Deuce Holdings Ltd. v. R., 97 DTC 921, [1998] 1 CTC 2550 (TCC)

Bell T.C.J.:

All statutory references, unless otherwise specified, relate to the Income Tax Act (“Act”).

Issues:

The issues are:

1 Whether two dividends, namely,

(a) a cash dividend of $988,498 paid by General Quilting Company Limited (“GQ”) to the Appellant, [1] and

(b) a deemed dividend under subsection 84(3) of $779,597

Should, as the Minister of National Revenue (“Minister”) treated them, be regarded as one dividend for the purposes of paragraph 55(3)(Z?), in which case, as submitted by the Minister, such dividend would not qualify as an exception to the application of subsection 55(2) thereby deeming the full amount of $1,768,095 to be proceeds of disposition of shares,

2 Whether the computation of

...(i) income earned or realized after 1971 and before the ... commencement of the series of transactions or events referred to in paragraph 3(a) [2]

should be made before or after federal and provincial income tax. An amount equal to the sum so computed is not included in the amount of any dividend deemed to be proceeds of disposition. [3]

3 Whether in computing “safe income” the dividend paying corporation must, as contended by the Minister, deduct:

(a) a retiring allowance of $111,500 paid by it to the manager of the Appellant, and

(b) a management fee of $104,000 paid by it to the Appellant after the agreed date of commencement of the series of transactions herein, which date is specified by the legislation to ter- minate the period during which “safe income” is computed. Their deduction would reduce “safe income”. [4]

Charts:

Reference is made to charts “A”, “B”, “C”, “D”, “E” and “F” attached to and forming part of these Reasons.

As set out in Chart A, Mile High Limited (“MH”) and the Appellant each owned 50 percent of the shares of GQ, being in each case 200,000 common shares and 70 Class A shares. GQ owned 40 percent, being 402, of the outstanding common shares of Fybon Industries Inc. (“Fybon”) and GQ held a promissory note in the amount of $800,000 made and delivered by Fybon to it.

As set out in Chart B, GQ, on July 8, 1988 paid a dividend of $988,498 by way of promissory note to MH. On the same day it paid a cash dividend of $988,498 to the Appellant. The Appellant, under paragraph 55(5)(f) designated portions of the dividend to be separate taxable dividends as follows:

(a) 98 separate dividends of $10,000 each,

(b) 1 separate dividend of $8,000, and

(c) 1 separate dividend of $498.

As set forth in Chart C, on July 8, 1988 GQ sold to each of MH and the Appellant 201 shares of Fybon and a 50 percent interest in the $800,000 note. As consideration for this sale, GQ received 20 “D” preferred shares of the Appellant having a redemption amount of $780,000, and 20 “D” special shares of MH having a redemption amount of $780,000.

As set forth in Chart D, on July 8, 1988 the Appellant and MH redeemed the 20 “D” preferred shares and 20 “D” special shares respectively and each issued a promissory note for $780,000 to GQ as the redemption price. Also, GQ purchased from each of the Appellant and MH 199,999 of its common shares and 70 “A” shares for $780,000 in each case and paid for same, in effect, by cancelling the promissory note for $780,000 which it had received from each of the Appellant and MH.

As set out on Chart E, GQ purchased its one common share from the Appellant for $2.

Chart F shows MH owning 100 percent, being one common share, of GQ.

Facts:

Mr. Larry Rotstein (“Rotstein”) a chartered accountant for GQ, stated in agreement with the Respondent, that the adjusted cost base of the 70 Class A shares of GQ held by the Appellant was $6,202.

Rotstein discussed a calculation of “safe income” of GQ as at July 8, 1988. That amount included the sum of $297,896 with respect to Fybon producing a total of $2,054,126, this total being submitted by the Appellant as the appropriate amount.

A subsequent computation by him as at March 30, 1988 showed a total of $1,958,523, one-half of which, being $979,261, was available to the Appellant. Both of the foregoing computations were made on an after income tax basis. The reason for the new computation is that the Appellant, who had regarded July 8, 1988 as the commencement of the series of transactions within the meaning of subsection 55(2), subsequently agreed with the Respondent that that date should be March 30, 1988. (see footnote 2)

Rotstein made another computation as at March 30, 1988 on a before tax basis. He made that computation based upon a letter from “Revenue Canada Taxation” dated December 7, 1994 to the attention of Appellant’s counsel over the signature of G.G. Grundell, Appeals Division, Toronto District Office, which stated in part,

We have reviewed your submission of October 31, 1994, and wish to make the following comments:

(a) we agree that you do not deduct Provincial or Federal taxes in the calculation of “safe income”. This was made clear by the Head Office Appeals in their statement that “safe income is based on taxable income”.

In addition, another letter over the signature of G.G. Grundell dated October 17, 1994 to Appellant’s counsel attached written comments from the Head Office of Revenue Canada stating,

We offer the following comments related to the taxpayer’s representations:

1) The taxpayer has raised the question of whether “safe income” should be based on the ordinary definition of income taking into account depreciation or on the definition of taxable income which takes into account capital cost allowance.

In our view, “safe income” should be based on taxable income....

Rotstein said that these letters were the only reason that he made the aforesaid calculations. He said also, however, that he had been instructed by the lawyers for both parties to the transactions to use a conservative computation method. He said that he made his computation for the full fiscal year and then pro-rated it back to what he regarded as the appropriate date. He stated that in making the computation for Fybon he commenced with its retained earnings of $36,478 as at August 31, 1987 and adjusted that figure. His computation for GQ on a before income tax basis was $2,311,211, one- half of which, being $1,155,605, was available to the Appellant. Rotstein also gave evidence respecting the computation of a management fee and said that, at the closing of the transaction on July 8, 1988, there was a great deal of negotiating finally resulting in the figure of $104,000, all of the discussion respecting that amount having taken place at that meeting. Rotstein stated that when the lawyer for Mr. Greenbaum (“Greenbaum”), principal of MH, forwarded a draft document of a “possible deal” to Andrew Tylman (“Tylman”), manager of the Appellant, Tylman asked Rotstein whether he could have a retiring allowance to be paid for the years of service that he had provided to GQ. Rotstein said that he calculated the amount to be $111,500. He stated that this computation was made after March 30, 1988. Rotstein also stated that he and his clients did not contemplate the need under paragraph 55(5)(f) to make any designation because they believed

...the Fybon transaction was a separate transaction under 55(3) and that the designation solely related to the dividend relating to the repurchase of the General Quilting shares after the Fybon interest had been transferred out of General Quilting and the designation relating to that dividend.

He subsequently stated that the designation applied to the actual cash dividend. Rotstein further testified that he thought there was enough “safe income” to cover the dividends and so there were no proceeds of disposition and no capital gain. He also responded to Appellant’s counsel’s question as follows:

Q. Well, to your knowledge, did General Quilting or any of the parties to the transaction consider the need to acquire any property in General Quilting prior to the transaction involving the division of the Fybon assets?

A. No. We were simply-we were just taking the shares of Fybon and the note in General Quilting Company Limited and moving it to the two corporate shareholders, Deuce and Mile High.

He then said that under his before income tax computation, “we are still fully covered”. He said that this meant that the dividend paid to both parties is less than the

total safe income on the before income taxes method.

He stated that on the after income tax method,

I believe we would be short by, in Deuce’s case, something like eight or nine thousand.

He referred to the designations totalling $988,498 and his “calculation for half the safe income” of $979,261 made as at March 30, 1988. He concluded that the difference of approximately $10,000 would be deemed under subsection 55(2) to be proceeds of disposition of shares. He then said that

I could deduct the cost base of the Class A preferred shares allocated to Deuce of $602,000. [5]

On cross-examination, Respondent’s counsel referred Rotstein to a letter written by him on September 14, 1992 to the Department of National Revenue (“Department”) in which he said that he was instructed to value the company for the purposes of a starting point in determining the buy-out price and that he was to take into consideration the management fee being negotiated and a retiring allowance which he was to calculate. He responded affirmatively to the question...

Would you agree with me that Mile High wanted to buy out the business interest in General Quilting?

He agreed with counsel that GQ had basically three assets, $2,000,000 of business assets, an $800,000 note receivable from Fybon and shares of Fybon. In answer to counsel’s question

As part of that buy-out, there was a transfer of the Fybon assets?

Rotstein replied

No. The transaction, as it was explained to me by the parties, and what they asked me to perform, was neither one wanted to give up their interest in Fybon. That was explained to me carefully so any values I was to perform as part of the buy-out of General Quilting was to exclude Fybon. That both parties would remain as participants in Fybon through another vehicle.

Rotstein testified that Greenbaum met with him having been very agitated over a dispute with Tylman and said “he wants him out of the company”. Greenbaum was concerned about a “shotgun” clause in the shareholder’s agreement. He wanted to make some arrangement with Tylman which would not invoke the exercise of that clause which had the potential of resulting in Tylman acquiring Greenbaum’s interest. Rotstein then said that they met with Greenbaum’s lawyer who advised that the Fybon assets could be moved out of GQ into the Appellant and MH. That lawyer instructed the assistant, Houser,

to get whatever information from me, or whatever, and to put something together and send it to Mr. Tylman as a starting point. And that is how the transaction started.

Rotstein also testified that

On the final day of closing there was still a dispute and they were still arguing over what the final price was. But that was only on the General Quilting business. It had nothing to do with Fybon.

He also said that his instructions from Greenbaum were very specific about excluding Fybon from the GQ transaction.

Respondent’s counsel asked the following question

Now what you are saying - is my understanding correct that from what you said that Mr. Greenbaum wished to buy out Mr. Tylman’s interest in General Quilting? '

Rotstein’s response was

No, he wished to buy the business of General Quilting. He wanted to exclude the interest in Fybon and asked me if there was a way that he could buy the business of General Quilting and exclude Fybon so that he could retain his share of Fybon, Mr. Tylman could retain his share of Fybon.

And he was specific that whatever was negotiated or started, as far as the transaction, that it should not be construed by Mr. Tylman as an exercise of the shotgun clause in their shareholder’s agreement.

Rotstein said that the payment of a management fee and retiring allowance would reduce the value of the Company. In answer to counsel’s statement

Now the impression I have from your letter ... is that it was always anticipated that there would be a management fee of some kind.

Rotstein said

Not by Mr. Greenbaum. Mr. Greenbaum is the one who started the transaction and Mr. Tylman responded a week later, or something like that. And I believe, in his first correspondence, he suggested a management fee and a retiring allowance.

But the transaction was started by Mr. Greenbaum and there was no mention of any management fee or retiring allowance.

Rotstein agreed with counsel’s suggestion that these two amounts were part of the compensation agreed to in order to reach a “buy-out arrangement”. He said that the retiring allowance was calculated on the basis of 34 years of service, five of which had been served during a period that the company had a pension plan, this information having been provided to him by Tylman.

In his letter of September 14, 1992 to “Revenue Canada Taxation” Rotstein said

It was determined by the parties involved that Fybon was not to form part of the buy-out. In order to accomplish this, the Fybon shares and promissory note owned by General Quilting were to be transferred 50:50 to Deuce and Mile High. Therefore the steps in the buy-out transaction were as follows:

Step 1.

Pay each of Mile High and Deuce a dividend equalling $988,498. This reduced the value of the company to essentially equal the value of the Fybon shares and promissory note.

Step 2.

Transfer the Fybon common shares and promissory note 50:50 to Deuce and Mile High in exchange for shares of Deuce and Mile High. By simultaneous share redemptions, General Quilting redeemed the shares it received from Mile High and Deuce for the Fybon interests transferred and Deuce redeemed all of their shares owned in General Quilting except for one common share each. All parties received promissory notes on the redemptions which were subsequently cancelled against one another. This transaction is commonly referred to as a Butterfly Transaction.

Step 3.

General Quilting buys the one common share remaining owned by Deuce for $2. This leaves Mile High as the only shareholder of General Quilting owning 1 common share.

Clearly, step 1 is a transaction contemplated by Section 55(2) of the Act. However, there existed enough “safe income” for this dividend to be paid. Step 2 definitely falls under Section 55(3)(b) of the Act. Since this is a butterfly transaction, Section 55(2) does not come into play and safe income is not an issue. Step 3 did not create a dividend because the redemption resulted in a return of paid up capital to Deuce of $2.

Rotstein testified that Articles of Amendment were obtained on March 31, 1988 by the Appellant and MH providing for the issue of Class “D” preference shares and Class “D” special shares respectively. He also testi- fied that he learned, after the fact, that General Quilting had borrowed $1,000,000 from a bank.

With respect to the computation of “safe income” for Fybon, Rotstein said that he did not have access to its tax returns and that Tylman had advised him that he felt the retained earnings would be close to the after tax retained income on an income tax basis. He stated that the lawyers had advised him to “go with that number”, being retained earnings, that there was urgency and that the number just wasn’t large enough to warrant computation in the normal way. He made it clear, on re-examination, that in the computation of “safe income” he would not deduct amounts such as the management fee and retiring allowances as at March 30, 1988 because they were not reflected as expenses until the next fiscal period. He also stated, with respect to the word “buy-out”, used many, many times by Respondent’s counsel, that

It’s a phrase that accountants, lawyers use when discussing a transaction. It doesn’t refer to legal mechanics or the way the transaction was set up. It is a term that is used by -- between parties where one will purchase shares or have shares redeemed so that one party is no longer part of a corporation or a business, you would use the phrase “he was bought out”.

He then stated in this case there was a share redemption. He said that if he were requested to make “an exact calculation of safe income,” he would not use retained earnings.

Tylman testified that the retiring allowance had not been agreed to by Greenbaum until the day of closing, July 8, 1988. He stated with respect to his April 4, 1988 letter to Greenbaum’s lawyer, that this was the first time any mention was made of a “pension” for Mr. Tylman. He stated that he had not, prior to the July 8, 1988 closing meeting, received confirmation that he would be paid the retiring allowance of $111,500. Tylman stated that the Fybon note for $800,000 held by GQ was divided into two notes of $400,000 each and the share certificate in GQ’s name for 402 shares of Fybon was divided into two share certificates for 201 shares each and that one note and one share certificate were given to MH and one note and one share certificate were given to the Appellant. He stated that he and Greenbaum were not getting along. Specifically, he said,

We had totally opposite views of how business should be conducted and my idea was always to minimize any involvement with him beyond which I have, and reduce it and what involvement that I had with him, to reduce it as much as possible.

So it was desirable from our point of view to have those shares owned directly by us rather than through some partnership or with Greenbaum.

And I, from Greenbaum’s point of view, I believe he also wanted to have these assets on his own because he had his own, you know, things he could do with it, pledge them to the bank, who knows what. So that he could act with them as he sees fit.

So that was a very desirable —. so a division of these assets would have been a very desirable outcome for both sides.

Tylman also said, with respect to the shareholder’s agreement and “the shotgun” clause that once the Appellant or MH began the process, it would ultimately lead to the acquisition of the entire interest of the other party in GQ. Tylman stated that Fybon was a very well run company, was “moving up” and he definitely wanted to keep all of GQ’s shares in that company. [6] He said that he proposed to Greenbaum that he, Greenbaum, take the GQ business and he, Tylman, would take the Fybon investment and that Greenbaum absolutely rejected that suggestion. He further testified that both he and Greenbaum were required to sign cheques and other bank documents respecting GQ. He said that he asked Rotstein to make a determination of potential retiring allowance sometime toward the end of April and that the amount was only accepted by Greenbaum on July 8, 1988.

Tylman testified that the Class “D” shares of the Appellant were created by an amendment to the Articles of the Appellant on March 31, 1988 because, as early as March 30, 1988, he and Greenbaum were in agreement to divide the Fybon assets independently of any other deals that may or may not be made. And, therefore, we put in motion the procedures needed to accomplish it.

He testified that the Appellant included the management fee of $104,000 in its income tax return. He said that the reduction of “safe income” by that amount caused the inclusion of such amount as capital gain resulting in double taxation. He said that the amount of $988,498 was paid as an ordinary dividend by GQ to the Appellant by cheque signed by Greenbaum alone. He said that he was not aware of any loan that GQ had bound itself to obtain from the Canadian Imperial Bank of Commerce at any time prior to July 8, 1988 and that he would not have allowed it had he known.

The Respondent produced Mr. Brian Kirwin, an official of the Department of National Revenue (“Department”), as a witness. He had prepared a schedule of the “safe income” of GQ, a schedule of the “safe income” of Fybon and a schedule showing the “safe income” of General Quilting Company Limited including Fybon as adjusted by the reassessment. He said that he, in making such calculations, used income as determined for tax purposes. He referred to the Grundell letter, supra, saying that the statement that provincial or federal taxes should not be deducted was an obvious error. He said that the “safe income” computation of both parties for GQ was $1,751,933 on an after-tax basis. [7] A reproduction of Exhibit A-6 and of Exhibit R-1 consisting of three schedules is attached to these Reasons. Also attached is Schedule III revised by me to show the comparative computations of the Respondent and Appellant. Kirwin said that,

Revenue took the position that the management fee benefitted prior periods. Obviously it could not benefit subsequent periods and therefore included the management fee in the calculation of safe income. By “included” I mean it reduced the safe income calculation as though those amounts had been booked and expensed in prior periods.

With respect to Rotstein’s use of retained earnings as at August 31, 1987 in computing the “safe income” of Fybon, Kirwin said that retained earnings do not necessarily reflect the tax return retained earnings. In describing the computation of the capital gain by the Minister, Kirwin said

The Department calculated the capital gain by aggregating the amount of the two dividends that were paid on July 8. The two dividends amounted to $1,768,095. From that sum was deducted the amount of the safe income calculated by the Department, which, based on 55(5)(f), amounts to $830,498. The result is the sum of $937,597. That amount becomes proceeds of disposition based on 55(2).

The capital gain rate in 1988 was two-thirds. Two-thirds of the $937,597 amounts to $625,065.

He then said that that figure did not take into account the adjusted cost base of the shares of General Quilting which, as stated above, was $6,202 to which should be added the sum of $200, being the paid up capital of the common shares. The total adjusted cost base would, therefore, be $6,402. In response to a question as to why the Department aggregated the two dividends, Kirwin said,

The Department considered the transactions which occurred on July 8 to effectively be one transaction and looked at the series of events that occurred here really before this transaction and immediately after the transaction. And it was our view that these transactions were part and parcel of a series of pre-ordained series of transactions and that the taxpayer had failed, taking that view, to comply with 55(3)(b) because there had not been a pro rata distribution of the assets to the respective parties. There had been the injection of $1 million in a bank loan from General Quilting prior to the commencement of this series of transactions, which was specifically prohibited by 55(3)(b) and that the spirit, the object and spirit of the section had not been complied with in the sense that the purpose of 55(3)(b) is to allow the splitting of assets between two parties so they can carry on their separate ways. That did not occur here. One taxpayer ended up with the business, one taxpayer ended up with effectively $1 million in cash and the further linkage between the transaction is the fact that in order to protect the capital gain on the General Quilting shares, the taxpayer had to utilize the safe income of Fybon. Without the safe income of Fybon, there would have been a capital gain here, which there should have been, we knew there should have been.

In response to a question from the Court respecting the propriety of using the safe income of Fybon, Kirwin said

No, only that the safe income of Fybon was used, therefore the transactions are linked or related in terms of having to take into account 55(3)(b) for the purposes of so-called reorganizing the assets.

With respect to federal and provincial taxes paid by Fybon, Kirwin stated that he was unable to disagree with the numbers used by Rotstein in his computation of “safe income” of Fybon. The numbers used by the Minister and by the Appellant are as follows:

The Minister, in making the above computation, deducted the larger amounts.

The following exchange, on cross-examination of Kirwin, respecting the management fee of $104,000 sets out the Appellant’s and the Minister’s position.

Q. What I am telling you, and you can disagree with me and, if you would, I would appreciate you saying so, that what Deuce has done is paid tax on this fund at the normal corporate rates on 100 percent of $104,000 and has paid tax at normal corporate rates on two-thirds of one-half of $104,000 in the same year. Isn’t that what happened?

A. That is true.

Q. And the only thing that distinguished the $104,000, if I can use double tax, although it’s not exactly double tax, because one is treated as a capital gain, a taxable capital gain and the other as a regular income. But the same general effect will be had in connection with the retiring allowance when it is ultimately paid out?

A. That’s true. But we both know that the tax effect on one taxpayer is not relevant for computing the tax effect on another taxpayer.

Q. How about the tax effect on the same taxpayer? How does that work? Can we use that to our advantage and against the respondent? And that is the taxpayer before this Court, Deuce Holdings Limited, taxed twice at different rates on the same amount?

A. As I already indicated to you, General and Fybon deducted the same amount. If you look down the chain, it’s even. It’s flat, save for the amount that was put in safe income.

Kirwin acknowledged that GQ had a new taxation year beginning on May 1, 1988. He insisted that the two foregoing amounts should be deducted in spite of the fact that they fell into a taxation year following the date of the commencement of the series of transactions, being the date at which the computation of “safe income” terminates. Kirwin said that it would be reasonable to deduct those payments in that computation even if they fell into a different taxation year of the payor corporation because,

If they benefitted the prior period, they merely booked them in the wrong period.

The following exchange took place,

Q. Booked them in the wrong period. The parties agreed in their contract and you are telling me that because they agreed in their contract, that Revenue can now say, “you made a mistake. You booked them in the wrong period”, despite what the parties agreed to?

À. Sure.

Q. Okay. Now tell me how they benefitted a period.

A. Well I presume that the management fee payment was to be made on behalf of the term 1983 through 1988.

Q. You presume?

A. That is the position the Minister took, yes.

Q. Well we know that there is a concept in law that relates to demolishing the basic presumption upon which the assessment rests. Is that an assumption upon which the respondent rests in making his assessment?.... I haven’t heard him say that that was one of the assumptions upon which the Minister rests in making the assessment. That’s what I am asking. Is it?

A. Yes sir.

Q. It is? I point out to my friend that, of course, it is not one of the ones referred to in the pleadings. And if the Minister now wants to rely upon that assumption, I raise the issue of onus. And this witness is now in a position to introduce evidence to prove the assumption, Your Honour. Otherwise, my position will be, in arguing, that this issue has not been proved by the Respondent.

Appellant’s counsel and Kirwin then had the following exchange

Q. So that I might have you identify the dividends that you are aggregating?

A. Yes.

Q. I have a copy of the respondent’s Reply and I am directing your attention to page 5, paragraphs (g) and (h).

A. $779,597, that is the number sir, yes.

Q. So that when you are discussing aggregate dividends, you are talking about those two dividends?

A. Yes sir.

Q. And one was an ordinary dividend and the other was a deemed dividend?

A. That’s correct.

Q. The second one was a deemed dividend?

A. 84(3) yes.

Q. Now did you at any time during the course of - was it your determination - I should ask you this, was it your determination that resulted in this assessment that is now before the Court?

A. No sir, I was not the auditor.

Q. I see. Well speaking for the respondent then, was it the respondent’s view at the time that the assessment was made, that the respondent need have no regard, and by that I mean simply discount, set aside and pay no attention to subsection 55(3) which refers to the treatment of any dividend? ...My notes are that the Minister considered that paragraph 3(b) did not apply?

A. That’s correct.

Q. So it’s 55(3)(b) you are talking about?

A. Okay. All right.

Q. Now did you consider the opening provisions of subsection 3?

A. Yes. It would have been considered, no question about that.

Q. Okay. Now in considering it, what effect did that have upon the respondent’s attitude or determination to aggregate these dividends?

A. I am trying to comprehend your question. I presume that you are taking exception with what we did because of the word “dividend” in the singular and not the plural. I am not sure what you are asking me so II can’t answer you.

Q. Here is what confronts us. I have a pleading and the Reply of the respondent among the assumptions that is has made, starting on page 4 of the Minister’s Reply and following through to page 6 contains reference to these two special dividends that I have just identified for you?

A. Yes. We spoke about those already.

Q. The dividend and this dividend?

A. Yes.

Q. The regular dividend and the deemed dividend, okay?

A. Yes sir.

Q. Now there is no suggestion that the Minister aggregated those dividends in his pleadings?

A. Well I don’t know what was placed in the pleadings.

Q. I am asking you whether in the course of making the assessment which refers to specifically, subsection (2) doesn’t apply to “any dividend” whether you thought that maybe it would be inappropriate to aggregate two dividends when this subsection specifies that you can treat any dividend differently than another dividend, if that other dividend meets certain requirements?

A. Yes. It makes reference to a singular dividend.

Q. I am asking you whether the respondent considered the application of this section before the reassessment was issued?

A. I have already answered that he did.

Q. Okay. Now you have indicated in your answer, to a question asked you by my friend with respect to the application of subsection 3(b), you said that there was no prorata distribution?

A. That’s correct.

Q. Now identifying the dividend as it related to Fybon under subsection (3)(b), are you telling me that there was no prorata distribution of assets?

A. Of Fybon?

Q. Yes.

A. Particularly?

Q. Yes.

A. No, there was a prorata distribution of the assets of Fybon.

Q. So that if we speak of subsection (3)(b) applying to the Fybon dividend, there was indeed a prorata distribution within the meaning of that paragraph?

A. Well I’m not sure that it is within the meaning of the paragraph because our position is that the paragraph was not complied with in the aggregate, looking at the transaction, as I stated earlier, as a whole transaction.

Q. Yes.

A. All of the transactions from the beginning to the end.

Q. Ah, yes. But as it applied to the Fybon dividend there was a prorata distribution?

A. Individually there was, yes.

Q. Okay.

Analysis and Conclusion:

1. The first issue is whether the cash dividend of $988,498 and the deemed dividend under subsection 84(3) of $779,597 should be regarded as one dividend for the purposes of paragraph 55(3)(b) of the Act. The Respondent has contended that the two dividends should be regarded as one dividend only and that such dividend does not qualify as an exception under paragraph 55(3)(b) to the application of subsection 55(2). It is described in RESPONDENT’S OUTLINE OF ARGUMENT as “Dividend for ss. 55(2) 1,768,095”. The result would be that the total of the two dividends would be deemed to be proceeds of disposition of the shares. The pertinent portions of both paragraphs are set forth as follows:

(2) Deemed proceeds or capital gain. - Where a corporation resident in Canada has after April 21, 1980 received a taxable dividend in respect of which it is entitled to a deduction under subsection 112(1) of 138(6) as part of a transaction or event or a series of transactions or events that commenced before April 22, 1980 one of the purposes of which (or, in the case of a dividend under subsection 84(3), one of the results 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 reasonably be considered to be attributable to anything other than income earned or realized by any corporation after 1971 and before the transaction or event or the commencement of the series of transactions or events referred to in paragraph (3)(a), notwithstanding any other section of this Act, the amount of the dividend (other than the portion thereof, if any, subject to tax under Part IV that is not refunded as a consequence of the payment of a dividend to a corporation where the payment is part of the series of transactions or events)

(a) shall be deemed not to be a dividend received by the corporation;

(b) where a corporation has disposed of the share, shall be deemed to be proceeds of disposition of the share except to the extent that it is otherwise included in computing such proceeds: and

(c) where a corporation has not disposed of the share, shall be deemed to be a gain of the corporation for the year in which the dividend was received from the disposition of a capital property.

(3) Exception. - Subsection (2) does not apply to any dividend received by a corporation,

(b) if the dividend was received in the course of a reorganization in which property of a particular corporation was transferred, directly or indirectly, to one or more corporations (each of which is in this paragraph referred to as a “transferee”) and, in respect of each type of property so transferred, the fair market value of the property so received by each transferee was equal to or approximated the proportion of the fair market value of all property of that type owned by the particular corporation immediately before the transfer that

(i) the aggregate of the fair market value immediately before the transfer of all shares of the capital stock of the particular corporation owned by the transferee at that time

is of

(ii) the fair market value immediately before the transfer of all the issued shares of the capital stock of the particular corporation at that time,

except that this paragraph does not apply in respect of a transfer where, in contemplation of and before the transfer property has become property of the particular corporation, a corporation controlled by the particular corporation or a predecessor of any such corporation otherwise than as a result of

(iii) an amalgamation of corporations each of which was related to the particular corporation.

(iv) the winding-up of a corporation that was related to the particular corporation.

(v) a transaction to which subsection (2) would, but for this subsection, apply,

(vi) a disposition of property by the particular corporation or a corporation controlled by it to another corporation controlled by the particular corporation,

(vii) a disposition of property by the particular corporation or a predecessor thereof for consideration that consists only of money or indebtedness that is not convertible into other property, or of any combination thereof, or

(viii) a prescribed transaction.

The opening words of paragraph 55(3) state that subsection (2) does not apply to any dividend received by a corporation if the circumstances in subsection (3)(b) exist. Respondent’s counsel said,

The position of the Department throughout has been that these two dividends must be viewed together and if you view those two dividends together you will offend 55(3)(b) because there was a borrowing of a million dollars resulting in an acquisition of an asset by the Company in contemplation of the transaction which took place. And the design of the section is to prevent buy-outs and the funding of buy-outs. So that it is in that context that the issue of 55(3)(b), pro- ration, receipt of cash, and whether any exemption to those rules applies.

I do not comprehend what is meant by the statement that the two dividends must be viewed together. It is clear that paragraph 55(3)(a) applies “to any dividend received by a corporation”. The term any dividend means one dividend. That is clear. It is also clear from the evidence that, in the course of a reorganization, property of GQ, namely, 201 of the 402 common shares of Fybon owned by GQ and a 50% interest in the promissory note for $800,000 owing by Fybon to GQ were transferred to each of MH and the Appellant in exchange for shares having a redemption amount of $780,000. On the redemption of those shares a dividend of $779,597 was deemed by subsection 84(3) to have been paid by GQ and received by the Appellant. As required by paragraph 55(3)(b) property transferred to each of MH and the Appellant was identical as was the fair market value of that property. [8] Furthermore, before such transfer, no property in contemplation of such transfer, became the property of GQ. Tylman’s uncontradicted evidence, which I accept, was that Greenbaum did not wish to buy Tylman’s interest in GQ but rather the business of GQ. I repeat Tylman’s evidence that

...He wanted to exclude the interest in Fybon and asked me if there was a way that he could buy the business of General Quilting and exclude Fybon so that he could retain his share of Fybon, Mr. Tylman could retain his share of Fybon.

Further, Tylman was clear about the Fybon transaction when he stated that he and Greenbaum were in agreement

to divide the Fybon assets independently of any other deals that may or may not be made. And, therefore, we put in motion the procedures needed to accomplish it.9 [9]

This dividend must be viewed in the same manner in which it would be viewed had no other dividend been paid. The Respondent’s urge to treat the total of the two dividends as one dividend for the purpose of deeming proceeds of disposition not only offends the meaning of the words “any dividend” but also invalidates the exception to such treatment provided by paragraph 55(3)(b). For these reasons, I conclude that the deemed dividend of $779,597 will not be deemed to be proceeds of disposition within the meaning of subsection 55(2).

The cash dividend of $988,498 paid by GQ to the Appellant was treated by the Appellant as deemed proceeds of disposition under subsection 55(2). To the extent of “safe income” discussed below, that dividend will not be deemed to be proceeds of disposition under that subsection.

2. The second issue is whether the computation of “safe income” is made before or after tax. The question is what is meant by the words

Income earned or realized ... after 1971 and before ... the commencement of the series of transactions...

which it is agreed commenced on March 30, 1988. These words could have been defined or described so that the consideration of this issue would have removed unnecessary uncertainty from that portion of the nearly 300 words constituting this subsection. The description in paragraph 55(5)(c), namely,

the income earned or realized by a corporation for a period throughout which it was a private corporation shall be deemed to be its income for the period otherwise determined on the assumption that no amounts were deductible by the corporation by virtue of paragraph 20(1 )(gg) or section 37.1;

not only does not assist in determination of whether the computation of “safe income” is made before or after tax but, by omitting any reference to tax, indeed suggests that tax should not be deducted.

Appellant’s counsel presented submissions as to why the computation should be made before tax. He argued that “very simply, income is profit”. He referred to subsection 9(1) which states,

Subject to this Part a taxpayer’s income for a taxation year from a business or a property is the taxpayer’s profit from that business or property for the year.

He referred to First Pioneer Petroleums Ltd. v. Minister of National Revenue (1974), 74 D.T.C. 6109 (Fed. T.D.) and reference therein to Attorney General v. Ashton Gas Co. (1905), [1906] A.C. 10 (U.K. H.L.) at 12 where the Lord Chancellor, the Earl of Halsbury, observed

Profit is a plain English word: that is what is charged with income tax.... The income tax is a charge upon the profits: the thing which is taxed is the profit that is made and you must ascertain what is the profit that is made before you deduct the tax - you have no right to deduct income tax before you ascertain what the profit is.

Counsel then pointed out that paragraph 18( 1 )(a) of the Act forbids the deduction of amounts in computing income that were not laid out for the purpose of gaining or producing income and posed the question

How can you then deduct the tax if you are trying to compute income?

He also pointed out that paragraph 55(5)(c) could have included the words, ...otherwise determined after the deduction of corporation tax and tax otherwise payable under this Act.

Unhappily, it seems that one must journey beyond the words in section 55 in order to determine whether the computation should be made after tax. That is unfortunate when the legislation could have made it clear. It is logical that subsection 55(2) take into account the fact that proceeds that would, but for a dividend, have been realized on a disposition at fair market value of any share immediately before that dividend, would have been computed after tax. The fair market value of a share, so far as the income element is concerned, would be valued on an after tax basis. No purchaser would rationally pay a price for a share of the capital stock of a corporation without taking into account tax paid or payable on that corporation’s income.

It may be simplistic to suggest that the words

Other than income earned or realized ... after 1971 and before ... the series of transactions

obviously mean after tax income, that being the only income earned in that period that would be available for distribution by way of dividend. Such suggestion would fail to take into account

a) the cogent argument of Appellant’s counsel which gave the words under review their plain meaning,

b) the fact that the Income Tax Act has, in the past, been specific in using terms such as “tax-paid undistributed income” and “tax-paid surplus on hand” [10] , and

c) appraisal surplus, from which a dividend can be paid, may be said to be attributable to income “earned or realized”.

Before tax profit is not wholly distributable. Although it is dangerous to speculate on what the legislation was intended to mean, I conclude that in this case it is only the portion of the “income earned or realized” by the dividend paying corporation remaining after tax that should be included in computing “safe income”.

3. The third issue is whether in computing “safe income” the dividend paying corporation must deduct the retiring allowance of $111,500 and the management fee of $104,000. Those amounts were not liabilities at the end of the “safe income” computation period, namely, March 30, 1988. Tyl- man’s uncontested evidence was that the retiring allowance had not been agreed to by Greenbaum until the day of closing, July 8, 1988. He also said that his April 4, 1988 letter to Greenbaum was the first time any mention was made of a “pension” for him. Rotstein was unchallenged in his evidence that there was a great deal of negotiating at the July 8, 1988 closing resulting in the figure of $104,000 paid as a management fee.

The Respondent’s counsel said

These amounts were part of the compensation. Mr. Tylman regarded them as part of the compensation. They were negotiated as part of the compensation. And they formed part of the compensation. The second argument is, in any event, they are liabilities which relate to a prior period ... because they relate to services provided in a prior period.

The foregoing amounts were not only not liabilities on March 30, 1988, the final date for computation of “safe income”, but were not even liabilities at the end of the fiscal period after that date and before the closing. They would not be taken into account in determining the company’s accounting income until they were liabilities and they would not be taken into account in determining a corporation’s taxable income until they were liabilities. How, therefore, can they possibly be treated as reductions of “income earned or realized” for the purpose of applying subsection 55(2) to characterize a sum equal to the total of those two amounts as proceeds of disposition? The Respondent’s deduction of these amounts is simply wrong.

Computation of “Safe Income”:

Schedule III as revised by me showing what the Appellant’s computation of safe income would be, given findings that I have made, shows “total safe income” of $941,196. Those findings are:

(a) It was incorrect for the Appellant to use retained earnings of Fybon in its computation of “safe income”,

(b) The sum of $63,013 computed by the Respondent should be $65,230, this taking into account the Appellant’s undisputed figures for both federal and provincial tax, and

(c) No deduction for the management fee of $104,000 and the retiring allowance of $111,500 should be made.

Designations:

Taxpayers are obliged, as was the Appellant in this case, to make designations of dividends under paragraph 55(5)(f). It reads as follows

For the purpose of this section ... where a corporation has received a dividend any portion of which is a taxable dividend,

(i) the corporation may designate in its return of income under this Part for the taxation year during which the dividend was received any portion of the taxable dividend to be a separate taxable dividend, and

(ii) the amount, if any, by which the portion of the dividend that is a taxable dividend exceeds the portion designated under subparagraph (i) shall be deemed to be a separate taxable dividend.

The inclusion of this requirement in the Act is absolutely absurd. The section could have functioned satisfactorily without paragraph (f). Simply stated, any amount of dividend in excess of “safe income” would be deemed to be proceeds of disposition. However, for reasons that may never surface, this unfortunate and unnecessary appendage caused the Appellant to make ONE HUNDRED designations. It is not my intention to analyze those designations and the effect of same. Suffice it to say that the Appel- lant received a cash dividend of $988,498 which it treated as proceeds of disposition on filing its return and, by my finding, had “safe income” of $941,196. The designations will, presumably, be used in computing the amount of deemed proceeds of disposition.

For all of the foregoing reasons, the appeal is allowed to the extent that:

(1) The Minister incorrectly treated the cash dividend of $988,498 and the deemed dividend of $779,597 as one dividend, subsection 55(2) not applying to the latter,

(2) The computation of “safe income” must be made after the deduction of federal and provincial income tax, and

(3) The sums of $111,500 paid as a retiring allowance and the sum of $104,000 paid as a management fee should not be deducted in the computation of “safe income”.

The Appellant is entitled to costs.

Exhibit A-6

General Quilting Company Limited Calculation of Safe Income ‘After Income Taxes Method‘ As At March 30, 1988

General Quilting Company Limited Calculation of Safe Income ‘After Income Taxes Method

General Quilting Company Limited Share of Safe Income (40%) ‘After Income Taxes Method As At March 30, 1988 Fybon Industries Limited

General Quilting Company Limited Share of Safe Income (40%) ‘After Income Taxes Method

1988 safe income - 40%

Exhibit R-1

Schedule 1 — Safe Income of General Quilting Company Limited General Quilting Company Limited

Safe Income April 30, 1983 - April 30, 1987 $ 1,528,367 Add: Stub Period Income May 1, 1987 - March 30, 223,566 1988

[(335/366)X$244,254]

Total Safe Income $ 1,751,933 $315,060

Schedule II — Safe Income Of Fybon Industries (Note: 1/2 allocable to Deuce)

Schedule III — Safe Income of General Quilting Company Limited Including Fybon

As Adjusted by Reassessment

General Quilting Company Limited

Safe Income April 30, 1983 - April 30, $ 1,528,367 1987

Add: Stub Period Income May 1, 1987 - 223,566 March 30, 1988

Schedule III — Safe Income of General Quilting Company Limited Including Fybon

As Adjusted by Reassessment

Appellant’s

Computation

General Quilting Company Limited

Safe Income April 30, 1983 - April 30, $ 1,528,367 $ 1,528,367 1987

Add: Stub Period Income May 1, 1987 - 223,566 223,566 March 30, 1988

Schedule III — Safe Income of General Quilting Company Limited

Notes:

Using Appellant’s undisputed figures for federal and provincial tax and computing Fybon’s ‘safe income not using retained earnings but on the basis employed by the Respondent.

Appeal allowed in part.