Bernstein v. MNR, 77 DTC 5187, [1977] CTC 328 (FCA)

Hyde, DJ (concurred in by Ryan and Le Dain, JJ):—Appellant (Bernstein) has appealed from a judgment of the Trial Division (December 17, 1973) which dismissed his appeal from his assessment for the year 1964 under the Income Tax Act (RSC 1952, c 148).

The dispute arises from the election by Bernstein as to the manner in which a stock option benefit, amounting to $99,800 received by him in 1964, should be taxed as provided in section 85A of the Act. The arithmetic by which the contested tax is arrived at is not in question but only the right of Bernstein to make the election provided for in subsection 85A(2).

Bernstein was both an employee and a shareholder of Highland Knitting Mills Inc (Highland)—in fact he was the President of the Company and beneficial owner of fifty per cent of its capital stock, the other fifty per cent being beneficially owned by one Kamichik, its Vice- President and Secretary-Treasurer.* [1] Bernstein and Kamichik incorporated Highland in 1956 to take over their unincorporated partnership business of manufacturing and distributing knitted clothing—a success ful operation as indicated from its increase in sales from $350,000 in 1956 to $1,100,000 in 1964.

By a complicated series of transactions Highland acquired 20,000 5% non-cumulative non-voting redeemable preferred shares of a wholly owned subsidiary corporation, Berkam Investments Limited (Berkam), at the par value of $10 each in October 1964.* [2] On November 23, 1964 Highland gave Bernstein and Kamichik each the option to purchase 10,000 of Berkam preferred shares for the sum of $200 which option they each exercised on December 11, 1964.

On December 14, 1964 Berkam redeemed these preferred shares so that Bernstein received $100,000 for an outlay of $200 or the substantial benefit of $99,800—the basis of the disputed assessment.

The issue on appeal is whether the stock option benefit received by the appellant is one contemplated by section 85A, and the appellant is, therefore, entitled to elect the special calculation of tax provided for by subsection 85A(2).7 [3]

His original assessment of June 28, 1965 was made on the basis of this election but by notice of reassessment dated June 25, 1969 he was reassessed and denied the right to make such election so that the sum of $99,800 was added to his ordinary taxable income for 1964. He filed an objection but the reassessment was confirmed and his appeal to the Federal Court was dismissed in the Trial Division—hence the present appeal.

The reassessment was based on subsection 85A(7) which reads:

85A. (7} This section does not apply if the benefit conferred by the agreement was not received in respect of, in the course of or by virtue of the employment.

Appellant’s principal attack on the judgment appealed from is directed against the reasoning (at p 18 [6051]) that:

. . . appellant and Mr Kamichik were the sole shareholders as well as being bona fide employees and that in their capacity as sole shareholders of Highland they caused it to so act as to confer a benefit on them which, although Stated to be conferred by virtue of their employment, was in actual fact received by them in consequence of their being able as sole shareholders of the company to so control its actions as to cause this benefit to be paid.* [4] It was not, therefore, received by virtue of their employment within the meaning of subsection 85A(7) but rather by virtue of their being shareholders of the company with the result that section 85A cannot be used in the case of appellant as an exception preventing the application of subsection 137(2) and paragraph 8(1)(c) of the Act. The appeal is therefore dismissed with costs.

Read out of context this might imply that an employee who was a controlling shareholder could not qualify for the election provided in subsection 85A(2) which I do not consider to be so. All the factors surrounding the granting of the benefit by the corporation must be taken into consideration.

One of these factors is certainly that Bernstein and Kamichik were the sole shareholders, each for one half. But that is not enough by itself, given the fact that they were also the most important employees.

under this Part, in lieu of the amount that would otherwise be payable, an amount equal to the aggregate of

(a) the tax that would be payable by the employee for the year under this Part if no benefit were so deemed to have been received by him in the year,

and

(b) the amount, if any, by which

(i) the proportion of the benefit so deemed to have been received that the aggregate of the taxes that would have been payable by the employee under this Part for the 3 years immediately preceding the taxation year (before making any deduction under section 33, 38 or 41), if no benefit were deemed by paragraph (a), (b), (c) or (d) of subsection (1) to have been received by him in those years, is of the aggregate of the employee’s incomes for those years minus the benefit deemed by paragraph (a), (b),

(c) or (d) of subsection (1) to have been received by him in those years,

exceeds

(ii) 20% of the amount of the benefit so deemed to have been received.

For reasons not explained, while Bernstein and Kamichik each received salaries of $17,000 in 1963, in 1964 Bernstein’s was $34,000 while Kamichik’s was only $18,000, and still the stock option benefit was conferred on them equally.

Moreover, this transaction required the appropriation of a substantial part of Highland’s earned surplus on which tax had been paid. Compared with a salary or bonus adjustment, which would have been a deductible expense to the company, it was from that point of view not in the company’s interest but designed, taxwise, particularly to favour the recipients. While it is true that Bernstein and Kamichik had rendered most valuable services there were other employees who, if there had been no share control, might reasonably have been expected to participate in such an important employee benefit arrangement. For example Mr Rosan (transcript p 223) testified that there were three long-term employees who had been with Messrs Bernstein and Kamichik since 1950 or earlier, before the business was incorporated, who in 1964 were receiving comparatively modest salaries of $7,000 a year.

Furthermore, Highland was obliged to borrow from its bankers to provide the $200,000 it paid Berkam for its preferred shares which loan was repaid on January 8, 1965 with loans from Bernstein and Kamichik of an equal amount against which they each received from Highland promissory notes of $100,000. Although these notes bore interest at 6% per annum, Mr Rosan testified that this interest was waived by Messrs Bernstein and Kamichik.

As subsection 85A(7) indicates, the exception provided for stock option benefits is that they be received as employees not as shareholders. That an employee may incidentally be a shareholder does not disqualify him but when it is evident, as I believe it has been shown to be the case in this instance, that the options were granted because these employees were shareholders—in fact the only ones—they cannot qualify.

Obviously, the self-serving statement in the option agreement (Exhibit Mc vol 1, p 70) that the benefit is conferred on Bernstein “in respect of and by virtue of his employment’’ does not establish that as a fact. When one reads Rosan’s testimony (particularly pp 183 to 232) it is clear that the two partners did not want to take the surplus earnings out of the company through dividends in the normal way because of the tax impact and that this scheme was devised by Mr Rosan, with legal advice, to accomplish indirectly what they did not wish to do directly.

I believe that the factors I have noted are sufficient to show that appellant Bernstein does not escape the proviso of subsection 85A(7).

I would dismiss this appeal with costs.