to be a disposition. The shareholder is deemed to acquire the shares issued on the payment of a stock dividend at a cost equal to the amount of the stock dividend. That is to say, the cost to the shareholder of the shares issued to the shareholder is equal to the amount of the dividend, which in mm is equal to the amount by which the PUC of the corporation was increased as a result of the declaration of the stock dividend and the issuance of the shares in payment thereof. This is the effect of ss. 52(3). "Where a shareholder of a corporation has, after 1971, received a stock dividend in respect of a share owned by the shareholder of the capital stock of the corporation, the shareholder shall be deemed to have acquired the share or shares received by the shareholder as a stock dividend at a cost to the shareholder equal to the total of (a) (a.1) (b) where the stock dividend is a dividend, the amount of the stock dividend, where the stock dividend is not a dividend, nil, and where an amount is included in the shareholder's income in respect of the stock dividend under subsection 15(1.1), the amount so included."

Note that this means that the cost of the shares to an individual shareholder is the amount of the dividend and does not include the gross-up under para. 82(1)(b).

4. Stock Splits and Stock Consolidations

The division or consolidation of shares under a stock split or a stock consolidation which results in no change in the number of shareholders, no change in their respective and relative interests in the corporation, and occurs on a proportionate basis in respect of each class of shares does not result in income tax consequences to either the corporation or the shareholder. Instead, the adjusted cost base to the shareholder of the shares held by him and the PUC of the already issued shares is proportionately increased or decreased.

Interpretation Bulletin IT-65 - Stock Splits and Consolidations

(This material is still relevant as of January 2012) Date: September 8, 1972

284 Where all the shares of a class of stock of a corporation are replaced by a greater or lesser number of shares of the same class of stock of the same corporation in the same proportion for all shareholders, in circumstances where there is no change in the total capital represented by the issue, there is no change in the interests, rights or privileges of the shareholders and there are no concurrent changes in the capital structure of the corporation or the rights and privileges of other shareholders, no disposition or acquisition is considered to have occurred. The cost of the new shareholding to each shareholder will be the cost of the old shareholding divided into a different number of shares, e.g. in a 2 for 1 split each old share will be represented by two shares and if the cost of the old share was $100 the cost of each new share is $50 and in a 1 for 10 consolidation if the cost of an old share was $5 the cost of a new share is $50. Where the original shares were owned by a taxpayer on December 31, 1971, the median rule provided in subsection 26(3) of the Income Tax Application Rules, 1971, will apply. For example, if the taxpayer owned shares of X Corporation which he acquired before 1972 at a cost of $25 each and the value on valuation day was $40 each, then subsequently these were split 5 for 1, each new share will be considered to have a cost of $5 and a V-Day value of $8.

5. Inter-Corporate Dividend Deduction Under ss. 112(1) i. Purpose

The purpose of ss. 112(1) is relatively simple. The theory of integration requires that dividends received by corporations not be subject to taxation, otherwise there would be a systematic disappearance of assets as income passes from one corporation to another in the form of dividends. Since dividends generally represent income that has already been subject to corporate tax, it is only when this after-tax income is distributed to individuals that it ought to be taxed again. Subsection 112(1) accomplishes this by allowing corporations to deduct, in calculating taxable income, an amount equal to the aggregate of all taxable dividends received from taxable Canadian corporations or from corporations resident in Canada and controlled by the recipient.

ii. Section 112(3)

The payment of dividends may reduce the value of the shares on which the dividends are paid. This could result in a capital loss on the ultimate disposition of the shares, especially if a large amount of corporate surplus were to be distributed by way of dividend. Generally: the amount of any loss from the disposition of a share that is capital property of an individual (other than a trust) is reduced by the total of the amount of capital dividends received on the share [paragraph 112(3)(a)], and the amount of any loss from the disposition of a share that is capital property of a corporation is reduced by the total of taxable dividends deductible in computing taxable income under section 112, capital dividends and life insurance capital dividends received on the share [paragraph 112(3)(b)].

285

Subsection 112(3.01) excludes from the dividends contemplated in subsection 112(3), any dividend received: when the taxpayer and persons with whom the taxpayer was not dealing at arm's length did not own in total more than five per cent of the issued shares of any class of the capital stock of the payer corporation, and on a share that the taxpayer owned throughout the 365 day period that ended immediately before the disposition.

The foregoing stop-loss rules cannot be circumvented by interposing a partnership between the taxpayer and the share that is capital property [subsections 112(3.1), (3.11) and (3.2)]. Note that the provision applies to dividends that may have been paid long ago. One must therefore undertake an historical analysis to determine to what extent the provision might apply to reduce a capital loss. Section 112(3.1) and (3.2) extend these rules to dispositions of shares that are capital property by a partnership or trust of which the corporation is a member or beneficiary.

iii. Subsection 112(4), (4.1), (4.2) and (4.3)

Subsection 112(4) contains a similar rule to the rule in ss. 112(3.1) except that it applies not only to corporations but also to individuals where the payor corporation is a taxable Canadian corporation, it applies only if the share is not a capital property, with respect to individuals as shareholders, it applies to all dividends except capital gains dividends, and with respect to corporations as shareholders, it applies to all dividends except capital gains dividends and taxable dividends to the extent that such taxable dividends are not deductible under ss. 112, 115(1) or 138(6) of the Act.

Subsection 112(4.2) and (4.3) extend this rule to losses on inventory shares incurred by a partnership or trust. In addition, s. 112(4.1) adjusts the fair market value of the share for purposes of inventory accounting. Before any loss is otherwise realized, ss. 112(4.1) requires the amount of the dividend to be added to the value of the shares for purposes of the rules relating to the valuation of inventory if the 365 day and 5 % test are not met.

6. Tax Consequences to Corporation Paying Dividends

Generally, the only consequence of an income tax nature to the corporation paying the dividend is that the dividend is not deductible for income tax purposes. It is not an expenditure made for the purpose of gaining or producing income but instead is a distribution of previously taxed income.

286 An exception is the refundable dividend tax rules that we have already examined. Payment of a taxable dividend by a private corporation can result in a dividend refund pursuant to s. 129 of the Act. A second and major exception is the payable by a corporation under Part VI.1 on taxable dividends paid by a corporation on short-term preferred shares or on taxable preferred shares. The purpose of the Part VI.1 tax is to eliminate after-tax financing through preferred shares by corporations which have accumulated non-capital loss carry forwards or other available tax deductions so as to not be currently taxable.

i. Capital Dividends Interpretation Bulletin IT-66R6 - Capital Dividends

May 31, 1991 (This material is current as of January 2012) Election under Subsection 83(2) 1. A private corporation may elect, under subsection 83(2), in prescribed manner and form (section 2101 of the Regulations and Form T2054) to pay its shareholders a dividend out of its capital dividend account. Subject to 17 to 19 below, no part of a capital dividend is included in computing Part I income of a shareholder resident in Canada. Additionally, no amount is deducted in computing the adjusted cost base of a shareholder's shares for such a dividend, provided that the election is made for the full amount of the dividend. Capital dividends paid to non-residents are subject to non-resident tax under subsection 212(2). 2. An election to pay a capital dividend should be filed on Form T2054 no later than the day on which the dividend becomes payable or the first day on which any part of the dividend is paid, whichever is earlier. For this purpose, a dividend becomes payable on the day stipulated by the resolution of the directors declaring the dividend. An election must be made on the full amount of the dividend and, accordingly, may not specify that the dividend is payable partly from its capital dividend account and partly from another source. A capital dividend may not be paid by a public corporation even though it previously had been a private corporation and there was a balance in its capital dividend account immediately before it became a public corporation. Capital Dividend Account Components of the Capital Dividend Account 6. The rules for determining the balance in the capital dividend account are provided in paragraph 89(1)(b). The amount of each component of the capital dividend account is computed on a cumulative aggregate basis for a particular "period". This "period" begins on the first day of the first taxation year ending after 1971 and after the corporation last became a private corporation, and ends immediately before the balance in the capital dividend account is to be determined.

For example, if a corporation that has been a private corporation with a March 31 year-end since its incorporation in 1960, pays a capital dividend on April 1, 1989, the relevant "period" for the calculation of its capital dividend account is April 1, 1971 to April 1, 1989.

287

The capital dividend account for a given "period" consists of: The aggregate of: (a) (b) (c) the excess of the non-taxable portion of capital gains over the non-deductible portion of capital losses (including business investment losses) incurred by the corporation (see 8 and 9 below for exclusions), the aggregate of capital dividends received by the corporation, the non-taxable portion of gains resulting from the disposition, in the period, of eligible capital property of each business of the corporation as described in subparagraph 89(1)(b)(iii) (see the related Department of Finance Explanatory Notes for S.C. 1988, c. 55 (formerly Bill C-139; Royal Assent September 13, 1988) dated June 1988 and the current version of IT-123), the net proceeds of a life insurance policy received after May 23, 1985 by the corporation as beneficiary under the policy and such proceeds received after 1971 and before May 24, 1985 where the corporation was a beneficiary under the policy prior to June 29, 1982 (see the current version of IT-430 entitled, Life Insurance Proceeds Received by a Private Corporation or a Partnership), and the balance, if any, in the corporation's life insurance capital dividend account immediately before May 24, 1985 less: the aggregate of all capital dividends that became payable by the corporation in the period.

(d)

(e) (f)

7. In addition to receiving capital dividends by way of a cash, stock, specie or deemed dividend, a corporation's capital dividend account may also be increased as a result of an amalgamation of two or more corporations or a winding-up of a subsidiary. Paragraph 87(2)(z.1) provides for the transfer of the capital dividend account of a predecessor corporation to the new corporation on an amalgamation. Similarly, by a cross-reference to paragraph 87(2)(z.1), paragraph 88(1)(e.2) provides for the transfer of the capital dividend account of a subsidiary corporation to its parent on a winding-up. However, for amalgamations or windings-up occurring after 4 p.m. Eastern Daylight [Saving] Time, September 25, 1987, paragraph 87(2)(z.1) provides circumstances in which the capital dividend account of a predecessor or subsidiary corporation will not be transferred on an amalgamation or winding-up. The capital dividend account of a corporation will not be transferred in any case where, if immediately before the amalgamation or winding-up, a capital dividend were paid by it, the dividend would have been deemed to be a taxable dividend by reason of the anti-avoidance rule in subsection 83(2.1) (see 21 and 22 below). For example, if a corporation acquires all of the shares of another corporation that had a balance in its capital dividend account and winds it up, the capital dividend account of the other corporation will not be transferred if one of the main purposes of the share acquisition and wind-up was to obtain the capital dividend account. Exclusions 8. Excluded from the amount determined in 6(a) above, for dispositions occurring after November 12, 1981, is the portion of realized capital gains or losses on property, other than designated property, which can reasonably be considered to have accrued during any period that the property was held by a corporation when it was not a private corporation, an investment corporation, a mortgage investment corporation, or a mutual fund corporation. Under paragraph 89(1)(b.1) "designated property" of a private corporation includes: (a) any property acquired by it before November 13, 1981, or after November 12, 1981 pursuant to a written agreement entered into on or before November 13, 1981,

288 (b) (c) (d) any property acquired by it from another private corporation with which it was not dealing at arm's length (other than pursuant to paragraph 251(5)(b)) at the time, if the property was designated property to the other private corporation, a share acquired by it in exchange for another share that was designated property of the corporation in a transaction to which section 51, 85.1, 86 or 87 or subsection 85(1) applied, or a replacement property (as described in section 44 and discussed in the current version of IT259 entitled, Exchanges of Property ) for a designated property that was disposed of involuntarily as described in subparagraphs 54(h)(ii), (iii) or (iv).

9. Also excluded from the amount determined in 6(a) above, for dispositions occurring after November 26, 1987, is the portion of the realized capital gains or losses on property, other than designated property, which can reasonably be considered to have accrued during any period that the property or property for which it was substituted, was held by a corporation that was (a) controlled, directly or indirectly in any manner whatever (see subsection 256(5.1)), by one or more non-resident persons and, after November 26, 1987, the property became the property of a Canadian-controlled private corporation, otherwise than as a consequence of the change in residence of one or more shareholders of the corporation, or (b) exempt from tax under Part I of the Act and, after November 26, 1987, the property became the property of a private corporation that was not exempt from tax under Part I. These exclusions apply where the status of the corporation changes after November 26, 1987 or the property is acquired, after November 26, 1987 on a rollover basis by the Canadian-controlled private corporation or the private corporation that was not exempt from tax as the case may be. Note: If draft legislation released by the Minister of Finance on February 18, 1991 [Bill C-18, Royal Assent December 17, 1991 ed.] is passed into law as currently proposed, the exclusions discussed in (a) and (b) above will also apply to dispositions of designated property after November 26, 1987. Receipt of a Capital Dividend 14. The full amount of any dividend received by a corporation in respect of which the payer corporation made an election under subsection 83(2) is normally added to its capital dividend account regardless of whether or not the full amount is deemed to be a capital dividend. However, where a subsection 184(3) election is made by the payer for such a dividend, only the amount of the deemed separate capital dividend under paragraph 184(3)(a) is added (see 18 to 19 below). Excessive Elections 17. Where a corporation makes an election described in 2 or 3 above, and the full amount of the dividend does not qualify as a capital dividend, subject to 18 and 19 below, none of it will be included in computing the income of a shareholder resident in Canada but the corporation would be subject to tax under subsection 184(2). The applicable rate of tax is 75% of the non-qualifying portion of the dividend. If the non-qualifying portion of a dividend paid by a corporation in its 1988 taxation year and before June 18, 1987 resulted from the change in the portion of capital gains and losses that are included in computing the capital dividend account, subsection 184(2.1) will give relief from the tax otherwise payable under subsection 184(2) by providing that the non-qualifying portion be determined as if the corporation's taxation year ended December 31, 1987. The liability for the tax arises at the time that the election is made and (unless the tax is paid when the election is filed) interest at prescribed rates is added for the period from the date of the election to the date of payment.

289 New section 185(4) states that every person who has received a capital dividend or capital gains dividend is jointly and severally liable with the corporation for any Part III tax that becomes payable as a result of the dividend. The nature and extent of this potential liability, which applies to dividends paid after July 13, 1990, is discussed in subsections 185(4) to (6). 18. As an alternative to the payment of tax under subsection 184(2) in respect of an excessive election, a private corporation, with the concurrence of every shareholder entitled to the dividend and whose address was known to the corporation, may elect under subsection 184(3) to have the portion of the dividend that does not qualify as a capital dividend treated as a separate taxable dividend. The election must be made in the manner prescribed in section 2106 of the Regulations and within 90 days from the date of mailing of a notice of assessment in respect of the tax under subsection 184(2) that would otherwise be payable. If the dividend became payable after June 28, 1982 and before May 24, 1985, the election could specify that some or all of the excess be a separate dividend paid out of the corporation's life insurance capital dividend account and only the balance of the dividend that did not qualify as a capital dividend or a life insurance capital dividend would be a taxable dividend. New section 184(4) further restricts filing the election under subsection 184(3). In addition to the restrictions detailed above, the election will not be valid, by virtue of subsection 184(4), unless (a) it is made within thirty months of the day on which the dividend became payable, or (b) all the shareholders concur with the election, in which case, notwithstanding subsections 152(4) to (5), such assessment of tax, interest and penalties payable by such shareholders for any taxation year may be made as is necessary to take the corporation's election into account. Anti-Avoidance Rule 21. Subsection 83(2.1) is an anti-avoidance rule which may apply to a capital dividend paid after 4 p.m. Eastern Daylight Saving Time on September 25, 1987 where one of the main purposes for which the shareholder acquired the share on which the dividend was paid was to receive the capital dividend. Where subsection 83(2.1) applies, the dividend will be received by the shareholder as a taxable dividend and consequently will be included in the shareholder's income. Further, if the dividend is received by another corporation, it will not be included in computing the recipient corporation's capital dividend account. The dividend will be a capital dividend, however, for the purposes of determining any liability of the payor corporation for tax pursuant to section 184 in respect of an excessive election and of computing its capital dividend account. 22. Subsections 83(2.2) to (2.4) provide exceptions where the anti-avoidance rule in subsection 83(2.1) will not apply. They are as follows: (a) Subsection 83(2.2) provides that the anti-avoidance rule will not apply to a capital dividend paid to an individual where all or substantially all of the corporation's capital dividend account consisted of amounts other than those specified in paragraphs 83(2.2) (a) to (d). (b) Subsection 83(2.3) provides that capital dividends paid by a corporation will be exempt from the anti-avoidance rule in situations where it is reasonable to consider that the purpose for paying the dividend was to distribute net life insurance proceeds which were received due to death. (c) Subsection 83(2.4) provides that the anti-avoidance rule will not apply, in most circumstances, to a capital dividend paid to a related company where all or substantially all of the corporation's capital dividend account consisted of amounts other than those specified in paragraphs 83(2.4) (a) to (e).

290

ii. When Are Dividends Received Horkoff v. R.

1996 CarswellNat 1793, [1996] 3 C.T.C. 2737, 97 D.T.C. 621 (Tax Court of Canada) Beaubier J.T.C.C.: 1 These appeals were heard jointly on common evidence at Calgary, Alberta on August 8, 1996 pursuant to the General Procedure. Both Appellants testified and called their chartered accountant, Larry Shelley. The Respondent called Patricia McCulloch, an employee of Revenue Canada. 2 The Appellants were assessed on the basis that they received taxable dividends in 1990 in the following amounts: Edward N. Horkoff: $81,992.70 Marion Horkoff: $78,777.30 They appealed and alleged that they received the dividends in 1991, the year in which they reported the dividends. 3 The dividends were paid to them by Horkoff Surveys Ltd. ("HSL"). The Appellants' shares in HSL were sold to DataSpan Technology Inc. ("DSI"). It is the agreements and occurrences respecting this sale which lie at the root of the dispute between the parties. 4 The chronology is as follows: 1. January 14, 1991 - Horkoffs and DSI signed an offer by DSI to purchase Horkoffs' shares in HSL. Paragraphs 1, 2 and 3 of the offer read: January 11, 1991 MR. and MRS. ED HORKOFF 123 Mount Victoria Place S.E. Calgary, Alberta T2Z 1P1 Dear Mr. and Mrs. Horkoff: Re: OFFER TO PURCHASE ALL ISSUED AND OUTSTANDING SHARES OF HORKOFF SURVEYS LTD. ("HORKOFF" OR THE "COMPANY") The undersigned, DataSpan Technology Inc. (the "Purchaser") hereby offers to purchase all of the issued and outstanding shares in the capital stock of the Company from Ed Horkoff and Marion Horkoff (collectively referred to as the "Vendors") for the consideration and on the terms and conditions following: 1. The Purchased Shares 1.1 The shares which are subject to this offer are 100% of the issued and outstanding shares in the capital stock of the Company (the "Purchased Shares") to be purchased as follows: (a) effective December 31, 1990, the Purchaser shall purchase 2,475 Class "B" shares from Ed Horkoff, 25 Class "B" shares from Marion Horkoff, and 24 Class "A" shares from Marion Horkoff; and (b) effective January 1, 1991, the Purchaser shall purchase 51 Class "A" shares from Ed Horkoff and 25 Class "A" shares from Marion Horkoff. 2. The Purchase Price 2.1 The Purchaser, subject to the terms and conditions of this Agreement, agrees to purchase and the Vendors agree to sell the Purchased Shares for the sum of One Million Dollars ($1,000,000.00) (the "Purchase Price").

291 2.2 The Purchase Price shall be satisfied by the Purchaser issuing the Vendors 4,000,000 common shares in the capital stock of the Purchaser (the "Common Shares") duly registered in the names of the Vendors as follows: (a) effective December 31, 1990, as to 990,000 common shares to Ed Horkoff and 730,000 common shares to Marion Horkoff; and (b) effective January 1, 1991, as to 1,530,000 common shares to Ed Horkoff and 750,000 common shares to Marion Horkoff, being the pro rata holdings of the Vendors in the Company. 2.3 At the Vendor's sole election, the purchase and sale evidenced by this Agreement shall be effected in such a manner so as to ensure minimum tax liability under the Income Tax Act of Canada (the "ITA"). Should the Vendors so elect: (a) both parties shall thereafter execute all forms and documents and effect all filings within the time limits prescribed by the ITA necessary to effect a tax- deferred sale of the Purchased Shares pursuant to section 85 of the ITA and the parties hereby elect the Purchase Price as the "proceeds of disposition" and "cost" of the Purchased Shares; and (b) the parties acknowledge that they consider the Purchase Price to be the fair market value of the Purchased Shares as at the Closing Date. If the aggregate of the fair market value of the Purchased Shares should be determined, whether: (i) by a tribunal or court of competent jurisdiction, (ii) by agreement with Revenue Canada, Taxation, or (iii) otherwise by agreement between the Vendor and the Purchaser, to be greater or less than the Purchase Price, then the Purchase Price shall be adjusted by being increased or decreased so as to equal the aggregate of the fair market value so determined and the Purchase Price payable pursuant to paragraph 2.1 shall be adjusted accordingly, such adjustments to be effective as of the Closing Date. 3. Closing Date and Effective Date 3.1 The completion of the purchase of the Purchased Shares pursuant to this offer shall occur on January 18, 1991, or such other date as may be agreed to as between the parties (the "Closing Date"), and shall take place at the offices of DataSpan Technology Inc., Suite 400 Aquitaine Tower, 540 - 5th Avenue S.W., Calgary, Alberta. The effective date of the purchase and sale shall be 11:59 p.m. Calgary time on December 31, 1990 in respect of the shares set out in paragraph 2.2(a) above and 1:00 p.m. Calgary time on January 1, 1991, in respect of the shares set out in paragraph 2.2(b) above. 5 Paragraph 4 contains numerous conditions that both parties had to comply with by closing date. One, that the Horkoffs be released from their bank guarantees on behalf of HSL, was not met and was waived by the Horkoffs at the closing. Paragraph 5 makes these conditions in law which must be complied with by each party at or prior to closing. 2. February 13, 1991, closing occurred and all resolutions and documents were signed, including the resignation of Marion Horkoff as a director of HSL. 3. January 16, 1991 is the date on the share certificates of DSI that the Appellants received on February 13, 1991 at closing. 6 The Notices of Appeal state that the Horkoffs passed a resolution dated as of December 30, 1990 declaring a dividend which was to be paid no later than May 1, 1991 to the holders of common shares of record at the close of business on December 30, 1990. The Reply admits that the Horkoffs passed a resolution dated December 30, 1990 declaring a dividend. The answer states that the Appellants did not receive a taxable dividend from HSL in the 1990 taxation year. Rather it was received in the 1991 taxation year. On the evidence before the Court, the dividends were declared on February 13, 1991 to be paid to the holders of common shares of record "on the date of this

292 resolution". (see Exhibit A-1, Tab 18). The actual amount of the dividend was not known until the morning of February 13, 1991. 7 Thus, on the evidence before the Court: 1. The offer dated January 13, 1991 had specific conditions which had to by complied with before closing. The condition that the Horkoffs' guarantees must be released was not only a very important condition of the transaction, it is a vital condition in any such contract. 2. No dividend was declared until February 13, 1991. 3. No dividend was paid or transferred to the Appellants until after the amount of the dividend was known and the resolution was passed on February 13, 1991. 4. HSL would not have declared or paid any such dividend, had the sale of its shares to DSI not proceeded on February 13, 1991.

8 In this case the Respondent proposes to backdate the dividend and the receipt of the dividend to the date fixed in the dividend declaration. However the assessments of the Horkoffs must be based upon the date they received the dividend. Receipt did not occur and could not have occurred in 1990. It occurred in 1991. On the evidence before the Court the dividend was actually paid to the Appellants by a transfer of assets, funds, and a loan in 1991. 9 The appeals are allowed. These matters are referred to the Minister of National Revenue for reconsideration and reassessment pursuant to these reasons. The Appellants are awarded their party and party costs. Appeal allowed.

7. Shareholder Benefits ss. 15(1)

As we have seen, where business is carried on through a corporation, there are two levels of taxation. First there is the tax that must be paid by the corporation on the income earned by it, and second, there is the tax which is paid by the shareholders of the corporation on the distribution to them of the after-tax earnings of the corporation through the declaration and payment of dividends. For certain kinds of income, the rate of tax assessed under Part I of the Act on the corporation when combined with the "gross-up" and dividend tax credit rules may result in approximately the same amount of tax being paid by the individual on income earned and flowed through a corporation as compared to income earned by him directly. Nevertheless, this is simply a structuring of the tax rates and the "gross-up" and dividend tax credit rules such that this integration is achieved. It does not deny the fact that there are still two levels of taxation: tax paid at the corporate level and then tax paid at the individual shareholder level on the payment of dividends. The payment of dividends is the normal procedure by which the shareholder benefits from the distribution of property by the corporation to him. Nevertheless, there is nothing to prevent a corporation from making a distribution of funds or property to its shareholders by means other than the declaration and payment of dividends. The purpose of ss. 15(1) is to tax those additional modes of distribution. The prefacing words to ss. 15(1) read as follows: "Where at anytime, in a taxation year a benefit is conferred on a shareholder, or on a person in contemplation of the person becoming a shareholder, by a corporation otherwise than by".

293 Ss. 15(1) is designed, in the broadest possible language, to require the inclusion in the shareholder's income of benefits conferred upon him by the corporation otherwise than by way of dividend or other specifically excluded type of transactions. Ss. 15(1) can almost be considered to be a penalty provision since the quantity of the benefit or advantage that is conferred upon the shareholder must be included in his income as ordinary income and is not treated as a dividend. That is to say, individual shareholders who receive cash dividends from taxable Canadian corporations are entitled to the benefit of the "gross-up" and dividend tax credit. Similarly, corporate shareholders are entitled to the deduction under ss. 112(1). Such is not the case with ss. 15(1): it makes no provision for treatment of the benefit or advantage as a dividend and simply requires the quantum of the benefit or advantage to be included in income. Taxable benefits include transfers of property by a shareholder to the corporation at a price in excess of FMV, sales of property by the corporation to a shareholder at a price less than FMV, excessive expenses reimbursed to the shareholder, services performed for the shareholder without fair payment, and forgiveness of shareholder indebtedness. There are four exceptions to the application of ss. 15(1). These are set out in paragraphs 15(1)(a), (b), (c), and (d). The exceptions are as follows. (i) Para. 15(1)(a). Ss. 15(1) does not apply to any benefit, payment or appropriation which occurs on a reduction of capital, on the redemption, cancellation or acquisition by the corporation of its shares, or on the winding-up, discontinuance or reorganization of its business, or otherwise by way of any transaction to which s. 88 applies. As we shall see, there are specific rules dealing with reductions of capital, redemptions, cancellations and acquisitions of shares by a corporation and the winding-up of a corporation. Para. 15(1)(b). Ss. 15(1) does not apply to any amounts that are distributed by way of a dividend or a stock dividend. Ss. 15(1) is designed to catch benefits which are not shared pro rata amongst all shareholders of a particular class. Para. 15(1)(c). Ss. 15(1) does not apply where all holders of common shares of the capital stock of a corporation are given the right to buy additional shares of the corporation. For this purpose, the rights acquired in respect of each common share to acquire additional shares must be identical to the rights acquired in respect of any other common share (with an exception for differing voting rights of new shares to be acquired providing that such voting differences do not affect the fair market value of such new shares). The application of ss. 15(1) is excluded in these circumstances because the holders of common shares have not received a financial benefit because there has been no improvement in their respective positions. Para. 15(1)(d). Any transaction described in paras. 84(1)(c.1), (c.2) or (c.3): which we will not be looking at. These provisions apply to banks, insurance companies and corporations that attempt to convert contributed surplus into paid up capital.

(ii)

(iii)

(iv)

There is one final exception to ss. 15(1). It does not apply to the extent any amount is deemed to be a dividend by s. 84. S. 84 applies to certain types of increases in paid-up capital, to a reduction of capital, a redemption, cancellation or acquisition by a corporation of its own shares, and the windingup, discontinuance or reorganization of a corporation's business. Any benefit, appropriation or payment that is to be taxed under ss. 15(1) has to have been received by the shareholder in his capacity as shareholder and not in some other capacity. For example, a person who is a shareholder of a department store and who takes advantage of a special bargain

294 being offered whereby products are being sold at less than their fair market value may be considered to have received a benefit but it would be in his capacity as a customer of the store and not in his capacity as shareholder, since the received benefit is available to all customers and is not being directed toward him as shareholder. Consider the following decision.

Arpeg Holdings Ltd. v. R.

Citation: 2008 CarswellNat 143, 2008 FCA 31, [2008] 2 C.T.C. 140, 2008 D.T.C. 6087 (Eng.), 372 N.R. 363 J.D.D. Pelletier J.A :

The last issue is the question of the benefits to shareholders and, in particular, the value to be given to those benefits. The shareholder benefits in question in the appeal are the use of properties located at Whistler and at Crescent Beach. The Whistler properties are three shares of Whistler Ski Lodges Ltd which entitle the appellants to the exclusive use of three properties located in Whistler B.C. The evidence was that the properties were not rented in the 1997 and 1998 taxation years, which are the years in respect of which the individual appellants were re-assessed. The properties were used for business use 25 days annually and for personal use 51 days annually in those years. The fair market value of the rent which could be charged for the use of each Whistler property was $134.79 per day.
16

The Crescent Beach property is a home located on land which was acquired as a farm property. Over the years, parcels of the original acquisition were sold and the farm operations moved elsewhere. The home remained on the property and was used as a summer residence for the months of July and August of each year by Mrs. Bertha Mathisen. The home was not rented in the years in question. The fair market value of such accommodation was between $2,000 and $2,500 per month.
17

The Minister reassessed the individual appellants with respect to the Whistler and Crescent Beach properties on the "cost of capital approach" in which the benefit is equal to the notional return earned if the capital cost of the asset were invested at a prescribed rate. That calculation yielded a gross benefit with respect to the Whistler and Crescent Beach properties in the following amounts which were allocated between the shareholders on the basis of their share holdings. The amounts in question were:
18

1997 Whistler Crescent Beach

19

1998 35,829.48 38,603.00

$ $

29,364.61 32,885.00

In the case of the appellant Mrs. Bertha Mathisen, the appellants argue that the value of the benefit, however calculated, must be reduced by the amount of corporate expenses which she paid in respect of the property. The mechanics of such transactions were that the corporation paid the expenses and reduced the amount of its obligation to Mrs Mathisen (her shareholder loan account) by the same amount. The appellants challenge the Minister's cost of capital approach on the ground that it amounts to a mis-reading of this court's reasons in Youngman v. R., [1990] F.C.J. No. 341, 90 D.T.C. 6322 (Fed.
20

295 C.A.) and Fingold v. R., [1997] F.C.J. No. 1250 (Fed. C.A.). The appellants say that both of these cases involve properties which were constructed or acquired for the benefit of the shareholder. The appellants also say that, unlike Youngman and Fingold, the properties in question in this case were acquired for business purposes. It simply transpired over time that personal use was made of the properties. The distinction suggested by the appellants is not relevant. As this court said in Youngman, the first step is to identify what the benefit is, that is, what the company did for the shareholder. The second step is to determine what the shareholder would have had to pay to obtain that benefit if he or she were not a shareholder. In both Youngman and Fingold, the Court found that the benefit was the right to have at their disposal the property in question. In Youngman, the property was a house built to the shareholders' specifications. In Fingold, it was a luxury condominium purchased and renovated for the use of the shareholder and his wife. In both cases, the corporation's capital was tied up in properly which did yield a return. The cost of the benefit is the income which that capital could have earned had it been productively employed during the taxation year in question. That is what a person dealing at arm's length would have to pay for the use of that capital.
21

In the present case, the properties were not on the rental market in the years in question. While there were days in which the properties were used for business functions, the properties were at the shareholders' disposition on any other occasion, even if they chose not to make use of them. Thus the proper measure of the benefit is not the cost of renting equivalent accommodation for the period of actual personal use, but is the corporate income foregone by having the corporation's capital tied up in unproductive assets. The Tax Court judge did not err in confirming the Minister's approach to the assessment of the benefits received by the shareholders.
22

The last issue was the adjustment to be made, if any, with respect to the benefits conferred oh Mrs. Mathisen. In the case of the Whistler properties, Mrs Mathisen had access to the properties on the same basis as the other shareholders but she incurred the cost of certain corporate expenses with respect to those properties. With respect to the Crescent Beach property, Mrs. Mathisen was the only shareholder who made any personal use of the property but, once again, she incurred the cost of certain corporate expenses in relation to the maintenance and upkeep of the property.
23

The Tax Court judge refused to consider any deduction with respect to these payments oh the basis that no evidence was led to establish a reasonable apportionment. In my view, the Tax Court judge erred on this point. The ledgers for the properties in question are available and it is possible to identify the various heads of expenses paid in relation to the properties. Mrs. Mathisen should get no credit for personal expenses such as telephone and cable. She should be credited with the payments made to B.C. Hydro to the extent of the business use of the properties. Fixed costs such as condominium fees, taxes, insurance should be credited in full. The details of the calculation are left to the Minister. In summary, the amount of the benefits conferred on Mrs. Mathisen is to be reduced by the amount of the adjustments permitted above.
24 25

In the end, I would dispose of these appeals as follows: 1. I would allow the appeal in File No. A-537-06 with costs fixed at $1,500 and disbursements and I would remit the matter to the Minister for reassessment on the basis that, in the calculation of the shareholder benefit received by the appellant, she is to be given credit for certain payments made as provided in paragraph 24 of the Reasons for Judgment. 2. I would dismiss the appeals in Files Nos. A-539-06, A-538-06, A-540-06, A-541-06, A-54206, A-543-06 and A-544-06 with one set of costs and disbursements in each file.

296 3. A copy of these reasons will be placed in each file.

Lloyd Youngman v. Her Majesty The Queen, [1990] 2 C.T.C. 10 (FCA)

Case Commentary The appellant taxpayer, his wife and children were the only shareholders of A Ltd. A Ltd. acquired a parcel of land in 1966 with the intention of subdividing it into residential plots. By the summer of 1978 the arrangement had not received municipal approval and the scheme appeared to be doomed to failure. The taxpayer and his wife decided to have the company build them a house on the land. The house was completed in December 1978 at a total cost of $395,549. Beginning February 1979, the taxpayer paid the company rent of $1,100 a month. The Minister decided that in 1979 the company had conferred a benefit on the couple equal to $18,625 each, which was taxable under paragraph 15(1)(c). The assessment was upheld by the Tax Review Board and the Federal Court Trial Division (see [1986] 2 C.T.C. 475). The taxpayer appealed to the Federal Court of Appeal, which held that the question to be resolved was whether the taxpayer had received a benefit or advantage equal to $6,526 in excess of the rent paid by the couple. This required determining what the shareholder would have to pay in similar circumstances in order to get the same benefit from a company of which he was not a shareholder. In this case the benefit or advantage was not only the right to occupy the house as long as he wished, but the fact that it was built for him in accordance with his specifications. In the Court's opinion it was impossible to determine with accuracy the amount of such rent. The decision turned on a fact that was not mentioned in the Trial Division decision, namely that the taxpayer had loaned the company more than $100,000, without interest, to help finance the construction of the house and that the rent otherwise payable should have been reduced by an amount equal to the interest which normally would have been payable on the loan. The Court stated that, under paragraph 15(1)(c), what is to be added to the income of the shareholder is the value of the benefit that he received rather than the cost of the benefit to the company. Pratte, J.A., however, added the contradictory statement that the cost of the benefit may be taken into consideration in determining the value of the benefit, but no judicial authority was mentioned. The term "free market value" was used in the judgment. Is that expression intended to mean the same as "fair market value"? Another interesting feature of this case was that the Minister, in calculating the amount of the "gross benefit", included the $28,452 which was equal to nine per cent of the amount of the "return on investment of $316,135.79". In the Trial Division [1986] 2 C.T.C. 475 at 478 McNair, J. stated that one of the four grounds of the plaintiff's appeal was that the notional nine per cent return "is nothing more than a flagrant example of imputed taxation inasmuch that the tax collector is telling the taxpayer what might have been saved to the pocket if $395,500 of corporate funds had not been tied up in an imprudent investment." The judge stated that this submission "dovetails" with the taxpayer's first two submissions and "can be conveniently dealt with as part thereof." The first two submissions were: (1) that the assessment raises an issue of fact as to the fair market rental value of the property and (2) the Crown had substituted the word "cost" for the words "amount or value thereof" in paragraph 15(1) (c). McNair, J. went on to state that, in summary, the real issue, from the taxpayer's standpoint, is whether the amount or value of the benefit is synonymous with the fair market rental value of $1,100 a month.

297 In the Federal Court of Appeal it was not necessary to deal with the issue because, as pointed out above, the Minister had not considered the fact that the taxpayer had loaned the company $100,000 without interest. Pratte, J.A. said that he did not understand the contention that the reassessment was bad because it was a form of "imputed taxation" on a "notional income" since it was based on the assumption that the company "should have made at least a nine per cent yield on its investment."

8. Shareholder Loans
The purpose of ss. 15(1) is to subject to taxation amounts received by shareholders outside the normal modes distribution of corporate funds such as by way of dividend. Subsection 15(2) deals with situations where loans are made by a corporation to a shareholder in instances where the corporate lender may not normally enforce its right to payment against the shareholder.

i. Subsection 15(2)
Subsection 15(2) of the Income Tax Act is designed to prevent a corporation from distributing its funds tax-free to a shareholder by means of a loan to the shareholder. When a shareholder receives a loan from or becomes indebted to a corporation, the amount of the loan or indebtedness is included in the shareholder's income in the year that the loan arises. There are a number of exceptions to the subsection 15(2) income inclusion--most notably in subsection 15(2.4), for certain types of loans that are received by shareholders who are also employees of the corporation. Such loans may include a loan to an employee who is not a specified employee of the corporation (that is, he or she generally holds less than 10 percent of the shares); a loan to enable an employee to acquire a dwelling; a loan to enable an employee to acquire a motor vehicle; and a loan to enable an employee to acquire previously unissued shares of capital stock of the corporation. For these exceptions to apply, however, it must be reasonable to conclude that the employee received the loan because of his or her employment and not because of "any person's share-holdings." In addition, at the time the loan was made, bona fide arrangements must have been made for repayment of the loan or debt within a reasonable time. The most commonly relied upon exception to subsection 15(2) is contained in subsection 15(2.6). Subsection 15(2.6) excludes the application of subsection 15(2) where a loan or indebtedness is repaid within one year after the end of the taxation year of the lender or creditor in which the loan was made or indebtedness arose and it is established by subsequent events that the repayment was not part of a series of loans or repayments. In other words, the loan or indebtedness cannot appear on two consecutive balance sheets of the lender or creditor. Whether or not a loan made by a corporation to an employee is considered to have been received by the employee because of his or her employment and not because of "any person's share-holdings" is a question of fact.

ii. Interest-Free and Low-Interest Loans. Subsection 80.4

Subsection 80.4(2) deems a benefit to have been received by a shareholder who receives an interestfree or low-interest loan from the corporation of which he is a shareholder. It also includes amounts owed by the shareholder to the corporation which result otherwise than from loans, such as amounts unpaid on an acquisition of property from a corporation. The deemed benefit is deemed by ss. 15(9) to constitute a benefit conferred on the shareholder for the purposes of ss. 15(1), and is thereby included in the shareholder's income.

298 Ss. 80.4(2) applies to a shareholder (other than a corporation resident in Canada but including a partnership except for those whose sole members consist of such corporations), a person connected with the shareholder, as defined in ss. 80.4(8), and to a member of a partnership or a beneficiary of a trust that is a shareholder. Subsection 80.4(2) extends beyond the immediate corporation in which the shares are held to include a related corporation and a partnership of which the corporation or related corporation is a member. Ss. 80.4(2) provides that the amount of the deemed benefit consists of interest calculated at whatever may be the prescribed rate in force at the relevant time or times, less whatever amount of interest is actually pad not later than 30 days after the end of the year. The "prescribed rate" of interest means the rate that is prescribed for the purposes of the provision. Para. 80.4(3)(a) provides that the deemed interest benefit of ss. 80.4(2) does not apply to a loan or debt where the lender's ordinary business includes the lending of money, such as a bank, provided the terms of the loan or debt, including the rate of interest, are, in light of all the circumstances, at least as onerous as those that would have been agreed upon between parties dealing at arm's-length, and the loan or debt is not made or incurred by virtue of the shareholding. Para. 80.4(3)(b) provides that neither does the deemed interest benefit rule apply where the loan itself is included in the shareholder's income under s. 15(2). That is to say, if the taxpayer is to be taxed on the principle amount of the loan, he will not be taxed as well on a deemed interest benefit.

iii. Case Law Guiseppe Perlingieri and Roma Construction (Niagara) Ltd. v. Minister of National Revenue
[1993] 1 C.T.C. 2137, 93 D.T.C. 158, Tax Court of Canada The appellant was the majority shareholder and an employee of R Ltd. R Ltd. was building a home for the appellant on a parcel of land in St. Catharine, Ontario. In March 1985, R Ltd. loaned the appellant $100,000. The loan was repayable on demand without interest. The appellant repaid the loan in April 1987. R Ltd.'s year-end was February 28. The issue was whether the $100,000 ought to be included in the appellant's income pursuant to subsection 15(2). At the trial of this appeal, there were initially several other issues to be decided but all issues other than the aforementioned issue were settled at the commencement of trial. HELD: The issue was whether a loan payable on demand was a bona fide arrangement for repayment of the loan within a reasonable time. At the time the loan is made the creditor and debtor must be aware of the arrangements made between them for the repayment of the loan. The debtor must know when he must repay the loan at the time the loan is made. Because a demand loan is open ended with respect to repayment, at the time the loan is made the creditor may or may not know when he will demand payment and the debtor does not know when he will have to make payment. Hence no bona fide arrangement indeed no arrangement at all has been made at the time of the demand loan for its repayment. Accordingly, the appellant's appeal was dismissed with respect to this issue but was allowed and referred back for reassessment in accordance with the settlement between the parties. Appeals allowed in part.

299

Sandia Mountain Holdings Inc. v. Canada

[2007] 1 C.T.C. 2278 AMENDED JUDGMENT:-- The appeal [2003-1672(IT)G] from the assessment made pursuant to the Income Tax Act in respect of the 1993 taxation year is allowed and is referred back to the Minister of National Revenue for reconsideration and reassessment on the basis that the unreported income shall be reduced by $88,677.00. The appeals from the assessments made pursuant to the Income Tax Act in respect of the 1994, 1995, 1996, 1997 and 1998 taxation years are allowed and the assessments are referred back to the Minister of National Revenue for reconsideration and reassessment on the basis that the interest expenses disallowed in each of those years shall be allowed as claimed. The appeal from the assessment in respect of the 1999 taxation year is dismissed. Costs are awarded to the Respondent in the amount equal to 50% of the total tariff prescribed in respect of all the appeals heard on common evidence. The appeals [2003-1686(IT)G] from the assessments made pursuant to the Income Tax Act for the 1991 and 1992 taxation years are allowed. The appeal from the assessment in respect of the 1993 taxation year is allowed and the assessment is referred back to the Minister of National Revenue for reconsideration and reassessment on the basis that the unreported income assessed as a taxable benefit shall be reduced by $88,677. The basis for confirming the balance of the amount assessed as a benefit in respect of such years shall be pursuant to subsection 15(2) of the Act. The appeals in respect of the 1994, 1995, 1996, 1997 and 1998 taxation years are allowed and the assessments are referred back to the Minister for reconsideration and reassessment on the basis that the unreported income assessed as a taxable benefit in each of those years shall be reduced by all interest amounts incurred by Sandia Mountain Holdings Inc. and attributed to the Appellant as a taxable benefit in those years. The basis for confirming the balance of the amount assessed as a benefit in each of those years shall be pursuant to subsection 15(2) of the Act. The reassessment in respect of the 1999 taxation year is confirmed on the basis that the amount assessed as a benefit shall be pursuant to subsection 15(2) of the Act. Each party shall bear their own costs. REASONS FOR JUDGMENT 1 HERSHFIELD T.C.J. (orally):-- The appeals of Ms. Kulla and Sandia Mountain Holdings Inc. ("Sandia") were heard on common evidence. Ms. Kulla was an officer and the sole shareholder of Sandia since November 1991. 2 Ms. Kulla was reassessed for her 1991 to 1999 taxation years (inclusive). The first six of those years were reassessed beyond the normal reassessment period pursuant to subsection 152(4). 3 Ms. Kulla was reassessed in each of the subject years on the basis that Sandia paid certain of her personal expenses in varying amounts in each of the subject years and thereby conferred benefits on her in her capacity as an officer and shareholder. The Respondent relies on subsections 6(1) and

300 15(1) of the Income Tax Act (the "Act"). I note however that in an Amended Reply, section 6 is relied on only in respect of Ms. Kulla's 1991 and 1992 taxation years. Further, Ms.Kulla was assessed penalties pursuant to subsection 163(2) of the Act for failing to include the subject benefits in computing her income in each of the subject years. 4 Sandia was reassessed for its 1993 to 1999 taxation years (inclusive) ending July 31. The first of these years was reassessed beyond the normal assessment period pursuant to subsection 152(4). 5 Sandia was reassessed under section 9 of the Act in each of the subject years on the basis that it misrepresented rental income amounts paid to it by a related (sister) company -- The Shield & Sword Inns Limited ("S & S"). Penalties were assessed under subsection 163(2) in respect of the understated rental income for each of the subject years. Penalties were also assessed under subsection 162(1) for the late filing of returns for the 1994 to 1999 taxation years (inclusive). Further, certain interest expenses claimed were denied pursuant to paragraphs 18(1)(a) and 20(1)(c) of the Act in respect of the 1994 through 1998 taxation years (inclusive). 6 The trial of the subject appeals involved the testimony of five witnesses including one expert and a number of read-ins from examinations for discovery and a read-in of a second expert witness's affidavit along with a transcript of his examination, all taking place over a six day period. While some challenges were presented in respect of findings of facts relating to reassessments beyond the normal assessment period and penalties under subsection 163(2) in respect of which the Respondent has the burden of proof, the taxation issues per se in my view are straightforward. Sandia Reassessments 7 Dealing first with the Sandia reassessments the question is whether certain amounts received from S & S were on account of rent. 8 Sandia and S & S entered into a rental agreement for the occupation and use of a 50-room motel/tavern which included an adult entertainment lounge. The property had been owned by S & S until 1987 when it was transferred to Sandia. The reason for the sale was to help creditor proof against liabilities that might arise in the course of operations. At the time the motel was leased for use as a detention centre. This was felt to present unusual liability risks as did its bar and lounge business in respect of which liability for impaired driving had become an issue. 9 The lease agreement made in 1987 with Sandia specified a fixed monthly rent of $15,000. There was one formal adjustment to the rent in 1992 allowing Sandia as tenant to defer its obligations ostensibly indefinitely at its choice which, for tax purposes, does not in my view create in the years in question an obligation to pay more than $10,000 a month as rent. As well I note that S & S rent expense claims never exceeded $120,000 per year. The accountant for Sandia, S & S and Ms. Kulla testified that he believed the rental charges were intended to be and did reflect the market value of the property. However he also testified that rent adjustments were required to eliminate income in Sandia. Sandia had few deductions and as a result had too much income by virtue of the rental receipts under the lease agreement even at the reduced rent of $10,000 per month. To flatten its income, posted rental amounts received were adjusted downward after the end of the year and the excess receipts were treated as an advance from S & S. These adjustments were shown on Sandia's statements as "unrealized income" or "economic recoveries". 10 Accordingly, in the subject years, the amounts Sandia reported as rental income were significantly less than the stipulated, paid and received payments from S & S. Sandia's posted rent receipts were as follows: Posted Rent Receipts Unrealized Income/

301 Economic Recovery (treated as loans) $152,000 87,000 57,000 93,000 92,000 89,000 99,000

1993 1994 1995 1996 1997 1998 1999

$190,667 107,000 103,200 104,000 120,000 120,000 120,000

After taking out amounts treated as loans from S & S, the reported rent was as follows:

1993 1994 1995 1996 1997 1998 1999

Income Reported $38,667 33,333 31,200 23,000 28,000 31,000 21,611

11 The unrealized income/economic recovery amounts were added back to income under the reassessments so that the assessed amounts were as follows:

1993 1994 1995 1996 1997 1998 1999

Additional Rent $152,00 87,000 57,000 93,000 92,000 89,000 99,000

12 1993 is the only year where amounts brought into income as rent exceeded the amount payable under the lease. Indeed it is higher than the unadjusted rent of $15,000 per month, further supporting the idea that not all payments received by Sandia and posted as rent could in fact be rent. Payments beyond rental amounts owing were credibly advanced as loans. Accordingly for 1993 the rental inclusion should be reduced by $70,677. However, having concluded that it is not unreasonable to regard some part of the posted rent payments as a loan it is helpful to refer to the amounts claimed as rental expense in S & S. In 1993 the amount claimed as rental expense was $102,000. Although S & S had a different year-end (December 31), the reassessments and Reply treat S & S's filed rent expense amount as Sandia's rent receipts for all years except 1993 notwithstanding year-end differences. On that basis I find that the same treatment should be applied in 1993 so that the assessed rent should be reduced by $88,677 as opposed to the $70,677 referred to above. 13 The Appellants' position was that I should go further and treat the rent adjustments as loans and reduce rent receipts accordingly. The argument is that the intentions of the parties as ultimately shown on financial statements were to amend the written lease and charge a floating rent. The Appellant presented two expert opinions to support this method of accounting, in particular Derek Rostant, who testified that it would be acceptable to reduce recorded rent as being a liability from

302 Sandia back to S & S. Rostant's expert report described the proper journal entries to be Debit Cash $120,000, Credit Rental Income $120,000; Debit "Unrealized Revenue" $90,000, Credit Loan from Shield $90,000. That this was not done in the case at bar does not advance the Appellant's argument. 14 Indeed, the expert evidence relied on by the Appellants is of no assistance. Notwithstanding that GAAP allows for or requires adjusting entries to reflect actual realizations of items such as rent, it is a legal question as to what those realizations are. The expert opinions were based on assumed facts that did not give the full picture and were given on the basis that the statements in respect of which the opinion was applicable were subject to GAAP with Notes to the Statements regarding related party transactions. Since these were Notice to Reader Statements the reporting format was different than the format contemplated by the opinion. 15 I also point out in respect of this issue that if there were loans in such substantial amounts made each year, the payable should increase. In fact, as pointed out by Respondent's counsel, they decreased which is hard to explain when income was flattened every year and no other sources of funds are apparent. 16 I have noted and indeed relied on S & S's posted treatment of its rent expenses. I have done so contrary to the Appellant's own assertion that S & S adjusted its rent expense claims to match the rent reduction amounts claimed by Sandia. Indeed the manner in which the accountant said S & S treated the rent adjustments only enhances the Respondent's position and further supports my impression that the recasting of the rents was nothing more than a covert unscrupulous attempt to avoid taxation. That is, contrary to Sandia's assertion that S & S ultimately claimed lower rent payments than shown on its statements is a dubious one. On that point I simply note that the accounting for such purported reduction is so wanting in transparency and the accountant's explanation so inadequate that I am unconvinced that there were genuine and timely adjustments to the expense claims made by S & S. The accountant said he decreased the cost of sales in S & S to account for the rent adjustments but reconciliations of such covert adjustments required reconciliation with further adjustments all serving to totally obscure the true financial picture of S & S. If S & S had the burden to establish that the rent expenses claimed were adjusted downward by the unrealized income amounts shown on Sandia's statements, it would have failed to meet that burden. 17 Accordingly, subject to my consideration of the statute barred years issue, I find that the reassessments adding rental income to Sandia's income must stand with an adjustment being allowed in respect of 1993 as noted above. 18 As to interest expenses denied Sandia, I am satisfied on the evidence that same were incurred all or substantially all for the purposes of gaining and producing income. National Bank mortgage documents refer to the refinancing and renovation of the hotel. I have the testimony of two witnesses, Ms. Kulla and her son-in-law (who managed the hotel and assisted Ms. Kulla in dealing with the bank in regard to this mortgage) that the borrowed funds in respect of which interest was denied were used in part for refinancing the hotel and in part for renovations to it. While further documentary evidence would have been better evidence and while their testimony was self-serving and admitted to the hypothetical possibility of personal interest expenses being incurred and while on a number of other points their testimony was not always credible, I am satisfied as to the probability that the borrowed funds giving rise to the interest expense in issue were expended on the hotel as asserted by the Appellants. The Respondent's theory as to the funds being used to finance lands owned by Ms. Kulla was not admitted and is so speculative that it does little to discredit the witnesses on this point. Ms. Kulla

303 19 Turning now to the issues pertaining to Ms. Kulla, I note that the asserted benefits relate to three shareholder loan accounts. One such account was maintained for each of three categories of personal benefit. Firstly there was a horse racing stable; secondly there was a farm property which was rented out; and thirdly, there were payments for Ms. Kulla's personal use automobile. 20 I am satisfied that the entries that were made by Sandia's full-time bookkeeper in respect of these personal items, and accounted for by Sandia on behalf of Ms. Kulla, were likely accurate. Nothing in this case suggests otherwise in my view. Speculation and innuendo as to that not being the case is based on the Respondent's position that the Appellant's assertions, and bookkeeping and accounting records, must be regarded as unreliable. The Respondent adds to this some credibility issues with which I do not disagree. However, I do not embrace the Respondent's position in regard to the record keeping of personal expenditures. While original receipts and similar records were not available, it seems apparent that daily or regular postings or notations were in fact made by the fulltime bookkeeper of all transactions relating to these personal accounts. This is not a case of a total absence of business records. The accountant recorded these postings in three separate accounts and then consolidated them in a shareholders loan account. Perhaps this approach made things harder to track but certainly there was nothing sinister about it, so far at least. 21 What happens next however is that payments against balances due by Ms. Kulla are credited so as to eliminate any such balance due by her. The timing of applying the credits is such to ensure no taxable benefit is created. The method employed to do this was to have S & S clear the account with Sandia and then make corresponding adjustments to its shareholder loan account maintained for Ms. Kulla. Since each company had a different year-end, loan balances could be effectively shifted between the two companies so that there was always a timely repayment of the balance payable by Ms. Kulla to each of the companies so as to avoid a taxable benefit under subsection 15(2) of the Act. 22 The application of subsection 15(2) is alleviated by subsection 15(2.6) subject to an express anti-avoidance provision set out in that subsection. Subsection 15(2) includes in income, loans to shareholders and subsection 15(2.6) eliminates the income inclusion if the loan is repaid within a year unless the repayment is part of a series of loans and repayments. That is, the manipulation employed to avoid the application of a taxable benefit provision was not at the stage of posting outlays for Ms. Kulla's benefit, but rather was focused on the repayment of the loan accounts. The Sandia shareholder loans were made to disappear on a timely basis so as to avoid application of 15(2). Returns were filed on the basis that 15(2) did not apply regardless that 15(2.6) required that loans repaid in the manner employed by the parties were subject to the income inclusion provided for in 15(2). 23 In short then, what was done and continued to be done throughout the subject period was to create a series of loans and repayments amongst Sandia, S & S and Ms. Kulla so as to avoid liability for tax under subsection 15(2) of the Act. The accountant for the Appellant admitted to this at the hearing. 24 However, the auditor for the Canada Revenue Agency ("CRA"), who testified at the hearing as well, admitted that he did not fully understand what had happened until sitting through the hearing. He was not as sophisticated in covert accounting as the Appellant's advisor. Further, there is no doubt that the auditor was being stalled and misled prior to the reassessment being issued. For example, at the time of the objection the unrealized rent amounts were argued to be uncollected bad debts. As well, Ms. Kulla was unresponsive. In the circumstances, faced with taxpayers doing little to assist the audit and not being forthright (or as it turns out honest) about the actual goings on in respect of shareholder benefits, I find no fault on the auditor's part in proceeding as he did. The reassessment and confirmation assumed the operative provisions were subsection 15(1). The auditor understandably took the view that Sandia had paid the subject amounts for the personal benefit of

304 Ms. Kulla without the proper accounting for the expenditure as a shareholder loan. There were no loans outstanding as shown on the statements. 25 However what emerges is a fresh issue; namely whether the reassessment under subsection 15(1) can stand in light of the more specific assessing provision contained in subsection 15(2) and if not, whether the basis for the reassessment can be changed to take into account facts as revealed at trial.4 Principles of statutory construction generally prefer application of the more specific provision and in this case that affords Ms. Kulla a better result. Assessing under subsection 15(2) entitles her to a deduction of the income inclusion when the loan amount is repaid. This may have occurred in 2003 according to her testimony. Assessing under subsection 15(1) affords no such benefit. I note here as well that there is some older authority for applying similar specific loan benefit provisions over general benefit provisions. Valle Estate v. M.N.R. and Herbacz v. M.N.R. 26 The Respondent relies on 15(1) as the primary assessing position. One premise on which the Respondent seems to rely is that since they were not assessed as loans -- 15(2) does not apply. Along the same lines the Respondent argues that book entry credits do not constitute payments. While I do not agree that the credits in this case are not payments and would distinguish authorities cited by the Respondent, and while I do not agree that the chosen assessing section determines its correctness, I am not satisfied that 15(1) cannot apply if for any reason 15(2) cannot apply. This would include applying 15(1) should the application of 15(2) be barred by virtue of it being raised too late even where the reason it is raised late is due to the Appellant's own covert dealings. 27 I note here as well that the Respondent argues that there were no loans. My findings are otherwise. I am satisfied the payments made by Sandia on Ms. Kulla's behalf were not recorded without purpose. I accept the probability that amounts were paid by Sandia for Ms. Kulla's benefit as advances to be accounted for, repaid by her, at some point in the future. As noted, the problem is the series of loans and repayments. 28 This takes me to consider the statutory provisions relating to late reliance on a different charging provision of the Act to confirm an assessment on appeal. The provision of the Act that has application is subsection 152(9). There are recent authorities dealing with this provision. 29 The Respondent argues that 152(9) permits alternative arguments at any time and that there is no distinction between an alternative argument and an alternative basis for assessment which is to say an alternative basis for assessment is permitted at any time. The Respondent relies on The Queen v. Anchor Pointe Energy. 30 As well the Respondent relies on G.M.A.C. v. The Queen. In this case Justice Rip noted that facts are known to the taxpayers and as additional facts are made known additional assessing sections may become apparent. As well the correctness of the reasons for making an assessment is not the issue. The Court is concerned with the validity of the assessment which is a dollar amount. 31 The Appellant argues that the Respondent cannot now raise 15(2) as it not only changes the statutory basis for the assessment but involves different transactions. It is argued that Anchor only allows a new basis for assessing where such new basis did not involve different transactions such as in Pedwell v. The Queen. 32 I do not agree with the Appellant's construction of 152(9) and the authorities relied on do not support the Appellant's arguments. There are no new transactions in my view of the type considered in Pedwell that must be considered in the application of 15(2) versus 15(1). We are concerned here with payments made for the benefit of a shareholder -- that is the relevant transaction. Taken together or one at a time they are the identical transactions that give rise to the question of which taxing

305 provision to apply. That the Appellants and their advisers have obscured the records so as to frustrate the Respondent's ability to apply the right basis of assessment surely cannot be used to shield the Appellants from the application of the correct assessment provision. As alluded to in G.M.A.C. this Court determines the correctness of the amount assessed in the year assessed and in this case the amount assessed in the years assessed is the same whether 15(1) or 15(2) is applied. The more specific section should apply. However as stated, this is not to suggest that but for the application of 15(2) I would not apply 15(1). 33 At this point I note that the Respondent did not assess the actual payments it determined that Sandia had paid on Ms. Kulla's behalf. The Respondent capped the reassessments at the amount each year that equalled the unrealized income that Sandia did not report as rental income. The theory of this approach seems to be that this was unreported profit that disappeared from Sandia's coffers. It was, in a manner of speaking, the unreported income that was bonused out to Ms. Kulla without Ms. Kulla reporting the income. The reassessments then effectively tax the bonus in Ms. Kulla's hands without a deduction to Sandia. While I have accepted the accounting for the payments made by Sandia on Ms. Kulla's behalf I am not prepared to penalize Ms. Kulla further by refusing to allow her the benefit of the assessing approach taken by the CRA. If that approach caps her benefit at amounts equal to the missing unreported income in Sandia, her benefit must be reduced by the $88,677 referred to earlier in these Reasons.10 34 Before looking at the next set of issues affecting both Ms. Kulla and Sandia, namely barred assessment years and penalties, there is one last benefit issue to be dealt with. Ms. Kulla was reassessed as having received a benefit for the interest amounts Sandia was reassessed as having paid on her behalf and for her benefit. Having found these interest amounts to have been paid on account of Sandia's own debt incurred for income producing purposes, the related reassessments adding these interest amounts to Ms. Kulla's income must be vacated. Statute Barred Years & Penalties 35 I turn now to the question of the statute barred years and the penalties.

36 In regard to penalties, Appellants' counsel has argued that the Minister has not brought proper evidence of the calculation of the penalties and accordingly they should be struck down. He cites the decision in Hans v. The Queen, of Justice Bowie at paragraph 20 where relying on a comment made by the then Associate Chief Justice Bowman in Urpesz v. The Queen, that the Minister can only sustain the penalties if he proves the correctness of the amount of the penalty. Appellants' counsel argues the Minister has not done so in this case because he did not bring evidence at the trial as to the calculation. Indeed the auditor testified that he did not check the calculations. 37 While the Judge's comment in Urpesz, an appeal under the informal procedure, does not elaborate as to what is meant by, or what it might take to prove, the correctness of the amount of the penalty, the suggestion of Appellants' counsel that it requires evidence of the correctness of the calculation to be brought at trial does not follow and Justice Bowie's observations in Hans, an appeal under the general procedure, do not go that far either. In Hans Justice Bowie stated that in that case the Minister had not discharged his burden of showing that the precise penalties imposed were justified. He added and I quote: "Neither the Reply nor the evidence reveals how the Minister computed the penalties that he imposed." 38 The question then arises as to what is meant by "how the Minister computed the penalties that he imposed". For one, it might mean that the Reply must set out the exact calculation of the income subject to the penalty and the percentage applied. If the Reply sets out the penalty amount that is shown clearly as 50% of the income shown as subject to the penalty, then the Reply in my view has

306 met the test set out by Justice Bowie in cases such as the one at bar where identifying the amount that the penalty is assessed against and the applicable percentage are clearly the only relevant amounts needed to establish the correctness of the penalty assessed. 39 The importance of the Reply dealing adequately with the calculation of penalties is also shown in Francavilla v. The Queen13 where the Minister's Reply did not refer to the penalties and on that basis Justice Rip deleted the penalties. That is clearly not the case in respect of the appeals at bar. 40 Accordingly, Appellants' counsel's submission that in order for a penalty to be assessed properly the Minister must call an auditor to the stand and have them testify as the calculation of the penalties is one with which I cannot agree. Unlike the case of Hans and Francavilla, the Replies in the subject appeals sufficiently address the 163(2) penalties. Furthermore, Respondent's counsel presented documentary evidence (exhibit R-15) to demonstrate the income upon which the 163(2) taxes would be based. There is no possible debate as to the correctness of the calculations of the penalties in respect of either appeal. They are fixed and afford no discretion or variation even by this Court once the income amounts properly subject to penalty have been proven. Are the Requirements for Imposing Penalties and Assessing Beyond the Normal Period Met? 41 I turn now to the tests and analysis for assessing beyond the normal assessment period in subsection 152(4) and for assessing penalties under subsection 163(2). 42 The relevant provisions of the Act provide that in the case of assessing beyond the normal reassessment period, the Minister can only do so if: (a) the taxpayer or person filing the return (i) has made any misrepresentation that is attributable to neglect, carelessness or willful default or has committed any fraud in filing the return or in supplying any information under this Act. 43 Respondent's counsel advanced two preliminary arguments in respect of this provision. Firstly he suggested that the person filing the return was the accountant since he prepared it or, alternatively, he argued that the tax preparer should be regarded as the filer for the purposes of this provision. I reject these submissions. The Respondent has not established that the person who signed the return was other than the respective Appellants. Indeed, evidence supports the contrary. The Appellants were the persons filing the returns, and there are no authorities warranting a construction of the subject section that suggests that the preparer should be regarded as the filer. Indeed, the authorities suggest otherwise when they deal with attributing knowledge to the taxpayer who signs and files returns. Further, tax preparer penalties now in the Act suggest that they are dealt with separately. 44 The second preliminary argument made by the Respondent refers to the Federal Court of Appeal decision in Nesbit v. The Queen he argued that any incorrect statement on a return is a misstatement. While that is true the provision does not open assessment periods beyond the normal periods if the misrepresentation is, for example, innocent. The easiest test for the Minister to meet is establishing on a balance of probability that the taxpayer was neglectful or careless. In Nesbit, for example, a missed decimal point creating a $700,000 under-reporting was found at least to be careless -- the taxpayer signing should be careful to pick-up such obvious mistakes. In the case at bar the under-reporting was anything but obvious in respect of both Appellants. Indeed the manner by which income was under-reported was not even apparent to the auditor who may have had more information at his disposal than Ms. Kulla. The Respondent's counsel still argues that it should have been obvious, regardless of the methods employed, to anyone who has ever filed a tax return, as Ms.

307 Kulla had done for years, that showing no income on tax returns warranted enquiry when it would have been clear to her that there was money being made and she was benefiting personally. 45 Ms. Kulla's testimony was to plead innocence in respect of having any knowledge of what her accountant was doing even though it appears she signed both personal returns and corporate returns. The accountant testified as well that he didn't discuss these matters with her. 46 Some background is now required.

47 Ms. Kulla had nothing to do with Sandia, S & S, horses and farms until her husband died in November of 1991. The stable and farm were owned by her husband, not her. That she became actively involved at some point following her husband's death, is clear from the evidence. However the death of her husband and her first arrival on the scene in late 1991 is a circumstance that merits consideration. She was 52 years old and not involved in the business. Indeed, although for a very brief period on the incorporation of Sandia she held some shares, she was not a shareholder or employee at the end of its 1991 taxation year (July 31). To assess her benefits in respect of her 1991 year which ended less than two months after her husband died, defies logic. Clearly I can attribute no neglect or carelessness to Ms. Kulla in these circumstances. 48 Further, I note that under her husband's control, the profits of Sandia were being expensed as management fees. It is these fees that are being added to Ms. Kulla's income as a benefit. Presumably if the fees were not paid in any other way except as benefits re the farms, stable and vehicle, they should be included as benefits but how would this be apparent to a widow new on the scene even in her 1992 taxation year? When she filed the return for that year she would have been a widow for some 16 months -- barely time for probate of some estates. The Minister bears the burden of proof. I see no satisfactory evidence that establishes when she became the recipient of benefits and even if there was, I see no carelessness or neglect on her part in signing returns that show no income at this point. 49 Accordingly, I find that the reassessments of Ms. Kulla for 1991 and 1992 are beyond the reassessment period allowed for under 152(4) and her appeals for those years are allowed. 50 As to future years however the situation changes in my view. By early 1994 when she would be looking at her 1993 tax return she had to be a party to the unscrupulous goings on. At that time Sandia had filed its 1993 return. While I acknowledge the likelihood that there were games being played with the management fees employed during her husband's tenure that continued after his death, most likely in my view without Ms. Kulla's knowledge or acquiescence, that scheme was less covert than the one I have described above in relation to the deceitful way in which rent adjustments were being made. That repugnant scheme was first employed in Sandia's 1993 year and it is not a bit credible to me that by that time Ms. Kulla was not a party to such new scheme. While I have allowed a 52 year-old widow the benefit of common sense regarding the passing of an estate, that is not to say that I see her as a shrinking violet. She is the one signing the cheques -- the signing officer -attending at the hotel premises regularly and meticulously watching the books. This is a family business and there is another similar establishment owned by immediate family members. Ms. Kulla did not strike me as an idle owner and the testimony of the witnesses that suggest that she never asked the accountant what was going on is neither reliable nor credible. Even if she did not make enquires there is a compelling line of cases that establishes gross negligence where a taxpayer simply turns a blind eye in circumstances warranting enquiry. This was a situation warranting enquiry. I will say more of gross negligence in the context of penalties. 51 I make these findings in spite of Appellant's counsel's argument that the subject misrepresentations were made solely by Ms. Kulla's accountant and without her knowledge. While it is

308 not necessary for me to make a finding on the point, it is a fine line between authorities that suggest one can attribute the negligence or gross negligence of the accountant and authorities that refer to turning a blind eye to the negligence of one's agents. Whether Ms. Kulla knew exactly what the accountant was doing is irrelevant. He was her authorized agent. He was Sandia's authorized agent. Whether or not she had a proper understanding of the accounting methods used in the reporting of her income and that of Sandia in 1993 and subsequent years, she must have been aware not only that income was not declared but that the books were being manipulated to achieve this result. Indeed I have little doubt she was likely an active player in the covert structuring of or restructuring of the transactions in issue in respect of calculating and reporting both her income and that of Sandia. 52 Further, I make these findings in spite of arguments that Ms. Kulla was just carrying on what her husband set up. Her husband trusted the accountant for 25 years without problems -- why should she be expected to question his methods? Well, his methods did change under her watch so even if following someone you thought you can trust were a determinative factor in this case, which it is not, the facts do not support the argument. Examples of changes under her watch are the creation of rent adjustments and not filing returns on time. Returns for 1994, 1995, 1996 and 1997 were not filed until roughly the time that 1997 returns were required to be filed. This was due to waiting to see if a loss acquisition could be used to save taxes. Ms. Kulla had to know tax returns were to be filed annually. She had to know this was not done for at least three years. She had to know that they were not filed because there were reorganization and take-over plans being considered to utilize another company's losses. She had to know that despite S & S being profitable, neither S & S, Sandia or her personal return allowed for that income to be taxed. This speaks to her credibility that she knew nothing. 53 Accordingly, I find the assessment of Ms. Kulla's 1993 and subsequent years, 1994 through 1996, were assessed within the time permitted under section 152(4). 54 The basis of such finding also supports a finding of gross negligence which is the threshold test for imposing penalties under 163(2). That subsection imposes the penalties assessed on every person who, knowingly, or under circumstances amounting to gross negligence, has made or has participated in, assented to or acquiesced in the making of a false statement or omission in a return, form, certificate, statement or answer filed or made in respect of a taxation year. Applying the test for what constitutes gross negligence as set out in Venne v. The Queen15 warrants finding that there has been gross negligence in this case. The test there sets out that gross negligence must be taken to involve greater neglect than simply a failure to use reasonable care. It must involve a high degree of negligence tantamount to intentional acting or indifference as to whether the law is complied with or not. I have little doubt that Ms. Kulla knew of and approved of or concurred with the accountant's attempts to avoid the application of applicable taxing provisions by failing to report income required to be reported. Even if she was not directly involved there was a knowing concurrence that satisfies the test in Venne. Accordingly, the application of 163(2) penalties is affirmed for Ms. Kulla's years 1993 through 1999 inclusive. 55 Similarly in respect of Sandia, Ms. Kulla was the directing mind behind the company. Her gross negligence constitutes the gross negligence of the company. The 1993 financial statements for Sandia, approved by Ms. Kulla, were dated January 1994. That is, even though 1993 returns for Sandia would have been filed earlier than when Ms. Kulla filed her 1993 return, I do not see that the difference of those few months as assisting Sandia. Accordingly, Sandia's 1993 taxation year was assessed within the time permitted under subsection 152(4) and the application of 163(2) penalties is affirmed in respect of all years assessed -- 1993-1999 inclusive. 56 Lastly, I note that the late filing penalties assessed against Sandia have not been challenged and will stand.

309

Lust v. R. [2007] 3 C.T.C. 23 (FCA) MALONE J.A.: I. Introduction 1 The appellant is a self-employed researcher and has worked for a number of years to develop a leaching technology for the extraction of gold from raw ore (the Process). Mr. Lust appeals to this Court from a judgment of a Judge of the Tax Court of Canada (Judge) dated July 30, 2004 (unreported), which upheld personal assessments against him for the taxation years 1998 and 1999 totalling $117,849 inclusive of interest. 2 The Minister of National Revenue (Minister) grounded these assessments on subsection 15(2) and section 80.4 of the Income Tax Act, R.S.C. 1985, c. 1 (5th Supp) (Act), having determined that certain expense monies advanced to Mr. Lust were loans received in his capacity as the majority shareholder of Extrac Minerals Ltd. (Extrac) that remained unpaid (see Respondent's Reply at paragraph 3). Extrac is an Alberta company that Mr. Lust incorporated to advance the development and promotion of the Process. 3 In case of reference, subsection 15(2) is reproduced in part as follows:

15(2)Where a person (other than a corporation resident in Canada) or a partnership (other than a partnership each member of which is a corporation resident in Canada) is (a) a shareholder of a particular corporation, ... and the person or partnership has in a taxation year received a loan from or has become indebted to the particular corporation, any other corporation related to the particular corporation or a partnership of which the particular corporation or a corporation related to the particular corporation is a member, the amount of the loan or indebtedness is included in computing the income for the year of the person or partnership [Emphasis added]. (2.6) Subsection 15(2) does not apply to a loan or an indebtedness repaid within one year after the end of the taxation year of the lender or creditor in which the loan was made or the indebtedness arose, where it is established, by subsequent events or otherwise, that the repayment was not part of a series of loans or other transactions and repayments. *** II. Proceeding in the Tax Court of Canada 4 The appellant appealed the assessments to the Tax Court of Canada under its informal procedure. Although it is difficult to characterize Mr. Lust's various complaints before the Tax Court, his core argument was that the Minister erroneously interpreted the meaning of a July 17, 1995 contract (the Development Agreement) between Pre-Min Resources Ltd., a Saskatchewan corporation (Pre-Min), and Extrac as well as the nature of certain expense monies advanced there under. 5 Mr. Lust gave evidence and called two witnesses from Canadian Revenue Agency (CRA). The evidence of Brenda Gay Rahier, who was in the Verification and Enforcement Branch of CRA at the time of Mr. Lust's reassessment, is relevant to the current appeal. No witnesses were called by the Minister.

310 6 While Mr. Lust did not retain legal counsel and the court record is somewhat muddled, the following facts are uncontested: (a) Mr. Lust incorporated Extrac and was at all material times a director and majority shareholder of that company. No income tax returns were ever filed on behalf of Extrac because, according to Mr. Lust, it never had income to report. (b) Mr. Lust was also a director of Pre-Min until 2001. (c) The Development Agreement was drawn by Mr. Lust who has no legal training and no legal or tax advice was ever sought or obtained prior to its execution. (d) Under the Development Agreement, Pre-Min obtained from Extrac the worldwide rights to use the Process. Extrac agreed to supply, pay for and make available to Pre-Min its proprietary chemicals used in the Process. In return, Pre-Min agreed to pay Extrac a gross overriding royalty of 5% on all ore processed. (e) Because the Process still needed refinement, section 7 of the Development Agreement was drafted to cover certain start-up expenses, including the purchase of equipment and chemicals by Extrac, and its promotion of the Process. It reads as follows: i. 7. Pre-Min agrees to pay for the development of the process until such time that the royalty payments to Extra cover these expenses. Pre Min in the interim will supply to Extrac and/or Donald Lust expense money to work on the process as a loan the amounts to be determined from time to time by mutual agreement. This loan is to be repaid out of the 5% royalty to be paid to Extrac upon going into production at a mutually agreed upon rate. (f) Under Clause 7 of the Development Agreement, Pre-Min advanced directly to Mr. Lust $50,000 in 1998 and $60,000 in 1999. Neither amount has been repaid to Pre-Min according to its balance sheet placed in evidence. Specifically, the Pre-Min balance sheet for 1999 lists these amounts as loan receivables owed by Extrac. (g) None of these direct advances to Mr. Lust were ever repaid. (h) Pursuant to formal notices dated March 19, 2001, the Minister increased the appellant's income in the following terms and in the following amounts:

311

1998 Subsection 15(2) shareholder loan Subsection 80.4 interest benefit Total 1999 Subsection 15(2) shareholder's loan Subsection 80.4 interest on benefit Total

$50,000 $ 1,424 -------$51,424 $60,000 $ 6,425 -------$66,425

7 In his reasons, the Judge first reviewed the wording of the Development Agreement and determined that Pre-Min and Extrac were the only parties to that agreement and that the funds advanced by Pre-Min were not loans to Mr. Lust personally, but rather were loans to Extrac. As no receipts were placed in evidence by Mr. Lust for any of the alleged expenditures, the Judge reluctantly determined that the appellant had "siphoned off" all of the advances for his own use, thus giving rise to the Minister's assessments, which he confirmed. There is no analysis in his reasons as to the application of subsections 15(2) of the Act. III. Analysis 8 The purpose of subsection 15(2) is to include in a shareholder's income amounts received from a corporation in the guise of loans or other indebtedness. In his reply to the appellant's notice of appeal, the Minister characterized the funds received by Mr. Lust as subsection 15(2) shareholder loans and relied on a number of assumptions including the following: j) the Payments were a loan made to Extrac and not to the Appellant; ... l) Extrac is responsible for the repayment of the loan; m) the Appellant received the Payments in his capacity as majority shareholder of Extrac; 9 In my analysis, the Judge correctly determined that the parties to the Development Agreement were Pre-Min and Extrac, and not Mr. Lust, and that Extrac was responsible to repay the loan. Mr. Lust was mistaken that he was a party to that agreement. The Judge also correctly determined that Clause 7 amounted to a direction from Extrac to Pre-Min to pay expense advances to Extrac and/or Mr. Lust in the amounts and at the times agreed upon by these two corporate parties. Essentially, Mr. Lust was a third party to the Development Agreement and was expected to use the money for the benefit of Extrac for developing and promoting the Process. On this evidence, assumptions j) and l) advanced by the Minister that the payments were made as a loan to Extrac stand. 10 A dispute exists, however, as to the nature of the benefits received by Mr. Lust; i.e. are they shareholder loans as the Minister alleged in his notice of March 19, 2001 or is there another basis for Mr. Lust's indebtedness to Extrac for the purpose of that subsection? (1) Shareholder Loan? 11 The evidence on this point comes from Ms. Rahier, a CRA auditor. Her testimony is reproduced below: Mr. Grewal, Counsel for the Respondent, Cross-Examines the Witness:

312 Q Miss Rahier, can you tell us why you assessed this money as a loan to (sic) Extrac to the Appellant rather than a straight appropriation of the money? A I considered it an appropriation. That was the original letter. And went towards 15(2), which the Income Tax Act simply says, any loans or indebtedness of a shareholder to its company can be assessed to the shareholder. ... in your capacity as the shareholder of Extrac [you] are responsible for those funds since they were paid in your name. We assessed you as if they were a loan so if you did, in the future, repay them or prove the expenses, you could be allowed a deduction. ... So it's actually a loan. It's not a loan between you and Extrac. It's an indebtedness that you've created by being paid from Pre-Min for money that's supposed to be Extrac's (Appeal Book, page 283 at lines 13-14). 12 There is no doubt that by receiving the expense monies and using some of it for his own personal use Mr. Lust received a benefit. However, there is no evidence that the money paid directly to Mr. Lust by Pre-Min was a shareholder loan by Extrac to Mr. Lust, a fact of which CRA officials were aware of (Appeal Book at page 283, lines 10-13). The only repayment requirement that is evident from the record is Extrac's obligation to repay Pre-Min. It is noteworthy that the reported cases in connection with subsection 15(2) involve a direct loan of money by a corporation to the shareholder (see, for example: Lavoie v. Canada (1995), 95 D.T.C. 673 (T.C.C.); Newton v. Canada, [1997] 3 C.T.C. 2631 (T.C.C.); Meeuse v. Canada (1994), 94 D.T.C. 1397 (T.C.C.)). (2) Another basis of Indebtedness? 13 In his reasons, the Judge failed to characterize the nature of the indebtedness, which he determined did exist (see Appeal Book at page 14, lines 15-17). The question must be asked, therefore, is there a legal basis on which to find that Mr. Lust was obliged to pay to Extrac a sum equivalent to the amounts advanced to him by Pre-Min? In my analysis, there is as far as the advances have been used by Mr. Lust for personal expenses. 14 Under Clause 7 of the contract, Mr. Lust has received money which another, Extrac, is liable to repay to Pre-Min. In other words, Mr. Lust received a benefit from Pre-Min at Extrac's expense, for which he is liable to Extrac for unjust enrichment, if indeed the enrichment is unjust. Whether an enrichment is unjust depends on whether there is an enrichment of the defendant, a corresponding deprivation of the plaintiff, and an absence of juristic reason for the enrichment (see Garland v. Consumers' Gas Co., 2004 SCC 25, [2004] 1 S.C.R. 629 at para. 30, 237 D.L.R. (4th) 385). 15 In purchasing this benefit for Mr. Lust under Clause 7, Extrac cannot be taken to have intended to make him a gift. Corporations cannot normally give away company property to a shareholder. However, Extrac, and its shareholders, have an interest in the development of the Process, since this will enable them to earn royalties from Pre-Min. Hence, if the money advanced by Pre-Min to Mr. Lust was spent on this purpose, the advance was for the benefit of Extrac. 16 A person is liable in restitution to pay for benefits acquired as a result of services rendered by another if the services were requested. In my view, Clause 7 is a sufficient indication that Extrac requested that the advances to Mr. Lust be spent on the Process. In these circumstances, Mr. Lust would not be unjustly enriched at Extrac's expense as long as he spent the money on developing and promoting the Process. 17 The Minister assumed that the entire advances from Pre-Min were spent on Mr. Lust's living expenses. Mr. Lust would not produce into evidence any receipts for chemicals and equipment purchased for the Process due to confidentiality issues. However, he did produce receipts for

313 expenses for accommodation, meals and fuel incurred for promotional activities. He said at one point that more than half of the advances were spent on purchasing supplies for the Process over the entire period from 1996 to 1999. 18 His evidence was less clear when it came to the 1998 and 1999 taxation years, by which time most of the equipment had been purchased. Consequently, he said that he must have spent a significant portion of the advances in those years on promotion, which, as I understand it, he estimated at $1,000 per month. The Judge discussed this issue with Mr. Lust at pages 24-26 of the transcript and it is the subject of cross-examination and further discussion at pages 51-63. 19 The Judge believed that Mr. Lust had spent some of the money on the stipulated purposes; however, he declined to allow him to deduct any amounts in the absence of receipts (see Appeal Book at page 15, lines 6-21). He believed that Mr. Lust could get back from the company any money that he had spent on purchasing chemicals. On this evidentiary record, I do not think that it is possible to say that the Judge made a palpable and overriding error in concluding that there was not adequate proof of what portion of the advances Mr. Lust had spent for the benefit of the company as opposed to personal expenses. Accordingly, unjust enrichment has been established. IV. Conclusion 20 In summary, Mr. Lust was indebted to Extrac on the basis of unjust enrichment for the amount of the advances used for his personal expenses. In the absence of evidence of how much he spent for the benefit of the company, he is liable to Extrac, for the full amount, which must be included in his income for 1998 and 1999. When and if Extrac pays Pre-Min, Mr. Lust may be called upon to discharge his indebtedness to Extrac. At that time he will then be able to deduct any payment that he makes to Extrac from his income for that year. 21 Accordingly, I would dismiss the appeal but without costs.

Davidson v. R
1999 CarswellNat 715, [1999] 3 C.T.C. 2159, 99 D.T.C. 933 (TCC) Appeal by taxpayer from inclusion of loan in income. Bowie T.C.J.: 1 The issue in this appeal is whether the Appellant, at the time she received a certain loan, made bona fide arrangements for its repayment within a reasonable time. If she did, then the requirements of subsection 15(2) of the Income Tax Act (the Act) are met. If she did not, then they are not met, and the amount of the debt is to be taxed as income in her hands in the 1990 taxation year. 2 The following are the pertinent parts of subsection 15(2), as it read at the relevant time: Where a person (other than a corporation resident in Canada) or a partnership (other than a partnership each member of which is a corporation resident in Canada) is a shareholder of a particular corporation, is connected with a shareholder of a particular corporation or is a member of a partnership, or a beneficiary of a trust, that is a shareholder of a particular corporation and the person or partnership has in a taxation year received a loan from or has become indebted to the particular corporation, to any other corporation related thereto or to a partnership of which the particular corporation or a corporation related thereto is a member, the amount of the loan or indebtedness shall be included in computing the income for the year of the person or partnership, unless

314 (a) ... (ii) in respect of an individual who is an employee of the lender or creditor or the spouse of an employee of the lender or creditor to enable or assist the individual to acquire a dwelling... and bona fide arrangements were made, at the time the loan was made or the indebtedness arose, for repayment thereof within a reasonable time; or 3 Counsel for the Appellant set out in writing the following facts, which are not in dispute. 1. At all relevant times the Appellant was an employee and shareholder of 3408 Investments Ltd. (the Company). 2. On or about August 28, 1990, the Company advanced a loan to the Appellant in the amount of $95,000 to enable the Appellant to acquire a personal residence (the Housing Loan). The loan was interest free. 3. The Appellant provided the Company with two demand promissory notes in the aggregate amount of $95,000 ($70,000 and $25,000) as security for the Housing Loan. 4. At the time that the Housing Loan was made, the sole director of the Company, Ken Davidson (the husband of the Appellant) passed a resolution approving the making of the Loan. This resolution is evidenced in writing. 5. The Appellant included interest calculated in her income as interest pursuant to section 80.4 of the Income Tax Act (the Act) in her income in each year in respect of the Housing Loan. 6. By Notice of Reassessment dated May 12, 1994 the Minister of National Revenue reassessed the Appellant to include in her income for the 1990 year the amount of the Housing Loan, pursuant to subsection 15(2) of the Act, on the basis that no bona fide arrangements were made for the repayment of the loan within a reasonable time. 7. By Notice of Reassessment dated July 15, 1996 the Minister reassessed the Appellant in respect of her 1990 taxation year, pursuant to subsection 165(3) of the Act by, inter alia, decreasing her income by $3,356 in respect of loan interest, but otherwise confirmed the inclusion of the Housing Loan in her income for the year. It is therefore common ground that the Appellant is entitled to succeed in this appeal if she can shown that bona fide arrangements were made to repay the loan within a reasonable time.

4 Mrs. Davidson's husband testified that, following a career in banking, he took a job with the British Columbia Enterprise Corporation, where he worked during the latter part of the 1980s. Initially, most of his work was in Vancouver, but as time went on it took him increasingly to Victoria. Eventually, his employer requested that he move to Victoria, which he agreed to do in 1990. Mr. and Mrs. Davidson had a young family, and they decided to buy a house in Victoria. For this they had to borrow $95,000. 5 The arrangement by which they chose to fund the purchase was this. Mr. Davidson had earlier formed the Company. He owned 35% of the shares, all of class A. The Appellant owned 35%, and the remaining 30% were held by a trust for their minor children, of which Mr. and Mrs. Davidson were the trustees. The Appellant's and the trust's were class B shares. The Company had assets of $90,000 in the form of term deposit certificates which were to mature in September 1990, shortly after the closing of their house purchase in Victoria, which was to take place at the end of August. The Company borrowed $90,000, which it then loaned to the Appellant, who used it to make the down payment on the house. The proceeds of the term deposits were then applied in September to retire the Company's bank loan. 6 Mr. Davidson was aware that there were certain requirements that had to be met to avoid tax becoming payable on the full amount of the loan. He said in his evidence that he had an informal discussion with a tax lawyer at the Vancouver firm of Russell & Dumoulin about this proposed method of financing the purchase, and was advised that, in order to avoid the pitfalls of subsection 15(2) of

315 the Act, bona fide arrangements must be made for repayment within a reasonable time. This, he was told, meant five years. The director's resolution and the promissory notes were prepared for him by other lawyers in the firm, one a business lawyer and the other a tax lawyer. The lawyer whom he consulted corroborated this evidence. 7 Mr. and Mrs. Davidson both testified that they discussed the matter of repayment prior to the transaction, and that they agreed that the loan would be repaid within the five-year period. The repayment was to be effected by declaring a dividend on the class B shares of $90,000, which would be used to repay the loan. At that time Mrs. Davidson was pursuing studies at Kwantlen College in Vancouver. Their original intention was that she would resume her course at Camosan College in Victoria in the fall of 1991, and complete it by the fall of 1992, and then be able to re-enter the work force. At this time she would have income that would enable her to pay the tax that would be eligible on the dividend. 8 The first problem that arose for the Appellant was that, when she applied for admission to Camosan College in Victoria, she discovered that it was not possible to complete the course that she had begun in Vancouver in one year, as she had planned. She and Mr. Davidson then amended their original plan. Instead, she enrolled in a course at the University of Victoria, and they decided to declare the dividend and effect the repayment of the loan in January, 1994. This would be well within the five-year period agreed on earlier, and would give her until April 1995 to pay the tax on the dividend. 9 The Appellant's second problem arose in the fall of 1993, when Revenue Canada decided to audit the company, and this loan transaction attracted the attention of the auditor. Mr. Davidson testified that he told the auditor of their plan to make repayment within the five-year period, but the auditor, unmoved by this, reassessed Mrs. Davidson for the 1990 year on the basis that there was no bona fide arrangement made in August 1990 for repayment of the loan within a reasonable time. He also testified that the repayment was not made in 1993, or thereafter, only because the Revenue Canada auditor told him that they should not do so pending the completion of the audit. Nor was repayment made in 1995, because by then Mrs. Davidson had paid the tax pursuant to the reassessment. If the appeal succeeds, he said, then the repayment will be made. 10 The question whether the Act's requirement that a bona fide arrangement for repayment be made at the time of the loan transaction raises a number of questions in the context of these facts. 1. Must the arrangement for repayment be in writing, either as part of the borrowing document, or otherwise? 2. Must the arrangement be contractually binding? 3. Must the arrangement provide for repayment on a date certain? 4. Does the requirement that there be a bona fide arrangement require that the Court examine the proposed source of the funds from which repayment will be made? If so does the proposed use of the dividend to be paid on the trust's shares negate the bona fides of the arrangement? 5. If it is found that a bona fide arrangement was made as the Act required, is it negated by the failure to make the repayment in accordance with that arrangement? Before I address these questions, however, I wish to make two observations. The first is that the Respondent, quite correctly in my view, did not suggest that five years is more than a reasonable time for the repayment of a housing loan. Counsel for the Respondent put the case squarely on the basis that the Appellant and her husband were not to be believed. He referred to their evidence as reverse tax planning, by which he really meant ex post facto tax planning, or, less politely, fabrication of a story which would meet the requirements of subsection 15(2) after the audit began. Regrettably, he did not put this theory to the witnesses when they testified. He cross-examined Mr. Davidson only briefly, and made no suggestion to him that his evidence concerning the repayment arrangement was

316 a fabrication. He did not cross-examine the lawyer at all. His cross-examination of the Appellant was even more brief than that of her husband, and it too did not even hint at an issue of credibility. Counsel who proposes to invite a finding that the other party's witnesses are lying has a duty to raise that with them when cross-examining. Failure to do so is unfair to the witness, and ought not to be countenanced.* In these circumstances, I will not make a finding that the witnesses fabricated their evidence. 11 The second observation which I make here is that it is apparent that the Appellant's husband was the architect of the arrangement by which the down payment was to be made. Mrs. Davidson's evidence indicated that she was, at best, vaguely conversant with the manner in which the arrangement was to work. I do believe, however, that she acquiesced in what her husband proposed, and, in particular, that she agreed with him that repayment would be made before the elapse of five years from August 28, 1990. She did so because she believed that that was what the Act required of her if she was not to be taxed on the full $90,000 in 1990. The purpose of the loan, and its repayment at a later date, was to permit the Appellant and her husband to use the $90,000 accumulated in the Company as a down payment, while deferring the need to pay income tax on the dividend until a later date. There is, of course, nothing wrong with that, so long as the arrangement for repayment meets the requirements of the Act. 12 I turn now to the questions which I have identified above.

question 1 13 I see no reason to require that the arrangement for repayment be part of the instrument which evidences the borrowing, or that it be in writing at all. No such requirement is imposed by the words of paragraph 15(2)(a). Had Parliament wished to require a written arrangement, it could easily have added the words in writing. I have no mandate to add words to the Act, absent something in the context requiring it.* question 2 14 Parliament's use of the expressions bona fide arrangements in the English version and des arrangements ont t conclus de bonne foi in the French version seems clearly intended to include arrangements which are not contractually binding. The plain meaning of the word arrangement, in both languages, indicates that. The proper meaning of the word, in the context in which it appears, is as it was described by Lord Denning, giving the advice of the Privy Council in Newton v. Commissioner of Taxation of the Commonwealth of Australia:* Their Lordships are of opinion that the word arrangement is apt to describe something less than a binding contract or agreement, something in the nature of an understanding between two or more persons a plan arranged between them which may not be enforceable at law. This describes accurately the arrangement made between the Appellant and her husband, acting for the Company. question 3 15 Counsel for the Respondent relies on the decisions of this Court in Kanters* and Perlingieri,* and on the decision of the Federal Court of Appeal in Silden,* for the proposition that without a date certain being specified for repayment of the loan there cannot be compliance with the requirements of paragraph 15(2)(a). In Kanters, the loan was made by an oral agreement, with no provision for repayment being discussed. The intent was apparently that repayment would be made when the borrower became financially able to do so. In Perlingieri , the loan was payable on demand, but there

317 was no collateral arrangement, as there is here, as to when repayment would take place. The loan in Silden was to be repaid by the Appellant to his employer only if he left the company's employ, or if he ceased to own the house. Pratte J.A., speaking for the Court, said:* The real question therefore is not whether the arrangements relating to the repayment of the loan were reasonable but whether, pursuant to those arrangements, the loan was to be reimbursed within a reasonable time. That question cannot, in this instance, be answered in the affirmative since the arrangements that were made at the time of the loan did not permit to determine with any certainty the time within which it had to be reimbursed. 16 It is not a provision for repayment on a date certain which the Act requires, but simply an arrangement for payment within a reasonable time. In the present case there was an arrangement which placed a five year limit on the duration of the loan, a factor which was not present in any of the cases relied on by counsel for the Respondent. This is sufficient to satisfy the requirement for an arrangement for repayment within a reasonable time. Support for this result is found in the judgment of McArthur J. in Dionne c. R.* question 4 17 I expressed some concern during the hearing of this appeal about the evidence of Mr. Davidson to the effect that his intention, which I believe the Appellant subscribed to, was that the house loan would be repaid to the Company with the proceeds of a dividend of $90,000 to be declared on the class B shares, 46% of which were owned by the trust for minor children. It appeared from his evidence that the intention was to apply the dividend payable to the trust against the Appellant's indebtedness. I raised the question whether this was a bona fide arrangement. Counsel for the Respondent did not address this in argument. The position of counsel for the Appellant, as I understood him, was that the expression bona fide in paragraph 15(2)(a) modifies only the obligation or the intent to make the repayment, and that the Court ought not to inquire into appropriateness of the intended source of funds. Upon consideration, I have concluded that the sphere of inquiry which this paragraph in the legislation raises does not go beyond the genuineness of the Appellant's intention to repay the loan in accordance with the requirements of the arrangement. Evidence tending to show that funds will, or conversely will not, be available to satisfy the debt at the appropriate time is relevant to this inquiry, but it must be weighed along with all the other evidence relevant to the bona fides of the arrangement. 18 I do not believe that Mr. Davidson's evidence as to his intention to use the dividend to repay the loan negates the bona fides of the arrangement in this case. There is no evidence before me as to the terms of the trust, nor does the evidence establish that Mr. and Mrs. Davidson, in their capacity as the trustees, would simply make a gratuitous payment of trust funds for the benefit of Mrs. Davidson. Mr. Davidson said in his evidence that if necessary they could borrow the funds, or part of them, to make the repayment when the time came. They might well have done so, either as the result of taking legal advice, or otherwise. question 5 19 Counsel for the Respondent asks me to consider the fact that the loan had not been repaid at the time of the hearing, some eight years after the indebtedness arose, and three years after the date when, according to the evidence, repayment was to be made. As with the previous question, I start with the observation that what the Act calls for is a bona fide arrangement made at the time the loan was entered into. If that is established, then the Appellant is saved from the inclusion of the amount of the loan in the computation of income that would otherwise flow from the opening words of subsection 15(2). Again, if Parliament had intended to deny the taxpayer the benefit of non-inclusion in those

318 cases where the arrangement for repayment was not fulfilled, it could easily have enacted words to bring about that result. 20 Evidence that payment was not made in accordance with the arrangement is relevant to the issue of bona fides, but it is not conclusive on that issue. It calls for an explanation, and the explanation given by both the Appellant and her husband was that the Revenue Canada auditor told Mr. Davidson, in effect, that the status quo should be maintained until the audit was completed. Completion of the audit brought with it the assessment now under appeal. The Appellant has paid the tax, and it is understandable that she would not wish both to pay the tax under section 15, and also to repay the loan to the Company, which is now dormant, and have to pay tax a second time on the same $90,000 when a dividend is declared. I do not accept counsel's suggestion that the Appellant was bound to call the auditor to corroborate the evidence as to this discussion. If it was not true, then the Respondent could have called the auditor to give that evidence. No such suggestion was even put to Mr. Davidson or Mrs. Davidson in cross-examination. I accept their explanation, and I find that the fact that the loan was not repaid within the five year period does not detract from the bona fides of the original arrangement. 21 To summarize, I find that when the housing loan was made from the Company to the Appellant in 1990 there was a bona fide arrangement made at the same time that she would repay it within five years. I also find that five years was, in the context, a reasonable time. 22 The appeal is allowed, with costs. Appeal allowed.

Interpretation Bulletin IT-119R4 - Debts of Shareholders Certain Persons Connected With Shareholders
Date: August 7, 1998 (This bulletin is still the current law as of January 2012) Shareholders are generally taxable on amounts received from a corporation. The purpose of subsection 15(2) is to include in a shareholder's income amounts received from a corporation in the guise of loans or other indebtedness, with specific exceptions provided in the law. This bulletin discusses the tax implications to a person or partnership who is a shareholder of a corporation, connected with a shareholder of the corporation, or who owns shares of the corporation through a partnership or trust, of a loan or indebtedness from that corporation, a related corporation or a partnership of which that corporation or a related corporation is a member. It comments on the factors that determine whether or not the loan or indebtedness must be included in the income of the debtor and on the timing of such inclusion. It also discusses the deductibility of repayments and the effect of a series of loans and repayments. The various issues are discussed under the following main headings: General 1. A person or partnership, described in 2 below, that has in a taxation year received a loan from or become indebted to (a) a particular corporation; (b) any other corporation related to the particular corporation; or (c) a partnership of which the particular corporation or a related corporation is a member,

319 will be required to include the amount of the loan or indebtedness (hereinafter referred to as the "loan") in income for that year under subsection 15(2), unless the loan comes within the exceptions discussed in this bulletin. An entity described in (a), (b), or (c) is referred to herein as the "lender" or "creditor," depending on the circumstances. Loans that are not subject to subsection 15(2) may give rise to a benefit included in income under subsection 15(1) pursuant to subsection 15(9), if no interest or a low rate of interest is charged. For comments concerning taxable benefits arising from interestfree or low-interest loans, see the current version of IT-421, Benefits to Individuals, Corporations and Shareholders from Loans or Debt. 2. The "person or partnership" referred to in 1 above is a person (other than a corporation resident in Canada) or a partnership (other than a partnership each member of which is a corporation resident in Canada) that is (a) a shareholder of the particular corporation in 1(a) above; (b) connected with a shareholder of the particular corporation (see 5 below); or (c) a member of a partnership, or a beneficiary of a trust, that is a shareholder of the particular corporation. An entity referred to in (a), (b), or (c) is referred to herein as the "borrower" or "debtor," depending on the circumstances. 4. The phrase "a taxation year," in subsection 15(2), refers to that of the borrower. The date on which a loan was made determines the taxation year of the borrower in which the loan is included in income under this subsection. For example, if subsection 15(2) applies to a loan that a corporation makes to an individual on November 30, 1995, and the loan falls in the corporation's taxation year ending on June 30, 1996, the loan will be included in the individual's 1995 income. If the borrower is a partnership, the phrase "a taxation year," in subsection 15(2), means the fiscal period of the partnership. Similarly, when the lender is a partnership, the phrase "the taxation year" referred to in subsection 15(2.6) means the fiscal period of that partnership. 6. When a loan or other obligation of a shareholder to a corporation is settled or extinguished by payment of less than the amount of the obligation outstanding, or by no payment, subsection 15(1.2) determines the value of the benefit that is to be included in the shareholder's income under subsection 15(1). Subsection 15(1.2) deems the value of the benefit to be the "forgiven amount" at the time the loan was settled or extinguished, the "forgiven amount" being defined in subsection 15(1.21). See the current version of IT-432, Benefits Conferred on Shareholders, for a discussion of subsection 15(1.2). Exceptions: Loans Made for Specific Purposes General 7. If a borrower can establish that a loan falls within the provisions of one of subsections 15(2.2) to (2.6), the loan will not have to be included in income under subsection 15(2). The provisions of subsection 15(2.3) to (2.5) provide for exceptions to including loans in income when the loan is provided for a specific purpose whereas subsections 15(2.2) and (2.6) simply provide that subsection 15(2) does not apply to loans when certain circumstances exist. Subsection 15(2.2) is described in 37 below, while subsections 15(2.3) to (2.5) are discussed in 8 to 23 below and subsection 15(2.6) is discussed in 24 to 29 below. While a written agreement is the preferable means of establishing that a loan exists, a written agreement is not necessary; however, in its absence there must be convincing evidence that a loan exists. Such evidence could include a corporate resolution setting out the loan, the terms of its

320 repayment and such a corporate resolution should be reflected in the financial statements of the corporation. 8. The exception in subsection 15(2.3) applies when the loan is made to borrowers (whether or not they are employees) if the loan is made in the ordinary course of the lender's business (see 15 and 16 below) and bona fide arrangements were made, at the time the loan was made, for repayment within a reasonable time (see 12 below). 9. (a) (b) (c) (d) (e) (f) The exception in subsection 15(2.4) applies when the loan is made to: an individual who is an employee of the lender but not a specified employee of the lender (see 22 and 23 below), pursuant to paragraph 15(2.4)(a); an individual who is an employee of the lender or is the spouse of an employee of the lender to acquire a dwelling (see 17 - 19 below), pursuant to paragraph 15(2.4)(b); an employee to acquire previously unissued fully paid shares of a corporation (see 20 below), pursuant to paragraph 15(2.4)(c); or an employee to acquire a motor vehicle to be used in the performance of the employee's job (see 21 below), pursuant to paragraph 15(2.4)(d); where for loans made after April 25, 1995, it was reasonable to conclude that the employee or the employee's spouse received the loan because of the employee's employment and not because of any person's shareholdings, and at the time the loan was made, bona fide arrangements were made for repayment of the loan within a reasonable time (see 12 below).

For the purposes of paragraph 15(2.4)(e), as described in (e) above, a loan is considered to have been made after April 25, 1995, if the funds are advanced to the borrower after that date. 10. The exception in subsection 15(2.5) applies when a loan is made in respect of a trust, if all the following conditions are met: (a) (b) (c) the lender is a private corporation; the corporation is the settlor and sole beneficiary of the trust; the sole purpose of the trust is to facilitate the purchase and sale of the shares of the corporation or a related corporation at their fair market value from or to the employees of the corporation or the related corporation (other than, for loans made after June 19, 1996, to employees who are specified employees of the corporation or of a related corporation); and at the time the loan was made, bona fide arrangements were made for repayment of the loan within a reasonable time (see 12 below).

(d)

11. Whether or not a loan made by a corporation to an individual is considered to have been received by that individual in his or her capacity as an employee or as a shareholder involves a finding of fact in each particular case. When a public corporation makes a loan to a shareholder on the same terms and conditions as to other employees who are not shareholders, the loan is normally considered to be a loan received by virtue of that individual's office or employment rather than his or her shareholdings. However, when the opportunity to borrow funds is only made available to shareholders or when the terms and conditions attached to loans to employee-shareholders are more favourable than those attached to loans to other employees, the loan will be considered to have been made to the employee-shareholder in his or her capacity as a shareholder unless the facts clearly indicate otherwise. 12. In considering whether any arrangements for repayment were bona fide, the extent to which the arrangements have been carried out by the borrower is reviewed and, if the borrower is in default, any unusual circumstances that might have hindered them from being carried out. Whether or not the

321 period allowed for repayment is "within a reasonable time" is a question of fact. In a given situation, one of the factors considered in determining what is a reasonable time is the normal commercial practice which would prevail in a similar situation. For example, for a housing loan, normal commercial practice requires the borrower, among other things, to give the lender some security (not necessarily a mortgage) and to repay any balance on the loan should the property be sold while an amount is still owing. 13. As noted in 8 above, the exception in subsection 15(2.3) applies to loans made to borrowers whether or not they are employees, whereas the exceptions in subsection 15(2.4) apply when the borrowers are also employees of the lender or, in the case of paragraph 15(2.4)(b) relating to the acquisition of a dwelling, the spouse of such an employee. The exception in paragraph 15(2.4)(c), relating to the acquisition of shares, also applies to loans made to an employee of a corporation related to the lender. 14. The exceptions in paragraphs 15(2.4)(b) to (d) apply only if a specific loan was made for a qualified purpose described in one of those provisions and is used for that purpose. If a borrower also has other loans that do not qualify for one of these exceptions, the borrower must be able to prove that the part of the total balance of loans, that was used for a qualified purpose, meets all of the conditions necessary to qualify for that exception. This would normally require that any loan which qualifies for one of the exceptions in paragraphs 15(2.4)(b) to (d) be maintained in a separate account. Employee and Specified Employee 22. An "employee" is defined in subsection 248(1) to include an officer; consequently, a director of a corporation is an employee. In subsection 248(1), a "specified employee" of a person is defined as an employee of the person who is a specified shareholder of the person or who does not deal at arm's length with the person. A "specified shareholder" of a corporation means a taxpayer who owns, directly or indirectly, not less than 10% of the issued shares of any class of the capital stock of the corporation or of any other corporation that is related to the corporation. 23. Subsection 15(2.7) provides that for the purposes of section 15, an individual who is an employee of a partnership is deemed to be a specified employee of the partnership where the individual is a specified shareholder of one or more corporations that, in total, are entitled, directly or indirectly, to not less than a 10% share of any income or loss of the partnership. Exception: Repayment Within One Year 24. Subsection 15(2.6) provides that if the loan is repaid within one year from the end of the taxation year of the lender in which the loan was made and if the repayment is not part of a series of loans or other transactions and repayments (see 28 and 29 below), the loan is not included in the income of the borrower under subsection 15(2). 25. The giving of a promissory note by a borrower or the assumption of the loan by another person does not constitute repayment of a loan received by that borrower. 26. A loan need not necessarily be repaid in money. The borrower can make repayments, wholly or in part, by a bona fide transfer to the lender of real or personal property. A transfer of property constitutes repayment only to the extent of the fair market value of the transferred property at the time of the transfer.

322 27. Repayments are considered to apply first to the oldest loan or debt outstanding ("first-in, firstout basis") unless the facts clearly indicate otherwise. Whether Repayment Is Part of a Series of Loans or Other Transactions and Repayments 28. It is a question of fact whether or not a repayment of a loan is part of a series of loans or other transactions and repayments. In most cases, when there are only a few loans or other transactions and a few repayments made during a taxation year of a lender, there is no such series. However, when only one loan or other transaction and one repayment occur in each taxation year of a lender, a series of loans or other transactions and repayments may still be in evidence. This could occur, for example, when a repayment is of a temporary nature, such as a loan that is repaid shortly before the end of the year and the same amount, or substantially the same amount is borrowed shortly after the end of the year. Such a repayment of a temporary nature is not considered to decrease the loan balance in applying subsection 15(2) and paragraph 20(1)(j) to a series of loans or other transactions and repayments (see 34 to 36 below). 29. Persons affected by subsection 15(2) may have loan accounts, drawings accounts, or other similarly named accounts that contain several charges for loans, payments made to third parties on behalf of the shareholder, advances against future salaries, rents or anticipated dividends or other charges, and one or more repayments. If a shareholder has an account with a number of these features (a running loan account), all of the relevant factors will be considered to determine whether a series of loans or other transactions and repayments exists. Bona fide repayments of shareholder loans that result from, for example, the payment of dividends, salaries, or bonuses, are not part of a series of loans or other transactions and repayments. Deduction of Repayment If Not Part of a Series 30. Paragraph 20(1)(j) provides that when a borrower has repaid all or part of a loan that was included in income for a preceding year under subsection 15(2), the amount of the repayment is deductible in calculating income for the year in which the repayment is made. However, no deduction is allowed: (a) if the borrower was a corporation, to the extent that the amount of the loan was deductible from its income for the purpose of calculating taxable income in the year the loan was made; or (b) if the repayment is made as a part of a series of loans or other transactions and repayments. 31. The comments in 24 to 29 above, on what constitutes a repayment and whether a repayment is part of a series of loans or other transactions and repayments, apply for the purposes of determining the deduction of a repayment as provided for in paragraph 20(1)(j). 32. As paragraph 20(1)(j) refers to a "taxpayer" and the Act defines a "taxpayer" as including a "person" and a "person" as including a legal representative after death, the deceased taxpayer's estate can claim the deduction under this paragraph in the year a repayment is made. In order to make the claim, the deceased must have included the amount of the loan in income in a preceding taxation year. 33. Paragraph 20(1)(j) applies to a partnership if a loan subject to subsection 15(2) has been included in calculating the income of the partnership in a preceding year and the partnership subsequently repays the loan. Application of Subsection 15(2) and Paragraph 20(1)(j) When "a Series"

323 34. When there is a series of loans or other transactions and repayments (see 28 and 29 above), the exception in subsection 15(2.6) does not apply unless bona fide repayments are made. Loans which do not meet this test are included in income pursuant to the opening words of subsection 15(2) without allowing the one year for possible repayment, unless they come within one of the other excepting provisions of subsections 15(2.3) to (2.5). 35. To determine the amount to be either included under subsection 15(2) or deducted under paragraph 20(1)(j) in calculating the income of a particular taxation year of the borrower, the account must be analyzed. A temporary repayment (see 28 above) is not considered to be a repayment and will not be recognized as a decrease of the account balance.

9. Indirect Payments and Benefits ss. 56(2)

The Act contains numerous provisions designed to prohibit the indirect transfer of property as a means of avoiding or reducing tax. These provisions attempt to prevent a taxpayer from avoiding taxation by treating payments directed by the taxpayer to a third party as having been received by the taxpayer or by treating a benefit conferred by the taxpayer on a related person in the context of certain reorganizations as an immediate or deferred capital gain. Subsection 56(2) has potential application in any situation where a payment or transfer of property is made to a person at the direction or concurrence of another taxpayer. It is intended to prevent a taxpayer from avoiding tax on income by directing an amount to a third party. A payment or transfer of property will be subject to subsection 56(2) where the following conditions are satisfied: i. ii. iii. iv. there is a payment or transfer of property to a person other than the taxpayer; the payment or transfer is pursuant to the direction of or with the concurrence of the taxpayer; the payment or transfer is for the taxpayer's benefit or for the benefit of some other person which the taxpayer desired to confer on the person; and; the payment or transfer would have been included in computing the taxpayer's income if it had been received by the taxpayer.

For some time, the focus was on the potential application of subsection 56(2) to income-splitting through the use of discretionally dividends. The CRA took the position that the payment of dividends represents a transfer of property to a person at the direction or concurrence of the other shareholders (generally in their capacity as directors). However, this line of reasoning was rejected by the Supreme Court of Canada in The Queen v. McClurg, 91 D.T.C. 5001 (S.C.C.). Dickson, C.J. stated at page 5012: Had a dividend not been declared and paid to a third party, it would not otherwise have been received by the taxpayer. Rather, the amount simply would have been retained as earnings by the company. Consequently, as a general rule, a dividend payment cannot reasonably be considered a benefit diverted from a taxpayer to a third party within the contemplation of subsection 56(2).

324 Unfortunately, Dickson, C.J. went on to suggest that the dividend sprinkling arrangement in McClurg was justified on the basis that the shareholder who received the dividends had made a real contribution to the business of the corporation. Although such remarks were clearly obiter and blur the distinction between a return on investment (dividends) and compensation for services performed (employment or business income), the CRA therefore took the position that subsection 56(2) would continue to apply to discretionary dividends unless the dividends represented reasonable compensation for services performed by the shareholder. The CRAs view, however, was rejected by the Federal Court-Trial Division in The Queen v. Neuman, 94 D.T.C. 6094 (F.C.T.D.) which again confirmed the inapplicability of subsection 56(2) although the recipient of the dividend did not make a valuable contribution to the corporation. The Neuman case was appealed to the Federal Court of Appeal which reversed the Trial Court decision. Not surprisingly, the matter was appealed to the Supreme Court of Canada and the taxpayer was again successful. Subsection 56(2) does not apply to a dividend sprinkling arrangement. As expected, the Department of Finance has moved to foreclose this income-splitting opportunity by legislative enactment, specifically in the form of a kiddie tax. See section 120.4.

Melville Neuman, Appellant v. Her Majesty the Queen, Respondent

1998 CarswellNat 685, [1998] 3 C.T.C. 177 (S.C.C.) Judge: L'Heureux-Dube, Gonthier, Cory, McLachlin, Iacobucci, Major, Bastarache JJ.

Iacobucci J.: 1 The principal question raised by this appeal is whether dividend income, paid by a closely held family corporation to a non-arm's length shareholder who has not contributed to or participated in the business of the corporation, in this case Ruby Neuman, should be attributed to the shareholder's spouse, The appellant Melville Neuman, for income tax purposes in accordance with s. 56(2) of the Income Tax Act, S.C. 1970-71-72, c. 63 as amended (the "ITA"). I conclude that s. 56(2) does not apply to dividend income such that the dividend income received by Ruby Neuman cannot be attributed to the appellant for income tax purposes. 1. Facts 2 The appellant was at all material times a lawyer with the Firm of Neuman, MacLean in Winnipeg. The appellant and his partners at the law firm each owned 1,285.714 common shares in Newmac Services (1973) Ltd.("Newmac"), which owned commercial property in downtown Winnipeg, including the offices of Neuman, MacLean. The appellant acted as secretary of Newmac. The appellant's wife. Ruby Neuman, had no involvement in the business of Newmac. 3 On April 29, 1981, the appellant incorporated Melru Ventures Inc. ("Melru") as a family holding company. Rothstein J. of the Federal Court, Trial Division found that Melru was incorporated for tax planning and income splitting purposes and that it had no other independent business purpose ((1993), [1994] 2 F.C. 154 (Fed. T.D.), at p. 160). 4 The capital structure of Melru provided for different classes of shares with different rights and privileges. The dividends were to be declared at the sole discretion of the directors; distributions could be done selectively among the various classes of shares. The rights and conditions of the Class "G" and "F" shares are as follows:

325 (a) the holders of Class "G" shares shall in each year, in the discretion of the directors, be entitled out of any or all profits or surplus available for dividend to non-cumulative dividends at such rate as may from time to time be declared on any such shares but not exceeding the equivalent of 1% per annum en "redemption price" above the maximum prime bank rates... all dividends paid or declared and set aside for payment in any fiscal year, after making payments on Class "G" shares and preference shares of dividends declared shall be paid firstly on Class "F" shares until dividends aggregating 1 per share on the Class "F" shares then outstanding have been paid and then any additional dividends shall be set aside for payment on common shares until the common shares then outstanding shall have received 1 per share and any additional dividends shall be paid on Class "F" shares until they receive that fraction of profits properly available for payment of dividends as the number of Class "F" shares then outstanding bear to the total number of Class "F" shares and common shares then outstanding and the balance shall in the discretion of the directors be paid on common shares or set aside for future payment on common shares at the discretion of the board of directors.

... (e)

5 Pursuant to an agreement dated April 29, 1981, the appellant sold his shares in Newmac to Melru for 1,285.714 Class "G" shares of Melru. The shares were sold on a tax-deferred basis pursuant to s. 85(1) of the ITA and they were described as having a fair market value of $120,000. On May 1, 1981, a meeting of the first director was held at which the appellant was appointed president and Ruby Neuman was appointed secretary. One voting common share of Melru was issued to the appellant for $1. A special general meeting of the shareholders was held that same day at which the appellant resigned as first director and was elected director of Melru until the first annual meeting of the corporation. Ruby Neuman acted as secretary at this meeting. That same day there was a meeting of the board of directors which the appellant chaired. A resolution was passed authorizing the issue of 1,285.714 Class "G" shares to the appellant in accordance with the agreement of sale. A second resolution was passed authorizing the issue of 99 non-voting Class "F" shares to Ruby Neuman at $1.00 per share. 6 The first annual meeting of shareholders was held on August 12, 1982. Ruby Neuman was elected sole director of Melru and the appellant and Ruby Neuman were appointed as officers. 7 In 1982, Melru received $20,000 in dividends on the Newmac shares. These were the first dividends paid on the Newmac shares. A board of directors meeting was held on September 8, 1982 at which time Ruby Neuman declared a dividend in the amount of $5,000 to be paid on the Class "G" shares and another dividend of $14,800 to be paid on the Class "F" shares. The minutes indicate that the holder of the common shares (i.e., the appellant) was prepared to have money set aside for future payment on his shares. 8 Ruby Neuman immediately loaned $14,800 to the appellant and she received in return a demand promissory note as security. Ruby Neuman died in 1988. The loan was not repaid. 9 Rothstein J. made the following relevant findings of fact (at pp. 160-61): 1. The dividends declared by Ruby Neuman on her own Class "F" shares and the appellant's Class "G" shares were declared pursuant to a discretionary dividend clause in the Articles of Incorporation of Melru. The dividends of $14,800 on the "F" shares and $5,000 on the "G" shares were arbitrary numbers.

326 2. Ruby Neuman made no contribution to Melru, nor did she assume any risks for the company. 3. The appellant's evidence was that when his wife was elected director of Melru, he explained to her the duties of a director, that directors manage the corporation, that they have a duty to the corporation, and that they make the decisions. The appellant said that he made recommendations to his wife which she accepted but that the decision as to the declaration of dividends was hers. 10 The dividend income paid to Ruby Neuman in 1982 was attributed to the appellant as being a payment or transfer of property made pursuant to the direction of or with the concurrence of the appellant as described in s. 56(2) of the ITA and he was assessed tax on this income. 11 The appellant appealed his 1982 assessment to the Tax Court of Canada and in 1992 the assessment was vacated: [1992] 2 C.T.C. 2074 (T.C.C.). (Proceedings had been delayed pending the final determination in McClurg v. Minister of National Revenue, [1990] 3 S.C.R. 1020 (S.C.C.).) The respondent appealed to the Federal Court, Trial Division without success, but a further appeal to the Federal Court of Appeal was successful: (1996), [1997] 1 F.C. 79 (Fed. C.A.). 2. Judicial History A. Tax Court of Canada 12 Sarchuk T.C.C.J. allowed the appellant's appeal and referred the assessment back to the respondent for reconsideration on the basis that the dividend income received by Ruby Neuman was not to be included in the appellant's income under s. 56(2). In reaching this conclusion, he relied on the opinion expressed by this Court in McClurg that as a general rule s. 56(2) does not apply to dividend income. Sarchuk T.C.C.J. acknowledged Dickson C.J.'s obiter dicta in McClurg (at p. 1054): ...if a distinction is to be drawn in the application of s. 56(2) between arm's length and non-arm's length transactions, it should be made between the exercise of a discretionary power to distribute dividends when the non-arm's length shareholder has made no contribution to the company (in which case s. 56(2) may be applicable), and those cases in which a legitimate contribution has been made. 13 However, Sarchuk T.C.C.J. was of the view that since this comment was obiter he was not bound by it. In his opinion, the Court had left open the question of the applicability of s. 56(2) to nonarm's length transactions and the possibility of piercing the corporate veil to stop complex tax avoidance schemes. However, the case at bar, in his view, did not warrant this action. Although there were facts that would support the attribution of the income back to the appellant, the plan could not be described as a "blatant tax avoidance scheme" (p. 2085). B. Federal Court of Canada, Trial Division 14 Rothstein J. dismissed the appeal from the decision of the Tax Court on the grounds that s. 56(2) was not designed to prevent income splitting in the context of the director-shareholder relationship. 15 He first considered whether Ruby Neuman, in declaring the dividend, was acting under the direction or with the concurrence of the appellant. Rothstein J. said he was "reluctant to presume that Ruby Neuman was acting pursuant to the direction of, or with the concurrence of, the [appellant] when she, as director, declared dividends on behalf of Melru" (p. 162). Although this would determine the appeal, this point was not pressed by the parties, and Rothstein J. did not decide the case on this point.

327

16 Rothstein J. went on to consider this Court's holding in McClurg; the McClurg decision was critical to the outcome of the case at bar since the only material difference between the facts, in Rothstein J.'s view, is that Ruby Neuman made no contribution to Melru while Wilma McClurg did make contributions to the corporation from which she received dividend income. 17 Applying McClurg, Rothstein J. concluded that the declaration of dividends pursuant to the discretionary dividend clause was valid and he then went on to consider the tax law issue. Rothstein J. noted that in McClurg Dickson C.J. recognized two prerequisites to the application of s. 56(2): that the dividend income would otherwise have been obtained by the reassessed taxpayer, and that the payment must be a "benefit" for which there was no adequate consideration. Dickson C.J. concluded that s. 56(2) did not generally apply to dividends since the reassessed taxpayer would not have received the money if it had not been paid to the shareholder because it would have been retained as earnings by the company. Dickson C.J. also concluded that, on the facts in McClurg, the dividend income received by Wilma McClurg was consideration for the significant contribution which she made to the corporation; the dividend received by her was not, therefore, a "benefit". 18 Rothstein J. concluded that Dickson C.J. had not intended to dispose of the McClurg case on the basis of Wilma McClurg's contributions to the corporation; rather, his comments about her contributions were intended to address the third precondition to the application of s. 56(2) articulated in the provision itself, i.e., was the money "for the benefit of the taxpayer or as a benefit that the taxpayer desired to have conferred on the other person"? 19 Rothstein J. proceeded to consider Dickson C.J.'s suggested exception to the general rule that s. 56(2) does not apply to dividend income. Rothstein J. recognized that this Court did not determine in McClurg whether a distinction can be made between non-arm's length and arm's length transactions because in McClurg the recipient of the dividend made a legitimate contribution to the company; therefore the dividend did not constitute a benefit to Wilma McClurg and s. 56(2) could not apply for that reason. 20 The problem faced by Rothstein J. was whether, on the facts before him, where Ruby Neuman had made no contribution to the company and the receipt of the dividend was thus a "benefit" to her, a distinction must be drawn between non-arm's length and arm's length transactions. He concluded, relying on Urie J.'s ruling in the Federal Court of Appeal in McClurg v. Minister of National Revenue (1987), [1988] 2 F.C. 356 (Fed. C.A.) (which ruling had not been overturned by the reasons of Dickson C.J.), that there is nothing in s. 56(2) which contemplates a distinction between non-arm's length and arm's length transactions. Rothstein J. noted that this Court found, in more general terms, that there was no distinction between arm's length and non-arm's length transactions (Stubart Investments Ltd. v. R., [1984] 1 S.C.R. 536 (S.C.C.)). 21 Having found that a distinction cannot be drawn between non-arm's length and arm's length transactions in the application of s. 56(2), Rothstein J. decided that he need not consider whether a dividend payment is a benefit for the purposes of s. 56(2) where the recipient did not make a contribution to the corporation. 22 Rothstein J. noted that there is nothing in the ITA which suggests an overall intention to prevent income splitting; an income splitting transaction must actually violate a section of the ITA in order for the Minister to challenge it. 23 In the absence of sham, and with all corporate formalities having been observed, Rothstein J. held that the transaction was valid and he dismissed the appeal. C. Federal Court of Appeal

328

24 The Federal Court of Appeal allowed the respondent's appeal and held that the appellant was taxable on the dividend income receive by Ruby Neuman. The court held that the dictum of Dickson C.J. in McClurg regarding the possible application of s. 56(2) in non-arm's length transactions was binding on the Trial Division. The court relied, in reaching its conclusion, on the fact that the incorporation of Melru and the declaration of the dividend to Ruby Neuman had no bona fide business purpose and lacked commercial reality. In reaching its conclusion, the court essentially pierced the corporate veil. 25 The court was of the view that the respondent had satisfied the four elements necessary to invoke s. 56(2): (1) payment or transfer made to a person other than the taxpayer; (2) made at the direction of or with the concurrence of the taxpayer; (3) for the taxpayer's benefit; and (4) the payment would have otherwise been included in the taxpayer's income. 26 More specifically, the court found that Ruby Neuman was acting with the concurrence of the appellant when she declared the dividends. The court also held that the payment of the dividend was "for the benefit of the taxpayer" as required by s. 56(2). The appellant benefited through a reduction in his own tax liability; he benefited a second time by having his wife lend him the money interest-free. In addition, the court found that the property would have been included in the appellant's income had it been received by him and not Ruby Neuman by operation of ss. 12(1)(j) and 82(1) of the ITA. 27 Next the court had to deal with this Court's ruling in McClurg that s. 56(2) does not generally apply to dividend income because the reassessed taxpayer would not have received that money had it not been paid to the shareholder. In order to overcome that general rule, the court invoked the exception to the rule recognized by Dickson C.J. in obiter in McClurg: that where a non-arm's length shareholder does not make a legitimate contribution to the corporation, a person who directed or concurred in the payment of a dividend to that shareholder could be assessed for taxes on the amount of the dividend under s. 56(2). The court concluded (at p. 111) that the recognition by Dickson C.J. of this possible exception to the rule is binding on courts as it represents the "considered opinion of a majority" of the Supreme Court of Canada. 28 The court then found that the facts before them Fit within the exception detailed in McClurg. Unlike Wilma McClurg, Ruby Neuman had made no contribution to Melru, a company which was incorporated solely for tax planning and income splitting purposes. The court found that applying s. 56(2) "would not be contrary to the commercial reality of the declaration of the dividend to Ruby Neuman, since there was none" (p. 105). 29 The appellant argued that the court should apply Outerbridge Estate v. Canada (1990), [1991] 1 F.C. 585 (Fed. C.A.), which stands for the proposition that there is a fifth precondition to the application of s. 56(2) which requires proof that the payee would not be subject to tax on the dividend income. The court declined to find that there was a fifth precondition to the application of s.56(2). 30 As a result, the Federal Court of Appeal allowed the appeal and affirmed the Minister's assessment attributing the dividend income received by Ruby Neuman to the appellant. 3. Issues 31 The central question raised by this appeal is whether the dividend income received by Ruby Neuman should be attributed to the appellant for tax purposes under s. 56(2) of the ITA. Section 56(2) provides:

329 56.... (2) A payment or transfer of property made pursuant to the direction of, or with the concurrence of, a taxpayer to some other person for the benefit of the taxpayer or as a benefit that the taxpayer desired to have conferred on the other person shall be included in computing the taxpayer's income to the extent that it would be if the payment or transfer had been made to him. 32 In order for s. 56(2) to apply, four preconditions, each of which is detailed in the language of the s. 56(2) itself, must be present: (1) the payment must be to a person other than the reassessed taxpayer; (2) the allocation must be at the direction or with the concurrence of the reassessed taxpayer; (3) the payment must be for the benefit of the reassessed taxpayer or for the benefit of another person whom the reassessed taxpayer wished to benefit; and (4) the payment would have been included in the reassessed taxpayer's income if it had been received by him or her. I agree that these four prerequisites to attribution are an appropriate analytical framework for the interpretation of s. 56(2) (see Cattanach J. in both Murphy v. R. (1980), 80 D.T.C. 6314 (Fed. T.D.), at pp. 6317-18, and in Fraser Cos. v. R. (1981), 81 D.T.C. 5051 (Fed. T.D.), at p. 5058). 33 Because I conclude that s. 56(2) does not apply to dividend income since dividend income, by its very nature, cannot satisfy the fourth precondition absent a sham or other subterfuge, it is not necessary to discuss the other three prerequisites to the application of s. 56(2). 4. Analysis A. Introduction. 34 As the judicial history of this appeal reveals, the interpretation of this Court's majority decision in McClurg lies at the heart of the present case. This Court held in McClurg that generally s. 56(2) will not apply to dividend income. However, Dickson C.J. suggested in obiter in McClurg that s. 56(2) may apply where dividend income is distributed through the exercise of a discretionary power to a nonarm's length shareholder who has made no legitimate contribution to the company (at p. 1054). The Federal Court of Appeal felt bound by the potential exception articulated by Dickson C.J. in obiter since the facts in the present case were similar to the facts in McClurg with the only material difference being that Ruby Neuman, unlike Wilma McClurg., had not made any contribution to the corporation. 35 A large part of my analysis will involve a review of the holdings in McClurg. Before I turn to McClurg, however, I wish to make some observations to place the present debate into its proper perspective. First, s. 56(2) strives to prevent tax avoidance through income splitting; however, it is a specific tax avoidance provision and not a general provision against income splitting. In fact, "there is no general scheme to prevent income splitting" in the ITA (V. Krishna and J. A. VanDuzer, "Corporate Share Capital Structures and Income Splitting: McClurg v. Canada" (1992-93), 21 Can. Bus. L.J. 335, at p. 367). Section 56(2) can only operate to prevent income splitting where the four preconditions lo its application are specifically met. 36 Second, this case concerns income received by Ruby Neuman during the 1982 taxation year at which time the ITA did not provide specific guidelines to deal with corporate structures designed for the purposes of income splitting and tax minimization. Professor V. Krishna, in an article entitled "Share Capital Structure of Closely-Held Private Corporations" (1996), 7 Can. Curr. Tax. 7, at p. 9, made the following comment with respect to income splitting in the corporate context:

330 Except when specifically curtailed by the Income Tax Act (for example, by the attribution rules), income splitting per se is not a sanctioned arrangement. Thus, corporate structures that facilitate income splitting in private companies should not be penalized without clear statutory language and intent. [Emphasis added.] Parliament has since fashioned legislation to regulate corporate income splitting (s. 74.4 of the ITA, introduced in 1985), but this legislation does not apply to the present appeal. 37 Third, this appeal is limited to the interpretation and application of s. 56(2) of the ITA; the appeal is not based on the general anti-avoidance rule set out in s. 245 of the ITA ("GAAR"). GAAR came into force on September 13,1988 and it applies only to transactions entered into on or after that date. 38 Fourth, the respondent has not argued that the appellant was involved in a sham or an artificial transaction and this was acknowledged by counsel for the respondent during the hearing. 39 Finally, it is important to remember that this Court held unanimously in Stubart, supra, at p. 575, that a transaction should not be disregarded for tax purposes because it has no independent or bona fide business purpose (Estey J. wrote for himself and Beetz and McIntyre JJ,; Wilson J. wrote concurring reasons for herself and Ritchie J.). Thus, taxpayers can arrange their affairs in a particular way for the sole purpose of deliberately availing themselves of tax reduction devices in the ITA. Estey J. rejected the suggestion that a distinction must be drawn between non-arm's length and arm's length transactions in the application of this principle (at pp. 570-72). According to Stubart, therefore, nonarm's length arrangements can also be created for the sole purpose of taking advantage of tax reduction devices. 40 With these points in mind, I now turn to the decision of the Court in McClurg.

B. McClurg 41 McClurg involved a taxpayer and business associate who were the sole directors of a corporation which they had set up and in which they and their wives were shareholders. The corporation operated an International Harvester truck dealership. The capital structure of the corporation provided for three classes of shares with different rights and privileges: Class A shares were common, voting and participating shares; Class B shares were common, non-voting and participating where so authorized by the directors; and Class C shares were preferred non-voting shares. The dividends were to be declared at the sole discretion of the directors; distributions could be done selectively among the three classes of shares. Essentially, the capital structure was designed to permit income splitting. 42 Jim McClurg and his associate held class A and C shares whereas their wives held class B shares. In 1978, 1979, and 1980 the wives of the directors each received $100/share on their Class B shares: $10,000/year. These were the only dividends declared in those years. 43 Wilma McClurg made legitimate contributions to the business. She exposed herself to extensive liability by assisting in the financing of the business. She also worked as an administrative assistant, drove a truck when necessary, and generally fulfilled needs as they arose. 44 The Minister reassessed Jim McClurg's income for 1978 to 1980 on the basis that $8000 of the $10,000 in dividends paid to his wife each year was attributable to him through the operation of s. 56(2). The Minister also challenged the validity of the discretionary dividend provision. (i) The ratio in McClurg.

331 45 Dickson C.J., writing for himself and Sopinka, Gonthier and Cory JJ. (Wilson, La Forest and L'Heureux-Dube JJ. in dissent) first: dealt with the issue of whether the discretionary dividend provision was valid as a matter of corporate law; he concluded that it was. He then turned to the tax issue and he held that the dividend income paid to Wilma McClurg was not attributable to her husband for income tax purposes through the operation of s. 56(2). 46 This Court concluded that, as a general rule. s. 56(2) does not apply to dividend income since, until a dividend is declared, the profits belong to the corporation as retained earnings. The declaration of a dividend cannot be said, therefore, to be a diversion of a benefit which the taxpayer would have otherwise received (at p. 1052). Dickson C.J. explained the ruling as follows (at p. 1052): While it is always open to the courts to "pierce the corporate veil" in order to prevent parties from benefitting from increasingly complex and intricate tax avoidance techniques, in my view a dividend payment does not fall within the scope of s. 56(2). The purpose of s. 56(2) is to ensure that payments which otherwise would have been received by the taxpayer are not diverted to a third party as an antiavoidance technique. This purpose is not frustrated because, in the corporate law context, until a dividend is declared, the profits belong to a corporation as a juridical person: [B. Welling, Corporate Law in Canada (1984), at pp. 609-10]. Had a dividend not been declared and paid to a third party, it would not otherwise have been received by the taxpayer. Rather, the amount simply would have been retained as earnings by the company. Consequently, as a general rule, a dividend payment cannot reasonably be considered a benefit diverted from a taxpayer to a third party within the contemplation of s. 56(2). [Emphasis added.] 47 Although not explicitly stated, Dickson C.J.'s preceding comments concern the fourth precondition to the application of s. 56(2): that the payment would have been included in the reassessed taxpayer's income if it had been received by him or her. In essence, dividend income does not satisfy this prerequisite to attribution since the reassessed taxpayer would not have received the income had it not been paid to the shareholder. In effect, this Court implicitly interpreted the fourth precondition to include an entitlement requirement; entitlement is used in the sense that the reassessed taxpayer would have otherwise received the payments in dispute. This was correctly noted by Rothstein J. at the Federal Court, Trial Division in similar terms where he acknowledged that Dickson C.J.C. qualified the application of s. 56(2) by requiring that the payment in issue "would otherwise have been obtained by the reassessed taxpayer" (p. 164). 48 An entitlement requirement in the sense I have described is consistent with the stated purpose of s. 56(2), which is to capture and attribute to the reassessed taxpayer "receipts which he or she otherwise would have obtained" (McClurg, at p. 1051). Dividend income cannot pass the fourth test because the dividend, if not paid to a shareholder, remains with the corporation as retained earnings; the reassessed taxpayer, as either director or shareholder of the corporation, has no entitlement to the money. 49 This is the only interpretation which makes sense and which avoids absurdity in the application of s. 56(2), as noted by Dickson C.J. (alp. 1053): ...but for the declaration (and allocation), the dividend would remain part of the retained earnings of the company. That cannot legitimately be considered as within the parameters of the legislative intent of s. 56(2). If this Court were to find otherwise, corporate directors potentially could be found liable for the tax consequences of any declaration of dividends made to a third party....this would be an unrealistic interpretation of the subsection consistent with neither its object nor its spirit. It would violate fundamental principles of corporate law and the realities of commercial practice and would "overshoot" the legislative purpose of the section.

332 50 I note that the decision in Outerbridge Estate, supra, which was rendered shortly before this Court's ruling in McClurg, appears to challenge the view that where a taxpayer is not entitled to a payment that payment cannot be attributed to him or her under s. 56(2). Outerbridge Estate, however, did not involve the attribution of dividend income. 51 In Outerbridge Estate, the majority shareholder in an investment company caused the corporation to sell some of its shares to his son-in-law, who was also a shareholder in the corporation, for a price of $100 per share. The Minister calculated the fair market value of the shares at approximately $1,000 per share and reassessed the majority shareholder under s. 56(2) by adding as income the difference between what the son-in-law paid for the shares and their market value. 52 Marceau J.A., writing for the court, held that the fact that the taxpayer had no direct entitlement to the shares did not preclude attribution since there was no indication that s. 56(2) was intended to be so confined. Marceau J.A. concluded (at p. 593) that: [w]hen the doctrine of "constructive receipt" is not clearly involved, because the taxpayer had no entitlement to the payment being made or the property being transferred, it is fair to infer that subsection 56(2) may receive application only if the benefit conferred is not directly taxable in the hands of the transferee. [Emphasis added.] Marceau J.A. distinguished the Federal Court of Appeal's ruling in McClurg where Urie J. held that s. 56(2) does not apply to dividend income, which holding was affirmed by this Court, as follows (at pp. 591-92): [t]he McClurg decision was concerned with a declaration of dividend in accordance (in the views of the majority) with the powers conferred by the share structure of the corporation) and I do not see it as having authority beyond the particular type of situation with which it was dealing. 53 I agree with Marceau J.A.: Outerbridge Estate concerned the conferral of a benefit which was not in the form of dividend income. The application of s. 56(2) to non-dividend income was not before this Court in McClurg and it is not before this Court in the present case. But the entitlement requirement implicitly read into the fourth precondition of s. 56(2) in McClurg clearly applies to dividend income. 54 I conclude that, unless a reassessed taxpayer had a preexisting entitlement to the dividend income paid to the shareholder of a corporation, the fourth precondition cannot be satisfied and consequently s. 56(2) cannot operate to attribute the dividend income to that taxpayer for income tax purposes. (ii) The obiter dicta in McClurg and the exception to the general rule. 55 The finding that dividend income cannot satisfy the fourth precondition to the application of s. 56(2), as modified by the implicit entitlement requirement, was dispositive of the McClurg case. La Forest J. agreed with the majority's conclusion that bona fide dividend income does not fall within the scope of s. 56(2). However, he dissented on the finding under corporate law that the discretionary dividend clause was valid; therefore the dividend income at issue in McClurg was not, in his view, bona fide and s. 56(2) applied (see p. 1073). 56 Despite these conclusions, Dickson C.J. went on to consider the third precondition, that the payment must be for the benefit of the reassessed taxpayer or for the benefit of another person whom the reassessed taxpayer wished to benefit, and in so doing, he qualified his earlier interpretation of the fourth precondition. In his view, Wilma McClurg's receipt of the funds was not a "benefit" as required by s. 56(2) (the third precondition) since her contributions to the corporate enterprise could be described as a "legitimate quid pro quo and were not simply an attempt to avoid the payment of

333 taxes" (p. 1054). Since Wilma McClurg had made legitimate contributions to the corporation, the application of s. 56(2) "would be contrary to the commercial reality of this particular transaction" (p. 1053). 57 Dickson C.J. seemed to be of the view that the character of a shareholder's dividend income is to be determined by that shareholder's level of contribution to the corporation. This approach ignores the fundamental nature of dividends; a dividend is a payment which is related by way of entitlement to one's capital or share interest in the corporation and not to any other consideration. Thus, the quantum of one's contribution to a company, and any dividends received from that corporation, are mutually independent of one another. La Forest J. made the same observation in his dissenting reasons in McClurg(at p. 1073): With respect, this fact is irrelevant to the issue before us. To relate dividend receipts to the amount of effort expended by the recipient on behalf of the payor corporation is to misconstrue the nature of a dividend. As discussed earlier, a dividend is received by virtue of ownership of the capital stock of a corporation. It is a fundamental principle of corporate law that a dividend is a return on capital which attaches to a share, and is in no way dependent on the conduct of a particular shareholder. [Emphasis added]. 58 Dickson C.J.'s finding that Wilma McClurg's contributions to the corporation resulted in the dividend being consideration for her efforts rather than a "benefit" as required by s. 56(2) opened the door to his obiter comments which have led to some confusion (at p. 1054): In my opinion, if a distinction is to be drawn in the application of s. 56(2) between arm's length and non-arm's length transactions, it should be made between the exercise of a discretionary power to distribute dividends when the non-arm's length shareholder has made no contribution to the company (in which case s. 56(2) may be applicable), and those cases in which a legitimate contribution has been made. 59 Dickson C.J. is suggesting, it would seem, that where a non-arm's length shareholder receives a dividend from a corporation to which he or she has made no contribution (the dividend income therefore constituting a "benefit" for the purposes of s. 56(2) in Dickson C.J.'s view), precondition four, interpreted by him to include an entitlement requirement, is automatically considered satisfied, or need not be satisfied, with the result that s. 56(2) applies. 60 In my view, it is wrong to suggest that there may be an exception to the rule that s. 56(2) does not apply to dividend income where the recipient of the dividend income in a non-arm's length transaction has not made a "legitimate contribution" to the corporation. In so stating, I assume, of course, that proper consideration was given for the shares when issued. I am not aware of any principle of corporate law that requires in addition that a so-called "legitimate contribution" be made by a shareholder to entitle him or her to dividend income and it is well accepted that tax law embraces corporate law principles unless such principles are specifically set aside by the taxing statute. 61 Furthermore, there is no principled basis upon which this distinction can be drawn; the fact that a company is closely held or that no contribution is made to the company by a shareholder benefiting from a dividend in no way changes the underlying nature of a dividend. Neither the fact that the transaction is non-arm's length nor the fact that the shareholder has not contributed to the corporation serves to overcome the conclusion that dividend income cannot satisfy the fourth precondition to attribution under s. 56(2). 62 Moreover, the obiter comments raise the difficult task of determining what constitutes a legitimate contribution. What will be the criteria upon which one can ascertain with any degree of precision or certainty that a contribution is legitimate?

334 63 Finally, the requirement of a legitimate contribution is in some ways an attempt to invite a review of the transactions in issue in accordance with the doctrines of sham or artificiality. Implicit in the distinction between non-arm's length and arm's length transactions is the assumption that non-arm's length transactions lend themselves to the creation of corporate structures which exist for the sole purpose of avoiding tax and therefore should be caught by s. 56(2). However, as mentioned above, taxpayers are entitled to arrange their affairs for the sole purpose of achieving a favourable position regarding taxation and no distinction is to be made in the application of this principle between arm's length and non-arm's length transactions (see Stubart, supra). The ITA has many specific antiavoidance provisions and rules governing the treatment of non-arm's length transactions. We should not be quick to embellish the provision at issue here when it is open for the legislator to be precise and specific with respect to any mischief to be avoided. 64 To summarize, it is inappropriate to consider the contributions of a shareholder to a corporation when determining whether s. 56(2) applies. Dividends are paid to shareholders as a return on their investment in the corporation. Since the distribution of the dividend is not determined by the quantum of a shareholder's contribution to the corporation, it would be illogical to use contribution as the criterion that determines when dividend income will be subject to s. 56(2). The same principles apply in the context of both non-arm's length relationships such as often exist between small closely held corporations and their shareholders, and arm's length relationships such as exist between publicly held corporations and their shareholders. 5. Conclusion 65 For the foregoing reasons, s. 56(2) does not apply to the dividend income received by Ruby Neuman. The appeal is therefore allowed, the decision of the Federal Court of Appeal is reversed, and that portion of the respondent's assessment which attributes the dividend income received by Ruby Neuman to the appellant is set aside with costs throughout. Appeal allowed

Technical Interpretation 2006-0175601E5 -- Discretionary dividends

September 13, 2006 This is in reply to your letter of March 10, 2006, wherein you requested a technical interpretation in respect of the following situation: 1. The shareholders of an operating corporation ("Opco") are three holding corporations, namely, Holdco1, Holdco2 and Holdco3. 2. Holdco1, Holdco2 and Holdco3 are not related persons within the meaning of subsection 251(2) of the Income Tax Act (the "Act"). 3. The issued and outstanding capital stock of Opco includes Class A common shares, Class B common shares and Class C common shares. 4. Holdco1 holds 200 Class A common shares, Holdco2 holds 100 Class B common shares and Holdco3 holds 200 Class C common shares of the capital stock of Opco. Each of the Class A common shares, Class B common shares and Class C common shares was issued at

335 the relevant time for an amount which was equal to the fair market value ("FMV") thereof and such consideration was paid in full by the subscriber to the issuer. Each of the different classes of common shares carries the right to one vote per share. 5. The share rights, restrictions, privileges and conditions of the different classes of common shares of Opco each contain a distinct right to a priority payment on dissolution. 6. The articles of incorporation for Opco provide that dividends that may be declared at the discretion of the board of directors on any one or more of the Class A common shares, Class B common shares and/or Class C common shares on a discretionary basis. It is intended that a holder of any one or more of the Class A common shares, Class B common shares or Class C common shares of the capital stock of Opco may receive at the discretion of the board of directors of Opco a dividend from Opco to the exclusion of the holders of the other classes of common shares. 7. Each of Holdco1, Holdco2 and Holdco 3 is and will remain connected to Opco for all applicable purposes under Part IV of the Act. It is not expected that the payment of any one dividend or series of payments of dividends in aggregate will be sufficient to affect the FMV so as to prevent any one or more of Holdco1, Holdco2 and Holdco3 from being connected with Opco for the purposes of Part IV of the Act. 8. No single shareholder has de jure control of Opco. You enquire as to the applicability of subsection 56(2) or subsection 245(2) in respect of the abovedescribed situation. It is your view that the payment of discretionary dividends as described in the foregoing fact situation will not result in the application of either subsection 56(2) or subsection 245(2) as a result of the Supreme Court of Canada's decision in Neuman v. R., [1998] 3 C.T.C. 177, ("Neuman") provided that a shareholder receiving a dividend on a class of shares does not do so where a pre-existing entitlement of such dividend amount lies with another shareholder of the corporation. You note that the foregoing fact situation is among arm's length parties that have chosen to govern their affairs pursuant to a comprehensive unanimous shareholders agreement. You state that such agreement does not provide for any pre-existing entitlement to dividends on any particular class of shares. You also assert that the distinct share rights of the Class A common shares, Class B common shares and Class C common shares of Opco as described are sufficient for corporate law purposes to constitute separate classes of shares. You conclude that as a result of none of the common shareholders having a pre-existing entitlement to a dividend payable by Opco, subsection 56(2) will not be applicable. You further conclude that subsection 245(2) should not apply because the foregoing situation does not constitute an avoidance transaction or series of transactions involving a misuse of a provision or an abuse of the Act read as a whole. OUR COMMENTS Written confirmation of the tax implications inherent in particular transactions is given by this Directorate only where the transactions are proposed and are the subject matter of an advance income tax ruling request submitted in the manner set out in Information Circular 70-6R5, dated May 17, 2002. Where the particular transactions are completed, the inquiry should be addressed to the relevant tax services office. The following comments are, therefore, of a general nature only and are not binding on the Canada Revenue Agency.

336 Consistent with the Supreme Court of Canada's decision in Neuman, we agree that, generally, subsection 56(2) will not apply to arrangements involving the payment of dividends by a corporation, provided that the applicable taxpayer does not have a pre-existing entitlement to the dividends, and provided that proper consideration was given for the shares when issued. While you have represented that each of the Class A common shares, Class B common shares and Class C common shares was issued at the relevant time for an amount equal to the FMV thereof, we suggest that it may be difficult to determine the FMV of shares which carry an entitlement to discretionary dividends. In a phone conversation of August 3, 2006, you have advised that Opco has sufficient undistributed "income earned or realized after 1971" within the meaning of section 55 of the Act ("safe income on hand") to cover the dividends paid by Opco to each of its shareholders. Consequently, subsection 55(2) will not apply to the dividends received by each of Holdco1, Holdco2 and Holdco3. We have not previously encountered the use of discretionary shares in this type of situation. Consequently, the determination of the application of subsection 245(2) to the above-described series of transactions would necessitate a review of all the pertinent facts and relevant documentation and would best be dealt with within the context of an advance income tax ruling request.

Peddle v. Canada [2004] 2 C.T.C. 3111 JUDGMENT:-- The appeal from the assessment made under the Income Tax Act for the 1998 taxation year is allowed and the assessment is referred back to the Minister of National Revenue for reconsideration and reassessment on the basis that the amount of $7,000.00 not be included in the Appellant's income. In all other respects the appeal is dismissed, in accordance with the attached Reasons for Judgment. The Respondent shall have its costs. REASONS FOR JUDGMENT 1 CAMPBELL T.C.J.:-- This appeal is in respect to the Appellant's 1998 taxation year. The Appellant in 1998 reported a total income of $19,375.00. In reassessing the Appellant the Minister of National Revenue (the "Minister") included in his income an unreported shareholder benefit in the amount of $46,000.00 and unreported interest income of $3,600.00. Penalties of $5,805.25 were also assessed. The Minister relies on subsections 15(1), 56(2) and 163(2) and paragraph 12(1)(c) of the Income Tax Act (the "Act").

The Evidence: 2 The Appellant was involved in several corporations and partnerships. He was a 50% shareholder, along with his brother-in-law Michael Hennick, in 058541 New Brunswick Ltd., which operated under the trade name Riverside Estates ("Riverside"). He testified that he was a major decision-maker in this company's affairs. This company was a general contracting company involved in road and residential construction. The Appellant's evidence was that he resigned from this company, and was no longer a part of it, as of January 19, 1998, due to a falling out with the other shareholder Michael Hennick. He produced (Exhibit A-3) a certified copy of a Notice of Change of Directors form which had been filed with Consumer and Corporate Affairs for the Province of New Brunswick on January 15,

337 1998. Although he testified that he intended to resign as shareholder, he produced no evidence, except for this resignation of directors form, to support this claim.

3 The Appellant was involved at this time with another New Brunswick company, 504897 New Brunswick Ltd. He testified that he was a shareholder in this company along with his wife. He stated that Michael Hennick was "involved to a certain degree" with the company but that the Appellant himself was the sole decision-maker, as well as the individual authorized to sign cheques for this company. The company operated under two trade names, Brunswick Auto Mart ("Brunswick") and River Road Auto Sales ("River Road"). Brunswick was involved in commercial automobile sales. Again he testified that he had sole control of Brunswick.

4 On September 15, 1997, Riverside purported to purchase an excavator from Big 'D' Farm Machinery ("Big D") for $310,000.00, with financing to be arranged and a certified cheque provided on delivery. The handwritten invoice (Tab 7 of Exhibit R-1) for the excavator was prepared by Dana Atkinson, an employee of Big D. The Appellant testified that Dana Atkinson also worked on a parttime basis for Brunswick selling automobiles on commission. This invoice listed the HST at $46,500.00 with a deposit being paid of $5,000.00 and then incorrectly quoted the balance due as $341,500.00, instead of the correct balance of $351,500.00. According to the Appellant, he was surprised by the discrepancy of $10,000.00 in the bottom figure amount and said that he had not seen this invoice before. It appeared that no one involved in this transaction had caught this error or if they had, they neglected to bring it to the Appellant's attention.

5 The Appellant signed and filed the HST return for Riverside on October 1, 1997 claiming an input tax credit of $46,500.00 in respect of the purchase of this excavator.

6 According to the evidence of the auditor his investigations disclosed that the excavator, which matched the serial number on the invoice, had been sold elsewhere in Massachusetts in October 1997.

7 The Appellant did confirm that he was aware that Riverside had not purchased the excavator before January 1998 when he testified he had walked away from the company. He also confirmed that he had never arranged any financing for the purchase of this excavator.

8 On January 2, 1998, pursuant to the HST return filed by Mr. Peddle on behalf of Riverside, the Government issued a refund cheque to 058541 N.B. Ltd. c/o William Peddle in the amount of $45,359.85. The difference in the amount claimed and refunded was due to prior payroll liabilities and tax owed by Riverside. This refund cheque was endorsed by the Appellant and deposited into the bank account of Riverside on January 12, 1998.

338 9 According to the Appellant, as of January 19, 1998, he had parted ways with Riverside. He testified that he knew that Eagle Auto Sales ("Eagle"), a company that Brunswick did business with in respect to buying and selling vehicles, was interested in purchasing his shares. He decided to just pass his shares over to Eagle for no consideration at a time when Riverside owned three lots, an older excavator and now had the refund amount of $45,359.85 sitting in its account. He produced no corporate records or any other evidence to support that this share transfer actually occurred.

10 On January 26, 1998, the Appellant issued a cheque for $46,000.00 from Riverside to Eagle Auto Sales, although according to his evidence he was no longer a shareholder of Riverside. He stated that he issued this cheque to Eagle because he neglected to have the Riverside corporate bank account transferred over to Eagle at the time of the sale of his shares.

11 A subsequent transaction involving the Appellant occurred on this same day, January 26, 1998, when Eagle issued a cheque for $39,000.00 to Brunswick. It was then deposited to Brunwick's account on January 26, 1998. The Appellant entered an invoice (Exhibit A-5) dated January 26, 1998 from Brunswick to Eagle for the purchase of a 1990 Toyota vehicle, a boat, a hoist and tools in support of this transaction. The Respondent alleges that the difference of $7,000.00 between the $46,000.00 cheque issued by Riverside to Eagle and the $39,000.00 cheque issued by Eagle to Brunswick was retained by Eagle to satisfy an existing debt owed to Eagle by Brunswick on the purchase of a Ford Escort vehicle. The Appellant's evidence was that he did not know anything about that particular vehicle as Brunswick and Eagle were involved with many vehicle transactions.

12 Following the transactions involving the cheques for $46,000.00 and $39,000.00, on the same day, January 26, 1998, Brunswick issued a cheque to the Appellant in the amount of $9,000.00. Brunswick issued additional cheques to the Appellant for $3,000.00 each on February 22, 1998 and March 22, 1998. Another cheque for $1,000.00 was issued on April 18, 1998. These four cheques were referred to as "for shareholder loan" in the working papers of Brunswick (Tab 4 of Exhibit R-1) which listed specifics of cheques issued to the Appellant in 1998. The other cheques on this list were not referenced as shareholder loans. The Appellant testified that he put money into Brunswick and most of these cheques on that list represented repayment of loans. He produced no evidence to support this claim except for his testimony.

13 In 1998, Brunswick expensed $3,600.00 on account of interest in shareholder's loans. The corporate 1998 tax return expensed this amount as one of its operating expenses (Tab 14, Exhibit R1). The Appellant did not report this interest income.

Issues: 14 Following are the four issues which must be decided in this appeal:

(1) Whether the Appellant failed to report a benefit of $39,000.00 received from Riverside, and if so, whether subsection 15(1) applies to include this amount in the Appellant's income;

339 (2) Whether the Appellant failed to report a benefit of $7,000.00 conferred on Brunswick, and if so, whether it is to be included in his income pursuant to subsection 15(1), or if it cannot, whether it can be included pursuant to subsection 56(2); (3) Whether the Appellant failed to report interest income of $3,600.00 and if he did, whether this amount should be included in his income pursuant to paragraph 12(1)(c); (4) Whether penalties were properly assessed pursuant to subsection 163(2).

Analysis: Issue No. 1 15 Subsection 15(1) states:

15. (1) Where at any time in a taxation year a benefit is conferred on a shareholder, or on a person in contemplation of the person becoming a shareholder, by a corporation otherwise than by (a) the reduction of the paid-up capital, the redemption, cancellation or acquisition by the corporation of shares of its capital stock or on the winding-up, discontinuance or reorganization of its business, or otherwise by way of a transaction to which section 88 applies, (b) the payment of a dividend or a stock dividend, (c) conferring, on all owners of common shares of the capital stock of the corporation at that time, a right in respect of each common share, that is identical to every other right conferred at that time in respect of each other such share, to acquire additional shares of the capital stock of the corporation, and, for the purpose of this paragraph, (i) where (A) the voting rights attached to a particular class of common shares of the capital stock of a corporation differ from the voting rights attached to another class of common shares of the capital stock of the corporation, and (B) there are no other differences between the terms and conditions of the classes of shares that could cause the fair market value of a share of the particular class to differ materially from the fair market value of a share of the other class, the shares of the particular class shall be deemed to be property that is identical to the share of the other class, and (ii) rights are not considered identical if the cost of acquiring the rights differs, or (d) an action described in paragraph 84(1)(c.1), (c.2) or (c.3), the amount or value thereof shall, except to the extent that it is deemed by section 84 to be a dividend, be included in computing the income of the shareholder for the year.

16 The Minister wants to use this subsection to include in the Appellant's income for the 1998 taxation year the $39,000.00 received by Brunswick from Eagle on January 26, 1998. None of the conditions or exceptions referred to in this subsection are applicable here.

340 17 The taxability asserted by the Minister is based upon a chain of events which has its origin in the purported purchase of an excavator by Riverside. I accept as a fact that Riverside never purchased this excavator. The auditor's inquiries revealed that it had been sold in the United States and not in Canada. The Appellant himself testified that the excavator had not been purchased by Riverside as late as January 1998. Because no excavator was purchased, Riverside never became liable to pay the tax pursuant to Part IX of the Excise Tax Act. Therefore it was never entitled to claim the input tax credit of $46,000.00 which it claimed in October 1997 and received in January 1998. The Appellant's only explanation of why, on October 1, 1998 he filed a return claiming this input tax credit for an excavator that had not been purchased was that he thought that was usual and good practice to file for it before the tax was paid.

18 The Appellant was a 50% shareholder of Riverside and testified he was involved 100% in all decision-making in that company. Several weeks after this amount was received from the Government and deposited to Riverside's corporate account, the Appellant, on January 26, 1998, directed and authorized the issuance of, and signed a cheque in the amount of $46,000.00 from Riverside to Eagle.

19 There were no documents or any other type of evidence produced during the hearing which would connect the issuance of this cheque to a business transaction or any type of transaction between these corporate entities, other than the Appellant's vague, unacceptable and unsubstantiated claims of the sale of his shares to Eagle.

20 His evidence was that he had divorced himself from Riverside about mid-January 1998 and that the only reason he was able to sign this cheque was because the corporate account had not been signed over to Eagle, which had supposedly purchased his shares. According to the Appellant, by writing this cheque he was merely emptying the account and providing the money in the corporate account to the new owner, Eagle. However I simply cannot accept his evidence. He brought nothing to Court to substantiate this claim other than a Notice of Change of Director form which says nothing about his status as a shareholder in Riverside in January 1998. I did provide him with an opportunity to seek additional documentary evidence during the hearing, but he produced nothing further. It strikes me as a very odd sort of way to do business even if one is conducting one's business affairs informally.

21 After Eagle received the $46,000.00, it immediately, on the very same day, issued a cheque for $39,000.00 to Brunswick, another corporate entity for which by his own admission, he was the directing mind and sole decision-maker. Brunswick credited this amount to the Appellant as a loan payable. Subsequently, commencing again on the same day, January 26, 1998, cheques began issuing to the Appellant, as referenced in the working papers "for shareholder loan".

22 There is no evidence before me to support any of the Appellant's claims. The handwritten invoice produced by the Appellant (Exhibit A-5), to substantiate the exchange of the $39,000.00 between Eagle and Brunswick, listed the items sold by Brunswick to Eagle in a very different and

341 unique manner, unlike that which normal business practice would dictate; for example the least expensive item (the Toyota vehicle) worth $9,000.00 was listed beside "total sale price", with the remaining items (hoist, tools and boat) valued at $30,000.00 listed in a box on the invoice entitled "remarks". This alone is not sufficient to invalidate this invoice but according to the auditor's evidence, which I accept, a search of Eagle's corporate records disclosed no such purchases. The Appellant's corporate records were never made available either to the auditor or the Court for review. There was no other documentation except this invoice produced by the Appellant to suggest that Eagle had actually purchased these items and, according to the auditor, Eagle's books contained no such reference.

23 Once the $39,000.00 had been transferred by Eagle to Brunswick, four cheques totalling $16,000.00 and referenced as shareholder's loans were issued by Brunswick to the Appellant between January 29, 1998 and April 18, 1998. The working paper lists other cheques which were issued to the Appellant in 1998 for various amounts but they were not referenced as shareholder loans and the evidence was unclear as to what these cheques were for. If all of the cheques issued to Bill Peddle in this time period were in respect to the repayment of shareholder loans as he contends, then they should have all been so referenced.

24 There is no doubt that the $16,000.00 which the Appellant received from Brunswick via four cheques is taxable to him as a benefit conferred pursuant to subsection 15(1). Regardless of how this scheme evolved, the $39,000.00 clearly found its way into the corporate account of Brunswick and as a result is a shareholder benefit to the Appellant. Without supporting documentation from the Appellant, I accept the Minister's assumptions that the funds are traceable back to Riverside. Although there is no clear evidence of the additional $23,000.00 being paid by Brunswick to the Appellant, it is clearly a debt created by the company to the Appellant for no consideration and therefore subsection 15(1) is engaged and the benefit is considered conferred.

25 The Minister's assessment of the shareholder benefit under subsection 15(1) is based on the premise that the Appellant set up a scheme whereby an input tax credit based on a false claim filed by Riverside was transferred from Riverside to Brunswick through Eagle and eventually dispersed to the Appellant via payment of shareholder loans. I think it makes very little difference where this $46,000.00 originated, although all of the evidence points to it arising from the input tax credit claimed by Riverside. I think it is sufficient here that the funds left Riverside and, with totally inadequate or absolutely no supporting records and documents, flowed into Eagle and from Eagle found its way into Brunswick's account and eventually, some or all of it, to the Appellant.

26 Before I deal with the next issue, I believe a few comments are necessary in respect to two of the Respondent's assumptions. These assumptions at paragraph 8(m) and (n) state: 8. In so reassessing the Appellant, the Minister relied on, inter alia, the following assumptions: ... (m) Dana Atkinson received a cheque issued by Riverside and signed by the Appellant, dated September 30, 1997, in the amount of $5,000.00 purportedly as a deposit for the excavator;

342 (n) Dana Atkinson issued a cheque dated September 27, 1997 payable to the Appellant and Brunswick in the amount of $4,400.00 as reimbursement of the deposit amount on the excavator;

27 These assumptions were demolished at the hearing by the Respondent's own exhibits. The cheque referred to in assumption (m) was actually issued by River Road Auto (Tab 9, Exhibit R-1) and not by Riverside. The cheque referred to in assumption (n) was made payable to the Appellant and River Road Auto (Tab 8, Exhibit R-1) and not to the Appellant and Brunswick. These assumptions were meant to implicate Dana Atkinson in the preparation of the false excavator invoice between Riverside and Big D Machinery. Although these two specific assumptions failed, I do not view that failure as fatal to the Minister's remaining assumptions. Even if Dana Atkinson had never been involved and the $39,000.00 had flowed into Brunswick's coffers by more legitimate avenues than utilized here, the Appellant in accessing the monies would have run afoul of subsection 15(1).

28

The appeal will be dismissed as it relates to this first issue.

Issue No. 2 29 This issue arises when Riverside's cheque for $46,000.00 is deposited to Eagle's account and Eagle uses some of these funds to satisfy a debt of $7,000.00 owed to it by Brunswick in respect to a Ford Escort vehicle. The Minister submitted that pursuant to the Appellant's direction, Riverside paid $46,000.00 to Eagle and from this amount further directed Eagle to deduct the balance Brunswick owed Eagle respecting the purchase of a Ford Escort and to pay the remaining $39,000.00 to Brunswick. In satisfying Brunswick's indebtedness to Eagle, the Respondent argued that subsection 15(1) applied to properly include the $7,000.00 in his income.

30 Subsection 15(1) does not apply here. I conclude that it was not a shareholder benefit because Brunswick received the benefit, not the Appellant and Brunswick was not a shareholder of Riverside.

31 In the alternative the Respondent argued that subsection 56(2) applied to catch this $7,000.00, which required the Appellant to include it in his income.

32

Subsection 56(2) states:

56. (2) A payment or transfer of property made pursuant to the direction of, or with the concurrence of, a taxpayer to some other person for the benefit of the taxpayer or as a benefit that the taxpayer desired to have conferred on the other person (other than by an assignment of any portion of a retirement pension pursuant to section 65.1 of the Canada Pension Plan or a comparable provision of a provincial pension plan as defined in section 3 of that Act or of a prescribed provincial pension plan) shall be included in computing the taxpayer's income to the extent that it would be if the payment or transfer had been made to the taxpayer.

343 The Department of Finance Technical Note to this subsection makes it clear that it was not intended to make an amount taxable that might not otherwise be so. It reads: 1987 TN: Subsection 56(2) provides that where a taxpayer directs or concurs in the payment of an amount to another person, that amount shall be included in the taxpayer's income where, if it had been paid to him, it would have been so included. ... In other words, subsection 56(2) is meant to operate in the circumstances where a taxpayer attempts to avoid paying tax on an amount that would otherwise be taxable to him under one of the other provisions of the Act, by directing that the amount be paid to another taxpayer instead. Where a taxpayer directs an amount taxable to him to another person, he cannot escape taxability on that amount because this subsection will come into play. However, the amount so directed must have been taxable under one of the other provisions of the Act before subsection 56(2) will apply.

33 Cattanach, J. in Fraser Companies Ltd. v. The Queen, 81 DTC 5051 set out the following four preconditions that must be satisfied in order for subsection 56(2) to apply: 1. There must be a payment or transfer or property to a person other than the taxpayer. 2. The payment or transfer is pursuant to or with the concurrence of the taxpayer. 3. The payment or transfer must be for the taxpayer's own benefit or for the benefit of some other person on whom the taxpayer desired to have the benefit conferred. 4. The payment or transfer would have been included in computing the taxpayer's income if it had been received by him instead of the other person.

34

All four criteria are satisfied in the present case because:

(1) Property was transferred from Riverside to Brunswick through Eagle Auto Sales. (2) The payment was made pursuant to or with the concurrence of the Appellant. (3) The payment was made for the benefit of Brunswick. (4) The payment would have been taxable to the Appellant if it had been received by him.

35 However since there is no requirement that a taxpayer actually receive or be entitled to the payment in order to be held liable under subsection 56(2), the Federal Court of Appeal added a fifth element to the test in order to prevent the Minister from using it to tax the same amount twice. [M.N.R. v. Bronfman, [1965] C.T.C. 378, at paragraph 15.] In Smith v. Canada, [1993] F.C.J. No. 740 at paragraph 22 Mahoney, J. quoted with approval the following comments of Marceau, J. in Winter v. R.: ... the validity of an assessment under subsection 56(2) of the Act when the taxpayer had himself no entitlement to the payment made or the property transferred is subject to an implied condition, namely that the payee not be subject to tax on the benefit he received. And that: ... when the doctrine of constructive receipt is not clearly involved, because the taxpayer had no entitlement to the payment being made or the property being transferred, it is fair to infer that subsection 56(2) may receive application only if the benefit conferred is not directly taxable in the

344 hands of the transferee. Indeed, as I see it, a tax-avoidance provision is subsidiary in nature; it exists to prevent the avoidance of a tax payable on a particular transaction, not simply to double the tax normally due nor to give the taxing authorities an administrative discretion to choose between possible taxpayers. [Outerbridge Estate v. Canada (subnom Winter v. R.), [1991] C.T.C. 113 at 117118.]

36 In other words, subsection 56(2) should not apply where it results in double taxation. The applicability of this so-called fifth condition was confirmed in both the Supreme Court decision of Neuman v. The Queen, 98 DTC 6297 (S.C.C.) and the Federal Court decision of The Queen v. Ferrel, 99 DTC 5111 (F.C.A.).

37 There was no evidence before me which would indicate whether or not Brunswick paid income tax on the $7,000.00 benefit which it received when its debt to Eagle was paid for nil consideration. It is unlikely Brunswick paid tax. But if it paid tax, the application of subsection 56(2) would result in the inappropriate double taxation which the Federal Court spoke of.

38 I would allow the appeal in respect to this issue as the Respondent simply failed to address let alone prove all necessary preconditions to the application of subsection 56(2).

Issue No. 3 39 The Minister alleges that Brunswick paid $3,600.00 to the Appellant as interest on a shareholder loan and that the Appellant failed to report this amount in computing his income.

40

Paragraph 12(1)(c) states:

12. (1) There shall be included in computing the income of a taxpayer for a taxation year as income from a business or property such of the following amounts as are applicable: ... (c) Interest -- subject to subsections (3) and (4.1), any amount received or receivable by the taxpayer in the year (depending on the method regularly followed by the taxpayer in computing the taxpayer's income) as, on account of, in lieu of payment of or in satisfaction of, interest to the extent that the interest was not included in computing the taxpayer's income for a preceding taxation year;

41 At page 3 of Tab 14 of Exhibit R-1, the income tax return for 504897 New Brunswick Ltd., Brunswick expensed $3,600.00 as interest on a shareholder loan. The Appellant argued that although this amount did appear on his books as an interest expense payable to him it was an accounting error and was therefore never paid to him.

345 42 The onus is on the Appellant to overcome the assumptions and he did not do so here. Mere allegations without appropriate records and books to substantiate his claim cannot be accepted in circumstances and facts such as these which were set in motion to deceive.

43 Since he has not discharged the onus which is upon him the appeal as it relates to this issue will be dismissed.

Issue No. 4: 44 The Minister imposed penalties here because through a series of events the Appellant knowingly or under circumstances amounting to gross negligence appropriated funds from Riverside to his own use and to the use of Brunswick, which he controlled.

45

The onus here shifts and is clearly upon the shoulders of the Respondent.

46

Subsection 163(2) states:

163. (2) Every person who, knowingly, or under circumstances amounting to gross negligence, has made or has participated in, assented to or acquiesced in the making of a false statement or omission in a return, form, certificate, statement or answer (in this section referred to as a "return"), filed or made in respect of a taxation year for the purposes of this Act, is liable to a penalty ...

47 The false statement made in respect of the purchase of the excavator was for the purpose of obtaining an input tax credit under the Excise Tax Act, and is therefore not relevant to the assessment of penalties under subsection 163(2) of the Income Tax Act. However, the Appellant has also clearly and knowingly participated in, assented to and acquiesced in the making of other false statements in respect of amounts appropriated from Riverside and diverted to his own use and the use of Brunswick. Depending on how the Appellant directed Brunswick to treat the $7,000.00 amount referred to in issue 3, he may have also participated in a false statement in this respect. There is simply no evidence in this regard.

48 The Appellant's actions here go far beyond a mere oversight or the failure to use reasonable care. The Appellant was involved in a number of companies and businesses. He produced no reasonable documentation to support his claims. There is much more than mere inadvertence here. The Appellant's conduct is both reckless and wilful. The Minister was justified in assessing the penalties pursuant to subsection 163(2) for the 1998 taxation year. *NOTE: As per Williams v. R., [2005] 1 C.T.C. 2789 (TCC), a loan is not a payment or transfer and thus not caught by subsection 56(2).

346 10. Kiddie Tax s. 120.4 120.4 Tax on split income [Kiddie tax] -- (1) Definitions -- The definitions in this subsection apply in this section. "excluded amount", in respect of an individual for a taxation year, means an amount that is the income from a property acquired by or for the benefit of the individual as a consequence of the death of (a) a parent of the individual; or (b) any person, if the individual is (i) enrolled as a full-time student during the year at a post-secondary educational institution (as defined in subsection 146.1(1)), or (ii) an individual in respect of whom an amount may be deducted under section 118.3 in computing a taxpayer's tax payable under this Part for the year. "specified individual", in relation to a taxation year, means an individual who (a) had not attained the age of 17 years before the year; (b) at no time in the year was non-resident; and (c) has a parent who is resident in Canada at any time in the year. "split income", of a specified individual for a taxation year, means the total of all amounts (other than excluded amounts) each of which is (a) an amount required to be included in computing the individual's income for the year (i) in respect of taxable dividends received by the individual in respect of shares of the capital stock of a corporation (other than shares of a class listed on a designated stock exchange or shares of the capital stock of a mutual fund corporation), or (ii) because of the application of section 15 in respect of the ownership by any person of shares of the capital stock of a corporation (other than shares of a class listed on a designated stock exchange), (b) a portion of an amount included because of the application of paragraph 96(1)(f) in computing the individual's income for the year, to the extent that the portion (i) is not included in an amount described in paragraph (a), and (ii) can reasonably be considered to be income derived from the provision of goods or services by a partnership or trust to or in support of a business carried on by (A) a person who is related to the individual at any time in the year, (B) a corporation of which a person who is related to the individual is a specified shareholder at any time in the year, or (C) a professional corporation of which a person related to the individual is a shareholder at any time in the year, or (c) a portion of an amount included because of the application of subsection 104(13) or 105(2) in respect of a trust (other than a mutual fund trust) in computing the individual's income for the year, to the extent that the portion (i) is not included in an amount described in paragraph (a), and (ii) can reasonably be considered (A) to be in respect of taxable dividends received in respect of shares of the capital stock of a corporation (other than shares of a class listed on a designated stock exchange or shares of the capital stock of a mutual fund corporation), (B) to arise because of the application of section 15 in respect of the ownership by any person of shares of the capital stock of a corporation (other than shares of a class listed on a designated stock exchange), or

347 (C) to be income derived from the provision of goods or services by a partnership or trust to or in support of a business carried on by (I) a person who is related to the individual at any time in the year, (II) a corporation of which a person who is related to the individual is a specified shareholder at any time in the year, or (III) a professional corporation of which a person related to the individual is a shareholder at any time in the year. (2) Tax on split income -- There shall be added to a specified individual's tax payable under this Part for a taxation year 29% of the individual's split income for the year. (3) Tax payable by a specified individual -- Notwithstanding any other provision of this Act, where an individual is a specified individual in relation to a taxation year, the individual's tax payable under this Part for the year shall not be less than the amount by which (a) the amount added under subsection (2) to the individual's tax payable under this Part for the year exceeds (b) the total of all amounts each of which is an amount that (i) may be deducted under section 121 or 126 in computing the individual's tax payable under this Part for the year, and (ii) can reasonably be considered to be in respect of an amount included in computing the individual's split income for the year.

Kiddie Tax - 1999 Federal Budget Proposed Amendments

A variety of provisions in the Income Tax Act prevent individuals from splitting income within families. These rules, known as the attribution rules, are designed to prevent high-income individuals from transferring their income to family members who are taxed at lower marginal tax rates, or who can receive income tax-free. However, the government is concerned about tax planning techniques which, in its view, have been developed to avoid the application of the attribution rules, and the support for income splitting provided by recent case law, including the decision of the Supreme Court of Canada in Neuman v. Minister of National Revenue, [1998] 3 CTC 177, and the decision of the Federal Court of Appeal in The Queen v. K. Ferrel, [1999] 2025 ETC. In response, the Budget proposes the addition of a new measure to prevent the transfer of income from high-income individuals to their children aged 17 or under. Where the proposed measure applies to a receipt of income by a minor child, the minor will be subject to a special tax liability. First, the minor will be taxed on such income at the top marginal tax rate instead of the normal graduated rates. Second, any income caught by the proposed new rule will not be eligible for any deductions or credits other than the dividend tax credit and foreign tax credit. The following types of income will be subject to the proposed measure: taxable dividends and other shareholder benefits on unlisted shares of Canadian and foreign companies (received directly or through a trust or partnership); and income from a partnership or trust, where the income is derived by the partnership or trust from the business of providing goods or services to a business carried on by a relative of the child or in which the relative participates. With respect to income received as taxable dividends, a relative of the minor will not need to be involved in the company in order for the proposed measure to apply.

348 This kiddie tax does not apply to: income from employment or personal services of the minor; dividends received on any listed shares; income from property acquired on the death of a parent; income from any property inherited by disabled individuals who are eligible to claim the disability tax credit; income from any property inherited by individuals who are in full-time attendance at a postsecondary institution; and individuals who have no parent resident in Canada in the year. The parent of a minor child who is liable for tax under this provision will be jointly and severally liable for that tax where the parent was active in the business from which the income subject to tax was derived. To avoid double taxation, a deduction in computing taxable income of the minor child will be introduced to ensure income subject to the proposed measure will not also be subject to ordinary income tax. It is also proposed that, where income is subject to this proposed measure, it will not be subject to the attribution rules. It is intended that the new rule be in effect for the 2000 and subsequent taxation years to allow time for consultation with taxpayers regarding the details of its implementation. 2011 Budget Amendment; Certain taxable capital gains are now subject to kiddie tax.

Demers c. R.
2006 TCC 504
1 This is an appeal from an assessment under the Income Tax Act (the "Act") for the 1999 taxation year. 2 By this assessment, the Minister of National Revenue (the "Minister") added to the Appellant's income $60,000 with regard to taxable dividends of $48,000 paid on August 23 and December 31, 1999, on class D shares of the capital stock of Genex Communications Inc. ("Genex") issued in the names of his two minor daughters on March 3, 1999.. 4 For the purposes of the appeal, the parties submitted an agreement on certain facts, which reads as follows: 1. Genex Communications Inc. ("Genex") was incorporated on June 16, 1996, under the Canadian Business Corporations Act, R.S.C. (1985), c. C-44). (9(a) of the Reply to the Notice of Appeal). 2. Genex operates a radio station (CHOI FM) in the city of Qubec. (9(b) of the Reply to the Notice of Appeal). 3. Genex's fiscal year ends on August 31 of each year. (9(c) of the Reply to the Notice of Appeal). 4. During the period in issue, Genex's authorized capital stock consisted in of the following categories of shares: (i) Class A: voting and participating; (ii) Class B: voting and participating; (iii) Class C: non-voting, non-participating, non-cumulative dividend of 4%, nonpreferential, callable and puttable at the amount of capital paid; (iv) Class D: non-voting, non-participating, non-cumulative dividend. (9(d) of the Reply to the Notice of Appeal). 5. Before March 3, 1999, Genex's issued and paid capital stock was distributed as follows: (i) Appellant: 45,000 class A shares;

349
(ii) Tlmdia Inc.: 10,000 class A shares; (iii) Tlmdia Inc.: 5,000 class B shares; (iv) Octave Inc.: 15,000 class B shares; (v) Tlmdia Inc.: 500,000 class C shares; (vi) Appellant: 1 class D share. (9(e) of the Reply to the Notice of except for (i)). 6. On March 3, 1999, the following shares of Genex capital stock were issued in favour of the following shareholders: (i) Appellant: 6,000 class B shares; (ii) Tlmdia Inc.: 2,000 class B shares; (iii) Octave Inc.: 2,000 class B shares; (9(f) of the Reply to the Notice of Appeal). 7. On March 3, 1999, the shareholders of Genex accepted the subscriptions of Valrie Rochette Demers and Marie-Nol Rochette Demers for one class D share each of the capital stock of Genex and authorized the issue of these shares. (9(g) of the Reply to the Notice of Appeal). 8. Valrie Rochette Demers was born on October 8, 1992 and Marie-Nol Rochette Demers was born on April 14, 1996. (9(h) of the Reply to the Notice of Appeal). 9. On March 3, 1999, Valrie Rochette Demers was 6 years old and Marie-Nol Rochette Demers was 2 years old. (9(i) of the Reply to the Notice of Appeal). 10. During the period in issue, Tlmdia Inc. was a company not related to Genex. (9(j) (in part) of the Reply to the Notice of Appeal). 11. During the period in issue, Octave Inc. was a company controlled by Jean Morin and this company was not related to Genex. (9(k) of the Reply to the Notice of Appeal). 12. During the period in issue, the Appellant was sole director and chief executive officer of Genex. (9(l) of the Reply to the Notice of Appeal). 13. The Appellant is the father of Valrie Rochette Demers and Marie-Nol Rochette Demers. (9(m) of the Reply to the Notice of Appeal). 14. During Genex's fiscal year from September 1, 1997 to August 31, 1998, the Appellant received advances of $36,000 $ ($3,000 per month) from Genex and a dividend of $12,000 on his class D share of Genex's capital stock. (9(u) of the Reply to the Notice of Appeal). 15. During Genex's fiscal year from September 1, 1998 to August 31, 1999, the Appellant received $36,000 in advances ($3,000 per month) and Genex declared a total dividend of $36,000 on class D shares of its capital stock in circulation. (9(x) of the Reply to the Notice of Appeal). 16. The dividend mentioned in point 15 of this paragraph was declared on June 28, 1999, and paid on August 23, 1999. (9(y) of the Reply to the Notice of Appeal). 17. In payment of the dividend of $36,000 mentioned in point 15 of this paragraph, Genex issued: (i) a $12,000 reduction of the advances account; (ii) a cheque for $12,000 made out to Valrie Rochette Demers; and

350
(iii) a cheque for $12,000 made out to Marie-Nol Rochette Demers. (9(z) of the Reply to the Notice of Appeal). 18. On December 31, 1999, the Appellant transferred the class D share that he held in the capital stock of Genex to 3689735 Canada Inc. (9(dd) of the Reply to the Notice of Appeal). 19. During the period from September 1, 1999 to December 31, 1999, the Appellant received $12,000 in advances ($3,000 per month) and Genex declared, on December 31, 1999, a total dividend of $36,000 on the class D shares of its capital stock in circulation. (9(ee) of the Reply to the Notice of Appeal). 20. In payment of the dividend of $36,000 mentioned in point 19 of this paragraph, Genex issued: (i) a cheque for $12,000 made out to 3689735 Canada Inc.; (ii) a cheque for $12,000 made out to Valrie Rochette Demers; and (iii) a cheque for $12,000 made out to Marie-Nol Rochette Demers. (9(ff) of the Reply to the Notice of Appeal). 21. The unanimous agreement of August 31, 1997 between Genex shareholders set out at clause 4.1.8 that the expression "Demers' compensation," for the purposes of said agreement, which also provided that any increase in the Appellant's compensation had to be approved by the shareholders of Genex, [TRANSLATION] "... includes any salary, bonus or other form of benefit (including personal use of contra advertising, at the value of said contra advertising) paid in favour of Mr. Demers or any person who is related or connected to him within the meaning of Canadian tax legislation, including dividends on class D shares, adjusted for the purposes of the tax laws applicable to companies." 5 On August 21, 1997, the Appellant signed with Genex a first one-year agreement concerning his compensation as chief executive officer. The agreement covered the period from September 1, 1997 to August 31, 1998 (Exhibit I-1). Clause 3 set out the following: 3. In return for services provided hereunder, CHOI will pay the chief executive compensation as follows Form of compensation a. Base salary b. Apartment c. Automobile d. Automobiles expenses e. Dividends on class D shares f. Professional fees Annual amount $ 60,000 10,000 8,000 4,000 36,000 12,000 $ 130,000 a. Payable according to the practices in use at CHOI. b. In accordance with the lease currently in effect with CHOI. c. In the form of an exchange contract. d. Upon production of supporting documentation.

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e. Declared on August 31, 1998, with an advance of $3,000 on the 1st of each month. f. Payable to Rochette Demers c.a. $1,000 on the 1st of each month. 6 On June 29, 1998, the Appellant signed a second one-year agreement with Genex concerning his compensation as chief executive officer. The agreement covered the period from September 1, 1998 to August 31, 1999. [Similar compensation arrangement]. 7 A third agreement, again concerning the Appellant's compensation as chief executive officer of Genex, was signed on June 28, 1999, for the period from September 1, 1999 to August 31, 2000. [Similar compensation agreement]. 8 In July 1996, Genex acquired the assets of the radio station CHOI FM from Tlmdia. Approval of the transaction by the Canadian Radio-television and Telecommunications Commission was delayed until September 1997. The Appellant, previously vice-president of Tlmdia, owned 60% of the voting and participating (class A) shares of the capital stock of Genex and one non-voting class D share. Two other shareholders, Tlmdia and Les Entreprises Octave Inc. ("Octave"), shared 40% of the voting and participating (class A and B) shares of Genex's capital stock. Another shareholder, Les Entreprises de Radiodiffusion de la Capitale Inc., owned non-voting and non-participating preferred (class C) shares of Genex's capital stock. 9 On August 31, 1997 the shareholders signed a unanimous shareholder agreement taking away from the directors the powers vested in them under the law, reserving the exclusive exercise of these powers to holders of ordinary (class A and B) shares (Exhibit I-4, clauses 3.2 and 4). These powers that the ordinary shareholders intended to exercise themselves included the power to issue shares or other securities of Genex and the power to effect any increase in the Appellant's compensation as chief executive officer of Genex (Exhibit I-4, clauses 4.1.5 and 4.1.8). The Appellant's compensation was also fixed at a minimum of $150,000 and a maximum of $500,000 per year (Exhibit I-4, clause 4.5). 10 In his testimony, the Appellant explained that the different agreements concerning his compensation represented a sort of budget, a global envelope that the ordinary shareholders could control thanks to the unanimous shareholder agreement (Exhibit I-4). However, these are indeed agreements providing the terms of the Appellant's compensation. It cannot be denied that all of the shareholders holding voting shares unanimously agreed to pay dividends on class D shares and that advances of $3,000 per month payable to the Appellant were provided to reflect these dividends, which were to be declared and paid later. 11 On March 3, 1999, class D shares were issued, one each, in favour of each of the Appellant's minor daughters, for the sum of $1 each. According to Marie-Claude Poitras, tax avoidance officer from the Canada Revenue Agency, no payment was made by the Appellant's daughters or on their behalf and a simple accounting entry for $2 was made in Genex's travel expense account. This fact was not contested by the Appellant, who simply affirmed that it was possible, as he did not check everything. 12 On the same day, an agreement was made between Genex and all of its shareholders, including the Appellant's two daughters represented by the Appellant and his spouse as legal tutors (Exhibit I-5). According to this agreement, the legal tutors agreed that the Appellant would exercise alone, on behalf of their daughters, all rights associated with the shares they held. Moreover, the Appellant's two daughters offered to sell him their class D shares on December 31, 1999, for an amount equal to the subscription price. This offer was accepted by the Appellant in the same agreement. 13 In his testimony, the Appellant admitted that this issue of one class D share each to his daughters was done with a view to reducing his tax burden to a minimum. 14 On August 23, 1999, a dividend of $36,000 was paid on the three class D shares of Genex's capital stock, i.e. a dividend of $12,000 per share. Cheques for $12,000 were issued in the names of each of the Appellant's daughters and deposited in their accounts. The amount was then transferred to the Appellant's bank account and was used to pay back the advances received from Genex (Exhibits I-6 and I-7). Moreover, each of the Appellant's daughters, who were represented by their mother as legal tutor, granted the Appellant interest-free loans of $12,000 that the Appellant could pay back through contributions to their registered education savings

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plans (Exhibits I-8 and I-9). The Appellant stated that he had indeed made contributions to the registered education savings plans of each of his daughters. His contribution, according to what he indicated at the audit, came to $15,000. No document has been offered to prove this fact. 15 On December 31, 1999, another dividend of $36,000 was paid on class D shares of Genex's capital stock. As the Appellant had transferred his class D share to 3689735 Canada Inc. on the same day, this company received a dividend of $12,000. The Appellant's two daughters also received dividends of $12,000 each on their class D shares of the capital stock of Genex. Just like in August 1999, $12,000 was then transferred from each of their bank accounts to the Appellant's bank account, then used to reimburse the advances received from Genex (Exhibits I-6 and I-7). According to the Appellant, he was also granted loans, corresponding to the amounts transferred, by his daughters, who were represented by their mother as legal tutor. No documentation has been provided to this effect. 16 On January 1, 2000, each of the Appellant's daughters allegedly transferred their class D share of Genex's capital stock to 3689735 Canada Inc., a company controlled by the Appellant (Exhibit I-10). 17 Exhibit I-12 gives the breakdown of Genex's advances to the Appellant over the years. On August 30, 1998, after paying a dividend of $12,000 on the only class D share issued at that time, held by the Appellant, the advances of $36,000 paid by Genex to the Appellant were reduced to $24,000. From September 1, 1998 to August 31, 1999, additional advances were paid to him ($3,000 12 months). The total of $60,000 was reduced by $36,000 by the dividend paid on August 23, 1999, of which $24,000 was paid on the two shares issued in the names of the Appellant's daughters. The balance of $24,000 plus additional advances of $12,000 given from September 1 to December 31, 1999 ($3,000 4 months) was reimbursed by the dividend of $36,000 paid on December 31, 1999, of which $24,000 was paid on the two shares issued in the names of the Appellant's daughters. 18 Counsel for the Appellant submitted that the agreements signed between him and Genex were drafted by the Appellant himself, who was not an expert in that area, that these agreements did not necessarily reflect the intention of the parties, that they were not mandatory and that the objective sought was simply to set out a budget allowance for his compensation. According to him, even if the term "compensation" was used to include dividends on class D shares of Genex capital stock, it is a description that is not necessarily accurate since a dividend is not paid as compensation, but simply as the result of owning shares. 19 According to counsel for the Appellant, the agreements provided for payment of dividends on class D shares and not only on the share of this class held by the Appellant. According to him, it had been provided that other class D shares of the capital stock of Genex could be issued. Counsel for the Appellant submitted that, despite the advances, the Appellant had no right to dividends that had not yet been declared, that his daughters had become fully entitled shareholders and that, as such, they were entitled to the dividends on the class D shares of the capital stock of Genex that each of them owned. 20 Counsel for the Appellant argued that income splitting through dividends was a legitimate and recognized tax planning technique until the Act was amended by the addition of section 120.4, applicable from 2000 onward. 21 In support of his arguments, Counsel for the Appellant cited Neuman v. Minister of National Revenue, [1998] 1 S.C.R. 770 (S.C.C.), a decision of the Supreme Court. This Court was referred to Stubart Investments Ltd. v. R., [1984] 1 S.C.R. 536 (S.C.C.), Shell Canada Ltd. v. R., [1999] 3 S.C.R. 622 (S.C.C.) and Singleton v. R., [2001] 2 S.C.R. 1046 (S.C.C.), also decisions of the Supreme Court. 22 Counsel for the Respondent argued first of all that the issue of shares to the Appellant's daughters and the repurchase of the shares by the Appellant in a contract signed on the same day was a sham and that there had never been any intention for the Appellant's daughters to become and remain true shareholders of Genex. First, he pointed out that the shares were never paid for, as is required by subsection 25(3) of the Canadian Business Corporations Act, and that their cost was simply considered a Genex expense. Furthermore, he submitted that their value exceeded $1 when they were subscribed, considering the dividends they carried. In short, counsel for the Respondent argued that only the Appellant was truly a class D shareholder in the capital stock of Genex, that the dividends were payable to him on a monthly basis in the form of advances and that the dividends on the

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class D shares issued in the names of the Appellant's daughters ended up being used to reimburse advances received by the Appellant from Genex. He also argued that the notes signed by the Appellant in favour of his daughters carried no interest, which was unusual, and that the girls had never been reimbursed, despite the fact that the Appellant stated that he had made contributions to their registered education savings plans. 23 Another argument put forward by counsel for the Respondent is that the Appellant's daughters were only used as nominees by the Appellant, who put himself in a situation of conflict of interest by abusing, in a way, his position as tutor for the purposes of issuing shares in his daughters' names, buying their shares in his name, transferring the amount of the dividends on their shares to his personal bank account and issuing notes to them, which were never honoured. According to counsel for the Respondent, the different transactions completed by the Appellant were in violation of the provisions of the Civil Code of Quebec concerning conflict of interest in the administration of the property of others or the rules on presumed sound investments, to which the administrators of such property are bound to observe. In support of his arguments, he invoked articles 208, 1304, 1305, 1310, 1312, 1314, 1315 and 1339 of the Civil Code of Quebec. 24 Furthermore, counsel for the Respondent submitted that the Appellant, as chief executive officer of Genex, was entitled to a certain compensation defined in the unanimous shareholder agreement, including, according to the terms of the agreements with Genex, $36,000 per year in dividends paid monthly in advances of $3,000. In August 1998, an amount of $24,000 in advances had not yet been paid in dividends and its payment was simply carried forward to the following year (Exhibit I-2). According to counsel, this fact demonstrates that the Appellant had a pre-existing right to this amount, which was part of his compensation. Counsel for the Respondent therefore argued that the Appellant, by allowing shares to be issued to his daughters, actually transferred to them an employment income to which the Appellant had a pre-existing right under the agreements with Genex. According to him the word "transfer" received a very broad interpretation and could include the issue of shares. Therefore, since the Appellant transferred an employment income to which he was entitled under the agreements with Genex, subsection 56(4) of the Act should apply and the Appellant should be taxed on the taxable amount of $48,000 in dividends transferred to his daughters. 25 In support of his arguments, counsel for the Respondent referred to [numerous] decisions.

26 The shareholders, by their unanimous shareholder agreement, signed on August 31, 1997, took away from the Appellant, sole director of Genex, all of the powers normally vested in him under the law, reserving them exclusively to themselves (Exhibit I-4, clause 3.2). The shareholders holding so-called "ordinary" shares agreed that what is referred to in clause 4.1.8. of the agreement as any increase in "Demers' compensation" be subject to their approval. This expression is defined as follows: ... "Demers' compensation" includes any, salary, bonus or other form of benefit (including personal use of contra advertising, at the value of said contra advertising) paid in favour of Mr. Demers or any person who is related or connected to him under the meaning of Canadian tax legislation, including dividends on class D shares, adjusted for the purposes of the tax laws applicable to companies. 27 Through three yearly agreements, of which the last one, dated June 28, 1999, was for the period from September 1, 1999 to August 31, 2000 (Exhibit I-3), the shareholders holding voting shares of Genex's capital stock set what they called the Appellant's "compensation" as chief executive officer for the year. Regardless of the word used, it was clearly a matter of determining the maximum amount that the Appellant could receive, whether in straight compensation or in benefits, whatever they may be, from the company. Among these benefits, these shareholders agreed to pay dividends on class D shares, but paid in advances of $3,000 per month to the Appellant until the dividends were actually declared. The Appellant received these advances each month and reimbursed them using the dividends paid on August 23 and December 31, 1999, on the three class D shares issued at the time, including one share issued to each to his two minor daughters on March 3, 1999. On December 31, 1999, the Appellant and his spouse, acting as legal tutors of the children, had the shares issued in the children's names, and the children offered to sell them, on the same day, to the Appellant, who accepted to purchase them. Obviously the purpose of the whole transaction was for the children to receive two thirds of the dividends that would be paid on class D shares in 1999 and to resell them immediately after. I believe this operation is a sham. Moreover, the evidence shows that the shares issued to the Appellant's minor daughters were never really paid for and that there was no intention that they would in fact become or remain real shareholders of Genex. Simply adding $2 for the purchase of shares as an expense in the "travel" account

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to balance the books demonstrates that no real contribution was made by the Appellant's daughters for the purchase of their class D shares of Genex's capital stock. This is in violation of section 25(3) of the Canadian Business Corporations Act, and it can be concluded that the issue of one class D share of Genex's capital stock to each of the Appellant's daughters was not done in a valid manner. On that question, the facts of this case are clearly distinct from those in Neuman v. Minister of National Revenue, supra, in which Iacobucci J. pointed out in paragraph 60 that he assumed that "proper consideration was given for the shares when issued." Even if such tax planning is allowed, it still has to be demonstrated that all of the legal conditions essential to its validity have been met; that has not been done in this case. 28 I will add that the artificial aspect of the entire transaction is also reflected in the notes signed by the Appellant -- one for each of his daughters -- regarding the amounts of $12,000 transferred to his own bank account after the dividends were paid to them on August 23, 1999 (Exhibits I-8 and I-9). That the notes carried no interest is one thing. But that the Appellant planned to reimburse the sums allegedly owed to his daughters via contributions to their registered education savings plans seems to me entirely abusive and artificial. That is to claim to reimburse a debt to the children by using money that is supposed to belong to them to make contributions to their registered education savings plans. In addition, the Appellant never offered any proof of such contributions, nor did he demonstrate that notes had also been signed in relation to the dividends paid on December 31, 1999. 29 Even if it were possible to hold that the issue of category D shares to the Appellant's daughters was valid, I find that the Appellant and his spouse used their position as legal tutors to use their minor daughters as nominees to issue to each of them a class D share of Genex's capital stock so that they could receive dividends on these shares in place of the Appellant. Through a yearly agreement, the shareholders with voting shares, acting under the unanimous agreement, set at $36,000 per year the dividends that would be paid on class D shares and decided that advances of $3,000 would be paid to Appellant in the meantime, which was done. Indeed, both the unanimous agreement and the yearly agreements with the Appellant describe the dividends on class D shares as part of the Appellant's "compensation" for his services as chief executive officer. Even if this description is erroneous in law and dividends are related essentially to ownership of shares (see Neuman v. Minister of National Revenue, supra, paragraphs 57 et seq.), the holders of voting shares had nonetheless agreed that the sums in question would be paid to him in advances of $3,000 per month. In this context, the decision to have one class D share each issued to each of the Appellant's minor daughters to pay them part of the same sums in the form of dividends appears artificial, especially given that no real contribution was provided to Genex for the issue of these shares, as I mentioned above. I find that, as legal tutors, the Appellant and his spouse simply used their daughters as nominees to receive sums that were clearly intended for the Appellant and which he should have included in his income. 30 I find that this is sufficient to rule on the appeal, which is dismissed, with costs to the Respondent.

VII. Paid-up Capital and the Concept of Deemed Dividends

1. General Comments
The concept of paid-up capital under Canadian income tax law is important because it represents the amount that can be paid or distributed to shareholders of a corporation as a return of capital. That is to say, the Income Tax Act allows a shareholder to receive back the paid-up capital of his shares taxfree. Any amount that is returned to the shareholder in excess of the paid-up capital of the share is essentially deemed to be a return of profits and is taxed under the Act as a deemed dividend. The purpose of allowing a shareholder to receive his capital back tax-free is to put the shareholder who finances a corporation through equity capital in the same position as a shareholder who causes his corporation to finance through funds borrowed from the shareholder. In both cases, the equity or borrowed funds can be returned tax-free as a return of capital or a return of principal.

355 Whether or not the amount returned to the shareholder in excess of paid-up capital was in fact generated through profits is not relevant. The corporation could obtain funds otherwise than through the earning of profits. It could have earned capital gains, two-thirds of which would have been taxed. It could have received amounts of cash or could have received property the value of which exceeds the amount credited to paid-up capital, as we will see later. It could have won the 6/49 lottery. It could have had cash or property gifted to it. The point is that the source is not relevant. The rule is simple: if the amount that is returned to the shareholder exceeds the PUC of the share, the excess is deemed to be a dividend and is taxable like ordinary dividends. This concept applies only to funds or property returned or distributed to the shareholder by way of a reduction in corporate capital, a redemption or acquisition of shares by the corporation or on a winding-up of the corporation. Property or cash distributed by way of an ordinary dividend is taxed as an ordinary dividend regardless of whether the corporation has profits and regardless of paid-up capital calculated for tax purposes. (Under corporate law, however, dividends cannot be paid which would otherwise have the effect of reaching into stated capital for corporate purposes.) The concept also does not apply to benefits that are taxed under s. 15(1). It applies only to distributions on reductions of capital, redemptions or acquisitions of shares by the issuer thereof, and to distributions on a winding-up. As we have seen, it also applies in determining the amount of a stock dividend. The purpose of s. 84 is to prevent surplus that would otherwise be distributed by way of a taxable dividend from being distributed tax-free or by way of a capital gain. In CIR v. Burrell, (1924) 9 T.C. 27 (English Court of Appeal), it was held that when a company is wound-up, any undistributed profits on hand at the time of the winding-up which are distributed to the shareholder are not considered to be distributed by way of dividend. Instead the undistributed assets simply form part of the assets which are distributed on the winding-up. In the absence of s. 84, such profits would be received as a capital gain and not as a taxable dividend. The purpose of s. 84 is to put the shareholder in the same position as if the undistributed profits were distributed by way of taxable dividend. Similarly, s. 84 ensures that any amounts distributed on a redemption of capital or repurchase of shares, which are not normally dividends, are taxed as dividends to the extent the amounts distributed on a class of shares exceed the paid-up capital of that class.

2. Application of s. 84
Section 84 applies in four cases. (a) (b) (c) On artificial increase of paid up capital. Ss. 84(1). Winding-up. Ss. 84(2) provides that on a winding-up, amounts distributed to holders of a particular class of shares in excess of the PUC of that class are deemed to be a dividend. Redemption, Acquisition or Cancellation of Shares. Ss. 84(3) provides that amounts distributed on a redemption, acquisition or other cancellation of shares of a particular class in excess of the PUC of that class are deemed to be a dividend. Reduction of Capital. Ss. 84(4) provides that where a corporation has reduced the PUC of any class of shares otherwise than by way of a redemption, acquisition or cancellation of any shares of that class, the amount distributed is deemed to be a dividend to the extent it exceeds the amount by which the PUC of that class has been reduced.

(d)

356 These rules only apply to corporations resident in Canada. To avoid duplications, ss. 84(2) and 84(3) will not apply if ss. 84(1) applies, ss. 84(3) does not apply if ss. 84(2) applies and ss. 84(4) does not apply if ss. 84(2) or (3) apply. If there is a distribution to a shareholder otherwise than on a winding-up, a redemption or acquisition of shares or a reduction of capital, it is not subject to s. 84. It generally will be an ordinary dividend or a taxable benefit under ss. 15(1). Note that ss. 15(1) specifically states that it is not applicable to a dividend (para. 15(1)(b)) nor to an amount that is deemed to be a dividend under s. 84. The effect of this is that s. 84 deems distributions in excess of PUC on a winding-up, reduction in capital or redemption, acquisition or cancellation of shares to be a dividend. Because these transactions will generally occur on a pro rata basis to all shareholders of the corporation or at least to all holders of a class of shares of the corporation, the Act treats the distribution in excess of PUC as a dividend. If the shareholder is a corporation, s. 112(1) will apply to eliminate the dividend from taxable income for Part I purposes and Part IV tax could be applicable. In the case of individuals, the "grossup" and dividend tax credit rules will apply. Hence, ordinary dividends and deemed dividends under s. 84 are granted the same tax treatment. However, if a payment or distribution does not qualify as an ordinary dividend and s. 84 does not apply, then ss. 15(1) will apply to include the amount in income as a shareholder benefit.

3. Definition of Paid-Up Capital. Ss. 89(1)

(a) PUC of a Class of Shares.

The PUC of a class of shares of a corporation is defined in paragraph (b) of the definition of "paid-up capital" found in s. 89(1). If the time of determination is after March 31, 1977, the PUC of the class of shares is equal to the PUC determined under corporate law and without reference to the provisions of the Income Tax Act, subject to the adjustments provided for in the Act. That is to say, the starting point is corporate law. Corporate law does not always use the term "paid-up capital"; indeed, the modern Business Corporation statutes use the term "stated capital". Generally, whether the term used is stated capital or paid-up capital, corporate law will contain some concept of (i) the par value of the shares (the value of the shares on issuance as indicated on the share certificate), in which case the paid-up capital of the class is the par value per share multiplied by the number of shares of that class issued and outstanding, or the amount of the aggregate of the consideration received by the corporation on issuance of the shares.

(ii)

This amount, calculated under corporate law for each class of issued shares, becomes the paid-up capital of that class of shares for purposes of the Act, subject to specific adjustments under the Act. Note that contributed surplus that does not form part of PUC under corporate law will not be included in PUC for purposes of the Act. If a corporation issues shares in consideration of a receipt by it of property worth $100 and pursuant to the appropriate corporate statute, the amount added to the stated capital of that class of shares for purposes of corporate law is less than $100, or the par value per share of that class issued multiplied by the number of shares of that class so issued is less than

357 $100, the addition to PUC for purposes of the Act will be the lesser amount. This could increase the amount of any future deemed dividend. See for example ss. 26(2) and 26(3) of the ABCA. Once the PUC of a class of shares has been determined under paragraph (b) of the definition of "paid-up capital" found in ss. 89(1), it is easy to determine the PUC of each share of that class and the PUC of the whole corporation. (b) PUC of a Particular Share.

To determine the PUC of a single share at a particular time, paragraph (a) of the definition of "paid-up capital" in ss. 89(1) says to take the PUC of the class of shares to which that share belongs and divide that amount by the number of shares of that class that are issued and outstanding at that time. For example, if Corporation XYZ has issued 500 class A shares, with a total PUC of $2500, the PUC of any one class A share will be $5. (c) PUC of the Whole Corporation.

To determine the PUC of all the shares of a corporation at a particular time, paragraph (c) of the definition of "paid-up capital" in s. 89(1) says to simply add up the PUC of all the classes of shares of the corporation issued and outstanding at that time. Under corporate law, PUC of a class of shares is always averaged out over the class. For example, if shareholder A pays $100 for 100 common shares of Corporation XYZ upon its incorporation, and later shareholder B is sold 100 common shares of Corporation XYZ from treasury at a total cost of $150, the stated capital of the class of common shares will be $250 for corporate law purposes. For purposes of the Income Tax Act, the PUC of the class of common shares will be $250 pursuant to subparagraph (b)(iii) of the definition of "paid-up capital" in s. 89(1). If one were to calculate the PUC of the class on a per share basis, paragraph (a) of the "paid-up capital") definition would say that the PUC per share is $250 divided by 200 shares or $1.25 per share. Hence, Mr. A paid $1.00 per share for shares which originally had a PUC per share of $1.00 but now have a PUC per share of $1.25. Mr. B paid $1.50 per share but the shares he holds have a PUC of $1.25 per share. This is because the PUC is always calculated for corporate law purposes as a class by class calculation and this is adopted for tax purposes as the PUC of the class. It also means that the PUC per share for tax purposes is the average PUC per share of the class as recalculated from time to time when new shares are issued by the corporation from treasury. To put it another way, while each shareholder will have his own ACB of shares acquired by him whether from treasury or otherwise which will not be affected by the issuance of new shares, the PUC of his shares is the average PUC of all shares of that class issued and outstanding.

4. Adjustments to PUC under the Act

Subparagraph (b)(iii) of the "paid-up capital" definition in ss. 89(1) provides that corporate PUC of a class of shares must be adjusted under certain provisions of the Act, if applicable, and it is this adjusted amount that is the PUC of that class for purposes of the Act.

5. Operation of Section 84
Increases in Paid-up Capital

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(i)

Deemed Dividend

A resident corporation that increases the paid-up capital of its shares is deemed to have paid a dividend, unless the increase results from: -The payment of a stock dividend; -The issuance of shares for net assets of equal value; -The issuance of shares to reduce a liability of equal value; or -A transaction that reduces the paid-up capital of some other class of shares of the corporation by an equivalent amount. Butfor this rule, a corporation could capitalize its retained earnings distribute them as a return of PUC on a tax-free basis to its shareholders. (ii) Inadequate Consideration

Where a corporation issues shares with a paid-up capital in excess of the consideration it received for the shares, all of the shareholders of that particular class are deemed to have received a proportional dividend. (iii) Cost Base

Where an adjustment to PUC triggers a deemed dividend, the amount of the dividend is added to the cost base of the shareholder's shares. The result is that the amount taxed as a dividend is not included again in income in the calculation of the capital gain or loss upon disposition of the shares. (iv) Stock Dividends

An increase in the paid-up capital of a corporation as a consequence of the declaration of a stock dividend does not give rise to a deemed dividend. The shareholder must include his or her pro rata share of the dividend in income. Concurrently, the shareholder increases the adjusted cost base of the shares on which the dividend is paid by the amount included in his or her income. Assume: A corporation increases its paid-up capital by capitalizing $50,000 of its retained earnings.
Equity Structure $ Before 1,000 Class A shares 1,000 Class B shares Retained Earnings 50,000 10,000 100,000 160,000 $ After 100,000 10,000 50,000 160,000

The Class A shareholders are deemed to receive a dividend of $50 for each share held. The adjusted cost base of each Class A share is increased by $50.

359 (v) Pro Rata Dividend

A dividend that is deemed to have been paid on shares as a result of a PUC adjustment is also deemed to have been received by each shareholder of the class on a pro rata basis. Assume: A corporation has the following balance sheet:
$ Assets Liabilities 1,000 Class A shares Retained earnings Liabilities and Equity 100,000 20,000 50,000 30,000 100,000

In exchange for land valued at $25,000, the corporation issues an additional 500 shares to A, its principal shareholder, and increases its stated capital by $40,000. Another shareholder, B, owns 80 Class A shares which she purchased for $50 per share from the corporation.
Balance Sheet After Share Issue $ Assets Liabilities 1,500 Class A shares Retained earnings Liabilities and Equity 125,000 20,000 90,000 15,000 125,000

In effect, the corporation has "diluted" its stock by $15,000. Then:

Increase in PUC of class Increase in net assets Deemed dividend (subs. 84(1) Number of shares outstanding Dividend/share Total dividend to B ($10 x 80) ACB of B's share before transaction (per share basis) Add: deemed dividend ACB of Bs share after transaction $ 40,000 (25,000) 15,000 1,500 10 $

800 50 10 60

360 (vi) Conversion of Shares

Where corporate shares are converted from one class into another, the amount paid on the conversion should be equal to the increase in the paid-up capital of the new share issue. Assume: A corporation's share structure at the end of its fiscal year is as follows: 1,000 Convertible Class A shares 1,000 Class B shares $ 5,000 20,000 $25,000

The Class A shares are convertible into Class B shares on a one-for-one basis. If one-half of the Class A shares are converted into Class B shares, the new share structure would be as follows: 500 Convertible Class A shares 1,500 Class B shares $ 2,500 22,500 $25,000

Since the amount paid on conversion ($2,500) is equal to the paid-up capital of the Class A shares that were converted, the transaction does not give a rise to a deemed dividend. Liquidation or Winding up At common law, payments to shareholders on the liquidation of a corporation are considered to be on account of capital. Thus, in the absence of a special rule for tax purposes, liquidation payments paid out of a corporation's pre-liquidation earnings would be converted from income into tax free capital. (i) Deemed Dividends

The Act modifies the common law rule. A resident corporation that distributes its property to its shareholders on its winding-up or discontinuance or on the reorganization of its business is deemed to have paid a dividend. The dividend is equal to the amount by which the value of the property distributed exceeds the amount by which the paid-up capital of the corporation is reduced through the distribution.* Shareholders of the class affected by the distribution are deemed to receive a dividend equal to their pro rata shareholding. (ii) Reduction in Proceeds

The amount of the deemed dividend is excluded from the proceeds of disposition of the shares cancelled upon winding-up. The effect of these rules is that an amount distributed by a corporation to its shareholders on its winding-up or discontinuance or the reorganization of its business may be divided into two portions: (1) The amount paid in excess of the reduction in paid-up capital is deemed to be a dividend, and is taxed as income; and (2) The remaining portion (the amount that represents the reduction in paid-up capital) is returned to the shareholder as a payment on account of capital, which reduces the adjusted cost base of the shares.

361

A resident corporation has a paid-up capital of $5,000 divided into 5,000 Class A shares with a paidup capital of $1 per share. The corporation discontinues its business, makes a cash distribution of $3 per share, and reduces its paid-up capital to nil. The tax consequences to an individual shareholder who owns 500 of the issued Class A shares purchased at $1 per share are as follows: 1. Dividend deemed paid by corporation: Cash distribution Less: reduction in paid-up capital Dividend deemed by subs. 84(2) 2. 500 5,000 Dividend deemed received by individual: x $10,000 $ 1,000 $ 15,000 (5,000) $ 10,000

3. Adjustment to cost base of shares: ACB of shares before payment (assumed) Less: pro rata (10%) reduction in paid-up capital ACB of shares after payment 4. Summary:

$500 (500) $

Deemed dividend $2/share -- 500 shares Return of capital $1/share X 500 shares $3/share X 500 shares Total

$ 1,000 500 $ 1,500

Redemption, Acquisition or Cancellation of Shares (i) Deemed Dividend

A resident corporation that redeems, acquires or cancels any of its shares (except on its winding-up or discontinuance or a reorganization of its business, or on the open market) is deemed to have paid a dividend on the redeemed, acquired or cancelled shares. The dividend is equal to the excess of the amount paid by the corporation to its shareholders over the paid-up capital of the shares cancelled. The shareholder is deemed to have received a dividend which is directly proportionate to the number of shares cancelled over the total number of shares cancelled. (ii) Reduction in Proceeds

The deemed dividend is not included in the shareholder's proceeds from the disposition of the shares. The purpose of this provision is to ensure that all amounts paid by a resident corporation to acquire its own shares are taxable to the shareholder, except to the extent that the amount paid represents a

362 return of paid-up capital. Thus, the shareholder does not have the payment taxed as a deemed dividend and a capital gain when he or she disposes of the shares. (iii) Capital Gain

In addition to any amount deemed to be a dividend, a shareholder may also realize a capital gain or loss from the acquisition of shares. Payments to a shareholder on account of a redemption of shares do not give rise to a shareholder benefit.* Subsection 84(3) does not apply where a corporation purchases its own shares on the open market in a normal stock market transaction. An individual owns 100 redeemable shares. Consider the following alternatives: Case A $ 100 100 500 Case B $ 100 300 500

PUC ACB FMV

The shares are redeemed at their fair market value in a private (non-market) transaction. Then: Case A Case B $ $ (i) Redemption price 500 500 PUC (100) (100) Deemed Dividend (ii) Cash received Less Deemed Dividend Proceeds of Disposition ACB Capital Gain (Loss) Reduction of Paid-up Capital (i) Deemed Dividend 400 500 (400) 100 (100) $NIL 400 500 (400) 100 (300) $(200)

A corporation may return its share capital to its shareholders on a tax-free basis. A resident corporation that reduces its paid-up capital* and makes a payment to its shareholders in excess of the reduction, is deemed to have paid a dividend equal to the amount by which the payment exceeds the reduction in the paid-up capital of its shares. (ii) Pro Rata Distribution

A shareholder who holds shares of the class that has had its paid-up capital reduced is deemed to receive a pro rata share of the dividend that is deemed to have been paid by the corporation.* At the

363 same time, the adjusted cost base of the shares is reduced by deducting the pro rata portion of the reduction in paid-up capital. (iii) Public Corporations

An amount paid by a public corporation on a reduction of its paid-up capital is deemed to be a dividend unless the reduction takes place on a redemption, acquisition or cancellation of its shares, on a winding-up or as part of a reorganization of capital. Negative Adjusted Cost Base A return of PUC is not taxable in the shareholder's hands and is thus preferred to a dividend distribution, especially for an individual. PUC is usually based on the original issue price of shares, not on the current shareholder's adjusted cost base (ACB). A shareholder's ACB may be less than the shares' PUC if, for example, the shareholder bought shares for less than their PUC or acquired treasury shares at less than the average issue price for the class. If the PUC reduction exceeds the shareholder's ACB, he faces a capital gain. Moreover, a PUC distribution reduces the shareholder's ACB. However, if the PUC distribution is reinvested in additional shares, then the average ACB is continually refreshed and the shareholder may benefit from future tax-deferred PUC distributions. Eliminating Double Taxation There are special rules to eliminate the possibility of double taxation. Subsection 84(4) does not apply in respect of a reduction in the paid-up capital of a corporation if the transaction leading to the reduction can fit under either subsection 84(2) or 84(4.1). Similarly, a deemed dividend described in subsections 84(2) and (3) does not arise to the extent that the transaction falls within subsection 84(1); nor is there a subsection 84(3) deemed dividend if the transaction can fit under subsection 84(2). These rules prevent overlapping or double taxation of the same transaction. Where a portion of a dividend deemed to be paid under any of subsections 84(2), (3) or (4) consists of shares of the corporation paying the dividend, for the purposes of determining the amount of the dividend, the shares are valued at their paid-up capital. As a result of this rule, there is no deemed dividend to the extent of the paid-up capital of the shares.

6. Review of the Concept of Paid Up Capital

The following article provides an excellent overview of the concept of paid up capital. NOTE: The first 10 pages will be very useful now. You should review the remainder of the article after you have studied sections 85 and 84.1.

Paid-Up Capital Planning (Canadian Tax Foundation)

Jennifer J. Smith*** and Shiyamala S. Devon**** Paid-up capital (PUC) is a concept of fundamental importance to the tax system. Its primary role is in determining the tax consequences of corporate distributions and reorganizations. Of foremost significance is the fact that PUC generally can be distributed to shareholders on a tax-free basis. The

364 manner in which PUC is calculated in particular circumstances is critical to the availability of tax-free treatment. In some circumstances, certain provisions of the Income Tax Act may apply to result in dividend income to the shareholder, which may be subject to tax. This article discusses some of the planning and pitfalls relating to the calculation of PUC. Particular issues addressed include recent developments in the application of the section 84.1 surplus-stripping rule, private versus public company share redemptions and returns of capital, exceptions to the deemed dividend rule, capitalization of contributed surplus, and PLIC shifts. Introduction The rules relating to the calculation of paid-up capital (PUC) can be utilized by the attentive tax planner to capitalize on tax savings. At the same time, failure to consider the PUC implications of a transaction can often result in significant adverse tax consequences. The starting point for the calculation of PUC is the corporate law concept of stated capital. However, the Income Tax Act contains a number of adjustments to stated capital to determine PUC. The first part of this article discusses the concept of PUC generally and scenarios in which important PUC issues arise. The second part of the article explores a number of particular PUC issues, including recent developments in the application of the section 84.1 surplus-stripping rule, private versus public company share redemptions and returns of capital, exceptions to the deemed dividend rule, capitalization of contributed surplus, and PUC shifts. Overview of PUC What is PUC? In simple terms, PUC is share capital for tax purposes. It is a crucial element in tax planning because PUC is effectively a measure of the amount that can be returned tax-free to shareholders from the corporation, assuming sufficient adjusted cost base (ACB). Any amount recovered from the corporation in excess of the PUC amount will be treated as dividend income, which may or may not be subject to tax. PUC represents, in theory, the amount of money shareholders put into the corporation from their after-tax dollars. Since that amount has already been taxed, the shareholders are protected from being taxed again on that same amount. However, since PUC is an averaged concept, individual shareholders may find that the PUC attributable to the shares they hold is not equivalent to the amount paid on issue of their shares. While this feature can have adverse tax implications for some shareholders in certain circumstance, it also gives rise to many planning opportunities, some of which are discussed in the second part of this article. Deemed Dividends There are numerous provisions of the Act dealing with the tax consequences of dividends and deemed dividends to both the corporation and its shareholders. Corporate law recognizes dividends paid in cash, in stock, and in kind. In addition, the Act accords certain corporate transactions that are capital in nature the same tax treatment as dividends by characterizing such transactions as giving rise to deemed dividends. These transactions include an increase in PUC without a corresponding increase in the net asset value of the corporation (subsection 84(1) of the Act); payments made by the corporation on the repurchase of its shares to the extent that the amounts paid exceed the PUC of the shares as determined pursuant to the Act (subsection 84(3)); distributions made on the winding up of a corporation (subsection 84(2)) to the extent that the distribution exceeds the PUC of the corporation for tax purposes; and distributions made by way of reduction of the corporate capital to the extent that such distribution exceeds the PUC for tax purposes of the particular shares (subsection 84(4)). The

365 Act also deems a dividend to have been paid in certain circumstances when an individual sells shares to a corporation with which the vendor does not deal at arms length (sections 84.1 and 212.1). The Canada Business Corporations Act makes specific allowance for stated capital to be increased. However, subsection 84(1) of the Income Tax Act provides that an increase in PUC without a corresponding increase in the corporations net asset value results in a deemed dividend. The Canada Customs and Revenue Agency (CCRA) also maintains that in the event that a disposition of shares to a third party results in a capital gain and not a dividend, it may have the right to assess a deemed dividend (McNichol et al. v. The Queen, 97 DTC 111 (TCC) and Geransky v. The Queen, 2001 DTC 243 (TCC)).. Subsection 84(1) exempts certain events from the application of the automatic deemed dividend rules specifically, if the corporation payment is via a stock dividend (paragraph 84(1)(a)); if the increase in PUC in one share class is counterbalanced by a corresponding decrease n PUC in another class (paragraph 84(1)(b)); and if the payment amounts to a capitalization of contributed surplus (paragraph 84(1)(c)). It is important to note t hat in the case f paragraph 84(1)(a), when a stock paid out by the corporation, the amount of the stock dividend paid must be equal to the resulting increase in PUC and may not necessarily be equal to the fair market value (FMV) of the issued stock. (See also Praxair Canada Inc. v. The Queen, 93 DTC 5100 (FCTD)). Calculation of PUC The calculation of PUC is not specifically prescribed in the Act. Rather, the initial calculation of PUC is based on the relevant corporate law. The amount calculated under corporate aw is usually referred to as the stated capital of a corporation; the amount of stated capital is usually indicated on the corporations financial statements. The stated capital is then subject to adjustment by specific provisions of the Act referred to in subsection 89(1) in order to determine the PUC. In the event that the stated capital of a corporation is calculated in a foreign currency, PUC is calculated using the rate of exchange in effect at the time the particular entries to stated capital occurred. Paragraph 89(1)(a) confirms that the PUC of shares is an averaged concept, calculated on a class-byclass or series-by-series basis. That is, the PUC of shares within one class or series will be uniform since the disparate amounts of PUC paid for each share will be averaged across the class. Consequently, any change with respect to the PUC of certain shares in a class will be reflected in the PUC of the other shares of the class. For example, the corporation cannot reduce the PUC of certain shares without correspondingly decreasing the PUC of all other shares of that class. Any consideration received from a shareholder for which the shareholder does not receive shares is not included in PUC unless it is included in the stated capital account. As a result of the averaged nature of PUC and the possibility that the shareholder redeeming shares did not originally purchase his shares from the corporation, the amount of money paid by the shareholder for his or her shares may not be the amount that the taxpayer gets back tax-free from the corporation. It appears that PUC cannot be a negative amount, on the basis of the use of the concept in the Act.1 If a negative PUC were possible, it might result in a situation where the deemed dividend on a redemption was greater that the proceeds of disposition, a result that is clearly not intended by the Act. In any relevant, if one can consider PUC to be calculated by means of an algebraic formula, section 257 will apply to deem any negative amount to be nil. Calculation of Stated Capital

366 As discussed above, stated capital is the starting point for the calculation of PUC. It is the notional account that keeps track of the amount of consideration received by the corporation in exchange for its shares. In Canada, each of the 10 provinces and three territories has legislation that directs the creation of corporations. In addition, the CBCA allows for federal incorporations. As a result, there are 14 different statutes, each of which provides specific rules for the determination of and changes to legal PUC, and rules regarding its distribution. For the most part, these statutes have similar rules for tracking stated capital. Each class or series of shares will have its own stated capital account to be credited with the amount of the consideration received from each issuance. Stated capital is an averaged concept; the stated capital per share is averaged across the class or series. Stated capital must be adjusted whenever shares are issued or shares are redeemed or purchased for cancellation. For corporate law purposes, stated capital is most important in the context of the solvency test that must be met in order for a corporation to redeem any shares: first, the corporation must be able to pay its liabilities as they come due, both before and after the redemption amount is paid out; and second, the realizable value of the corporations assets after redemption must not be less than the aggregate of the liabilities and the stated capital of shares ranking equal to or higher than the shares being redeemed. The main distinction between the various statutes is whether they provide for the creation and issuance of shares with a par value. The CBCA and most provincial statutes no longer allow for the issuance of such shares. Furthermore, shares of corporations incorporated in these jurisdictions may not be issued until fully paid for in either money, past services, or property. For this purpose, property generally does not include promissory notes or promises to pay. Where a corporate statute permits the issuance of shares with a par value, the stated capital addition is generally limited to the par value of the shares. This is the case even if the value of the property transferred to the corporation is greater than the aggregate par values of the shares issued. For example, if the par value of a share is $100 and 10 shares are issued, the addition to the stated capital of those shares is $1,000, irrespective of the FMV of the consideration received by the issuer (assuming that the consideration is not less than $1,000). As a result, premiums paid on the issuance of par value shares are usually shown as contributed surplus for accounting and corporate purposes, will not form part of PUC for tax purposes, and may be withdrawn from a corporation only as a taxable dividend. Separate Classes of Shares Since stated capital and PUC are calculated on a class-by-class basis, the conventional advice that has been given to prospective shareholders (who are likely paying more for their shares than the original investors) is that they should invest in a separate class of shares to avoid the averaging effect. However, since the new investor will likely wish to purchase shares that have identical rights to the shares issued to the original investors, the question arises whether a corporation can have multiple classes of shares with identical rights. The term class is not specifically defined in the Act. The CCRA has stated that, provided that the shares are treated as separate classes under corporate law, the shares are regarded as separate classes for purposes of the Act. This causes a concern since the equality principle of corporate law dictates that classes of shares must be treated equally in connection with the payment of dividends and the distribution of capital unless the articles of incorporation specifically provide for unequal treatment. Therefore, shares that are nominally in different classes but have identical rights may, at law, be regarded as identical shares. Tax planners have traditionally recommended that for separate classes of shares to be created, there should be some distinction in the share conditions, even if it is relatively minor. For

367 example, one approach commonly used is to provide one class with a small priority (say, $100) over another class upon liquidation. One may question whether such a minor distinction effectively overrides the equality principle. It has also been suggested that a simple solution to the PUC averaging rule is to issue shares within a class in series. Subsection 248(6) of the Act provides that where shares within the same class are issued in multiple series, each such series is treated as a separate class and PUC is computed on a series-by-series basis. This provision ensures that the PUC of each series will be accounted for separately and without regard to amounts paid up on other series or redemptions made of shares of other series. However, this provision was not intended to be used as a means for differentiating what would otherwise be identical shares under corporate law rules. Therefore, there is some reluctance to rely on this rule alone to override the equality principle. The case of The Queen v. McClurg,, 91 DTC 5100 (SCC), provides support for the position that the presumption of equality can be rebutted by the use of discretionary dividend clauses. This case involved an income-splitting arrangement with classes of shares having similar, though not identical, rights. The articles of incorporation provided for three categories of shares: class A which were common, voting, and participating shares; class B, which were common, non-voting, and participating where authorized by the directors; and class C, which were preferred, non-voting shares. All three classes of shares carried the distinction and right to receive dividends exclusive of other classes of shares in the corporation. The taxpayer, a director of the company, held class A shares and his wife held class B shares. During the relevant period, he received salaries and bonuses, but no dividends. His wife, who held class B shares, received annual dividend distributions of $10,000. In other words, dividends were paid on one class of shares and not on the other. The minister reassessed the taxpayer on the basis that the dividends should be attributed equally to all of the common shares, no matter what class, and notwithstanding the express condition attaching to the class B shares that they carried the right to receive dividends exclusive of other classes of shares in the company. The taxpayer unsuccessfully appealed the reassessment to the Tax Court of Canada, but this decision was overturned by the Federal Court Trial Division. The ministers appeals to the Federal Court of Appeal and the Supreme Court of Canada were both unsuccessful. The Supreme Court of Canada held that discretionary dividend clauses may be validly used, since they are not contrary to common .aw or corporate law principles. Chief Justice Dickson, writing for the majority, stated that the presence of a discretionary dividend clause can only be interpreted as creating differences between share classes, since that is the rationale for the clause. This approach was confirmed in the case of Neuman v. The Queen,, 98 DTC 6267 (SCC). In summary, it appears that simply naming otherwise identical shares as separate classes or series is not a sufficient distinction to create a separate class for corporate law purposes. If one wishes to avoid the averaging of PUC by utilizing separate classes of shares, it appears that, on the basis of Chief Justice Dicksons comments, discretionary dividend clauses can be utilized. However, it should be noted that in McClurg, each class of shares had some unique features. Prudence suggests that there should be some distinction in the share attributes. PUC Adjustments The adjustments to the PUC of a class of shares mandated by subsection 89(1) can be broadly grouped into four categories.

368 1. provisions intended to limit PUC where shares are issued in the context of a reorganization, including share conversions, the tax-deferred transfer of assets into a corporation in exchange for shares, amalgamations, and share-for-share exchanges (see, for example, the rules in subsections 51(3), 85(2.1), 85.1(2.1), 86(2.1), 87(3) and (9), 138(11.7), and 139.1(6) and (7) 2. provisions intended to prevent the removal of surplus from a corporation in the form of a return of capital rather than as a dividend, as provided in sections 84.1, 84.2, and 212.1; 3. provisions that ensure that the PUC of the shares of a corporation that has immigrated to Canada will not be greater than the tax cost of the corporations assets less the amount of its liabilities (see subsections 128.1(2) and (3)); and 4. provisions that adjust the PUC to take into account the flowthrough of certain expanses to holders of flowthrough shares (see subsections 66.3(2) and (4), 192(4.1), and 194(4.1)). A detailed review of these various adjustment provisions has been covered elsewhere and is beyond the scope of this article. However, there are some issues that are worth highlighting, including the distinction between the respective PUC implications of rollovers under sections 85 and section 85.1, and recent developments in the law concerning the application of section 84.1. Sections 85 and 85.1 Both section 85 and section 85.1 can provide a rollover where a taxpayer sells shares of one taxable Canadian corporation to another taxable corporation in exchange for shares of the second corporation. When there are many diverse shareholders, a share-for-share exchange under section 85.1 is easier to accomplish than a section 85 rollover, because there is no need for each shareholder to file an election. The provisions of section 85.1 apply automatically unless the vendor includes any gain or loss on the transaction in his or her income tax return. Despite the administrative ease of such rollovers, there may be some disadvantages to relying on section 85.1. For example, in a section 85 rollover, the PUC of the new shares will be limited to the ACB of the old shares to the vendor, provided that this is the amount jointly elected. On the other hand, under section 85.1, the PUC of the new shares will be limited to the PUC of the old shares. In addition, the cost of shares acquired by a transferee in a transaction completed under section 85 will be equal to the elected amount set out in the section 85 election. By contrast, the cost of any shares acquired in a share-for-share transaction under section 85.1 will be equal to the lesser of the FMV and the PUC of the acquired shares, both of which are measured immediately before the exchange. In many cases, the PUC of the old shares will be less than their ACB, and a section 85 election will therefore be the preferred course of action. There may, however, be circumstances in which the PUC exceeds or is equal to the ACB, and a section 85 election will therefore be the preferred course of action. There may, however, be circumstances in which the PUC exceeds or is equal to the ACB of the acquired shares. In this case, the parties may prefer to have the transaction structured as a section 85.1 exchange rather than a section 85 exchange. Traditionally, most transactions involving exchanges of public company shares have relied on the rules of section 85.1, even if the ACB of the old shares is greater than their PUC, given that there is no need for each shareholder to file an election. However, it has been pointed out that the use of section 85 elections to achieve tax-planning advantages should not automatically be dismissed in this context. Sometimes the tax advantages to shareholders will be significant enough to outweigh the additional administrative burden.

369 Section 84.1 Section 84.1 has been called the income tax provision from hell for many tax practitioners. The purpose of section 84.1 is to prevent the removal of corporate surplus as a distribution of capita rather than a taxable dividend where there is a non-arms-length transfer of shares. This is a valid antiavoidance purpose, but section 84.1 is complex and arbitrary, making it a potential trap for the unwary. Apparently, a significant number of claims have been made to professional liability insurers as a result of practitioners overlooking the implications of section 84.1. The type of transaction that section 84.1 is designed to prevent may best be illustrated through an example. Assume that Ms. X is the sole owner of the shares of Opco. The Opco shares have a PUC and ACB of $1,000 and a current FMV of $10,000. Opco also has $10,000 of cash. Rather than paying personal tax on a dividend from Opco, Ms. X forms Holdco and sells the Opco shares to Holdco in return for a $10,000 note, claiming the capital gains exemption. Opco and Holdco are then amalgamated and the note is paid using the cash from Opco. To prevent this type of arrangement from succeeding, section 84.1 provides for a reduction in the PUC of any shares issued by the purchaser corporation (paragraph 84.1(1)(a)) or may deem any nonshare consideration received from the purchaser corporation to be a dividend (paragraph 84.1(1)(b)). The provision of section 84.1 will generally apply where a taxpayer (other than a corporation) disposes of shares of a corporation resident in Canada (the subject corporation) to another corporation (the purchaser corporation) with which the taxpayer does not deal at arms length, and immediately after the disposition, the subject corporation would be connected with the purchaser corporation (within the meaning assigned by subsection 186(4) as modified by section 84.1). As a result of the application of section 84.1, Ms. X will be deemed to have received a dividend under paragraph 84.1(1)(b). The amount of the deemed dividend is determined by the formula (A+D)-(E+F), where A is the increase in the legal PUC of the purchaser; D is the FMV of the non-share consideration; E is the greater of the PUC and the ACB of the transferred shares; and F is the total reduction in the PUC resulting from the application of paragraph 84.1(1)(a).

The deemed dividend to Ms. X will therefore be (0+$10,000)-($1,000+0)=$9,000. If, instead of receiving a note, Ms. X had been issued preferred shares of Holdco redeemable for $10,000, paragraph 84.1(1)(b) would not have applied. However, paragraph 84.1(1)(a) would have restricted the PUC of the preferred shares to $1,000, so that Ms. X would be subject to deemed dividend treatment on a future redemption of these shares. Arms-Length Test As noted, section 84.1 will apply only when the purchasing corporation does not deal at arms length with the vendor of the shares. The question of what constitutes arms length for these purposes has been considered in two recent court cases and a CCRA technical interpretation. In the case of Hickman v. The Queen, 2000 DTC 2584, the Tax Court of Canada held that section 84.1 applied when a taxpayer transferred shares to a holding company owned by a family trust. Since

370 this kind of transaction is a fairly common estate-freezing technique, the case should be read closely by those engaged in estate planning. As is typical of most family trusts, the trustees consisted of the taxpayer, the taxpayers spouse, and an independent third party. However, the trust agreement provided for decisions of the trustees to be made by way of majority vote. As a result, the Tax Court held that the taxpayer and the holding company were not dealing at arms length on the basis that the taxpayer and her husband were in a position to control decisions of the trust through a majority vote. It is fairly standard practice for family trust agreements to have one independent trustee and to require unanimous decisions of the trustees. Query whether the result in Hickman would have been different had this been the case. The taxpayer will be considered to deal not at arms length with the corporation pursuant to the provisions of paragraph 84.1(2)(b) where the taxpayer is a member of a group of fewer than six persons that controlled the subject corporation immediately before the disposition and a member of the same group of persons that controlled the purchaser corporation immediately after the disposition. The CCRA has taken the position in the past that it can add together the shares held by any five or fewer persons for the purposes of paragraph 84.1(2)(b), whether or not such persons act in concert to exercise control of the corporation. The recent Federal Court of Appeal decision in Silicon Graphics Limited v. The Queen, 2002 DTC 7112 (FCA), considered the meaning of control by one or more persons in the context of the definition of Canadian-controlled private corporation (CCPC) in subsection 125(7). The principles set out in that case appear to have invalidated the CCRAs approach. The taxpayer in the Silicon Graphics case claimed CCPC status and enhanced scientific research and experimental development benefits under subsection 127(10.1) and section 127.1 The issue before the Tax Court of Canada was whether the taxpayer was controlled, directly or indirectly in any manner whatever, by one or more non-resident persons within the meaning of the CCPC definition in subsection 125(7) and the extended meaning of control in subsection 256(5.1). The taxpayers common shares were widely held and more than 50 percent of those shares were owned by unrelated non-residents. The Tax Court concluded that the non-resident shareholders had de jure control of the taxpayer because they held the simple majority of voting shares, notwithstanding that there was no common connection between them. The taxpayer appealed to the Federal Court of Appeal. The court equated the phrase control by one or more persons in the CCPC definition with the phrase control by a person or group of persons, and, on the basis of prior case law, agreed with the taxpayer that in order for a group of persons to be in a position to exercise de jure control, a common connection, the Federal Court of Appeal overturned the Tax Court of Canadas decision. The CCRA did not seek leave to appeal Silicon Graphics to the Supreme Court of Canada and has acknowledged that it accepts the findings in the case. Therefore, the correct position appears to be that fewer than six persons referred to in paragraph 84.1(2)(b) must be acting in concert before they will be considered to control a corporation for purposes of section 84.1. In a recent technical interpretation, the CCRA considered the application of section 84.1 to a group of unrelated shareholders who transferred their shares of Opco to a holding company, Holdco. In the CCRAs view, the shareholders were acting in concert and therefore factually did not deal at arms length with Holdco. Holdco was viewed as merely accommodating the shareholders by entering into the share purchase transaction, since it did not have any independent interest in acquiring such shares. This seems to be a harsh result from a policy standpoint, given that the shareholders were unrelated and had independent interests vis--vis one another.

371 Some plans have attempted to utilize an arms-length relationship to circumvent section 84.1. The most well known of such cases is McNichol et al. v. The Queen. This case involved four lawyers who owned a company whose only asset was $320,000 cash. They sold the shares of the company for cash proceeds of $300,000 to another company owned by one of their clients. The capital gain from the sale of the shares was sheltered by the $100,000 capital gains exemption (now repealed). Both companies were amalgamated a few days later, with the end result that the clients company was left with approximately $20,000 more cash than it had before the commencement of the transactions and the lawyers ultimately divested themselves of their interest in their company on a tax-free basis. The CCRA applied section 84.1 on the ground that the lawyers and the clients corporation dealt with each other on a non-arms-length basis. As well, the general anti-avoidance rule (GARR) in section 245 was applied to the series of transactions. The court did not agree with the CCRAs assertion as to the non-arms-length relationship between the parties. Therefore, section 84.1 was not technically the provisions that ultimately resulted in the taxing of the transactions. However, the court found that GARR should apply to the series of transactions, whose only purpose was the stripping of surplus from the company. The court concluded that the taxpayers had misused sections 38 and 110.6 of the Act. The result in McNichol leads to the conclusion that although certain transactions can be designed to technically circumvent provisions such as section 84.1, if the transactions are void of any bona fide business purpose, GAAR may apply. Other relevant cases are RMM Canadian Enterprises Inc. et al. v. The Queen 97 DTC 302 (TCC), and Nadeau v. The Queen, 97 DTC 324 (TCC). The result in McNichol should be contrasted with the tax treatment of a shareholder leveraged buyout, a series of transaction that has been given express approval by the CCRA. In a relatively recent technical interpretation, the CCRA considered the following scenario. Mr. A, Mr. B, and Mr. X each hold a one-third interest in the issued capital stock of Opco. Mr. A and Mr. B wish to purchase the shares of Mr. X in Opco for $100,000. Mr. A and Mr. B from Newco, in which they hold equal shares. Newco purchases the shares of Mr. X in Opco for $100,000 and pays for them by issuing a promissory note for the same amount. Opco buys back the shares held by Newco for $100,000. Newco uses that money to repay the $100,000 promissory note issued to Mr. X. The CCRAs view is that neither section 84.1 nor GAAR applies to the series of transactions. However, the CCRA has indicated that if Mr. X were selling only a portion of his shares of Opco to Newco, the application of GAAR would be considered. In other words, the selling shareholder has to be severing his or her relationship with the corporation. The policy rationale for this requirement is unclear. Various PUC Issues Share Redemptions The Impact of the Solvency Test A private company shareholders agreement may provide that the shares of a departing shareholder will be acquired by the corporation itself, rather than by the remaining shareholders. The corporate statutes that govern the company place limitations on the capacity of the corporation to acquire its shares based on a solvency test, and the question often arises whether the CCRA can challenge a particular transaction if it fails to meet the solvency test. For example, under the CBCA, in order to redeem or repurchase shares, there must be reasonable grounds for believing that

372 the corporation will, after the redemption or repurchase of the shares, be able to pay its liabilities as they become due; and the realizable value of the corporations assets after the payment will not be less than the total of its liabilities and stated capital.

If this solvency test cannot be met, one possible solution is for the corporation to return capital rather than redeem shares. The comparable test for payments in reduction of capital requires only that the value of assets not be less than liabilities. In any event, it is doubtful that the CCRA has the right to challenge a share capital redemption that is in breach of the solvency test. The CBCA, like most provincial corporate statutes, provides that if shares are redeemed or purchased for cancellation contrary to the solvency tests outlined above, the directors of the corporation are jointly and severally liable to restore to the corporation the money so paid. It is the shareholders, and in some cases creditors, who have a right to bring action against the directors; however, the redemption itself is not invalidated, and no party other than an aggrieved shareholder or creditor has the right to challenge the corporate action. If, as in many private corporations, the directors and the shareholders are the same persons, such a challenge is highly unlikely. Support for this argument can be found in the Supreme Court of Canadas decision in Continental Bank Leasing Corporation v. The Queen et al. (98 DTC 6505). In that case, the minister of national revenue reassessed the taxpayer on the basis that a partnership transaction was invalid since, under section 174(2) of the Bank Act, a bank could not, directly or indirectly, participate in a partnership in Canada. The majority in that case concluded that public policy required that breaches of the Bank Act should not lead to the invalidation of contracts and other transactions. Further, section 20(1) of the Bank Act, which stipulated that no act of a bank is invalid by reason only of a contravention of that statute, supported the view that Parliament never intended breaches of the Bank Act to render bank transactions null and void. Presumably, a similar argument could e made with respect to a breach of the solvency test under the CBCA. Deemed Dividend Treatment When a corporation resident in Canada acquires its own shares, the tax treatment will differ greatly from that applying to a sale between shareholders. Subsection 84(3) has the result of transforming what would otherwise be a capital gain into a deemed dividend, in order to prevent the distribution of a corporations accumulated profits to shareholders under cover of a redemption of its own shares by the corporation. The corporation is generally deemed to have paid a dividend (on the class of shares so acquired) equal to the difference, if any, between the amount paid for the shares and their PUC. By definition, the term proceeds of disposition excludes any deemed dividends; consequently, the shareholder will generally be deemed to have disposed of is or her shares for proceeds equal to the amount received minus the amount of the deemed dividend. Depending on whether the proceeds exceed or are less than the ACB of the shares, a capital gain or loss may arise. Consequently, it is possible to receive a sum in an amount that is greater than the shareholders ACB, and have both a deemed dividend and a capital loss. For example, if the shares have a value of $10,000, an ACB to the shareholder of $1,000, and a PUC of $500, their redemption for $10,000 will generate a deemed divided of $9,500 ($10,000 minus PUC of $500), which can be taxable to the shareholder, as well as a capital loss of $500 (ACB of $1,000 minus deemed proceeds of disposition of $500). Purchase by a Corporation of Its Shares on the Open Market

373

Paragraph 84(6)(b) provides that subsection 84(3) does not apply to a purchase by a corporation of any of its shares in the open market, if the corporation acquired those shares in the manner in which shares would normally be purchased by any member of the public in the open market. The CCRA has made the following statement concerning this open market exception: It is the departments opinion that the phrase in the manner in which shares would normally be purchased by any member of the public in the open market, means that the shares must be purchased on a stock exchange or over the counter through an independent middleman in accordance with the procedures and requirements of the relevant securities legislation and the bylaws of the relevant stock exchange. If the vendor and the purchaser have made an arrangement with respect to the purchase and sale of the shares in question, the purchase will not be considered to be carried out in the manner in which any member of the public would normally purchase shares in the open market. The CCRAs interpretation was approved in the case of Mrette v. The Queen, 96 DTC 3209, a Tax Court case decide under the informal procedure. Mr. Mrette was a shareholder of a corporation in which he held 25 percent of the shares. The corporation redeemed part of its shares, and MR. Mrette received $15,000. He reported a capital gain with respect to the redemption and attempted to rely on the paragraph 84(6)(b) exception. In dismissing the taxpayers appeal, Mr. Justice Bowman found that the ordinary usage of the phrase open market covers at least three ideas: 1. free participation by the public; 2. the absence of any restrictions on prices; and 3. the effect of supply and demand on prices. He concluded that these characteristics are present in the case of a public corporation whose shares are quoted on the exchange. There can be no open market when the sale of shares to a corporation is governed by a private agreement between shareholders and the corporation. As a result, unless a higher court comes to a different view, the open market exception appears to be fairly limited in its application. Anti-Avoidance: Part II.1 Even if a corporation is able to meet the open market exception, part II.1 of the Act may apply to impose a tax on the dividend-paying corporation. Part II.1 contains anti-avoidance provisions that are intended to prevent a corporation from distributing its surplus to individual or non-resident shareholders in such a manner that the shareholders realize a capital gain eligible for the capital gains exemption or a treaty exemption, rather than a taxable dividend. Part II.1 tax generally applies only to public corporations and to other corporations resident in Canada that have a class of shares that is purchased and sold on the open market. The measure takes the form of a special 45 percent tax to be paid by the corporation that is intended to approximate the shareholder tax that would have been paid had the distribution been received as a dividend. Subsection 183.1(2) provides that the tax will apply only where it may reasonably be considered, having regard to all the circumstances, that proceeds of disposition have been paid by a corporation or by a person with whom it does not deal at arms length as a substitute for dividends that would otherwise have been paid in the normal course by the corporation. These words are intended to exclude dividends that would have arisen in special or unusual circumstances, such as on a corporate reorganization. The test in subsection 183.1(2) is an objective one to be applied by a review of all the relevant circumstances.

374

According to the Department of Finance explanatory notes, some of the relevant circumstances in making this determination could include the corporations past dividend policy; the amount, if any, of dividends paid for the current year; and any objective evidence of the corporations intention to pay amounts instead of dividends. An example of a transaction to which subsection 183.1(2) may apply is an acquisition of shares for an amount that reflects a future dividend payment. For example, a share may be issued for $50 and be redeemable for $100. Just before the redemption date, the share could be purchased for the $100 amount in the open market by the issuing corporation or by a non-arms length person so that the shareholder realizes a capital gain rather than a deemed dividend. It appears that part II.1 tax would be imposed on the corporation. Returns of PUC Under the CBCA, the shareholders, by a minimum two-thirds vote, can authorize a distribution of a reduction of capital. Subsection 84(4) of the Act will deem the corporation to have paid, and the shareholders to have received, a dividend equal to the excess of the amount paid over the amount by which the PUC is reduced. There are several advantages to structuring a distribution as a return of PUC, rather than as a redemption of shares or a taxable dividend. First, the entire distribution could be received free of tax by the shareholders (assuming sufficient ACB). For example, assume that a corporation has issued shares with a PUC of $5 per share and an FMV of $10 per share. The corporation is in a position to make a distribution of $5 per share. A dividend of this amount would be fully taxable to individual shareholders. If instead the corporation chose to redeem a portion of its shares, a deemed dividend of $5 per share would also result. On the other hand, a reduction of capital of $5 per share can be received by shareholders on a tax-free basis, assuming that the shareholders ACB is at least equal to PUC. A return of capital can be utilized to minimize a companys capital tax liability without the disadvantage of tax at the shareholder level. There may also be advantages to a PUC reduction from a corporate law standpoint. It requires fewer legal steps than share redemptions and does not change the number of issued and outstanding shares. Further, as discussed earlier, while the solvency test for the payment of a dividend requires the value of assets to be not less than liabilities and the stated capital of all shares, the comparable test for payments on a reduction of capital require only that the value of assets be not less than liabilities. To summarize, a distribution by way of a return of capital will often be preferable to the other alternatives. There is an exception to this generalization where subsection 84(4.1) applies. Subsection 84(4.1) provides that where a public corporation reduces the PUC of a class, other than by way of a redemption, acquisition, or cancellation of shares of t hat class, the full amount paid is deemed to have been paid and received as a dividend regardless of the PUC of that class. Subsection 84(4.1) does not apply to a transaction described in section 86 or subsection 84(2). Therefore, it is possible for a public corporation to distribute property as a tax-free return of capital as part of the reorganization of its share capital using the rollover provisions of section 86. Two recent transactions that used the reorganization-of-capital mechanism are the merger of TransCanada Pipeline Limited and NOVA Corporation and the proposed reorganization of Trimin Enterprises Inc.

375 As noted, subsection 84(4.1) does not apply to a transaction described in subsection 84(2). Subsection 84(2) provides that where any corporation that is resident in Canada distributes property to its shareholders on the winding up, discontinuance, or reorganization of the corporations business, such distribution is deemed to be a dividend to the extent that the amount distributed exceeds the amount by which the PUC of the shares held by such shareholders is reduced on the distribution. The terms winding up and discontinuance are relatively easy to interpret in that they appear to refer to the actual or proposed cessation of the corporations business. The term reorganization is broader in scope. The CCRA considered the meaning of reorganization of [the corporations] business in a technical interpretation dated November 9, 1988. The hypothetical situation considered was as follows: Pubco, a public corporation and a taxable Canadian corporation, wished to transfer all of its directly owned Canadian business assets to a new wholly owned subsidiary (Newco) under section 85 in exchange for common shares of Newco. Pubco also owned various other subsidiaries that carried on business in other jurisdictions. In connection with the above transfer, Pubco reduced the PUC of its common shares by distributing the Newco shares to its common shareholders. The reduction of PUC was carried out in accordance with the appropriate corporate law for an amount equal to the value of the Newco shares.

The CCRA stated that generally its position would be that the transfer of the Canadian assets by Pubco to Newco and the distribution of the shares of Newco would be a discontinuance or reorganization of Pubcos business for purposes of subsection 84(2), provided that the Canadian assets transferred constituted a business of Pubco that was separate and distinct from all its other businesses. The CCRA referred to the case of Kennedy v. MNR, 72 DTC 6357,in which it was concluded that reorganization as used in subsection 81(1) of the former Act meant the conclusion of the conduct of the business in one form and its continuance in a different form. Apart from Kennedy, very little case law and few administrative pronouncements exist to assist in the interpretation of the precise meaning of the term reorganization in subsection 84(2). However, even a relatively narrow interpretation of this term may provide certain public companies with an opportunity to circumvent subsection 84(4.1) and effectively make a payment in reduction of PUC in appropriate circumstances. In another, more recent ruling, the CCRA again found that subsection 84(2) could be used by a pubic company to circumvent subsection 84(4.1) and effect a return of capital by such a company to its shareholders in the context of a reorganization of the public companys business. That situation involved a segregation of the assets of two different businesses in order to provide shareholders with the opportunity to maximize the value of their investment in each business and facilitate the ongoing funding of each business. A comfort letter issued by the Department of Finance, dated July 2, 1998, indicated that the department would be recommending an amendment to subsection 84(4.1) that would generally enable a public corporation to make a tax-free return of capital to its shareholders. The proposed amendment has not yet materialized, and it is understood that the department is considering limiting its potential application. Capitalizing Contributed Surplus

376 Under the CBCA, neither contributed surplus nor retained earnings constitute a component of stated capital, and thus neither are included in calculating PUC for the purposes of the Act. The capitalization of contributed surplus can be an effective means of increasing PUC prior to a return of capital. In general, subsection 84(1) applies to deem a dividend to have been paid by a corporation on a class of shares whenever the PUC of the class of shares has been increased in other than specified circumstances. However, paragraph 84(1)(c.3) permits, in certain defined circumstances, the capitalization of a portion of contributed surplus without triggering a deemed dividend to the shareholder. The concept of contributed surplus is not defined in the Act or the CBCA. For accounting purposes, the CICA Handbook describes contributed surplus as follows: Contributed surplus has frequently been taken to include only amounts paid in by shareholders, but it may include capital donations from other sources. Contributed surplus in the form of surplus paid in by shareholders includes premiums on shares issued, any portion of the proceeds of the issuance of shares without par value not allocated to share capital, gain on forfeited shares, proceeds arising from donated shares, credits resulting from redemption or conversion of shares at less than the amount set up as share capital, and any other contribution by shareholders in excess of amounts allocated to share capital. The circumstances in which contributed surplus can be capitalized are outlined in subparagraphs 84(1)(c.3)(i) to (iii). Under subparagraph 84(1)(c.3)(i), the contributed surplus must have arisen on the issuance of a share of that class or a share of another class for which the former was substituted, after March 31, 1977, and none of sections 51, 66.3, 84.1, 85, 85.1, 86, 87, or 212.1 or subsections 192(4.1) or 194(4.1) applied to the share issuance. These restrictions severely limit the application of subparagraph 84(1)(c.3)(i). The subparagraph will have application only in situations where there is a contribution of property to a corporation in a transaction in which shares are issued, the stated capital of the shares was less than the value of the property, and no tax-free rollover (or certain other provisions of the Act) applied to the share issuance. An example is a situation in which par value shares are issued for consideration in excess of the par value. Subparagraph 84(1)(c.3)(ii) has more general application. It allows the conversion of contributed surplus into PUC of a class of shares where the surplus arose on a previous contribution of property, other than a share issuance, by a shareholder of that class. It is not unusual for a parent company to fund the activities of a subsidiary without receiving shares in the corporation. In this case, the resulting surplus can be converted into PUC of that class of shares, and the shareholder will also normally get an increase in the ACB of the shares. The PUC can then be returned to the shareholder free of tax assuming sufficient ACB. This mechanism can be a useful tool for capital tax planning. Frequently, Canadian high technology companies are financed by US-resident venture capitalists. These investors often insist that a US parent company be set up that will advance funds to the Canadian subsidiary as required to support its research and development activities. If the advances are set up as interest-free intercompany loans, there may be imputed interest to the US parent company for US tax purposes. If these advances are set up as contributed surplus, they may be converted into PUC before year-end. If there is a potential capital tax liability, the Canadian subsidiary can return capital to the US parent before year-end and avoid or minimize capital tax. This assumes that the Canadian Subsidiary has sufficient cash and that, of course, the return of capital is not treated as a dividend for US tax purposes. Note that for public corporations, subsection 84(10) limits the amount of contributed surplus that can be converted into PUC under paragraph 84(1)(c.3) without triggering a deemed dividend. Generally, the contributed surplus for these purposes is reduced by previous dividends paid by the public

377 corporation in excess of its retained earnings at the same time the dividends were paid. Presumably, the intent of this limitation is to discourage public corporations from paying dividends out of capital. Share Conversions Section 84 allocates deemed dividends on a pro rata basis among shareholders of a particular class. Thus, all shareholders of that class will experience a deemed dividend in the course of certain events. For example, subsections 85(2.1) and 85.1(2.1) may result in a deemed dividend across a share class since these provisions effect a PUC reduction. Similarly sections 51 and 86 may cause a deemed dividend since shares of one class are converted to those of a new class. Shareholders affected by such conversions and reductions may be subject to unintentional deemed dividends. Vigilant tax planning can preclude this result via several methods. For example, the stated capital of the convertible shares could be limited to the PUC calculated under paragraph 89(1)(c). Alternatively, ion a jurisdiction permitting par value shares, such shares could be issued on the initial transaction so as to limit the stated capital upon a conversion of shares. Shifting Share Capital Where there is an amalgamation or merger of two corporations, there can be deemed dividend consequences for shareholders of those corporations. That is, if the PUC of the newly amalgamated corporation immediately after the amalgamation or merger is greater than the aggregate PUC of the two corporations before the event, a shareholder will realize a deemed dividend. The deemed dividend will be in the amount of the excess and is allocated pro rata among the shareholders. Consequently, even prudent shareholders who requested their own class or series so as to preclude PUC dilution may be detrimentally affected in this manner upon the amalgamation or merger. New shareholders who paid full value for their shares also may be affected; upon amalgamation, they too can be subject to the deemed dividend. However, if a class retains identical characteristics after the merger to its pre-merger status, the amalgamated corporation may elect under paragraph 87(3.1)(d) to avoid any such PUC reduction with respect to the particular class. On an amalgamation, the CBCA enables the amalgamated entity to stipulate its stated capital as an amount equal to the PUC of the shares of the predecessor corporations, thus avoiding the application of subsection 87(3). The amalgamation agreement can then allocate the stated capital among the classes of shares in the manner agreed to by the shareholders. This gives rise to an opportunity to shift PUC from one class of shares to another, or load up one class of shares with the PUC that was previously spread among multiple classes of shares. Such shifting of share capital can be particularly useful when the long-term plan is to redeem shares or return the capital of shares held by a particular shareholder. For example, a corporation planning to redeem some of its shares may wish to avoid negative tax implications for its individual shareholders. It could create an affiliate and then amalgamate with the affiliate. Any individual shareholders could be offered redeemable retractable preferred shares in the newly formed amalgamated company. The amalgamation agreement would allocate enough PUC to equal the FMV of the shares (assuming that there was sufficient PUC in the predecessor corporations shares). The result to the individual shareholders would be no deemed dividend and the potential for capital gains. The amalgamated corporation would be left with very little, if any, PUC in its remaining shares. Of course, there must be sufficient PUC in the predecessor corporations shares to facilitate this mechanism in the first place.

378 PUC shifts can also be achieved on section 86 reorganizations. The question that then arises is whether such shifts can be challenged under GAAR. The CCRA has ruled that a shift in PUC occurring as part of a section 86 reorganization of capital is generally acceptable where the amount of PUC allocated to each shareholder was equal to the amount that would have been allocated if separate classes of shares had been acquired when the shareholder initially subscribed for treasury shares. It has been argued that the CCRAs position is too narrow and that PUC shifts should generally be acceptable under GAAR on the following basis: Transactions that increase the PUC of a holders shares are not transactions where the economic substance or the commercial reality of the arrangement is fundamentally different from the intended tax substance. In addition, an arrangement involving a PUC shift does not involve the manipulation of any particular provision of the Act. The calculation of stated capital is a corporate law concept with real and substantial corporate law effect, independent of any tax consequences. The Act defines PUC as the amount of stated capital as determined under the relevant corporate statute.

This position has not been tested in the courts. Interposing an Arbitrager Another astute PUC option in the context of the creation of an affiliate involves giving shareholders a choice of corporations to which they could sell their shares. For example, in the event that a corporation wished to purchase its shares for cancellation from its shareholders, the corporation could opt to create an affiliate also resident in Canada. Then shareholders could have the option of choosing to which corporation they sold their shares. To optimize PUC planning, shareholders would be well advised to sell some of their shares to the issuer corporation and the remaining portion of shares to the affiliate. In that way, the deemed dividend and capital loss realized by the shareholder upon sale to the corporation could be counteracted by the capital gains realized upon sale to the affiliate. The affiliate and corporation could then merge after purchasing the desired shares, effecting a repurchase without causing negative tax consequences for shareholders. Another option to avoid the deemed dividend consequence would be to advise shareholders to sell their shares to an independent arbitrager. Then the shareholders would be able to receive capital gains treatment rather than deemed dividend treatment. The corporation could in turn purchase the shares from the arbitrager. However, it should be noted that the CCRA is of the opinion that such a scenario could have deemed dividend consequences. This was the approach taken by the courts in the McNichol and RMM cases. However, in those cases, the underlying assets consisted mainly of cash. Query whether the courts would make a distinction if the underlying assets were business assets. PUC Reduction in Windups In normal circumstances, where a corporation is wound up, under subsection 84(2) a dividend is deemed to have been paid to a shareholder to the extent that that shareholder receives any benefit in excess of the PUC decrease in the shareholders class of shares. However, in the event that a parent corporation winds up one of its subsidiaries (in which the parent owned at least 90 percent of the capital stock of the subsidiary), under subsection 88(1) there is a scenario in which the parent can realize an immediate capital gain as a consequence of PUC. For example, where the parents ACB of

379 the subsidiarys shares is less than the lesser of the tax value of the subsidiarys assets and the subsidiarys PUC, an immediate capital gain will be realized as a result of assumptions made by the CCRA because of the close relationship of parent corporations to their subsidiaries. However, this scenario can be avoided by passing a special resolution reducing the PUC of the subsidiary before the windup without making a payment to the parent corporation. In that event, no deemed dividend will occur. Non-Residents Purchasing Shares of Canadian Corporations It is common practice for a non-resident involved in a takeover of a Canadian company to incorporate a Canadian acquisition company. This is mainly done to avoid potential deemed dividend treatment on a future redemption or return of capital by the Canadian target. The non-resident will typically fund the Canadian acquisition company with debt or equity, which can usually be repatriated at a later date free of Canadian and US tax. This acquisition strategy can also avoid the potential application of section 212.1. As noted earlier, this is an anti-avoidance rule similar to section 84.1, placed in the Act to prevent non-residents from attempting to remove dividends from Canada tax-free and escape withholding tax consequences. Section 212.1 states that if a non-resident person sells shares of a Canadian corporation to another Canadian corporation and takes back shares of the latter corporation, thereby gaining control (more than 50 percent of shares), the PUC of the newly issued shares (that is, those that cross the border) will be decreased to that of the original shares. Also, any boot or share consideration received in excess of the PUC will be deemed a dividend and not given capital gains treatment. (See RMM Canadian Enterprises). Accordingly, when section 212.1 applies, there is potential for immediate tax consequences. If the non-resident made a direct purchase of the shares of the target corporation and subsequently transferred them to a holding company in exchange for the shares of the holding company, the provisions of paragraph 212.1(1)(b) would limit the PUC of the shares of the holding company to the PUC of the shares of the target that were transferred to the holding company (less the amount, if any, of any non-share consideration also received by the non-resident on the transfer). If the non-resident received non-share consideration from the holding company on the transfer in excess of the PUC of the targets shares, the excess would be deemed to be a dividend by virtue of paragraph 212.1(1)(a). Accordingly, the amount of PUC that can be returned to the non-resident in these circumstances is the same as the amount that could have been returned by the target directly to the non-resident. The optimal strategy, then, is for the non-resident to first establish a Canadian acquisition company. If the non-resident has already entered into an agreement with the vendor of the target to purchase the shares, the benefit of the agreement can be assigned by the non-resident to a new Canadian holding company before the completion of the purchase of the shares of the target. Conclusion PUC is a powerful tax-planning tool for transactions between corporations and their shareholders. While, in theory, PUC is a simple concept, which essentially allows taxpayers to receive tax-free that which they invested in the corporation, the reality is much more complicated owing to the many adjustments to PUC required under the Act. The tax planner must be constantly aware of the potential consequences of PUC in every transaction involving both residents and non-residents. Deemed dividends pose a significant tax consequences that shareholders may or may not desire. Indeed, the potential for deemed dividend recognition by shareholders may drive the structure of corporate acquisitions. While rollovers do exist that can often delay the tax consequences of low PUC, the tax planner must be cognizant of the effects of PUC to ensure that no inadvertent tax recognitions occur.

380 However, the potential for significant tax recognition created by PUC is born of PUCs great potential for tax savings. Accordingly, tax planners should constantly keep PUC in mind as a strategic planning too, so as to maximize its potential benefits while avoiding its pitfalls.

VIII. Section 85: Tax-Free Transfers of Property to a Corporation

1. General Rule
In the absence of application of s. 85 of the Act, a transfer of property to a corporation is a taxable transaction. The transferor must recognize proceeds of disposition equal to the value of the consideration receivable by him. This may result in a capital gain, a capital loss, recapture of capital cost allowance, or ordinary income in the case of a disposition of inventory. Where the transferor and the transferee corporation do not deal at arm's length, s. 69(1)(b) operates to deem the proceeds of disposition to be no less than the fair market value of the property transferred. What are the income tax consequences of a disposition of property to a corporation in the absence of a s. 85(1) election? The following summary applies whether or not the consideration received back by the transferor includes treasury shares issued by the transferee corporation. (a) Non-Depreciable Capital Property. The transferor will recognize a capital gain or a capital loss to the extent of the difference, if any, between the proceeds of disposition and the adjusted cost base of the property transferred. Examples: Land is transferred to a corporation. (i) FMV of $100,000 ACB of $40,000 The consideration is $60,000 of cash, $10,000 worth of promissory notes, and shares of the transferee worth $30,000, for a total consideration of $100,000. The transferor would recognize a capital gain of $60,000. (ii) Shares of a public corporation are transferred to a corporation. FMV of $20,000 ACB of $25,000 The consideration is shares of the transferee worth $20,000. The transferor would recognize a capital loss of $5,000. Note that s.40(2), (3) and (4) will deny a capital loss where a corporation or partnership disposes of capital property to a corporation that, immediately after the disposition, is affiliated with the taxpayer as defined in subsection 251.1. In other words, this provision prevents a taxpayer from recognizing a capital loss on the transfer of property to a controlled corporation. The definition of superficial loss provides a similar rule in the case of an individual. See also subsection 40(3.6) for the stop loss rule that applies on the disposition of shares to a corporation with which the taxpayer is affiliated.

381 (b) Depreciable Property. Where depreciable property is transferred, two types of income may be recognized. First, capital gain will be recognized to the extent the proceeds of disposition exceed ACB. Depreciable property is also capital property and therefore the normal capital gain rules apply. Note that a capital loss cannot arise on a disposition of depreciable property (s. 39(1)(b)(i)). Second, the undepreciated capital cost ("UCC") of the class of property to which the transferred property belongs will be reduced by the lesser of (i) the proceeds of disposition minus any outlays and expenses made or incurred for the purpose of making the disposition, and (ii) the capital cost of the particular depreciable property. This will reduce the amount of capital cost allowance ("CCA") that may be claimed by the transferor in the future. If the UCC account becomes a negative amount (because the lesser of the proceeds of disposition and the capital cost exceeds the UCC) then the excess is added to income as ordinary income. This is referred to as recapture of CCA. Examples: (i) A building is transferred to a corporation. FMV ACB UCC = = = $60,000 $50,000 $20,000

The consideration is shares of the transferee worth $60,000. The transferor will recognize a capital gain of $10,000 and ordinary income of $30,000, being recapture of capital cost allowance. (ii) Oil and gas equipment is transferred to a corporation. FMV ACB UCC = = = $300,000 $700,000 $250,000

The consideration is $300,000 of boot (or non-share consideration). The transferor will recognize ordinary income of $50,000, being recapture of capital cost allowance. No capital loss will be recognized per s. 39(1)(b)(i). (c) Inventory. Where inventory is transferred, the excess of the sale proceeds over the cost of the inventory will be treated as ordinary income. Example: (i) An item of inventory is transferred to a corporation. FMV = COST = $100 $ 75

The consideration is stock of the transferee worth $100. The transferor will recognize ordinary income of $25.

382

2. Purpose of S. 85(1)
S. 85 is designed to allow a taxpayer to transfer property to a corporation on a tax-free basis provided the transferor receives at least one share of the capital stock of the transferee as consideration for the transfer. S. 85 allows transferor and transferee the opportunity to select the proceeds of disposition of the property to the transferor and the cost of the property to the transferee, and to have that amount also become the total cost to the transferor taxpayer of the consideration received back from the transferee. S. 85 enables a taxpayer or a partnership to transfer certain assets to a taxable Canadian corporation for proceeds of disposition which, for tax purposes, may be less than the FMV of the assets. S. 85 provides rules which enable the transferor and the transferee corporation to elect an amount that, for income tax purposes, is deemed to be the transferor's proceeds of disposition and the transferee corporation's cost amount of the acquired asset. If the transferor's cost amount, as defined in s. 248(1), of a particular property is chosen as the elected amount for purposes of the transfer, the transferor will not realize any gain for income tax purposes. In this manner, all or a portion of the potential capital gain, recapture of capital cost allowance, or income which might otherwise arise on a transfer of property to a corporation may be deferred. The rollover under s. 85 provides only a deferral of tax, not an exemption from tax. Because the transferee corporation acquires the asset at a cost equal to the elected amount, tax may be payable on a future disposition of the transferred property by the transferee corporation, or on a future disposition by the transferor of the shares of the transferee corporation. Rules are included in s. 85 to limit the parameters of the elected amount. Rules are also provided to determine the cost of the consideration received by the transferor from the corporation. There are also a number of tax avoidance rules included in the section.

3. Who can use S. 85(1)?

S. 85(1) can be made applicable where a taxpayer disposes of certain properties to a taxable Canadian corporation for consideration that includes shares of the capital stock of the corporation. The transferor must be a "taxpayer". This term is defined in s. 248(1) to include any person whether or not liable to pay tax. As a result of the definition of "person" in s. 248(1), the effect is that any individual, trust or corporation may be a transferor for the purposes of s. 85(1). Note that the transferor need not be a resident of Canada: the section is equally applicable to transferors that are non-residents. The transferee, however, must be a "taxable Canadian corporation". Hence, the transferee cannot be a non-resident corporation or a corporation incorporated outside of Canada (unless such a corporation can qualify as a "Canadian corporation" and therefore a "taxable Canadian corporation" as that term is defined in s. 89(1)).

4. Assets eligible for Application of S. 85(1)

S. 85(1) refers to "eligible property" as being the type of property to which the section applies. "Eligible property" is defined in s. 85(1.1) which outlines nine categories of assets which may be transferred. (i) Capital Property. Capital property is defined in s. 54 as including any depreciable property of the taxpayer and including any property, any gain or loss from the

383 disposition of which, would be a capital gain or loss. Capital property of a non-resident which is real property, an interest therein or an option in respect thereof, is not eligible for application of s. 85(1). (ii) (iii) (iv) (v) Capital Property that is real property (or an interest or other option therein) owned by a non-resident insurer and used by it in carrying on an insurance business in Canada. Canadian Resource Property. Foreign Resource Property. Eligible Capital Property. S. 85(1) permits the tax-free transfer of eligible capital property to a corporation. This is to allow a rollover of goodwill and other intangibles acquired by virtue of an eligible capital expenditure. Inventory. Inventory, other than real property (or an interest in or an option in respect thereof), is eligible for the application of s.85(1). A Security or Debt Obligation (other than a capital property or inventory) held by an insurance corporation or a moneylender. Capital Property that is real property, an interest in or an option in respect thereof owned by a non-resident person and used by such person in the year in a business carried on in Canada. A NISA Fund No. 2.

(vi) (vii) (viii)

(ix)

5. The Requirement to Issue Shares

The consideration received by the taxpayer for the property transferred must include shares issued by the transferee corporation. Technically, this requirement applies to each separate property being transferred. Technically, if any property is disposed of to the transferee corporation for consideration that does not include shares, the provision will not apply, and instead the general rules governing dispositions of property will prevail. Because the term "share" is defined in ss. 248(1) to include a fraction of a share, it is not necessary to issue one share for each particular property transferred. For example, on a transfer of a number of properties, it is not necessary that one share be issued for each particular property transferred provided that at least one share is issued as consideration for all of the property transferred such that it can be said that in respect of each property transferred, part of the consideration consisted of at least a fraction of a share.

6. Formalities of the Election Requirement

The rollover under ss. 85(1) is not automatic. It is only applicable if the transferor and the transferee corporation elect that it apply. The election must be made in prescribed form and within the time prescribed in ss. 85(6). The election form is form T2057 and in that form the parties to the election

384 must set out a specific elected amount for each asset to be transferred. If an asset is transferred but is not listed, the normal rules applying to the disposition of property will be invoked and where the parties do not deal at arm's length, ss. 69(1) will ensure that the minimum proceeds of disposition for tax purposes are deemed to be the FMV of the property transferred. Ss. 85(6) provides that the election must be made on or before the day that is the earlier of the days on or before which either the transferor or the transferee must file a tax return for the taxation year in which the disposition of property occurs. If the election is not filed within the allowed time period, or is incorrectly filed, there are rules in ss. 85(7), (7.1) and (8) which in certain cases allow for late filing or the filing of amended elections subject to the payment of penalties. The following decision also addresses the important issue of the 'scope' of the election.

Deconinck (S.E.) v. Canada

[1990] 2 C.T.C. 464, 90 D.T.C. 6617, (F.C.A.) Hugessen, J.A.: 1 This is an appeal from a judgment of Cullen, J. ([1988] 2 C.T.C. 213; 88 D.T.C. 6410). The only issue is with respect to the scope of an election made by the taxpayer under section 85 of the Income Tax Act, R.S.C. 1952, c. 148 (am. S.C. 1970 71 72, c. 63) (the "Act") at the time of filing his return for the 1975 taxation year. The trial judge held that the Minister, who had based himself on the election itself as well as on certain additional information furnished by the taxpayer's accountants a few months later, was correct in limiting the scope of the election to certain properties which the taxpayer had owned on December 31, 1971, and in not including certain other properties acquired between that date and the date of the election. 2 We are satisfied that the trial judge arrived at the correct conclusion and are in general agreement with his reasons. 3 An election by a taxpayer under section 85 must be made in such a way that it is possible to determine in respect of which property it is made. It is not enough for a taxpayer simply to intend to elect in respect of a given property; he must actually do so. 4 In the present case, the election was in the most general terms imaginable, speaking only of "Land" and of "Building" with no further description. An analysis of the figures given in the election form shows that only the properties owned by the taxpayer as at December 31, 1971 were in fact included. When, at the Minister's request, further details were furnished by the taxpayer's accountant, they still did not include all the properties which the taxpayer now says he intended to include in the election. In fact, the alleged intention to include those properties was only disclosed to the Minister with the filing of the amended statement of claim in the Trial Division, almost nine years later. In those circumstances, it is impossible for the taxpayer to say that the Minister was wrong to assess him on the basis of the election actually made. 5 The appeal will be dismissed with costs.

Appeal dismissed.

385

7. Examples
Non-depreciable capital property FMV ACB = = $100,000 $ 40,000

In the absence of a ss. 85(1) election, the transferor would recognize a capital gain of $60,000. If the consideration issued to the transferor includes shares of the capital stock of the transferee, an election under ss. 85(1) may be made. If made, the elected amount selected by the transferor would presumably be $40,000. That amount would be deemed to be the proceeds of disposition of the property to the transferor such that the transferor would thereby not recognize any gain or loss since the transferor's proceeds of disposition would equal the transferor's ACB. Depreciable Property FMV ACB UCC = = = $60,000 $50,000 $20,000

In the absence of a ss. 85(1) election, the transferor would recognize a capital gain of $10,000 and ordinary income in the form of recapture of previously claimed capital cost allowance of $30,000. If the consideration issued to the transferor includes shares of the capital stock of the transferee, an election under ss. 85(1) may be made and if made, the elected amount selected by the transferor would presumably be $20,000. Therefore there would be no recapture of capital cost allowance because the proceeds of disposition would equal the undepreciated capital cost. Note also since this is a transfer of depreciable property ss. 85(5) applies so that the transferee would take on the ACB and UCC of the transferor for the property. Inventory FMV = COST = $100 $ 75

In the absence of a ss. 85(1) election, the transferor would recognize ordinary income of $25. If the consideration issued to the transferor includes shares of the capital stock of the transferee and an election under ss. 85(1) is made, the elected amount selected by the transferor would presumably be $75. Accordingly, no income would arise since the proceeds of disposition would equal the cost of the inventory transferred.

8. Rules Governing the Elected Amount

Para. 85(1)(a) to (e.4) set out general rules which govern the amount that the parties may select as the elected amount for purposes of application of ss. 85(1) to a particular transfer, and the tax consequences of the selection of that amount.

386 (i) Para. 85(1)(a). This is the most important rule in ss. 85(1). The elected amount is deemed to be the transferor's proceeds of disposition and the transferee corporation's cost of the property. Para. 85(1)(b). Subject to para. 85(1)(c), the elected amount must not be less than the FMV of any non-share consideration ("boot") received on the transfer. To put it another way, ss. 85(1) requires that shares be issued by the transferee corporation as consideration for the transfer, but the transferee corporation can also issue non-share consideration such as cash, a future promise to pay in the form of a promissory note, or any other form of property provided that the FMV of that non-share consideration or "boot" does not exceed the elected amount. If the FMV of the boot does exceed the elected mount, then the elected amount is, subject to para. 85(1)(c), adjusted up to equal the FMV of the boot. Para. 85(1)(c). The elected amount cannot exceed the FMV of the property transferred to the transferee. If the elected amount does exceed the FMV of the property being transferred, then the elected amount is adjusted down to equal the FMV of the property being transferred. In the case of a conflict with the rule in para. 85(1)(b), the rule in para. 85(1)(c) overrides.

(ii)

(iii)

Paras. 85(1)(b) and (c) establish a floor and a ceiling for the elected amount. However, if the FMV of the transferred property is less than the FMV of the boot received by the transferor, then para. 85(1) (c) overrides and it is the lesser amount that is deemed to be the elected mount. For example, suppose land that is capital property is transferred to a corporation for consideration that includes shares, the land has an ACB of $10,000 and a FMV of $50,000. If the elected amount is $10,000, and the transferor receives no more than $10,000 in boot, then $10,000 will be the transferor's proceeds of disposition by virtue of para. 85(1)(a) and no capital gain will result in the transfer. If the parties elect $10,000 but the transferor receives boot of $40,000, para. 85(1)(b) provides that, notwithstanding the election of $10,000, the parties are deemed to have elected $40,000 being the value of the boot and consequently a $30,000 capital gain would result to the transferor. If the parties elect $75,000 as the elected amount, then para. 85(1)(c) would deem the elected amount to be $50,000 being the FMV of the property transferred and a $40,000 a capital gain to the transferor would be the result. If the parties elect $60,000 and the transferor receives $75,000 in boot, para. 85(1)(b) would increase the elected amount to $75,000 and para. 85(1)(c) would keep the elected amount down at $50,000. Because para. 85(1)(b) is subject to para. 85(1)(c), the elected amount would be deemed to be $50,000. A $40,000 capital gain would result. In addition, however, the transferor would be treated as having received a shareholder benefit under ss. 15(1) equal to the excess of the purchase price (including the value of the shares received from the transferee) over the FMV of the property purchased. In addition to these general limitations, there are a number of further limitations which provide parameters for elected amounts in respect of particular categories of eligible property transferred. (c.l) Inventory and non-depreciable capital property. Pursuant to para. 85(1)(c.1), the elected amount cannot be less than the lesser of the FMV of the transferred property

387 and the cost amount to the taxpayer of the property at the time of the disposition. The cost amount of capital property, other than depreciable property, is defined in ss. 248(1) to be its ACB. The cost amount of inventory equals its value at that time for purposes of computing income. For example, where non-depreciable capital property is transferred and the property has the following attributes FMV ACB = = $125 $115

the elected amount cannot be less than $115. If the elected amount selected for purposes of the election was $100, para. 85(1)(c.1) would boost the elected amount up to $115. The reason is that the Act does not want the taxpayer to claim a loss of $15 on the transfer of property to a corporation. If the rules in ss. 85(1) are designed to allow a taxpayer to defer a capital gain, the rules are also not going to allow the taxpayer to create a capital loss. The same rules apply to inventory. If in the example above it was inventory being transferred instead of capital property, the elected amount could not be less than $115. As noted above, pursuant to para. 85(1)(c) the elected amount could also not exceed $125 since that is the FMV of the property being transferred. (e) Depreciable property. Under para. 85(1)(e), the elected amount for depreciable property cannot be less than the least of the UCC to the transferor of all property of that class, the cost to the transferor of the particular property sold, and its FMV at the time of the sale. For example, consider the transfer of a building to a corporation with the following attributes. FMV = COST (ACB) = UCC of Class = $600,000 $900,000 $800,000

Para. 85(1)(e) would prevent the elected amount from being less than $600,000. If the actual elected amount selected on the election was $430,000, para. 85(1)(e) would boost the elected amount to $600,000. A terminal loss would be allowed equal to $200,000 being the difference between the UCC and the FMV, but the taxpayer could not elect an amount lower than $600,000 and thereby attempt to increase the amount of the terminal loss. Similarly, the elected amount could not exceed $600,000 as a result of para. 85(1)(c) since that is the FMV of the property transferred. (e.2) Paragraph. 85(1)(e.2). The indirect gift rule. Para. 85(1)(e.2) operates as an antiavoidance provision where one of the results of a s. 85 rollover is that it can reasonably be considered that a benefit has been conferred by the transferor on a related person (other than a corporation that is a wholly-owned corporation of the taxpayer immediately after the transfer). This rule prevents the transferor from indirectly transferring the value of property so as to confer a benefit on a related person. Where this paragraph applies, the elected amount is deemed to be increased by the value of the benefit.

388

Para. 85(1)(e.2) is of concern for example whenever the transferor does not own all the shares of the transferee corporation and some of the shares are owned by a person related to the transferor. The provision requires a calculation of the difference between the FMV of the transferred property immediately before the disposition and the greater of (i) the FMV immediately after the disposition of all consideration received by the transferor, including shares of the corporation, and (ii) the elected amount. If it is reasonable to regard any portion of this difference as a benefit that the transferor desired to have conferred on a person related to the transferor, the elected amount is deemed to be increased by the portion considered to be a benefit, except for purposes of calculating the ACB of the shares received on the transfer. For Example Dad owns 10 common shares of Opco and the kids between them own 9 common shares. Dad then uses a s. 85 rollover to transfer personal property with FMV of $1,000 and ACB of $100 to Opco. An election is made of $100 and Dad takes back 1 common share of Opco. Without para. 85(1)(e.2) Opco would have an asset with ACB of $100 and FMV of $1000 so all Opco Shareholders (including the kids) will benefit. Para. 85(1)(e.2) then applies since FMV of $1,000 before the rollover is greater than the FMV of $100 of the share after and Dad is found to be trying to confer a benefit from the excess on his kids. So the amount of the election is deemed to be 9/20 (the kids proportion of the shares) of the difference between the FMV and the elected amount = 9/20 * ($1,000 - $100) = $405. This $405 will be the elected amount so it will be included in Dads income. For Opco their ACB will not then become $405, it will remain at $100. Because the provision refers to a benefit that the taxpayer desired to have conferred on a "person related to the taxpayer", it could also apply where property is transferred to a transferee corporation that is related to the taxpayer (but is not a wholly-owned corporation of the taxpayer). The effect of the rule is that the transferee must give consideration (shares plus boot) having a fair market value equal to the fair market value of the property transferred. Another question that has been raised about the operation of paragraph 85(1)(e.2) is centered on the wording in the provision which refers to the fair market value of the property at the time of the disposition. If new shareholders are not introduced until some time after the rollover, will the provision be invoked? (e.3) The overriding conflict rule. Para. 85(1)(e.3). Para. 85(1)(e.3) prevails where a conflict arises between the general and the specific rules in s. 85(1). Where the amount deemed to be elected under paras. 85(1)(c.1), (d) or (e) is greater or less than the amount deemed to be elected under para. 85(1)(b), as qualified by para. 85(1)(c) the elected amount is deemed to be the greater of the two amounts.

For example, assume that a depreciable property being the sole asset in a particular class is transferred to a corporation and the property has the following attributes. FMV UCC COST (ACB) Non-share consideration received Elected amount otherwise selected = = = = = $ 8,000 $ 5,000 $ 10,000 $ 6,000 $ 4,000

Para. 85(1)(e) would deem the elected amount to be equal to the least of ACB, UCC and FMV, or $5,000 instead of the $4,000 actually selected. Para. 85(1)(b) would deem the minimum elected

389 amount to be equal to the value of the boot, or $6,000. Para. 85(1)(e.3) resolves this conflict by deeming the higher of the two amounts, $6,000, to be the elected amount. Accordingly, recapture of $1,000 would result on the transfer.

9. Tax Consequences i. to the Transferee Corporation

Para. 85(1)(a) provides a general rule that the elected amount will equal the transferor's proceeds of disposition and the transferee's cost of the property. There is a special rule in ss. 85(5), however, that applies to a transfer of depreciable property where the original capital cost to the transferor exceeds the proceeds of disposition of the property determined in accordance with ss. 85(1). The capital cost to the transferee corporation is deemed to be equal to the transferor's capital cost and the difference between this amount and the elected amount is deemed to have been allowed to the transferee corporation as capital cost allowance in respect of the property in computing income for taxation years before the acquisition. For example, consider the following depreciable property which is transferred by a taxpayer to a transferee corporation. FMV = UCC = COST (ACB) = $ 90 $ 80 $ 100

The transferor would likely select $80 to be the elected amount to avoid recognition of recapture on the transfer. In the absence of ss. 85(5), the cost to the transferee corporation would be set at $80. If the property were then sold by the transferee corporation at its FMV of $90, a $10 capital gain would result. This does not seem appropriate since if the transferor had sold the property for $90, the transferor would have had $10 of recapture. Accordingly, for the purpose only of the rules relating to capital cost allowance and recapture, ss. 85(5) sets the cost of the property to the transferee corporation at $100 and deems the $20 difference between $100 and the $80 elected amount to be CCA previously claimed by the transferee corporation. The result is that the UCC of the property to the transferee corporation is set at original cost of $100 less CCA of $20 equals $80, and any disposition of the property for proceeds in excess of $80 would result in a recapture of $20. Ss. 85(5) operates only for the purpose of the capital cost allowance and recapture rules. The ACB for capital gains purposes is equal to the elected amount pursuant to para. 85(1)(a). Hence, the ACB for capital gains purposes is the elected amount of $80, and the UCC for capital cost allowance purposes is also $80. If the transferee corporation were to sell the property for its FMV of $90, there would be recapture of $10. While it would appear that there would also be a capital gain of $10, para. 39(1)(a) reduces a capital gain by any amount that is also taxed as ordinary income.

ii. to the Transferor

390 The elected amount sets the proceeds of disposition of the property transferred to the transferor. This is the effect of para. 85(1)(a). Paras. 85(1)(f), (g) and (h) set the cost to the transferor of the consideration received by the transferor from the transferee corporation. In the absence of these provisions, the general rule would set the cost of the consideration received at an amount equal to the value of the property given up to get that consideration i.e. the FMV of the property transferred. Because ss. 85(1) allows the transferor to transfer property to the transferee on a tax-deferred basis, it also provides for a lower cost base to the transferor of the consideration received from the transferee corporation. Ss. 85(1) sets the cost to the transferor of the consideration received from the transferee corporation in a manner that allocates the total cost among the different types of consideration so received. This is done according to the following rules. (i) Para. 85(1)(f). The cost of any non-share consideration (i.e. "boot") received by the transferor is deemed to be equal to its FMV pursuant to para. 85(1)(f). That is to say, the cost of any boot such as a promissory note from the transferee corporation or any other property, other than shares of the capital stock of the transferee, is set at an amount equal to the FMV of such property. Remember, that if the FMV of this boot exceeds the elected amount, then the elected amount is automatically boosted, subject to para. 85(1)(c), to equal the FMV of the boot pursuant to para. 85(1)(b). So while the transferor cannot accept boot at an amount in excess of what would otherwise be selected as the elected amount, whatever amount of boot is selected will have a cost to the transferor equal to FMV. Para. 85(1)(g). The cost of any preference shares received as consideration by the transferor is deemed to be the lesser of the FMV of those shares and the amount by which the transferor's deemed proceeds of disposition (i.e. the elected amount) exceeds the FMV of the boot. Para. 85(1)(h). Finally, the cost of any common shares received by the transferor is deemed to be equal to the transferor's deemed proceeds of disposition (i.e. the elected amount) less the aggregate of the FMV of the boot and the deemed cost of any preference shares received by the transferor. That is to say, whatever is left after the elected amount is first allocated to the FMV of the boot and then to the preferred shares is then allocated to the cost of any common shares received by the transferor.

(ii)

(iii)

For example, suppose non-depreciable capital property is transferred with the following attributes FMV = $150 ACB = $100 and suppose that the consideration consists of Cash FMV of Common Shares = = $75 $75

and suppose that the elected amount is $100. The cost of the boot received is $75 since that is its FMV. Assuming no preference shares are received, the cost of the common shares is equal to the elected amount of $100 minus $75 being the FMV of the boot, or $25. Note that the difference between the cost of these new common shares and their FMV is exactly $50, which is the difference between the FMV of the property transferred and its

391 ACB. This is one of the effects of ss. 85(1): the potential gain on the property at the time it was transferred to the transferee corporation becomes a potential gain not only to the transferee corporation but also in respect of the shares of the transferee corporation held by the transferor. This gives rise to the potential for double taxation. If the transferor had received preference shares with an FMV of $25 in addition to the cash and the common shares, the cost of the preference shares would be $25 and the cost of the common shares would be zero. This is because the $100 of elected amount is first allocated to boot (equal to FMV of the boot), then allocated to preference shares (up to the amount not exceeding the FMV of the preference shares) and any residual is allocated to the common shares. The cost of the common shares is not limited by the FMV of those shares. If more than one class of preference shares is received, then the portion of cost that is allocable to the preference shares is prorated among the classes of preference shares based on their relative FMVs. Similarly, if more than one class of common shares is received, the portion of cost (being the remaining difference) allocable to the common shares is prorated among all classes of common shares based on their relative FMVs. Remember that the result of these rules is potential double taxation. In the example above, the cost to the transferee corporation of the non-depreciable capital property transferred to it will be the elected amount of $100. If the property were sold the next day for its FMV of $150, the transferee corporation would have a $50 capital gain. In the meantime, if the transferor were to sell its shares of the transferee received by it on the transfer at an amount equal to their FMV, it would also recognize a gain of $50. This is because $75 of the $100 elected amount has been allocated to the boot and the remaining $25 is allocated, firstly, to any preference shares received, and secondly, to any common shares received. Since those preferred shares and common shares together should have a fair market value equal to $75, being the excess of the FMV of the property transferred over the boot received, any disposition of those shares for their value of $75 would result in a $50 capital gain. Hence, there has been double taxation. This double taxation would not have arisen if the transferor had simply sold the property to a buyer for $150 and recognized a $50 capital gain. Where the transferee corporation is a Canadian-controlled private corporation, one-quarter of any capital gain recognized by the corporation on the disposition by it of the transferred property will go to the capital dividend account and the other three-quarters will be subject to the dividend refund mechanism under s. 129 if the capital gain is from a Canadian source. This will reduce the effect of the double taxation where these circumstances apply.

10. Other Examples

Non-Depreciable Property FMV ACB = = $60,000 $15,000 = = = = $10,000 $20,000 $30,000 $15,000 = = $15,000 $0

Non-share consideration received Preferred shares received Common shares received Elected amount

Proceeds of Disposition to Transferor Gain or Loss to Transferor

392 ACB to Transferee of Property ACB to Transferor of Boot ACB to Transferor of Preferred Shares = = = $15,000 $10,000 Lesser of (i) FMV of PS (ii) EA- FMV of Boot = $5,000

ACB to Transferor of Common Shares =EA - FMV of Boot - ACB of PS = $0 The position of the transferee is that it has capital property with an ACB of $15,000 and FMV of $60,000 for a future potential gain of $45,000. The position of the transferor is that the transferor has: (A) (B) (C) Boot with ACB of $10,000 and FMV of $10,000; P.S. with ACB of $5,000 and FMV of $20,000; C.S. with ACB of 0 and FMV of $30,000.

The transferor faces a potential future capital gain of $15,000 on the preferred shares and $30,000 on the common shares. This total potential future capital gain of $45,000 is the same potential capital gain on the property transferred to the corporation. Depreciable Property FMV = $180,000 ACB = $120,000 UCC = $90,000 Non-share consideration received = $30,000 Preferred shares received=$50,000 Common shares received = $100,000 Elected Amount = $90,000 Proceeds of Disposition to Transferor = $90,000 Gain or Loss or Recapture or Terminal Loss to Transferor = $0 ACB to Transferee of Property = $90,000 UCC to Transferee of Property ss. 85(5). $120,000 - ($120,000-$90,000) = $90,000 ACB to Transferor of Boot = $30,000 ACB to Transferor of Preferred Shares = Lesser of (i) FMV of P shares = $50,000 (ii) EA - FMV of Boot = $90,000 - $30,000 = $60,000 or $50,000 ACB to Transferor of Common Shares = EA - FMV of Boot - ACB of PS = $10,000 The position of the transferee is that it has depreciable property with an ACB and UCC of $90,000 for a future potential recapture of $90,000. The position of the transferor is that the transferor has: (A) (B) (C) Boot with ACB of $30,000 and FMV of $30,000; P.S. with ACB of $50,000 and FMV of $50,000; C.S. with ACB of $10,000 and FMV of $100,000.

393 The transferor faces a potential future capital gain of $90,000 on the common shares. This total potential future capital gain is equal to the total of the potential recapture of $30,000 and capital gain of $60,000 on the property transferred to the corporation.

11. Impact of ss. 15(1)

In any particular transfer to a corporation, if the value of the shares received back by the transferor plus the value of any boot is greater than the value of the property conveyed, there is potential application of ss. 15(1). For example, supposing a non-depreciable capital property is transferred to a corporation and the property has the following attributes FMV =$ 150 ACB = $100 and suppose that the elected amount is $100, and the consideration consists of $75 cash and shares with a FMV of $75. Because the FMV of the property transferred equals $150 and the FMV of the consideration received back equals $150 ($75 of boot and $75 of shares), ss. 15(1) is not applicable. Suppose, however, that boot of $125 is received in addition to the $75 of shares. The elected amount cannot exceed $150 because of para. 85(1)(c), but there will be a $50 shareholder benefit under ss. 15(1) since the corporation has benefited the shareholder by paying $200 for property worth only $150.

12. Subsection 85(2.1)

Ss. 85(2.1) operates to adjust the PUC of the shares of the transferee corporation that are received by the transferor to the elected amount, less boot. That is to say, the PUC of the shares of the transferee is reduced by an amount determined in accordance with the following formula: (A- B) x C/A where: A= B= the PUC of the shares issued by the transferee corporation otherwise determined; the cost to the transferee corporation of the property acquired by it (i.e. the elected amount) less the FMV of any boot received by the transferor.

The C/A mechanism applies where shares of more than one class are issued by the transferee corporation and operates to spread the reduction in PUC over the various classes. Ss. 85(2.1) does not apply where s. 84.1 applies. That is, where the property being transferred is shares of the capital stock of a corporation resident in Canada and the shares are being transferred by an individual to a non-arm's length transferee corporation and the subject corporation and the nonarm's length transferee are thereafter connected corporations and an election is made under ss. 85(1), then s. 84.1 will be applicable and ss. 85(2.1) will not. However, if s. 84.1 does not apply where shares of a subject corporation are transferred to a transferee corporation because the other conditions of s. 84.1 are not met but a ss. 85(1) election is made, then ss. 85(2.1) will be applicable.

394

Ss. 85(2.1) has the effect of converting ordinary income and capital gain into dividend income to be recognized at some future date on a redemption or repurchase of the shares by the corporation, or on a winding-up of the corporation. For Example, A uses a s 85 rollover to transfer property with ACB of $20 and FMV of $100 into Opco. The elected amount is $20, made up of $10 in Boot plus common shares. From corporate law the shares are worth $90 (FMV of the asset minus the Boot), so thats PUC pending the ss. 85(2.1) PUC grind. Assume only common shares exist so C/A = 1. So A = $90, the PUC otherwise determined under corporate law. B = $20 - $10 = $10, the elected amount of $20 minus the Boot of $10. So (AB)*C/A = ($90 ($20 - $10)) * 1 = $80. PUC then is the $90 otherwise determined minus the formula, so $90 - $80 = $10. This is right, and follows the intuition that the ss. 85(2.1) PUC grind will reduce PUC to any portion of the elected amount not accounted for in Boot taken back.

13. Section 84.1

S. 84.1 will be applicable on the transfer by an individual of shares of a corporation resident in Canada to a non-arm's length corporation and the subject corporation and the transferee corporation are thereafter connected. If a ss. 85(1) election is made, that will affect the cost to the transferor of the shares received back from the transferee corporation and the cost to the transferee of the shares of the subject corporation. S. 84.1 will operate to set the PUC of the shares of the transferee corporation. Ss. 85(2.1) does not apply if s. 84.1 applies. If s. 84.1 does apply it acts very similarly to ss. 85(2.1) and will grind PUC down to the greater of ACB and PUC of the shares being transferred. Note s. 84.1 is dealt with more extensively under X. Tax Avoidance Transactions.

14. Tax Planning

(a) Attributes of property to be transferred. The type of property to be transferred to the taxable Canadian corporation should be carefully reviewed before the transfer is implemented. For example, it must be determined that any real estate owned by a Canadian resident is not inventory. If the transferor is a non-resident, real estate, whether capital property or inventory, is not eligible unless used in a business carried on in Canada. A transfer of shares of another corporation must be carefully examined to see if s. 84.1 will be applicable. Remember that s. 84.1 applies to set the PUC of the shares of the transferee corporation regardless of whether or not an election is made under ss. 85(1). The two are mutually exclusive; s. 84.1 sets the PUC of the shares of the transferee and ss. 85(1) sets the cost to the transferee of the property transferred and the cost to the transferor of the consideration received by him. Should an election under ss. 85(1) be made? It is not always desirable to make an election under ss. 85(1) even where the property transferred has an FMV greater than its cost. For example, suppose an individual holds nondepreciable capital property with an FMV of $100 and an ACB of $25. However, that individual also has $150 of capital losses from other transactions. The individual may prefer to transfer the property to the transferee corporation without making an election under ss. 85(1) such that $75 of capital gain would be recognized. The $75 of capital gain would be sheltered by $75 of

(b)

395 the $150 of capital loss and the individual would end up with a cost base in the shares of the transferee corporation of $100 instead of $25. (c) Consideration received. Where boot is also to be received, it should not exceed the elected amount. As we have seen, para.. 85(1)(b) will increase the elected amount up to an amount equal to the FMV of the boot if the boot would otherwise exceed the elected amount, subject to the limitation in para. 85(1) (c). That is to say, if property to be transferred has an FMV of $100 and an ACB of $25, and the elected amount is $25, one should ensure that the boot taken back does not exceed $25. If it does, the elected amount will be increased up to the FMV of the boot. Assume Sellco has capital property with a mortgage in excess of cost. Sellco transfers the property to Buyco pursuant to section 85 (electing at cost) and issues Buyco a note for the excess mortgage. Buyco assumes liabilities up to the cost of the property, issues shares to Sellco for the balance of the value of the transferred property, and in consideration for the Sellco note assumes the excess mortgage liability. Effectively, Sellco has paid Buyco to assume the excess mortgage liability. Subsequently, Buyco redeems the shares and surrenders the note to Sellco as consideration. These transactions place the property and the mortgage in Buyco. For transactions after December 31, 2000, the CRA considers the entire mortgage to have been assumed as consideration for the transferred property, and paragraph 85(1)(b) increases the agreed amount to the amount of the mortgage. The CRA did confirm that paragraph 85(1)(b) does not apply if the non-share consideration given (including the assumption of debt by the purchaser) is allocated among several properties, transferred to the purchaser, and retained by the purchaser, provided that the amount allocated to each asset is not greater than the amount elected in respect of each asset. The reference to the property being retained by the purchaser is troubling; it suggests that a purchaser cannot dispose of property transferred to it as part of the series of transactions without triggering the application of paragraph 85(1)(b). Similarly, ensure that the FMV of all consideration received by the transferor (boot plus shares) does not exceed the FMV of the transferred property to avoid the application of ss. 15(1). Similarly, the PUC of the shares received should not exceed the FMV of the transferred property or a deemed dividend may result in ss. 84(1). (d) Ensure that the provisions of para. 85(1)(e.2) are not applicable. Other factors. Bear in mind that there will be two assets following the transfer. Whereas before the transfer, the transferor owned the transferred property, after the transfer the transferred property will be owned by the corporation and the transferor will now own additional shares of the transferee. Double taxation can arise on a disposition by the corporation of the property and a subsequent disposition by the shareholder of the shares. Use a promissory note to extract ACB from property. Rollover of Land Inventory A direct rollover of real estate inventory to a corporation is prohibited on the ground that real estate inventory is ineligible property under subsection 85(1). The taxpayers, who were land developers, circumvented this limitation by rolling the land inventory to a partnership under subsection 97(2), which contains no such limitation, and in a series of transactions effectively

(e) (f)

396 achieved a rollover to a lossco owned by them and then used the losses to offset the income gain on the land's subsequent sale. The CRA argued that GAAR applied. In Loyens, 2003 TCC 214, the TCC found that the Act's provisions were used in conjunction with a pre-existing partnership and corporations to structure the taxpayer's transactions in the most tax-efficient manner. These transactions accorded with normal business practice and were entered into for bona fide business reasons. The TCC concluded that this use of the Act's provisions does not amount to misuse or abuse, but rather constitutes the use for which they were designed. While GAAR was not found to apply in XCO Investments Ltd. v. R., [1997] 2 C.T.C. 286, the Federal Court of Appeal did apply a tax avoidance provision, subsection 103(1). Subsection 103(1) states that where members of a partnership have agreed to share income or loss in a specified proportion and the principal reason for the agreement may reasonably be the reduction or postponement of tax then the amount of income or loss can be reduced to what is reasonable. In this case, the taxpayers entered into a partnership with Woodwards who had sustained taxable losses recently. The partnership then sold realty and apportioned income and gains on the sale to all partners equally causing Woodwards to earn a profit while the taxpayers realized tax savings. Subsection 103(1) applied and the judge concluded that 80% allocation to Woodwards was unreasonable in view of fact that Woodwards contribution was risk-free.

15. Case Law Peter Dale and Bernard Dale v. Her Majesty The Queen
[1994] 1 C.T.C. 2303, 94 D.T.C. 1100, Tax Court of Canada, Bowman, J.T.C.C. NOTE: Case was appealed to the Federal Court of Appeal on the issue of whether the Nova Scotia order was binding on the Tax Court judge and it was found that this order was binding between the taxpayers but it was not binding on the Tax Court judge. The Tax Court judge erred in going on to reason that an order allegedly having retroactive effect could not create a state of affairs in an earlier year that did not in fact exist. The Nova Scotia court granted the June 25, 1992 order on the basis of s. 44 of the Nova Scotia Companies Act which authorized its courts to deem something to have occurred on a date already past. It was not for the Minister to undermine the legislation by refusing to recognize the clear effect of the deemed event. Furthermore, s. 44 did not have the revisionist effect advanced by the Minister of rewriting fiscal history. Shares were issued, but not validly so until such time as either supplementary letters patent were obtained in Prince Edward Island or the Nova Scotia court granted the June 25, 1992 order. Therefore, the June 25, 1992 order of the Nova Scotia court was binding on the Minister and constituted proof of the fact that as of the end of the 1985 taxation year the preference shares in D Co. were validly issued and outstanding. The following excerpt is from the Tax Court of Canadas decision and discusses the issue of capital dividends: One is left therefore with relatively few essential facts upon which to form a legal conclusion as to the effectiveness in law of the section 85 rollover and the declaration of a capital dividend.
40

397 (a) We have a binding agreement between the Dales and their company to transfer the property for a consideration that included shares, followed by a valid transfer of the property to the company in 1985. (b) We have an issuance in 1985 of two preference share certificates to the Dales in purported satisfaction of the company's obligations under the agreement. They were given to Mr. Ward, the solicitor, who testified that they were lost. I accept his testimony. Replacement certificates were issued on July 10, 1989 and this fact was reflected in the share transfer register. (c) We have a meeting of shareholders on December 28, 1985 resolving that the secretary be instructed to apply for supplementary letters patent. (d) We have a number of resolutions, both before and after the continuance into Nova Scotia, sanctioning and ratifying the resolution of December 28, 1985 relating to the increase in the authorized capital and the adoption by the shareholders of the Memorandum of Association setting out the increased share capital. (e) We have a certificate of the Nova Scotia Registrar of Companies certifying that the authorized capital of the Dale Corporation Ltd. upon its continuance into Nova Scotia on July 27, 1989 consisted of $6,000,000 divided as described above. (f) We have an order by the Supreme Court of Nova Scotia that the authorized share capital of the company be declared to have been amended in accordance with Schedule A thereto effective December 28, 1985. What do we not have? Supplementary letters patent from Prince Edward Island sanctioning a bylaw increasing the authorized capital.
41 42

In considering whether this omission is fatal to the appellants' case I propose to start from what I believe to be a solid footing, and that is the situation on June 25, 1992 when Mr. Justice MacDonald made his order. By that time, were the preference shares validly issued to the appellants? Counsel for the respondent does not dispute that they were and, although that is an admission of law not binding on either the parties or the court, I am in respectful agreement with her.
43

Subsection 133(4) of the Nova Scotia Companies Act provides in part as follows:
133 (4)(a) without prejudice to the power of the company to vary or amend the same, the articles of continuance and the by-laws of the company shall, respectively, constitute the memorandum and articles of association of the company; (b) the share capital of the company shall be the existing share capital and the liability of the shareholders thereon shall continue to be limited.

It was argued that the "existing share capital" with which the company came into Nova Scotia was the original share capital of the Dale Corporation, since the resolution that the share capital be increased was not confirmed by supplementary letters patent as required by sections 32, 34, and 35 of the Prince Edward Island Companies Act (R.S.P.E.I. 1988, c. C-14).2
44

The adoption of the memorandum and articles of association by the shareholders and the resolutions passed at the meeting of December 6, 1988, containing the increased share capital which acts were again sanctioned at the meeting of May 22, 1991 (after the company had continued into Nova Scotia), make it clear that at least by June 25, 1992 the share capital was as set out in the articles of association. The petition to the registrar of joint stock companies of Nova Scotia, dated July
45

398 17, 1988, relating to the continuance into Nova Scotia had attached the proposed memorandum of association "unanimously adopted by the shareholders of the company".
46

Section 23 of the Nova Scotia Companies Act reads as follows:

23 (1) Subject to this Act and to the conditions contained in its memorandum, a company may by special resolution, alter or add to its articles, and any alteration or addition so made shall be as valid as if originally contained in the articles and be subject in like manner to alteration by special resolution. (2) The power of altering articles under this section shall, in the case of an unlimited company formed and registered under this Act, extend to altering any regulations relating to the amount of capital or its distribution into shares, notwithstanding that those regulations are contained in the memorandum. R.S., c. 81, section 23.

47 48

The resolution of May 22, 1991 is a special resolution as defined in section 87 of that Act.

We may then proceed from the premise that at the very latest by June 25, 1992 and probably by May 22, 1991 if not July 27, 1989 the share capital was increased and any defects in the issuance of the preference shares to the appellants were cured. Whether the Supreme Court of Nova Scotia had the power to make an order that had retroactive effect to a time that predated the continuance into Nova Scotia when the company was subject to Prince Edward Island law may be moot but even if, by including the words in his order of June 25, 1992 "effective December 28, 1985" and "as at December 31, 1985", Mr. Justice MacDonald exceeded his jurisdiction, it does not follow that the order should not be given effect within the limits of his powers as a superior court of Nova Scotia with respect to a company that, by June 25, 1992, was clearly subject to the laws of Nova Scotia. Thus, whether by reason of Mr. Justice MacDonald's order or by the resolution of May 22, 1991, or by the petition of July 17, 1989 giving rise to the continuance into Nova Scotia on July 27, 1989 the company had completely fulfilled its obligations under the agreement of December 28, 1985. It is perhaps open to question whether, if the order of MacDonald, J. is treated as having effect only on the day it was made and not having retroactive effect, it added anything to the petition of July 17, 1989 and the resolution of the shareholders of May 22, 1991. Counsel for the respondent argued that the order of MacDonald, J. might be binding as between the shareholders and the company but it could not bind the Minister. The correctness in law of that statement is questionable. In the absence of a specific statutory provision, (such, for example, as section 68 of the Income Tax Act) the Minister is not free to pick and choose which legal relationships he will recognize and which he will not. The Minister is seldom, if ever, a party to legal relations between subjects although they affect him in that they create the foundation from which tax consequences emanate. The Minister takes those relations as he finds them. The question is not whether he recognizes them. Rather, it is what is the true effect of the relations. Here we have an obligation to issue preference shares in consideration of the transfer of a building. The fulfilment of that obligation required, under Prince Edward Island law, a by-law increasing the authorized capital and a confirmation thereof by supplementary letters patent. That corporate step was not completed and the authorized capital was not increased until the company became subject to Nova Scotia law. This is not a matter of rewriting history, as counsel suggests, but of fulfilling all of the steps necessary to complete the company's obligations some time after the year in which the transfer takes place. It was part of the company's binding contractual obligations to increase its share capital under the laws of the province to which it became subject, Nova Scotia. The subsequent actions rectified the earlier omission and validated what, in their absence, would otherwise have been at least irregular, if not invalid.3 The result is that the appellants' title to the preference shares was perfected.
49

I hope that in my attempt to set out and deal with the respondent's position I do no disservice to Ms. Goldstein's able and lucid presentation of the Crown's case. She contended that whatever might
50

399 have been the effect of the subsequent actions that were designed to correct the failure to obtain supplementary letters patent, the irrefutable fact remains that the issuance of the preference shares was, as of December 31, 1985, unauthorized. From this position she contends that no corrective action after 1985 could avail to validate the section 85 election, the efficacy of which requires that the transfer of the capital property be "for consideration that includes shares of the capital stock of the corporation". Her position was that the shares had to be validly issued within the taxation year in which the rollover takes place. I presume that the taxation year referred to is that of the corporation issuing the shares. If this theory were correct it would mean that even if supplementary letters patent had been obtained on January 2, 1986 the section 85 rollover would have been invalid. This is not in my view a reasonable interpretation of section 85. The expression "consideration that includes shares" does not, as counsel suggests, imply that the share must necessarily be issued simultaneously with the transfer of property to the company or indeed within the same taxation year. What is essential is that there be either an actual issuance of shares or a binding obligation to do so at the time of transfer and that the shares be issued within a period of time that, in all the circumstances, is reasonable. There is no basis, in my view, for confining the word "consideration" to executed consideration. Consideration is of two kinds -- executed and executory -- and it would be an unwarranted restriction on that term to limit it to only one of the two types.4
51

The events in 1985, including the issuance of share certificates, were not nullities. They were simply incomplete. They were part of the fulfillment of the company's obligations under the contract. As soon as it was discovered that the necessary capitalization needed to issue the preference shares had not been obtained the directors and shareholders took the steps that they considered necessary to cure the defect. It should be borne in mind that it was not until September 1988 that, following the termination of the receivership, the corporate records were returned to officers of the company. The steps to correct the defect were ultimately taken in a jurisdiction that did not require supplementary letters patent. Where a corporate act is commenced under the laws of one province and the company continues under the laws of another jurisdiction before the corporate act is perfected, whatever steps are needed to complete the act must of necessity be those required by the laws of the new jurisdiction. After continuing into Nova Scotia the company obviously could not obtain supplementary letters patent from Prince Edward Island.
52

Counsel for the respondent, in support of her position that "consideration" did not include a promise to issue shares, referred to paragraph 66.1(6)(a) of the Income Tax Act, which uses the words "as consideration for shares ... of the capital stock of the corporation issued to him or any interest in such shares or right thereto". From this she argued that the absence of similar language in the opening words of subsections 85(1) and (2) implied a legislative intent to exclude executory consideration. Counsel for the appellants on the other hand suggested that precisely the opposite conclusion should be drawn from the use in paragraph 85(1)(b) of the words "... of the consideration therefor (other than any shares of the capital stock of the corporation or a right to receive any such shares)...". In a statute such as the Income Tax Act which increasingly resembles a patchwork quilt produced by different quilters working independently of each other, such comparisons may not necessarily be determinative. The wording of paragraph 85(1)(b) itself does, however, tend to support the respondent's position. It is, moreover, consistent with the established meaning of consideration and the overall purpose of section 85. That section is intended to operate in a commercial context to permit taxpayers to effect transfers of property in consideration of shares without the immediate tax consequences that such a transfer would entail. It should not be given an unduly restrictive interpretation that would defeat its purpose.
53

Counsel for the respondent contended that the judgment of the Supreme Court of Canada in Minister of National Revenue v. Benaby Realties Ltd., [1968] S.C.R. 12, [1967] C.T.C. 418, 67 D.T.C. 5275, supports the position that all of the necessary corporate steps to perfect the issuance of shares
54

400 must be completed within the year. That decision does not in my view support the proposition for which she contends. It settled the question of the year in which the proceeds of expropriation are to be taken into account and in so doing rejected the English concept of the reopening a taxpayer's books for a previous year to take account of a subsequent event, as illustrated in Newcastle Breweries Ltd. v. C.I.R. (1927), 12 T.C. 927. The problem dealt with in Benaby, supra, the timing of the recognition of income, is not that with which we are faced here, which involves a transfer of property in 1985. In no other year can the tax consequences of that transfer be recognized. The question is whether the appellants have fulfilled the conditions necessary for the application of section 85. The only condition that the respondent contends has not been met is that contained in the words "for consideration that includes shares". For the reasons set out above I think the condition has been met. The second issue, the declaration and payment of the capital dividend on the preferred shares requires a different analysis. Subsection 83(2) permits a private corporation to elect that a dividend that "becomes payable ... to shareholders of any class of shares of its capital stock" be a capital dividend to the extent of its capital dividend account. In light of my conclusion that the election under section 85 was valid it follows that the company's cost of the property was deemed to be the amount elected in the prescribed form under section 85. Accordingly on its disposition of the property to Hoque it realized a capital gain and it had a capital dividend account within the meaning of paragraph 89(1)(b). It cannot, however, be said that a dividend became payable in 1985 on a class of shares of the company's capital stock. It was not necessary for my decision under section 85 that for the purposes of these appeals I give effect to the stated retroactivity of the order of MacDonald, J. of June 25, 1992. Compliance with section 85 did not require that all steps necessary to perfect the issuance be completed in the year provided that the "consideration" for the transfer included shares. The same reasoning is not available in the case of a dividend under subsection 83(2). For dividends to be payable on a class of shares at a particular time all steps necessary for the valid issuance of the shares must in fact and in law have been completed at that time. Dividends cannot become payable on embryonic shares. I do not think that the decision of the Federal Court of Appeal in Hillis v. The Queen, [1983] C.T.C. 348, 83 D.T.C. 5365, supports giving retroactive effect to the order of MacDonald, J., particularly where to do so would involve recognizing a retroactive amendment as of December 28, 1985 to the share register of a company that on that date was not subject either to the law of Nova Scotia or to the jurisdiction of the Nova Scotia Court. Although the three judges who decided Hillis gave very different reasons, only one, Heald, J., based his decision upon the retroactive effect of the Saskatchewan Court under the Dependants' Relief Act. In a later decision, Boger Estate v. Minister of National Revenue, [1993] 2 C.T.C. 81, 93 D.T.C. 5276, Mr. Justice Heald, at page 86 (D.T.C. 5280), commented on the Hillis decision and quoted from the judgment of Mr. Justice Clement:
55 In my opinion the provisions come into operation upon the death of the intestate and effect an indefeasible vesting in the beneficiary of the interest provided, to which the Administrators must give effect albeit subject to dealings with the vested interest by the beneficiary. In this view, the vesting of the interest is not dependent upon an order of the court granting administration of the intestate's estate: it takes place by force of imperative statutory provision operating at the moment of death of an intestate. [Emphasis added.]

As I read the Hillis decision and the subsequent decision in Boger it would appear that, whatever might be the effect of a specific statutory provision, a court order purporting to have retroactive effect cannot create a state of affairs in an earlier year that did not in fact exist.
56

In the result the amounts of $80,000 paid to each appellant by the company and purporting to be capital dividends under subsection 83(2) of the Income Tax Act are not in my opinion dividends within
57

401 the meaning of that subsection but rather are benefits to the appellants as shareholders under subsection 15(1) and properly included in their income.

Bugera v. Minister of National Revenue

2003 CarswellNat 863, 2003 FCT 392, 2003 D.T.C. 5282, [2003] 3 C.T.C. 256, 231 F.T.R. 197. Federal Court of Canada, Trial Division. Dawson J. Income tax --- Corporations -- Reorganizations -- Section 85 --- Taxpayers were family who owned pub -- Corporate reorganization was accomplished by estate freeze and later estate thaw -Freeze allowed future equity in pub to be accumulated in children's names and allowed parents to benefit from capital gain exemption -- Taxpayers' tax advisor did not file elections pursuant to s. 85 of Income Tax Act -- Taxpayers became aware of advisor's omission after time to file elections had expired -- Taxpayers sold shares in pub to third party -- Acting on advice of new tax advisor, taxpayers paid estimated penalties, interest and taxes to Minister -- Minister declined to exercise discretion to allow filing of late elections -- Taxpayer brought application for judicial review -Application dismissed -- Minister's findings were not patently unreasonable -- Filing of properly signed elections and payment of properly identified monies were not prerequisite to exercise of Minister's discretion -- Intention of s. 85(7.1) of Act not thwarted if taxpayer was required to include properly filed elections and penalties were properly estimated -- Minister's consideration that five of seven of taxpayers' signatures were absent from election was not unreasonable -- No evidence that monies paid to Minister were designated as estimated penalties or that Minister was provided with explanation of payments -- Minister did not err by considering other factors, including investments made by taxpayers without which no s. 85 election would have been necessary -- Minister's finding taxpayers' actions amounted to retroactive tax planning was not unreasonable -Minister's conclusion that failure to file proper elections arose from negligence or carelessness was not unreasonable.

16. Transfers of Capital Property (Stop Loss Rules)

A number of rules will apply to prevent the taxpayer from claiming an immediate loss on the transfer of assets to a corporation. The stop-loss rules are sprinkled throughout the Act. The main provisions are:

section 40 (non-depreciable capital property); subsection 13(21.2) (depreciable property); subsections 14(12)-(13) (eligible capital property); subsections 18(13)-(16) (non-capital shares, bonds, and inventory); subsection 69(11) (dispositions at less than fair market value); and subsection 112(3) (shares sold by a corporation).

402 The stop-loss provisions generally serve to suspend the denied loss in the transferor's hands; however, there are several notable exceptions. The "superficial loss" rule is closely related to the stop-loss rules. A superficial loss is triggered on the disposition of property if the disposing taxpayer or an affiliated person acquires the same or identical property during a period that begins 30 days before or ends 30 days after the disposition and such a person owns the property at the end of the 30-day period (paragraph 40(2)(g) and section 54). The superficial loss rules generally deny the recognition of a capital loss where a taxpayer disposes of capital property and an affiliated party acquires it or identical property within 30 days of the disposition and holds it after that time. An individual is affiliated with a corporation if the individual or his spouse controls it. In that event, the corporation adds the amount of the denied loss to the ACB of the property received. A transfer of a stock portfolio with both gains and losses may be effected on a taxdeferred basis using elections under section 85 of the Act. The gain shares are transferred at an elected amount equal to ACB. In the case of the loss shares, the elected amount cannot exceed the fair market value of the shares. The individual's loss on the transfer of those shares is denied but added to the corporation's ACB of the shares. The superficial loss rules do not apply if the transferor is a corporation and the transferee is an affiliated person. (Corporations are affiliated if they are controlled by the same person or by affiliated persons.) In that case, the losses are suspended in the transferor's hands until the property is sold to an arm's-length party. At that time, the loss is realized, but it may only be deducted by the transferor. A capital loss may be of little use unless the transferor realizes capital gains from other sources in the future. These rules are described below in the Technical Notes provided by the CRA. These notes accompanied the new legislation. [Technical Notes June 20, 1996] New subsections 40(3.3) and (3.4) set out rules that defer losses on certain dispositions of non-depreciable capital property. Under new subsection 40(3.3), these rules apply where (1) a corporation, trust or partnership has disposed of a non-depreciable capital property, (2) the transferor or a person "affiliated" with the transferor acquires the transferred property or an identical property (either of which is termed the "substituted property") during the period that begins 30 days before and ends 30 days after the disposition, and (3) at the end of that period, the transferor or an affiliated person owns the substituted property. Where these conditions are met, new subsection 40(3.4) provides that no loss may be recognized on the transfer. Instead, any loss is deferred until the earliest of the following events: a subsequent disposition of the property to a person that is neither the transferor nor a person affiliated with the transferor (provided that for 30 days after that later disposition neither the transferor nor an affiliated person owns the substituted property or an identical property acquired after the beginning of the 61-day period described above); a deemed disposition of the property under section 128.1 (change of residence) or subsection 149(10) (change of taxable status); in the case of a corporation, an acquisition of the corporation's control; where the substituted property is a debt or a share, a deemed disposition under section 50; or

403 where the transferor is a corporation, a winding-up of the transferor (other than a winding-up to which subsection 88(1) applies). The closing words of new subsection 40(3.4) clarify the result where a transferor partnership ceases to exist after a disposition, but before any of the events that would trigger recognition of the deferred loss. Where a partnership would otherwise cease to exist after a disposition to which subsection 40(3.4) applies, the partnership is treated for the purposes of paragraph 40(3.4)(b) as not having ceased to exist, and each person who was a member of the partnership at the time of the disposition is treated as having remained a member of the partnership. This deemed continuation of the partnership (and of the membership of each partner) continues until the time that is immediately after the first of the events that trigger the partnership's loss. New subsections 40(3.3) and (3.4) replace subsection 85(4), insofar as subsection 85(4) applied to transfers of non-depreciable capital property. Subsection 85(4) operated to the same effect in denying the recognition of a loss on the transfer of such property to persons such as a corporation controlled by the transferor or a person that controlled the transferor. However, these new subsections differ from subsection 85(4) in two material respects. First, they do not apply to transfers by individuals other than trusts, but can, as a result of the adoption of the definition of "affiliated persons" in new section 251.1, have application to transfers of non-depreciable capital property transferred to individuals, corporations and partnerships in cases where subsection 85(4) would not have applied. Second, the denied loss is not added to either to the cost of any shares held by the transferor in the transferee after the disposition, or to the cost to the transferee of the transferred property. Instead, the loss is preserved in the transferor's hands to be deducted as a loss from the transferred property when it is no longer owned by an affiliated person, when it is deemed to have been disposed of under other provisions of the Act, or when control of a corporate transferor is acquired. (An exception arises in the case of shares of a corporation's capital stock that are disposed of to that corporation. See new subsection 40(3.6).) New subsection 40(3.3) and (3.4) apply to dispositions of property that take place after April 26, 1995, subject to certain exceptions. These are found in clause 156, and generally exclude transactions in progress before April 27, 1995. Readers should refer to the notes to clause 156 for more detail. [November 20, 1996] New subsection 40(3.5) sets out four special rules that apply for the purposes of the loss deferral rule in new subsection 40(3.4). First, paragraph 40(3.5)(a) provides that a right to acquire a property (other than a right that is security for a debt or similar obligation) is treated as being identical to the property. Second, paragraph 40(3.5)(b) treats a share that is acquired in exchange for another share under any of sections 51, 85.1, 86 or 87 as identical to that other share. Third, paragraph 40(3.5)(c) clarifies the result where the property that gives rise to a deferred loss under new subsection 40(3.4) is a share of a corporation that is subsequently merged with one or more other corporations (except where the preceding paragraph already applies to the share) or is wound up into its parent corporation. In such a case, the surviving corporation -- that is, the corporation formed on the merger or the parent corporation -- is treated as continuing to own the share as long as that surviving corporation is affiliated with the transferor. Finally, paragraph 40(3.5)(d) applies where the property-giving rise to the deferred loss is a share which is subsequently redeemed, acquired or cancelled by the issuing corporation. Except where

404 either paragraph (b) or (c) applies to the share, the transferor is deemed to continue to own the share while the issuing corporation is affiliated with the transferor. (3.6) Loss on shares -- Where at any time a taxpayer disposes, to a corporation that is affiliated with the taxpayer immediately after the disposition, of a share of a class of the capital stock of the corporation (other than a share that is a distress preferred share as defined in subsection 80(1)), (a) the taxpayer's loss, if any, from the disposition is deemed to be nil; and (b) in computing the adjusted cost base to the taxpayer after that time of a share of a class of the capital stock of the corporation owned by the taxpayer immediately after the disposition, there shall be added that proportion of the amount of the taxpayer's loss from the disposition (determined without reference to paragraph (2)(g) and this subsection) that (i) the fair market value, immediately after the disposition, of the share is of (ii) he fair market value, immediately after the disposition, of all shares of the capital stock of the corporation owned by the taxpayer. See also paragraph 40(20(g)) and definition of superficial loss in section 54.

Cascades Inc. c. R.
2009 FCA 135 M. Nadon J.A.: This is an appeal of a decision of Justice Lucie Lamarre of the Tax Court of Canada, 2007 CCI 730 (T.C.C. [General Procedure]), dated December 6, 2007, allowing the respondent's appeal from a determination of loss made under subsections 40(3.3), 40(3.4) and 40(3.5) of the Income Tax Act, R.S.C. 1985 (5th Supp.), c. 1 (the "Act") for the 2000 taxation year. The judge held that the respondent Cascades Inc. ("Cascades") was entitled to claim a capital loss of $15,941,608 during its 2000 taxation year, as this loss was not deemed to be nil pursuant to subsection 40(3.4) of the Act.
1

The only issue raised by the appeal is the interpretation of subsections 40(3.3), 40(3.4) and 40(3.5) of the Act. We must consider whether paragraph 40(3.5)(c) applies if one of the conditions set out at paragraphs 40(3.3)(a), 40(3.3)(b) and 40(3.3)(c) has not been met. More specifically, the issue is to determine the meaning of "apply" at paragraph 40(3.5)(c)
2 4 5

The facts in this case are not disputed. They may be briefly summarized as follows.

At the end of May 2000, Cascades held 71.1% of the common shares of Les Industries Paperboard International Inc. ("PII"). The adjusted cost base of the 33,025,966 PII shares held by Cascades was at that time $68,783,154, and their fair market value was $52,841,546. On September 8, 2000, 3715965 Canada Inc. (the "corporation") was incorporated, and Cascades became the sole shareholder. The corporation is a corporation affiliated with Cascades within the meaning of section 251.1 of the Act.
6

On December 5, 2000, Cascades sold all of the shares in PU that it held to the corporation, for consideration equal to the fair market value of those shares, thereby realizing a capital loss of $15,941,608 (adjusted cost base of $68,783,154 minus the proceeds of disposition of $52,841,546). The consideration received by Cascades was 33,025,966 common shares of the corporation.
7

405 On December 31, 2000, that is, 26 days later, PII and the corporation merged, and the corporation formed on the merger was 384894-9 Canada Inc. ("PII Fusionco"). At the time of the merger, each of the common shares of the corporation held by Cascades was converted into a common share of PII Fusionco. PII Fusionco is a corporation affiliated with Cascades within the meaning of section 251.1 of the Act. In computing its taxable income for the 2000 taxation year, Cascades claimed a capital loss of $15,941,608 realized on the sale of the common shares in PII.
8

On January 23, 2004, the Minister of National Revenue (the "Minister") deemed Cascades' loss to be nil under subsections 40(3.4), 40(3.4) and 40(3.5) of the Act. Cascades appealed that decision of the Tax Court of Canada, and that appeal was allowed and is at issue here.
9

Tax Court of Canada decision Justice Lamarre began her analysis by reviewing the principles governing the interpretation of tax statutes, as developed by the Supreme Court of Canada. Those principles involve, among other things, the relevance of a textual interpretation of such statutes and the importance of reading their provisions in context, that is, within the overall scheme of the legislation. The Supreme Court also explained that, where Parliament has specified precisely what conditions must be satisfied to achieve a particular result, it is reasonable to assume that Parliament intended that taxpayers would rely on such provisions to achieve the result they prescribe.
10

Having considered those principles of interpretation, Justice Lamarre concluded that it is obvious that the conditions of subsection 40(3.3) must all be met for subsection 40(3.4), which provides that a loss is deemed to be nil, to apply. However, paragraph 40(3.3)(c) stipulates that, at the end of the period referred to in the subsection, the transferor (in this case, Cascades) or a person affiliated with the transferor must own the substituted property (in this case, the PII shares). Consequently, when considering only subsections 40(3.3) and 40(3.4), Cascades' loss cannot be deemed to be nil, since, at the end of the period in question, no entity owned the PII shares, given that PII had been merged with the corporation and no longer existed.
11

The Minister had nevertheless claimed that subsection 40(3.5), and in particular paragraph 40(3.5)(c), specifically allowed him to deem the loss to be nil, since that paragraph provides that the corporation formed on the merger (in this case, PII Fusionco) is deemed to own the share while it is affiliated with the transferor. However, on analyzing the application of subsection 40(3.5), the judge determined that this subsection applied only if subsections 40(3.3) and 40(3.4) already applied, since paragraph 40(3.5)(c) states that "where subsections 40(3.3) and 40(3.4) apply to the disposition by a transferor of a share of the capital stock of a corporation, and after the disposition the corporation is merged with one or more other corporations, ... the corporation formed on the merger ... is deemed to own the share while it is affiliated with the transferor" [emphasis added]. Consequently, since the conditions of subsection 40(3.3) had not all been met, and as subsection 40(3.4) therefore did not apply either, paragraph 40(3.5)(c) did not apply in this case and could not provide a basis for the Minister to deem the loss to be nil.
12

In her analysis of subsection 40(3.5), the judge explained that, if Parliament had meant to say what was argued by the Minister, it could have expressed it more explicitly, for example by using terms such as the following at paragraph 40(3.5)(c): "where subsections (3.3) and (3.4) [relate to or concern] the disposition by a transferor of a share of the capital stock of a corporation ...". Rather, the judge interpreted paragraph 40(3.5)(c) as stating that the transferor may claim its loss if a merger occurred after the 61-day period (which is the period mentioned in subsection 40(3.3)), otherwise the entitlement to claim the loss would be lost.
13

406 Moreover, in the judge's opinion, the stop-loss rule in subsection 40(3.4) does not necessarily apply to the present case. That rule is a specific anti-avoidance measure to prevent taxpayers from immediately recognizing a latent capital loss on non-depreciable capital property, whereas the restructuring proposed by Cascades was not done for this purpose, according to the judge.
14

C. Did Justice Lamarre err in finding that the respondent was entitled to claim the loss? With those principles in mind, I now turn to the interpretation of subsections 40(3.3), 40(3.4) and 40(3.5) of the Act.
24 25

Subsection 40(3.4) provides that the transferor's loss, if any, from a disposition is deemed to be nil if the three conditions of subsection 40(3.3) are met, that is: the corporation (the transferor) disposes of a particular non-depreciable capital property, in this case, shares (paragraph 40(3.3)(a)); the transferor or a person affiliated with the transferor acquires a property that is, or is identical to, the particular property during the period that begins 30 days before and ends 30 days after the disposition (paragraph 40(3.3)(b)); and the transferor or a person affiliated with the transferor owns the substituted property at the end of the period (paragraph 40(3.3)(c)). The parties agree that the first two conditions set out at paragraph 40(3.3)(a) and (b) have been met. As for the third condition, set out at paragraph 40(3.3)(c), at first blush, it has not been met because neither the transferor nor the person affiliated with the transferor owned the shares at issue at the end of the period in question. This is so since those shares, i.e. those of PII, no longer exist because PII has been merged with another company and thus no longer exists. 26 Were the analysis to end there, Cascades could therefore claim its capital loss, as the three conditions of subsection 40(3.3) have not been met to allow the Minister to deem the loss to be nil, under subsection 40(3.4). However, subsections 40(3.3) and (3.4) must be interpreted in relation to subsection 40(3.5), which, in its preamble, states that the following presumptions apply "[f]or the purposes of subsections 40(3.3) and 40(3.4)". Subsection 40(3.5) provides four presumptions at paragraphs 40(3.5)(a) to (d). Here, it is paragraph 40(3.5)(c) that is at issue; it provides as follows, and I reproduce it again for convenience On the basis of the phrase "where subsections 40(3.3) and 40(3.4) apply" in paragraph 40(3.5) (c), Justice Lamarre concluded that the three conditions of subsection 40(3.3) had to be met before paragraph 40(3.5)(c) could apply. With respect, I am of the opinion that the judge misinterpreted the text of paragraph 40(3.5)(c). In my view, that paragraph does not require that the three conditions of subsection 40(3.3) be met before the presumption within may apply. If Parliament had intended to give paragraph 40(3.5)(c) the meaning the judge attributes to it, the paragraph could have been written as follows, with a comma, in particular: "where subsections 40(3.3) and 40(3.4) apply, and where there is a disposition by a transferor of a share ...".
27

My interpretation of paragraph 40(3.5)(c) is consistent with the preamble of subsection 40(3.5), which states that the following presumptions apply "[f]or the purposes of subsections 40(3.3) and 40(3.4)". Following this preamble, only paragraphs 40(3.5)(c) and (d) begin with the words "where subsections 40(3.3) and 40(3.4) apply". Consequently, it must be understood that the four paragraphs of subsection 40(3.5) contain presumptions that apply, as stated in the preamble, for the purposes of subsections 40(3.3) and 40(3.4), but that paragraphs 40(3.5)(c) and (d) provide additional clarifications: these paragraphs apply only where subsections 40(3.3) and 40(3.4) "apply to" a particular situation, that is, the disposition of shares of the capital stock of a corporation, and after the disposition (in the case of paragraph 40(3.5)(c)), the corporation is merged with one or more other corporations.
28

407 In my opinion, the words "s'appliquer " have the meaning given by Le Nouveau Petit Robert, 2004 to the verb "s'appliquer": "[tre] applicable ", "concerner", or "viser". Consequently, the presumption stated at paragraph 40(3.5)(c) applies where subsections 40(3.3) and 40(3.4) "visent", "concernent", or "sont applicables " the situation described in paragraph 40(3.5)(c).
29

A reading of the English wording of paragraph 40(3.5)(c) leads me to the same conclusion. According to the Oxford Compact Thesaurus, 2005, the word "apply" means "pertain", "relate", "concern", "deal with". Therefore, it must be understood that the presumption in paragraph 40(3.5)(c) applies where subsections 40(3.3) and 40(3.4) "pertain to", "relate to", "concern", or "deal with" the case described at paragraph 40(3.5)(c).
30

Without that interpretation of "apply to", the introductory part of paragraphs 40(3.5)(c) and (d) would he redundant, given the preamble of subsection 40(3.5). As regards paragraph 40(3.5)(c), it therefore provides a presumption that applies not only for the purposes of subsections 40(3.3) and 40(3.4), but specifically for the purposes of those subsections where there is a disposition by a transferor of a share of the capital stock of a corporation, and after the disposition the corporation is merged.
31

A reading of the other paragraphs of subsection 40(3.5), and in particular paragraphs (a) and (b), further confirms my opinion that it is not necessary that subsections (3.3) and (3.4) already apply before the presumptions of subsection (3.5) may be relied on. In fact, paragraphs 40(3.5)(a) and (b) must be consulted to understand the meaning of a "property that is identical", a phrase that is mentioned but not defined at paragraph 40(3.3)(b). Paragraphs 40(3.5)(a) and (b) indicate, first, that a right to acquire a property is deemed to be a property that is identical to the property itself and, second, that a share of a corporation that is acquired in exchange for another share is deemed to be a property that is identical to the other share.
32

Accordingly, it is clear that subsection 40(3.5) contributes to a better interpretation of the scope of subsections 40(3.3) and (3.4). The conditions that must be met for paragraph 40(3.5)(c) to apply are the disposition by a transferor of a share of the capital stock of a corporation and, after the disposition, the merger of the corporation with one or more other corporations. If these conditions are met, the presumption applies: in analyzing subsections 40(3.3) and (3.4), one must bear in mind that the corporation formed on the merger is deemed to own the share while it is affiliated with the transferor.
33

In this case, a textual interpretation of subsections 40(3.3), (3.4) and (3.5) therefore leads to the conclusion that it is not necessary that the conditions set out at paragraphs 40(3.3)(a) and (b) all be met and, consequently, that subsections 40(3.3) and (3.4) apply before subsection (3.5) may apply. Moreover, in light of the overall scheme of the legislation and of the provisions in question, they should be seen as establishing a stop-loss rule. As Gerald D. Courage points out in his article Utilization of Tax Losses and Debt Restructuring, 2006 Ontario Tax Conference, (Toronto; Canadian Tax Foundation, 2006), 9:1-86, at page 2:
34 ... the Act contains a number of so called "stop-loss rules" where there has been a transfer of property with an accrued loss within a statutorily defined closely held group. While the transfer might otherwise be treated as a sufficient realization so as to permit recognition of the loss, nevertheless the loss is denied until the property (or, in some cases, property received in exchange on the transfer) is transferred out of the group, at which point there is effectively a "true" realization by the group of the loss for tax purposes.

As the appellant suggests in her memorandum of fact and law, the judge's decision leads to an illogical result: where there is, such as in this case, a disposition of shares followed by a merger during the period ending 30 days after the disposition, the rule would not apply, and taxpayers could
35

408 deduct their loss for the year of disposition, even if that loss was not actually realized by the group of affiliated corporations. However, where a merger occurs after the period ending 30 days after the disposition, subsection 40(3.4) would apply, and the loss would be deemed to be nil until it was actually realized by the group of affiliated corporations. For these reasons, I therefore conclude that the presumption set out at subsection 40(3.5)(c) applies and, consequently, that the third condition of subsection 40(3.3), that is, the one stated at paragraph 40(3.3)(c), has been met: at the end of the period referred to in paragraph 40(3.3)(b), PII Fusionco, which is a corporation affiliated with Cascades, is deemed to own the shares of PII, despite the fact that PII has been merged and no longer exists. Subsection 40(3.4) therefore applies, by virtue of subsection 40(3.3), and Cascades' loss from the disposition of the shares in PII is deemed to be nil.
36

Lastly, I can only conclude that the judged erred in considering Cascades' intent in her analysis of the provisions at issue. In fact, the judge indicated at paragraph 36 of her reasons that the restructuring proposed by Cascades was not done with the intent to prematurely realize a loss. The judge explains at paragraph 34 of her reasons that the aim of the restructuring was to improve Cascades' worth on the financial markets and to support its future growth. However, as the appellant points out, Cascades' intent is not relevant to an analysis of subsections 40(3.3), (3.4) and (3.5). The stop-loss rule in those subsections contains no test of intent. If the conditions of subsection 40(3.3) are met, the rule must apply, regardless of the taxpayer's intent.
37

Disposition For these reasons, I would allow the appeal with costs, set aside the decision of the Tax Court of Canada and, rendering the judgment that should have been rendered, dismiss with costs the respondent's appeal from a determination of loss made by the Minister reducing the capital loss claimed by the respondent for the 2000 taxation year by $15,941,608.
38

Transfers of Depreciable Property Technical Notes [June 20, 1996] Federal Budget subsection 13(21.2) applies on the transfer, by a person or partnership, of a depreciable property whose tax cost is greater than the amount that would otherwise be the transferor's proceeds from the transfer. Where these conditions exist, and the transferor or a person "affiliated" with the transferor holds or has a right to acquire the property 30 days after the disposition, no loss may be recognized on the transfer. Instead, such a loss is deferred until the earliest of the following events: a subsequent disposition of the property to a person that is neither the transferor nor a person affiliated with the transferor (provided that neither the transferor nor an affiliated person acquires or has a right to acquire the property within 30 days after that later disposition); a change in the property's use from an income-earning to a non-income-earning purpose; a "deemed disposition" of the property under section 128.1 (change of residence) or subsection 149(10) (change of taxable status); where the transferor is a corporation, an acquisition of control of the transferor; or where the transferor is a corporation, a winding-up of the transferor (other than a winding-up under subsection 88(1)).

409

The tax cost of a depreciable property is, for the purposes of this rule, treated as being the proportion of the undepreciated capital cost of the class to which the property belongs that the value of that property is of the value of all properties in the class. The amount by which that tax cost exceeds the amount that would otherwise be the transferor's proceeds of disposition of the transferred property's value is treated as the capital cost of a property, of the same class as that from which the property came, acquired by the transferor before the taxation year in which the transfer took place. This new property will be treated as being owned by the transferor until the earliest of the events described above. As a result, the transferor will be permitted to claim capital cost allowance (CCA) after the transfer on the difference between the transferred property's tax cost and the transferor's proceeds of disposition otherwise determined. As well, any portion of the difference not claimed as CCA may be eligible for recognition as a terminal loss when any of the events described above occurs, provided the transferor has no other properties of the same class. New subsection 13(21.2) replaces subsection 85(5.1), which denied the recognition of a loss on the transfer of a depreciable property to a corporation controlled by the transferor or that controlled the transferor. However, new subsection 13(21.2) differs from subsection 85(5.1) in two material respects. First, new subsection 13(21.2) does not apply to transfers by individuals other than trusts, but can, as a result of its adoption of the definition of "affiliated persons" in new section 251.1 (see the commentary on that section for a fuller description), apply to depreciable property transfers to individuals, corporations and partnerships in cases where subsection 85(4) would not have applied. Second, the new rule does not pass the excess of tax cost over a property's value on to the transferee but instead retains it in the transferor's hands to be amortized and (to the extent of any unamortized portion) deducted as a terminal loss. Finally, new subsection 13(21.2) provides, in paragraph (g), that the "subsequent owner" of the transferred property -- that is, the transferor or a person affiliated with the transferor -- is treated for the purposes of measuring any potential recapture with respect to the transferred property as having the same capital cost of the property as it had to the transferor, and as having deducted as capital cost allowance in previous years the amount by which the capital cost of the transferred property exceeds the property's value at the time of disposition. In summary, subsection 13(21.2) prevents the transfer of property with a "pregnant loss" from being used as a method of transferring a high capital cost where property has declined in value. Before this rule, section 85(5.1) could be used to prevent section 20(16) from giving the transferor a terminal loss, thus transferring the high cost base to the transferee, and effectively allowing the sale of tax losses in certain circumstances. For the parallel rule with respect to capital losses, see subsection 40(3.3) and (3.4). For eligible capital property, see subsection 14(12); for certain inventory, see subsections 18(13)-(16). Eligible Capital Property (Technical Notes June 20, 1996 Budget) New subsection 14(12) applies where a corporation, trust or partnership has disposed of eligible capital property and would, but for this new rule, have been entitled as a consequence of the disposition to claim a deduction under subsection 24(1) for any undeducted amounts remaining in its cumulative eligible capital pool in respect of that business. (In general terms, subsection 24(1) would ordinarily permit such a deduction where the taxpayer has ceased to carry on the business and no longer owns any eligible capital property of value with respect to that business.) Where (1) these conditions exist, (2) the transferor or a person "affiliated" with the transferor acquires an identical property or the transferred property itself (either of which is termed the "substituted property") within

410 the period beginning 30 days before and ending 30 days after the disposition, and (3) the transferor or an affiliated person owns the property at the end of that period, no deduction may be recognized on the transfer. Instead, such a deduction is deferred until the earliest of the following events: a subsequent disposition of the property to a person that is neither the transferor nor a person affiliated with the transferor (provided that for 30 days after that subsequent disposition neither the transferor nor an affiliated person owns either the substituted property or an identical property acquired after the beginning of the period described above); a change whereby the property no longer constitutes eligible capital property of a business of the transferor or an affiliated person; a "deemed disposition" of the property under section 128.1 (change of residence) or subsection 149(10) (change of taxable status); in the case of a corporation, an acquisition of the corporation's control; or where the transferor is a corporation, a winding-up of the transferor (other than a winding-up under subsection 88(1)).

If subsection 14(12) applies, the transferor will be treated as continuing to own eligible capital property of the business in respect of which the transferred property was used. This will enable the transferor to continue to claim annual cumulative eligible capital amounts under paragraph 20(1)(b) in respect of the remaining eligible capital property pool, and to claim a loss for any portion of the pool that remains undeducted when any of the events described above occurs. New subsection 14(12) replaces subsection 85(4), insofar as subsection 85(4) applied to transfers of eligible capital property. Subsection 85(4) operated to the same effect in denying the recognition of a loss on the transfer of eligible capital property to persons such as a corporation controlled by the transferor. However, new subsection 14(12) differs from subsection 85(4) in two material respects. First, it does not apply to transfers by individuals other than trusts, but can, as a result of its adoption of the definition of "affiliated persons" in new section 251.1 (see the commentary on that section for a fuller description), apply to eligible capital property transfers to individuals, corporations and partnerships in cases where subsection 85(4) would not have applied. Second, the new rule does not add the denied deduction to the cost of any shares received by the transferor in exchange for the property but, instead, retains it in the transferor's hands to be amortized and (to the extent of any unamortized portion) deducted under subsection 24(1).

17.

Price Adjustment Clauses Interpretation Bulletin IT-169 - Price Adjustment Clauses

August 6, 1974 (This bulletin remains the Departments position as of January 2012)

Reference: Section 3 (also section 69 and subsection 15(1)) 1. Where property is transferred in a non-arm's length transaction, the parties sometimes include a price adjustment clause in the covering agreement. This bulletin deals with those agreements which state that if the Department determines that the fair market value of the property is greater or less than the price otherwise determined in the agreement, that price will be adjusted to take into account

411 the excess or the shortfall. The Department is only concerned in the valuation for purposes of administering the Act and determining the tax consequences. It is neither a valuator nor an arbitrator for the parties. If the parties have agreed that, if the Department's value is different from theirs, they will use the Department's value in their transaction, that is their choice and the Department will recognize that agreement in computing the income of all parties, provided that all of the following conditions are met; (a) The agreement reflects a bona fide intention of the parties to transfer the property at fair market value and arrives at that value for the purposes of the agreement by a fair and reasonable method. (b) Each of the parties to the agreement notifies the Department by a letter attached to his return for the year in which the property was transferred (i) that he is prepared to have the price in the agreement reviewed by the Department pursuant to the price adjustment clause, (ii) that he will take the necessary steps to settle any resulting excess or shortfall in the price, and (iii) that a copy of the agreement will be filed with the Department if and when demanded. (c) The excess or shortfall in price is actually refunded or paid, or a legal liability therefore is adjusted. 2. Whether the method used by the parties to determine fair market value is fair and reasonable in the Department's view will depend on the circumstances in each case. 3. In recognizing the price adjustment clause, appropriate adjustments in computing the income of all parties to the agreement will be made in their taxation years in which the property was transferred. If the purchaser has filed returns and claimed capital cost allowances, deductions from income based on cumulative eligible capital, or exploration and development expenses in respect of the property for taxation years subsequent to that in which it was transferred, any necessary adjustments will be made in those subsequent years. Likewise, any reserves claimed by the vendor to defer the reporting of income will be adjusted. 4. Amended Forms T2022 on the sale of accounts receivable or amended agreements on the price paid for inventory may be required. 5. If all the conditions mentioned in paragraph 1 are met, the Department will not apply subsection 15(1) to tax a benefit to shareholders. 6. Where taxpayers have included price adjustment clauses in agreements that relate to transactions reported in tax returns already filed, they should notify the District Office immediately if they wish to have the clause considered in the light of the comments in this bulletin.

18. General Review and technical filing requirements Interpretation Bulletin IT-291R3 - Transfer of Property to a Corporation under Subsection 85(1)
January 12, 2004 (This publication is accurate as of January 2012) Summary This bulletin discusses the rollover provisions of the Act whereby a taxpayer may elect to transfer eligible property to a taxable Canadian corporation in exchange for consideration that includes at least one share of the corporation. Eligible property includes most capital property, Canadian or

412 foreign resource property, eligible capital property and inventory, other than inventory that is real property. Where the taxpayer and the corporation agree upon an amount that does not exceed the fair market value of the property disposed of and is not less than the fair market value of any non-share consideration that is received, the amount agreed upon becomes, subject to certain specific limitations, the taxpayers proceeds of disposition and the corporations cost of the property. By choosing an appropriate amount within those limits the property can be transferred on a tax-deferred basis, that is, the corporation assumes the taxpayers potential income tax liabilities for the property. Discussion and Interpretation Definitions For the purposes of this bulletin: All or substantially all when the level of 90% of whatever is being measured is reached, the all or substantially all requirement is considered to have been met. Non-share consideration means all the consideration received by the vendor other than shares of the transferee corporation or a right to receive such shares. Share means a share or a fraction of a share of the capital stock of a corporation. 6. Canadian resource property, which is defined in subsection 66(15), may include real property. Consequently, notwithstanding the exclusion in paragraph 85(1.1)(f) concerning real property that is inventory, a taxpayer, including a dealer in Canadian resource property to which subsection 66(5) applies, may transfer real property that is Canadian resource property to a taxable Canadian corporation under subsection 85(1). 7. By virtue of subsection 85(1.11), a foreign resource property, or an interest in a partnership which derives all or part of its value from one or more foreign resource properties, will not be an eligible property for a transfer to a non-arms length corporation where it may reasonably be considered that one of the purposes of the disposition, or series of transactions which includes the disposition, is to increase any persons entitlement to claim a foreign tax credit under section 126. This provision applies for dispositions occurring after December 21, 2000. 8. If accounts receivable of a taxpayer are being transferred to a corporation under subsection 85(1) as part of the transfer of all or substantially all of the taxpayers business to the corporation, any loss on the sale will generally be a capital loss to the taxpayer. Where the purchase is on capital account and an election is filed under subsection 85(1), the transferee is not entitled to claim deductions under paragraph 20(1)(l) or (p) for a reserve for doubtful debts or bad debts on the accounts acquired and any gain or loss on realization of the accounts is a capital gain or loss. The use of the rollover provisions of subsection 85(1) precludes the use of a section 22 election for the accounts receivable. However, where the other assets of a business are being rolled under subsection 85(1), the accounts receivable may be sold using section 22 provided that no election under subsection 85(1) is filed for the receivables. See the current version of IT-188, Sale of Accounts Receivable, for a discussion of the election under section 22. 9. By virtue of subsection 85(1.2), an election under subsection 85(1) for property of a non-resident person described in 4(h) above may be made only if (a) immediately after the disposition the transferee was controlled by (i) the transferor,

413 (ii) a person or persons related (otherwise than by reason of a right referred to in paragraph 251(5)(b)) to the transferor, or (iii) persons described in (i) and (ii); (b) all or substantially all of the property used in the business carried on in Canada and in which the real property was used is disposed of by the transferor to the transferee; and (c) the disposition was not part of a series of transactions that resulted in control of the transferee being acquired at any time after the disposition. Limits for Agreed Amount 10. General Limits Subsection 85(1) generally provides that the agreed amount can neither exceed the fair market value of the property disposed of (the upper limit under paragraph 85(1)(c)) nor be less than the fair market value of the non-share consideration received for it (the lower limit under paragraph 85(1)(b)). If the fair market value of the property disposed of is less than the fair market value of the non-share consideration received, the lesser amount must be the agreed amount (see 11 for an example). Additional Limits The agreed amount determined under the general limits is further subject to specific limits in paragraphs 85(1)(c.1), (d) and (e). These specific limits, which are in turn subject to paragraph 85(1)(e.3), provide that the agreed amount is compared with the fair market value of the property disposed of. As a result, a loss on disposition of the property can only be recognized where the propertys fair market value at the time of disposition is less than the other specified limits in paragraphs 85(1)(c.1), (d) and (e) at the time of disposition. However, such loss may be denied as a result of the application of subsection 13(21.2), subsection 14(12), subparagraph 40(2)(g)(i) or subsection 40(3.4) as described in s 22 to 25. I Interaction of paragraphs 85(1)(b), (c.1) and (e.3) Paragraph 85(1)(c.1) applies in the calculation of the agreed amount on the disposition of inventory, capital property (other than depreciable property of a prescribed class - see the comments on paragraph 85(1)(e) below), a security or debt obligation used or held in an insurance or money lending business (other than a capital property, inventory or mark-to-market property of a financial institution), a specified debt obligation (other than a mark-to-market property) of a financial institution, and a NISA Fund No. 2. Paragraph 85(1)(b) provides that the lower limit is generally the fair market value of the non-share consideration received. However, paragraph 85(1)(c.1) stipulates an additional lower limit which is equal to the lesser of the fair market value of the property disposed of and the cost amount of that property. In the case of a conflict between the lower limits set out in paragraph 85(1)(b) and paragraph 85(1)(c.1) as described above, paragraph 85(1)(e.3) provides that the agreed amount will be the greater of the two amounts. See 12 for an example of the application of paragraph 85(1)(c.1). II Interaction of paragraphs 85(1)(b), (d) and (e.3) Paragraph 85(1)(d) applies in the calculation of the agreed amount on the disposition of eligible capital property of a business. Paragraph 85(1)(b) provides that the lower limit is generally the fair market value of the non-share consideration received. However, paragraph 85(1)(d) sets out an additional lower limit which is equal to the least of 4/3 of the cumulative eligible capital of the business the fair market value of the property disposed of, and the cost of that property.

414 In the case of a conflict between the lower limits set out in paragraph 85(1)(b) and paragraph 85(1)(d) as described above, paragraph 85(1)(e.3) provides that the agreed amount will be the greater of the two amounts. See 13 for an example of the application of paragraph 85(1)(d). III Interaction of paragraphs 85(1)(b), (e) and (e.3) Paragraph 85(1)(e) applies in the calculation of the agreed amount on the disposition of depreciable property of a prescribed class. Paragraph 85(1)(b) provides that the lower limit is the fair market value of the non-share consideration received. However, paragraph 85(1)(e) establishes an additional lower limit which is equal to the least of the undepreciated capital cost of all the property of the class, the fair market value of the property disposed of, and the cost of that property. In the case of a conflict between the lower limits set out in paragraph 85(1)(b) and paragraph 85(1)(e) as described above, paragraph 85(1)(e.3) provides that the agreed amount will be the greater of the two amounts. See 14 for an example of the application of paragraph 85(1)(e). Example of General Limits 11. This example demonstrates the tax effect where: (a) the original agreed amount and (b) the fair market value of the consideration exceed (c) the fair market value of the property transferred. Assumptions The type of eligible property is not relevant. Original Agreed Amount $100(a) Fair market value of property transferred 80(c) Consideration: Fair market value of non-share consideration received $149 Fair market value of share consideration received 1 Total Consideration $150(b) The agreed amount would be deemed by paragraph 85(1)(b) to be $149 except that paragraph 85(1) (c) (which deems the agreed amount to be $80) takes precedence over paragraph 85(1)(b). The excess of the fair market value of the total consideration received over the fair market value of the property transferred, $70, less any portion which may be deemed by section 84 to be a dividend is taxable in the hands of the transferor as a benefit pursuant to subsection 15(1). See the current version of IT-432, Appropriation of Property to Shareholders. Example of the application of paragraph 85(1)(c.1) 12. This example demonstrates the tax effect where: (a) the original agreed amount is less than the lesser of (b) the fair market value of the property and (c) its cost amount. Assumptions The property is inventory or capital property other than depreciable property of a prescribed class. Original Agreed Amount $100(a) Fair market value of the property at the time of disposition $150(b) Cost amount to the transferor at the time of disposition $120(c)

415 Consideration: Fair market value of non-share consideration received $ 90 Fair market value of share consideration received 60 Total Consideration $150 The agreed amount is deemed by paragraph 85(1)(c.1) to be $120, the lesser of the fair market value of the property and its cost amount to the transferor at the time of disposition. The transferor is thereby prevented from creating a loss on the disposition. The term cost amount of capital property or inventory, as discussed in this example, is defined in subsection 248(1) as being respectively the adjusted cost base or its value at the time of disposition as determined for the purpose of computing the transferors income. However, in this example if the non-share consideration received for the property is instead $150, this latter amount is deemed by paragraphs 85(1)(b) and (e.3) to be the agreed amount. Paragraph 85(1) (c) has no application because the amount deemed by paragraph 85(1)(e.3) to be the agreed amount is not greater than the fair market value of the property at the time of disposition. Example of the application of paragraph 85(1)(d) 13. This example demonstrates the tax effect where: (a) the original agreed amount is less than the least of (b) the fair market value of the property, (c) its cost, and (d) 4/3 of the cumulative eligible capital of the relevant business. Assumptions The taxpayer has only one business. The property is eligible capital property. Original Agreed Amount $100(a) Fair market value of the property at the time of disposition 180(b) Cost of the property to the taxpayer 200(c) 4/3 of the cumulative eligible capital immediately before the disposition 160(d) Consideration: Fair market value of non-share consideration received $100 Fair market value of share consideration received 80 Total Consideration $180 The agreed amount is deemed by paragraph 85(1)(d) to be $160, that is, the least of 4/3 of the cumulative eligible capital, the cost of the property and the fair market value of the property at the time of disposition. There is therefore no amount deductible pursuant to paragraph 24(1)(a) because threequarters of the deemed proceeds of disposition of $160 equals the balance of the cumulative eligible capital immediately before the disposition. See also 24. Example of the application of paragraph 85(1)(e) 14. This example demonstrates the tax effect where: (a) the original agreed amount is less than the least of (b) the fair market value of the property, (c) its cost, and (d) the undepreciated capital cost (UCC) of all the property of the relevant class. Assumptions The property is the remaining depreciable property of a prescribed class.

416 The transaction is not subject to subsection 13(21.2) (see 23). Original Agreed Amount

$40(a ) Fair market value of the property at the time of disposition 65(b) Cost of the property to the transferor 90(c) UCC of all property of that class immediately before the disposition 80(d) Consideration: Fair market value of non-share consideration received $40 Fair market value of share consideration received 25 Total Consideration $65 The agreed amount is deemed by paragraph 85(1)(e) to be $65. A terminal loss of $40 otherwise arising is reduced to $15, an amount that reflects the actual decline in the value of the property. The $25 difference is the excess of the fair market value of the property ($65) over the amount originally agreed upon by the taxpayer and the corporation ($40). Transfers of Depreciable and Eligible Capital Property 15. Where more than one depreciable property of a prescribed class, or more than one eligible capital property are transferred simultaneously to a corporation under subsection 85(1), paragraph 85(1)(e.1) provides that each such property is transferred separately, in the order designated by the taxpayer. If the taxpayer does not designate any such order, the Minister will designate the order. The purpose of paragraph 85(1)(e.1), in providing that each property is transferred separately in a designated order, is to allow a reduction in the UCC of the class, or the cumulative eligible capital, as each property is transferred. Where property is being transferred to only one transferee, the order in which properties are transferred will only become significant where consideration other than shares is received on the transfer, e.g., where cash and shares are included in the consideration. The following is an example of the application of paragraph 85(1)(e.1) to the transfer of two depreciable properties of the same prescribed class: Assumptions Cost of Property A $100 Fair market value of Property A 80 Fair market value of non-share consideration received for Property A 80 Cost of Property B 500 Fair market value of Property B 400 Fair market value of non-share consideration received for Property B NIL UCC of the class 300 The taxpayer stipulates that the properties are to be transferred at the minimum allowable amounts and designates the order to be Property A followed by Property B. To achieve the best result, the taxpayer should elect $80 for Property A which, when deducted from the UCC of the class, leaves a balance of $220. Property B would then be transferred at an agreed amount of $220 and no recapture of capital cost allowance results. If the order of transfer was Property B followed by Property A, Property B would have to be transferred at an amount of $300 and the UCC of the class would be reduced to nil. Property A cannot be transferred at an agreed amount of nil because of the non-share consideration of $80 received for it. Property A must therefore be transferred at an amount of $80 pursuant to paragraphs 85(1)(b) and 85(1)(e.3) and recapture of capital cost allowance of $80 results. Benefits Conferred on a Related Person 18. Where a taxpayer transfers property to a corporation under subsection 85(1) and the fair market value of the property that is transferred to the corporation exceeds the greater of:

417 (a) the fair market value of all consideration (including shares of the corporation) received by the taxpayer and (b) the amount agreed upon by the taxpayer and the corporation and it is reasonable to regard any part of the excess as a benefit that the taxpayer desired to confer on a person related to the taxpayer, the provisions of paragraph 85(1)(e.2) will operate to increase the amount otherwise agreed upon by the amount of the benefit. Paragraph 85(1)(e.2) does not apply where the transferee is a wholly owned corporation of the taxpayer. A wholly owned corporation is defined in subsection 85(1.3) to mean a corporation all of the issued and outstanding shares of which (other than directors qualifying shares) belong to: (c) the taxpayer, (d) a corporation that is a wholly owned corporation of the taxpayer, or (e) any combination of persons described in (c) or (d). The definition of wholly owned corporation would include second and lower-tiered wholly owned subsidiaries. For example, where A Co owns all of the issued and outstanding shares of B Co which in turn owns all of the issued and outstanding shares of C Co which owns all of the issued and outstanding shares of D Co, D Co would qualify as a wholly owned corporation of A Co for the purposes of paragraph 85(1)(e.2). Shares of the Transferor 20. In certain circumstances it may be desirable to transfer shares of a corporation to the corporation under subsection 85(1). For example, this technique may be used to crystallize a capital gains exemption without having to incorporate a new corporation. While this technique can be effective to achieve the desired tax consequences, certain precautions must be observed. For example, the aggregate amount of any non-share consideration received for the shares plus the paidup capital of the new shares received as consideration on the transfer cannot exceed the paid-up capital of the old shares which are the subject of the transfer or a deemed dividend under subsection 84(3) will arise. This is so because the acquisition of the share by the corporation is an acquisition of its shares for the purposes of subsection 84(3) and the amount paid will, by virtue of subsection 84(5), include the amount by which the paid-up capital of the class of new shares has increased by virtue of their issue. In addition, a dividend may arise under subsection 84(3) where the legal paid-up capital of the new shares exceeds the paid-up capital of the old shares (see 29). Cost to Transferor of Consideration Received from the Corporation 21. Paragraphs 85(1)(f), (g) and (h) apply for the purposes of determining the cost of any property received as consideration by the transferor. The aggregate cost of the consideration will be equal to the agreed amount as determined by subsection 85(1) (but not including any amount arising as a result of the application of paragraph 85(1)(e.2)). Paragraphs 85(1)(f), (g) and (h) allocate the cost as follows (assuming that only one type of non-share consideration, and one class of either preferred or common shares, or one class of both, are received): (a) non-share considerationthe cost is deemed to be the lesser of the fair market value of the nonshare consideration received and the fair market value of the transferred property, (b) preferred sharesthe cost is deemed to be the lesser of the excess of the agreed amount over the fair market value of non-share consideration and the fair market value of all preferred shares receivable by the transferor as consideration for the disposition, and (c) common sharesthe cost is deemed to be the balance of the agreed amount after deducting the portions attributed to the non-share consideration and the preferred shares. Where more than one type of non-share consideration, or more than one class of either preferred or common shares, or both, are received as consideration for the transfer, paragraphs 85(1)(f), (g) and (h) will allocate the aggregate cost of the non-share consideration, the preferred shares or the common shares as determined under (a), (b) or (c) above to such property based on the proportion

418 that the fair market value of each particular property is of the aggregate fair market value of that type of consideration received. Loss From Disposition of Property 22. Various stop-loss rules may apply where a taxpayer transfers a property with an accrued loss to a person who is an affiliated person of the taxpayer. Subsection 251.1(1) contains the rules to determine when persons are affiliated with each other. Subsection 251.1(1) provides, amongst other things, that affiliated persons, or persons affiliated with each other, include (a) a corporation and (i) a person who controls the corporation, (ii) each member of an affiliated group that controls the corporation, and (iii) a spouse or common-law partner of a person described in subparagraph (i) or (ii); (b) two corporations, if (i) each corporation is controlled by a person, and the person who controls one corporation is affiliated with the person who controls the other corporation, (ii) one corporation is controlled by a person, the other corporation is controlled by a group of persons, and each member of that group is affiliated with that person, or (iii) each corporation is controlled by a group of persons, and each member of each group is affiliated with at least one member of the other group; and (c) a corporation and a partnership, if the corporation is controlled by a particular group of persons each member of which is affiliated with at least one member of a majority-interest group of partners of the partnership, and each member of that majority-interest group is affiliated with at least one member of the particular group. Control for the purposes of determining whether persons are affiliated persons means controlled directly or indirectly in any manner whatever which, pursuant to subsection 256(5.1), expands the concept of control to include what is often considered to be de facto control. See the current version of IT-64, Corporations: Association and Control, for a discussion of subsection 256(5.1). 23. The provisions of subsection 13(21.2) will apply to the transfer of a loss property which is depreciable property of a prescribed class to a corporation which is an affiliated person (see 22) of the transferor when, on the 30th day after the transfer, an affiliated person of the transferor owns or has the right to acquire the transferred property. Where the provisions of subsection 13(21.2) are applicable, subsection 85(1) is not applicable and the proceeds of disposition are basically deemed to be such that the transferor is denied any terminal loss that might otherwise arise. In such a case, the terminal loss will be suspended and will not be available to the transferor until the time that is immediately before the earliest of the events listed in clauses 13(21.2)(e)(iii)(A) to (E). In the meantime, the transferor is deemed to own a depreciable property having a capital cost equal to the amount of the denied loss and will be entitled to claim capital cost allowance thereon. 24. The provisions of subsection 14(12) may apply to restrict the deduction under paragraph 24(1) (a) on the disposition of eligible capital property to a corporation that is an affiliated person of the transferor. Subsection 14(12) applies where, during the period that begins 30 days before and ends 30 days after the disposition, the transferor or a person affiliated with the transferor acquires the particular property or property that is identical to the particular property and, at the end of the period, the transferor or a person affiliated with the transferor owns the property or substituted property. In such a case, the deduction under paragraph 24(1)(a) will be suspended and will not be available to the transferor until the time that is immediately before the earliest of the events listed in paragraphs 14(12)(c) to (g). In the meantime, the transferor is deemed to own eligible capital property in respect of a business and will be entitled to claim a deduction under paragraph 20(1)(b) for such property.

419 25. Subparagraph 40(2)(g)(i) or subsection 40(3.4) may apply where a loss property which is a capital property is transferred to a corporation which is an affiliated person of the transferor. The stoploss rules will generally apply where, during the period that begins 30 days before and ends 30 days after the disposition, the transferor or a person affiliated with the transferor acquires the particular property or property that is identical to the particular property, and at the end of the period, the transferor or a person affiliated with the transferor owns the property or substituted property. Where either of these provisions applies it deems any capital loss arising on the disposition to be nil. Where the transferor is an individual (other than a trust), the capital loss will be a superficial loss within the meaning of section 54 and subparagraph 40(2)(g)(i) will apply to deny the loss. By virtue of paragraph 53(1)(f) the amount of the denied capital loss of the individual will be added to the adjusted cost base of the capital property owned by the corporation. Where the transferor is a corporation, trust or partnership, it is the rule in subsection 40(3.4) which will apply to deny the loss. In such a case, the capital loss will be suspended and will not be available to the transferor until the time that is immediately before the earliest of the events listed in subparagraphs 40(3.4)(b)(i) to (v). Rollovers of Capital Property 26. In circumstances where a corporation has acquired, on a rollover basis under subsection 85(1), property that was non-depreciable capital property of a controlling shareholder or of an affiliated corporation, the CRA will generally accept that the nature of the property has not changed solely because the corporation resold the property within a relatively short period of time following the rollover. Taxable Canadian Property 27. Where a taxpayer transfers taxable Canadian property to a corporation under subsection 85(1), all the shares of the corporation received by the taxpayer as consideration for the transfer are deemed to be taxable Canadian property pursuant to paragraph 85(1)(i). Contribution of Capital 28. Where subsection 85(1) applies to a transfer of property which results in a contribution of capital to the transferee corporation, no adjustment to the adjusted cost base of any shares of that corporation is permitted under paragraph 53(1)(c). For example, where eligible property that has a fair market value equal to $100 is transferred at an agreed amount of $100 in exchange for one preferred share with a paid-up capital and a redemption amount of $10, the $90 difference is not a contribution of capital that can be added to the adjusted cost base of the preferred share. Reduction of Paid-up Capital 29. Subsection 85(2.1) is an anti-avoidance rule that is intended to prevent the removal of taxable corporate surpluses as a tax-free return of capital in circumstances where sections 84.1 and 212.1 do not apply. (See the current version of IT-489, Non-Arms Length Sale of Shares to a Corporation, for a discussion of sections 84.1 and 212.1.) Subsection 85(2.1) applies where property is transferred to a corporation pursuant to subsection 85(1) or (2) and the increase in the paid-up capital of the issued shares of the corporation as a result of the transfer (generally an amount equal to the paid-up capital of the share consideration) exceeds the cost to the corporation of the property less the fair market value of any non-share consideration. In any such case, paragraph 85(2.1)(a) requires the paid-up capital of the shares of the corporation to be reduced by the amount of the excess. The paid-up capital reduction is allocated among the classes of shares of the corporation based upon the increase to their respective stated capitals under the relevant corporate law as a result of the transfer. An example of the application of paragraph 85(2.1)(a) is as follows: Assumptions The property is other than shares described in section 84.1 or 212.1.

420 Fair market value of property transferred Cost of property to the transferor Agreed Amount Stated capital for corporate purposes of the shares issued Consideration Fair market value of non-share consideration received Fair market value of share consideration issued Total Consideration $125 100 100 60 $65 60 $125

Pursuant to paragraph 85(2.1)(a) the decrease in the paid-up capital arising from the transaction is $25 being the amount by which the increase in the stated capital exceeds the excess of the agreed amount over the fair market value of the non-share consideration received. The formula in subsection 85(2.1) may yield anomalous results where the property transferred is shares of the corporation itself as described in 20 above. Consider the following situation: X, an individual, owns 5% of the issued common shares of Opco having a cost amount and paid-up capital of $100,000 and a fair market value of $600,000. In order to realize a capital gain and make use of the deduction available under subsection 110.6(2.1), X transfers the common shares of Opco to Opco in return for preferred shares of Opco having a fair market value of $600,000. X and Opco elect under subsection 85(1) to transfer the shares at an agreed amount of $600,000. Since X deals at arms length with Opco, the corporate law of most jurisdictions will require Opco to add to the stated capital of the preferred shares issued to X an amount equal to the fair market value of the consideration received for their issue, i.e. $600,000 being the fair market value of Xs common shares of Opco. Since the increase in the paid-up capital of the issued shares of Opco as a result of the transfer does not exceed the cost to Opco of the common shares less the fair market value of any non-share consideration, subsection 85(2.1) will not apply to reduce the paid-up capital of the preferred shares issued to X. Consequently, as noted in 20, by virtue of subsection 84(3) and 84(5), X will be deemed to have received a dividend of $500,000. Anti-Avoidance Rules 33. Subsection 69(11) is an anti-avoidance provision that may apply, in certain circumstances, to deny a tax-deferred transfer under subsection 85(1). Where it applies, the transferor will be deemed to have disposed of the property for proceeds equal to its fair market value at that time. Subsection 69(11) will apply where as part of a series of transactions a taxpayer disposes of property on a taxdeferred basis and it may reasonably be considered that one of the main purposes of the series is to obtain the benefit of a tax deduction or other entitlement (including tax exempt status) which is available to a person who is not affiliated with the taxpayer (see 22) in respect of a subsequent disposition of the property. For purposes of subsection 69(11), the affiliated person rules are to be read without the extended definition of control found in subsection 256(5.1). In other words, only de jure control is considered

85(1) Rollovers Checklist

i. What types of property can be transferred under ITA ss. 85(1)?

421

1. 2. ii. 3. 4. 5. 6. 7.

Is the property proposed to be transferred "eligible property"? See ITA ss. 85(1.1) for list of "eligible property": capital property (other than real property owned by a non-resident) Canadian resource property certain foreign resource property eligible capital property (goodwill) inventory (other than real property (e.g. work-in-process) real property held as capital property and used by a non-resident in a Canadian branch (subject to conditions in ITA ss. 85(1.2)) real property held as capital property where both the property and consideration received in respect of the transfer used by a non-resident insurer in the course of carrying on insurance business in Canada securities or debt obligations used in the insurance business or in the business of lending money NISA Fund No. 2 Is property of type that cannot be "rolled"? Consider examples: real property inventory real property held as adventure in the nature of trade [consider Friesen case] interests in real property (options, leases, etc.) owned by non-resident or which is inventory real property owned by non-residents (or if part of Canadian branch see below) deferred financing charges life insurance policies (unless held as inventory ); policies are not capital property (ITA subpara. 39(1)(a)(iii)) mark-to-market property held by financial institutions (ITA s. 142.2) prepaid expenses income interest in a trust employee stock option accounts receivable Consider special characteristics of property proposed to be transferred. If real property is involved, is it inventory? Is it held as an adventure in the nature of trade? If real property is involved, is it owned by a non-resident? If partnership interest is being transferred, does the partnership own real estate that is inventory? Is the person transferring the partnership interest a nonresident (Consider GAAR)? If property is a mortgage receivable, does this constitute an interest in real property? [See ITA ss. 248(4)] Does property transferred include accounts receivable? Consider election under ITA ss. 22(1) (T2202) if part of a sale of all or substantially all the business.

422 8. Is transferor claiming a reserve under ITA para. 20(1)(n) or subpara. 40(1)(a)(iii) claimed in respect of a receivable? If so, remember transfer will negate the right of transferor to take a reserve and reserve not available to transferee corporation. Are any of the assets intangibles (e.g. goodwill, patents, licences) which do not appear on the balance sheet? What is their tax cost? If "nil", elect $1 .00 ("Nil" is not an amount f or purposes of a valid ITA ss. 85(1) election.) Are any of the assets depreciable property which are fully depreciated? (E.g. Class 12 (tools), films; Class 29 (manufacturing and processing equipment), etc.) Elect $1 .00, not "nil". Were any of the assets owned on V-Day (consider special rules affecting elected amount). Does partnership interest to be transferred have a negative ACB? Cannot be rolled" to the corporation. Is the property an interest in a limited partnership in respect of which the partner has limited partnership losses? Is property to be transferred to the corporation and property owned by the corporation "identical property "? Will ACB's be averaged? Is this desirable or not? If property is shares of a foreign affiliate consider impact under various rules (e.g. Reg. 5905(5)(a)). Is depreciable property being transferred? Consider impact of ITA ss. 85(5) and/or other CCA inheritance provisions. Is there a continuity of classes for depreciable property? Consider Reg. 1102(l4) and (14.1). Are the transferor and transferee non-arm's length? Is property "rental property" or "leasing property" to transferor or transferee? Does transfer result in making the property "rental" or "leasing" property? Consider implications. Are there identical capital properties acquired partly before and partly after V-day that should be elected on in two separate elections? Are the liabilities associated with the property in excess of its cost amount (consider CRA revised position re. ITA para. 85(l)(b))? Transferee Considerations Is transferee a taxable Canadian corporation? If transfer of rental properties or leasing properties, will transferee qualify as a principal business corporation to permit full CCA claims? A rollover of assets or business is the sale or other disposition of those assets or the business to a new legal person and a new taxpayer. Consider implications to the business, transferee and transferor of:

9.

10. 11. 12. 13. 14. 15. 16. 17. 18. 19. 20. iii. 21. 22. 23.

423 24. iv. 25. the repayment of government subsidies, which will not increase costs of property (ITA ss. 3(7.1) and para. 53(2)(k)); the loss of ITAR 21 protection for non-governmental rights the loss of replacement property rollovers scientific research carryovers the capitalization of interest under ITA s. 21 (to be made only by the taxpayer who incurred the expense) loss utilization loss of continuity of reserves (ITA paras. 20(l)(n), 20(1)(l), 20(1)(p) and subpara. 40(1)(a)(iii)) Does the issuance of share consideration by the corporation to the transferor result in a change of control? Consider, inter alia: a deemed year-end a potential loss of capital dividends if public controls loss of net capital loss carryovers and restrictions on non-capital loss carryovers application of ITA ss. 111 (4), etc. Transferor Considerations Review CCA issues if depreciable property transferred. Transferor unable to claim CCA on property if transfer occurs prior to year-end. Can transferor claim terminal loss if transferee arms length. Consider 50% rule. Will transferee be required to prorate CCA under Reg. 1100(1)(a) if taxation year less than 12 months. If only some assets are transferred, consider whether disproportionate part of UCC could be transferred. Consider whether the stop-loss rules in ITA ss. 13(21.2) to the exclusion of ITA 85. If non-resident transferor of shares of a Canadian corporation, review for the application of ITA s. 212.1. If non-resident transferor, consider ITA s. 116 certificate requirement. If a non-resident is transferring taxable Canadian property to a public company, consider effect of ITA para. 85(1)(i), which deems consideration received to be taxable Canadian property. Consider whether ITA s. 85 election is necessary if non-resident has treaty protection for capital gains. If debt is issued as consideration to non-resident transferor, consider the thin capitalization rules (ITA ss. 18(4)). If transferor is non-resident, consider relevant non-Canadian tax implications. Consult with client's foreign tax advisors. If non-corporate Canadian resident transferor not at arm's length with transferee corporation and shares are being transferred, consider ITA s. 84.1. Does ACB of subject shares exceed paid-up capital of subject shares? Consider type of consideration to be taken back and implications under ITA ss. 85(2.1). Elected amount.

26. 27. 28. 29. 30. 31. 32. 33. v.

424

34. 35.

Ensure that a share or shares (or a fraction of a share) of the transferee corporation is issued as part of the consideration for each asset transferred to the corporate transferee. Allocate debts transferred to specific assets or pro-rate to ensure that non share consideration or boot does not exceed elected amount f or each asset. If debt secured by one of the assets can still reallocate against other assets with sufficient basis in excess of related debt. Each asset "rolled over" must have an elected amount. An elected amount cannot be "nil". Ensure that the "boot" (non-share consideration) does not exceed the elected amount or the fair market value of the asset. If it exceeds elected amount, will result in adjustment of elected amount to equal boot. If it exceeds fair market value can result in a shareholder benefit - ITA ss. 15(1). Value of consideration received by transferor should equal fair market value of the property to avoid the benefit provisions of ITA subpara. 85(l)(e.2). Consider the use of a price adjustment clause for assets which are difficult to value to avoid risks under ITA subpara. 85 (1)(e.2) or ss. 84(1). Should price adjustment clause be in the agreement of purchase and sale? Should it be in the share rights, e.g. adjustment of redemption/retraction amount of preferred share consideration? Consider paid-up capital restrictions and possible grind of paid-up capital under ITA ss. 85(2.1) or ITA s. 84.1. Ensure low paid-up capital and high-redemption shares to avoid the adverse effect of ITA s. 84.1. Review the jurisdiction of incorporation to ensure that such shares can be created and issued for corporate law purposes. Review fair market value of property transferred. Ensure elected amount does not exceed the FMV of transferred property (ITA subpara. 85(l)(c)). If property is depreciable property, ensure elected amount is not less than the least of the UCC, the cost, and the FMV of property. If persons who are non-arm's length to transferor are shareholders of transferee corporation, consider ITA subpara. 85(1)(e.2) (benefit). Consider also the price adjustment clause in the agreement of purchase and sale or the rights and restrictions attaching to the preferred shares.

36. 37.

38. 39.

40. 41.

42. 43. 44.

45. 46. 47.

Is an ACB adjustment clause required? Consider impact of stop-loss rules replacing ITA ss. 85(4), etc. to transfer where properties have accrued capital losses. Ensure that all adjustments in computing the cost amount of an asset are taken into consideration (for example, ITA ss. 83(1) dividend received on shares, contribution of surplus, etc). Compliance Matters

v.

425

48.

File election (form T2057 or T2058) by the earlier of the times at which the transferor or transferee must file a tax return. For a partnership, the relevant taxation years are those of the partners. The transferor must file the election form. Review the form carefully. Read the instructions. The form is regularly amended. Make sure you are using the up-to-date version of the prescribed form. Comply with the specific requirements and formalities set out in the prescribed election forms. Review Information Circular 76-19R3, June 17, 1996. When property is held in a co-tenancy, each co-tenant must file a separate election. File the appropriate Quebec or other provincial election form where the corporation is subject to Quebec income tax or tax in any other province that collects taxes separately from the federal authorities. Where an election is made on depreciable assets or eligible capital property, review the order in which the disposition is to take place (ITA subpara. 85(1)(e.1)). If transferor is a partnership, ensure that all partners have signed the ITA ss. 85(2) election. Other considerations Consider whether the transaction could be regarded as a dividend strip, or whether the GAAR could apply. Review ITA ss. 55(2) and s. 245. Review the corporate histories of the transferor and transferee concerning paid-up capital of subject shares previous paid-up capital deficiency Consider whether ITA s. 85.1 could or should apply in the case of a share transfer. Consider double taxation impact of rollover. Consider impact of ITA ss. 69(11) if transfer part of a transaction involving losses or deductions of a specified person. Consider impact of attribution rules in designing consideration. Consider effect of ITA ss. 20(17) and (18) on inventory allowance. Review timing of transfer to ensure that inventory allowance is available as it applies to inventory on hand at beginning of the y ear. Other Tax Considerations

49. 50. 51. 52. 53.

54. 55. vi. 56. 57. 58. 59. 60. 61. 62. 63.

vii.

426 64. Review the implications of GST and provincial sales tax: most provinces provide for tax-free rollovers between related taxpayers where there is a minimum level of share ownership and in certain cases a minimum post-transfer holding period. Review elections under the Excise Tax Act to determine whether a transaction may be exempt from the GST (For example, consider whether an election is possible under ETA 167). For transfers of real property, consider whether conditions in section 221 of the Excise Tax Act are met to permit self - assessment of GST. Provincial land transfer taxes normally will apply. Refer to the relevant legislation f or exceptions. Non-Tax Considerations Ensure that the accounting treatment has been thoroughly reviewed, especial where there is a non-arm's-length transaction, including step-ups in values or financial statements. Deferred taxes associated with the assets being transferred may give rise to accounting complexities. Review the effect on any government assistance programs if substantial business assets are being transferred. Consider whether it is necessary to have a corporation repay any present or future government assistance. Ensure that purchase of assets does not give rise to Investment Canada implications. If so, obtain necessary approvals. If leaseholds, licences, franchises, partnership interests, co-ownership interests, etc. are being transferred, review legal documents to determine if consents are required. Consider nature of the property to determine whether there are any legal restrictions on transferability. If shares of private corporation are being transferred, consider share transfer restrictions. Review transferability of all fringe benefit programs, pension plans, etc.; advise appropriate government authorities, transfer any insurance policies, etc. Ensure that transfer of property does not trigger obligation to repay debt (e.g. "due on sale" clause). If mortgage to be assumed, ensure it is assumable. If business to be carried on by transferee corporation with transferred assets requires licence, ensure licence obtained. Otherwise there may be breach of provincial or federal statute with ensuing penalties or invalid transactions. Ensure compliance with the bulk sales acts of the province(s). In a rollover of a business, the transferee is a new employer and CPP or OPP must start again if the year is other than a calendar year. What will the share consideration given by the transferee corporation consist of?

65.

66.

viii. 67.

68. 69. 70. 71.

72. 73. 74. 75.

76. 77. 78.

427

79. 80.

Are the shares authorized or must they be created? Will there be any other consideration given by the transferee corporation (promissory note, assumption of debt, etc.)? Will the note be a bill of exchange or not? What will be the interest rate? Will the note be secured? Is any of the transferred property held in trust? By whom? Does the transferor hold registered title to the transferred property or beneficial title, or both? Does the transferred property include tangible assets like chattels, equipment, vehicles, etc. where physical possession is desirable to convey title? Is any registration of the transfer of specific property required to be made to make the transfer valid and effective? Is the transferor a director of the transferee corporation and is a disclosure of interest and specially tailored directors or shareholder resolutions required? What is to be the effective date of the transfer? Are there special date considerations involving year-end, CPP, EI, installments, etc.? Who will prepare election forms and attend to filings? Client's accountants or law firm? Clarify responsibility with client in writing. What is the authorized capital of the corporation? Will any special class of shares to be issued as consideration for the transfer have to be created to complete the rollover? Is the corporation in good standing? Has it been dissolved? Has a search of all liens, encumbrances, judgements, etc. against the corporation been conducted to ensure assets will not be exposed to creditors after the roll-over? Is the proposed transfer a fraudulent preference or fraudulent conveyance (i.e. is it intended to defeat, hinder, or delay creditors or does it result in a preference?) If the transaction is a fraudulent preference or conveyance, consider legal and ethical rules to which lawyer is subject and if this is an issue, withdraw. Is fair market value received by the transferor as consideration for the transferred property? If transferor and corporation not dealing at arm's length, consider ITA 160.

81. 82. 83. 84. 85. 86. 87. 88. 89. 90. 91. 92. 93. 94.

Note: Alberta After May 21, 2001 Alberta Corporate Income Tax Act must file a copy of prescribed federal form with province. If an Alberta elected amount differs from the federal amount, both Alberta and federal forms must be filed must have Alberta Allocation factor.

428

IX. Tax Avoidance Transactions

1. Section 84.1
PRIVATE COMPANY REORGANIZATIONS: COMMON PROBLEM AND PITFALLS By Cary Heller, John Oakey, & Enzo Testa, Ontario Tax Conference, CTF 2008 Introduction The upfront tax planning involved with private company reorganizations is extremely critical given the numerous amount of anti-avoidance provisions and specifically worded technical provisions of the Income Tax Act. Any transaction executed without full knowledge of the tax ramifications could result in unforeseen taxes, penalties and potentially a law suit. The purpose of this paper is to review some of the more common anti-avoidance provisions and technical traps that exist within the Income Tax Act as it relates to private company reorganizations; such as: shareholder benefits, indirect gifting, corporate attribution, association, etc. This paper is not meant to provide a full review of all potential traps that would cover off all possible transactions as this would result in a paper probably equal in size to the Income Tax Act itself. This paper will also provide some practical tips that could be utilized to eliminate or minimize the impact of these potential tax problems. Section 84.1- Deemed Dividends Purpose It's easy to access corporate funds on a tax free basis. A minor reorganization, create a holding company, a share transfer triggering a capital gain eligible for exemption and voila! If only it were that simple. Section 84.1 of the Income Tax Act ("the Act") is a frequently misunderstood and overlooked section of the Act. It has been described as "both subtle in its application and severe in its consequences". Unsurprisingly, it is also a frequent source of legal actions brought against tax practitioners. Very generally, the purpose of section 84.1 is to deny an individual the ability to withdraw funds from a corporation on a tax free basis using the adjusted cost base of their shares which may have arisen directly or indirectly through the use of the capital gains exemption or by way of a V-Day bump. It is otherwise known as an anti-corporate surplus stripping rule. Note that this section will apply even where subsection 85(1) is utilized. As such the paid up capital provisions in section 85 are overridden by section 84.1 Interpretation So what does it all mean? The first thing one needs to determine is whether or not it even applies. Generally this section applies when: i) An individual transfers shares of one corporation (the "subject corporation") to a "purchaser corporation"; ii) The individual does not deal at arm's length with the subject corporation; and iii) Immediately after the transfer the two corporations are "connected". Assuming that the preamble applies, what is the impact? There are two possible results, one or both of which can arise. First, the paid-up capital of any shares received as | consideration may be reduced (i.e. the PUC capital grind) and second, the transferor may be deemed to receive a dividend. The PUC Grind The paid up capital of the shares of the purchaser corporation received by the individual on the transfer is reduced to the arm's length adjusted cost base of the shares of the subject corporation

429 transferred. In other words, the total paid up capital and boot (non-share consideration) issued by the purchaser corporation cannot exceed the modified adjusted cost base of the subject corporation shares. The Deemed Dividend If the purchaser corporation issued boot (i.e. non share consideration such as a promissory note or cash) to the transferor which exceeds the aforementioned modified arm's length adjusted cost base, then a deemed dividend will arise (to the transferor ). This modified arm's length adjusted cost base is often referred to as "hard ACB". Hard ACB 1) If shares are purchased for $1 and V-day value is $10, only the $1 is hard ACB. 2) If,a person received shares from the estate of a deceased taxpayer (other than a spouse), due to the deemed disposition on death the hard ACB is equal to the fair market value on death (assuming no capital gains exemption was used on death, and there were no prior V-Day bumps or CGE realized by the decedent or a related person). 3) If an individual is gifted shares from a parent who uses their capital gains exemption to shelter the gain on transfer, the hard ACB is the parent's original cost base.

The Mechanics
In the normal situation, where a taxpayer is desirous of transferring his shares without any tax consequences, the paid up capital, cost base and the elected amount will be the same, therefore, satisfying the provisions in both s. 84.1 and section 85. In consequence, neither a capital gain or a deemed dividend will arise. However, suppose the taxpayer wishes to realize a partial capital gain to offset a capital loss incurred in the year. If the paid-up capital and the cost base of the transferred shares is the same and is less than the elected amount, to avoid a deemed dividend, the taxpayer still must not receive non-share consideration exceeding the paid-up capital of the old shares. If nonshare consideration received in such a case equals the elected amount, a capital gain will arise on the transfer as well as a deemed dividend by virtue of section 84.1. However, the taxpayer will not be taxed on both amounts. When computing the proceeds of disposition on the transfer of his shares to the holding company, the amount deemed to be a dividend under section 84.1 is subtracted.1 As a result, no capital gain is realized, and tax is payable only with respect to the deemed dividend. Consider the following examples: Non-Arm's Length Sale of Shares, S. 84.1 (Some Examples) 1. FMV PUC ACB = = = $100 30 30

If the shareholder was to distribute cash by way of dividend or was to wind up OpCo or have it repurchase his shares, the shareholder would face a dividend, deemed or otherwise, of $70, this being the excess value over the paid up capital. Suppose the shareholder was to sell the shares to Holdco, a corporation with which he does not deal at arm's length.
1

Para. 54(h)(xi).

430

a.

The consideration is $100 cash. i. ii. S. 84.1(1)(a) would be inapplicable because the consideration does not include shares. S. 84.1(1)(b) would deem a dividend to be received at that time equal to: = = = (A + D) (E + F) (0 + $100) - ($30 + 0) $100 - $30 $70

This is the right answer because this is the amount of dividend, deemed or otherwise, he would have received if he had received $100 of cash from OpCo (excluding a distribution taxable as a s. 15(1) benefit which presumably the shareholder would ensure would not apply). Note that the same answer would obtain if it were $100 of property other than cash that were received by the shareholder, e.g., a promissory note for $100, shares of a subsidiary of Holdco, Government of Canada Treasury Bills, gold bullion, or other "boot". iii. The proceeds of disposition (otherwise determined) of the OpCo shares to the shareholder are $100, but s. 54 'proceeds of disposition' (k) reduces the proceeds to the extent of the portion thereof that is deemed by s. 84.1(1) to be a dividend. Therefore, the proceeds of disposition would equal $100 - $70 = $30

The shareholder would therefore have a capital gain (loss) equal to net proceeds of disposition less ACB = b. $30 - $30 = 0

The consideration is shares of Holdco with a value of $100. No boot is issued. (The shareholder would presumably insist on receiving shares of Holdco worth $100 since he is transferring $100 worth of property.) These shares might be common shares or preferred shares. i. S. 84.1(1)(a) would apply to reduce the PUC of the Holdco shares. In the absence of s. 84.1(1)(a), the PUC of the class of Holdco shares issued to the shareholder would be increased by $100 pursuant to corporate law since Holdco would have received property with a value of $100 as consideration for the issuance of its shares. What s. 84.1(1)(a) does is reduce that PUC by: = = (A - B) x C/A ($100 - $30) x C/A $70 x C/A

431 The reduction in PUC will be $70. The C/A factor is a mechanism that allocates the PUC reduction where Holdco issues more than one class of shares. If only one class of shares is issued, then C/A = 1. The PUC of the Holdco shares issued is then increased by $100 under corporate law and decreased by $70 under s. 84.1(1)(a) resulting in a net increase in PUC under s. 89(1)c.(ii)(c) of $30. This is the right answer since the PUC of the shares of OpCo transferred was $30. ii. S. 84.1(1)(b) would deem a dividend to be paid in the following amount: = = (A + D) - (E + F) ($100 + 0) - ($30 = $70) 0

This is the right answer. Since the $70 excess of FMV of OpCo over the PUC of OpCo has been totally resolved by reducing the PUC of the Holdco shares from $100 down to $30, there is no need to deem a dividend to be paid. iii. Since there is no deemed dividend, s. 54 'pod' (k) would not apply. Therefore, the proceeds of disposition of the OpCo shares would equal $100. The shareholder would therefore have a capital gain (loss) equal to net proceeds of disposition less ACB. = = $100 - $30 $70

There would be an immediate capital gain of $70. There is also a potential deemed dividend of $70 whenever the Holdco shares are redeemed or acquired by Holdco, since the redemption/acquisition price would presumably be $100 and their PUC is $30. Because the shareholder's ACB in the Holdco shares would be $100, a $70 capital loss would arise on the redemption/acquisition of those shares since s. 54(j) would reduce the proceeds of disposition by the amount of the deemed dividend. c. The consideration consists of $60 worth of Holdco shares and a promissory note in the amount of $40. i. S. 84.1(1)(a) would reduce PUC by: = = (A - B) x C/A ($60 - 0) x 1 $60

The PUC would be reduced by $60. Hence, PUC of the Holdco shares will go up by $60 under corporate law and down by $60 under s. 84.1 so that the net increase in PUC under s. 89(1)(c)(ii)(c) will be nil. (ii) S. 84.1(1)(b) would trigger a deemed dividend in the amount of:

432

= =

(A + D) - (E + F) ($60 + $40) - ($30 + $60) $10

This makes sense. Out of the $70 excess of FMV of OpCo over the PUC of OpCo shares, $60 was resolved by a reduction in the PUC of Holdco and $10 by an immediate deemed dividend. (iii) S. 54(k) would reduce the proceeds of disposition (otherwise determined) of the OpCo shares by the deemed dividend of $10. Therefore, the proceeds of disposition would equal: = $100 - $10 $90

There would be an immediate capital gain (loss) equal to $90 - $30 = $60 There is also a potential deemed dividend of $60 whenever the Holdco shares are redeemed or acquired by Holdco, since the redemption/acquisition price would presumably be $60 and their PUC is 0. Because the shareholder's ACB in the Holdco shares would be $60, a $60 capital loss would arise on the redemption/acquisition of these shares since s. 54(j) would reduce the proceeds of disposition by the amount of the deemed dividend. What s. 84.1 has done is ensure that the shareholder cannot step up the PUC of shares held by him by simply selling his OpCo shares to a non arm's length company for shares of the transferee having a PUC greater than the PUC of the OpCo shares transferred. Nor can he receive boot in excess of $30 on a tax free basis since $30 was the PUC of his OpCo shares. He cannot do better by dealing with Holdco than he could if he had continued to hold his OpCo shares. 2. FMV = PUC = ACB = $100 $ 10 $ 30

In this case, his ACB exceeds the PUC of his shares. In theory, he should be able to receive back only $10 of PUC in the form of Holdco shares or $10 of boot from Holdco. But s. 84.1 always allows the shareholder to get back an amount equal to the greater of his ACB and the PUC of his shares. This is not in accordance with the theory of s. 84 since the shareholder would be taxed on a $90 deemed dividend if he caused OpCo to reacquire all of his shares. But he would also have a $20 capital loss due to s. 54(j) so s. 84.1 allows him to take back $30 of boot of PUC from Holdco. This is why B and E in the formula refer to the greater of PUC and ACB. Note that the effect of this is to put the shareholder in the position of being able to use Holdco to extract, tax free, corporate surplus up to the ACB of his OpCo shares whereas his current situation is that he can only extract $10 of surplus out of OpCo on a tax free basis (albeit creating a $20 capital loss which is of use only to the extent he has taxable capital gains not subject to he capital gains exemption).

433 Suppose the shareholder was to sell the shares to Holdco, a corporation with which he does not deal at arm's length. a. The consideration is $100 of boot. i. ii. S. 84.1(1)(a) would not apply because no shares are issued. S. 84.1(1)(b) would deem a dividend to be received by the shareholder in the following amount: = = (A + D) - (E + F) (0 + $100) - ($30 + 0) $70

The dividend is equal to $70, being the excess of $100 over the greater of PUC and ACB. Note that if the shareholder had caused OpCo to be wound up or to repurchase his shares and $100 had been distributed to him, he would have had a deemed dividend of $90 and a capital loss of $20. The capital loss would be available to offset capital gains but would only be useful to him if such capital gains were not subject to the capital gains exemption. iii. S. 54(k) would reduce the proceeds of disposition (otherwise determined) of the OpCo shares by the deemed dividend of $70. Therefore, the proceeds of disposition would equal: = $100 - $70 $30

There would be an immediate capital gain (loss) equal to: = b. $30 - $30 0

The consideration is $100 worth of shares of Holdco. i. S. 84.1(1)(a) would reduce the PUC of the Holdco shares as follows: = = (A - B) x C/A ($100 - $30) x 1 $70

The Holdco shares would have a PUC = $100 - $70 = $30. ii. S. 84.1(1)(b) would deem a dividend to be received by the shareholder in the following amount: = = (A + D) - (E + F) ($100 + 0) - ($30 + $70) 0

434 iii. S. 54(k) would not apply since there is no deemed dividend. Therefore, the proceeds of disposition of the OpCo shares would equal $100. The shareholder would have an immediate capital gain (loss) equal to: = $100 - $30 $70

There is also a potential deemed dividend of $70 whenever the Holdco shares are redeemed or acquired by Holdco, since the redemption/acquisition price would presumably be $100 and their PUC is $30. Because the shareholder's ACB in the Holdco shares would be $100, a $70 capital loss would arise on the redemption/acquisition of these shares since s. 54(j) would reduce the proceeds of disposition by the amount of the deemed dividend. c. The consideration is $40 of Holdco shares and $60 of boot. i. S. 84.1(1)(a) would reduce the PUC by: = = (A - B) x C/A ($40 - 0) x C/A $40

The Holdco shares would have a PUC = $40 - $40 = 0. ii. S. 84.1(1)(b) would deem a dividend to be received by the shareholder in the following amount: = = (A + D) - (E + F) ($40 + $60) - ($30 + $40) $30

This makes sense: $40 of reduction in PUC of the Holdco shares and $30 of deemed dividend equals the $70 excess of FMV of OpCo over ACB of OpCo. iii. S. 54(k) would reduce the proceeds of disposition (otherwise determined) of the OpCo shares by the deemed dividend of $30. Therefore, the proceeds of disposition would equal: = $100 - $30 $70

There would be an immediate capital gain (loss) equal to: = $70 - $30 $40

There is also a potential deemed dividend of $40 whenever the Holdco shares are redeemed or acquired by Holdco, since the redemption/acquisition price would presumably be $40 and their PUC is 0. Because the shareholder's ACB in the Holdco shares would be $40, a $40 capital loss would arise on the redemption/acquisition of

435 these shares since s. 54(j) would reduce the proceeds of disposition by the amount of the deemed dividend. d. The consideration is $85 of Holdco shares and $15 of boot: i. S. 84.1(1)(a) would reduce the PUC by: = = (A - B) x C/A ($85 - $15) x C/A $70

The Holdco shares would have a PUC = $85 - $70 = $15. ii. S. 84.1(1)(b) would deem a dividend to be received equal to: = = (A + D) - (E + F) ($85 + $15) - ($30 + $70) 0

There would be no deemed dividend since the whole of the $70 has been resolved through the reduction in PUC. iii. S. 54(k) would not apply since there is no deemed dividend. Therefore, the proceeds of disposition of the OpCo shares would equal $100. There would be an immediate capital gain (loss) equal to: = $100 - $30 $70

There is also a potential deemed dividend of $70 whenever the Holdco shares are redeemed or acquired by Holdco, since the redemption/acquisition price would presumably be $85 and the PUC is $15. Because the shareholder's ACB in the Holdco shares would be $85, a capital loss of $70 would arise on the redemption/acquisition of these shares since s. 54(j) would reduce the proceeds of disposition by the amount of the deemed dividend. 3. FMV = PUC = ACB = $100 $ 30 $ 10

The PUC reductions under s. 84.1(1)(a) and the deemed dividends under s. 84.1(1)(b) would be the same as in both 1 and 2 above since the greater of PUC and ACB is still $30. The capital gain, however, in each case would be $90 except where a deemed dividend arises under s. 84.1(1)(b), in which case the proceeds of disposition would be reduced by the deemed dividend pursuant to s. 54(k). The capital gain would equal the excess of the reduced proceeds of disposition minus the ACB of $10. Note, however, that there is no advantage in using Holdco since the PUC is greater than ACB and hence the PUC reduction or deemed dividend will put the shareholder in the same position as his current position in terms of his ability to extract corporate surplus. Note also that if the shareholder had caused OpCo to be wound up or to repurchase his shares, and

436 $100 had been distributed to him, he would have had a deemed dividend of $70 and a capital gain of $20.

Private Company Reorganizations: Common Problem and Pitfalls

(Article Continuation) By Cary Heller, John Oakey, & Enzo Testa, Ontario Tax Conference, CTF 2008 Examples 84.1 Not Applicable / No Effect 1) In the above hard ACB scenario (2), assume that we are dealing with shares upon which no capital gains exemption was claimed on death. Let's say original ACB and PUC was $1 and fair value on death was $10. The ACB to the recipient will be $10. However, assuming for instance that these were shares of an operating company, there is no corresponding increase in PUC on death. If Opco redeems the shares for $10, the recipient will have a $9 deemed dividend. Alternatively the survivor could incorporate a new company and transfer the shares of Opco to that company tax free. The shares taken back will have PUC and ACB of $10. Opco could redeem the shares held by Holdco (with a resulting tax-free inter-corporate dividend) and Holdco could then redeem the shares held personally free of tax. While 84.1 is applicable, there is no PUC grind. 2) Assume A and B incorporate Opco with ownership 90% and 10% respectively. Incorporation is 90/10 commons for $90/$10. The value of Opco is $7.5 million and B wishes to be taken out. If B's shares are redeemed by Opco for $750,000, he will receive a dividend of $749,990. Alternatively A could transfer her shares to Aco tax-free. Aco could then purchase the shares of Opco held by B for a $750,000 note. This will give B a $749,990 capital gain which he will shelter with his capital gains exemption. Opco could then pay a tax free intercorporate dividend to Aco which would then pay down the note. As B and Aco are at arm's length, section 84.1 is inapplicable. 84.1 Applicable / Full Effect Just to illustrate how easy a trap 84.1 can be, picture the following: 1) Daughter purchases mother's company in 2008 for $750,000. The ACB of the shares to Mom is nominal. She pays for the acquisition by way of a note and Mom shelters the gain with her capital gains exemption. In 2011, you are appointed as accountant to daughter. She tells you that she owns Opco and has an ACB of $750,000 in her shares. You advise her to transfer her shares to Newco under subsection 85(1) of the Act and to take back one share and a note for $750,000 which she can then draw on tax free. At the same time you would do well to ensure your insurance premiums are paid in full. The $750,000 will be considered a dividend under 84.1 due to the fact that her ACB came about as part of a transaction in which a non-arm's length person (i.e. Mom) used her capital gains exemption. 2) Enzo and Cary incorporate TAX GUYS Inc. Due to their exceptional skills, the company grows in value so that in a year it is worth $1.5 million. Cary wants out so he can take his half and go to Rama. Dave, Cary's brother is in the same line of business and wants to buy into the company. Dave sets up DaveCo and DaveCo borrows $750,000 to buy out Cary. Cary plans on using his capital gains exemption on the sale. Unfortunately even though there is no surplus stripping per se, section 84.1 will apply to cause the sale proceeds to be considered a dividend. Cary transferred shares to a non-arm's length corporation (DaveCo) which immediately thereafter is connected with Tax Guys Inc. Cary took back consideration (cash) in excess of his ACB.4 Fortunately, Cary hit the jackpot (tax-free) at Rama so all is well.

437

Case Law Hickman [2000 D.T.C. 2584 (TCC)] Mrs. Hickman owned 42 out of the 100 shares outstanding in Opco. Holdco owned 48 shares of Opco and in turn, Holdco was owned by a trust for Mrs. Hickman's three adult children. Decisions of the trust were to be made by a majority of its three trustees, two of which were Mrs. Hickman and her husband. Mrs. Hickman sold her shares to Holdco for $425,407 plus one preferred share of Holdco. The amount of the consideration in excess of PUC ($425,407 - $42 = $425,365) was determined to be a deemed dividend. Why Did 84.1 Apply? i) Mrs. Hickman was an individual who disposed of shares of one corporation to another. ii) The vendor and purchaser were not at arm's length (Mrs. Hickman was related paragraph 251(1)(a) to the related group that controlled Holdco her and her husband paragraph 251(5) (a). iii) After the transfer Holdco and Opco were connected. Juliar [Ontario Supreme Court, 2001] A husband and wife sold shares of one company to another, taking back as consideration promissory notes. The CRA assessed them under section 84.1 . The Juliars were able to receive a rectification order from the Ontario Superior Court of Justice on the premise that the result of the transaction was not the intent. Instead, the promissory notes were replaced by a share issuance and the deemed dividend under section 84.1 did not apply. | It would be nice if taxpayers could always have this argument in their back pocket on any tax planning. However, CRA has indicated that they will aggressively oppose rectification orders when the transaction reflects the intent, but not the tax results. In other words, they are not of the view that rectification is the condoning of retroactive tax planning. Osler [FCA, 2002] The taxpayer sold shares of his Opco to companies controlled by his children and their spouses. The proceeds exceeded his cost base and the taxpayer applied his capital gains exemption. The Minister reclassified the proceeds as a deemed dividend on the basis that the father and the children's companies were not at arm's length and the children's companies were connected with Opco under subsection 186(4) of the Act. Most notably, none of the purchaser corporations owned more than 10% of Opco after the transaction. The Tax Court of Canada held that section 84.1 only refers to connected within the meaning of subsection 186(4) which results in connected status where control is held directly or when a company controls more than 10% of the votes and value of another. As none of the children's companies controlled Opco outright and none owned more than 10%, the TCC concluded 84.1 was inapplicable. The FCA overturned this decision noting that: "The incorporation of the word 'connected' under subsection 186(4) was obviously intended to give section 84.1 a wide scope, and a reading of subsection 186(4) which, in effect, limits the benefits of the capital gains exemption in the case at hand on the basis that the purchaser corporations were controlled by the taxpayer's children is consistent with the scheme of the Act. Therefore, I can see no basis for the | conclusion of the Tax Court Judge that the word 'controlled' in subsection 186(4), as incorporated by subsection 84.1(1), can refer to something other than 'control' as defined under Part IV. As the respondent has conceded that if this definition applies, a deemed dividend does arise under subsection 84.4(1), the decision of the Tax Court must be set aside to the extent that it held otherwise." Interestingly enough, the FCA's decision and interpretation was in line with subsection 186(7) of the Act (new legislation enacted prior to the decision) which clarifies that in reading the meaning of the

438 term "connected" under subsection 186(4), the expanded definition of control under subsection 186(2) will apply. Subsection 186(2) of the Act provides for connected status when common control of two corporations exists and control exists when more than 50% of voting rights are owned by nonarm's length parties together. This was clearly the case in Olsen. Brouillette [2005 TCC 203] In this case, the TCC found that 84.1 and GAAR did not apply. The facts, very much simplified are as follows: Mr. B and Mr. R each owned 50% of the shares of Opco. Mr. R wanted to exit Opco. Mr. B and two unrelated individuals incorporated Purchaseco in which Mr. B was not a controlling shareholder. Mr. B and Purchaseco incorporated Holdco as to 51%/49%. Holdco purchased Mr. R's interest in Opco for $500,000 (using proceeds from an Opco loan plus the share subscription proceeds from Purchaseco). Mr. B then transferred his common shares of Opco to Holdco (under subsection 85(1)) for $500,000 of non-voting, non-participating preferred shares of Holdco with nominal paid-up capital. At this juncture Opco was wholly owned by Holdco. At some point subsequently, Mr. B sold his preferred shares of Holdco to Purchaseco for a $500,000 non-interest-bearing demand note (with a minimum annual payment as Opco's cash flow permitted). Under a shareholders' agreement, Mr. B and Purchaseco agreed that Purchaseco would use all dividends received from Holdco to make payments on the promissory note. CRA concluded that Mr. B was not dealing at arm's length with Purchaseco and that section 84.1 applied. Therefore the proceeds of the sale of shares received by Mr. B from Holdco resulted in a deemed dividend. CRA also argued that GAAR applied as Mr. B and Purchaseco were acting in concert. The TCC concluded that section 84.1 did not apply. Mr. B and Purchaseco were dealing at arm's length because their interests were distinct. The purchasers wished to acquire a new business without having the old shareholders ultimately involved and this was the plan all along. Mr. R retired immediately while under the terms of the demand note, Mr. B was to leave within five years (he actually left within two years). The parties' use of the same accounting firm for their tax-planning did not mean that they were acting in concert as it was they, not the professional advisers, who ultimately made the final decisions out of their own self interest. Further, Mr. B did not control Purchaseco. The TCC also found that GAAR did not apply. Desmarais [2006 DTC 2376] Mr. D owned 15% of ACo while 85% was held by six arm's length shareholders. The shares of ACo owned by Mr. D had a fair market value of $120,000 with nominal PUC and ACB. Mr. D, along with his brother, owned BCo as to 50/50 and those shares also had nominal PUC and ACB. Mr. D set up Holdco transferring 9.8% of his Aco shares (leaving him with 5.2% personally) in exchange for Holdco Class A preferred shares electing under subsection 85(1) at fair value crystallizing a gain upon which he used his capital gains exemption. The PUC of the Class A shares of Holdco was $120,000 as section 84.1 did not apply as Holdco was not connected with Aco. Further, Mr. D transferred his shares of BCo to Holdco in exchange for Holdco Class B preferred shares. Fair value was $210,000 and so a gain was triggered to which his capital gains exemption was applied. In this case 84.1 applied to reduce the PUC of the Class B preferred to nominal. BCo then paid a dividend to Holdco (intercorporate tax-free) which then redeemed the Class A preferred shares for $120,000 with no tax consequences. CRA applied GAAR to this "misuse or abuse" of section 84.1 and the TCC agreed on the following basis: 1) There was a tax benefit;

439 2) Desmarais argued the business purpose was to pool his investments in one company, Aco. However the TCC found that the transfer of only 9.8% of his Aco shares was an avoidance transaction taken for no other reasonable reason than to obtain a tax benefit; 3) The TCC found the transactions were abusive as it could not reasonably be concluded that a tax benefit was consistent with the object and spirit of the provisions relied upon. In essence, Desmarais used his position with Aco to draw down or strip out BCo's surplus. McMullen [2007 TCC 16] Mr. A and Mr. B each owned 50% of Opco. They wanted to split up and steps were taken so that each would effectively own a branch of Opco (with different values) and so that Mrs. B could also become a shareholder. Through a series of complicated transactions, Mr. A sold his shares of Opco to a new company owned by Mrs. B (B Co) for a promissory note of $150,000. Mr. A reported a capital gain of $50,000. CRA attempted to apply several sections of the Act including GAAR to re-characterize the $150,000 of proceeds as a dividend. Among these sections was section 84.1. In CRA's view, section 84.1 is an anti avoidance provision which is meant to block a shareholder from stripping out corporate surplus via a non-arm's length sale of shares of one company to another ultimately connected with the first. They argued this was exactly the result in McMullen and that therefore paragraph 84.1(1)(b) applied, resulting in a deemed dividend. Clearly the parties were not related. Therefore in concluding that paragraph 84.1(1)(b) was inapplicable, the Court examined whether or not the parties were factually at arm's length. The Court concluded that buyer and seller do not act in concert simply because the agreement which they seek to achieve can be expected to benefit both. The Court went on to say that the use of the same professional advisors does not factually create a non-arm's length circumstance.

Planning Considerations: Are they at arms length?

Unrelated parties may act at non-arm's-length as a matter of fact. Numerous technical interpretations issued by the CRA deal with sales to ostensibly arm's-length employees or shareholders. The Technical Interpretations point out that even where the parties are not related they may be considered to be acting not at arm's length if it can be determined that there is an understanding between them to act in a predetermined manner--that is, that they are acting in concert. Whether or not persons are acting in concert is a question of fact. The key criterion is whether the parties are asserting independent economic positions on the important aspects of the transaction: Swiss Bank Corp. (SCC 1972). If both parties receive independent accounting and tax advice with respect to the purchase, there is a strong presumption that they are acting at arm's length. Technical Interpretation 2002-0159525 dealt with a situation in which a niece or nephew was to purchase shares from an uncle using a corporation. Under section 251, an uncle is not related to a niece or nephew--that is, they are at arm's length unless they are dealing at non-arm's-length as a matter of fact. Both parties were to consult with the same tax specialist. The CRA confirmed that, at a particular time, it is a question of fact whether unrelated parties are dealing with each other at arm's length. The CRA noted that having only one tax specialist involved was not, in and by itself, conclusive as to the existence of non-arm's-length dealing. However, this element, in combination with others, may contribute to the finding that a non-arm's-length relationship does exist as a matter of fact.

440 Although section 84.1 may appear linear at first glance, it is complicated enough to warrant close scrutiny when an individual sells shares to a corporation. Situations involving buy-sell agreements and divorce settlements should also be carefully analyzed in this regard.

2. Capital Gains Strips: Section 55 i. Overview

As we have seen, corporations may transfer dividends tax free between themselves. Private corporations may be subject to a special Part IV tax, but even this will be avoided where the transferee corporation owns more than 10% of the transferor. As a consequence it became quite fashionable in the corporate tax world, to convert what would otherwise be a capital gain into a taxfree intercorporate dividend. Section 55 is designed to block these so-called capital gains strips, and will convert the tax-free intercorporate dividend into a capital gain for purposes of determining tax liability. There are a number of requirements in order for s. 55 to apply: 1. 2. 3. 4. 5. a taxable dividend must be received by a corporation which is deductible under s. 112, one of the purposes or results of the transaction was to effect a "significant reduction" in the capital gain which would have resulted on a disposition of the shares, the dividend can be reasonably attributed to anything other than post 1971 retained earnings, no Part IV tax is paid (i.e. the two corporations are connected and no dividend refund was received), a disposition of property to an unrelated person or significant increase in the interest of any unrelated person has occurred.

Obviously this provision is targeted at arm's length transactions. Note that para 55(5)(e) deems brothers and sisters to be arms length for this provision thereby extending the potential scope of application of the section. The following flow chart may be helpful in analyzing section 55 situations: 1. Taxable dividend/s 112 deductions? YES 2. Unrelated? YES 3. Was Part IV tax paid? YES section 55 does not apply UNLESS NO section 55 does not apply NO section 55 does not apply

441 a dividend refund is received NO 4. Is the dividend attributable to Post 1971 retained earnings? NO 5. YES 55(2) does not apply since tax was paid by the corporation (retained earnings is after tax dollars)

55(2) deems the entire dividend to be proceeds of disposition

ii. Application: Deemed Proceeds or Capital Gain

Subsections 55(2) to (5) were enacted primarily to counter transactions known as "capital gain strips", which were made possible because of the effectively tax-free status of most intercorporate dividends. For example, prior to the enactment of subsection 55(2), a corporation that desired to sell its shares in another corporation could first receive a tax-free dividend. It would then sell its shares at a price reduced by the amount of the dividend, thereby decreasing the capital gain which would otherwise have been realized had the sale been made without a dividend being declared. A seller might also avoid the realization of capital gains on other property it owned by transferring the property to the purchasing corporation using the subsection 85(1) election and receiving back preferred shares with a redemption price equal to the value of the transferred property but with a low paid-up capital. Most of the proceeds on a redemption of the shares would be deemed to be a tax-free dividend in the hands of the corporation. In each case, of course, other anti-avoidance rules might apply. By virtue of subsections 55(2) to (5), an intercorporate dividend will be deemed generally to be proceeds of disposition of shares or a capital gain where the dividend would result in a significant reduction in the portion of the capital gain attributable to anything other than income earned or realized by any corporation after 1971. Application Deemed Proceeds or Capital Gain Circumstances in Which Subsection 55(2) Will Apply Subsection 55(2) will deem a dividend received by a corporation to be a capital gain or proceeds of disposition (other than the portion subject to Part IV tax that is not refunded as a consequence of the payment of a dividend to a corporation where the payment is part of the series of transactions or events) under the following circumstances: (a) the taxpayer was a corporation resident in Canada; (b) the taxpayer received after April 21, 1980 a taxable dividend in respect of which it was entitled to a deduction under subsection 112(1) (corporations generally) or subsection 138(6) (life insurers); (c) the taxable dividend was received as part of a transaction or event or a series of transactions or events (other than as part of a series of transactions or events that commenced before April 22, 1980);

442 (d) one of the purposes of such transaction, event or series of transactions or events (or, in the case of a deemed dividend under subsection 84(3), one of the results) was to effect a significant reduction in the portion of the capital gain that, but for the dividend, would have been realized on a disposition at fair market value of any share of capital stock immediately before the dividend; and (e) such portion of the capital gain could reasonably be attributable to anything other than income earned or realized by any corporation after 1971 and before the transaction or event or the commencement of the series of transactions or events referred to in paragraph 55(3)(a). It should be noted that subsection 55(3) provides certain exceptions to the application of subsection 55(2) which also must be taken into account. See below under "Exceptions to Subsection 55(2)". Taxable Dividend The dividend referred to in subsection 55(2) may be an ordinary taxable dividend or may be a deemed dividend pursuant to section 84 of the Act. As dividends paid out of the capital dividend account or life insurance capital dividend account are not taxable dividends, subsection 55(2) would not be applicable. Part of a Transaction or Series of Transactions The rules only refer to dividends received after April 21, 1980 and do not apply to a dividend if it is part of a series of transactions that started before April 22, 1980. However, where a dividend was received or the series of transactions started before that date as a part of a transaction or series of transactions that would artificially or unduly reduce a capital gain, the transaction might fall under former subsection 55(1) (discussed below). Purpose and Result Tests Subsection 55(2) will apply to an intercorporate dividend if it is shown that one of the purposes of the transaction or event or series of transactions or events was to effect a significant reduction in the particular portion of the capital gain that would otherwise have been realized. Thus, the taxpayer must demonstrate that none of the purposes of the transaction was to effect the reduction of the capital gain. It will apparently not be sufficient for the taxpayer to show that the main purpose of the transaction was a business purpose. In the case of a deemed dividend under subsection 84(3), it merely need be shown that one of the results of the transaction or series of transactions was the reduction of the capital gain. This is an objective test which can be established without reference to the intention of the parties. Significant Reduction In most cases, the Department suggests that "a significant reduction in the portion of the capital gain" will be measured on a dollar rather than on a percentage basis. Capital Gains Attributable to Post-1971 Income Subsection 55(2) does not apply to a dividend that effects a reduction in a capital gain that is attributable to income earned after 1971. It would appear that "income" in subsection 55(2) refers to income determined under the Act. However, the Department takes the position that in order to pay a dividend out of post-1971 earnings which does not offend subsection 55(2) (often referred to as a "safe dividend"), such income must in fact be "retained in the corporation". It is thus necessary to

443 calculate income for the relevant years, and then deduct from that amount taxes (including provincial taxes), charitable donations, dividends previously paid (except non-taxable dividends such as those paid out of 1971 CSOH, TPUS and the capital dividend account) and non-allowable expenses, a calculation reminiscent of "control period earnings" under the former designated surplus provisions. Owing to the operation of paragraph 55(5)(c), the post-1971 income of a private corporation is also to be calculated on the assumption that no amounts were deductible for inventory allowance (former para. 20(1)(gg)) or the additional allowance for scientific research (sec 37.1). A resident corporation that is not a private corporation (e.g. a public corporation or subsidiary of a public corporation) is also to calculate its income for the purposes of subsection 55(2) on the assumption that no amounts were deductible by virtue of former paragraph 20(1)(gg) or section 37.1, and in addition it is to include in income an amount equal to the excess of capital gains over taxable capital gains (i.e. the non-taxable portion of the capital gain) for the period reduced by the excess of capital losses over the allowable capital losses (i.e. the non-deductible portion of the capital losses) for the period (subpara. 55(5)(b)(ii)). In addition, there is included in income 25 per cent of the proceeds received (or which the taxpayer became entitled to receive) in respect of the disposition of eligible capital property in the period less the sum of 331/3 per cent of its cumulative eligible capital at the commencement of the period and 25 per cent of the eligible capital expenditures in the period. These rates are based upon the inclusion rate of 75 per cent under section 14 in respect of eligible capital property applicable for taxation years of corporations commencing after June 30, 1988. Where the period commenced before the corporation's "adjustment time" (immediately after the commencement of its first taxation year commencing after June 30, 1988) under subsection 14(5), the amount to be added in respect of the untaxed portion of the proceeds for the period before the adjustment time is based on the previous inclusion rate of 50 per cent instead of the 75 per cent. Special rules also apply where an amount has been deducted in respect of a bad debt under subsection 20(4.2) relating to the proceeds of disposition of eligible capital property or included in income by reason of paragraph 12(1)(i.1) on the recovery of such a bad debt (subpara. 55(5)(b)(iii)). See also section 14 and paragraph 89(1)(b). Paragraph 55(5)(d) defines the income of a corporation for the period during which it was a foreign affiliate of another corporation essentially as the amount that would have been deductible by the latter corporation, by virtue of paragraph 113(1)(a) or 113(1)(b), in respect of a dividend arising under subsection 93(1) of the Act on the full amount of the proceeds of disposition if the affiliate were sold, i.e. the exempt surplus and the amount recognized in respect of underlying foreign tax on taxable surplus under the foreign affiliate rules. The calculation of post-1971 income commences with the later of January 1, 1972 and the date of acquisition of the shares and continues until that point in time immediately before the transaction or event or commencement of the series of transactions or events referred to in paragraph 55(3)(a) leading to the receipt of the dividend (the so-called "holding period"), under the Department's interpretation. Thus, all income earned or realized after 1971 will not be recognized for the purposes of subsection 55(2), as income earned after 1971 but before the acquisition of the shares will, in theory, already be reflected in the adjusted cost base of the shares. It should also be noted that prior to amendments to the Act in 1983, the holding period commenced with the later of January 1, 1972 and the date of acquisition and possibly continued until the declaration of the dividend itself. However, with effect for dividends received after November 12, 1981, the income of a corporation earned or realized subsequent to the transaction or event or commencement of the series of transactions or events referred to in paragraph 55(3)(a) cannot be used to reduce the tax liability resulting from the application of subsection 55(2).

444

The word "any" in the phrase "income earned or realized by any corporation" apparently is intended to permit the consolidation of post-1971 income within a corporate group. Generally, such consolidation will only be permitted between the corporate group's parent and its subsidiaries, but the Department has indicated that consideration will be given to including in the consolidation the post-1971 income of any corporation over which the parent may exercise significant influence with respect to its operating and financial decisions, even though the parent does not legally control the corporation. If a subsidiary is wound-up under subsection 88(1), its post-1971 income (or losses) will be considered to flow through to the parent. Paragraph 55(5)(a) provides that the portion of any capital gain attributable to any income expected to be earned or realized by a corporation after the receipt of the dividend is deemed for greater certainty to be a portion of the capital gain attributable to anything other than post-1971 income. This would indicate that the value of goodwill in a corporation derived from the capitalization of anticipated future income, if distributed as a dividend, would be caught by subsection 55(2) and treated as a capital gain. As a general rule, the official view is, therefore, that a portion of a gain "that is attributable to anything other than income earned or realized after 1971" is that part of the value of the shares that is attributable to unrealized and untaxed appraisal and accounting surpluses of a corporation (net of unrealized appraisal and accounting losses). It would include, among other things, appreciation of assets and goodwill related to future earnings. Dividends Subject to Part IV Tax Prior to amendments to the Act in 1983, subsection 55(2) did not apply to any portion of the dividend subject to tax under Part IV of the Act. Generally, before November 12, 1981, refundable Part IV tax of 25 per cent was eligible where a private corporation received a dividend from a portfolio investment in shares of another Canadian corporation. For a more detailed explanation of Part IV tax, see the commentary to this Part. With respect to dividends received after November 12, 1981, the above exception to subsection 55(2) only applies if the Part IV tax paid on the dividend is not refunded as a consequence of the payment of a dividend to a corporation where the payment is part of the series of transactions or events. Presumably, this exception will still apply where the refund of Part IV tax is due to the payment of a dividend to an individual, or the payment of a dividend to a corporation was not part of the series of transactions or events. Allocation of Post-1971 Income to Shares Each share of a corporation is apparently only regarded as entitled to its proportionate share of the post-1971 income of the corporation during the relevant holding period of the share. Thus, a shareholder holding 50 per cent of the shares in a corporation is presumably only "entitled" to 50 per cent of the post-1971 income during the relevant holding period, out of which a safe dividend can be paid. If a corporation has different classes of shares, it appears that income would be considered to be attributable to each particular class in the same ratio in which each class would be entitled if all earnings of the corporation, but not share capital, were to be distributed. Timing of Deemed Capital Gain

445

Where a dividend is subject to subsection 55(2) and the shares are disposed of, paragraph 55(2)(b) deems the dividend to be proceeds of disposition and the resulting gain will be taxed in the year of disposition. Where the shares are not disposed of, paragraph 55(2)(c) deems the dividend to be a gain in the taxation year in which the dividends are received from the disposition of capital property. Dividends already treated as gain under paragraph 55(2)(c) apparently will not be treated as additional proceeds of disposition under paragraph 55(2)(b) at the time the shares are disposed of.

iii. Exceptions to s. 55
55(3)(a) Canada Revenue Agency Technical Notes Subsection 55(3) sets out circumstances in which subsection 55(2) does not apply to dividends. Paragraph 55(3)(a) provides an exemption from the application of subsection 55(2) for dividends received in certain related-party transactions. In particular, paragraph 55(3)(a) exempts dividends received as part of a series of transactions or events that does not result in a disposition of property to, or a significant increase in interest in any corporation of, any person who is not related to the corporation that received the dividend. Paragraph 55(3)(a) allows for, amongst other things, certain dispositions of money as well as of property for proceeds equal to the fair market value at the time of disposition. Therefore a deemed dividend arising on a redemption of shares received on a transfer of property under section 85 to a related corporation for sale outside the related group may now be exempted from the application of subsection 55(2) as may a disposition of money on the payment of dividends. In particular, subsection 55(2) will not apply to dividends received by a corporation (the "dividend recipient") if as part of a transaction or event or a series of transactions or events in which the dividend was received there was not at any particular time a disposition of property to a person or partnership who was an unrelated person immediately before the particular time other than a disposition of (1) money for the payment of dividends or the reduction of paid-up capital of shares, and (2) property for proceeds that are not less than its fair market value at the time of disposition; an increase in the total direct interest in any corporation of one or more persons or partnerships who were unrelated persons immediately before the particular time unless the increase resulted from a disposition of shares of a corporation for proceeds of disposition that are not less than the fair market value of those shares at the time of the increase; a disposition to a person or partnership who was an unrelated person immediately before the particular time of shares of the corporation that paid the dividend (the "dividend payer") or property more than 10% of the fair market value of which was at any time during the series derived from the shares of the dividend payer; after the time the dividend was received, a disposition to a person or partnership who was an unrelated person immediately before the particular time of shares of the dividend recipient or property more than 10% of the fair market value of which at any time during the series is derived from shares of the dividend recipient; or a significant increase in the total of all direct interests in the dividend payer of one or more persons or partnerships who were unrelated persons.

446

Granite Bay Charters Ltd., Appellant and Her Majesty The Queen, Respondent
2001 CarswellNat 1360, 2001 D.T.C. 615, [2001] 3 C.T.C. 2516. Tax Court of Canada Bowie T.C.J.: 1 This appeal is from an assessment under the Income Tax Act (the Act) for the taxation year 1994. The issue it raises is a narrow one. The Appellant is deemed by section 84 of the Act to have received a dividend upon the redemption of certain shares of Greenstone Creek Logging Ltd. (Greenstone) which it owned. Subsequently, Mr. and Mrs. Cox, who owned all the shares of both the Appellant and Greenstone, sold their Greenstone shares at arms length. The Minister of National Revenue has assessed the Appellant on the basis that subsection 55(2) of the Act applies to deem the proceeds of the redemption to be proceeds of disposition giving rise to a taxable capital gain, rather than a taxfree intercorporate dividend. The Appellant contends that subsection 55(2) does not apply, because the transaction is saved by paragraph 55(3)(a) of the Act, as the redemption by Greenstone of its shares was not part of a series of transactions or events that resulted in the sale by Mr. and Mrs. Cox of their Greenstone shares The Reassessments 28. Based on the advice provided by Mr. Huxham and Mr. Ruskin, the Appellant filed its 1994 T2 corporate income tax return indicating that the Dividend was an intercorporate dividend includable in income under subsections 82(1) and 84(3) of the Act but deductible under subsection 112(1) of the Act. 29. By a Notice of Reassessment dated July 27, 1998, the Minister of National Revenue reassessed the Appellant to tax by adding $323,245 to the income of the Appellant. This amount was calculated as: Deemed Dividend $756,525 Less: pro rata safe income attributable to the Greenstone shares transferred to the Appellant $325,532 Deemed proceeds of disposition per s. 55(2) $430,993 Taxable capital gain (75%) $323,245 30. The Appellant accepts for purposes of this litigation that the safe income of Greenstone is attributable pro rata to each Greenstone share. Hence, only $325,532 of the Dividend is attributable to safe income in respect of the Greenstone shares acquired by the Appellant and redeemed by Greenstone. . 4 In written argument filed at the hearing, counsel for the Appellant framed the issue this way: The Appellant agrees that if the dividend it was deemed by subsection 84(3) of the Act to have received on the redemption of the Greenstone shares is "part of a transaction or event or series of transactions or events" that includes the disposition of the Greenstone shares by Mr. and Mrs. Cox to 392896 B.C. Ltd., then subsection 55(2) of the Act applies and this appeal fails. Counsel for the Appellant has stated his position succinctly in paragraph 12 of his written argument:

447 The Appellant's argument is simple. The December 31, 1993 reorganization giving rise to the deemed dividend cannot be part of a series of transactions or events resulting in the sale of the shares of Greenstone to 392896 B.C. Ltd. because the Coxes could not possibly have contemplated that particular sale of shares. They were not actively selling the company, they did not know with any degree of certainty there would be a sale, they did not know of the purchaser's existence, the purchase price or anything concrete to do with a potential sale. All the Coxes knew is that if a potential purchaser did appear, they would be willing to discuss a sale with that party. The transaction lacked the degree of interconnection and interdependence required by the relevant jurisprudence to be considered a series of transactions. 5 In 454538 Ontario Ltd. v. Minister of National Revenue,1 Sarchuk J. had to consider the meaning of the expression "series of transactions or events" as it appears in subsection 55(2) of the Act. The Appellant, attempting to bring itself within the grandfather provision in the subsection, took the position that disagreements and hostility among three shareholders occurring in the period between 1975 and 1979 formed part of a series of events which culminated in a reorganization and sale of the business in 1980. Sarchuk J. noted the lack of a nexus between the events of the 1970s and the later reorganization and sale of shares, and held that they were not a series of transactions or events beginning prior to April 1980. In reaching this conclusion, he said:2 The evidence adduced on behalf of the appellant fails to establish a reasonable nexus between the impugned transaction and any event or transaction which took place prior to April 22, 1980. There was no serious intention on the part of the Mazzoccas to dispose of their interests in Tri-M prior to late summer and fall of 1980. Romantino's testimony made it clear that he and his brother were bent on retaining their interest and this is confirmed by D'Angela's understanding of what Romantino and Mauro were endeavouring to obtain from Brunner. He described his instructions in September 1980 as: I think the first was to see whether - the Mazzoccas did not really want to sell their interest. They would have preferred to find someone that would have just taken over Manley's interest and eliminate the problem, the animosity and the mistrust that had existed. They just wanted to change partners. Counsel for the appellant contended that Robertson's comments, and thus the Department's position, were premised on the assumption that, where the transactions giving rise to the reduction in capital gains were contemplated then the transactions or events occurring at that preliminary stage would form part of the series of transactions or events. He argued that the appellant met this test. I do not agree. The transaction contemplated by subsection 55(2) is the disposition at fair market value of a share of capital stock as a result of which the corporation received a taxable dividend in respect of which it was entitled to a deduction under subsection 112(1) or subsection 138(6) of the Act. It is difficult if not impossible to point to one single item of evidence which supports the existence in the minds of the Mazzoccas or their corporations of such "contemplation" prior to April 22, 1980. A generalized desire to rid oneself of a problem is an insufficient base upon which one can make the quantum leap to the conclusion sought. The phrase "series of transactions or events" must be read in its grammatical and ordinary sense reflecting the context in which it is found, the scheme and object of the Act and the intention of Parliament. Bearing this stricture in mind it seems reasonable to conclude that in order for the events to form part of a series they must follow each other in time and must somehow be logically or reasonably connected to one another. Furthermore the appellant and 539 themselves must intend that the series of transactions be linked together to achieve the

448 specific result in this case being the disposition of the shares of Tri-M to 461 in the circumstances and in the manner previously described. This approach is consistent with the dictionary definitions of the words, "series", "transaction" and "event". This passage has since been quoted with approval by Cullen J. in C.P.L. Holdings Ltd. v. R.,3 and by Archambault J. in Industries S.L.M. Inc. c. Ministre du Revenu national4. 6 In Industries S.L.M., Archambault J. examined dictionary definitions in both French and English, as well as the academic literature, in his consideration of the meaning of the expression "series of transactions or events". He also considered the purpose of the legislation, and said:5 ...This subsection is an anti-avoidance provision designed to prevent an artificial or undue reduction of the capital gain that a taxpayer would have realized if he had simply sold his shares at their fair market value.... Having regard to these objectives of subsection 55(2), what scope can be given to the expression "series of transactions" and when did this series of transactions commence? In my view, the expression series of transactions must have a meaning that is sufficiently broad to enable tax authorities to prevent an artificial or undue reduction, but that, at the same time, is as narrow as possible so as not to penalize a taxpayer needlessly.... 7 Counsel for the Appellant placed great reliance on the judgment of this Court in Meager Creek Holdings Ltd. v. R..6 In that case the Crown argued that a dividend declared in February 1990 and a sale of shares which took place the following December were a series of transactions or events for the purposes of subsection 55(2) of the Act. In rejecting this contention O'Connor J. said:7 [29] I accept the credibility of the witnesses for the Appellant. All but Proctor were subjected to rigorous cross-examinations and although certain inconsistencies were shown, these were not in my opinion crucial. Witnesses Burridge, Pickering and Harris were consistent in their position that it was the budget which provoked the declaration of the dividends and not any possibility of a sale with the resultant reduction in the capital gain. The fact that 26 other companies in similar situations as Meager, Tyee Pemberton and CRB, were advised by Burridge immediately before the budget to declare dividends is a strong indication that the purpose behind the declaration of dividends was to avoid any distribution tax that the budget might have contained rather than a desire to effect a reduction in a capital gain on a disposition of shares. [30] Moreover, I do not agree that a series of transactions or events occurred. The dividends were declared in February, 1990 but the sale discussions only began in August, 1990 with the sale of one-third of the shares of Tyee and Pemberton occurring December 31, 1990. Admittedly Pickering in October, 1989 offered to sell his shares to Turner. However, this was related to Pickering's health problems and was not indicative of a contemplated sale of the business in whole or in part to any prospective purchaser. Further, in my view, the French versions of the subsections in question do not alter these conclusions. [31] Also, I cannot accept Respondent's argument that any possible future sale can suffice to bring subsection 55(2) into play. There must be a series of transactions or events contemplated. To accept Respondent's argument could open the door to the subsection being applied to almost any declaration of inter-corporate dividends. Meager Creek was not a case in which the dividend arose under subsection 84(3), and so the purpose of the series of transactions or events, if there was a series, was crucial to the result. O'Connor J.'s conclusion, in the passage that I have quoted above, was that the evidence before him

449 established that the purpose behind the declaration of the dividend was to pre-empt a possible taxing provision that might have been included in a forthcoming budget, and not to reduce a possible capital gain on a future disposition of shares. Having reached that conclusion, it followed that there was no nexus to be found between the dividend and the disposition some 10 months later. In fact, there was no sale in contemplation until August, about six months after the dividend was declared. . 14 The actual transactions which gave rise to the subsection 84(3) deemed dividend were a sale by Mr. and Mrs. Cox of shares in Greenstone to Granite Bay , and the redemption of those shares by Greenstone for a conveyance to Granite Bay of its non-logging assets. The agreements to sell the shares and the corporate resolutions are all dated December 31, 1993; they may have been executed as late as January 11, 1994. In either event, there was an agreement in place at the time between Mr. and Mrs. Cox and Dougan Logging for the sale of all the outstanding shares of Greenstone. The dividend had prepared Greenstone for sale by removing from it the non-logging assets. There can be no doubt that if the Dougan sale had been completed, it would have been the culmination of a series of events within subsection 55(2). If Dougan Logging had assigned its rights under the December 1993 agreement to another purchaser and it had completed the sale, it would have come within subsection 55(2). In my view, a change in the identity of the purchaser, where the intention to sell remained intact throughout and the hiatus is as short as this one, cannot divorce the share redemption from the subsequent sale of the Cox shares. 15 Counsel for the Appellant placed great emphasis on the passage which I have quoted from the judgment of O'Connor J. in the Meager Creek case, and, in particular, his rejection of the proposition that "...any possible future sale can suffice to bring subsection 55(2) into play." 8 However, it is clear from the latter part of that pararaph that O'Connor J. was only concerned not to give subsection 55(2) an interpretation so expansive that it would embrace future sales not yet in contemplation. In this he echoed the concern expressed earlier by Sarchuk J. in 454538 Ontario Ltd., and by Archambault J. in Industries S.L.M. Inc. However, the facts of this case are at the other end of the spectrum; to conclude that no nexus existed between the corporate reorganization and the redemption of the Greenstone shares in December or January and the sale of the Cox shares in February would be to ignore the obvious tax-avoidance purpose of subsection 55(2), as well as the words of subsection 248(10). 16 Counsel also argued that the decisions of the House of Lords9 in the step transaction cases support the notion that the transactions should not be considered to be a series unless the identity of the final purchaser was known throughout. The step transaction doctrine was developed in England as a common law remedy to counter tax avoidance schemes which were developed in a legislative vacuum. It is not surprising that the House of Lords limited the doctrine to those situations where the transactions were pre-ordained. I do not think that their reasoning in doing so should be applied to limit unduly the efficacy of specific anti-avoidance legislation. 17 The appeal is dismissed. The Respondent is entitled to costs.

Appeal dismissed.

Recent Cases of Significance

By F. Quo Vadis, B.C. Tax Conference, CTF 2004

450 The Queen v. Kruco Inc. [2001 DTC 668 (TCC) & 2003 DTC 5506 (FCA)] In Kruco Inc. v. The Queen the corporate taxpayer reported a deemed dividend pursuant to subsection 84(3) of the Act following the repurchase of some of the shares it held in the capital stock of Kruger Inc. The Minister rejected the determination of safe income as determined by the taxpayer and made three negative adjustments two of which involved investment tax credits. The Minister argued that where the capital cost for property acquired by the taxpayer was reduced as a consequence of an investment tax credit received by the taxpayer, the resulting capital cost allowance ("CCA") was less than what would otherwise have been the case. The difference between the CCA that would have been available, without adjustment for the investment tax credits, and the actual (lower) amount of CCA claimed gave rise to "phantom income" which according to the CRA's administrative practice, should be excluded from the determination of safe income. The Minister also argued that where an investment tax credit is required to be included in the income of a taxpayer, the inclusion is also considered to be phantom income and should be excluded from the determination of safe income. Noel, JA for the Federal Court of Appeal largely adopted the reasons of the Tax Court Judge who had found that the words "income earned or realized" in subsection 55(2) must be taken to mean income as otherwise computed under the Act for tax purposes. A private corporation's "income earned or realized" is deemed under paragraph 55(5)(c) of the Act to be its income otherwise determined modified to deny deductions under two, now largely historic, provisions of the Act. The Court held that an attempt to deduct phantom income from "income earned or realized" for purposes of subsection 55(2) was not in conformity with how income was mandated to be determined in accordance with paragraph 55(5)(c) of the Act. As such it was "not open to the Minister to modify the amount which Parliament has deemed to be a corporation's "income earned or realized" for purposes of subsection 55(2)". The Court did, however, indicate that no violence is done to the deeming provision by the reduction of safe income through cash outflows, such as dividends and taxes paid, since these outflows take place after income has been computed in conformity with paragraph 55(5)(c). 729658 Alberta Ltd. v. The Queen [2004 TCC 274] In 729658 Alberta Ltd. the Tax Court of Canada determined how safe income should be calculated where a corporation receives dividends on shares acquired on a partial subsection 85(1) rollover and later sells those shares to an arm's length party. In the case two unrelated individuals each owned 50% of the shares of Targetco, a Canadian controlled corporation. Each shareholder had an inherent capital gain of approximately $12.4 million and each had attributable safe income of about $1.9 million. In the week before the sale of Targetco shares to an arm's length buyer, each of the shareholders sold their shares to their own wholly owned Alberta corporations in exchange for a $10.4 million promissory note and Common shares. Under subsection 85(1) of the Act each of the shareholders elected $10.4 million as the agreed amount for the proceeds of disposition on the transfer of their shares to their respective holding companies. The individual's reported taxable dividends of $10.4 million each (presumably due to application of subsection 84.1(1) of the Act). Targetco then paid taxable dividends to the two holding companies in an amount equal to the safe income attributable to the shares held by those companies. Finally each holding company sold its shares of the Targetco to a third party purchaser for cash consideration. In reassessing the corporate holding companies for 1997, under subsection 55(2) of the Act, the Minister re-characterized approximately 5/6ths of the dividends they received from Targetco as capital gains. The Minister's position was that the accrued gain rolled to the holding companies ($1,932,802) represented only approximately 1/6th of the entire accrued capital gain applicable to the shares

451 ($12,391,437) so that only 1/6th of Targetco's safe income should be attributable to the holding companies. This case ultimately turned on the meaning of the phrase "reasonably attributable", since only dividends that can "reasonably be attributable to anything other than income earned or realized" are to be re-characterized as capital gains under subsection 55(2). The Court stressed that subsection 55(2) should be given a purposive interpretation in accordance with its object and spirit. The Crown's position was inconsistent with the object and spirit of the legislation in that a pro-rata allocation of safe income would not allow safe income to be distributed as tax-free inter-corporate dividends. The Court held that the accepted approach is that gain is first allocated to "income earned or realized" and, only if dividends exceed this amount, is gain allocated to "unrealized appreciation in the value of underlying assets". The Court cited CRA's Robertson rules which indicated that subsection 55(2) is intended to be limited to cases of genuine tax avoidance and that common sense should prevail. The Court found that there was no tax leakage by virtue of the individuals rather than their holding companies paying tax on the disposition of the shares of Targetco or because the gain was realized in the form of dividends rather than capital gains. The Queen v. Canadian Utilities Limited et al [2004 FCA 234] In the case of The Queen v. Canadian Utilities Limited et al the facts are quite complex but can be simplified for the substantive issue at hand. The corporate taxpayers, Canadian Utilities Limited and Can Utilities Holdings Limited, were public corporations. Both of these corporations had historically paid regular dividends on their listed shares. The shares were widely held by various unrelated individuals and corporations. In late 1995, Forest Oil Corporation, a US corporation, conditionally agreed to acquire all of the issued shares of ATCOR, a public corporation that was controlled by a related group of shareholders that included the corporate taxpayers. To affect the acquisition, ATCOR was amalgamated with a newly formed company. In early 1996 the corporate taxpayers and the other public shareholders received, on a tax-deferred basis, redeemable shares in the amalgamated ATCOR in exchange for their old shares. Forest Oil Corporation, through a Canadian subsidiary, then acquired the only Common share in the amalgamated ATCOR for a nominal amount. Funding was provided to redeem the corporate taxpayer's shares in the amalgamated ATCOR and to acquire the shares held by the other ATCOR shareholders. The taxpayers received deemed dividends under subsection 84(3) to the extent that the redemption proceeds on the amalgamated ATCOR shares exceeded the paid up capital of those shares. These inter-corporate deemed dividends passed tax-free under Part I of the Act pursuant to subsection 112(1), but were subject to Part IV tax. The corporate taxpayers paid out sufficient dividends of their own in 1996 and 1997 to obtain full Part IV tax refunds. As a result neither of the corporate taxpayers paid any unrefunded tax in respect of the disposition of their ATCOR shares. The Minister reassessed the taxpayer's 1996 and 1997 taxation years by applying subsection 55(2) and treating the taxpayer's redemption proceeds on their ATCOR shares as capital gains rather than dividends. As noted, both corporate taxpayers had historically paid regular dividends. Canadian Utilities Limited had paid dividends on its Common shares since 1950 (but for two years) and Canadian Utilities Holdings Limited had paid dividends on its Preferred shares from 1994 to 1998 inclusive. The trial judge referred to such dividends as "normal course dividends".

452 In the appeal to the Federal Court of Appeal there were two issues. The first issue was whether the payment of normal course dividends was part of a series of transactions contemplated by subsection 55(2) , one of the results of which was to effect a significant reduction in the capital gain that would have been realized on the disposition of the amalgamated ATCOR shares owned by the corporate taxpayers. The second issue, assuming the first issue was decided in favour of the Minister, was to what extent the Part IV tax exception in subsection 55(2) did not apply because the refund of Part IV tax caused by the payment of the normal course dividends was due to the payment of those dividends not only to individuals but also to corporations. The Tax Court Judge had found that the payment of normal course dividends was not part of the series of transactions that gave rise to the deemed dividends on the redemption of the amalgamated ATCOR shares. The trial judge had therefore concluded that subsection 55(2) did not apply since the normal course dividends were independent of the share redemption | transactions. The Crown appealed the matter to the Federal Court of Appeal. Rothstein, JA for the Federal Court of Appeal stated that recourse must be had to the common law definition of "series" since the term "series" is not defined in the Act. He referred to the "preordination test" as espoused in OSFC Holdings Ltd. v. The Queen.40 Under that test, each transaction in the series must be preordained to produce a final result. Preordination means that, when the first transaction of the series is completed, all essential features of the subsequent transaction or transactions are determined by persons who have the firm intention and ability to implement them. The Court held that the fact there was "a genuine independent purpose and existence" for a particular transaction, such as the payment of the normal course dividends, was not sufficient to remove that transaction from the series of other preordained transactions. If the parties intend that a transaction with an independent purpose and existence will assist in achieving the composite result and have the ability to ensure that the independent transaction is carried out and the transaction is in fact carried out, the independent transaction will be considered a part of the series. For this reason the normal course dividends were determined to be part of the common law series for the purposes of subsection 55(2). The fact that they had an independent purpose and existence was of no consequence to the issue of whether they were part of the series. The second issue raised by the Minister was that of how dividends should be allocated, whether to individuals or corporations, for purposes of the Part IV tax exception to subsection 55(2). The Minister took the position that the Part IV tax exception in subsection 55(2) should be allocated on the same proportion as the allocation of dividends paid to individuals. For example, in the case of Canadian Utilities Limited 43.273% of its dividends were paid to individuals. The Minister therefore stated that only 43.273% of that corporation's dividend refund could be treated as having arisen from the payment of dividends to individuals and therefore only 43.273% of its dividends paid would be eligible for the Part IV exception in subsection 55(2). The taxpayers took the position that the Part IV tax exception should be based on the actual amount of dividends paid to individuals, not the proportion of total dividends paid to individuals versus that dividends paid to corporations. The Court concluded that the Minister's argument was simply not supported by the language of the Act and that there was nothing in subsection 129(1) that suggested that, when dividends were paid both to individuals and to corporations, dividend refunds were to be allocated on a pro-rata basis between them. In the absence of any statutory direction to apportion or allocate dividend refunds on a pro-rata basis between dividends paid to corporations and dividends paid to individuals, a taxpayer could make the allocation or apportionment on the basis most beneficial to it.

453

X. Capital Reorganizations
1. Share for Share Exchanges s. 85.1
Prior to 1974, an exchange of shares in one corporation for shares in another corporation was not able to be completed on a rollover basis, except pursuant to elections under section 85. The mechanics involved in section 85 elections render them difficult to use in share exchange takeovers of public corporations. As a result, most takeovers of public corporations require a shareholder who agreed to the share exchange to recognize a gain for tax purposes on the difference between the adjusted cost base of his old shares and the fair market value of the new shares he received. Consider the following example. Corporation A, a public bicycle manufacturing company, has its eye on Corporation B, a public tire manufacturing company. Each share has an adjusted cost base of $1.00 and a fair market value of $100.00. Corporation A offers the shareholders of Corporation B (the acquired corporation) shares in Corporation A (the purchaser corporation) in exchange for their shares. In the absence of special rules, each of the shareholders of Corporation B who accepted the offer would be treated for tax purposes as though he had disposed of his shares for proceeds of disposition equal to the fair market value of the shares received in exchange, presumably $100.00. Accordingly, each would realize a $99 capital gain. In order to facilitate this form of corporate takeover, section 85.1 was introduced in 1974. Where the section applies, the shareholders of Corporation B referred to in the example above are entitled to a complete rollover in respect of the exchanged shares. Corporation A will recognize as its adjusted cost base of the shares of Corporation B, an amount equal to the lessor of their fair market value and their paid up capital immediately before the exchange. Subject to certain limitations, section 85.1 applies in two situations. The first is where shares of Canadian corporation1 are issued to shareholders of another corporation (that is a taxable Canadian corporation) in exchange for their shares of that corporation. The second is where shares of one foreign affiliate of a taxpayer are disposed of by the taxpayer to another corporation that immediately after the disposition is a foreign affiliate of the taxpayer, and the taxpayer receives consideration that includes shares of the transferee foreign affiliate.2 Each situation will be discussed in turn.

i. Overview
Section 85.1 impacts separately on both the vendor shareholder and the purchase corporation. In addition, the provisions of the section apply on a shareholder by shareholder basis. It is possible, therefore, that some but not all of the shareholders of an acquired corporation may take advantage of section 85.1. Subsection 85.1(1) sets out a number of conditions that must be met by each vendor shareholder in order to receive rollover treatment on the exchange, and by the purchase corporation. Subsection 85.1(2) then qualifies subsection 85.1(1) by providing that those rules will not apply where the parties are not dealing at arms length both before and after the exchange, where a section 85 election has filed, or where non-share consideration has been received.
1 2

See para. 89(1)(a). A similar rule is contained in paragraph 95(2)(c) where a foreign affiliate of a taxpayer disposes of shares to a second foreign affiliate of the taxpayer to a corporation which, immediately following the disposition, is also a foreign affiliate of the taxpayer.

454

ii. The Requirements of Subsection 85.1(1)

In order to fall within the provisions of subsection 85.1(1), all of the following conditions must be met by the purchaser corporation and by the vendor shareholder exchanging his shares in the acquired corporation for shares in the purchaser corporation. The vendor shareholder receiving shares in the purchaser corporation must have received the shares after May 6, 1974. b. The purchaser corporation must be a Canadian corporation. c. The shares given up by the vendor shareholder in exchange for shares of the purchaser corporation must be capital property in his hands. d. The purchaser corporation must issue its own shares as consideration for the vendor shareholders' shares. e. The vendor shareholder must receive as consideration for the disposition of shares of any particular class in the acquired corporation, shares of any particular class in the purchaser corporation. Conditions a. and b. are self-explanatory. However, a number of points should be noted with respect to conditions c., d., and e. First, section 85.1 will not operate where the vendor shareholder's shares are not capital property in his hands. The combined effect of paragraph 54(b) and the definition of "capital property" in subsection 248(1) will thus exclude from the rollover a trader or dealer in securities. These sections provide that "capital property' includes shares any gain or loss from the disposition of which would be a capital gain or loss. A trader in securities would receive income rather than a capital gain on the disposition of his shares and, for this reason his shares are not capital property. Condition 4 requires that the purchase corporation issue its own shares as consideration for the vendor's shares. Thus, the rollover will not apply where the purchase corporation attempts to exchange shares other than its own such as, for example, shares which it owns in another corporation. Notwithstanding this limitation, the shares acquired by the vendor from the purchaser corporation need not be newly issued treasury shares. In jurisdictions where the purchaser corporation is permitted to acquire its own shares without canceling them,3 these shares may be used to satisfy the rollover requirements. Further, it appears that where a right to receive additional shares in the purchase corporation is included in the exchange, for example, under an earn-out agreement, the rollover may not operate.4 In fact, as will be discussed later, the receipt of any non-share consideration by the vendor shareholder will prevent the rollover unless structured carefully. Assume that Vendor Co. is owned equally by A, B and C. Acquirer Co. is owned equally by X, Y and Z. Acquirer Co. wants to takeover Vendor Co. A, B and C can exchange their shares in Vendor Co. for shares in Acquirer Co. by making an election under s. 85. Alternatively, s. 85.1 is an automatic provision which applies when the following conditions are met: 1. The vendors of the shares sold (i.e. A, B and C) and Acquirer Co. are at arm's length (before and after the share for share exchange); a.

See Interpretation Bulletin IT-450, June 13, 1980 and subsection 37(5) of the Canada Business Corporations Act, S.C. 1974-75, c. 33, as amended. 4 See R.G. Witterick, Acquisitions of Shares of Private Corporations in Arms Length Transactions, 1978 Corporate Management Tax Conference, 120, 128. For a contrary view, see P.E. McQuillan, Financing Corporate Acquisitions, Ibid, 145 at 146.

455

2. 3.

The only consideration received from Acquirer Co. (a Canadian corporation) is shares of a single class taken from treasury (the "no boot" rule); and The shares sold (i.e. Vendor Co. shares) must be capital property (and shares of a taxable Canadian corporation).

The test to determine if the vendors and the purchaser deal at arm's length after the exchange is whether the vendor and/or persons the vendor is non-arm's length with control the purchaser or owned greater than 50% of the FMV of all outstanding shares of capital stock of the purchaser. When s. 85.1 applies the results are: 1. 2. 3. 4. POD to A, B, and C for Vendor Co. shares = ACB of Vendor Co. shares ACB to A, B, and C for Acquirer Co. shares = ACB of Vendor Co. shares ACB to Acquirer Co. of Vendor Co. shares = lesser of PUC or FMV of Vendor Co. shares PUC to Acquirer Co. and A, B and C is a maximum of FMV subject to a ss. 85.1(2.1) PUC grind

The current provisions apply only if the vendor and purchaser are Canadian corporations. A similar rollover in described in subsections 85.1(5) and (6) applies where foreign shares are exchanged for foreign shares. This rollover is described further at the end of this section.

Interpretation Bulletin IT-450R - Share for Share Exchange

April 8, 1993 (Information is current as of January 2012) Summary This bulletin discusses the rules applicable to a share for share exchange carried out under section 85.1 of the Act. These provisions are generally intended to provide a tax-free rollover to a taxpayer who held shares in an acquired corporation and, for example, in the course of a takeover or attempted takeover, the taxpayer exchanged those shares for shares in the corporation that purchased the acquired corporation. In order for the rollover to apply, the taxpayer must have held the shares in the acquired corporation as capital property and the consideration received for these shares must be newly issued shares of the purchasing corporation. The cost to the purchaser of each of the shares of the acquired corporation is generally the lesser of the fair market value of the share and its paid-up capital. Discussion and Interpretation Where Subsection 85.1(1) Applies 1. Subsection 85.1(1) applies where a taxpayer (vendor), who holds shares in a corporation (acquired corporation), exchanges them for shares in the capital stock of a purchasing corporation (purchaser). [Note the acquired corporation must be a taxable Canadian corporation]. In order for the conditions in subsection 85.1(1) to be satisfied, the purchaser must be a Canadian corporation, as

456 defined in paragraph 89(1)(a), and the vendor must hold the shares (exchanged shares) in the acquired corporation as capital property. The shares acquired by the vendor in the exchange must be newly issued shares from the treasury of the purchaser and cannot consist of stock options, bonds or income debentures. The following diagrams further illustrate the operation of subsection 85.1(1): BEFORE THE EXCHANGE i) Purchaser proposes to take over Acquired Corporation.

Canadian Corporation

(Purchaser)

Taxpayer (Vendor)

Acquired Corporation

THE EXCHANGE ii) Share for share exchange under subsection 85.1(1) occurs. treasury shares of Purchaser issued to Vendor

Canadian Corporation

(Purchaser)

Taxpayer (Vendor)

Acquired Corporation

shares of Acquired Corporation owned by Vendor (exchanged shares) are transferred to Purchaser

AFTER THE EXCHANGE

457 iii) Vendor is now a shareholder of Purchaser and Purchaser is a shareholder of Acquired Corporation.

Canadian Corporation

(Purchaser)

Taxpayer (Vendor)

For share exchanges occurring before June 6, 1987, the shares of the purchaser acquired by the vendor did not have to be newly issued treasury shares of the purchaser. Thus, they could have been shares of the purchaser acquired by other means if the jurisdiction under which the purchaser was incorporated permitted a company to acquire its own shares without cancelling them. Where Subsection 85.1(1) Does Not Apply 2. Subsection 85.1(1) will not apply, for example, where a taxpayer acquires shares of Corporation A (purchaser corporation) from Corporation A in exchange for other shares in Corporation A or acquires shares of Corporation A from a shareholder of Corporation A in exchange for shares of Corporation X. Subsection 85.1(1) will also not apply, by virtue of subsection 85.1(2), where: (a) immediately before the exchange, the vendor and the purchaser were not dealing at arm's length (see 3 below), (b) immediately after the exchange, the vendor or persons with whom the vendor did not deal at arm's length, or the vendor together with such persons, (i) controlled (de jure) the purchaser, or (ii) beneficially owned shares of the capital stock of the purchaser having a fair market value of more than 50% of the fair market value of all of the outstanding shares of the capital stock of the purchaser, (c) the vendor and the purchaser have filed an election under subsection 85(1) or (2) with respect to the exchanged shares (see 4 below), or (d) the vendor receives consideration other than shares of a particular class of the capital stock of the purchaser for the exchanged shares (however, see 6 and 7 below for exceptions to this rule). 3. Paragraph 251(5)(b) is applicable in the determination of whether persons deal at arm's length for the purposes of paragraph 85.1(2)(a) discussed in 2(a) above. A share for share exchange agreement constitutes a right to acquire shares as described in paragraph 251(5)(b). Therefore, if the purchaser will control the acquired corporation following the exercise of the right, the purchaser and the acquired corporation will be related immediately before the exchange pursuant to subparagraph 251(2)(b)(i). If a vendor corporation controls (de jure) the acquired corporation at the same time, those two corporations also will be related pursuant to subparagraph 251(2)(b)(i), and, as a consequence, the vendor and the purchaser will be related by virtue of subsection 251(3). Therefore, the vendor and the purchaser will be deemed not to be dealing at arm's length immediately before the exchange for purposes of paragraph 85.1(2)(a). 4. If a vendor and the purchaser have elected under subsection 85(1) on the exchanged shares, subsection 85.1(1) will not apply to that particular exchange by virtue of paragraph 85.1(2)(c).

458 However, this will not preclude another vendor, who has exchanged shares as part of the same arrangement, from benefitting from subsection 85.1(1) as long as that vendor has not elected under subsection 85(1) and the exchange has otherwise satisfied all the conditions in subsection 85.1(1). Tax Consequences to the Vendor 5. Unless the vendor chooses to include any portion of the gain or loss in income for the taxation year in which the exchange occurred, the rollover provisions of subsection 85.1(1) apply automatically to the exchange and no election is required to be filed. Under paragraph 85.1(1)(a), the vendor is deemed to dispose of the exchanged shares at their adjusted cost base and to have acquired the shares of the purchaser at a cost equal to the adjusted cost base of the exchanged shares immediately before the exchange. Also, where the exchanged shares were taxable Canadian property of the vendor, the shares of the purchaser acquired by the vendor in the exchange will be deemed to be taxable Canadian property. 6. The situation often occurs, in a share for share exchange, where a vendor cannot exchange all of its shares in the acquired corporation for the specified number of shares in the purchaser corporation because of the particular exchange agreement. This can result in the vendor becoming entitled to a fractional share in the purchaser. Most corporations will not issue these fractional shares. In lieu of fractional shares the agreement will usually provide for the vendor to receive cash or other non-share consideration from the purchaser. The application of subsection 85.1(1) will generally not be denied in these circumstances. In addition, if the value of the cash or other non-share consideration received in this manner does not exceed $200, the taxpayer may ignore the computation of the gain or loss on the partial disposition and reduce, by the amount of that value, the adjusted cost base of the shares received. Alternatively, the gain or loss may be reported. Where the value of the non-share consideration exceeds $200 the taxpayer must report the gain or loss. In either case, subsection 85.1(1) may be utilized in respect of the shares exchanged for shares of the purchaser corporation. 7. A vendor may receive shares of the purchaser for some of the exchanged shares and cash or other consideration for other exchanged shares. In these cases, subsection 85.1(1) may be utilized for the exchanged shares for which shares of the purchaser were received, as long as the vendor can clearly identify which shares were exchanged for cash or other consideration and which were exchanged for shares of the purchaser. Where the vendor receives shares and cash or other consideration for each exchanged share, subsection 85.1(1) may be utilized for the fraction of each exchanged share for which only share consideration was received, provided that the purchaser's offer clearly indicates that the share consideration will be exchanged for a specified fraction of each share tendered and the nonshare consideration will be given for the remaining fraction. In these situations, the cash or other nonshare consideration received represents proceeds of disposition of shares or fractions of shares of the acquired corporation as a consequence of the sale of those shares or fractions of shares by the vendor to the purchaser. 8. Similarly, a vendor may receive shares of one class for some exchanged shares and shares of another class or of another series of the same class for other exchanged shares. Subsection 85.1(1) may be utilized in respect of each exchange as long as the manner in which shares were exchanged for each class or series of shares received is clear. This will apply where the exchanged shares are all of one class or are of more than one class. If cash or other consideration is received instead of a fraction of a new share, the comments in 6 or 7 above will apply in respect of each exchange. Tax Consequences to the Purchaser

459 9. Paragraph 85.1(1)(b) provides rules applicable to the purchaser, which apply even if the vendor has otherwise reported a gain or loss. For share exchanges occurring after February 17, 1987, the cost of each exchanged share to the purchaser is the lesser of: (a) its fair market value immediately before the exchange, and (b) its paid-up capital immediately before the exchange. Where the exchange took place before February 18, 1987, the cost of the exchanged shares to the purchaser was nil unless, at any time after the exchange and before the disposition of those shares, the purchaser owned shares of the capital stock of the acquired corporation (c) to which were attached at least 10% of the votes which could be cast for any and all purposes by shareholders of the acquired corporation and (d) that represented at least 10% of the fair market value of all of the issued and outstanding shares of the acquired corporation. In such circumstances, the cost of each exchanged share to the purchaser was its fair market value immediately before the exchange. 10. For share exchanges occurring after June 5, 1987, subsection 85.1(2.1) provides rules for computing the paid-up capital of the shares of the purchaser where, as a result of an exchange to which subsection 85.1(1) applies, the increase in the paid-up capital of all of the outstanding shares of the purchaser exceeds the paid-up capital of the exchanged shares acquired. Paragraph 85.1(2.1)(a) requires that the paid-up capital of any particular class of shares be reduced by that proportion of the excess that the increase in the paid-up capital of that class of shares is of the increase in the paid-up capital of all classes of shares. Paragraph 85.1(2.1)(b) provides for a paid-up capital addition where paragraph 85.1(2.1)(a) previously required a reduction in the paid-up capital of a class of shares. This addition will apply where subsection 84(3), 84(4) or 84(4.1) subsequently deems a dividend as having been paid on shares of that class. The paid-up capital additions for a class of shares may not exceed the previous paid-up capital reductions for that class that resulted from the application of paragraph 85.1(2.1)(a).

2. Internal Reorganizations: Reorganization of Capital

For many reasons, a corporation may wish to reorganize its share capital. For example, the corporation may wish to issue a class of non-voting shares to investors, but only has common shares outstanding. The reorganization may involve the disposition of its existing shares ("old shares") in exchange for other shares ("new shares") of the corporation. Since most capital reorganizations would give rise to a disposition (see IT 448 below), a capital gain would normally arise. Section 86 and section 51 are provisions which will allow the taxpayer to defer the realization of the capital gain on the old shares exchanged for the new shares, provided that the requirements of the section are met. According to 86(3), 86 will not apply where section 85 applies.

i. Section 86
a. General Rules Section 86 is often used to exchange one class of shares for another, (i.e. preference shares with special dividend rights may be exchanged for common shares with winding-up rights). Another common use of section 86 is to freeze the taxpayer's interest in an operating company. In that case the taxpayer would exchange old common shares for preferred shares which would not participate in the future growth. The result is a freeze of any accrued gain on the old shares as at the date of the

460 exchange. The gain would not be realized until the preferred shares are disposed of. Future growth of the operating corporation would accrue to the common shareholders. In either case the transaction can be affected on a tax-free basis. On the disposition of the old shares exchanged for the new shares, the increase in value (the capital gain) is not taxed provided that the following requirements are met: a. b. c. all of the shares of that particular class owned by the taxpayer must be exchanged; the taxpayer must receive consideration in return that includes shares of the same corporation; and the transaction must be in the course of a reorganization of capital of the corporation.

When the above requirements are met, section 86 applies automatically (no elections are required), provided that section 85 did not apply to the transaction. The results of the share exchange are as follows: a. b. c. the cost of the non-share consideration ("boot") received is its fair market value ("FMV") - 86(1)(a), the ACB of the new shares to the taxpayer is the ACB of the old shares minus the FMV of any boot - 86(1)(b), and the POD of the old shares is the ACB of the new shares plus the FMV of the boot received - 86(1)(c).

It becomes evident that if the taxpayer receives boot in excess of the ACB of the old shares, a capital gain will still be triggered. Also, keep in mind that subsection 84(1) will also apply to deem a dividend should the PUC of the new shares be increased. Therefore, the PUC of the new shares should equal the PUC of the old shares exchanged minus the FMV of any non-share consideration received, if a deemed dividend is to be avoided. For Example if A owns common shares of Opco with PUC and ACB of $10 and FMV of $100 and A wants to trade those shares for a different class of shares. If the conditions of s 86 are met A can make the share exchange and the new shares will have a PUC and ACB of $10 and FMV of $100. The transaction will not be characterized as a disposition and there will be no immediate tax consequences to A. The Gift Rule in ss. 86(2) Notwithstanding that section 86 applies automatically where the requirements set out in paragraphs 86(1)(a) to (c) are met, if: a. the FMV of the old shares before the exchange is greater than the cost of any nonshare consideration received plus the FMV of the new shares received, and

461 b. it is reasonable to regard any portion of this excess as a benefit the taxpayer desired to have conferred on a related person, subsection 86(2) applies. Where subsection 86(2) and not subsection 82(1) applies the following rules are applicable: i. o o ii. iii. POD of the old shares are deemed to equal the lesser of: FMV of the old shares, and cost of the boot received + the amount of the benefit The capital loss on the disposition of the old shares is deemed to be $0; and The cost of the new shares is deemed to be equal to the ACB - (the cost of boot + the amount of the benefit).

The result is either an immediate capital gain or a decrease in the ACB of the new shares. Private Company Reorganizations: Common Problems and Pitfalls by Cary Heller, John Oakey, & Enzo Testa, Ontario Tax Conference, CTF 2008 Example - Subsection 86(2) Facts i) Assume the same facts as the prior example but Mrs. X receives cash consideration of $900 and 910 common shares so that the total consideration received equals the fair market value of the property transferred. The elected amount under subsection 85(1) remains at $900 so that Mrs. X has no cost base for the 910 common shares received. ii) Mrs. X exchanges her 910 common shares ("the old shares") of GiftCo, having a fair market value of $9,100 ($10,000 x ) for 100 Class A preferred shares which are redeemable and retractable for $10 per share and have a non-cumulative dividend entitlement. iii) Mrs. X and GiftCo do not elect under the provisions of subsection 85(1) for the subsequent exchange so that the provisions of section 86 automatically apply. Under the provisions of subsection 86(2) there is a gift of $8,100 determined as follows: Fair market value of old shares (910 common) $9,100 Less -fair market value of non-share consideration -fair market value of new shares (100 Class A) (1,000) Gift amount $8,100 Mrs. X will be deemed to have sold her 910 common shares of GiftCo for $8,100, being the lesser of: | i) the total of the fair market value of the non-share consideration (NIL) plus the gift amount ($8,100); and ii) the fair market value of the old shares ($9,100). As a result, Mrs. X will realize a capital gain of $8,100 and will not have any cost base in her 100 Class A preferred shares. The family trust's cost base in its 90 common shares remains at $90. This is the same result as that under paragraph 85(1) (e.2) with the exception that in this example the adjusted cost base of the property in GiftCo is $900 whereas under subsection 85(1) (e.2) it was increased to $9,000.

Example - Subsection 86(2)

462 This example will illustrate the result if Mrs. X attempts to increase the adjusted cost base of the property in GiftCo by not using the provisions of subsection 85(1) and then making a gift under section 86 . Facts i) Same as the prior example except Mrs. X and GiftCo do not elect for the initial property transfer to take place under the provisions of subsection 85(1). As Mrs. X has received consideration of $10,000 (i.e. $900 cash and 910 common shares which have a fair market value of $9,100) for the transfer of the property, she will realize a capital gain of $9,100 ($10,000 - $900) and the 910 common shares of GiftCo will have an adjusted cost base equivalent to their fair market value of $9,100. When Mrs. X exchanges the 910 common shares for 100 Class A preferred shares, the gift amount of $8,100, as calculated in Example 5, will remain unchanged. As a result she will be deemed to have sold the 910 common shares, realizing a capital loss of $1,000 which will be denied under paragraph 86(2)(d). Under the provisions of paragraph 86(2)(e) , the adjusted cost base of the 100 Class A preferred shares, which ordinarily would be the adjusted cost base of the old shares or $9,100, will be ground down by the gift portion of $8,100 to $1,000. The family trust's adjusted cost base for its 90 common shares remains at $90. Note that while the capital gain realized Mrs. X has increased by $1,000 compared to the prior example, the adjusted cost base of the property in GiftCo has increased by $9,100 and the cost base of the 100 Class A preferred shares received by Mrs. X has increased by $1,000. b. PUC Adjustments ss. 86(2.1)

A s. 86 Rollover also can lead to an adjustment in PUC under ss. 86(2.1) in substantively the same manner as has previously been notes under ss. 85(2.1) and s. 84.1. c. Foreign Spinoffs

Excerpts from The Taxation Of Corporate Reorganizations CTa(Andrew W. Dunn, Derek G. Alty, Brian R. Carr, And Christopher J. Steeves The Act did not previously permit Canadian shareholders of US or other foreign corporations to receive share distributions on spin-off transactions without experiencing adverse tax consequences. The United States and other jurisdictions have long had rules that are intended to permit tax-free reorganizations involving a spin-off where a shareholder's economic interests are largely unchanged. In the US context, demergers of public corporations generally qualify for tax-free treatment for US shareholders under the provisions of section 155 of the Internal Revenue Code. [fn 22] Historically, relief from adverse Canadian tax treatment could only be sought administratively by means of a federal remission order. One such remission order was granted in 1985 by the Department of Finance to Canadian shareholders in respect of the court-ordered breakup of American Telephone and Telegraph Company. [fn 23] However, in a 1999 technical interpretation, [fn 24] the CRA noted that it was the Department of Finance's position that a remission order would not be granted if the spin-off was voluntary on the part of the corporation involved.

463 Section 86.1 represents legislative recognition by the Department of Finance that Canadian shareholders should be exempted from tax on foreign spin-offs where such distributions are exempt from tax in the foreign corporation's home jurisdiction. Section 86.1provides that the amount of an "eligible distribution" received by a shareholder shall not be included in computing the shareholder's income. Further, the provisions of subsection 52(2) that provide for a disposition at fair market value for assets distributed as part of a dividend in kind will not apply. [fn 25] As a general rule, where the requirements of section 86.1 are met, the cost amount of a shareholder's original shares is allocated between the original shares and the spin-off shares on a pro rata basis based on fair market value at the time of the distribution. [fn 26] This allocation of the cost amount to the original shares and the spin-off shares applies for all purposes of the Act, including the foreign property provisions contained in part XI. In order for section 86.1 to apply to a transaction, an eligible distribution must be made in respect of all of a shareholder's common shares in the capital stock of the distributing corporation ("the original shares") and the distribution must consist solely of the common shares of another corporation owned by the distributing corporation ("the spin-off shares"). Section 86.1 applies retroactively and may apply to otherwise taxable distributions received after 1997. [fn 27] For these purposes, an "eligible distribution" includes spin-off transactions that are either US distributions or prescribed distributions. Where the spin-off is a US distribution, the transaction must not be taxable in the United States, the original shares held by the shareholder must be widely held and actively traded on a prescribed stock exchange [fn 28] in the United States at the time of the distribution, and both the distributing corporation and the spin-off corporation must be resident in the United States at the time of the distribution and can never have been resident in Canada. A prescribed distribution is defined as a spin-off transaction in a foreign jurisdiction other than the United States which is not taxable under its laws, where at the time of the distribution the shareholder's original shares were widely held and actively traded on a prescribed stock exchange, [fn 29] and where at the time of the distribution both the distributing corporation and the spun off corporation were resident in the same foreign country, other than the United States, with which Canada has a tax treaty and were never resident in Canada. Finally, the distribution must be prescribed subject to such terms and conditions as are considered appropriate in the circumstances. The CRA has indicated that these distributions will be prescribed by regulation and that taxpayers will be required to approach the Department of Finance to request that such regulations be promulgated. [fn 30] For a distribution to qualify as an eligible distribution, the distributing corporation must provide certain information to the minister of national revenue before the end of the sixth month following the day on which the distributing corporation first distributes a spin-off share in respect of the distribution or September 12, 2001 (the day that is 90 days after royal assent), whichever is later. [fn 31] The distributing corporation must provide information establishing that, at the time of the distribution, the shares of the class including the original shares were widely held and actively traded on a prescribed stock exchange; that the distributing corporation and the other corporation were never resident in Canada; the distribution date; the type and value of property distributed to the shareholders resident in Canada; the name and address of each Canadian-resident shareholder; that the distribution is not taxable under the applicable US laws, in the case of an eligible distribution, or the laws of the foreign country, in the case of a prescribed distribution; and such other matters as are required, in prescribed form. [fn 32]

464

The CRA has recently confirmed that it is not the responsibility of the Canadian-resident shareholders to provide the information described above, but rather the responsibility of the distributing corporation. [fn 33] Finally, in order for the distribution to be received tax-free, the shareholder receiving the distribution must make an election in writing filed with the shareholder's tax return for the taxation year in which the distribution was received, as required under paragraph 86.1(2)(f). The shareholder must provide information satisfactory to the CRA to establish the number, cost amount, and fair market value of the original shares immediately before (and after) [fn 34] the distribution; the number and fair market value of the spin-off shares immediately after the distribution; and such other matters as are required, in prescribed form. Where the eligible distribution is made before October 18, 2000, paragraph 86.1(2)(f) requires that the election be filed before July 2001; however, the enabling legislation permits elections to be filed before September 21, 2001. [fn 35] Where the election is made in respect of an eligible distribution that occurred in 1998 or 1999, the Canadian-resident shareholder must provide details concerning the manner in which the distribution was originally reported and details of any subsequent dispositions of original shares and spin-off shares as may be required to determine capital gains and losses. [fn 36] Section 86.1 does not provide for late filed elections, nor is a taxpayer entitled to apply for relief under the Fairness Package in respect of late, amended, or revoked elections. No election under paragraph 86.1(2)(f) is required if the shareholder is subject to part XI, as is the case, for example, for tax-exempt entities and registered deferred-income plans. [fn 37] Special rules are provided with respect to the calculation of the value of property described in the inventory of a shareholder's business. Subsection 86.1(4) provides that an eligible distribution to a shareholder of a spin-off share is deemed not to be an acquisition in the fiscal period of the business in which the distribution occurs and, for greater certainty, the value of the spin-off share is to be included in computing the value of the inventory at the end of that fiscal period. Finally, subsection 86.1(5) allows the CRA to effectively turn back the clock and assess beyond the normal reassessment period if the spin-off transaction ceases to be non-taxable in the relevant foreign jurisdiction and, therefore, no longer meets that condition stipulated in subsection 86.1(2) with respect to eligible distributions. As noted by the CRA, [fn 38] Canadian and US corporations have increasingly been rationalizing their operations and undergoing corporate reorganizations that involve spin-offs. In both circumstances, the economic position of Canadian shareholders of these corporations who receive share distributions has not been changed. Under the current provisions of the Act, Canadian shareholders of Canadian corporations obtain rollover treatment on such share distributions. Now Canadian shareholders of US corporations and, in the future, corporations resident in other foreign countries will at least have the potential to avoid the immediate Canadian taxation of the spin-off distribution. Notwithstanding this potential deferral, the limitations imposed on the application of section 86.1 are significant. First, the requirement that the distribution consist solely of the common shares of another corporation owned by the distributing corporation may severely limit a Canadian shareholder's ability to rely on section 86.1. In many circumstances, corporate bonds and other indebtedness or other different classes of shares are distributed to shareholders as part of a corporate reorganization. Query

465 whether section 86.1 would apply where the distribution included rights under a shareholders' rights plan that arguably have a nominal value. On a practical level, the information requirements imposed on the foreign distributing corporation may also impose a substantial impediment to the utilization of this provision. For example, where a large US multinational corporation is undertaking a corporate spin-off transaction, Canadian shareholders may not be significant enough to warrant the cooperation necessary from the distributing corporation. Presumably, if the US corporation cooperates fully with Canadian tax authorities, it may be obliged to do the same for the jurisdiction of residence of all of its shareholders around the globe. Conclusion Subsection 85.1(5) and section 86.1 are, in many ways, fundamentally quite similar to their "domestic" counterparts, subsection 85.1(1) and section 55. Subsection 85.1(5) is an automatic rule requiring no elections to be filed and of more general application. As a result, some planning opportunities may exist, in particular for non-residents. On the other hand, section 86.1 is very restrictive and requires elections to be made by both the shareholders and the distributing corporation. As a result, there may be very limited circumstances in which all of the conditions for its application will be met. In any event, the introduction of subsection 85.1(5) , section 86.1, and other recent amendments [fn 39] appears to be a signal that the Department of Finance is willing to take significant steps in allowing foreign corporations to improve their access to Canadian capital markets.
Footnotes 22 Internal Revenue Code of 1986, as amended. 23 Remission Order, PC 1985-1476, SI/85-83 (1985), vol. 119, no. 10 Canada Gazette Part II 2203-5. 24 CRA document no. 9922675, September 10, 1999. 25 Notwithstanding the tax deferral for Canadian-resident shareholders, where the spin-off shares are taxable Canadian property, the foreign distributing corporation may be liable for Canadian income tax on any taxable capital gain in respect of the disposition (see subsection 69(4) ). 26 Subsection 86.1(3) . 27 Presumably, to allow reassessments to be issued within the three years permitted under section 152 . 28 Regulation 3201 . 29 Ibid. 30 CRA, "Foreign Spin-Offs," question 6 (available on the Web at http://www.CRAadrc.gc.ca/tax/business/taxtopics/foreign-e.html). 31 Bill C-22, An Act To Amend the Income Tax Act, the Income Tax Application Rules, Certain Acts Related to the Income Tax Act, the Canada Pension Plan, the Customs Act, the Excise Tax Act, the Modernization of Benefits and Obligations Act and Another Act Related to the Excise Tax Act, SC 2001, c. 17, section 64(2)(a). 32 Paragraph 86.1(2)(e) . 33 Supra note 30, at question 7. 34 Ibid., at question 11. 35 Bill C-22, supra note 31, at section 64(2)(b). 36 Supra note 30, at question 12. 37 Section 205 . 38 Supra note 30, at question 2.

39 For example, the increase of the foreign property limit for registered plans to 30 percent (subsection 206(2) ).

Interpretation Bulletin IT-448 - Dispositions - Changes in Terms of Securities

(Information is current as of January 2012)

466 1. Alterations made in the rights, preferences, terms, conditions, restrictions or limitations attaching to shares, bonds, debentures, notes, certificates, mortgages, hypothecs, agreements of sale or similar obligations (hereinafter referred to as "changes in securities") frequently do not fall clearly within the lists of inclusions in, or exclusions from, the meaning of the term "disposition" contained in paragraph 54(c). The purpose of this bulletin is to discuss the factors that the Department considers in determining whether or not a disposition has taken place in such circumstances. However, the Department will not require that a disposition be reported by a holder of an altered security if there are no resultant tax consequences. Additionally, if such a holder fails to recognize a disposition in a situation described in this bulletin and the Department does not assess or reassess to give effect to the disposition within the statutory time limit, the tax consequences of a disposition occurring subsequent to the expiration of this time will be computed as though the prior disposition had not taken place. 2. By virtue of clause 54(c)(ii)(A), any transaction or event that involves the redemption in whole or in part or the cancellation of a security necessarily results in its disposition in the hands of the holder, even though the result achieved could have been accomplished by a change in terms. For example, a change in a right attaching to a security can be effected by an amendment to its original terms or by the cancellation of the original security and its replacement by another security identical in all respects except that the changed right is now incorporated. In the latter case a disposition necessarily takes place, while in the former case the significance of the change is the determining factor. 3. As a general rule, and subject to the first sentence in 2 above, the Department examines the effect achieved by a particular set of changes, rather than the method adopted to accomplish it. For example, the replacement of old share certificates with new certificates when there has been no change in terms does not mean that a disposition has occurred, nor is it to be assumed that no disposition is involved when a change in terms is not accompanied by the issuance of a new certificate. 4. In considering a particular fact situation, the Department endeavours to establish whether or not it is reasonable to regard the amended security being the same property as that which underwent the change. In evaluations of this nature it is obvious that no "hard and fast" rules of universal application can be formulated. The comments that follow must therefore be regarded as guidelines only and may not apply in a particular set of circumstances. 5. The addition of an optional conversion feature to a particular class of security does not generally involve a disposition. Changes in Terms of Debt Obligations 6. A change in the underlying security supporting a debt obligation is not usually regarded as a disposition of the obligation itself because in the normal situation, the holder's claim on the underlying security is only a contingent one. 7. The following changes in respect of the debt obligation itself (unless carried out pursuant to an authorizing provision in its original terms) are considered to be so fundamental to the holder's economic interest in the property that they almost invariably precipitate a disposition: (a) a change from interest-bearing to interest-free or vice versa, (b) a change in repayment schedule or maturity date, (c) an increase or decrease in the principal amount, (d) the addition, alteration or elimination of a premium payable upon retirement,

467 (e) (f) a change in the debtor, and the conversion of a fixed interest bond to a bond in respect of which interest is payable only to the extent that the debtor has made a profit, or vice versa.

8. Exceptions to the general rule set out in 7(b) above are made when the degree of change is minimal and of little relative importance in the circumstances. The general rule stated in 7(e) above is subject to a rollover at an amount equal to the adjusted cost base when a debt obligation of an amalgamating corporation becomes the obligation of the amalgamated entity on identical terms, and will not apply when a third party undertakes with a debtor to discharge the debtor's responsibilities under an obligation, while the debtor's liability to the holders is unaffected. Changes in the Terms of Shares 9. A shareholder's interest in a corporation consists of a bundle of rights and privileges attached to the shares by the articles of incorporation or the directors in accordance with the corporate law of the particular jurisdiction. Any changes in the basic relationships between one class of shareholder and another, and one class of shareholder and the corporation, usually necessitate amendments to the articles of incorporation. If amendments are made with respect to authorized but unissued capital stock, actual shareholder relationships are not involved and dispositions cannot arise. 10. Where there is only one class of share issued or where the holdings of each shareholder in each class are in the same proportion, any change in the rights attaching to a class does not alter their relative interests in the corporation. Thus, no disposition is considered to arise except in circumstances described in 2 above. 11. In some instances, the terms and conditions of an issue of shares will provide for an amendment to its own terms within limits. Where such a power is exercised (whether its authorization can be effected by the Board of Directors acting alone or whether approval of the particular class of shareholders is required), no disposition is involved because the possibility of such a change was always inherent in its bundle of rights. *12, 13. A reduction in paid-up capital that involves the redemption (see 2 above) or cancellation of a share gives rise, by necessity, to a disposition in the hands of the holder by virtue of clause 54(c)(ii) (A) of the Act. However, a reduction in the paid-up capital in respect of a share, not accompanied by a redemption or cancellation of that share, will not constitute a disposition of that share. 14. Following are examples of changes that are normally considered to be of sufficient substance to be regarded as dispositions: (a) a change in voting rights attached to shares that effects a change in the voting control of the corporation; (b) a change in a defined entitlement (e.g., a change in par value) to share in the assets of a corporation upon dissolution (preferred shares only); (c) the giving up or the addition of a priority right to share in the distribution of assets of the corporation upon dissolution; (d) the addition or deletion of a right attaching to a class of share that provides for participation in dividend entitlements beyond a fixed preferential rate or amount; (e) a change from a cumulative to a non-cumulative right to dividends or vice versa. 15. (a) Following are examples of changes that taken singly are not considered to be dispositions: the addition of the right to elect a majority of the directors of the corporation if, at that time, the shareholders of that class are already in a position to control the election of directors;

468 (b) (c) (d) (e) (f) (g) (h) (i) a change in the number of votes per share if the ability of any one shareholder to influence the day-to-day affairs of the corporation is neither enhanced nor impaired thereby; the giving up of contingent voting rights which, in the event they were exercised, would not be of sufficient number to control the affairs of the corporation; restrictions added or removed concerning transfer of shares; the addition of a right of redemption in favour of the corporation; stocks splits or consolidations (see IT-65); a change of shares with par value to shares without par value or vice versa, provided that there is no change in any pre-set entitlements to dividends and/or distribution of assets upon dissolution; a change in ranking concerning preference features, (e.g., 1st preference to 2nd preference); an increase or decrease in the amount or rate of a fixed dividend entitlement.

16. A combination of changes described in 15 above, whether occurring simultaneously or in a series, may, in appropriate circumstances, give rise to a disposition.

ii. Section 51 Conversion

Section 51 is another method of reorganizing the capital of a corporation, which may apply where subsection 85(1) or (2) and section 86 do not apply. It allows the taxpayer to convert debt into shares or shares into shares of a different class (e.g. fixed-value preferred shares) provided that the taxpayer receives no consideration other than the new shares. It has the advantage of permitting a reorganization of only some of the taxpayer's shares rather than all. Under paragraph 51(1)(a), the exercise of the conversion right will be deemed not to be a disposition of property. Under paragraph 51(1)(b), the ACB of the new shares is the ACB of the old shares. Subsection 51(2) is similar to both subsection 86(2) and paragraph 85(1)(e.2) and imposes adverse tax consequences when the FMV of the shares exchanged is greater than the FMV of the new shares issued and it is reasonable to assume that the taxpayer has conferred a benefit on a related person. Again, since nothing new is being acquired by the corporation, the PUC of the new shares cannot exceed the PUC of the old shares or deemed dividends will arise. Note subsection (4), which stipulates that section 51 does not apply to any exchange to which subsection 85(1) or 85(2) or section 86 applies, thus, if the conditions for the application of section 86 are satisfied, it will apply and not section 51. As with section 86, no election is necessary. You should also refer to the PUC adjustments in subsection 51(2.1).

Private Company Reorganizations: Common Problems and Pitfalls

by Cary Heller, John Oakey, & Enzo Testa, Ontario Tax Conference, CTF 2008 The rules in section 51 govern the tax treatment when shares of a corporation are acquired by a taxpayer in exchange for other shares of the corporation or a debt instrument of the corporation which under its term can be converted into shares. Unlike section 86, no consideration other than shares of the same corporation can be received on the exchange. However, there is no requirement that the taxpayer exchange all the shares of the class owned as under section 86. While the provisions of section 51 apply automatically, they specifically have no application if the provisions of subsections

469 85(1) or (2) or section 86 apply.33 Subsection 85(1) and (2) can be avoided by not electing for them to apply, but in order to have section 51 rather than section 86 apply to an exchange of shares it would be necessary to either not exchange all the shares of a class owned by the taxpayer or have the share exchange not occur "in the course of a reorganization of capital", a term which is not defined in the Act. When the provisions of 51 apply, the exchange, unlike an exchange under section 86, is deemed not to be a disposition and the adjusted cost base of the original shares or debt (referred to as "convertible property") becomes the adjusted cost base of the new shares. Curiously, paragraph 51(1)(e) specifically states that for purposes of subsection 74.4 and 74.5 (i.e. the super-attribution rules) an exchange under section 51 will be deemed to be a transfer of the convertible property by the taxpayer to the corporation. Section 86 does not contain a similar deeming provision. Presumably, this is due to section 51 deeming the exchange not to be a disposition for purposes of the Act (other than for the purposes of subsection 20(21) which requires a disposition in order to allow a taxpayer to deduct from income amounts previously reported as interest income) so that without this paragraph sections 74.4 and 74.5 would not otherwise apply as there would be no transfer to a corporation. Subsection 51(2) contains the gifting rules in situations where subsection 51(1) applies and the fair market value of the convertible property exceeds the fair market value of the | new shares and it is reasonable to regard any portion of the excess, or the gift portion, as a benefit the taxpayer desired to have conferred on a related person. In these situations the taxpayer will be deemed to have sold the convertible property for proceeds of disposition equal to the lesser of: i) the total of the adjusted cost base of the convertible property, plus the gift portion; and ii) the fair market value of the convertible property. Any capital loss realized as a result will be denied and the adjusted cost base of the new shares will be the lesser of: i) the adjusted cost base of the convertible property; and ii) the fair market value of the new shares plus the denied loss. Example Section 51 Facts i) Assume the same facts as Example 5 with the exception that Mrs. X purchases one additional common share for $10 and only exchanges 910 of her 911 common shares so that section 51 rather than 86 applies. Under subsection 51(2) the gift portion of $8,100 is determined as the excess of the fair market value of the 910 common shares ($9,100), over the fair market value of the 100 Class A preferred shares ($1,000) received on the exchange. Mrs. X will be deemed to have sold the 910 common shares for proceeds of $8,100, determined as the lesser of: i) the adjusted cost base of the shares (NIL) plus the gift portion ($8,100); and ii) the fair market value of the shares ($9,100). As a result, she will realize a capital gain of $8,100. Mrs. X will have an adjusted cost base of $NIL for her 100 Class A preferred shares, determined as the lesser of: i) the adjusted cost base of the convertible property (i.e. the 910 common shares) ($NIL); and ii) the fair market value of the 100 Class A preferred shares ($1,000) and the denied loss (NIL). The adjusted cost base of the property to GiftCo will be the amount elected under subsection 85(1) or $900 and the cost base of the 90 common shares owned by the family trust remains at $90.

470 Note that this is the same result in all respect as in Example 5. Example Section 51 Facts i) Assume same facts as Example 6 with the exception that Mrs. X purchases one additional common shares for $10 and only exchanges 910 of her 911 common shares so that the provisions of section 51 rather than those of section 86 apply and GiftCo do not elect under subsection 85(1) when the property is transferred to GiftCo. Mrs. X has a $9,100 capital gain ($10,000 - $900) on the initial disposition of the property and her 910 common shares of GiftCo have an adjusted cost base of $9,100. When she exchanges the 910 common shares, having a fair market value of $9,100 for the 100 Class A preferred shares with a fair market value of $1,000, the difference, or $8,100, represents the gift portion. As a result, her deemed proceeds of disposition on the exchange are $9,100, determined as the lesser of: i) the adjusted cost base of the 910 common shares ($9,100) plus the gift portion ($8,100), for a total of $17,200; and ii) the fair market value of the 910 common shares ($9,100). | As her deemed proceeds of $9,100 are equal to her adjusted cost base, there is no capital gain or loss on the exchange. Her adjusted cost base for the 100 Class A preferred shares will be $1,000, being the lesser of: i) the adjusted cost base of the 910 common shares ($9,100); and ii) the fair market value of the 100 Class A preferred shares ($1,000) plus the denied loss (NIL).

3. Consolidation of Taxable Canadian Corporations: Section 87 i. Overview

Excerpts from Amalgamations and Wind-ups by Ronald M. Richler. Tax Law for Lawyers. National Tax Law CLE Conference, Canadain Bar Association 2010. Amalgamations Overview Amalgamation is one of the key tools available to lawyers in reorganizing and merging corporations. From a legal and commercial perspective, amalgamation has the advantage of being a relatively straightforward transaction in the sense that if the requisite conditions can be met, the assets and liabilities of the predecessor corporations automatically become assets and liabilities of the amalgamated corporation on the effective date of the amalgamation without the need for complicated conveyancing. From a tax perspective, if one is aware of certain pitfalls and traps, amalgamation can produce excellent results. On the amalgamation, tax deferrals will usually be available at both the shareholder and predecessor corporation levels, transfer taxes will not be eligible and there will be no doubling up of employer contributions to the Canada Pension Plan and employment insurance. These results flow automatically without the need to file tax elections. Tax Considerations

471 Qualifying Amalgamation Section 87 contains numerous provisions that essentially result in tax-deferred rollovers for shareholders and other security holders of the predecessor corporations and rollovers and continuity of tax accounts for the predecessor corporations.5 Not all amalgamations that can be done for corporate purposes qualify under section 87. In order to qualify as an amalgamation for the purposes of section 87, the following conditions must be met (and certain relevant points are noted in respect of these conditions): There must be a merger of two or more corporations each of which was immediately before the merger, a "taxable Canadian corporation" to form one corporate entity.6 A "taxable Canadian corporation" is defined in subsection 89(l) to mean a corporation that is a "Canadian corporation" and not exempt from tax under Part 1. A "Canadian corporation" is defined in subsection 89(l) to mean a corporation that is resident in Canada and either incorporated in Canada or resident in Canada since June 18, 1971. For this purpose, a corporation resulting from the amalgamation of Canadian corporations is considered to be incorporated in Canada. By virtue of subsection 250(5.1), a corporation continued into Canada from outside the country is considered after the time of continuation to have been incorporated in Canada. All of the property (except amounts receivable from any predecessor corporation or shares of any predecessor corporation) of the predecessor corporations immediately before the merger must become property of the amalgamated corporation by virtue of the merger. Under certain corporate statutes, it is permissible for cash to be given as consideration or partial consideration for the exchange of shares of a predecessor corporation. If the cash were to come from one of the predecessor corporations, the cash would not become property of the amalgamated corporation, thereby disqualifying the amalgamation under subsection 87(l). As will be seen in the discussion below regarding rollovers available at the shareholder level, it is possible to achieve the same result by using redeemable shares that are redeemed shortly after the amalgamation. The CRA has taken the position that section 87 will apply where a shareholder receives cash or other property in lieu of a fractional share.7 The CRA has also taken the position that an amalgamation will not be disqualified when a leasehold or royalty interest of one predecessor corporation in the assets of another predecessor corporation is eliminated because the interests merge on the amalgamation.8

Checklists for amalgamations and wind-ups can be found in Catherine A. Brayley, "Merging Companies: A Practical Checklist for Amalgamations and Wind-Ups", in Report of the Proceedings of the Fifty-Second Tax Conference, 2000 Conference Reports (Toronto: Canadian Tax Foundation, 2001), 6:1-62. 6 Section 87 also das with mergers of foreign corporations but this topic is not covered in this paper. 7 Interpretation Bulletin IT-474R, paragraph 39. 8 Ibid., paragraph 5.

472 Similarly, if one predecessor corporation has a right or option to acquire shares of another predecessor corporation, the amalgamation will not be disqualified even though the right or option terminates on the amalgamation.9 Section 87 contemplates that one corporation may own shares of another predecessor corporation which will be cancelled on the amalgamation and the CRA has confirmed that no gain or loss will be realized on such cancellation10; but, as discussed below, gain can be realized by the parent predecessor corporation in respect of the shares of the subsidiary predecessor corporation that are cancelled on a vertical amalgamation, and, pursuant to the forgiveness of debt rules, gain can be realized if the adjusted cost base of the cancelled shares had previously been reduced under these rules. All of the liabilities (except amounts payable to any predecessor corporation) of the predecessor corporations immediately before the merger must become liabilities of the amalgamated corporation by virtue of the merger. All of the shareholders (except any predecessor corporation) who own shares of any predecessor corporation immediately before the merger must receive shares of the amalgamated corporation because of the merger. In order to accommodate vertical and horizontal short-form amalgamations, subsection 87(l. 1) deems shares of a predecessor corporation not cancelled on the amalgamation to be shares of the amalgamated corporation received by virtue of the merger provided that the amalgamation involves "subsidiary wholly-owned corporations". For this purpose, a "subsidiary wholly-owned corporation" does not have its usual definition in subparagraph 248(l) but rather means a corporation wholly-owned by another corporation, a subsidiary wholly-owned corporation of the other corporation or any combination of such persons.11 In order to accommodate certain triangular amalgamations, paragraph 87(9)(a) provides that shares received by a shareholder of a predecessor corporation from a taxable Canadian corporation that controls the amalgamated corporation immediately after the merger (the "parent") are deemed to be shares of the amalgamated corporation received by the shareholder by virtue of the merger. If a dissenting shareholder asks to receive cash, there is an interesting theoretical issue, given that the only rights a dissenter has are to receive payment of the fair value of the dissenter's shares, as to whether the dissenter has ceased to be a shareholder of the predecessor corporation prior to the amalgamation or, if not, whether the dissenter became a shareholder of the amalgamated corporation. The CRA has taken the position that a dissenting shareholder ceases to be a shareholder and that the amalgamation is not disqualified in these circumstances. 12 The CRA also is of the view that the dissenter realizes a capital gain or loss on payment, rather than a deemed dividend, on the basis that payment is received from a corporation different from that in which the dissenter was a shareholder.13 If on a squeeze-out amalgamation shareholders receive redeemable shares that are redeemed immediately following the amalgamation so that those shareholders cease to be shareholders of the
9

Ibid. Ibid., paragraph 42. This position is to be codified under proposed amendments to paragraph (n) of the definition of "disposition" in subsection 248(l) released on December 20, 2002. 11 Subsection 87(1.4). 12 CRA Document No. 2001-0091465, July 30, 200 1, and Interpretation Bulletin IT-474R, paragraph 8. 13 1987 CRA Round Table, question 59 and 1993 CRA Round Table, question 56.
10

473 amalgamated corporation, the CRA has taken the position that it would not apply the general antiavoidance rule to, among other things, disqualify the amalgamation.14 The merger cannot be a result of the acquisition of property of one corporation by another corporation pursuant to the purchase of that property by the other corporation or as a result of the distribution of that property to the other corporation on the winding-up of the corporation. If these conditions are met, the amalgamation will qualify under section 87 without the need for any elections to be filed. If an amalgamation does not qualify under section 87, it is likely that the predecessor corporations would not be regarded as disposing of their assets on the amalgamation if, under the relevant corporate law, the predecessor corporation does not cease to exist but rather continues as part of the amalgamated corporation.15 Nevertheless, it is usually considered desirable that an amalgamation qualify under section 87 because there would be considerable uncertainty about continuity of the various tax accounts and other tax attributes provided for at length in section 87 if that section were not applicable.16 Further, the rollover, described below, at the shareholder level would not be available with the result that shareholders would be deemed to have a taxable disposition for capital gain and loss purposes.17 Rules Applicable to Shareholders Rollover The definition of "disposition" in subsection 248(l), which is relevant to shareholders who hold their shares of a predecessor corporation as capital property, provides that a disposition includes a transaction by which any share is converted by virtue of an amalgamation of merger. Shareholders who hold their shares of a predecessor corporation as capital property will be entitled to a tax-deferred rollover under subsection 87(4) if the following conditions are met. The amalgamation must be a qualifying amalgamation under section 87, as described above. The shareholder must receive no consideration for the disposition of the shareholder's shares on the amalgamation other than shares of the amalgamated corporation. That is, no non-share consideration (boot) is permissible but, as noted above, the CRA permits cash to be received in lieu of fractional shares and has taken the position that the general anti-avoidance rule will not be applied if a shareholder receives redeemable shares that are immediately redeemed for cash. Because boot with even insignificant value would disqualify a shareholder from the rollover, one must be very careful that there are no related agreements that give the shareholder additional rights, such as rights to put the shares to another person or rights to vote the shares of another corporation.
14 15

Information Circular 88-2, paragraph 28. 1992 CRA Round Table, question 26 and CRA Document No. 2002-0169775. 16 The CRA has taken the position that the tax accounts and other tax attributes of the predecessor corporations would not flow through to the amalgamated corporation on a non-qualifying amalgamation: CRA Document No. 0003385, February 2, 2000. 17 It has been suggested that the rollovers under subsection 85(l) or 86(l) may apply but there is considerable doubt in this regard. See Alan M. Schwartz, supra footnote 3, at 9:74 75.

474

An issue that caused consternation within the tax community was a recent position of the CRA that rights under a typical shareholder rights plan do not form part of the bundle of rights that constitute a share and, therefore, might be considered to be boot. Many public corporations have shareholder rights plans that are designed to protect the corporation from an unfair takeover bid. Typically, the rights do not trade separately from the shares until certain defined events, at which point the rights permit shareholders to purchase shares at a significant discount. In fact, however, it is highly unlikely that the rights would ever be exercised. Instead, shareholder rights plans are designed to allow the directors a restricted amount of time to find a competing bidder. On an amalgamation, shareholders may receive such rights together with shares of the amalgamated corporation (or, on a triangular amalgamation, together with shares of the parent). Based on the CRA's position, there was concern that the rollover under subsection 87(4) (and other provisions such as subsections 51(l) and 85.1(1) that permit no boot) would not be available if shareholder rights were received together with shares. Fortunately, late in 2002, the CRA issued a favourable ruling that the rollover under subsection 87(4) would not be denied in these circumstances on the basis that the rights were received incidentally and not as "consideration" for the shares of the predecessor corporation.18 The CRA was able to reach this conclusion because the shareholder rights plan could have been cancelled before the amalgamation, the existence of the plan at the time of the amalgamation was not a condition to the amalgamation occurring and rights were not promised to, or bargained for by, the shareholders. To accommodate certain triangular amalgamations, paragraph 87(9)(a) provides that shares received by a shareholder of a predecessor corporation from the parent are deemed to be shares of the amalgamated corporation received by the shareholder by virtue of the merger. It must not be reasonable to regard the shareholder as desiring to confer a benefit on a related person in circumstances where the shares received by the shareholder on the amalgamation are worth less than the shares of the predecessor corporation held by the shareholder. If this condition is not met, the shareholder can realize a gain under paragraph 87(4)(c). If all these conditions are met, the shareholder will be deemed to have disposed of the shareholder's shares of a predecessor corporation for proceeds equal to their adjusted cost base immediately before the amalgamation. Accordingly, the shareholder will not realize a capital gain. It would appear that a shareholder would realize a capital loss if the shareholder had costs of disposition, however, it would be unusual in the context of an amalgamation for a shareholder to have any such costs.19 Under subsection 87(4), the shareholder is deemed to have acquired the shares of the amalgamated corporation at a cost equal to the shareholder's adjusted cost base of the shares of the predecessor corporation. If more than one class of shares of the amalgamated corporation are acquired by the shareholder, that cost is pro-rated between the classes based on their relative fair market values. The CRA has, however, taken the position that a shareholder who holds shares of two classes of a predecessor corporation that are each exchanged for shares of like classes of the amalgamated corporation can ignore the shift of cost between classes that would otherwise result and, instead, retain the same cost per class.20
18 19

CRA Document No. 2002-017716, December 19, 2002. Note that if the shareholder is subject to the conferral of benefit provisions, its capital loss is deemed to be nil under paragraph 97(4)(d). 20 Interpretation Bulletin IT-474R, paragraph 40 which contains the following illustration: For example, a shareholder might be in the following position:
ACB of shares in predecessor corporationsFMV of shares in new corporationCost of shares of new corporation under 87(4)preferred$1,000$1,000$110common1009,000990$1,100$10,000$1,100However, in this example, if the amalgamation

475

Rollover on Short-Form Amalgamation Notwithstanding that the amalgamated corporation does not issue shares on a vertical short-form amalgamation (the shareholders of the parent corporation continue as shareholders of the amalgamated corporation), the CRA takes the position that the shares of the parent corporation are converted to shares of the amalgamated corporation, that there is a disposition of those shares for the purposes of the definition of "disposition" in subsection 248(l) and that the rollover under subsection 87(4) applies.21 Moreover, the CRA takes the position that if there was more than one class of shares of the parent corporation, it would not apply paragraph 87(4)(b) to shift the adjusted cost base among the classes.22 With respect to a horizontal short-form amalgamation, while there does not appear to be any statutory provision that permits the parent corporation to add its adjusted cost base of its shares of predecessor corporations that are cancelled to its adjusted cost base of the shares of the predecessor corporation that are not cancelled, the CRA has taken the position that subsection 87(4) permits the adjusted cost base of the shares of the predecessor corporations to be aggregated in determining the parent's adjusted cost base of the amalgamated corporation.23

ii. Mechanics
Under subsection 87(1) an amalgamation is defined to mean a merger of 2 or more corporations, all of which are taxable Canadian corporations ("predecessor corporations"), to form one corporate entity ("the new corporation") in such a manner that: a. all of the property of the predecessor corporations becomes the property of the new corporation, b. all liabilities of the predecessor corporations become the liabilities of the new corporation by virtue of the merger, and c. all of the shareholders of the predecessor corporations receive shares of the capital stock of the new corporation by virtue of the merger, otherwise than as a result of the acquisition of property of one corporation by another or as a result of the winding-up of one corporation into another. The Act will deem certain corporate mergers to be amalgamations for the purposes of this section. Subsection 87(1.1) where a corporation and one or more of its subsidiary wholly-owned corporations, or two or more corporations each of which is a subsidiary wholly-owned corporation of the same corporation amalgamate and no shares are issued by the new corporation on the amalgamation, the condition in paragraph 87(1)(c) will be deemed to have been met. A "subsidiary wholly-owned corporation" is defined in subsection 87(1.4). The following illustrates the types of amalgamations this subsection provides for:
agreement provided that the preferred and common shares of the predecessor corporation are to be converted into preferred and common shares respectively of the new corporation, the Department will accept a cost of the preferred and the common shares of the new corporation of $1,000 and $100 respectively. 21 CRA Document No. 2001-0104355, November 1, 2002. 22 CRA Document No. 9226095, September 23, 1992. 23 CRA opinion of September 16, 1981 referred to in Claude Dsy, ed., Access to Canadian Income Tax (Markham, Ontario: Butterworths) (looseleaf), paragraph 87-62.

476

Parent Co. Parent Co.

100% Sub Co.

Paragraph 87(1.1)(a)

Parent Co. 100% 100%

Parent Co. 100%

Sub 1

Sub 2

Sub Co.

Paragraph 87(1.1)(b) In both these situations, no new shares are issued. The shareholders hold shares in Parent Co. both before and after the amalgamation. Subsection 87(9) also provides that where a wholly owned subsidiary of a taxable Canadian corporation (the "Parent corporation") amalgamates with another taxable Canadian corporation to form a new corporation which is controlled immediately after the merger by the Parent corporation that the third requirement in paragraph 87(1)(c) will be deemed to have been met. The following illustrates this type of amalgamation:

Parent Co.

Parent Co.

Sub Co.

Amalgamate s with

Public Co.

New Co.

477

Paragraph 87(9) When these requirements are met, a rollover is provided: 1. for the disposition of property by the predecessor corporations to the new corporation, and

2. for the shareholders of the predecessor corporations who would otherwise be deemed have disposed of their old shares. These rollovers are automatic, not elective. The CRA was Right: Section 87 is not Redundant By Joel Nitikman, Gordon Chu, and Michelle Moriartey, Canadian Tax Journal, 2008 *NOTE: This article discusses the Tax Court case . The case was upheld by the Federal Court of Appeal in 2009. CGU Holdings Canada Ltd. v. The Queen [2008 TCC 167 & 2009 FCA 20] Introduction Subsection 87(1) of the Income Tax Act defines an "amalgamation" ("a section 87 amalgamation") for the purposes of section 87 as a merger where the property, liabilities, and shareholders of the predecessor corporations ("the predecessors") as they existed the instant before the merger become the property, liabilities, and shareholders of the merged corporation ("Amalco") by virtue of the merger. The Act sometimes uses the word "amalgamation" outside the context of section 87 without defining it. In those cases, it appears that the reference is to any merger that is an amalgamation under corporate law, even if it is not a section 87 amalgamation ("a non-qualifying amalgamation"). If there is a section 87 amalgamation, subsection 87(2) treats Amalco, on the one hand, as a new corporation and, on the other hand, as a continuation of and the same corporation as the predecessors, so that many (but not all) of their various tax accounts flow through to Amalco. For many years, people have wondered what would happen to the predecessors' tax accounts on a non-qualifying amalgamation. One might say that, because under provincial and federal corporate law Amalco is deemed to be a continuation of the predecessors, the tax accounts should flow through to Amalco. There are three reasons why this is unlikely to be the correct answer. First, under most corporate statutes, the predecessors amalgamate to "continue" as one corporation, but Amalco is not deemed to be the "same" corporation as the predecessors. There is a specific vesting provision in each corporate statute that ensures that Amalco is deemed to own and be subject to the property and liabilities of the predecessors, which presumably would not be required if Amalco were the same corporation as the predecessors.

478 Second, if tax attributes flowed through to Amalco on a non-qualifying amalgamation, section 87 would be unnecessary and redundant. This would also defeat the purpose of the many sections in the Act that purport to apply only to a section 87 amalgamation. If those sections applied even on a non-qualifying amalgamation, the reference to section 87 in those sections would be meaningless. Moreover, this interpretation could lead to consequences clearly not intended by Parliament. For example, subsection 87(2.1) limits the carryback of losses from Amalco to a predecessor on a section 87 amalgamation, but if tax accounts flowed through on a non-qualifying amalgamation, then there would be no limit on loss carrybacks on a non-qualifying amalgamation. It is hard to imagine that Parliament intended this result. Third, at the shareholder level, subsection 87(4) provides a rollover on a section 87 amalgamation. On a non-qualifying amalgamation, the shareholders appear to have a potential gain or loss on the disposition of the shares of the predecessors. If tax accounts flow through on a non-qualifying amalgamation because Amalco is simply a continuation of (that is, the same corporation as) the predecessors, it is hard to see how there could be a disposition of the shares of the predecessors. But then the rollover in subsection 87(4) is completely unnecessary. The scheme of the Act appears to be that if the predecessors merge in a section 87 amalgamation, then they and Amalco get the benefits and the burdens of section 87, such that some tax accounts flow through and some do not, but with a guaranteed rollover at the shareholder level. If the predecessors merge under a non-qualifying amalgamation, then none of the tax accounts flow through (which may be good or bad, depending on the situation), and there is no rollover at the shareholder level. The CRA has taken the position that tax accounts do not flow through on a non-qualifying amalgamation, on the basis that if they did, section 87 would be redundant. Nevertheless, until the CGU case, the law on the point had not been clear. The CRA now appears to have been correct. The Facts GA Scottish was a Canadian corporation that was a "non-resident-owned investment corporation" (NRO). Under section 133, an NRO is a Canadian corporation owned by non-residents that is effectively taxed as if it were a non-resident of Canada. It pays a federal tax of 25 percent on its taxable income, which is refunded when the NRO pays or is deemed to pay dividends to its shareholders. That dividend is subject to a 25 percent withholding tax under part XIII, so that the net tax to the NRO and its shareholders is 25 percent. GA had a refundable tax account of $1.2 million for its taxation year ending February 29, 1999. On March 2, 1999, pursuant to the Canada Business Corporations Act (CBCA), GA amalgamated with two other corporations to form CGU. The amalgamation was a section 87 amalgamation. The two other corporations were not NROs. As a result, CGU was not an NRO pursuant to paragraph 133(8) (g), which requires all predecessors to be NROs before Amalco can be an NRO. In 2000, the Act was amended to phase out the NRO regime. However, that presented a timing problem, because an NRO cannot pay a dividend to recover its refundable tax until a year after the income creating the refundable tax is earned. If NROs were totally phased out in 2000, no dividends could be paid in 2001 to recover the federal tax paid in 2000. As a result, section 134.1 allows a corporation that was an NRO in a taxation year and stopped being an NRO in the following taxation year to elect to remain an NRO in that subsequent year. The Issue In the first taxation year following the amalgamation, CGU filed an election under section 134.1 in its name (that is, not in the name of GA) and CGU paid a dividend. It claimed a refund under section 133.

479 The CRA denied the refund on the basis that no election was permitted and that in any case CGU had no refundable tax account. Analysis CGU argued that, under corporate law, predecessors that amalgamate with each other do not cease to exist; they remain in existence inside Amalco. Thus, while CGU admitted that it was not the same company as GA, it argued that GA continued to exist, that GA had been an NRO and was not now an NRO, and that GA was therefore | entitled to make the election. Interestingly, CGU then argued that it (CGU) could make the section 134.1 election. (Presumably this argument was required because GA as a separate corporation, although notionally continuing to exist, had no employees or representatives who could file the election.) The court agreed with the Crown that Parliament likely never intended an amalgamated entity in CGU's position to be able to file the election, but nevertheless agreed with CGU that an election could be filed. As interpreted by previous case law, paragraph 87(2)(a), which deems CGU to be a new corporation, does not mean that GA ceased to exist because of the amalgamation. Further, CGU was a new corporation only for purposes of provisions dealing with the calculation of income and taxable income; the election was not such a provision. Since GA continued to exist after the amalgamation and GA was an NRO before the merger but not after, it met the conditions of section 134.1. The court noted that the Act had not been amended to overrule the case law limiting the effect of paragraph 87(2)(a); it therefore saw no reason to impose any limitation in this context, regardless of Parliament's likely intention in respect of section 134.1. According to the court, the Crown did not seriously argue that if an election were available, then CGU could not file it in its name rather than in GA's name. So the election was permitted and CGU was deemed to be an NRO. Although this aspect of the case rested on corporate law applicable to non-qualifying amalgamations, it did not deal with whether tax accounts flow through. It merely confirmed that the predecessors continue to exist after an amalgamation unless the corporate statute or the Act says otherwise. The fact that CGU was deemed to be an NRO was not the end of the case. CGU would win only if GA's refundable tax account flowed through to it on the section 87 amalgamation. Such a flow through was permitted for amalgamating NROs by subparagraph 87(2)(cc)(i). But nothing in section 134.1 referred to that subparagraph. The Crown therefore argued that GA's refundable tax account did not flow through to CGU. CGU made two arguments in response. First, CGU argued that the election in section 134.1 would be useless unless it automatically carried with it GA's refundable tax account. The court, however, was not persuaded by that argument. According to the court, it was a mere accident of wording and the historical limitation on the effect of paragraph 87(2)(a) that an election was permitted at all; the election was never really intended in these circumstances, and therefore it could not be assumed that the election automatically carried with it a flow through of the refundable tax accounts. It is difficult to dispute this conclusion; it seems clear that Parliament assumed that any election would be made by a corporation (including an Amalco under subparagraph 87(2)(cc)(i)) that had a refundable tax account, not that the election created or preserved an account that did not otherwise exist. CGU's second argument was that under the amalgamation provisions of the CBCA, CGU was deemed to be a continuation of GA and, moreover, all of GA's property, rights, and interests were deemed to belong to CGU. Thus, GA's refundable tax account belonged to CGU.

480

The court did not agree. It was clear to the court (and not disputed by CGU) that being a "continuation" of the predecessors did not mean that CGU was the "same corporation as" the predecessors. Further, the court noted that the refundable account was a notional tax account that existed only for purposes of the Act. It was not a property, right, or interest for purposes of the CBCA. The refundable account could not flow through to CGU unless the Act expressly flowed it through. That was done in subparagraph 87(2)(cc)(i), but that subparagraph did not apply to deemed NROs under section 134.1. CGU, therefore, had no refundable tax account and the dividend that it paid could not give rise to a refund. As discussed above, it is difficult to argue with this aspect of the judgment. Although the court did not say so expressly, section 87 and all the other provisions that apply only to section 87 amalgamations would be redundant if tax accounts flowed through on a non-qualifying amalgamation. Parliament appears to have enacted a complete code on the subject of tax accounts flowing through; there is no room to apply corporate law to notional tax accounts where section 87 does not apply, even though Amalco is a continuation of the predecessors. As the court said, notional tax accounts do not exist outside the four corners of the Act. It is not surprising that a corporate continuation under a provincial or federal corporate statute does not bring a notional tax account with it. Conclusion It is rare to have even one case decided on a fundamental principle such as the legal effect of an amalgamation. With Dow Chemical Canada Inc. v. The Queen and now CGU, we have had two in the past six months. What conclusions can be drawn from these cases? 1. Under corporate law, an amalgamated corporation is a continuation of the predecessors but it is not the same corporation as the predecessors.38 2. Various tax provisions may change that rule for specific purposes and deem the amalgamated corporation to be not only a continuation of the predecessors but in fact the same corporation as the predecessors. 3. Because of the first rule, notional tax accounts do not flow through to the amalgamated corporation under corporate law. They may flow through under | the second rule. If they do not flow through under the second rule, they cease to exist. 4. Except as otherwise prescribed by corporate law, predecessor corporations continue to exist "inside" the amalgamated corporation,39 but they do not have taxation years, file elections (or presumably anything else), pay dividends or obtain refunds, or have any other tax presence. Paragraph 87(2)(a) is a limited provision that applies only for purposes of calculating Amalco's income and taxable income (and presumably for any other section that depends on one of those two things). 5. The Act deems Amalco to be related to its predecessors (in some situations) after Amalco comes into being, but it is not dealing at arm's length with them before it exists.40 6. Section 87 and those sections that refer to a section 87 amalgamation form a complete code on the tax consequences of an amalgamation. It is not the court's role to fill any gap revealed in that code, whether filling that gap would benefit the taxpayer (CGU) or the Crown (Dow Chemical).41

4. Dissolution of Corporations: Section 88 Winding-Up i. Overview

Excerpts from Amalgamations and Wind-ups by Ronald M. Richler. Tax Law for Lawyers. National Tax Law CLE Conference CBA ( with permission)

481 From a tax planning perspective, there are two main categories of corporate wind-ups. The first, and the focus of this portion of the paper, is the wind-up of a subsidiary that is at least 90% owned by the parent and that qualifies for the rollover provisions of subsection 88(1). The second, which will be briefly described for comparison purposes, is a taxable wind-up. A wind-up under subsection 88(1) can be considered as an alternative to a vertical amalgamation under section 87 in that it can result in tax deferrals and continuity of tax accounts. A wind-up is a more difficult transaction from a legal and commercial perspective than an amalgamation because it involves, among other things, conveyancing of assets, consents of third parties, the potential for liability for certain transfer taxes and a continuing process following the general conveyance of assets to the parent to obtain articles of dissolution. For these reasons, a vertical amalgamation is usually the preferred route if it is available. In the past, there were two tax advantages available to a wind-up under subsection 88(1) that were not available on a vertical amalgamation, namely, the ability to bump up the cost of certain nondepreciable capital property of the subsidiary and the ability to carry back losses realized after the merger to shelter income of the parent before the merger. As seen in the previous section, vertical amalgamations have been put on an equal footing with wind-ups in these two respects. Accordingly, there are now even fewer occasions where a wind-up under subsection 88(1) would be preferred to a vertical amalgamation. Nevertheless, there are a number of situations where a wind-up would be considered: A wind-up could be used to merge a subsidiary with its parent in circumstances where an amalgamation is not possible under the relevant corporate law. For example, a subsidiary incorporated under the laws of Quebec could not be amalgamated with a CBCA parent and could not first be continued under the CBCA. It could, however, be wound up into the CBCA parent. The corporate law governing wind-ups does not require that the parent be governed by the same corporate statute as the subsidiary. Because a wind-up does not give rise to a deemed year-end of the parent (or the subsidiary), a wind-up might be considered if the merger could not take place at the time of the normal year-end of the parent and if it is undesirable to have a deemed year-end of the parent. Timing in respect of use of loss carryforwards inherited from a subsidiary differs depending on whether the merger is by way of wind-up or amalgamation. The fact that a parent does not have access to such losses until its first taxation year following the windup is often considered a disadvantage but, as will be seen, there are certain circumstances where a wind-up can extend the life of such losses. A wind-up of a subsidiary that is a public corporation would not result in the parent being deemed to be a public corporation whereas an amalgamation would result in the amalgamated corporation being a public corporation.

Subsection 88(1) applies to certain wind-ups where minority shareholders dealing at arm's length with the parent own up to 10% of the shares of the subsidiary. While an amalgamation of the parent and

482 the subsidiary could occur in these circumstances with the minority shareholders receiving shares of the amalgamated corporation (or shares of the parent on a triangular amalgamation), a vertical amalgamation could not. Therefore, the tax advantages of a vertical amalgamation, including the two noted above and the continuity of resource expenditures without streaming under subsection 97(1.2), would not be available. Having said this, doing a wind-up under subsection 88(1) when there are minority shareholders gives rise to a number of issues. Under general corporate law principles, shareholders must be treated alike; accordingly, it may not be possible to distribute cash or property of one type to the minority shareholders while transferring a business or property of another type to the parent. Also, as will be seen, the distribution of property to the minority shareholders is a taxable transaction to the subsidiary and to the minority shareholders. In my experience, minority shareholders are usually dealt with through mandatory force-out provisions of the relevant corporate statute or squeeze-out transactions rather than through wind-up procedures. Corporate Law Corporate law provides various procedures for both voluntary and involuntary wind-ups of a corporation. Because we are considering tax planning for mergers, only voluntary wind-ups will be considered. One must, of course, look to the corporate law in the jurisdiction in which the corporation was incorporated or continued. The following deals with corporations governed by the CBCA, but provincial law is similar. The CBCA provides two distinct methods to voluntarily wind-up a corporation. The simpler procedure, and the one most often used in the context of a wind-up of a wholly-owned subsidiary, is subsection 210(3) of the CBCA. Under this procedure, a corporation that has property or liabilities or both may be dissolved by special resolution of the shareholders (or, if it has more than one class of shares, by special resolution of the holders of each class whether or not they are otherwise entitled to vote) if: (a) (b) by the special resolution the shareholders authorize the directors to cause the corporation to distribute any property and discharge any liabilities; and the corporation has distributed any property and discharged any liabilities before it sends articles of dissolution to the Director.

The usual practice, in the case of a wholly-owned subsidiary, is to execute a general conveyance of assets to the parent and an assumption of liabilities by the parent shortly after passage of the special resolution. The subsidiary then proceeds to obtain any necessary third party consents and registers specific conveyances of assets in much the same manner as on a sale of assets. The checklist of items to be completed would include transferring employees and considering implications under any union agreements, reviewing contracts for assignability, ensuring that intellectual property rights are properly transferred and considering whether filing articles of dissolution must be deferred until any litigation involving the subsidiary is completed. With regard to liabilities, subsection 210(3) requires that these be discharged before filing the articles of dissolution. The assumption of liabilities by the parent at the time of the general conveyance would not, generally, result in a discharge of the liability. Accordingly, it is necessary to proceed to either have the parent pay the liabilities in the normal course or have the creditors consent to a novation of the debt so that only the parent is liable thereon.

483 If a tax-clearance certificate under subsection 159(2) is not obtained prior to the distribution of property, the directors of the subsidiary may be liable for the payment of taxes owing by the subsidiary up to the value of the property distributed. As a practical matter, the certificate is usually not requested in the case of a wholly-owned subsidiary. Instead, the parent would assume liability for taxes and indemnify the directors. This avoids the often lengthy delays in obtaining a subsection 159(2) certificate and permits the distribution of property to occur shortly after the passage of the special resolution. In the case of a wind-up under provincial corporate law (for example, the OBCA), the consent of the provincial revenue authorities may be required before articles of dissolution can be filed. Often, a considerable period of time will pass between the passage of the special resolution and the general conveyance until the corporation is in a position to file articles of dissolution. Once the articles are filed, the Director must issue a certificate of dissolution and, pursuant to subsection 210(6), the corporation ceases to exist on the date shown in the certificate of dissolution. A more involved procedure is provided under section 211 of the CBCA. This procedure also commences with the passage of a special resolution but requires filing a statement of intent to dissolve with the Director, at which point the corporation must cease to carry on business except to the extent necessary for the liquidation. The corporation must take reasonable steps to give notice of its intent to dissolve in each province where it carried on business and must notify each of its creditors. The corporation must adequately provide for the payment or discharge of all of its obligations. It then distributes any remaining property to its shareholders. At this point, it can file articles of dissolution and receive a certificate of dissolution. Under subsection 211(16), the corporation ceases to exist on the date shown in the certificate of dissolution. The section 210 procedure would usually be used in preference to the section 211 procedure on the wind-up of a wholly-owned subsidiary. If, however, the more complicated section 211 procedures are used, the subsidiary would, in practice, enter into a general conveyance of its assets to its parent and assumption of liabilities by the parent and follow the same checklist of steps to properly convey its assets to the parent. In respect of either procedure, subsection 226(2) of the CBCA provides, among other things, that a civil, criminal or administrative action or proceeding may be brought against a corporation that has been dissolved within two years after its dissolution as if the corporation had not been dissolved. Subsection 226(4) goes on to provide that a shareholder to whom any property has been distributed is liable to a person claiming under subsection 226(2) to the extent of the amount received by that shareholder on the distribution, and an action to enforce such liability may be brought within two years after the date of the dissolution. The Federal Court -Trial Division held that the Minister could assess tax against a corporation that had been dissolved and the corporation could object to the assessment under the analogous provision of the OBCA.24 Tax Considerations Wind-up Where Subsection 88(1) Not Applicable
24

460354 Ontario Limited, 95 D.L.R. (4h) 351; confirmed by the Federal Court of Appeal in The Queen v. Sarrif 94 DTC 6229. But see 510492 BC Limited v. The Queen, 2001 DTC 124 in which the Tax Court of Canada held that a corporation that had been assessed prior to dissolution could not appeal the assessment following its dissolution because the corporation was governed by the BC Company Act which did not have a provision analogous to subsection 226(2) of the CBCA.

484 To understand the implications of subsection 88(1), it is first necessary to describe the tax implications of a wind-up not eligible for the rollover provisions of that subsection. The main provisions that apply to a wind-up not eligible for the rollovers ofsubsection 88(1) are subsections 69(5), 84(2) and 88(2).25 Under subsection 69(5), on the wind-up of a corporation, the corporation is deemed to have disposed of the property appropriated to, or for the benefit of, a shareholder for proceeds of disposition equal to its fair market value immediately before the wind-up, and, the shareholders are deemed to have acquired the property at a cost equal to the same amount. If the corporation realizes a loss on property disposed of on the wind-up, paragraph 69(5)(d) provides that the various "stop-loss" rules referred to therein are not applicable. Under subsection 84(2), a dividend will be deemed to have been paid by a corporation resident in Canada when it distributes or otherwise appropriates property to or for the benefit of its shareholders on the "winding-up, discontinuance or reorganization of its business". The amount of the dividend is the value of the funds or property distributed or appropriated less the amount, if any, by which the paid-up capital in respect of the shares of the corporation is reduced. As pointed out in Interpretation Bulletin IT-126R2, the term "winding-up" is used in the Act in connection with both the winding-up of a business and the winding-up of a corporation's existence. Subsection 69(5) applies only when there is a winding-up that involves the termination of the corporation's existence whereas subsection 84(2) applies on either the winding-up of a business or the winding-up of a corporation's existence. For inexplicable reasons, the Bulletin refers to subsections 84(2), 88(1) and 88(2) but not to subsection 69(5). The Bulletin contains a number of useful interpretations which do not clearly apply to subsection 69(5). For example, the CRA takes the position that subsections 88(1) and (2) will be considered to apply even if the formal dissolution of a corporation is not complete but there is substantial evidence that the corporation will be dissolved within a short period of time. In particular, if a corporation is not dissolved because of the existence of outstanding litigation, the CRA will apply subsections 88(1) and (2) even though the rights and obligations under the outstanding lawsuits were retained by the corporation because they could not be transferred without prejudice to the corporation.26 The CRA also deals with the issue that properties may be distributed at various times throughout the winding-up period. In the context of paragraph 88(1)(a) which refers to rollovers at tax cost "immediately before the winding-up", the CRA takes the position that this term will be considered to mean immediately before a particular disposition. Because the Bulletin is silent with respect to subsection 69(5), it is not clear whether this interpretation is applicable for the purposes of determining the fair market value of property immediately before the winding-up". In the context of subsection 69(5), this phrase might be found to refer to the time immediately before the passing of the winding-up resolution.27 If there is a deemed dividend under subsection 84(2), subsection 88(2) permits the corporation to make use of various tax accounts, including the capital dividend account and the pre-1972 capital surplus on hand account, to reduce the impact of the dividend on its shareholders (and also permits these accounts to be increased by gains of the corporation arising on its wind-up). In order for subsection 88(2) to apply, all or substantially all of the property owned by the corporation must be distributed to its shareholders at a particular time, accordingly, the subsection operates properly only if there is a single such distribution as opposed to a series of distributions over the winding-up period.
25 26

For a detailed summary of these rules, see: Shafer, "Liquidation", supra footnote 24, at 10: 15-19. Interpretation Bulletin IT- I 26R2, paragraph 5. 27 This was the position of the CRA in Interpretation Bulletin IT-126R, the previous version of Interpretation Bulletin IT- I 26R2, which also did not refer to subsection 69(5).

485

In addition to being deemed to receive a dividend, a shareholder of a corporation will be regarded as disposing of the shares of the corporation when they are cancelled on the wind-up.28 The shares of a corporation that is being wound up would not, generally, be cancelled until a certificate of dissolution is issued. The CRA takes the position, however, that there is a disposition of the shares when subsection 88(1) or (2) applies to the corporation in circumstances where the dissolution has not yet occurred but there is substantial evidence that the corporation will be dissolved within a short period of time.29 If the disposition of the shares does not occur until after the shareholder receives the winding-up distribution, the shareholder would be required to reduce the adjusted cost base of the shares, under subparagraph 53(2)(a)(ii), by the amount of the reduction of paid-up capital on the distribution. For example, a shareholder who receives $100 as a winding-up distribution in respect of shares having $20 of paid-up capital and $30 of adjusted cost base will be deemed to receive a dividend of $80 at the time of the distribution (assuming the distribution represents a return of $20 of capital and a liquidating distribution of $80) and the adjusted cost base will be deemed to be reduced by $20. When the shares are cancelled, or otherwise regarded as disposed of, the shareholder will realize a capital loss of $10 (proceeds of nil less adjusted cost base of $10), subject to the stop-loss rules of subsection 112(3). Qualifying Wind-up Under Subsection 88(1) If a wind-up of a subsidiary qualifies under subsection 88(1), the subsidiary will not be deemed to realize a gain in respect of its assets and the parent will acquire these assets at their tax cost plus, in certain circumstances, the bump in respect of certain non-depreciable capital properties. The parent will not be deemed to receive a dividend, will not realize a capital loss in respect of its shares of the subsidiary and, in most cases, will not realize a gain thereon. Moreover, various provisions would apply to provide continuity in respect of loss carryforwards and other tax accounts of the subsidiary.30 In order to qualify under subsection 88(1), the following conditions must be met: 1. Both the subsidiary and the parent must be taxable Canadian corporations. This condition also applies to an amalgamation under section 87. See the comments in the discussion on qualifying amalgamations regarding the definitions of "taxable Canadian corporation" and "Canadian corporation". 2. Not less than 90% of the issued shares of each class of the capital stock of the subsidiary must be owned, immediately before the winding-up, by the parent and all of the shares that were not owned by the parent must be owned by persons with whom the parent was dealing at arm's length.

As noted above, the CRA has commented on the meaning of "immediately before the winding-up" in Interpretation Bulletin IT-126R2. The previous version of this bulletin stated that this phrase means "that point in time that directly precedes the
28 29

See paragraph (b)(i) of the definition of "disposition" in subsection 248(l). Interpretation Bulletin IT-126R2, paragraph 9. 30 For checklists, reference should be made to footnote 5.

486 implementation of the winding-up procedures".31 As mentioned above, the current version deals with this phrase only in the context of distributions of property taking place at various times throughout the winding-up period in the context of paragraph 88(1)(a). This position was taken to minimize problems with a series of such distributions and it is understood that the general position of the CRA, as stated in the prior version of the bulletin, has not changed. Because the implementation of the winding-up procedures generally commences with the passing of a special resolution of the shareholders, the 90% ownership threshold should be tested immediately before the passing of this resolution. Accordingly, subsection 88(1) would appear not to apply if the parent held less than 90% immediately before the passage of the shareholders' resolution but subsequently acquired additional shares to hold more than 90%.

As is generally true for the purposes of the Act, ownership means beneficial ownership. For example, if a share is registered in the name of a director but is held in trust for the parent (that is, a director's qualifying share), the CRA would regard the share as owned by the parent for these purposes.32 The arm's length tests are contained in section 251 and following. It will be necessary to determine that each minority shareholder is not related to the parent and, on the facts, deals with the parent at arm's length. 3. The subsidiary "has been wound up".

Unfortunately, the past tense is used in this phrase. This might be taken

to imply that all the steps to wind up the corporation have been completed, including the issuance of a certificate of dissolution. The CRA has, however, taken a more liberal position in Interpretation Bulletin IT-126R2 in which it states that a corporation is considered to have been wound up for the purposes of subsection 88(1) where the formal dissolution of a corporation is not complete but there is substantial evidence that the corporation will be dissolved within a short period of time. As noted above, an example is where the corporation delays obtaining the formal dissolution because it is involved in litigation, Another example is where a tax assessment received by the subsidiary results in a delay in applying for its dissolution.33 As a practical matter, if the subsidiary has followed the appropriate procedures to commence the wind-up, has dealt with its liabilities and has distributed its remaining property to its shareholders, the CRA will regard the corporation as having been wound up provided it can be shown that it is proceeding with the remaining steps leading to a certificate of dissolution. 34 (As discussed
31 32

Interpretation Bulletin IT-126P, paragraph 6. Interpretation Bulletin IT-488R2, paragraph 3. 33 Ibid, paragraph 20. 34 CRA letter of February 25, 1991 referred to in "Window on Canadian Tax (CCH Canadian Limited, 1991) (looseleaf), paragraph 1126.

487 below under "Loss Carryforwards and Carrybacks", the CRA has recently taken a different position on when a corporation has been wound up for the purposes of subsection 88(l.1).) If these conditions are met, the wind-up will qualify under subsection 88(1) without the need for any elections to be filed. The many rules in subsection 88(1) will apply "notwithstanding any other provision of this Act other than subsection 69(11)". As noted previously, subsection 69(11) is an avoidance rule designed to deny a rollover in respect of property where it can reasonably be considered that one of the main purposes of the transaction is to obtain the benefit of losses or other tax accounts available to a nonaffiliated person in respect of a subsequent disposition of the property, where arrangements for the subsequent disposition are made within three years of the transfer. Although a subsidiary will be affiliated with the parent, subsection 69(11) requires that the series of transactions be examined; and the relevant time to determine whether the subsidiary was affiliated is immediately before the series began. For example, if the parent acquired all the shares of a non-affiliated corporation that owned a capital property with a large accrued gain and wound up the corporation with the purpose of selling the capital property within three years after the wind-up and sheltering the capital gain with losses of the parent, subsection 69(l 1) would deem the subsidiary to have disposed of that capital property for fair market value proceeds at the time of the wind-up. Disposition of Property by the Subsidiary By virtue of paragraph 88(1)(a), each property, other than a partnership interest, a resource property or a specified debt obligation, distributed to the parent on the wind-up is deemed to have been disposed of by the subsidiary for proceeds equal to its cost amount immediately before the windingup. That is, the subsidiary will be eligible for a rollover unless, as described above, subsection 69(11) applies. The CRA takes the generous position that all property transferred to the parent by the subsidiary on the wind-up is considered to be property distributed to the parent on the wind-up even if certain of these properties might reasonably be considered to have been transferred to the parent in satisfaction of debt owing to the parent by the subsidiary or as consideration for the parent's assuming the liabilities of the subsidiary.35 The relevant time to determine the cost amount of property is "immediately before the winding-up". As noted above, property may be distributed at various times throughout the winding-up period. To avoid potential difficulties, the CRA takes the position that "Immediately before the winding-up" in respect of a particular disposition is considered to mean immediately before that particular disposition.36 Were it not for this position, the subsidiary might be deemed to realize a capital gain if between the time of the commencement of the wind-up and the distribution of a property the adjusted cost base of that property was reduced. For example, if the subsidiary owned a share of a corporation and received cash as a return of capital thereon after the commencement of the wind-up but before the share was distributed by the subsidiary, its adjusted cost base would have been reduced under subparagraph 53(2)(a)(ii) but the proceeds of disposition to the subsidiary would be deemed to be the higher adjusted cost base immediately before the commencement of the wind-up procedures. Under the CRA's administrative position, however, the subsidiary is deemed to have disposed of the share at its adjusted cost base immediately before the distribution of the share so that no gain results. If the amounts involved are significant, it would be advisable to confirm this administrative position through an advance tax ruling.
35 36

Interpretation Bulletin IT-488R2, paragraph 14. Interpretation Bulletin fT-126R2, paragraph 7 and IT-488R2, paragraph 13.

488

If a partnership interest is distributed, paragraph 88(1)(a.2) provides that it is deemed not to have been disposed of (except for the purposes of paragraph 98(5)(g)). Accordingly, if the subsidiary has a "negative" adjusted cost base in the partnership interest, it will not be deemed to realize a capital gain. Instead, the negative adjusted cost base will flow through to the parent because paragraph 87(2)(e. 1) will apply by virtue of paragraph 88(1)(e.2). Resource property is deemed to have been disposed of for proceeds equal to nil under subparagraph 88(1)(a)(1), resulting in no gain or loss to the subsidiary. The resource-related tax accounts, such as cumulative Canadian exploration expense and cumulative Canadian development expense flow through to the parent by virtue of subsection 88(1.5). As in the case of vertical amalgamation, the successor or "streaming" rules of section 66.7 will not apply to restrict the parent in the use of those accounts. Cost of Property to Parent The cost of each property distributed to the parent on the winding-up is determined under paragraph 88(1)(c). The general rule is that the parent's cost of each property is equal to the proceeds of disposition to the subsidiary of the property. As we have seen, the amount of the proceeds of disposition to the subsidiary is, generally, the cost amount of the property immediately before the wind-up. Paragraph 88(1)(c) provides that if there had been a reduction to the cost amount to the subsidiary of the property because of the application of the forgiveness of debt rules of section 80 on the wind-up, the amount of the reduction must be subtracted from the proceeds of disposition to the subsidiary, and the net result becomes the cost to the parent. This is a reasonable rule if the proceeds of disposition to the subsidiary had not already been reduced under section 80. Under section 80, and by virtue of the timing rule in paragraph 80.01(4)(d), the reduction in cost amount to the subsidiary would occur immediately before the distribution of the property to the parent. As we have seen, however, the administrative position of the CRA with regard to determining the proceeds of disposition is that the cost amount to the subsidiary is determined immediately before the distribution of the property rather than immediately before the commencement of the winding-up procedures. Under this administrative position, the proceeds of disposition would already be reduced by amounts under section 80 and it would be inappropriate to reduce the cost to the parent by this amount a second time. I am not aware of the CRA having considered this issue. In any event, as discussed below, an election is available under subsection 80.01(4) to avoid the application of section 80 in cases where the parent has filll tax cost in the debt of the subsidiary. It should also be noted that if the avoidance provision of subsection 69(11) applied to deem the subsidiary to have received fair market value proceeds of disposition, the cost to the parent will, nevertheless, be the cost amount to the subsidiary. As we have seen, in the case of a partnership interest, the parent inherits the adjusted cost base of the subsidiary including any negative adjustments that, in effect, give rise to a "negative" adjusted cost base. Most significantly, paragraph 88(1)(c) permits the cost of certain non-depreciable capital property to be bumped by the amount determined under paragraph 88(1)(d). These rules were discussed in the previous section dealing with vertical amalgamations. Taxation Year

489 Unlike an amalgamation, a wind-up does not give rise to a deemed year-end of the subsidiary (or the parent). Rather, the normal year-end will continue until articles of dissolution are issued, at which point, the final year-end will occur. Stop-Loss Rules If the subsidiary had been subject to one of the stop-loss rules (under subsection 13(21.2), 14(12), 18(15) or 40(3.4)) on a prior transfer of property to an affiliated corporation, the loss that is "warehoused", as discussed in the earlier discussion on amalgamations, will be carried forward to the parent by virtue of paragraphs 87(2)(g.3) and 88(1)(e.2). As described in that earlier discussion, this can be used as a planning tool in situations where there is concern that property with a "pregnant" loss may be recharacterized in the hands of the parent following a wind-up such that the loss would not be available to the parent. In these circumstances, instead of having the property transferred to the parent on the wind-up, the subsidiary might transfer it to an affiliated corporation prior to the wind-up, thereby triggering the stop-loss rule. The "warehoused" loss would flow to the parent on the wind-up and the parent would realize the loss when the property is sold by the affiliated corporation to a non-affiliated person. This might be preferable to having the subsidiary selling the property to a non-affiliated person prior to the wind-up and relying on the parent being able to use the loss carryforwards of the subsidiary because, as described below, these loss carryforwards would not be available to the parent until its first taxation year commencing after the commencement of the wind-up. Also, a "warehoused" loss realized by the parent could be carried back by it to a prior year but a loss carried forward from its subsidiary could not.37 Capital Cost Allowance Claims by the Subsidiary One implication of there not being a deemed year-end at the time of a wind-up is that the subsidiary will not be entitled to claim capital cost allowance in its taxation year in which it distributed its depreciable property. Under the capital cost allowance rules, capital cost allowance is available only in respect of the undepreciated capital cost to a taxpayer at the end of a taxation year. By way of contrast, capital cost allowance can be claimed (pro-rated if in a short taxation year) by a predecessor corporation in the taxation year that ends on an amalgamation. Reserves By virtue of paragraph 88(1)(e. 1), the subsidiary may, in the taxation year during which its assets were transferred to, and its obligations were assumed by, the parent on the windup, claim any reserve that would otherwise have been allowable. If the subsidiary continues to exist in a following taxation year, it is not required to include in its income any reserve that it chose to claim in the year of the winding-up distribution. Continuity in respect of reserves is provided under paragraph 88(1)(e.2) which would require any such reserves to be included in the income of the parent. For example, a reserve for doubtful debts under paragraph 20(l)(1) could be claimed by the subsidiary in its taxation year during which its assets were distributed to the parent, the parent would, under paragraph 88(1)(e.2) which refers to paragraphs 87(2)(g) and (h), include such reserves in its income in its taxation year during which it received the assets of the subsidiary and could claim an appropriate reserve for debts that are doubtful at the end of that taxation year. Application of Specific Amalgamation Rules

37

Andrew W. Dunn, supra footnote 72, at 13:16.

490 Paragraph 88(1)(e.2) provides that a long list of specific rules in section 87 apply equally to a wind-up under subsection 88(1) (with appropriate wording changes). Generally speaking, these rules are designed to flow-through various tax accounts of the subsidiary to the parent and provide continuity. Examples referred to previously include rules regarding partnership interests and reserves. In the context of an amalgamation, it is arguable (though not accepted by the CRA) that continuity is available without specific rules because the predecessor corporations are deemed to continue as the amalgamated corporation. On a wind-up, however, it is clear that specific rules are needed to provide such continuity as there is no equivalent corporate concept of the subsidiary continuing as part of the parent.

ii. Mechanics Subsection 88(1): Winding-up a 90% Owned Subsidiary

In the absence of a rollover, the dissolution of a corporation would be treated as if the corporation had sold all of its property at FMV to its shareholders in exchange for the shareholders' shares. Subsection 88(1) through (1.4) provides a rollover for the dissolution of certain 90% owned subsidiaries. The requirements for the rollover are as follows: Subsection 88(1) requirements: 1. 2. the corporation being dissolved (the "subsidiary") must be a taxable Canadian corporation, not less than 90% of the issued shares of each class of capital stock of the subsidiary must be owned by another taxable Canadian corporation (the "parent") immediately before the windingup, and All of the shares of the subsidiary that are not owned by the parent must be owned immediately before the winding-up by persons with whom the parent was dealing at arm's length.

3.

When these requirements are met, the following rules apply: 1. The Subsidiary's Proceeds of Disposition for its property distributed to the parent on the winding up, under paragraph 88(1)(a) is deemed to be: a. b. 2. 3. in the case of a Canadian resource property (as defined in paragraph 66(15)(c)) or a foreign resource property (as defined in paragraph 66(1)(f), nil, in the case of any other property, the cost amount to the subsidiary of the property which is the ACB of the property or in the case of depreciable property, its UCC.

The Parent is generally deemed to acquire the assets of the subsidiary at a cost base equal to the subsidiary's deemed POD; The Parent's POD for the disposition of the subsidiary's shares under paragraph 88(1)(b) is deemed to be the greater of: a. the lesser of:

491

i. ii. b.

the PUC of the shares held by the parent in the subsidiary, and the cost amount of property transferred by the subsidiary less the liabilities assumed by the parent corporation.

the ACB to the parent of the shares in the subsidiary.

iii. Mechanics: Subsection 88(2): Winding-Up Canadian Corporations

Ss. 88(2) applies to the winding-up of a Canadian corporation. The provision must be read in conjunction with subsections 69(5) and 84(2). Under subsection 69(5), assets which are distributed by the corporation to its shareholders on winding-up are deemed to have been disposed of at their fair market value by the corporation. Obviously, capital gains, recapture of capital cost allowance, or even income in the case of inventory, may be realized. If a capital loss is generated it is deductible because paragraph 40(2)(e) does not apply by virtue of subparagraph 69(5)(a)(ii). The shareholders' cost base of the property received would be FMV. The shareholders are entitled to receive in cash or property an amount equal to the PUC of the shares without any tax consequences. However, if they receive cash or property in excess of the PUC of their shares, a deemed dividend will arise under subsection 84(2). Basically, no rollover is available on a winding up, however, subsection 88(2) does provide some tax relief in the form of special rules to facilitate the distribution of the capital dividend account ("CDA") and the pre-1972 capital surplus on hand ("CSOH"). Pre-1972 CSOH is defined and computed in subsections 88(2.1) and (2.2). This account exists as a result of 1971 tax reform after which capital gains became subject to tax. Pre-1972 CSOH is: a corporation's 1971 capital surplus computed under specific rules, PLUS the portion of the capital gains realized on the disposition of capital property owned on December 31, 1971 attributable to the period before this date, MINUS capital losses incurred on property owned on December 31, 1971 attributable to the period before this date.

What paragraph 88(2)(a) does for the purposes of computing the CDA and pre-1972 CSOH is to include any capital gains existing before the final distribution in the CDA and pre-1972 CSOH. This is accomplished by deeming the taxation year of the corporation to have ended before the final distribution of property. Also, each property distributed on the final distribution is deemed to have been disposed of at its FMV immediately before the end of the taxation year that was deemed to have ended before the final distribution.

492

The requirement that the subsection 84(2) deemed dividend provision include the CDA and pre-1972 CSOH accounts is set out in paragraph 88(2)(b): if the subsection 83(2) election is made, a separate dividend from the CDA account in an amount not exceeding the CDA is considered to have been paid, if the deemed winding-up dividend under subsection 84(2) exceeds the separate CDA dividend, an amount from pre-1972 CSOH is deemed not to be a dividend, any excess after the CDA dividend and pre-1972 deduction is a taxable dividend.

Each shareholder is deemed to have received a separate dividend from the CDA or taxable dividend in proportion to the number of shares held. Not only is there a deemed dividend to consider on the winding-up, but the shareholder is also deemed to have disposed of his/her shares for tax purposes and a capital gain or loss may result to the shareholder. POD are equal to the FMV of the consideration received less the CDA dividend and the taxable dividend (see paragraph (j) of the definition of "proceeds of disposition" in section 54.) but no pre-1972 CSOH adjustment is made to the POD.

493

Interpretation Bulletin IT-149R4 - Winding-Up Dividend

June 28, 1991 (Material is relevant as of January 2012) Summary This bulletin discusses the "winding-up dividend" that results when certain Canadian corporations are wound up. It also discusses how the Act establishes the portion of the amount, received by the shareholders in a winding-up, that is taxable in their hands. Essentially, the law provides that any amount received in excess of paid-up capital is deemed to be a dividend. However, depending on the type of corporation, this winding-up dividend can be broken into separate amounts arising from (a) the capital dividend account, (b) the capital gains dividend account, (c) the pre-1972 capital surplus on hand, and (d) after June 28, 1982 and before May 24, 1985, the life insurance capital dividend account. Any excess, after distributing the above amounts, is a taxable dividend. Discussion and Interpretation Distributions on Winding-up 1. Subsection 88(2) provides special rules to facilitate the distribution of property on the windingup (see 3 below) of a Canadian corporation to which subsection 88(1) does not apply. For subsection 88(2) to apply in the course of the winding-up of such a corporation, all or substantially all of the property owned by the corporation must be distributed to its shareholders. It does not require that there be a single distribution of property on winding-up. However, where there is a series of distributions in the course of winding-up, subsection 88(2) usually applies to the last such distribution, when it can be said that all or substantially all of the property owned immediately beforehand has been distributed to the shareholders. Generally, the only property owned by the corporation after this final distribution will be cash or other liquid assets to be used for the payment of taxes and any remaining costs of liquidation. If a relatively small amount of property remains in the corporation for distribution to the shareholders after the payment of these taxes and liquidation costs, both this distribution and the previous distribution will qualify under subsection 88(2). Timing of Distributions 2. To achieve the purpose of subsection 88(2), timing is of particular importance. The points in time specified and their significance are as follows: (a) "A particular time in the course of winding-up" is that point (i) when the final distribution of property is made, (ii) when, by virtue of subsection 84(2), the corporation is deemed to have paid and the shareholders are deemed to have received a dividend referred to in paragraph 88(2)(b) as the "winding-up dividend", and (iii) when an election is required under subsection 83(2), 133(7.1), or 83(2.1) as it read with respect to dividends paid after June 28, 1982 and before May 24, 1985, to pay tax-free dividends.

494 (b) (c) The "time of computation" of the corporation's capital dividend account, capital gains dividend account and pre-1972 capital surplus on hand is immediately before the time mentioned in (a) above. "Immediately before the time of computation" is when the taxation year of the corporation is deemed to have ended and a new taxation year to have commenced. In conjunction with subparagraph 88(2)(a)(iv), this "time of computation" ensures that the capital dividend account, the capital gains dividend account and the pre-1972 capital surplus on hand include any amount arising on or prior to the final winding-up distribution. "Immediately before the end of the taxation year" (the year deemed to have ended in (c) above) is when the property distributed at the particular time noted in (a) above is deemed to have been disposed of by the corporation. This permits the capital gains and other amounts arising on the distribution to be reflected in the accounts prior to the end of that taxation year.

(d)

Calculation of Separate Dividends 3. (a) (b) (c) (d) Paragraph 88(2)(b) provides that for the purpose of an election to pay a capital dividend under subsection 83(2), a capital gains dividend of a non-resident-owned investment corporation under subsection 133(7.1), or after June 28, 1982 and before May 24, 1985, a life insurance capital dividend under subsection 83(2.1), as it read for that period, portions of the winding-up dividend are considered to be separate dividends. These separate dividends are calculated as follows: For an election under subsection 83(2) (or subsection 133(7.1)), a separate dividend is deemed to be paid equal to the portion of the winding-up dividend that does not exceed the balance of the capital dividend account (or capital gains dividend account) immediately before such dividend is deemed to have been paid. Where the winding-up dividend exceeds the balance of the capital dividend account (or capital gains dividend account), the separate dividend is always equal to that balance and therefore an election (if any) under subsection 83(2) (or 133(7.1)) must be in respect of that balance. With respect to a winding-up ending after June 28, 1982 and before May 24, 1985, the portion of the winding-up dividend that exceeds the amount elected under subsection 83(2) or 133(7.1) as determined in (d) above, up to the amount of the corporation's life insurance capital dividend account, is also deemed to be a separate dividend. Provided an election in respect of the full amount was made under subsection 83(2.1) as it read for that period, such separate dividend is a non-taxable dividend. The portion of the winding-up dividend that exceeds the amount of the dividends elected under subsection 83(2), 133(7.1) or, after June 28, 1982 and before May 24, 1985, subsection 83(2.1) as determined in (d) and (e) above, up to the corporation's pre-1972 capital surplus on hand is deemed not to be a dividend. This portion is included under subparagraph 54(h)(ix) in the proceeds of the disposition of the shares. The portion of the winding-up dividend that exceeds the aggregate of (i) the separate dividend in (d) above (where an election is made), (ii) the separate dividend in (e) above, and (iii) the portion in (f) above is deemed to be a separate dividend that is a taxable dividend.

(e)

(f)

(g)

Each shareholder is deemed to have received separate dividends, determined as in (d), (e), and (g) above in proportion to the number of shares held. The separate components of the winding-up dividend, as discussed in (d) to (g) above, can be illustrated in the following table:

495

WINDING UP DIVIDENDS

Private Corporation (d), (e) 88(2)(b)(i) Capital Dividend or Life Insurance Capital Dividend (f) 88(2)(b)(ii) Pre-1972 CSOH (g) 88(2)(b)(iii) Taxable Dividend

Non-Resident Owned Investment Corp. (d) 133(7.1) Capital Gain Dividend (f) 88(2)(b)(ii) Pre-1972 CSOH (g) 88(2)(b)(iii) Taxable Dividend

Public Corporation

(f) 88(2)(b)(ii) Pre-1972 CSOH (g) 88(2)(b)(iii) Taxable Dividend

The example below illustrates the above allocation and ordering of the winding-up dividend for a private corporation. The following facts are assumed regarding the wind-up of a private corporation: Proceeds available on winding-up Paid-up capital of shares Balance in capital dividend account Balance in pre-1972 capital surplus on hand The application of paragraph 88(2)(b) is as follows: Proceeds on winding-up less: paid-up capital--paragraph 89(1)(c) Winding-up dividend--paragraph 84(2)(b) less: capital dividend account (election made) subparagraph 88(2)(b)(i) less: pre-1972 capital surplus on hand subparagraph 88(2)(b)(ii) Taxable dividend--subparagraph 88(2)(b)(iii) Assessment of Amounts 4. The amounts that are deemed to be separate dividends and the amount deemed not to be a dividend depend on the balance, as finally assessed by the Department, of (a) the capital dividend account (or capital gains dividend account), (b) the pre-1972 capital surplus on hand, and (c) after June 28, 1982 and before May 24, 1985, the life insurance capital dividend account, immediately before the winding-up dividend is deemed to have been paid. Where balances of these accounts as assessed differ from the amounts computed by the corporation at the time of the elections under subsection 83(2), 83(2.1) (as it read at that time), or subsection 133(7.1) $5,000,000 1,000,000 1,300,000 600,000

$5,000,000 1,000,000 4,000,000 1,300,000 2,700,000 600,000 $2,100,000

496 in respect of those separate dividends, the amount of each separate dividend and the related election will be adjusted to reflect the balances assessed. However, the corporation remains responsible for computing these accounts as accurately as possible in light of all the facts available at the time of the election. .