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Citation: 2004TCC474
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Date: 20040629
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Docket: 2003-194(IT)G
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BETWEEN:
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729658 ALBERTA LTD.,
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Appellant,
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and
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HER MAJESTY THE QUEEN,
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Respondent;
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Docket: 2003-195(IT)G
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AND BETWEEN:
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729656 ALBERTA LTD.,
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Appellant,
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and
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HER MAJESTY THE QUEEN,
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Respondent.
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REASONS FOR JUDGMENT
Woods J.
[1] The appellants, 729656 Alberta
Ltd. and 729658 Alberta Ltd., have been reassessed pursuant to
subsection 55(2) of the Income Tax Act in respect of
dividends that they received as part of a series of transactions
designed to extract so-called "safe income" on a
tax-deferred basis prior to an arm's length sale of
shares."Safe income" is the term commonly used
to describe the amount of corporate income that can be extracted
by way of tax-free intercorporate dividends without being
recharacterized as capital gains under subsection 55(2).
[2] The specific issue in these
appeals is how "safe income" should be determined if
dividends are received by a corporation on shares that were
acquired on a partial rollover under subsection 85(1) of the
Act. The Crown submits that safe income should be
apportioned on a pro rata basis if an accrued gain is
partly realized by a transferor under subsection 85(1). The
appellants submit that it is not reasonable to apportion safe
income on a pro rata basis on their particular facts
because the transactions do not offend the object and spirit of
subsection 55(2).
Overview of subsection 55(2)
[3] Subsection 55(2) is an
anti-avoidance provision that was introduced in the 1979 federal
budget. At the time of its introduction, the government was
concerned that taxpayers were engaging in transactions that
unduly reduced capital gains on a sale of shares by converting
proceeds of disposition into tax-free intercorporate
dividends.
[4] The relevant part of subsection
55(2) reads:
... one of the purposes of which ... was to effect a
significant reduction in the portion of the capital gain that,
but for the dividend, would have been realized on a disposition
at fair market value of any share of capital stock immediately
before the dividend and that could be reasonably be
attributable to anything other than income earned or realized by
any corporation after 1971 and before the safe-income
determination time for the transaction, event or series
...
(emphasis added)
[5] The legislative scheme is not
apparent from subsection 55(2). However, it was described by the
government at the time the section was introduced. The scheme was
succinctly described by Noel, J.A. in Kruco Inc. v. R.,
[2003] 4 C.T.C. 185 (F.C.A.):
The goal was to ensure that the capital gain inherent in the
shares of a corporation that is attributable to an unrealized
appreciation since 1971 in the value of the underlying assets of
the corporation was not avoided by the use of intercorporate
tax-free dividends (subsection 112(1)). At the same time,
Parliament did not want to impede the tax-free flow of dividends
that were attributable to income which had already been
taxed.
...
Conceptually, this approach captures the tax applicable to the
portion of the notional gain attributable to an increase in value
of the underlying assets while maintaining the tax-free treatment
of that part of this gain attributable to 'income earned or
realized' since 1971.
Facts
[6] The facts are not in dispute and
were provided by way of agreed statements. A summary of the
relevant facts, based on a written submission on behalf of the
appellants, is attached as an appendix to these reasons.
[7] Prior to the transactions at
issue, Ronald Lauterstein and Lewis Nickerson each owned 50
percent of the shares of Comcare Ltd., a Canadian-controlled
private corporation. On May 28, 1997, the shares of Comcare were
sold to an arm's length buyer. In the week leading up to the
share sale, Messrs. Lauterstein and Nickerson undertook a series
of transactions[1]
that was designed in part to defer tax on the amount of "safe
income" attributable to their shares.
[8] Prior to the series of
transactions, the shares of Comcare owned by each individual had
a fair market value of $12,429,037 and an adjusted cost base of
$37,600. Most of the value, then, represented accrued gain. The
safe income on the Comcare shares at that time was estimated to
be $1,932,802 and this calculation is not in dispute in these
appeals.
[9] The relevant transactions
undertaken during the week prior to the share sale were:
(a)
a transfer by Messrs. Lauterstein and Nickerson of the shares of
Comcare to their holding companies (the appellants);
(b)
the payment of taxable dividends by Comcare to the holding
companies aggregating $1,932,802; and
(c)
the sale of the shares of Comcare by each of the holding
companies to an arm's length buyer for cash consideration of
$10,393,335. The consideration was equal to the fair market
value of the shares of Comcare before the series of transactions
less the amount of dividends paid to the holding companies.
[10] These steps are typical of transactions
that are designed to access safe income and would not have been
controversial if the shares of Comcare had been transferred to
the holding companies at their adjusted cost base so that the
holding companies had inherited the entire accrued gain
($12,391,437). What has led to these transactions being
reassessed is that most of the accrued gain was realized by
Messrs. Lauterstein and Nickerson on the transfer. Only a small
portion of the accrued gain, an amount equal to the estimated
safe income ($1,932,802), was transferred to the holding
companies. This was effected by making elections under subsection
85(1) such that the deemed proceeds of disposition of the shares
of Comcare to Messrs. Lauterstein and Nickerson, and the deemed
cost of the shares of Comcare to the holding companies, was
$10,393,335.[2]
[11] The tax result that Messrs. Lauterstein
and Nickerson intended by this series of transactions was for
them to realize taxable dividends of $10,393,335 (on the transfer
of the shares of Comcare to the holding companies) and for the
holding companies to realize tax-free dividends from Comcare and
no gain on the sale of the Comcare shares. The Crown has not
suggested that this resulted in less tax than would be payable if
the transactions had been implemented in a more conventional
manner, with the holding companies inheriting the entire accrued
gain. If the holding companies had inherited the entire gain, the
individuals would not have realized any income and the holding
companies would have realized capital gains of $10,393,335.
[12] The Minister of National Revenue
reassessed tax for the 1997 taxation years of the holding
companies pursuant to subsection 55(2). A portion of the
dividends received by the holding companies was recharacterized
as proceeds of disposition and taxed as capital gains. The
Minister took the position that the safe income that was
attributable to the Comcare shares in the hands of the
individuals, which was admitted to be $1,932,802, should be
prorated when the shares were transferred to the holding
companies. The accrued gain that was rolled to the holding
companies ($1,932,802) represented approximately one-sixth
of the entire accrued gain ($12,391,437) and the Minister
reasoned that only one-sixth of the safe income should be
inherited by the holding companies. Therefore approximately
five-sixths of the dividends were recharacterized as proceeds of
disposition pursuant to subsection 55(2).
Issue
[13] The question to be determined is
whether a pro rata portion of the dividends received by
the holding companies should be recharacterized as proceeds of
disposition pursuant to subsection 55(2).[3]
Positions of parties
[14] The position of the Crown is that, on
the subsection 85(1) transfer, the safe income should be prorated
on the same basis that the accrued gain is prorated.The specific
arguments made in support of this position are:
(a)
because the safe income that was attributable to the portion of
the capital gain realized on the transfer to the holding
companies is reflected in the adjusted cost base of the shares to
the holding companies, it should not continue to be
double-counted as safe income;
(b)
requiring proration of the safe income is a reasonable extension
of generally accepted principles of interpretation of subsection
55(2);
(c)
the position is in accordance with the object and spirit of the
legislation which is reflected in the phrase "reasonably be
attributed;"
(d)
the position accords with the administrative practice of the
Canada Revenue Agency; and
(e)
it has been recognized in the tax literature.
[15] The appellants, on the other hand,
submit that since the transactions were intended to defer tax on
income that had been subject to tax in Comcare, there is no
reasonable basis to deny this result since it is in accordance
with the scheme of the Act.
[16] The parties also made submissions as to
which position should take precedence if I were to determine that
both positions were reasonable. The Crown submits that its
position trumps the position of the appellants and that
subsection 55(2) should be applied in this case: Nassau Walnut
Investments Inc. v. R.,[1998] 1. C.T.C. 33 (F.C.A.) and
Brelco Drilling Ltd. v. R., [1999] 3 C.T.C. 95
(F.C.A.). The appellants submit that these cases are not
relevant on these facts and that any ambiguity should be resolved
in favour of the taxpayer: Johns-Manville Canada Inc. v.
R., [1985] 2 C.T.C. 111 #2 (S.C.C.).
Analysis
[17] These appeals concern how an accrued
gain should be apportioned between "income earned or
realized" and "unrealized appreciation in the value of
underlying assets." The answer turns on the meaning of the
phrase "reasonably be attributable."
[18] Often when a provision of the
Act requires something to be allocated on a reasonable
basis, an averaging or proration is the most logical basis for
the allocation. I am not satisfied that this is appropriate in
this case. In my view, the word "reasonably" in the
context of this anti-avoidance provision implies that the accrued
gain should be allocated based on the particular circumstances of
the case to counter the mischief that was sought to be addressed.
That is the approach that has generally be adopted in
interpreting this section.
[19] In interpreting the phrase
"reasonably be attributable," there has never been any
suggestion that an accrued gain should generally be apportioned
on a pro rata basis between "income earned or
realized" and "unrealized appreciation in the value of
underlying assets." The accepted approach is that gain is
first allocated to "income earned or realized" and,
only if dividends exceed this amount, is gain allocated to
"unrealized appreciation in the value of underlying
assets." There is nothing in the statute that implies this
ordering but it is critical in order that subsection 55(2)
achieve the legislative purpose. I note this because it
illustrates that Parliament intended subsection 55(2) to be read
in context. I would also note that the so-called contextual
approach was endorsed by Revenue Canada when subsection 55(2) was
first introduced. In the so-called Robertson Rules published in
the proceedings of the 1981 annual conference of the Canadian Tax
Foundation, Revenue Canada attempted to give guidance to tax
advisers as to how to interpret the new section. Mr. Robertson
stated:
... The application of subsection 55(2) is intended to be
limited to cases of genuine tax avoidance and common sense should
prevail.
[20] The mischief that subsection 55(2) is
aimed at is clearly described in the 1979 federal budget which
introduced this provision. Because of its importance in these
appeals, I reproduce the relevant passage in its entirety:
Important amendments will be introduced to clarify and
reinforce the intent of the anti-avoidance provision relating to
artificial or undue reductions in capital gains.
Concerns have been expressed as to the legislative scope and
intended application of this anti-avoidance provision. A number
of plans have been developed whereby, as a preliminary step to
certain sales of shares, a corporate vendor extracts what are in
substance sale proceeds in the form of tax-free intercorporate
dividends or deemed dividends to decrease the value - or increase
the cost base - of the shares to the point where capital gains
tax is avoided. These tax-free dividends frequently exceed the
earnings of the corporation to be sold. Such excessive dividends
are usually motivated only by the vendor's desire to reduce
his exposure to capital gains tax.
As a general rule, the objective of the tax law is that on
most arm's-length and on certain non-arm's length
intercorporate share sales, a capital gain should arise at least
to the extent that the sale proceeds reflect the unrealized and
untaxed appreciation since 1971 in the value of underlying
assets. This objective will generally be achieved where tax-free
dividends on shares are limited to post-1971 taxed retained
earnings.
Rules will be introduced to clarify the intention of the law
in this respect. These rules will ensure that where it can
reasonably be considered that one of the main purposes of a
tax-free intercorporate dividend was to reduce the proceeds on a
disposition of a share, the capital gain otherwise determined
will be adjusted to reflect the extent to which aggregate
tax-free dividends have exceeded post-1971 taxed retained
earnings.
[21] Looking at the circumstances of these
appeals, the appellants argue that no tax has been avoided and
that the dividends received by the holding companies do not
exceed what the statutory scheme contemplates. I agree with this.
The series of transactions was designed to extract by way of
tax-free dividends the "income earned or realized" by
Comcare that contributed to the accrued gain. This is not in
dispute. The transactions also resulted in tax being paid on the
untaxed appreciation in the value of the underlying assets of
Comcare. Messrs. Lauterstein and Nickerson realized this income
in the form of taxable dividends. The Crown has not suggested
that there has been any tax leakage by having this tax paid by
Messrs. Lauterstein and Nickerson rather than by the holding
companies nor by having the gain realized in the form of
dividends rather than capital gains. The amount of tax that was
paid, then, appears to be what Parliament had intended.
[22] If the position of the Crown is
correct, and a proration is required, Comcare's "income
earned or realized" would not be distributed as tax-free
intercorporate dividends. The result of a pro rata
allocation would be that Messrs. Lauterstein and Nickerson
would realize income equal to the untaxed appreciation in the
value of Comcare's assets and the holding companies would
realize capital gains equal to five-sixths of Comcare's
"income earned or realized." Accordingly I conclude
that the Crown's position is not consistent with the scheme
of the Act. Accordingly, if subsection 55(2) is given a
purposive interpretation in accordance with its object and
spirit, the allocation by the appellants is reasonable and the
allocation suggested by the Crown is not.
[23] The Crown's position seems to be
that the phrase "reasonably be attributable" does not
allow this purposive interpretation and requires a proration.
Several times during argument counsel for the Crown indicated
that its interpretation was a technical one rather than one that
had been prompted by perceived tax avoidance in this case.
I now turn to the Crown's specific arguments.
[24] Double-counting - The Crown suggests
that safe income is partially reflected in the adjusted cost base
of the shares to the holding companies and should not continue to
be double-counted as safe income. This seems to be the
Crown's main argument and the difficulty that I have with it
is that it begs the question. If safe income is partially
reflected in the adjusted cost base of the shares, as the Crown
suggests, then safe income has been partly allocated to the gain
that was realized by Messrs. Lauterstein and Nickerson. This is
the very question that is at issue. If safe income is allocated
entirely to the accrued gain that is inherited by the holding
companies, as the appellants suggest, there would be no
"double counting."
[25] Extension of accepted principles - The
Crown suggests that its interpretation is a reasonable extension
of two widely accepted principles in the interpretation of
subsection 55(2). The first principle, referred to by the Crown
as the "holding period principle," is that
"income" is attributable to gain only if the income is
earned during the period of share ownership, that is, during the
period that the gain accrued. The second principle, referred to
by the Crown as the "rollover principle," is that safe
income flows through on a subsection 85(1) rollover in which the
transferee inherits the transferor's gain.
[26] I do not agree that the position of the
Crown in this case is a fair extension of these accepted
interpretations. Whereas the "holding period principle"
and the "rollover principle" are consistent with the
scheme of the Act as set out in the budget materials
above, the position of the Crown in this case is inconsistent
with that scheme.
[27] Scheme of the Act - The Crown
argues that its interpretation is in accordance with the scheme
of the Act. The argument is that the object and spirit of
the legislation permits tax to be deferred only where the
dividends can be reasonably attributed to income. The flaw with
this argument is that it also begs the question. The essential
question to be decided is how gain should be reasonably
attributed to "income" and "something
else."
[28] This argument might have some merit if
the phrase "reasonably be attributed" connotes an
averaging or proration. However, this is not the case. The
Canadian Oxford Dictionary defines the words
"reasonable" and "attribute" as follows:
reasonable 1 having sound judgment; moderate; ready to
listen to reason. 2 in accordance with reason;
not absurd. 3a within the limits of reason; fair
moderate (a reasonable request). b
inexpensive; not extortionate. c fairly good, average
(the food here is reasonable).
attribute 1 regard as belonging or appropriate to
(a poem attributed to Shakespeare). 2 ascribe
to; regard as the effect of a stated cause (the delays were
attributed to heavy traffic). 1a a quality
ascribed to a person or thing. b a characteristic
quality. 2 a material object recognized as
appropriate to a person, office or status (a sceptre is an
attribute of majesty). 3 Grammar an
attributive adjective or noun.
These definitions suggest that the allocation should be fair
and moderate. They do not require that there be an averaging or
proration.
[29] Administrative practice - The Crown
argues that its interpretation is in accordance with
administrative practice. The Crown referred to a statement by an
official of the Canada Revenue Agency at a regional tax
conference of the Canadian Tax Foundation suggesting that there
should be a proration of safe income if shares are transferred to
a holding company on a partially tax-deferred basis in order to
crystallize the capital gains exemption.
[30] The administrative practice that the
Crown has referred me to has no application to the facts in these
appeals. The statement by the Canada Revenue Agency applies where
a partial subsection 85(1) rollover is used to take advantage of
the capital gains exemption. It is not necessary to express a
view regarding this administrative practice. The facts in these
appeals are quite different from those that the Canada Revenue
Agency considered.
[31] Tax literature - The Crown argues that
its position is supported by the tax literature: Ton-That and
Sider, Understanding Section 55 and Butterfly Transactions.[4] The
relevant passage reads (p. 48):
However, if a complete rollover is not attained, some of the
safe income may be lost. If the elected amount is $500,000, the
gain that flows through to Holdco's shares will be $500,000
instead of $1 million. It seems reasonable that only $300,000 of
this gain would be attributable to safe income. On the transfer,
$500,000 of the gain was realized. There is no support for the
argument that the realized gain was first derived from the
portion of the $1 million gain that was attributable to something
other than safe income. It is more reasonable to say that 60
percent of the realized gain was attributable to safe income and
40 percent to something else.
This comment should be read in context - it is a short passage
in a 350-page book. While the views of tax practitioners should
be given careful consideration, Messrs. Ton-That and Sider
do not set out what arguments they considered in coming to this
conclusion. In my view, the reference provides little support for
the Crown's position.
Conclusion
[32] I would conclude that the appellants'
interpretation of subsection 55(2) is reasonable in the
circumstances of this case and the Crown's interpretation is not.
In light of this conclusion, it is not necessary that I consider
the arguments concerning the approach to be taken if both
interpretations were reasonable.
[33] The appeals will be allowed and the
reassessments referred back to the Minister to reassess on the
basis that the taxable dividends paid to 729656 Alberta Ltd. in
excess of $98,737, and the aggregate taxable dividends paid to
729658 Alberta Ltd., should not be recharacterized under
subsection 55(2).
[33] The appellants are entitled to their
costs.
Signed at Ottawa, Canada, this 29th day of June, 2004.
J.M. Woods J.
APPENDIX A
Summary of Relevant Facts
1. Messrs. Nickerson and
Lauterstein, two unrelated individuals, each owned 50 percent of
the shares of Comcare Limited, a Canadian-controlled private
corporation.
2. The shares of Comcare
owned by Mr. Lauterstein had an adjusted cost base of $37,600, a
fair market value of $12,429,037 and an inherent capital gain of
$12,391,437. The "safe income" attributable to Mr.
Lauterstein's shares immediately prior to the series of
transactions was $1,932,802 and the capital dividend account was
$102,900.
3. The shares of Comcare
owned by Mr. Nickerson had an adjusted cost base of $37,600, a
fair market value of $12,429,037 and an inherent capital gain of
$12,391,437. The "safe income" attributable to
Mr. Nickerson's shares immediately prior to the series
of transactions was $1,834,065 and the capital dividend account
was $102,900.
4. During the week prior
to selling their shares of Comcare, Messrs. Lauterstein and
Nickerson undertook the following transactions:
(a) The sale by Mr. Lauterstein
of his common shares of Comcare to 729658 Alberta Ltd.
("658"), a company owned 100 percent by him, in
consideration of the issuance of a promissory note in the amount
of $10,393,335 and 2,035,702 common shares of 658;
(b) The sale by Mr. Nickerson of his
common shares of Comcare to 729656 Alberta Ltd.
("656"), a company owned 100 percent by him, in
consideration of the issuance of a promissory note in the amount
of $10,393,335 and 2,035,702 common shares of 656; and
(c) Together with the holding
companies, made elections under subsection 85(1) of the
Act electing $10,393,335 as the "agreed amount"
for the purposes of the Act.
5. As a result of the
foregoing transactions, Messrs. Lauterstein and Nickerson each
realized taxable dividends in the amount of $10,355,735
(presumably under section 84.1) and the adjusted cost base of the
shares of Comcare to each of 656 and 658 was $10,393,335. The
adjusted cost base to Messrs. Lauterstein and Nickerson of their
respective 2,035,702 common shares of 658 and 656 was nil.
6. Comcare paid a series
of dividends totalling $2,035,702 to each of 658 and 656 as
follows:
a) taxable
dividends
$1,932,802
b) non-taxable capital
dividends $
102,900
Total
dividends
$2,035,702
7. The dividends were in
the form of stock dividends and the shares were redeemed for cash
shortly after their issuance.
8. On May 28, 1997, each
of 658 and 656 sold their common shares of Comcare for
$10,393,335, an amount equal to the adjusted cost base of their
respective shares of Comcare. The purchaser was 3358755 Canada
Ltd., a corporation dealing at arm's length with Messrs.
Lauterstein and Nickerson.
9. In reporting the
transactions for income tax purposes, Messrs. Lauterstein and
Nickerson each reported taxable dividends of $10,393,335.
658 and 656 reported the dividends received from Comcare as
tax-free and did not report any gain on the sale of the
shares.
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