Citation: 2003 FCA 284
CORAM: DESJARDINS J.A.
HER MAJESTY THE QUEEN
Heard at Montréal, Québec, on May 28, 2003.
Judgment delivered at Ottawa, Ontario, on June 26, 2003.
REASONS FOR JUDGMENT BY: NOËL J.A.
CONCURRED IN BY: DESJARDINS J.A.
Citation: 2003 FCA 284
CORAM: DESJARDINS J.A.
HER MAJESTY THE QUEEN
REASONS FOR JUDGMENT
 This is an appeal from a decision by Judge Dussault of the Tax Court of Canada (reported as Kruco Inc. v. The Queen, 2001 DTC 668);  4 C.T.C. 2053), in which he allowed the taxpayer's appeal from its 1989 assessment and referred the matter back to the Minister of National Revenue (the Minister) for reconsideration and reassessment on the basis that adjustments totalling $23,518,455 with respect to the investment tax credits of Kruger Inc. (Kruger) and one of its subsidiaries and attributable to the shares of Kruger's capital stock held by the respondent were not authorized by subsection 55(2) of the Income Tax Act (the Act).
 The issue to be decided turns on the income tax notion of safe income as it arises under subsection 55(2):
55(2) 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) or 138(6) as part of a transaction or event or a series of transactions or events (other than as part of 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
55(2) Lorsqu'une corporation résidant au Canada a reçu, après le 21 avril 1980, un dividende imposable à l'égard duquel elle a droit à une déduction en vertu du paragraphe 112(1) ou 138(6), comme partie d'une opération ou d'un événement ou d'une série d'opérations ou d'événements (sauf comme partie d'une série d'opérations ou d'événements qui ont commencé avant le 22 avril 1980) dont l'un des objets (ou, dans le cas d'un dividende visé au paragraphe 84(3), dont l'un des résultats) a été de diminuer sensiblement la partie du gain en capital qui, sans le dividende, aurait été réalisée lors d'une disposition d'une action du capital-actions à la juste valeur marchande, immédiatement avant le dividende et qui pourrait raisonnablement être considérée comme étant attribuable à quoi que ce soit qui n'est pas du revenu gagné ou réalisé par une corporation après 1971 et avant l'opération ou l'événement ou le début de la série d'opérations ou d'événements visés à l'alinéa (3)a), nonobstant tout autre article de la présente loi, le montant du dividende (à l'exclusion de la partie de celui-ci, si partie il y a, qui est assujettie à l'impôt en vertu de la Partie IV qui n'est pas remboursé en raison du paiement d'un dividende à une corporation lorsqu'un tel paiement fait partie de la série d'opérations ou d'événements)
a) est réputé ne pas être un dividende reçu par la corporation;
b) lorsqu'une corporation a disposé de l'action, est réputé être le produit de disposition de l'action, sauf dans la mesure où il est inclus par ailleurs dans le calcul de ce produit; et
(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.
c) lorsqu'une corporation n'a pas disposé de l'action, est réputé être un gain de la corporation pour l'année au cours de laquelle le dividende a été reçu de la disposition d'un bien en immobilisation.
 Also relevant to the disposition of the appeal is paragraph 55(5)(c) which provides:
55(5) For the purposes of this section,
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;
55(5) Aux fins du présent article :
le revenu gagné ou réalisé par une corporation pour toute une période au cours de laquelle elle était une corporation privée est réputé être son revenu pour la période déterminé par ailleurs en supposant qu'aucun montant n'a été déductible par la corporation en vertu de l'alinéa 20(1)gg) ou de l'article 37.1;
 Safe income, although not a statutory term, is an expression used in the tax community to designate the amount up to which tax-free intercorporate dividends may be paid without triggering a capital gain pursuant to subsection 55(2). Generally speaking it reflects a corporation's "income earned or realized" after 1971, subject to the refinements discussed below which form the subject matter of this appeal.
 The relevant facts are set out in full in the decision under appeal and need not be repeated. It is sufficient for present purposes to provide the following brief summary.
 Kruger has been a private corporation throughout the period relevant to the application of subsection 55(2) and paragraph 55(5)(c).
 Prior to August 30, 1989, the respondent was a minority shareholder of Kruger, holding 3,627,100 common shares (32.493 percent) and 100 preferred shares of its capital stock.
 From 1986, a dispute developed between the respondent and Kruger's senior management. The respondent filed a number of applications under the Canada Business Corporations Act, alleging a variety of acts and omissions constituting oppression against it as the minority shareholder.
 On August 25, 1989, the parties agreed to a settlement whereby Kruger repurchased the 3,627,100 common shares and the 100 preferred shares of its capital stock held by the respondent for $99,000,000 and $100 respectively, thereby giving rise to a dividend under the Act pursuant to subsection 84(3).
 As part of the settlement, Kruger guaranteed that not less than $70,000,000 of safe income would be attributable to the repurchased common shares.
 In its income tax return for the 1989 taxation year, the respondent took the position that a dividend of 73,000,000 had been paid out of safe income and reported a capital gain of $17,027,105 pursuant to subsection 55(2).
 In assessing the respondent, the Minister made three negative adjustments to the respondent's safe income, two of which were denied by the Tax Court Judge. The first of these adjustments was with respect to the investment tax credits for eligible property claimed by Kruger and one of its subsidiaries since 1971. Specifically, these credits once claimed, resulted in the reduction of the capital cost (or the undepreciated capital cost) of the property in question, pursuant to the application of paragraph 13(7.1)(e) and subparagraph 13(21)(f)(vii) of the Act.
 This prompted the Minister to make a negative adjustment to the computation of safe income on the ground that the reduced amount on which capital cost allowance could be claimed gave rise to phantom income, i.e. "income recognized in the computation of income under Division B of Part I of the Act although it is not supported by a corresponding cash inflow" (Memorandum of Fact and Law of the appellant, paragraph 4). A negative adjustment of $66,024,068 resulted from this change, 32,493% or $21,453,200 of which was attributed to the shares held by the respondent.
 The second adjustment made by the Minister resulted from the application of paragraph 12(1)(t), which requires the direct inclusion in income of investment tax credits where paragraph 13(17.1)(e) and subparagraph 13(21)(vii) do not apply. Again, the Minister was of the view that this inclusion was not supported by a corresponding cash inflow, thereby giving rise to what he described as phantom income. Out of an adjustment of $6,355,999 resulting from this change, $2,065,255 was attributed to the shares of the respondent.
 In making these negative adjustments, the tax avoidance officer for the Minister, Pierre Jolin, testified that he relied on the text of a presentation by John R. Robertson of Revenue Canada at the annual conference of the Canadian Tax Foundation in 1981. In his presentation, Mr. Robertson introduced 22 propositions concerning the calculation of safe income, which are generally referred to in the tax community as the Robertson rules. In particular, the Minister relied on Robertson's rule xx, which reads as follows:
There should be a deduction for any amount that has been included in taxable income that does not represent actual income earned by the corporation ......, for example, phantom income.
 Mr. Jolin acknowledged that the first adjustment was not strictly speaking a function of phantom income, but a consequence of the denial of the deduction of an expense actually incurred by reason of paragraphs 13(7.1)(e) and 13(21)(vii) of the Act. He went on to explain that the rationale behind this adjustment was nevertheless analogous to that applicable to phantom income (transcript of examination on discovery, Appeal Book, volume I, questions 201 to 206). No mention was made of the fact that the deduction in question is optional.
 On appeal to the Tax Court of Canada, the respondent contested the three negative adjustments made by the Minister to the computation of the safe income of Kruger. The Tax Court Judge allowed the appeal in part, concluding that the two adjustments made with respect to the investment tax credits were not justified. This is the decision under appeal.
Reasons of the Tax Court Judge
 The Tax Court Judge found that the words "income earned or realized" in subsection 55(2) must be taken to mean income for tax purposes. A private corporation's "income earned or realized" is deemed under paragraph 55(5)(c) to be its income otherwise determined on the assumption that no amounts were deductible by the corporation by virtue of paragraph 20(1) (gg) or section 37.1. Reference was made to the decision of Judge Sarchuk in 454538 Ontario Ltd. v. M.N.R., 93 DTC 427, where it was held that income otherwise determined is the income determined under Division B of Part I of the Act.
 Pursuant to subsection 55(2) and paragraph 55(5)(c), the Tax Court Judge found that adjustments to safe income at the computation of income stage were limited to those provided in paragraph 20(1)(gg) or section 37.1. If Parliament had intended there to be other adjustments, it would have so provided.
 In this regard, the Tax Court Judge recognized that certain adjustments could nonetheless be made which would not affect the computation of a taxpayer's income. Effectively, adjustments can and ought to be made concerning a taxpayer's cash position and involving balance sheet items that do not affect the calculation of income as such.
 In Deuce Holdings, Judge Bell found that a negative adjustment to safe income could be made for tax paid or payable. At page 931, he said:
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.
 Similarly, in Gestion Jean-Paul Champagne Inc. v. M.N.R 97 DTC 155, Judge Lamarre Proulx held that adjustments could be made for previously distributed profits, notably in the form of dividends, as well as for non-deductible expenses.
 The Tax Court Judge explicitly rejected the Minister's argument that negative adjustments could be made for what he referred to as phantom income, i.e. income resulting from the investment tax credits claimed by the appellant. The Minister's argument hinged on the decision of this Court in Canada v. Brelco Drilling Ltd.,  4 F.C. 35, where it was held that safe income must be "on hand", that is to say, disposable income.
 The Tax Court Judge distinguished Brelco on the basis that, in that case, the adjustment at issue (which derived from losses of foreign affiliates) did not affect the computation of income. In his view, these amounts could properly be deducted from safe income inasmuch as they reflected cash flow shown on the balance sheet and did not affect the computation of income.
 In the present case, the Tax Court Judge found that the adjustments made by the Minister affected the computation of income. In making the negative adjustments, the Minister had subtracted from safe income amounts which "are part of income for tax purposes which has been established as a tax base". As such, the Tax Court Judge held that the Minister had acted "directly contrary" to the wording of paragraph 55(5)(c) (reasons, paragraph 84).
 In responding to the Minister's assertion that the "real" or "actual" gain should be taxed by the extraction of the phantom income, the Tax Court Judge noted that the attempt to capture the "real" gain was illusory since the notion of income under the Act (which forms the basis for the computation of safe income) is itself a fiction (reasons, paragraph 83). In this respect, the Tax Court Judge referred to a series of examples which demonstrate that the notion of income for tax purposes differs from the economic or accounting notion of income.
 Finally, the Tax Court Judge commented that the adjustments made by the Minister led to double taxation. In his words (reasons, paragraph 84):
... accepting (the position of the Minister) would be tantamount to allowing the increase of Kruger's income for tax purposes brought about by the investment tax credits to be taxed once as regular income in its hands, and then, under the interpretation of subsection 55(2) put forward by the [Minister], allowing a corresponding amount to be taxed again in the hands of the appellant, Kruco, as a capital gain, which clearly also contravenes the spirit of the provisions at issue.
Contentions of the Appellant
 The appellant on behalf of the Minister concedes that the Tax Court Judge correctly held that the wording of paragraph 55(5)(c) does not allow phantom income to be removed in computing the "income earned or realized" by a corporation (Memorandum of Fact and Law, paragraphs 72 and 78). She argues, however, that this does not preclude a determination of whether the phantom income in issue can in fact contribute to the notional capital gain arising under subsection 55(2).
 According to the appellant, the deemed meaning of income merely provides a starting point for the safe income determination required by subsection 55(2). In making this last determination, one must not only ascertain whether this income was kept on hand but also whether it was ever disposable. The phantom income arising from the investment tax credits was never disposable and hence the capital gain in issue cannot be said to be "reasonably ... attributable" to this income. Nor can it be said that double taxation arises from the Minister's adjustments.
 In holding otherwise, the Tax Court Judge ignored the purpose of subsection 55(2) and the expression "reasonably ... attributable", which required him to extract the phantom income resulting from the investment tax credits from the income otherwise determined pursuant to paragraph 55(5)(c).
Analysis and Decision
 In my respectful view, the Tax Court Judge came to the correct conclusion, essentially for the reasons that he gave and that I have attempted to summarize in the preceding paragraphs.
 Contemporary tax literature shows that when subsection 55(2) was enacted, Parliament was confronted with a fundamental choice in selecting the appropriate legislative remedy to capital gain strips. 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.
 One of the options considered by Parliament was to exhaustively define an earnings account by reference to control periods, which would have allowed for the actual measurement of the capital gain inherent in the shares that was attributable to anything but income whenever a dividend was paid.
 However, this approach was thought to be complex and overly onerous. In their 1980 paper on capital gain strip rules, Brown and McDonnell report:
... the job of calculating such control period earnings, given all the complexities involved, and the fact that complex carryover provisions would have been required for all the reorganization sections of the Income Tax Act, would have lengthened the Income Tax Act by many more pages. Equally, the job of calculating, for each corporate shareholder at least, and perhaps for all shareholders of all Canadian corporations, a comprehensive control period earnings amount to be compared with actual dividends would have been a Gargantuan calculation for the taxpayers to prepare and for Revenue Canada to police. (Brown and McDonnell, "Capital Gains Strips: a Critical Review of the New Provisions", in 1980 Conference Report, Canadian Tax Foundation, 1981, pp. 60 and 61)
 A more focussed and less cumbersome approach was adopted. Subsection 55(2) (when read in conjunction with paragraph 55(5)(f)) provides, in effect, that when a dividend (paid or deemed) has effected a significant reduction of the capital gain which would have resulted from a notional sale of the shares at fair market value, and this gain can reasonably be attributed to anything other than "income earned or realized" after 1971, the dividend is deemed to be a capital gain to the extent of the portion so attributed. 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.
 What is of significance for our purposes is that, in making this apportionment, "income earned or realized" is "deemed" to be income otherwise computed (under the Act), subject only to the two exceptions mentioned in paragraph 55(5)(c) (in the case of a private corporation).
 The starting point for the subsection 55(2) apportionment was thus fixed by way of a deeming provision, leaving as the only other exercise the determination of that part of the notional capital gain which can "reasonably be considered to be attributable to anything other than" this income.
 There can be no doubt that this exercise calls for an inquiry as to whether "the income earned or realized" was kept on hand or remained disposable to fund the payment of the dividend. It follows, for instance, that taxes or dividends paid out of this income must be extracted from safe income (see Deuce Holdings Ltd., supra and Gestion Jean-Paul Champagne Inc., supra).
 The appellant argues that the phantom income in issue must be removed from "income earned or realized" on the same logic as dividends or taxes. Simply put, as this income does not correspond to any cash inflow, it is not (and can never have been) disposable or on hand. Hence, the appellant submits that it should also be removed from "income earned or realized".
 The problem with this argument is that it runs squarely against the fact that "income earned or realized" for purposes of subsection 55(2) is, in the case of a private corporation, deemed to be income computed in conformity with paragraph 55(5)(c). This provision is not merely presumptive; it is framed in mandatory terms and the state of affairs which it deems must be taken as a given.
 Reducing this income by reference to cash outflows, which take place after it has been computed in conformity with paragraph 55(5)(c), but before the dividend is paid, does no violence to the deeming provision since the deemed amount is accepted as the starting point and modified only by reference to subsequent events which are relevant to the subsection 55(2) computation, i.e. cash outflows which take place after the income has been determined - in conformity with the deeming provision - and which reduce the income to which the capital gain can be "reasonably ... attributable".
 However, what the appellant proposes is a modification in the actual computation of income under the Act on the basis that part of this income, although computed and made subject to tax in conformity with the Act, was in fact never on hand or disposable. This adjustment alters the amount which paragraph 55(2)(c) deems to be a private corporation's "income earned or realized". While the use made of this income once computed in conformity with this provision must be analysed to determine whether it remains disposable, the fact that this income is fixed by way of a deeming provision precludes an inquiry as to whether it was ever on hand or disposable. In short, it is not open to the Minister to modify the amount which Parliament has deemed to be a corporation's "income earned or realized" for purposes of subsection 55(2).
 Should there be any doubt in this regard, one need only consider the two exceptions which are reflected in paragraph 55(5)(c). These effectively add to the income which is otherwise deemed to be "earned or realized" the former inventory allowance (paragraph 20(1)(gg)) and the former additional deduction for research and development (section 37.1). As the appellant has correctly pointed out (Memorandum of Fact and Law, paragraph 76), this recognizes the fact that these two deductions are not associated with actual cash outflows.
 What this shows is that Parliament had in mind the issue which the appellant now seeks to address and nevertheless opted to deem a corporation's "income earned or realized" to be income computed under the Act subject only to the two stated exceptions. Against this background, it cannot be seriously argued that Parliament did not intend to make the income so "deemed" immutable.
 It is apparent from this brief analysis that Brown and McDonnell correctly identified the intent behind subsection 55(2) when they wrote in the passage quoted by the Tax Court Judge at paragraph 82 of his reasons:
The intent of subsection 55(2) is to permit a tax-free, intercorporate dividend to be paid to reduce a potential capital gain to the extent that the gain is attributable to the retention of post-1971 income. Conversely, it is intended to block a dividend payment that goes beyond this amount to reduce capital gains attributable to anything other than retained post-1971 income. There is an implicit assumption that one can determine the portion of any gain arising on the sale of the shares that is attributable to the retention of post-1971 income and the portion that is attributable to something else. The assumption appears to be that each dollar of retained post-1971 income will yield an equivalent dollar increase in the value of the shares in question and that a gain in excess of that amount must necessarily be attributable to something else. [Emphasis added]
 The assumption underlying subsection 55(2) requires that credit be given to the full amount deemed by Parliament to be a private corporation's income "earned or realized" in the computation of safe income. Once this is accepted, the Tax Court Judge's conclusion that the adjustments proposed by the Minister would result in taxing amounts which have already been taxed as income becomes self-evident.
 I would dismiss the appeal with costs.
Alice Desjardins J.A."
Gilles Létourneau J.A."
FEDERAL COURT OF APPEAL
NAMES OF COUNSEL AND SOLICITORS OF RECORD
STYLE OF CAUSE: HER MAJESTY THE QUEEN v. KRUCO INC.
PLACE OF HEARING: MONTREAL
DATE OF HEARING: MAY 28, 2003
REASONS FOR : NOËL J.A.
CONCURRED IN BY: DESJARDINS J.A.
DATED: JUNE 26, 2003
MR. GUY LAPERRIÈRE FOR THE APPELLANT
MS. SUSAN SHAUGHNESSY
MR. ANDRÉ P. GAUTHIER FOR THE RESPONDENT
MS. JOSÉE VIGEANT
SOLICITORS OF RECORD:
MORRIS A. ROSENBERG FOR THE APPELLANT
HEENAN, BLAIKIE FOR THE RESPONDENT