Hackbarth v. R., [1996] 1 CTC 2348

Mogan J.T.C.C.: — The appellant realized a capital gain of $41,105 in the fall of 1993 resulting in a taxable capital gain (at 75 per cent) of $30,829. When filing his income tax return for 1993, the appellant claimed the capital gain exemption under section 110.6 of the Income Tax Act, R.S.C. 1985 (5th Supp.), c. 1 (the “Act”) which, according to the appellant’s computations, had the effect of reducing his taxable capital gain to nil. The Minister of National Revenue reduced the appellant’s “cumulative gains limit” on the assumption that the appellant had a “cumulative net investment loss” as those phrases are defined in subsection 110.6(1) of the Act. The Minister’s computations are as follows:

Capital Gains Exemption claimed: $30,829

Less: Net capital losses (after 1984 and before 1993): 1,197

Sub-total: 29,632

Less: Cumulative net investment loss: 14,646

Revised Capital Gains Exemption: $14,986

According to the Minister’s computations, the appellant’s taxable capital gain would be reduced by $14,986 leaving him with a taxable capital gain of $15,843 ($30,829 minus $14,986).

The only issue in this appeal is whether the appellant had a “cumulative net investment loss” which is defined in subsection 110.6(1) as follows:

110.6(1) “cumulative net investment loss” of an individual at the end of a taxation year means the amount, if any, by which

(a) the aggregate of all amounts each of which is the investment expense of

the individual for the year or a preceding taxation year ending after 1987

exceeds

(b) the aggregate of all amounts each of which is the investment income of the individual for the year or a preceding taxation year ending after 1987.

In a nutshell, that loss is the amount by which investment expenses exceed investment income. For the purpose of section 110.6, the words “investment expense” and “investment income” are defined in subsection 110.6(1). The definitions are lengthy. In my view, for the purpose of this appeal those definitions can be rendered down to the following few words:

“investment expense” of an individual means an amount deducted in computing income from property.

“investment income” of an individual means an amount included in computing income from property.

The parties are in agreement that the appellant in 1993 had accumulated investment expenses of $14,646 which, on a stand-alone basis, would give him a cumulative net investment loss and thereby reduce his capital gains exemption. The appellant argues, however, that in 1993 he had accumulated investment income exceeding $50,000 which, if matched with his investment expenses, would reduce his cumulative net investment loss to nil and thereby leave him with a capital gains exemption almost equal to his taxable capital gain of $30,829. Therefore, the question really comes down to whether the appellant had income from property within the meaning of subsection 110.6(1).

The appellant is a professional geologist. From about 1980 up to and including 1993, he was employed within a group of associated corporations which I will call the “Stanley Group” carrying on business as professional consultants in engineering, geology and related scientific and technical fields. There are more than 800 persons employed by corporations within the Stanley Group but, of that number, only 100 were shareholders in 1993. In 1986, the appellant had been identified as one of the professional persons whom the Stanley Group wanted to retain and promote. At that time, he was offered the opportunity to become a junior shareholder. Upon becoming a shareholder, a number of formal agreements were signed which I will refer to below. In general, however, one had to be an employee in order to become a shareholder and, upon ceasing employment, a shareholder had to transfer his shares.

The appellant testified at the hearing and explained his three sources of income from the Stanley Group. He manages a business or corporation which he referred to as “Sentar” for which he is paid a salary. If the Sentar business is successful in a given year, he has the opportunity to earn a performance bonus. The third source is an amount which the appellant called an equity bonus based on the number of shares he owns in the parent company. It is necessary now to describe in more detail the actual arrangements within the Stanley Group.

The parent company is Stanley Engineering Group Inc. (referred to herein as “Group”) holding all of the shares of many wholly-owned subsidiaries. Stanley Associates Engineering Ltd. (referred to herein as “SAE”) is one of the wholly-owned subsidiaries which is in law the employer of all 800 employees. They are all on the payroll of SAE; they are in fact paid by SAE; and at year end they are issued a T4 form by SAE for income tax purposes. The appellant was not precise with respect to administrative details but it is his understanding that SAE paid all of the employees within the Stanley Group and then cross-charged the respective payroll costs to the various affiliated corporations for whom respective employees performed services. In this manner, it is likely that the appellant’s payroll costs would be cross-charged by SAE to Sentar. The 100 professional employees who are shareholders hold shares only in Group being the parent company.

In 1986, upon becoming a shareholder, the appellant entered into two formal agreements in writing with respect to his employment and equity in the Stanley Group. One agreement entitled “Employee Services Agreement” was a three-party agreement among SAE (called “Employer”), the appellant (called “Employee” Inc. (called “Group”). It had the usual provisions with respect to full-time services, compensation, termination, non-competition, confidentiality, etc. The compensation provision is important and so I will set it out in its entirety:

2.1 EMPLOYER will compensate the EMPLOYEE for his services to EMPLOYER as follows:

(a) Monthly salary and yearly bonuses in accordance with the current policy Of GROUP or as mutually agreed from time to time, and

(b) An annual before tax bonus calculated as follows, (See Appendix A attached hereto and forming part hereof).

(i) For the five (5) year period immediately following the date of purchase of each block of Class “B” shares of GROUP,

N x (E-R)

2

(ii) For all years after the initial five (5) year period immediately following the purchase of each block of Class “B” which the EMPLOYEE owns that block of shares or any portion thereof,

N x (E — R)

Where

E

Income of GROUP per equivalent fully participating share, before profit sharing and income taxes

R

Income of GROUP per equivalent fully participating share, retained by GROUP after profit sharing, after pre-tax dividends, but before income taxes

N

The number of Class “B” of each block owned by the EMPLOYEE

The amounts which the appellant described as his three sources of income from the Stanley Group fall within paragraph 2.1. The basic salary and performance bonus are in paragraph 2.1(a) and the equity bonus is in paragraph 2.1(b).

The second agreement entitled “Share Agreement” party agreement among Stanley Engineering Group Inc. (called “Group”), the appellant (called “Shareholder”) and Dr. Donald R. Stanley (an individual). It permitted the appellant to purchase certain Class “A” shares from the treasury of Group and certain Class “B” shares from Donald R. Stanley at stated prices. It provided time limits within which the purchase price of shares had to be paid, and a covenant by the appellant to loan certain amounts to Group in relation to the number of Class “B” shares he purchased. The Share Agreement contained the following provision:

2.1 If SHAREHOLDER ceases to be a full time employee of GROUP and/or any of GROUP’S subsidiary or affiliated Companies, for any reason, SHAREHOLDER shall be deemed to have offered to sell forthwith all his shares of GROUP to whomever the Board of Directors of GROUP shall name, and such offer shall remain open until accepted.

These first two agreements in writing were entered into on August 15, 1986. Similar agreements were signed on November 1, 1988 and again on September 13, 1991 but on the two later dates, Dr. Donald R. Stanley was not a party to the Share Agreement. Because of the requirement that each shareholder be an employee within the Stanley Group, the employee/shareholders had provided two different avenues through which they could receive the consolidated profits of the Stanley Group. They could receive pre-tax profits by way of bonuses; or they could receive post-tax profits by way of dividends.

The appellant argues that the equity bonus is income from property within the meaning of section 110.6 of the Act because it is based upon the pre-tax profits of the parent company (Group Inc.) and is paid in relation to the number of Class “B”. In this sense, it is different from his salary and performance bonus which are based upon the services which he personally performs as part of the management team. Because the Class “B” shares are capital property owned by the appellant, he argues that the equity bonus is income derived from the ownership of that property. And because the equity bonuses are in excess of $50,000, they would more than offset the appellant’s investment expenses in the range of $14,600 and leave him without any “cumulative net investment loss” to reduce the capital gains exemption.

That argument is attractive because of the obvious difference between the equity bonus and the performance bonus. On the other hand, a particular property will yield its own particular kind of income. A mortgage will yield interest. A lease will yield rent. A patent will yield royalties. And a share will yield dividends. For whatever reasons, the shareholders who control the parent company have decided that they would not distribute the consolidated after-tax profits of the Stanley Group by way of dividends but would use the ownership of Class “B” shares as a vehicle for paying pre-tax bonuses to the shareholders all of whom must be employees within the Stanley Group. Also, the pre-tax equity bonus is not paid by the parent company in which the appellant holds his Class “B” shares but is in fact paid by SAE, the subsidiary which pays him his salary and his performance bonus. The evidence disclosed that at the end of most years, SAE would issue two T4 forms to the appellant: one showing the aggregate of his salary plus performance bonus and the other showing his equity bonus.

I find it significant that the equity bonus is so clearly described as “compensation” in paragraph 2.1(b) of the Employee Services Agreement in which SAE is identified as “Employer” and the appellant is identified as “Employee”. In Friedberg v. Minister of National Revenue, [1992] 1 C.T.C. 1, 92 D.T.C. 6031, Linden J.A. delivered the judgment of the Federal Court of Appeal and stated at page 2-3, (D.T.C. 6032):

In tax law, form matters. A mere subjective intention, here as elsewhere in the tax field, is not by itself sufficient to alter the characterization of a transaction for tax purposes. If a taxpayer arranges his affairs in certain formal Ways, enormous tax advantages can be obtained, even though the main reason for these arrangements may be to save tax (see The Queen v. Irving Oil, [1991] 1 C.T.C. 350, 91 D.T.C. 5106, per Mahoney J.A.). If a taxpayer fails to take the correct formal steps, however, tax may have to be paid. If this were not so, Revenue Canada and the Courts would be engaged in endless exercises to determine the true intentions behind certain transactions. Taxpayers and the Crown would seek to restructure dealings after the fact so as to take advantage of the tax law or to make taxpayers pay tax that they might otherwise not have to pay. While evidence of intention may be used by the Courts on occasion to clarify dealings, it is rarely determinative. In sum, evidence of subjective intention cannot be used to “correct” documents which clearly point in a particular direction.

I cannot ignore the form in which the equity bonus is paid. Although it is clearly based upon the consolidated pre-tax profits of the parent company, it is in fact paid as part of the compensation package by SAE in its character as employer to the appellant in his character as employee.

The appellant’s agent argued that Revenue Canada regarded the equity bonus as employment income only because SAE had issued a second T4 to the appellant showing the amount of that bonus. I do not see it that way. In my opinion, the true nature of the equity bonus is employment income because that is the manner in which the Stanley Group has characterized the transaction in its Employee Services Agreement without any involvement from Revenue Canada.

The taxable capital gain actually arose in the fall of 1993 as the result of a corporate reorganization in which the Stanley Group became a public company. In January 1994, the appellant surrendered some of his Class “B” shares for redemption in circumstances which gave rise to a deemed dividend under subsection 84(3) of the Income Tax Act.

The appellant argues that the deemed dividend in January 1994 is really linked with the capital gain transaction in October 1993, and the amount of the deemed dividend (as income from property) would offset any investment expenses. There may be a link between those transactions but they occurred in two separate taxation years; and I was not shown how a deemed dividend in 1994, as income from property, could be anticipated in 1993 and used in the 1993 determination of “cumulative net investment loss”. For these reasons, the appeal will be dismissed.

Appeal dismissed.