The Canada Southern Ry. Co. v. The Queen, 82 DTC 6244, [1982] CTC 278 (FCTD), rev'd 86 DTC 6097, [1986] 1 CTC 284 (FCA)

Mahoney, J:—The only issue is whether amounts credited in lieu of dividends in 1972 and 1973 by the plaintiff to the trustees of The Penn Central Transportation Company, a non-resident shareholder carrying on business in Canada, were exempt from withholding tax under the Income Tax Act by virtue of subsection 805(1) of the Income Tax Act by virtue of subsection 805(1) of the Income Tax Regulations.

805. (1) Where a non-resident carries on business in Canada he shall be taxable under Part XIII of the Act on all amounts otherwise taxable under that Part except those amounts that may reasonably be attributed to the business carried on by him in Canada.

The question is whether, in the circumstances, the dividends might reasonably have been attributed to the business carried on by the trustees in Canada.

The trustees had included the dividends credited in the calculation of income from a business under Part I of the Act in their Canadian income tax returns for 1972 and 1973. The bottom line, however, was a loss, not a profit, in both years. Under Part XIII of the Act, if it applied, the trustees were liable to pay and the plaintiff to withhold a tax equal to 15% of the dividends credited, without deduction. The practice of reporting this dividend income under what is now Part I, rather than what is now Part XIII, appears to have been accepted by the Minister since the initial imposition of withholding tax under the Act.

The plaintiff owns a railway line running north of Lake Erie between the Detroit River and the Niagara River alaong with a number of branch lines in Canada and appurtenant facilities including most notably, connections with US lines at or near Detroit, Niagara Falls and Buffalo, a railway tunnel under the Detroit River and a bridge across the Niagara River, hereafter, collectively “the system”. In 1882, the Plaintiff entered into an agreement whereby The Michigan Central Railroad Company, hereafter “Michigan Central”, operated the Plaintiff’s system for the ensuing 21 years. Effective January 1, 1904, the Plaintiff leased the system to Michigan Central for 999 years. That lease was among the properties leased, effective February 1, 1930, by Michigan Central to The New York Central Railroad Company, hereafter “New York Central”. On February 1, 1968, New York Central merged with The Pennsylvania Railroad Company to form The Penn Central Transportation Company, whose assets and undertaking were transmitted to the trustees under US bankruptcy laws June 21, 1970. It is unnecessary for this purpose to take the history further. The trustees and The Penn Central Transporta tion Company need not, for this purpose, be distinguished and will hereafter be referred to as “Penn Central”.

Penn Central was, in the taxation years in issue, entirely in the position of Michigan Central under the 999 year lease vis-à-vis the plaintiff except that Penn Central Transportation Company need not, for this purpose, be distinguished and will hereafter be referred to as “Penn Central”.

Penn Central was, in the taxation years in issue, entirely in the position of Michigan Central under the 999 year lease vis-à-vis the plaintiff except that Penn Central owned some of the plaintiff’s shares directly, having succeeded to those acquired directly by New York Central,as well as enjoying, under the 999 year lease, all the relevant incidents of ownership of the shares owned by Michigan Central. Penn Central owned 99.8% of the outstanding shares of Michigan Central and 18,100 of the plaintiff's 150,000 outstanding shares. Michigan Central owned 89,163 of the plaintiff's shares and the remaining 42,737 were owned by the public. Thus, Penn Central, directly and indirectly owned about 71.5% of the plaintiff's outstanding shares.

The 999 year lease vested Michigan Central with everything but the bare legal ownership of the system. The plaintiff’s only material rights were to have the system returned to it at the end of 999 years and to be paid, after 1910, as rental, amounts sufficient to permit it to pay semiannual dividends of $1.50 per share on its outstanding shares. How much, if any, of the plaintiff’s stock was owned by Michigan Central at the inception of the 999 year lease is not in evidence. However, by 1930, when it leased the lease to New York Central, it owned 83,449 shares, or aboaut 55.6% of the equity. The properties leased to New York Central included not only the leasehold interest in the system but also, for the term of 999 years, all Michigan Central’s right, title and interest in those shares. New York Central owned no other shares in the Plaintiff in 1930 but, by 1968, it had acquired the 18,100 and Michigan Central had increased its holdings to 89,163. Michigan Central’s after-acquired shares would appear not to have been subject of the lease to New York Central. It therefore appears that Penn Central’s right to receive the dividends stemmed, as to 18,100 shares, from their direct ownership; as to 83,449 from the 99-year lease and, as to 5,714, from its 99.8% ownership of Michigan Central. In any event, the dividends attributable to all 107,263 shares were, in 1972 and 1973, credited directly to Penn Central by the plaintiff.

After 1930, New York Central was obliged to pay the rent. There was not, of course, an obligation on the plaintiff’s part, to pay any dividend but, through its control of the 83,449 shares, New York Central was in a position to see that it did. It made business sense for it to exercise power and it did. Up to and including the rental payment in late 1958 which put the Plaintiff in funds to pay the semi-annual dividend declared payable January 1, 1959, New York Central actually paid the semi-annual rental to the Plaintiff and received back the payment of the dividend to which it was entitled. On June 26, 1959, New York Central wrote the plaintiff and Michigan Central; “the Central” in the letter is New York Central. After reciting certain provisions of the leases, the letter went on:

Pursuant to the provisions of the Michigan Central Lease, the Central has paid to the Canada Southern as part of the rental under the Canada Southern Lease the amount of $450,000 annually (since 1910), being the amount equal to three per cent per annum upon the 150,000 shares of capital stock of the Canada Southern outstanding. From these payments of rent, the Canada Southern has declared and paid dividends on its stock, which (since 1910) have amounted to $1.50 per share semi-annually, or an aggregate of $450,000 annually, equal in other words to the amount of the annual rental payment. Such semi-annual dividends have in the past been made payable during the month following the month in which the semiannual rental payment is made and it is understood that this practice is expected to continue in the future.

Of the total of 150,000 shares of Canada Southern stock outstanding, 89,163 shares are owned by the Michigan Central, and that company’s right, title and interest in and to such stock is held by the Central under the Michigan Central Lease. The Central has accordingly received the dividends declared and paid by the Canada Southern on such stock since the effective date of the Michigan Central Lease.

The result is that the Central is, in effect, paying rent to itself in respect of the portion of rent paid back as dividends the next month.

In order to eliminate such unnecessary circuity of payments and in order to reflect the true situation more accurately, we propose that, commencing with the rental payment of July 1, 1959, and at each semi-annual payment date thereafter, the Central shall pay, by means of a waiver of dividend as below set forth, that portion of the semi-annual rent expressed to be payable under the Canada Southern Lease as shall amount to the product of the number of shares of stock of the Canada Southern owned on the dividend record date by the Michigan Central Lease times the per share rate (but not in excess of $1.50) of any semi-annual dividend declared on Canada Southern stock and unpaid, it being understood that appropriate accounting adjustments will be made by the Central, the Michigan Central and the Canada Southern to reflect the transactions in the accounts on this basis affective as of January 1, 1959.

During the period when such portion of the rent is paid by waiver as aforesaid, the Central shall and does hereby waive its right to receive semi-annual dividends (up to $1.50 per share) which, in each semi-annual period, would otherwise be paid from such rent on the stock of the Canada Southern then owned by the Michigan Central and held by the Central under the Michigan Central Lease.

This arrangement shall be deemed to be in compliance with the provisions of the Canada Southern Lease with respect to the payment of rent thereunder and shall not constitute an amendment or modification of the terms, provisions and conditions of that lease in any way. The arrangement shall continue until terminated by any company party hereto giving to the other parties at least 30 days’ written notice prior to the end of any such semi-annual period.

Please signify your concurrences in the foregoing by signing the enclosed copy of this letter in the space provided therefor and return such copy to us.

The plaintiff and Michigan Central concurred. That arrangement was in effect in 1972 and 1973 and, it appears, was applied, in practice, to the shares owned by Penn Central as well as those leased from Michigan Central.

The evidence is that neither Michigan Central nor New York Central would have had any interest in acquiring the plaintiff’s shares if they had not been renting its system. They acquired shares in the market when the price was such that the reduction in outflow of cash by way of dividends advantageously offset the cost of the purchase money. The primary motivation was reduction of payments to third parties. A secondary motivation was the desire eventually to eliminate all third party interests and to make the plaintiff a wholly owned subsidiary as, in effect, Michigan Central was. The trend to consolidation of ownership into large corporate organizations, as well as the consolidation of operations, through the medium of long term leases, had been a characteristic of the railroad industry in the northeastern United States for about a century and applied in Canada to American operated systems.

The circumstances considered in The Toronto Hamilton & Buffalo Railway Company v MNR, [1974] CTC 2270; 74 DTC 1195, were quite different. There Penn Central was a shareholder in the TH&B which carried on its own railway business in Canada; here it is a shareholder in the plaintiff which has carried on no railway business in Canada since at least 1903, if not 1882. Here Penn Central carried on a railway business in Canada utilizing the plaintiff’s system.

It was reasonable for Penn Central to regard the dividends credited to it as de facto payment to itself of rent it was obliged to pay to carry on its railway business in Canada. It follows that they were amounts that may reasonably be attributed to the business carried on by Penn Central in Canada and were amounts taxable under Part I, rather than Part XIII of the Act.

The assessments in issue are vacated. The plaintiff is entitled to its costs.