McClurg v. Canada, [1990] 3 S.C.R. 1020
Her Majesty The Queen Appellant
v.
Jim A. McClurg Respondent
indexed as: mcclurg v. canada
File No.: 20751.
1989: November 29; 1990: December 20.
Present: Dickson C.J.* and
Wilson, La Forest, L'Heureux‑Dubé, Sopinka, Gonthier and Cory JJ.
on appeal from the federal court of
appeal
Income
Tax ‑‑ Dividends ‑‑ Attribution ‑‑
Dividends declared and allocated to shareholders of a share class pursuant to
discretion of directors -- Other classes of shares not participating in
dividend ‑‑ Whether portion of dividend properly attributable to
other classes of shares ‑‑ Income Tax Act, S.C. 1970‑71‑72,
c. 63, s. 56(2).
Company
law ‑‑ Dividends ‑‑ Discretionary dividend as declared
and allocated at discretion of directors ‑‑ Whether derogation of
common law with respect to nature of shares or directors' duties ‑‑
Whether permitted by Saskatchewan Business Corporations Act ‑‑
Business Corporations Act, R.S.S. 1978, c. B‑10,
ss. 24(4), 40, 97, 234.
Respondent
and his partner were the only directors of a closely held company incorporated
under the Saskatchewan Business Corporations Act. The
Articles of Incorporation provided for three categories of shares: Class A
which are common, voting and participating shares; Class B which are common,
non‑voting and participating where authorized by the directors; and Class
C which are 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 said corporation". The two directors received no
dividends on either their class A or class C shares during 1978, 1979 and 1980
but received salaries, bonuses, and bonus entitlements. Their wives, who held
Class B shares, were voted a declaration and distribution of dividends
amounting to $10,000 each in each of these three years. Mrs. McClurg had
been actively involved in the firm's operations and had been paid a modest
salary.
The
Minister of National Revenue reassessed the respondent's income for 1978, 1979,
and 1980 on the basis that $8,000 of the $10,000 in dividends attributed to
Mrs. McClurg on her Class B shares was properly attributable instead to
the respondent pursuant to ss. 56(2) of the Income Tax Act. The
Minister's opinion was that the dividends declared in each of the years in
question should be attributed equally to all of the common shares, no matter of
what class and notwithstanding the express condition attaching to the Class B
shares that they shall carry the right to receive dividends exclusive of other
classes of shares in the company. The reallocation was made on the basis of
the number of Class A shares owned by the respondent in relation to the number
of Class B shares owned by Mrs. McClurg. The respondent's appeal to the
Tax Court of Canada was dismissed. The respondent further appealed from the
decision of the Tax Court judge by way of an action commenced in the Federal
Court of Canada, Trial Division. The appeal was allowed. The Minister's
appeal to the Federal Court of Appeal was dismissed.
At
issue here was whether the dividends received by Mrs. McClurg in respect of her
Class B common shares should be attributed in part to the respondent. A
preliminary issue was whether the discretionary clause constituted a valid
derogation to the common law rule of equality of distribution of dividends or
whether it was permitted under the Saskatchewan Business Corporations Act.
Held
(Wilson, La Forest and L'Heureux‑Dubé JJ. dissenting): The appeal should
be dismissed.
Per Dickson
C.J. and Sopinka, Gonthier and Cory JJ.: Discretionary dividend clauses may be
validly used because they are not expressly prohibited by the Act and are not
contrary to common law or corporate law principles.
The
power to pay dividends is an integral component of the Act's broad grant of
managerial power for directors and is expressly limited by restrictions in much
the same way as at common law. It is also qualified in that the general
managerial power, which rests in the directors of a company, is fiduciary in
nature and so must be exercised in good faith and in the best interests of the
company.
Shares
have an equal right to receive a dividend unless the Articles of Incorporation
provide otherwise. Their division into classes is a necessary condition to any
derogation of this presumption of equality either with respect to dividends or
to other shareholder entitlements. Section 24(4)(a) is to
ensure that shareholders are fully aware of their entitlements and privileges
to the extent that the presumption of equality is rendered inapplicable. The
determination of whether or not the share class rebuts this presumption is a
simple factual inquiry. The Articles of Incorporation rebutted the presumption
of equality here.
The
entitlement to be considered for a dividend is more properly characterized in
terms of a "right". A dividend is no less a "right" because
it is contingent upon the exercise of the discretion of the directors to
allocate the declared dividend between classes of shares. The directors are
bound by their fiduciary duty to act in good faith for the best
interests of the company in declaring and allocating any dividend. That duty
is not circumvented by the discretionary dividend clause. Many shareholder
rights may be qualified and contingent and the mere fact that they are fettered
does not render them anything less than shareholder rights.
A
discretionary dividend clause does not give rise to any inherent conflict
between the duty of the directors and their self‑interest. Their
allocation of dividends pursuant to such a clause can be exercised in the best
interests of the company. The fact that the directors may consider the
identity of shareholders does not necessarily render the declaration invalid on
the basis of a conflict of duty and self‑interest. The dividend
allocation clause simply divides conceptually what has been traditionally one
decision into two components ‑‑ declaration and allocation. The
discretionary powers of the directors have always included both, subject to the
provisions of the Articles of Incorporation.
Section
24(4)(b) of the Act recognizes that there must be shares
entitled to receive a dividend if a dividend is declared. This principle is
not defeated by a discretionary dividend clause because the identity of the
class eligible for a dividend simply remains unknown until the allocation takes
place. This conceptual division into declaration and allocation is not
substantively different from any derogation from the presumption of equality in
the payment of dividends.
It
would be inappropriate for this Court to determine the validity of use of a
discretionary dividend clause in the context of an income tax appeal. The Act
is facilitative and allows parties to structure corporations as they wish
subject to certain explicit exceptions. It also provides the means for a party
aggrieved by the corporation ‑‑ security holder, creditor, director
or officer ‑‑ to seek redress through the s. 234 oppression
remedy. No interested party here lodged such complaint, presumably because all
involved were satisfied with the way in which the directors were conducting its
affairs. Furthermore, it is a well-established principle at common law that
where shareholders are unanimously agreed to a transaction, inequality of
treatment does not render it ultra vires the company.
The
determination that the transaction occurred in the context of a director‑shareholder
relationship is dispositive. 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, 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 anti‑avoidance
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. 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).
An
allocation pursuant to a discretionary dividend clause is no different from the
payment of a dividend generally. In both cases, but for the declaration (and
allocation), the dividend remains part of the retained earnings of the company
and is therefore not within the legitimate parameters of the legislative intent
of s. 56(2).
The
payments to Mrs. McClurg represented a legitimate quid pro quo and
were not simply an attempt to avoid the payment of taxes. Her efforts expended
in the firm's operation, while not dispositive of the issue, was further
evidence that the dividend payment was the product of a bona fide
business relationship. If a distinction is to be drawn in the application of
s. 56(2) between arms' length and non arms' length transactions, it should
be made between the exercise of a discretionary power to distribute dividends
when the non arms' length shareholder has made no contribution to the company
(in which case s. 56(1) may be applicable), and those cases in which a
legitimate contribution has been made.
Per Wilson,
La Forest and L'Heureux‑Dubé JJ. (dissenting): The separation of share
ownership and control underlies many fundamental principles of corporate law.
Among these are the principle that the directors and officers of a corporation
owe a fiduciary duty to the corporation and the principle of equality of
shares. More than just a mere contractual right, the principle of equality of
shares developed as a measure of protection for the shareholder. Thus, when
more than one class of shares was created, the directors were not free to
discriminate arbitrarily between the classes when awarding a dividend.
Shareholder
rights include the right to a dividend, the right to vote, and the right to
participate in the distribution of assets upon dissolution of the corporation.
These rights must attach to the corporation's shares and the shareholders may
not agree to circumvent this principle.
A
discretionary dividend clause that permits the directors of a corporation to
choose which class is entitled to receive dividends to the exclusion of the
other classes is invalid at common law. It contravenes the principle that the
directors are not permitted to favour one class at the expense of the others.
It also contravenes the principle that dividends attach to shares and not to
shareholders because the directors would be making a discretionary allocation
primarily on the basis of the identity of the shareholders. To allow
discrimination on the basis of the identity of the shareholder ignores the
separation that is supposed to exist between the corporation and its
shareholders.
A
discretionary dividend clause, if valid, would entail a number of problems.
The shareholder would be completely dependent on the goodwill of the directors
and the minority shareholder would be placed in a near impossible position if
this goodwill were to be turned against that shareholder. It also places the
director in a position where he cannot fulfill his fiduciary obligations to the
corporation as a whole and so must be invalid at common law. The conflict of
interest is heightened when the director happens to be a shareholder of a class
to which dividends are awarded or from which some personal benefit is derived;
the situation can be compared to the usurpation of a corporate opportunity
properly belonging to the company.
Requiring
the mode of distribution to be expressly set out in the Articles of
Incorporation, which can only be amended by approval of the shareholders, is
consistent with the fiduciary obligation. If the directors hold preferred
shares, the common shareholders will have agreed to subordinate their dividend
interest to the preferred class of shares based upon "full
disclosure" of the maximum amount to which these preferred shares will
enjoy priority. With a discretionary dividend clause, there is no such
disclosure, since the amount and priority is left to be determined in the
future, wholly at the directors' discretion.
If
employees merit additional reward, the proper course to effect this is through
some form of compensation other than a dividend. A dividend is a return on an
investment. The directors, if they were to take into account the identity of
shareholders when declaring a dividend, would be improperly exercising the
discretionary dividend power.
The
discretionary dividend clause, even if it were valid under the common law,
would be insufficient to rebut the common law presumption of equality. All
three classes of shares are defined in substantially the same manner with
respect to their entitlement to dividends. Therefore, any difference between
the shares concerning their right to receive dividends would clearly not derive
from any differentiation between the shares; it would have to stem from the
actions of the directors of the corporation. Such a right, therefore, would
not derive from the share itself and would be invalid at common law.
Section
24(4)(a) of the Saskatchewan Business Corporations
Act requires that the mode of distributing dividends be expressly provided
for in the articles themselves. The section must be interpreted in accordance
with the principles of the common law and, in particular, with the principle
that shareholder rights be expressly provided for in the shares themselves.
Any departure from this principle must be explicitly stated. Section 24(4)(a) does
not clearly indicate an intent to provide corporate directors with a power
which they did not otherwise have at common law. The use of the discretionary
dividend clause is also inconsistent with the requirement in s. 24(3)(b) that
at least one class of shares must be entitled "to receive any dividend
declared by the corporation".
Even
when the Act specifically provides that the directors may be given the
discretion to determine the rights to be assigned to a series, this discretion
is not unlimited. The shareholders can give the directors the power to issue
series within a class and assign rights to those series but they may not
agree to give the directors the discretion to interfere with their right to
dividends or a return of capital by choosing to give another series priority.
The rights assigned to series, unlike classes of shares, may be altered without
amending the corporate constitution.
The
statute contemplates that shareholders will be protected from changes being
made to the rights attached to different classes of shares by virtue of the
fact that such rights may only be amended by altering the corporate
constitution. In theory, a shareholder can bring a suit if the directors are
alleged to exercise their discretion improperly. This remedy, however, entails
a significant burden and expense and is an inadequate means of protecting
shareholders from the potential for abuse created by the presence of a
discretionary dividend clause. The need for shareholder protection from abuse
of the discretionary dividend clause becomes all the more apparent given the
possibility that such a clause could be inserted in the Articles of
Incorporation of a large, publicly held corporation.
The
discretionary dividend clause has no socially useful purpose. Its only
apparent purpose is to facilitate tax avoidance through "income‑splitting"
and this purpose hardly supports the need to allow corporations to be
structured in this manner.
It
would be inappropriate to return the money paid out in dividends to the
corporation because the directors must be taken to have declared dividends in
the corporation's best interests. The dividends, therefore, should be
redistributed amongst the various classes of shares which must, absent a valid
differentiation between the shares, share equally in the dividend.
A
dividend payment does not fall within the scope of s. 56(2) of the Income Tax
Act in the typical situation where the dividend payment is within the
powers of the corporation and the shareholder is bona fide
entitled to the dividends. The contribution of a shareholder to the business
is irrelevant, however, because a dividend is a return on capital attaching to
a share and in no way dependent on the conduct of a particular shareholder.
The
four elements of s. 56(2) were met here. The payment in question
satisfied the requirement that there be a payment or transfer of property to a
person other than the taxpayer; the term "payment" has acquired no
technical meaning in the Income Tax Act and is to be
interpreted in its popular sense. The payment was made pursuant to the direction
of the taxpayer or with the concurrence of the taxpayer. An individual in
control of a corporation can be said to have directed a payment within the
meaning of s. 56(2) by exercising that control. The payment must be for
the benefit of the taxpayer or recipient. Here the payment to
Mrs. McClurg, which represented Mr. McClurg's dividend entitlement,
amounted to a benefit to Mrs. McClurg under s. 56(2). Finally, this
amount would have been included in Mr. McClurg's income had the allocation
been properly made.
Cases
Cited
By
Dickson C.J.
Referred
to: Burland v. Earle, [1902] A.C. 83; Bowater
Canadian Ltd. v. R.L. Crain Inc. (1987), 62 O.R. (2d) 752; De Vall v.
Wainwright Gas Co., [1932] 2 D.L.R. 145; Stubart Investments
Ltd. v. The Queen, [1984] 1 S.C.R. 536; The Queen v. Golden, [1986]
1 S.C.R. 209; Bronfman Trust v. The Queen, [1987] 1 S.C.R.
32; Miller v. M.N.R., 62 D.T.C. 1139; Perrault v. The Queen, [1979]
1 F.C. 155.
By La
Forest J. (dissenting)
Salomon
v. Salomon and Co., [1897] A.C. 22; Farrar v. Farrars,
Limited (1888), 40 Ch. D. 395; Borland's Trustee v.
Steel Brothers & Co., [1901] 1 Ch. 279; Canadian Aero Service
Ltd. v. O'Malley, [1974] S.C.R. 592; Henry v. Great
Northern Ry. Co. (1857), 1 De G. & J. 606, 44 E.R. 858; Jacobsen
v. United Canso Oil & Gas Ltd. (1980), 113 D.L.R. (3d) 427; Bowater
Canadian Ltd. v. R. L. Crain Inc. (1987), 62 O.R. (2d) 752; Rondeau v.
Poirier, [1980] C.A. 35; Birch v. Cropper, In
re Bridgewater Navigation Co. (1889), 14 A.C. 525; Champ v.
The Queen, 83 D.T.C. 5029; Stubart Investments
Ltd. v. The Queen, [1984] 1 S.C.R. 536; Murphy v. The Queen (1980),
80 D.T.C. 6314; Bronfman, A. v. M.N.R., [1965] C.T.C.
378.
Statutes
and Regulations Cited
Business Corporations Act, R.S.S. 1978,
c. B‑10, ss. 6(1)(c)(i), 24(3)(b), (4),
27, 40, 97(1), 170(1)(c), 234.
Canada Business Corporations Act,
S.C. 1974‑75, c. 33.
Companies Act, R.S.C. 1952,
c. 53.
Income Tax
Act, S.C. 1970‑71‑72, c. 63, ss. 56(2), 248(1).
Authors
Cited
Boivin, Michelle. "Le droit aux dividendes et le
dividende "discrétionnaire"" (1987), 47 R. du
B. 73.
Bryden, R. M. "The Law of Dividends", in
Jacob S. Ziegel, ed., Studies in Canadian Company Law.
Toronto: Butterworths, 1967.
Eisenberg, Melvin A. "The Legal Roles of
Shareholders and Management in Modern Corporate Decisionmaking" (1969), 57 Cal. L.
Rev. 1.
Fraser, William Kaspar. Company Law of
Canada, 5th ed. By J. L. Stewart and M. Laird Palmer.
Toronto: Carswells, 1962.
Goodman, S. H. Comment. "The Last Bastion for
Income‑Splitting? J.A. McClurg v. The Queen" (1986), 34 Can. Tax
J. 404.
Martel, Maurice and Paul Martel. La
compagnie au Québec, Les aspects juridiques, vol. I.
Montréal: Wilson & Lafleur Ltée, 1987.
Quessy, Pierre. "Les aspects corporatifs et
fiscaux des actions à dividende discrétionnaire", [1985] 7 R.P.F.S. 31.
Schmitthoff, Clive M. Palmer's Company Law, 23rd
ed., vol. 1. London: Stevens & Sons, 1982.
Wegenast, F. W. The Law of Canadian
Companies. Toronto: Carswells, 1979.
Welling,
Bruce. Corporate Law in Canada. Toronto:
Butterworths, 1984.
APPEAL
from a judgment of the Federal Court of Appeal, [1988] 2 F.C. 356, 84
N.R. 214, [1988] 1 C.T.C. 75, 88 D.T.C. 6047, affirming a
judgment of the Federal Court, Trial Division (1986), 2 F.T.R. 1, 86
D.T.C. 6128, reversing a decision of the Tax Court of Canada, [1984]
C.T.C. 2469, 84 D.T.C. 1379, dismissing respondent's appeal from a
notice of reassessment. Appeal dismissed (Wilson, La Forest and L'Heureux‑Dubé
JJ. dissenting).
Ian
S. MacGregor and Brent Paris, for the
appellant.
Robert
W. Thompson and Gordon Balon, for the
respondent.
The
judgment of Dickson C.J. and Sopinka, Gonthier and Cory JJ. was delivered by
//Dickson
C.J.//
DICKSON C.J. --
This is an income tax case. The question in the appeal is whether certain
dividends received by the wife of the respondent, Jim A. McClurg, in the years
1978, 1979, and 1980 in respect of Class B common shares of Northland Trucks
(1978) Ltd. (hereinafter Northland Trucks) should be attributed in part to the
respondent, an officer and director of Northland Trucks and the holder of the
controlling Class A common shares in the capital stock of that company.
I. Background
1. Relevant
Legislation
Income Tax
Act, S.C. 1970-71-72, c. 63:
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.
Business
Corporations Act, R.S.S. 1978, c. B-10:
24. ...
(4) The articles may provide for more than one class
of shares and, if they so provide:
(a)the rights, privileges, restrictions and conditions
attaching to the shares of each class shall be set out therein; and
(b)the rights set out in subsection (3) shall be attached
to at least one class of shares but all such rights are not required to be
attached to one class.
40. A corporation shall not declare or
pay a dividend if there are reasonable grounds for believing that:
(a)the corporation is, or would after the payment be,
unable to pay its liabilities as they become due; or
(b)the realizable value of the corporation's assets would
thereby be less than the aggregate of its liabilities and stated capital of all
classes.
97.--(1) Subject to any unanimous
shareholder agreement, the directors of a corporation shall:
(a)exercise the powers of the corporation directly or
indirectly through the employees and agents of the corporation; and
(b)direct the management of the business and affairs of
the corporation.
234.--(1) A complainant may apply to a
court for an order under this section.
(2) If, upon an application under subsection (1),
the court is satisfied that in respect of a corporation or any of its affiliates:
(a)any act or omission of the corporation or any of its
affiliates effects a result;
(b)the business or affairs of the corporation or any of
its affiliates are or have been carried on or conducted in a manner; or
(c)the powers of the directors of the corporation or any
of its affiliates are or have been exercised in a manner;
that is
oppressive or unfairly prejudicial to or that unfairly disregards the interests
of any security holder, creditor, director or officer, the court may make an
order to rectify the matters complained of.
2. The Facts
The
respondent is President of Northland Trucks, a company incorporated under the
Saskatchewan Business Corporations Act. The company was
established in 1978 upon purchase of an ongoing business, a dealership in
International Harvester trucks. The respondent and his partner, Veryle Ellis,
are the only directors of the company. The Articles of Incorporation provide
for three categories of shares: Class A which are common, voting and
participating shares; Class B which are common, non-voting and participating
where authorized by the directors; and Class C which are preferred, non-voting
shares. The Articles deal with the entitlement to dividends as follows:
Class A Common:
Common, voting and shall be participating shares
carrying the distinction and right to receive dividends exclusive of the other
classes of shares in the said corporation.
Class B Common:
Common, non-voting and shall be participating shares
where authorized to be participating shares by unanimous consent of the
Directors and the said shares shall carry the distinction and right to receive
dividends exclusive of other classes of shares in the said corporation.
Class C Preferred:
Preferred, non-voting shares which carry the distinction
and right to receive dividends exclusive of other classes of shares in the
said corporation, if the said dividends are authorized by unanimous resolution
of the directors.
Each
class of shares has the right to receive dividends exclusive of other classes
of shares in the company and the company is authorized to issue an unlimited
number of shares in each class.
The
clause "the distinction and right to receive dividends exclusive of other
classes of shares in the said corporation" in the definition of the share
classes is crucial to the analysis in this case; a primary question is whether
the clause, which gives to the directors unfettered discretion as to the
allocation of dividends among classes of shares, constitutes a valid derogation
to the common law rule of equality of distribution of dividends. For the sake
of simplicity, I will refer to it as the "discretionary dividend
clause" throughout these reasons.
Shares
in the company were issued at a price of $1.00 each, and the distribution of
shares demonstrates the closely held nature of the company:
NAME
|
CLASS A
COMMON
|
CLASS B
COMMON
|
CLASS C
PREFERRED
|
Veryle Ellis
|
400
|
-
|
37,500
|
Wilma McClurg
(wife of Jim McClurg)
|
-
|
100
|
-
|
Suzanne Ellis
(wife of Veryle Ellis)
|
-
|
100
|
-
|
|
|
|
|
In the
years 1978, 1979, and 1980, the directors, McClurg and Ellis, voted a
declaration and distribution of dividends as follows:
Wilma McClurg
|
$10,000
|
$10,000
|
$10,000
|
Suzanne Ellis
|
$10,000
|
$10,000
|
$10,000
|
|
|
|
|
The
form of resolution declaring the dividends was as follows:
It was noted and unanimously agreed by all the Directors
that Class "B" Shareholders receive dividends in the amount of
$100.00 per share for each issued share they hold.
BE IT RESOLVED
that payment of dividends to Class "B"
Shareholders are made as follows:
CLASS "B" SHAREHOLDER
|
NUMBER OF ISSUED
SHARES
|
DIVIDEND
PER SHARE
|
TOTAL
PAID
|
Wilma McClurg
Suzanne Ellis
|
100
100
|
$100.00
$100.00
|
$10,000.00
$10,000.00
|
Although
the two directors received no dividends on either their Class A or Class C
shares during this three-year period, they did not go unrewarded. They
received salaries, were paid bonuses, and bonus entitlements totalling,
according to the trial judge, in the case of the respondent, $33,968 in 1978,
$65,292 in 1979, and $57,900 in 1980. As well, the company's retained earnings
as of October 31, 1980 were $312,611 and as of October 31, 1981 were $421,481.
The directors of the company, as owners of the Class A shares (the only shares
participating as of right), alone were entitled as of right to share in the
accumulated profits of the company.
An
analysis of the equity of the two classes of shares is shown below:
Class
A Class B
Shares
Shares
Shares
Issued
800 200
Amount
Paid
800 200
Dividends
Received
NIL 60,000
Growth
Accruing to shares to Oct. 31, 1980312,611 NIL
Submissions
attached with the Notice of Objection of Mr. McClurg for the 1978, 1979 and
1980 taxation years show that at the end of the 1981 taxation year, the equity
(growth) per share stood at $527 per share for Class A common shareholders (an
amount of 1.75 times that of Class B shares) whereas the total growth (equity)
accruing to Class B common shares still remained at $300 per share.
|
Total
Reimbursement
to Oct. 31/81
|
Equity Growth
Retained to
Oct. 31/81
|
Total
|
Total $
Per Share
Owned
|
%
|
Jim McClurg
|
224,700
|
210,741
|
435,441
|
1,088.62
|
45
|
Veryle Ellis
|
224,700
|
210,741
|
435,441
|
1,088.62
|
45
|
Wilma McClurg
|
48,125
|
NIL
|
48,125
|
481.25
|
5
|
Suzanne Ellis
|
48,125
|
NIL
|
48,125
|
481.25
|
5
|
|
545,650
|
421,482
|
967,132
|
|
100
|
The
financing of the formation of the company must also be reviewed. For the
respondent's investment of 37,500 preferred shares, he borrowed $37,500 from
the Toronto Dominion Bank on a note co-signed by his wife and his
father-in-law. The latter provided further security in the form of a term
deposit certificate totalling $40,000. The purchase of the business was partly
financed by a loan from the vendor, security for which was provided, in part,
by the respondent and his wife through the placing of a second mortgage on
their jointly owned home in the amount of $25,000. Furthermore, Wilma McClurg
co-signed with the respondent a personal guarantee to the International
Harvester Company, the supplier of the company, with respect to a $500,000
debenture in connection with the business affairs of Northland Trucks.
Finally, the company opened a line of credit with the Toronto Dominion Bank,
initially for $50,000, and later increased to $200,000, which was guaranteed by
all of the shareholders. It is worth noting that the trial judge found that
Wilma McClurg had personal assets of between $15,000 and $20,000 during this
time, which indicates that her personal guarantee was not without significance.
The
role of Wilma McClurg in the business during the period in question also
warrants examination. The evidence indicates that she carried the title of
Administrative Assistant. As such, she assisted in the operation of the
business, performing a variety of tasks as the need arose -- including
stenography, bookkeeping, stocktaking, and driving a truck. For her efforts
she received a salary of $625 in 1978, $5,000 in 1979, and $5,000 in 1980. Of
the $30,000 received by Wilma McClurg in dividends during this period, $20,000
was reinvested by her in M.E. Investments Corporation, a company with a similar
structure to that of Northland Trucks and which involved the same shareholders
and directors. The purpose of M.E. Investments Corporation was the acquisition
of land upon which the operations of Northland Trucks were located. In
acquiring the land, a first mortgage was given. Wilma McClurg was a personal
guarantor of the mortgage.
On
January 14, 1982, by notices of reassessment, the Minister of National Revenue
reassessed the respondent's income for 1978, 1979, and 1980. The basis for the
reassessment was that in each of those years $8,000 of the $10,000 in dividends
attributed to Wilma McClurg on her Class B shares was properly attributable
instead to the respondent pursuant to ss. 56(2) of the Income Tax
Act. The Minister made this reallocation on the basis of the number of
Class A shares owned by the respondent in relation to the number of Class B
shares owned by Wilma McClurg. The position of the Minister is that the
dividends declared in each of the years in question should be attributed
equally to all of the common shares, no matter of what class and
notwithstanding the express condition attaching to the Class B shares that they
shall carry the right to receive dividends exclusive of other classes of shares
in the company. The respondent's appeal to the Tax Court of Canada was
dismissed. The respondent further appealed from the decision of the Tax Court
judge by way of an action commenced in the Federal Court of Canada, Trial
Division. The appeal was allowed. The Minister's appeal to the Federal Court
of Appeal was dismissed. Finally, leave to appeal was granted by this Court.
3. Judgments
Below
Tax
Court of Canada, 84 D.T.C. 1379
Goetz
T.C.J. found no evidence suggesting that the investment of Wilma McClurg in the
company was of any importance. He reasoned that the respondent and his partner
had full control of the company and he concluded, at p. 1381, that the share
structure was solely an income splitting device:
To my way of thinking the share set up and the
establishment of the Class "B" shares was a channel of Northland to
funnel payments of profits to the Appellant's wife and this was to the
Appellant's tax benefit and is prohibited by section 56(2).
Goetz
T.C.J. concluded, at p. 1381, that the dividends were a "blatant
effort" at conferring a benefit on the wives of the directors and he
further remarked, at p. 1382, that "the wives were the puppets of the
Appellant and Ellis and did as they were told". Finally, he determined
that the efforts expended by Wilma McClurg and her exposure under the
guarantees had no relevance to the payment of dividends. He dismissed the
appeal from the reassessment.
Federal
Court of Canada - Trial Division 1986, 2 F.T.R. 1
Strayer
J. began by considering the interpretation of s. 56(2), and he found, at p. 4,
that its literal meaning could require that "every dividend paid to any
shareholder of a company could be attributed to the income of directors
participating in a decision to pay the dividend". He continued:
Such a
dividend would be a "payment" "to some other person" with
the "concurrence" of the director. It could also be described as a
"benefit" that the director "desired to have conferred" on
the shareholder, it surely being desirable from the viewpoint of directors
that, where ever possible, dividends be paid to the shareholders of the company
in order to enhance their satisfaction with the company.
Strayer
J., reasoned, however, that the intention of the legislature could not have
been such a broad reading and found the subsection qualified in that, to fall
foul of s. 56(2), the taxpayer must seek to avoid receipt of funds that would
otherwise be payable to him and that the concept of payment of a "benefit"
is to be contrasted with payments for consideration.
In
the opinion of Strayer J., it could not be said that money payable to the
respondent was diverted to his wife so as to bring the situation within s.
56(2). He was not persuaded that the Articles of Incorporation must be
regarded as void in so far as they permit differential payment of dividends to
various classes of shareholders. Nor did he see any legal impediment to a
contract between the shareholder and the company which allows the directors of the
company to fix the amount of dividends payable in a given year to a given class
of shareholders. Since no dividends were payable as a matter of right to
holders of Class A shares, such as the respondent, without a resolution to that
effect being adopted by the directors, it could not be said that money payable
to him was diverted to his wife so as to bring the situation within s. 56(2).
Strayer
J. also was satisfied that the dividends paid to Wilma McClurg were not a
"benefit" within the contemplation of s. 56(2). The dividends were
paid within the context of a legal relationship between the shareholder and the
company pursuant to which she was entitled to receive dividends as declared
from time to time by the directors. The surrounding circumstances suggested to
him, at p. 5, that "this was a legitimate business relationship created by
all the necessary legal instruments and should not be treated as a sham".
Wilma McClurg had made a real contribution to the establishment of the business
through her personal guarantee and the share of the mortgage she assumed on the
house she owned jointly with the respondent. Furthermore, she had taken an
active part in the operation of the business for which she was paid only a
small salary. The appeal was allowed.
Federal
Court of Appeal, [1988] 2 F.C. 356
The
majority judgment at the Federal Court of Appeal was delivered by Urie J. and
was concurred in by Heald J. Urie J. began by expressing a difficulty in
appreciating how s. 56(2) could apply in a corporate context. A corporation
provides to its shareholders, by way of dividends, such portion of its earnings
as its directors deem advisable. Those directors do so in their capacities as
directors and not in their personal capacities, no matter how closely held the
corporation's shares. Urie J. had further difficulty understanding how "a
taxpayer," when acting as a director, satisfies any of the conditions
precedent for the application of s. 56(2). He reasoned, at p. 363, that:
Only the
most explicit language, which is not present in subsection 56(2), would justify
the notion that a director acting as such could be seen as directing a
corporation to divert a transfer or payment for his own benefit or the benefit
of another person, absent bad faith, breach of fiduciary duty or acting beyond
the powers conferred by the share structure of the corporation, none of which
bases have been alleged here.
Furthermore,
Urie J. felt that applying s. 56(2) in a corporate context would make no
distinction between arm's length and non-arm's length transactions, leaving all
directors at risk of having dividends declared by them, and paid to
shareholders who may be relatives, attributed to them for tax purposes. He
concluded that the section was not intended to apply to the directors of
corporations participating in the declaration of corporate dividends. He
dismissed the appeal.
Desjardins
J. dissented at the Court of Appeal. She began by observing that, unless
otherwise provided in the Articles of Incorporation or by statute, the rights
of the classes of shareholders to receive dividends are to be assessed on a
basis of equality. She disagreed with Strayer J.'s conclusion that the
description of the dividends found in the Articles of Incorporation constituted
a "derogation from the principle of equality amongst shareholders
recognized in the common law" (at p. 368), stating at p. 369:
What happens in the case at bar is that shareholders
in each class are given "the distinction and right to receive dividends to
the exclusion of other classes". From that perspective, they are all
equal. Moreover, no mathematical formula is given if a distribution were to
occur. . . . The directors obtain full control over the allocation if they
declare dividends. . . .
I
doubt that such a discretion to be exercised by way of a resolution of the
directors, can be equated with a derogation specific and substantive enough to
discard the common law rule of equality of distribution since there is no rule
by which the directors are to carry out their discretion.
The
moneys paid, in her opinion, ought to have been distributed equally amongst the
shareholders and there should have been included in the respondent's income
part of the dividends paid to his wife.
In
rejecting the trial judge's conclusion that there was a legitimate business
relationship between the respondent's wife and the company, Desjardins J.
remarked that there is no relationship between the services that a shareholder
brings to a company and his or her entitlement to a dividend. The dividends
come as a return on investment and attach to the share, rather than to the
shareholder.
Desjardins
J. was not persuaded that s. 56(2), if interpreted widely, would cover every
declaration of dividends. Once declared, the amount of the dividend received
on each share is governed by a mathematical formula which the director must
apply in accordance with the contract between the shareholders and the company.
II. Analysis
This
appeal raises issues relating both to corporate law and the law of income
taxation. In my view, it is useful to deal with the former first as the
analysis is beneficial in the determination of the application of s. 56(2) of
the Income Tax Act.
1. Corporate
Law Issues
I
begin the analysis with a statement of the obvious. The decision to declare a
dividend lies within the discretion of the directors of a company, subject to
any restrictions which have been included in the Articles of Incorporation.
This principle has long been accepted at common law and was explicitly
recognized by Lord Davey, speaking for the Judicial Committee of the Privy
Council, in Burland v. Earle, [1902] A.C. 83,
at p. 95, wherein the principle was described in terms of the "internal
management" of the company:
Their
Lordships are not aware of any principle which compels a joint stock company
while a going concern to divide the whole of its profits amongst its
shareholders. Whether the whole or any part should be divided, or what portion
should be divided and what portion retained, are entirely questions of internal
management which the shareholders must decide for themselves, and the Court has
no jurisdiction to control or review their decision, or to say what is a
"fair" or "reasonable" sum to retain undivided, or what
reserve fund may be "properly" required.
With
the advent of statutory regulation of corporations, the authority to pay
dividends, recognized at common law as part of the internal management of the
company, has been given statutory recognition. In the case at bar, the
governing legislation is the Saskatchewan Business Corporations
Act, (hereinafter S.B.C.A.). In my view, it cannot be disputed
that the power to pay dividends is an in tegral component of the broad grant of
managerial power for directors found in s. 97(1) of the Act, cited earlier. I
take it, both from an observation of the workings of corporations, and from
other provisions in the statute, that the section embraces the common law power
of directors. The power to declare dividends is expressly limited in the Act,
in much the same way as it was at common law. For example, s. 40 of the S.B.C.A., also
cited earlier, prohibits the declaration of a dividend if there exist
reasonable grounds to believe that to do so would leave the corporation unable
to pay its debts (s. 40(a)); or, if the payment of a dividend would render the
realizable value of the assets of the corporation less than the aggregate of
its liabilities and stated capital of all classes of shares (s. 40(b)).
Although these restrictions are not brought into play by the declarations of
dividends in issue in this appeal, the presence of those limitations in the Act
suggests that the power to declare dividends is statutorily limited only by
restrictions expressly stated.
Of
course, the power to declare dividends is further qualified by the fact that
the law has for many years recognized that the general managerial power which
rests in the directors of a company is fiduciary in nature. The declaration of
dividends, which is subsumed within that power, therefore is limited legally in
that it must be exercised in good faith and in the best interests of the
company. As Professor Welling recognized in his treatise Corporate
Law in Canada (1984), at p. 614, this limitation exists when any
disbursement is made by the directors of a company:
The
directors' general managerial power is a fiduciary one, owed to the
corporation. It must always be exercised in what the directors' from time to
time think is likely to serve the best interests of the corporation. It has
been consistently urged throughout this book that "the corporation",
as referred to in that context, means the legal and economic entity, not some
vague aggregation of the shareholders' wants. This means that dividends should
be seen as basically what they seem to be on a narrow, legalistic view:
corporate gifts. . . . giving it is permissible only to the extent that the
directors think that it will serve the corporate entity's best interest, as
they then perceive those interests; beyond this, the declaration of any dividend,
like any other unauthorized gift of corporate property, is a breach of
directors' duty.
In my
opinion, this is an accurate statement of the legal basis of the declaration of
a dividend in the context of the modern corporation.
Having
reviewed the legal basis for the payment of a dividend by a company, another
fundamental principle of corporate law can be restated. The appellant argues,
and it is conceded by the respondent, that the rights carried by all shares to
receive a dividend declared by a company are equal unless otherwise provided in
the Articles of Incorporation. This principle, like the managerial power to
declare dividends, has been well accepted at common law. The principle, or
more accurately, the presumption of equality amongst shares and the
prerequisites required to rebut that presumption, are described in Schmitthoff, Palmer's
Company Law, 23rd ed., vol. 1, at p. 387, para. 33-06:
Prima
facie the rights carried by the shares rank pari passu, i.e. the
shareholders participate in the benefits of membership equally. It is only
when a company divides its share capital into different classes with different
rights attached to them that the prima facie presumption of equality of shares
may be displaced.
In my
view, a precondition to the derogation from the presumption of equality, both
with respect to entitlement to dividends and other shareholder entitlements, is
the division of shares into different "classes". The rationale for
this rule can be traced to the principle that shareholder rights attach to the
shares themselves and not to shareholders. The division of shares into
separate classes, then, is the means by which shares (as opposed to
shareholders) are distinguished, and in turn allows for the derogation from the
presumption of equality: Bowater Canadian Ltd. v. R.L. Crain Inc. (1987),
62 O.R. (2d) 752 (C.A.), at p. 754 (per Houlden
J.A.).
The
concept of share "classes" is not technical in nature, but rather is
simply the accepted means by which differential treatment of shares is
recognized in the Articles of Incorporation of a company. As Professor
Welling, supra, succinctly explains, at p. 583,
"a class is simply a sub-group of shares with rights and conditions in
common which distinguish them from other shares". Indeed, the use of the
share class is recognized in the S.B.C.A.as the means by
which derogation from the principle of equality is to be achieved. The statute
thus explicitly requires that "the rights, privileges, restrictions and
conditions attaching to the shares of each class" must be expressly stated
in the Articles of Incorporation: s. 24(4)(a).
Having
outlined the underlying principles of corporate law relevant to the issues
raised on this appeal, the application of those principles to the facts can be
attempted. The appellant, the Minister of National Revenue, argues that the
discretionary dividend clause in the Articles of Incorporation of Northland
Trucks does not create discrete classes of shares with different rights to
dividends. Furthermore, the Minister contends that the clause creates no right
to dividends at all and, therefore, does not comply with the statutory
requirement in s. 24(4)(a). Consequently, the allocation of a dividend made
pursuant to the discretionary dividend clause must be disregarded because of
its failure to comply with the S.B.C.A. and with the
principles of corporate and common law. As a result, the presumption of
equality has not been rebutted and equality of distribution amongst the share
classes prevails. As I have earlier noted, Desjardins J. in her dissenting
reasons at the Court of Appeal accepted this argument, and held that the clause
permits the directors to create differences in dividend allocation "at
whim". She thus expressed doubts, at p. 369, as to whether:
. . .
such a discretion to be exercised by way of a resolution of the directors, can
be equated with a derogation specific and substantive enough to discard the
common law rule of equality of distribution since there is no rule by which the
directors are to carry out their discretion.
The
respondent argues, on the other hand, that the discretionary dividend clause is
a valid exercise of contractual rights between the company and its shareholders
in accordance with the common law and statute. Moreover, the right to receive
dividends in potentially unique amounts gives each share class different
rights. It is argued that this is a material distinction sufficient to create
separate share classes with differentiated dividend entitlements which, in turn,
validly derogates from the principle of equality.
I
agree with the arguments which the respondent has raised in this regard. In my
opinion, the discretionary dividend clause is both a valid means of allocating
declared dividends and is sufficient to rebut the presumption of equality
amongst shares. I find this determination, with respect to the presumption of
equality, to be a simple factual inquiry. In my view, 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. As far as
the statutory requirements are concerned, the purpose of s. 24(4)(a) is to
ensure that shareholders are fully aware of their entitlements and privileges
to the extent that the presumption of equality is rendered inapplicable. To my
mind, that purpose has been met since the dividend entitlements are clearly set
out in the description of the share classes. In this regard, I find the
argument of Quessy in his article "Les aspects corporatifs et fiscaux des
actions à dividende discrétionnaire", [1985] 7 R.P.F.S. 31, at
p. 45 to be persuasive:
[TRANSLATION] . . .
the inclusion in the articles of a discretionary dividend clause expressly
establishes that the corporation intends to derogate from the principle of
equality among shareholders. The provision included in the articles alters the
division of profits, which in the absence of such a provision would have to be
made in accordance with the principle of equality among shareholders.
I am in
full agreement with Strayer J. (at p. 5) that, with respect to the presumption
of equality, "the Articles of Incorporation specifically provide to the
contrary". In my view, then, the presumption of equality manifestly has
been rebutted.
I
find the appellant's arguments, as they relate to the validity of a
discretionary dividend clause in terms of general corporate law and the
requirements of the S.B.C.A., to be equally unpersuasive. Counsel
for the appellant placed considerable emphasis in his arguments upon the nature
of a shareholder "right", arguing that for the purposes of the
statute and common law, a right to a dividend comprises a right to a portion of
the total dividend declared, calculated according to the terms set out in the
share description if and when the directors decide to make a distribution of
the profits of the company. The appellant argues that the insertion of a
discretionary dividend clause in the Articles of Incorporation is insufficient
to confer a "right" since no corresponding "duty" is imposed
on the company to pay dividends on that class once a dividend has been
declared. Implicitly, Desjardins J. accepted this argument when she referred
to the ability of the directors to allocate dividends "at whim". The
appellant argues that this unconstrained discretion cannot be considered a
"right" which is conferred by the shares.
I
disagree with this analysis. In my opinion, the fact that dividend rights are
contingent upon the exercise of the discretion of the directors to allocate the
declared dividend between classes of shares does not render entitlement to a
dividend any less a "right". Rather, it is the entitlement to be
considered for a dividend which is more properly characterized in those terms.
I agree with the respondent that the Class B common shareholders of the company
have an entitlement comparable to that of a fixed dividend holder to receive a
dividend if the company's directors declare one. As well, the appellant's
argument that there is no corresponding "duty" on directors as
regards the "right" of shareholders is, in my view, specious. The
directors are bound by their fiduciary duty to act in good faith for the
best interests of the company in the declaration and allocation of any
dividend. That duty is in no way circumvented by the presence of a discretionary
dividend clause. Finally, I think that it should be borne in mind that many
shareholder rights may be qualified and contingent (voting rights, the right to
transfer shares, preferential rights to dividends, participation rights); yet
the mere fact that these rights are fettered does not render them anything less
than shareholder rights.
In a
similar vein, I do not agree that the absence of a mathematical formula for the
allocation of declared dividends in the Articles of Incorporation of the
company is dispositive of the issue of the validity of the discretionary
dividend clause. As the decision to declare a dividend and the determination
of the funds available for a dividend are already within the discretion of the
directors, it seems to me that a discretionary dividend clause is not a
significant departure or extension of that discretion: De Vall
v. Wainwright Gas Co., [1932] 2 D.L.R. 145 (Alta. C.A.). If shares are
divided into separate classes, one of which contains a preferred entitlement to
dividends declared by the company, the directors effectively have the
discretion to allocate dividends only to that preferred class. Thus, the
respondent could have achieved precisely the same allocation of dividends by
structuring the company so that Wilma McClurg and Suzanne Ellis constituted a
preferred class of shareholders with first entitlement to dividends. Such a
structure would be unimpeachable in terms of the principles of corporate law.
Furthermore,
it cannot reasonably be maintained that the presence of a discretionary
dividend clause inherently leads to a conflict of the duty of directors and
their self-interest any more than does the discretion to declare a dividend in
any company. Consequently, I cannot agree with those authors who take the
position that the allocation of dividends by directors, pursuant to a
discretionary dividend clause, inherently cannot be exercised in the best
interests of the company: see Martel and Martel, La compagnie au
Québec, Les aspects juridiques, vol. I, at pp. 18-10 through p.
18-14C; Boivin, "Le droit aux dividendes et le dividende
"discrétionnaire"" (1987), 47 R. du B. 73. I
agree with the argument of the respondent that it is unrealistic to think that
directors will not pay heed to the identity of shareholders and the
contribution to the company of those shareholders any time a decision is made
as to whether dividends of any sort should be declared. The fact that
directors may consider the identity of shareholders does not necessarily render
the declaration invalid on the basis of a conflict of duty and self-interest.
For example, the discretion could be exercised for the purpose of rewarding a
group of employees who comprise a preferred class of shareholders and who have
been encouraged to invest in a company. Surely the fact that the identity of
the holders of that class of shares was considered in the decision to declare a
dividend and in the determination of the quantum of the dividend would not
render the decision invalid. To reiterate, the limitation on the decision is
purely a fiduciary one and the entitlement of a shareholder is "to share
in the profits of the company when these are declared as dividends in respect
of the shares of the class of which his share forms a part"
[emphasis added]: Bryden, "The Law of Dividends", in Jacob S.
Ziegel, ed., Studies in Canadian Company Law, at p.
270. That right is in no way undermined by the presence of a discretionary
dividend clause.
In
other words, the clause simply divides conceptually into two components --
declaration and allocation -- what has been, traditionally, one decision. In
substance, though, the discretion which lies in the hands of the directors has
always included both, subject to the provisions of the Articles of
Incorporation. In this regard, the only other limitation upon the directors of
which I am aware is that "if a dividend is declared by [a] corporation . .
. there must be some shares entitled to receive the dividend": Welling, supra, at pp.
588-89. The principle has been given statutory recognition in s. 24(4)(b) of the S.B.C.A. In my
view, this rule is not defeated by the presence of the discretionary dividend
clause because the identity of the class eligible for a dividend simply remains
unknown until the allocation takes place. This conceptual division into
declaration and allocation is not substantively different from any derogation
from the presumption of equality in the payment of dividends. Consequently,
for this Court to find that the use of a discretionary dividend clause on these
facts was an invalid exercise of the discretion of the directors would be to
defeat the substance of what was achieved solely on the basis of its form.
Finally,
I question whether it would be appropriate for this Court to determine that the
use of a discretionary dividend clause is invalid in the context of an income
tax appeal. The purpose of the governing statute, the S.B.C.A., is
facilitative -- that is, it allows parties, with certain explicit restrictions,
to structure bodies corporate as they wish. As well, the Act provides the
means for an aggrieved party -- security holder, creditor, director or officer
-- whose interests have not been regarded fairly by the corporation, to seek
redress through the oppression remedy in s. 234 of the Act. No such complaint
has been lodged by any interested party in this case, presumably because all
those involved in this company are satisfied with the way in which the
directors are conducting its affairs. Furthermore, at common law it is a well
established principle that where shareholders are unanimously agreed to a
transaction, inequality of treatment does not render it ultra
vires the company: Wegenast, The Law of Canadian
Companies, at pp. 321-22. As I have found that the use of a
discretionary dividend clause is not prohibited expressly by the Act, nor
contrary to common law or corporate law principles, I think the permissive
spirit of the Act demands that a conclusion be reached that the use of the
clause is valid. As Quessy, supra, explained, at p. 48, the use of the
clause represents a legitimate exercise of the contractual rights between
shareholders and a company:
[TRANSLATION] . . .
the declaration and payment of a dividend by the directors on discretionary
dividend shares is a legal act under the Corporations Acts when the articles
contain a provision conferring greater discretion on them. We then have shares
of the capital stock carrying the right to receive any dividend declared.
Moreover, the articles contain an express provision indicating that the parties
intend to derogate from the principle of equality among shareholders.
Accordingly, as the parties to the contract are not acting contrary to public
order and not infringing the law, we are of the view that the terms of the
agreement concluded by them should be observed.
I
agree with this conclusion. Professor Eisenberg, more than two decades ago, in
his work on modern corporate law, "The Legal Roles of Shareholders and Management
in Modern Corporate Decisionmaking" (1969), 57 Cal. L. Rev. 1, at
p. 180, reasoned that "[i]n the case of the privately held corporation,
legal rules governing internal decisionmaking should be suppletory in nature
and based on the shareholders' probable expectations". Given that the
legislature has not chosen to disallow the discretionary dividend clause, and
no shareholder has taken remedial action against its use (presumably because
shareholder expectations have been realized by its exercise), it would be
paternalistic in the extreme for this Court to invalidate the clause at the
behest of the appellant Minister of National Revenue. If the legislature
determines that the use of the discretionary dividend clause undermines the
reasonable expectations of shareholders or is in some way unfair to an
interested party, then it is up to the legislature to limit the use of this
means of structuring corporate affairs.
In
conclusion, then, I find nothing untoward in the use of the discretionary
dividend clause in the allocation of corporate dividends. There is nothing in
the S.B.C.A. or at common law that prohibits this dividend
allocation technique.
2. Income Tax
Implications
Having
dealt with the corporate law issues raised by the use of a discretionary
dividend clause, I now turn to the primary issue raised in this appeal, namely,
the tax consequences of the allocation of dividends made pursuant to the
clause. This analysis entails an examination of s. 56(2) of the Income Tax
Act and its application to the facts at bar. Before proceeding with that
analysis, though, I would like to review briefly the method of interpretation
to be followed in applying the section.
Interpretation
of Taxing Statutes
In
recent years this Court, in an income tax appeal, has found it beneficial to
engage explicitly in the development of an interpretative approach to the Income Tax
Act, an approach which is wedded neither to a rule of "strict
construction" nor to an all-encompassing test of "independent
business purpose". This trend began with the judgment of Estey J. in his
majority reasons in Stubart Investments Ltd. v. The Queen, [1984]
1 S.C.R. 536. In that case, Estey J. undertook an extensive discussion of
interpretative techniques, and he drew a conclusion as to the preferred
approach to be taken by the Courts, at p. 576:
It seems
more appropriate to turn to an interpretation test which would provide a means
of applying the Act so as to affect only the conduct of a taxpayer which has
the designed effect of defeating the expressed intention of Parliament. In
short, the tax statute, by this interpretative technique, is extended to reach
conduct of the taxpayer which clearly falls within "the object and
spirit" of the taxing provisions.
Estey J.
expanded upon this test of "object and spirit" in his majority
judgment in The Queen v. Golden, [1986] 1 S.C.R.
209, at pp. 214-15:
. . .
the law is not confined to a literal and virtually meaningless interpretation
of the Act where the words will support on a broader construction a conclusion
which is workable and in harmony with the evident purposes of the Act in
question. Strict construction in the historic sense no longer finds a place in
the canons of interpretation applicable to taxation statutes in an era such as
the present . . . .
More
recently, in Bronfman Trust v. The Queen, [1987] 1 S.C.R.
32, I described the approach in terms of the need to discern the commercial
reality of a taxpayer's transaction, at pp. 52-53:
I acknowledge, however, that just as there has been
a recent trend away from strict construction of taxation statutes ... so too
has the recent trend in tax cases been towards attempting to ascertain the true
commercial and practical nature of the taxpayer's transactions. There has
been, in this country and elsewhere, a movement away from tests based on the
form of transactions and towards tests based on ... a "common sense
appreciation of all the guiding features" of the events in question. . . .
This
is, I believe, a laudable trend provided it is consistent with the text and
purposes of the taxation statute. Assessment of taxpayers' transactions with
an eye to commercial and economic realities, rather than juristic
classification of form, may help to avoid the inequity of tax liability being
dependent upon the taxpayer's sophistication at manipulating a sequence of
events to achieve a patina of compliance with the apparent prerequisites for a
tax deduction.
Thus,
in proceeding to analyze the tax consequences of the application of the
discretionary dividend clause, it is necessary to determine both the purpose of
the legislative provision and the economic and commercial reality of the
taxpayer's actions. To a certain extent, the latter inquiry in the case at bar
already has been answered by my determination that the use of the discretionary
dividend clause is a valid means whereby directors of a company can distribute
dividends. The question also is answered, in part, by the fact that it was not
argued by the appellant that the payment of dividends to Wilma McClurg was a
"sham". Therefore, to use the words of Estey J. in Stubart
Investments Ltd., supra, at p. 572, it cannot be said that
the transaction was "constructed as to create a false impression in the
eyes of a third party, specifically the taxing authority". Having
determined these preliminary issues, the purpose of s. 56(2) can be examined.
Subsection
56(2) of the Income Tax Act
In
attempting to discern the purpose of s. 56(2), it is helpful to refer to the
body of jurisprudence dealing with the subsection. A useful starting point is
an early case dealing with the predecessor section to s. 56(2): Miller v.
M.N.R., 62 D.T.C. 1139 (Ex. Ct.). In that case, Thurlow J.,
as he then was, in examining s. 16(1) of the Act, made some general comments,
at p. 1147, as to the anti-avoidance purpose of the provision which remain
relevant today:
In my
opinion, s. 16(1) is intended to cover cases where a taxpayer seeks to avoid
receipt of what in his hands would be income by arranging to have the amount
received by some other person whom he wishes to benefit or by some other person
for his own benefit. The scope of the subsection is not obscure for one does
not speak of benefitting a person in the sense of the subsection by making a
business contract with him for adequate consideration.
Strayer
J. noted, at p. 4, in respect of the Miller case:
Two
important qualifications are noted here: the first is that the taxpayer seek
"to avoid receipt" of funds, presumably funds that would otherwise be
payable to him; and the second is that the concept of payment of a
"benefit" is contrasted to payments for adequate consideration.
In
my opinion, the views of Thurlow J. and Strayer J. provide a sound foundation
for the interpretation of s. 56(2). The subsection obviously is designed to
prevent avoidance by the taxpayer, through the direction to a third party, of
receipts which he or she otherwise would have obtained. I agree with both
Thurlow J. and Strayer J. in their characterization of the purpose of the
section and, specifically, I concur with their view that the section reasonably
cannot have been intended to cover benefits conferred for adequate
consideration in the context of a legitimate business relationship.
Application
to the Facts
Having
discerned the purpose of the section and the proper approach in interpretation,
the next step in the analysis is apparent: a determination of the commercial
reality and practical nature of the respondent's transactions which were the
subject of reassessment by the Department of National Revenue. Urie J. in the
Court of Appeal found the determination that the transaction occurred in the
context of a director-shareholder relationship to be dispositive. I agree with
that conclusion, and with the skepticism expressed by Le Dain J. in Perrault
v. The Queen, [1979] 1 F.C. 155 (C.A.), at pp. 165-66, where he
questioned whether the words of s. 56(2) "were intended to apply to the
payment of a dividend". 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 anti-avoidance
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: Welling, supra, 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).
The
appellant argues, and Desjardins J. accepted in dissent in the Court of Appeal,
that s. 56(2) may be invoked at the point when the allocation is made of a
dividend declared by the directors pursuant to the discretionary dividend clause.
It is submitted that because, once declared, a dividend must be receivable by
one class of shares pursuant to s. 24(4)(b) of the S.B.C.A., a
portion of the dividend would have been received by the respondent in his
capacity as shareholder had the payments not been directed to Wilma McClurg by
him in his capacity as director. However, in discussing the use of the
discretionary dividend clause, I have already concluded that its validity
rests, in part, on the fact that allocations made pursuant to the clause are
substantively no different from allocations made pursuant to a mathematical
formula in the articles of incorporation of a company. Given that
determination, it would be formalistic in the extreme to reach the conclusion
that but for the payment to a third party shareholder, a director-shareholder
would be the recipient of a portion of the payment. Instead, my view is that
an allocation pursuant to a discretionary dividend clause is no different from
the payment of a dividend generally. In both cases, 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. I agree with both Urie
J. and Strayer J. in the courts below that 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.
Although
I have concluded that s. 56(2) does not apply to the declaration of dividends
generally, its application also would be contrary to the commercial reality of
this particular transaction. Strayer J. reviewed the evidence and reached the
conclusion that the background and context of the transaction could be
described as a "legitimate business relationship" (at p. 5), and he
found that:
. . .
the plaintiff's wife had made a real contribution to the establishment of the
company and business through the personal guarantee she gave and the share of
the mortgage she assumed on their jointly-owned home. The evidence presented
before me also satisfied me that she had taken an active part in the operation
of the business to the extent of her abilities and the requirements of the situation.
I find
this conclusion to be completely supported by the evidence. Wilma McClurg
played a vital role in the financing of the formation of the company. Although
I agree with Desjardins J., at p. 370 that, with respect to a shareholder,
"dividends come as a return on his or her investment", in my view
there is no question that the payments to Wilma McClurg represented a
legitimate quid pro quo and were not
simply an attempt to avoid the payment of taxes. In my opinion, Goetz T.C.J.
erred when he found that the dividends were a blatant attempt at tax
avoidance. Indeed, his dismissal of the relevance of Wilma McClurg's
contribution to the company and his description of her and Suzanne Ellis as
"puppets" pay no regard to the very real contributions, financial and
operational, made by Wilma McClurg. Furthermore, the efforts expended by Wilma
McClurg in the operation of Northland Trucks, while not dispositive of the
issue raised in this appeal, do provide further evidence that the dividend
payment was the product of a bona fide business relationship.
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. In the case of the latter, of which this appeal is
an example, I do not think it can be said that there was no legitimate purpose
to the dividend distribution.
III. Disposition
In
conclusion, I have found that: (i) the discretionary dividend clause is valid
in terms of the principles of corporate law and the provisions of the
Saskatchewan Business Corporations Act; (ii) the
declaration of a dividend is normally beyond the scope of s. 56(2) of the Income Tax
Act; and, (iii) the facts at bar provide no evidence that the business
arrangement was an attempt at tax avoidance, but rather that it was the product
of a business contract made for adequate consideration. As a result, I would
dismiss the appeal. Pursuant to the order of this Court granting leave to
appeal in this case, costs of the appeal will be payable by the appellant on a
solicitor-client basis.
The
reasons of Wilson, La Forest and L'Heureux-Dubé JJ. were delivered by
//La Forest
J.//
LA FOREST J.
(dissenting) -- This appeal is concerned with whether money received by Wilma
McClurg, wife of the respondent Jim A. McClurg, by virtue of a
"discretionary dividend" clause, may properly be attributed to the
respondent pursuant to s. 56(2) of the Income Tax Act, S.C.
1970-71-72, c. 63. The facts and the judgments of the courts below have been
set out at length in Chief Justice Dickson's reasons, and I do not propose to
repeat them. Rather, I will proceed directly to the legal analysis. Following
the basic framework of the opinion of the Chief Justice, the discussion is
divided into issues of corporate and tax law.
Corporate
Law Issues
Simply
put, the corporate law question raised by this appeal is whether the clause in
Northland Trucks (1978) Ltd.'s Articles of Incorporation purporting to give
each class of shares the "right to receive dividends exclusive of other
classes of shares in the said corporation" is a valid allocation of power
to the directors of the corporation under the Saskatchewan Business
Corporations Act, R.S.S. 1978, c. B-10. The clause is referred to as a
"discretionary dividend" clause because the mode of distribution of
dividends is not determined by the Articles of Incorporation themselves, but is
left to the "discretion" of the directors of the company.
In a
certain sense, the term "discretionary dividend" is a misnomer, since
it is a well-accepted principle of common law that the directors of a
corporation have the discretion to determine if and when a dividend should be
declared, and in what amount. This discretion is, of course, subject to
certain reasonable limitations. For example, s. 40(a) of the
Saskatchewan Business Corporations Act provides that a
dividend may not be declared if there are reasonable grounds to believe such
declaration would render the corporation unable to pay its debts. As well,
there is the overriding principle that the discretion must always be exercised
in a manner which is in the best interests of the corporation; see Welling, Corporate
Law in Canada (1984), at p. 614.
Although
the term "discretionary dividend" may be somewhat misleading, it is
nonetheless not difficult to understand how the label itself was first chosen.
Clauses such as the one contained in the Articles of Incorporation of Northland
Trucks give directors a power of discretion that they never previously had:
the power to discriminate between different classes of shares when determining
how a dividend should be distributed. Is this allocation of power to the
directors valid under the Saskatchewan Business Corporations
Act? To answer this question, it is necessary to examine both the
principles at common law and the statute itself.
The Common
Law
Since
the famous decision of the House of Lords in Salomon v. Salomon
and Co., [1897] A.C. 22, it has been a settled proposition of
law that a corporation has a separate legal existence, independent from that of
its shareholders. Even before Salomon, it had been said
that it was this proposition that lay at the "root" of corporate law: Farrar v.
Farrars, Limited (1888), 40 Ch. D. 395, at pp. 409-10.
The
independent legal existence of the corporation means that, while the
shareholder remains a proportionate owner of the corporation, he does not
actually own its assets. These assets belong to the corporation itself, as a
separate legal entity; Schmitthoff, Palmer's Company Law (23rd
ed. 1982), vol. 1, at p. 384, para. 33-01. Management of the corporation is
entrusted to its officers and directors with the shareholder's interest
protected through the distribution of shareholder votes. Thus, the corporate
entity is unique in that it allows the shareholder to alienate ownership of
property by placing it in a structure where the ownership of the property is
separated from the effective control over that property; see Welling, supra, at p.
81. The sole link between the shareholder and the company is the share, which
provides both a measure of the shareholder's interest in the company, as well
as of the extent of the shareholder's liability for the actions of that
company: see Borland's Trustee v. Steel Brothers & Co., [1901]
1 Ch. 279, at p. 288.
This
separation of ownership and control provides the basis for many of the
fundamental principles of corporate law. One example is the principle that the
directors and officers of a corporation owe a fiduciary duty to the
corporation: see Canadian Aero Service Ltd. v. O'Malley, [1974]
S.C.R. 592. In recognizing for the first time that the fiduciary duty owed by
directors to the corporation should be extended to senior officers of the
corporation as well, this Court focused upon the degree of control that the
officers were in a position to exercise in that case. Laskin J., as he then
was, speaking for the Court, there stated, at p. 610:
Strict
application against directors and senior management officials is simply
recognition of the degree of control which their positions give them in
corporate operations, a control which rises above day-to-day accountability to
owning shareholders and which comes under some scrutiny only at annual general
or at special meetings. It is a necessary supplement, in the public interest,
of statutory regulation and accountability which themselves are, at one and the
same time, an acknowledgment of the importance of the corporation in the life
of the community and of the need to compel obedience by it and by its
promoters, directors and managers to norms of exemplary behaviour.
Another
principle that I believe also stems logically from the separation of ownership
and control inherent in the corporation is the principle of equality of
shares. Since the shareholders are only proportionate owners of the company,
if their interest is to be adequately and fairly protected, those in the
position of control must treat all the shareholders, or more accurately, all
the shares, equally. Thus see Schmitthoff, supra, at p.
387, para. 33-06:
Prima
facie the rights carried by the shares rank pari passu, i.e. the
shareholders participate in the benefits of membership equally. It is only
when a company divides its share capital into different classes with different
rights attached to them that the prima facie presumption of equality of shares
may be displaced.
In
my opinion, the principle of equality of shares, like the principle of
fiduciary duty, developed as more than just a mere contractual right -‑ it
was a measure of protection for the shareholder that arose as a practical
consequence of the unique nature of the corporate structure itself. This
is so even though the parties could contract out of it to the extent that
shares could be created that did not themselves have equal rights. In such a
situation, the shareholder was still protected by virtue of the common law rule
that shareholder rights had to be attached to the share itself, and not to the
individual shareholder. Thus, while the shares had differentiated rights
depending upon the particular class to which they belonged, the shareholder
himself could not be discriminated against. For example, even when different
classes of shares were created, the shares within the various classes
themselves still had to be treated on an equal basis. It is thus put by
Wegenast, The Law of Canadian Companies (1979),
at pp. 320-21:
Apart
from provisions, duly adopted, for preferences as between different classes of
shares, and, where there are such preferences, then as amongst the members in
each respective class, shareholders are entitled to be treated on a basis of
equality. Shareholders may differ as to the wisdom of a particular course of
action, but once adopted it must be carried out without discrimination
amongst the shareholders or, as it is said in some of the cases, "for
the benefit of the company as a whole." [Emphasis added.]
More
significantly, even when more than one class of shares was created, the
directors were not free to discriminate arbitrarily between the classes
when awarding a dividend. As Fraser states in Company Law of Canada (5th
ed. 1962), at p. 532, quoting Lord Cranworth L.C. in Henry v. Great
Northern Ry. Co. (1857), 1 De G. & J. 606, at p. 638, 44 E.R. 858,
at p. 871:
[Where
there is more than one class of shareholders] it will [. . .] be the duty of
the directors to fix the amount of the fund retained with reference to the
general interest of all classes of shareholders, and not to favour any one
class at the expense of the other.
The
few Canadian cases that appear to have considered the issue have all held that,
even when the shareholders agree to do so, a company may not validly be structured
so as to derogate from the common law principle that shareholder rights must
attach to the shares themselves. When I speak of shareholder rights, I include
at least those three categories of rights that are considered to be
fundamental: the right to a dividend, the right to vote, and the right to
participate in the distribution of assets upon dissolution of the corporation.
In Jacobsen
v. United Canso Oil & Gas Ltd. (1980), 113 D.L.R. (3d) 427 (Alta.
Q.B.), the defendant company passed a by-law to the effect that no one person
was entitled to vote more than 1000 shares, notwithstanding the number of
shares actually held by that person. The company had originally been
incorporated under the Companies Act, R.S.C. 1952, c.
53. The court found the by-law invalid since the Companies Act
recognized the common law presumption of equality "that all shares confer
equal rights and impose equal liabilities and that if voting rights are to vary
separate classes of shares must be created so that the different numbers of
votes can be attached to the shares themselves and not to the holder"
(at p. 433) (emphasis added). The court also held that the by-law was invalid
under the Canada Business Corporations Act, S.C.
1974-75, c. 33, which superseded the Companies Act, the
Act upon which the Saskatchewan Business Corporations Act is
based.
In Bowater
Canadian Ltd. v. R.L. Crain Inc. (1987), 62 O.R. (2d) 752, the Ontario
Court of Appeal held invalid a "step-down" provision contained in the
respondent R.L. Crain Inc.'s Articles of Incorporation. The provision provided
for a special class of common shares that carried ten votes per share while in
the possession of the original shareholder, but that would carry only one vote
per share if transferred to another. The Court of Appeal followed the
reasoning of McRae J. in the court below, who, at p. 754, held that:
. . .
although there was no express prohibition in the CBCA against
a step-down provision, s. 24(4) of the Act should be interpreted in
accordance with the general principles of corporation law with the result
that the rights which are attached to a class of shares must be provided
equally to all shares of that class, this interpretation being founded on the
principle that rights, including votes, attach to the share and not to the
shareholder. [Emphasis added.]
Both Jacobsen and Bowater
recognize that the principle that shareholder rights must attach to the
corporation's shares is more than a mere contractual right: even the
shareholders themselves may not agree to circumvent this principle.
Another
case holding that rights attach to the share rather than the shareholder,
albeit in a different context, is Rondeau v. Poirier, [1980]
C.A. 35. In that case, the respondent claimed he was entitled to receive a
portion of the cumulative dividends paid on shares that were given by him to
his former wife as part of their divorce settlement. The respondent argued
that he should receive the dividends that were paid retroactively for the years
during which he possessed the shares. This argument was rejected by the Court
of Appeal, which held that the right to receive dividends is a contingent right
that does not actually arise until the dividends have been declared by the
corporation. Although the respondent had been the shareholder during the years
when most of these dividends were accumulated, any right to these dividends
passed with the shares when they were transferred (at p. 39).
Writing
for the majority of the Court of Appeal in Rondeau, Lamer
J., as he then was, noted at p. 37 that the shareholder's right to a dividend
encompasses the right to a particular mode of distribution once a dividend has
been declared:
[TRANSLATION] [The
shareholder] is entitled not to the profits, since the directors are not
obliged to distribute them, but to a portion and to certain modes of
distribution of profits if and when the directors decide on a distribution,
in other words, declare a dividend. [Emphasis added.]
In
my view, a discretionary dividend clause such as the one in this case, that
permits the directors of a corporation to choose which class is entitled to
receive dividends to the exclusion of the other classes, would be invalid at
common law. It contravenes the principle that the directors are not permitted
to favour one class at the expense of the others: see Fraser and Stewart, supra, at p.
532. Further, and the respondent does not dispute this point, if dividends are
allocated to the different classes on a discretionary basis, then the directors
will be making this allocation primarily on the basis of the identity of the
shareholders in the various classes. While the respondent contends that this
does not represent a significant departure from the existing state of the law,
I disagree, for it means, in effect, that the right to the dividend attaches
not to the shares, but to the shareholder: see Boivin, "Le droit aux
dividendes et le dividende `discrétionnaire'" (1987), 47 R. du B. 73, at
p. 92.
Again,
in my view, the rule that shareholder rights must attach to the shares
themselves is a principle which has its roots in the very nature of the
corporate structure. When the Articles of Incorporation create classes of
shares that have different rights, this normally does not require the directors
to discriminate between the shareholders ‑- the mode of distribution is
set out in the shares themselves. To allow discrimination on the basis of the
identity of those possessing the shares ignores the separation that is supposed
to exist between the corporation and its shareholders: see Martel and Martel, La
compagnie au Québec, Les aspects juridiques (1987), vol. I, at
p. 18-14B.
The
respondent, however, contends that, even in a situation where no discretionary
dividend clause exists, in a corporation with at least one class of preferred
share, the directors of a corporation effectively have the power to choose
which classes will receive dividends. They can do so by declaring dividends in
an amount small enough that only the preferred shares will partake. This,
however, is a discretion that is expressly limited by the terms of the Articles
of Incorporation. The need for protection is not as great, for the common
shareholder is not placed in a position where the director can award dividends
of any amount to a class other than his or her own. That shareholder knows
that if dividends are declared in excess of a specified amount, then his or her
class of shares will participate. If dividends are never declared in excess of
that amount, then at least the money is retained by the corporation. Where
there is a discretionary dividend clause, however, the shareholder is
completely dependent on the goodwill of the directors. The minority
shareholder is placed in a near impossible position if this goodwill turns
against him or her; see Martel and Martel, supra, at p.
18-14A. It is interesting to note that at least one commentator who writes in
favour of the discretionary dividend clause suggests that each shareholder's
"informed" consent to this sort of arrangement be obtained in advance
in writing, presumably to guard against just such an eventuality: see Quessy,
"Les aspects corporatifs et fiscaux des actions à dividende
discrétionnaire", [1985] 7 R.P.F.S. 31, at pp. 42-43.
In
my opinion, a second reason why the discretionary dividend clause is invalid at
common law is because it places the director in a position where he cannot
fulfill his fiduciary obligations to the corporation as a whole. The interests
of different classes of shareholders, where a discretionary declaration of
dividends is concerned, are necessarily divergent, since a dividend will be
declared for the benefit of one class of shareholders at the expense of the
others. As put by Martel and Martel, supra, at pp.
18-14 and 18-14A:
[TRANSLATION] It
would be impossible for him to justify this preference, since it is surely not
made in good faith in the interests of the company. In using their discretion
to favour certain shareholders, the directors are in an obvious conflict of
interest, particularly if they are themselves those shareholders or associated
with them. . . . The situation created by discretionary dividend clauses is
unprecedented, and places the directors in an impossible position: if they
favour certain shareholders by departing from the rule of equality, they are breaching
their obligations as agents or quasi-fiduciaries of the company, and in fact
are acting as agents of the shareholders they are favouring, or at least of
those who control the company.
The
conflict of interest is heightened when the director happens to be a
shareholder himself. When the discretionary dividend clause is utilized to
award dividends to a class in which the director holds shares, or from which he
derives some personal benefit, the situation can be compared to the usurpation
of a corporate opportunity properly belonging to the company. As Laskin J.
observed in the Canadian Aero Service Ltd. v. O'Malley, supra, at pp.
606-607, the fiduciary duty, at the very least, precludes the director
. . .
from obtaining for himself, either secretly or without the approval of the
company (which would have to be properly manifested upon full disclosure of the
facts), any property or business advantage either belonging to the company or
for which it has been negotiating; and especially is this so where the director
or officer is a participant in the negotiations on behalf of the company.
A
discretionary dividend clause gives the director a licence to secure, by virtue
of his position, a personal benefit at the expense of the corporation and its
shareholders without having to seek shareholder approval. By contrast,
requiring the mode of distribution to be expressly set out in the Articles of
Incorporation, which can only be amended by approval of the shareholders, is
consistent with the fiduciary obligation as described in the Canadian
Aero case. I note that, in the usual case, if the directors
themselves hold preferred shares, this does not present a problem, for the
common shareholders will have agreed to subordinate their dividend interest to
the preferred class of shares based upon "full disclosure" of the
maximum amount to which these preferred shares will enjoy priority. With a
discretionary dividend clause, there is no such disclosure, since the amount
and priority is left to be determined in the future, wholly at the directors'
discretion.
The
Chief Justice states that the fact that the directors take into account the
identity of shareholders when declaring a dividend does not necessarily create
a conflict of duty. As an example, he suggests that the directors could
validly exercise their discretion to allocate dividends so as to reward a group
of employees who comprise a class of preferred shareholders. With respect, it
seems to me that even this would constitute an improper exercise of the
discretionary dividend power. If the employees truly merit some additional
reward, the proper course would be to achieve this through some other form of
compensation, for example a bonus. A dividend is supposed to be a return on an
investment. On this point, I adopt the words of Desjardins J. of the Federal
Court of Appeal ([1988] 2 F.C. 356), at p. 370:
But
surely, there is no relationship, in company law, between the work and services
a shareholder brings to a company and his or her entitlement to a dividend if
declared. The dividends come as a return on his or her investment and not on account
of work and services he or she may render to the company. The dividend
attaches to the share and not to the shareholder.
In
any event, even if I did not find that the discretionary dividend clause was
itself invalid under the common law, I would find that the clause, at least as
designed in the present case, is insufficient to rebut the common law
presumption of equality. As earlier noted, it is well accepted that in the
absence of some differentiation between the shares, all shares must be treated
equally: see Birch v. Cropper, In re Bridgewater Navigation Co. (1889),
14 A.C. 525 (H.L.). The respondent contends that the fact that the classes of
shares have the potential to receive dividends in potentially different amounts
is sufficient to differentiate them. The fact remains, however, that all three
classes of Northland Trucks' shares are defined in substantially the same
manner with respect to their entitlement to dividends. Each class carries
"the distinction and right to receive dividends exclusive of other classes
of shares in the said corporation". As Professor Boivin, supra, notes,
at p. 94:
[TRANSLATION] . . .
if all the shares have a discretionary dividend clause, they are all on an
equal footing as regards dividends, even if there are certain distinctive
characteristics with respect to other rights or privileges. Far from breaching
the principle of equality, the clause thus used confirms it.
Any
difference between the shares concerning their right to receive dividends that
does exist clearly does not derive from any differentiation between the shares,
but would have to stem from the actions of the directors of the corporation.
This would, however, be a right that does not derive from the share itself, and
as such would be invalid at common law.
Having
found that the discretionary dividend clause contained in the Articles of
Incorporation of Northland Trucks was an invalid allocation of power at common
law, it remains to examine the Saskatchewan Business Corporations
Act to see if the statute changes this result.
The
Saskatchewan Business Corporations Act
Section
24(4)(a) of the Saskatchewan Business Corporations
Act provides that the corporation may derogate from the common law rule of
equality, by creating more than one class of shares:
24. . . .
(4) The articles may provide for more than one
class of shares and, if they so provide:
(a)the
rights, privileges, restrictions and conditions attaching to the shares of each
class shall be set out therein;
See also
s. 6(1)(c)(i).
The
question becomes whether the allocation of power to the directors of a
corporation to determine each class of shares' right to a dividend, once one
has been declared, is consistent with s. 24(4)(a), which
provides that such rights must be "set out" in the Articles of
Incorporation. There are two possible interpretations. The first is that it
is sufficient if the articles "set out" that the different classes of
shares have the "right" to receive a dividend that has been declared,
wholly at the discretion of the directors. The second is that the requirement
that the rights be "set out" requires that the mode of distribution
of the dividends be expressly provided for in the articles themselves.
I
start from the premise that s. 24(4)(a) must,
of course, be interpreted in accordance with the principles of the common law:
see Bowater, supra, at p. 754. It should be apparent
from the preceding analysis that, in my opinion, this would inevitably lead one
towards the second interpretation, since, at common law, shareholder rights had
to be expressly provided for in the shares themselves. If the Saskatchewan
legislature intended to depart from this principle, it could have stated so
explicitly. In my view, s. 24(4)(a) falls far short
of providing the clear expression necessary to indicate an intent to provide
the directors of a corporation with a power which they did not otherwise have
at common law.
I
note that this interpretation of s. 24(4)(a)
appears to be the most consistent with other provisions of the Act as well.
For example, s. 27 provides for the possibility of creating different
"series" within a class of shares, which may themselves be structured
so as to possess different rights. In contrast to its treatment of classes of
shares, the Act expressly provides that the directors of a corporation
may be given the discretion to determine the rights attaching to these series.
Section 27(1) reads:
27.--(1)
The articles may authorize the issue of any class of shares in one or more
series and may authorize the directors to fix the number of shares in and to
determine the designation, rights, privileges, restrictions and conditions
attaching to the shares of each series, subject to the limitations set out in
the articles.
It
is significant that, even when the Act specifically provides that the directors
may be given the discretion to determine the rights to be assigned to a series,
this discretion is not unlimited: see s. 27(2), (3), (4). In particular, the
directors may not assign to a series a higher priority in respect of dividends
or return of capital over any other series of the class that are still
outstanding (s. 27(3)). Thus, even though under the Act the shareholders can
give the directors the power to issue series within a class and assign rights
to those series, the shareholders may not agree to give the directors the
discretion to interfere with their right to dividends or a return of capital by
choosing to give another series priority. Why would the legislature find
it necessary to protect the shareholders by restricting the directors'
discretion in this manner? In my view, the answer lies in the fact that the
rights assigned to series, unlike classes of shares, may be altered without
amending the corporate constitution. As Professor Welling, supra, notes,
at p. 584, this distinction leads to a potential for abuse of power by the
directors:
The
result is clear although, from the point of view of shareholder protection, it
is initially astounding. The statute requires that discrimination between
different classes be strictly regulated by the corporate constitution, subject
to the remedies protecting adherence to the corporate constitution and
changeable only by the usual shareholder approvals. Strangely, discrimination within a
particular class need only be pre-meditated in the articles: the
details can be supplied from time to time by ordinary directors' resolutions,
without any shareholder participation at all. [Emphasis in original.]
Because
s. 27 allows the shareholders to give directors the power to discriminate
between series of shares, while leaving the directors with the ability to
"supply the details" of this discrimination themselves at a later
date, the legislature apparently found it necessary to limit this power, by
preventing the directors from discriminating in certain areas, specifically
with respect to priority over dividends. This attempt at protection would be
rendered futile if it were permissible for shareholders to give to directors
the same power to discriminate with respect to priority over dividends where
shareholder classes are concerned, through the use of a discretionary
dividend clause.
A
more reasonable interpretation of the statute is that it contemplates that
shareholders will be protected from changes being made to the rights attached
to different classes of shares by virtue of the fact that such rights may only
be amended by altering the corporate constitution. Section 170(1)(c) of the
Saskatchewan Business Corporations Act provides that:
170 (1) . . . the holders of shares of a class or . . . of
a series are entitled to vote separately as a class or series upon a proposal
to amend the articles to:
.
. .
(c) add,
change or remove the rights, privileges, restrictions or conditions attached to
the shares of such class . . . .
The
protection afforded by s. 170 for dividend rights can only be meaningful if the
mode of distribution must itself be set out in the Articles of Incorporation.
Otherwise, the section can effectively be circumvented because the directors
will have the power to change each class' allocation of dividends at will,
without the need for a shareholder vote. The importance of s. 170(1) as a mechanism
for protecting shareholder interests is evidenced by the fact that each class
of shares is entitled to vote, regardless of whether the shares normally carry
this right or not (s. 170(3)).
I
also find the use of the discretionary dividend clause in the present case to
be inconsistent with the requirement of the Act that at least one class of
shares must be entitled "to receive any dividend declared by the
corporation" (s. 24(3)(b)). On this point, I agree with the following remarks
of Professor Boivin, supra, at p. 93:
[TRANSLATION]
Assuming that the capital consists of a single class of shares and that these
shares carry a discretionary dividend, they do not confer, in our view, any
right to any dividends, which is not surprising since that is precisely the
aim. Even assuming that the share confers a right to a dividend, that right
cannot be interpreted as a right to receive "any dividend declared".
In
essence, the argument of the respondent distills down to a single point: the
Saskatchewan Business Corporations Act does not appear to
specifically prohibit the use of a discretionary dividend clause, and in the
absence of such explicit prohibition, the parties must be left free to contract
at will. If one were to carry this argument to its logical conclusion, there
would be nothing to prevent shareholders from passing a "discretionary
voting" clause, giving the directors the power to exercise all of their
votes as they see fit. Indeed, during the oral argument, counsel for the respondent
appeared to suggest that this, too, would be a permissible allocation of
power. I find that such an arrangement, which would leave the directors in
complete control of the corporation, with the power to prolong their tenure
indefinitely, to be completely unacceptable in that it would undermine
virtually all of the protection afforded to shareholders by the Act.
It
is true, of course, that the actions of the directors will always be subject to
the qualification that they are acting as fiduciaries for the corporation.
Thus, in theory, it is always open for a shareholder to bring a suit if he
feels the directors are exercising their discretion improperly. In reality,
however, one cannot overlook the significant burden and expense that this
remedy entails. In my view, placing the onus on shareholders to bring a suit
to vindicate their rights is an inadequate means of protecting them from the
potential for abuse created by the presence of a discretionary dividend clause.
If
this protectionist view seems somewhat patronizing, I would point out that
other provisions of the Saskatchewan Business Corporations
Act provide, in a similar manner, for the protection of shareholders from
arrangements to which they might otherwise agree. One example already referred
to is s. 27, which restricts the power that can validly be allocated to
directors to determine the rights and privileges of future series of shares. I
also note that the protection of the individual shareholder was one of the
major driving forces behind the extensive statutory reform that took place in
Canadian corporate law in the 1970s; see Welling, supra, at p.
502. The Saskatchewan Business Corporations Act is a product of
that reform, as is the Canada Business Corporations Act upon
which the Saskatchewan Business Corporations Act is modeled.
Corporate law has not yet evolved to the point where the freedom to contract at
any cost has become paramount to all other concerns.
The
need for shareholder protection from abuse of the discretionary dividend clause
becomes all the more apparent when one considers the possibility that such a
clause could be inserted in the articles of incorporation of a large, publicly
held corporation. I recognize that in this case we are dealing with a closely
held corporation, where there has been no allegation of a breach of fiduciary
duty by the directors, but the Saskatchewan Business Corporations
Act applies to large and small corporations equally. One rule of law must
stand for both. I hasten to add that, in my view, the primary reason that the
discretionary dividend clause is invalid is that it offends the principle that
the corporation has a separate legal existence from the shareholder. Since the
shareholders of closely held corporations are given preferential treatment,
such as limited liability, based upon the notion of this separation between
corporation and shareholder, it is not unreasonable for the state to require
them to respect this separation by structuring their corporation accordingly.
Against
the weight of these arguments, I can think of no socially useful purpose, and
counsel for the respondent could point to none, behind the employment of a
discretionary dividend clause. The only apparent purpose of such a clause is
to facilitate tax avoidance through "income-splitting", which does
little to persuade me of the need to allow corporations to be structured in
this manner: see Boivin, supra, at p. 106; see also comment,
"The Last Bastion for Income-Splitting? J.A. McClurg v. The Queen"
(1986), 34 Can. Tax J., at p. 404.
Having
found that the discretionary dividend clause used in the Articles of
Incorporation of Northland Trucks was invalid, it remains to determine how the
money distributed pursuant to that clause should be allocated. Since the
directors of Northland Trucks must be taken to have made the decision that the
declaration of the amount of dividends that were distributed was in the best
interests of the corporation, it would be inappropriate to now return this
money to the corporation. The proper solution, in my view, is to redistribute
the dividends amongst the various classes of shares. As previously discussed,
in the absence of a valid differentiation between the shares to the contrary,
all of the classes will share in the dividend equally. In the present case,
that means that the money will be allocated equally to the shares in classes A,
B, and C.
I
turn then to a consideration of the income tax consequences of the dividend
payments.
Income
Tax Consequences
General
I am
in agreement with the Chief Justice as to the proper approach to the
interpretation of the Income Tax Act generally, and s.
56(2) specifically, as well as the necessity of ascertaining the true nature of
the transaction in question. With deference, however, I am unable to agree
with him as to the application of s. 56(2) in the present case. Our
differences arise as a result of the interdependence of the corporate law and
income taxation issues in this case, and my finding that the discretionary
dividend clause is invalid.
Any
tax planning technique is open to challenge on the basis that the underlying
legal construct is invalid. This follows from the fundamental principle of
taxation law that the actual legal result of a transaction, rather than its
form, is relevant to tax liability. In Champ v. The Queen, 83
D.T.C. 5029 (F.C.T.D.), for example, a dividend payment was found to be invalid
in law, and the form of the payment was disregarded for tax purposes. In that
case, the taxpayer and his wife held two-thirds and one-third of the shares of
the corporation respectively. While the Articles of Association of the company
specifically stated that "dividends may be declared and paid according to
. . . the number of shares held", dividends were paid to only one class of
shares, which were held exclusively by the wife. The court found that the
taxpayer diverted his pro rata share of the dividends, and included
this indirect payment in his income by way of s. 56(2). The approach adopted
by the Federal Court in Champ is in keeping with the
"ineffective transaction" test for denying a taxpayer the benefit of
a particular transaction, which was articulated by this Court in Stubart
Investments Ltd. v. The Queen, [1984] 1 S.C.R. 536.
In
the present case, Mrs. McClurg received a dividend payment of $10,000 on the
basis of the discretionary dividend clause that has been found to be invalid.
Therefore, the taxpayer's characterization of the true nature of the payment
cannot stand. Instead, the analysis must proceed on the basis that the
dividend declared in each of the three years in question should have been
allocated equally to the shares in classes A and B. Of the $10,000 dividend
declared, then, $8,000 was payable to Mr. McClurg, and only $2,000 was payable
to Mrs. McClurg.
Before
turning to the specifics of the application of s. 56(2) to the facts at hand,
it is necessary to comment on two points raised by the Chief Justice. First,
he states that a dividend payment does not fall within the scope of s. 56(2).
I agree with this view so far as it refers to the typical situation where the
dividend payment is within the powers of the corporation and the shareholder is bona fide
entitled to the dividends. It must be emphasized, however, that $8,000 of the
dividend payment to Mrs. McClurg was not a bona fide
dividend payment, but a receipt of dividend income otherwise payable to her
husband. As was the case in Champ v. The Queen, supra, a
payment which is not in law a dividend payment cannot serve as a bar to the
application of s. 56(2).
Secondly,
I must comment on the relevance of Mrs. McClurg's contribution to the
business. At trial, it was found as a fact that Wilma McClurg contributed to
the establishment and operation of the business. The Chief Justice considers
this fact to be of relevance to the resolution of the matter before this Court,
because it indicates that the dividend payment was not the product of a blatant
tax avoidance scheme, but rather a benefit conferred for adequate consideration
in the context of a legitimate business relationship. In other words, the
dividend payment can be justified because of the efforts made by Mrs. McClurg
on behalf of the company.
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.
In
the present case, a $10,000 dividend was declared by the directors of Northland
Trucks and was allocated in its entirety to Mrs. McClurg, ostensibly in return
for work and services rendered to the company. Regardless of what motivated
the directors to allocate the dividends to Mrs. McClurg, if she were somehow bona fide
entitled to the dividends, it would be an entitlement based solely on her
ownership of shares of the corporation, and s. 56(2) would not apply. In other
words, s. 56(2) clearly is inapplicable to a transaction wherein a shareholder
is in receipt of a dividend properly allocated to his or her shares.
Application
of Section 56(2)
Turning
to the application of s. 56(2) to the instant case, I find it useful as a
starting point to break the provision down into its constituent parts. Such an
analytical framework was adopted by Cattanach J. in Murphy v. The Queen, 80
D.T.C. 6314 (F.C.T.D.), where he stated, at pp. 6317-18:
To fall within subsection 56(2) each essential
ingredient to taxability in the hands of the taxpayer therein specified must be
present.
Those four ingredients are:
(1)that there must be a payment or transfer of property
to a person other than the taxpayer;
(2)that the payment or transfer is pursuant to the
direction of or with the concurrence of the taxpayer;
(3)that the payment or transfer be for the taxpayer's
own benefit or for the benefit of some other person on whom the taxpayer wished
to have the benefit conferred, and
(4)that
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.
It must
be determined, then, whether these four elements or prerequisites to the
application of s. 56(2) are present in the transaction at hand.
With
regard to the first element, the term "payment" has acquired no
technical meaning in the Income Tax Act and is to be
interpreted in its popular sense: see Murphy, supra, at p.
6320. Furthermore, "property" is defined in very broad terms in s.
248(1) of the Income Tax Act, and specifically
includes money. It is also noteworthy that s. 16(1), the predecessor to s.
56(2), originally referred to a transfer of "money, rights or
things". Therefore, it appears that the payment in question satisfies the
first prerequisite to the operation of s. 56(2). This is confirmed by Champ v.
The Queen, supra, where it was held that the taxpayer
effected a "transfer of property" by directing the payment of
dividends.
The
second element provides that the payment or transfer be pursuant to the
direction of the taxpayer or with the concurrence of the taxpayer. The
respondent argued that the payment was made by the company, a legal entity
separate from the taxpayer, and to the extent that the taxpayer directed or
concurred in the payment of the dividend, this was done in his capacity as a
director of the corporation, and not in any personal capacity.
Under
s. 56(2), however, it is sufficient that such a payment be made with the
concurrence of the taxpayer. The facts indicate that the respondent, in his
capacity as a shareholder, did not object to the distribution of dividends.
The appellant argued that Mr. McClurg's failure to object to the payment to
Mrs. McClurg constituted implied concurrence. In other words, since Mr.
McClurg did not demand his share of the dividends, he implicitly accepted that
the company make an $8,000 payment to his wife. To this end, the appellant
relied on Bronfman, A. v. M.N.R., [1965] C.T.C. 378
(Ex. Ct.), at p. 385, in which Dumoulin J. held that the "abstention or
indifference" of shareholders who had the power to object to the actions
of directors was "tantamount to an approval" and sufficient to invoke
s. 16(1), the predecessor to s. 56(2).
In
my view, an individual in control of a corporation can be said to have directed
a payment or transfer of property within the meaning of s. 56(2) by exercising
that control. Furthermore, even if one accepts the contrary view that the
taxpayer did not direct the payment, the payment nevertheless was made with the
concurrence of Mr. McClurg in his personal capacity as a shareholder of the
company. Thus, the second precondition to the operation of s. 56(2) is met.
The
third precondition requires that the payment be for the benefit of the taxpayer
or recipient. Since Mrs. McClurg was entitled to only $2,000 in dividends, the
$8,000 portion of the payment representing Mr. McClurg's dividend entitlement
amounts to a benefit to her under s. 56(2). In addition, Mr. McClurg himself
obtained a benefit from the transaction by way of a reduction in income tax.
As explained by Cattanach J. in Murphy v. The Queen, supra, at p.
6318, this type of benefit goes to the very purpose of s. 56(2):
Subsection
56(2) is to impute receipt of income to the taxpayer that was diverted at his
instance to someone else. It is to cover cases where the taxpayer seeks to
avoid the receipt of what in his hands would be income by arranging to transfer
that amount to some other person he wishes to benefit or for his own benefit in
doing so. Apart from any moral satisfaction the practical benefit to the
taxpayer is the reduction in his income tax.
Finally,
it is obvious that the $8,000 dividend would have been included in Mr.
McClurg's income had the allocation been properly made.
Therefore,
the four prerequisites to the application of s. 56(2) have been met. Since
$8,000 of the $10,000 in dividends attributed to Wilma McClurg on her class B
shares was properly attributable to Mr. McClurg, this amount should be included
in the computation of his income.
Disposition
In
the result, I would allow the appeal and uphold the Minister's reassessment.
Appeal
dismissed with costs, WILSON, LA FOREST and L'HEUREUX‑DUBÉ JJ. dissenting.
Solicitor
for the appellant: John C. Tait, Ottawa.
Solicitors
for the respondent: Bennett Jones, Calgary.