Hugh Sullivan v. Minister of National Revenue, [1990] 2 CTC 2652, 91 DTC 43

Taylor, T.C.J.: —These are appeals heard in Toronto, Ontario, on September 1, 1989 and November 3, 1989 against income tax assessments for the years 1983, 1984 and 1985 in which dividends received by the appellant in the amounts of $51,000, $27,750 and $51,750 respectively, were reported as income of the appellant's wife, Mrs. Sullivan. The appellant's position was that by virtue of subsection 74(1) of the Income Tax Act, R.S.C. 1952, c. 148 (am. S.C. 1970-71-72, c. 63) (the "Act"), the dividend income at issue must be reported as that of Mrs. Sullivan, and could not be regarded as income to him. Because of the unusual nature of this matter I will quote extensively from the notice of appeal and the reply to the notice of appeal.

For the appellant:

- In May 1983, Mrs. Joan Sullivan, the taxpayer's spouse, caused a corporation, 551360 Ontario Ltd., to be formed.

- On May 12, 1983, Mrs. Sullivan subscribed and paid for 1,000 common shares for $1,000. These shares were issued to Mrs. Sullivan on May 12, 1983.

- On May 16, 1983, Mrs. Sullivan, under an agreement entered into on that date, sold her 1,000 shares in 551360 Ontario Ltd. to the taxpayer for $1,000, which amount was paid by the taxpayer on that date.

- On May 19, 1983, the taxpayer entered into an agreement with 551360 Ontario Ltd., under the terms of which all the issued shares of Hugh Sullivan Drugs Ltd., which were owned by the taxpayer, were sold to 551360 Ontario Ltd. Among other things, this agreement provided as follows:

- That the shares were to be sold for their fair market value at the effective date of the agreement.

- That the purchase Price of the shares was to be paid by the issue of 1,000 common shares of 551360 Ontario Ltd. with an aggregate paid-up capital of $52.98.

- That any difference between the purchase price of the shares of Hugh Sullivan Drugs Ltd. and the specified consideration of $52.98 in shares of 551360 Ontario Ltd. was to be recorded on the books of 551360 Ontario Ltd. as contributed surplus.

- That the Vendor and Purchaser would jointly elect and file an election under Section 85 of the Income Tax Act.

- The fair market value of the shares of Hugh Sullivan Drugs Ltd. at the time of the transaction was calculated to be $900,000.

- The Vendor and Purchaser jointly elected under Section 85 of the Income Tax Act that the proceeds of disposition of the shares to the Vendor and the cost of the shares be deemed to be $170,000, an amount thought to be equal to the adjusted cost base of the shares to the Vendor. It was discovered later that the amount did not represent the adjusted cost base of the shares, since certain tax-free dividends had not been allowed for. The elected amount was changed, with the agreement of Revenue Canada, to $128,642.

For the respondent:

- at the time of incorporation of 551360 Ontario Ltd. on May 12, 1983, Mrs. Joan Sullivan, the appellant's spouse, was the sole shareholder and director of this corporation;

- as of the date of the sale of the 1000 shares of shares of 551360 Ontario Ltd. sold by the appellant's spouse to the appellant, the fair market value of those shares was $1,000;

- Joan Sullivan, the appellant's spouse, incorporated 551360 Ontario Ltd. on behalf and for the benefit of the appellant and acted as agent for him in this regard;

- on May 24, 1983, Hugh Sullivan Drugs Ltd. declared a dividend in the amount of $660,000 in favour of 551360 Ontario Ltd., its sole shareholder;

- on May 31, 1984, Hugh Sullivan Drugs Ltd. declared a dividend in the amount of $132,000 in favour of 551360 Ontario Ltd., its sole shareholder;

- the three dividends in question declared by 551360 Ontario Ltd. in 1983, 1984 and 1985 were made possible only by the dividends it had received from Hugh Sullivan Drugs Ltd.

- The respondent relies, inter alia, upon the provisions of sections 3, 82 and 85, paragraph 12(1)(j) and subsection 74(1) of the Income Tax Act, R.S.C. 1952, Chapter 148, as amended, (the "Act") applicable to the 1983,1984 and 1985 taxation years of the appellant and subsection 44(4) of the Ontario Business Corporations Act, R.S.O. 1980, chapter 54.

Evidence

Counsel for the appellant put in full and complete testimony and evidence—and there was little if any dispute regarding the basic facts, although some points which will be highlighted later arose out of the testimony of the legal and accounting advisors to the appellant. Some of the basic data used to support the position of the appellant is reproduced hereunder and entitled "Schedules":

Schedule B (the financial statements of Hugh Sullivan Drugs Ltd. as at May 31, 1983, Exhibit A-5):

Retained Earnings —beginning of year	$744,037
Less: Dividends paid on common shares 660,000
Retained Earnings—end of year	84,037

Schedule C (the financial statements of 551360 Ontario Ltd. for the year ending May 31, 1983 (first year) Exhibit A-6):

551360 Ontario Ltd. Balance Sheet at 31st May 1983

Assets

Current

Cash $ 998 Term Deposits and guaranteed

investment certificates 523,000 Accrued interest receivable 17,029 Loan receivable—Hugh Sullivan Drugs Ltd. 53,353

594,380

Long Term Investments

Notes 1 (a) and 2 84,090

$678,470

Liabilities and Shareholder's Equity

Current

Advances from shareholder $ 355

Income taxes payable 345

700

Shareholder's Equity

Share capital

Authorized

1,000,000 common shares of no par value

1,000,000 redeemable preference shares with a par value of $1 each 4,000,000 participating special shares of no par value

Issued in the period

1,000 common shares for cash $ 1,000

1,000 common shares in exchange for

53

For the Period From Inception 12th May 1983 to 31st May 1983 551360 Ontario Ltd. Notes To Financial Statements At 31st May 1983

	1,053
Contributed surplus—Note 3	676,037
Retained earnings
Net income for the period	680
	677,770
	$678,470
551360 Ontario Ltd.
Statement of Earnings

Income
Interest	$ 1,027
Expenses
Bank charges		2
		1,025
Income Taxes		345
Net Income For the Period	$	680

1. Accounting Policies
Long term investments are accounted for on the equity basis.
2. Long Term Investments
5,001 common shares of Hugh Sullivan Drugs Ltd.	744,090
Add: Earnings since acquisition	—
	744,090
Less: Dividends received	$660,000
	$ 84,090
3. Contributed Surplus
Net book value of underlying assets
acquired on issue of common shares for
the common shares of Hugh Sullivan Drugs Ltd.	$744,037
Less: Dividends paid in the period on common shares	68,000
Balance, 31st May 1983	$676,037

On Exhibit A-7, (the required election form under section 85 of the Act), the following is recorded:

Date of Sale or Transfer: May 20, 1983

Property Disposed of:

Description: 5,001 common shares Hugh Sullivan Drugs Ltd.

Fair Market Value at time of disposition: $900,000

Consideration Received:

Description: 1,000 shares of 551360 Ontario Ltd.

Fair Market Value (See "Note"): Nil

Agreed Amount: *170,000

The agreed amount is intended to be the "cost amount” of properties for tax purposes.

Testimony regarding the above financial data presented to the Court established to my satisfaction that:

(a) the amount of $53 shown on the balance sheet of 551360 for the second 1,000 shares of 551360 issued to Mr. Sullivan was a reference to the value at which the 5,001 common shares of Drugs had been shown on the books of Drugs before transfer of those shares by Mr. Sullivan to 551360;

(b) the 551360 statement of earnings above did not include the $660,000 dividends from Drugs as part of income, it appeared as a deduction from "long-term investments";

(c) from the "Notes to financial statements of 551360”, the $744,090 shown under “long term investments" was calculated by adding together the $53 share capital in Drugs and the $744,037 retained earnings in Drugs—before payment of the dividends of $660,000;

(d) contrary to Note 3 to the financial statements of 551360, reproduced again below, the "contributed surplus" was not the result of "underlying assets" that had actually been acquired in the common share exchange covered by the section 85 rollover. The assets transferred from Drugs to 551360 had been the method by which payment had been made for the dividends declared by Drugs after the section 85 rollover had been completed, according to the appellant:

3. Contributed Surplus

Net book value of underlying assets

acquired on issue of common shares for

the common shares of Hugh Sullivan Drugs Ltd.

$744,037

As I understand the explanatory testimony, the differences in the recording of the events and transactions at issue, particularly (d) above, as contrasted with those which actually occurred, came about in large measure in an effort by Mr. Sullivan’s advisors to make the intricate steps in the process more understandable to Mr. Sullivan. This part of the recording of the events may have served to make somewhat more difficult the task of following the transactions, but it remains for the Court to examine the transactions and events for what actually did happen. I also note for the record that in Exhibit A-6 (above) the value of $53 was assigned to the 5,001 shares of Drugs, but I am not aware of any reason that it could not have been, indeed why it should not have been shown as "nil" to correspond with Exhibit A-7, other than the attempts of the appellant's advisors to make the transactions more understandable to Mr. Sullivan. But the difference in those two amounts—"nil" and "$53" is irrelevant for purposes of this appeal. Equally, shown on Exhibit A-7 (above) is "Agreed amount $170,000”, which represented the "cost amount" of the properties for tax purposes. That amount does not enter directly into this appeal either, since it has to do in large measure, as I understand it, with what might be described as the “V-day value” of the property transferred. Without trying to be too specific or definitive about it (since it does not enter into these proceedings) the appellant is saying that the 5,001 shares of Drugs had a V-day value of $170,000. I am aware that amount was later adjusted by agreement between the parties, but that also is irrelevant for my purposes.

Argument

I would quote briefly from the arguments presented on behalf of the appellant:

The Respondent, in his Reply, has submitted that subsection 74(1) does not apply in the circumstances before the Court. The principal reason he has given for this non-application is that—and I quote—"Since she"—referring to Mrs. Sullivan — "incorporated 551360 Ontario Ltd. and acquired 1,000 shares in that corporation for the benefit of. . .and the Appellant”. It is the Appellant's position that no principal agent relationship existed with respect to any part of the transactions in question.

The Respondent has also submitted that the dividends paid on the shares of 551360 Ontario Ltd., that these dividends were not income from the shares of 551360 Ontario Ltd., rather the Respondent argues the dividends were income from the shares of Hugh Sullivan Drugs Ltd. This argument, looking to the underlying source of the income for the purpose of characterizing the nature of the dividends, I submit is not supported. The Act does not provide a workable definition of "dividend"; we must take the ordinary meaning of it which has been established by the cases to be a ratable distribution other than a step in the reduction of capital. The scheme of the Act, I suggest, makes it clear that the source of income underlying the dividend is irrelevant in determining the treatment of the dividend for tax purposes.

In paragraph 8 of the Reply, the Respondent argues in the alternative that the dividends were not income from the first 1,000 shares issued to Mrs. Sullivan but were income from the second 1,000 shares only. Again this argument, I submit, is not supported. All of the 2,000 shared outstanding at the time of payment of the dividends were shares of the same class, that is common shares, all were owned by Mr. Sullivan and the dividends were declared on all the shares of that class. In common law there is a presumption that, in the absence of applicable restrictions in the articles of incorporation, all shareholders entitled to dividends on the shares they hold equally with every other shareholder. There is no provision in the articles of this company which would permit such a differentiation between two blocks of shares of the same class,. . . .

Another argument was made by the Respondent in paragraph 9 of his Reply. In this case, the Respondent argues that the property that was the original shares issued to Mrs. Sullivan, that is, the 1,000 shares, being the shares she took on incorporation and those that she received by resolution immediately after were somehow different from the shares subsequently held by Mr. Sullivan, because the transfer

of shares—apparently because the transfer of shares of the operating company had resulted in an increase in the value of the shares of the numbered company. It's clear that such an increase in value did take place, obviously can't be disputed. The shares themselves, however, had changed in no way. Their legal attributes had not changed; they had not changed in form nor in substance but only in value. So, the shares were the same shares although clearly affected by the transactions that took place.

Finally, the Respondent argues the taxpayer has attempted to do indirectly that which he cannot do directly, that is, split income with his spouse. The taxpayer doesn't deny—in fact it’s been quite readily admitted—that the purpose of this transaction was not a business purpose, that is, there was no intention that the holding company carry on a business or any particular venture. Although that could clearly happen in the future that was not in minds of the people forming the company at the time it was formed. And the taxpayer does not deny that the particular form this transaction took, that is, the issue of shares to the wife and the subsequent transfer to her husband does not deny that splitting of income is the result and was the result aimed for in this transaction. What he does deny, however, is that this should be viewed as reprehensible or indirect in any pejorative sense. The transaction, as was suggested to you previously, is not a sham transaction. The taxpayer never maintained that it had a business purpose other than a tax purpose and does not do so at this time. The transaction was not a sham. It created the legal relations it intended to create and it's clearly within the words of subsection 74(1).

Mrs. Sullivan received no dividends whatsoever. And the question is whether or not she is required to pay tax on those dividends even though she didn't receive them. It is the taxpayer's submission that the attribution rules apply and have that effect; and in many, many situations the application of the attribution rules in different circumstances—will give a ridiculous result, an apparently ridiculous result, but this result is because of the words of the Act and the method of enforcing them. But, effectively, she received no dividends.

[Emphasis added.]

And for the respondent:

The Minister, your Honour, has three basic submissions. . .First of all, in examining the transaction or transactions in this matter and interpreting the legislation, I would ask your Honour to firstly look at the substance of the transaction. . .to look at the intention and purpose of section 74 and the mischief that that section was aimed at prior to its repeal.

The second argument is that there was an agency relationship in the creation of and subsequent transfer of the shares.

The third argument is the intention of Parliament in section 74 to prevent income splitting. In my submission, it admits of no other possible purpose. And the Appellant is attempting to use section 74 to split income which is the exact mischief that that section is aimed at preventing. And it's the Minister's submission that where property is transferred but subsequent to the transfer something is done to the property, attributes are added to it, value is injected into it, that that changes, that somehow that no longer becomes the property transferred. . . . The interposition of a corporation doesn't alter the substance of the transaction. A taxpayer cannot add value to transferred property and then say that the income, the income that arose from the property is from the property transferred. You cannot alter the attributes of the property. What happened here, your Honor, is that Mrs. Sullivan transferred property to her husband. He then fundamentally alters that property by adding tremendous value to it. By the rollover, those shares are now worth $450,000, the one-half, whereas before they were worth $1,000. The income which results from those shares is not income from the property transferred, it is income from the operating company effectively. And really it is income from the value added to the property, added to the 1,000 shares originally owned by Mrs. Sullivan and transferred to her husband, to which Mr. Sullivan has added that extra value after the transfer. It's clear that but for the rollover and but for the contributed surplus, the numbered company could never have paid dividends, and I think that Mr. McNair agreed with that point.

[Emphasis added.]

Analysis

As can be seen the arguments presented by the parties concentrated largely, on the interpretation and application of section 74 of the Act. The parties were recalled to Court for the second day, and comments requested regarding certain aspects of section 85 of the Act also. I am not persuaded that the respondent's first and second arguments above meet directly the prime point of the appellant that the transaction under review fits completely within the confines of the words of subsection 74(1) of the Act. The first point of counsel for the respondent is somewhat akin to an “object and spirit” argument. That might have value in a supportive or interpretative way, but I fail to see it as effective as the basic position in making this assessment. With regard to counsel's second point—an "agency" relationship, there was no evidence presented at the trial on which I could conclude that in her own conduct Mrs. Sullivan was in that position. She had independent consultation, according to her, and had made no commitment to deal with the shares of 551360 in advance, as occurred in this appeal. I doubt that she was any more aware of the implications of the total program than was Mr. Sullivan, and she certainly followed advice. But I was not persuaded that based on that argument the entire proposition of the appellant could be rejected.

The critical point made by counsel for the appellant is that at the time the dividends were declared and paid by 551360 to Mr. Sullivan, there was no difference between the 1,000 shares originally issued to Mrs. Sullivan for $1,000 and sold to Mr. Sullivan for the same amount, and the 1,000 shares issued to Mr. Sullivan in exchange for his 5,001 shares in Drugs which at the time of exchange had a fair market value of $900,000. I do not see that the Minister's contra argument (the third above) is too explicit or complete, but in essence the Minister’s position is that "something" must have happened to, or been attributed to the original 1,000 shares purchased from Mrs. Sullivan to reflect one-half of that $900,000 fair market value, as I see it a reference more to section 85 of the Act.

As I understand the appellant's position, the Court should hold that the 2,000 shares of 551360 finally held by Mr. Sullivan were identical shares in all corporate respects, and therefore equally eligible for any declaration of dividends by 551360. The fact that the attribution rules under section 74 of the Act served to split that dividend income to the taxpayer's advantage, while objectionable to the respondent, should be accepted as the legal and proper end result. On the surface of it, that appears to be a sensible and tenable argument. However, as I see it, that depends on the appellant demonstrating, on the balance of probabilities, that the 2,000 shares of 551360 were identical in all respects and so entitled for purposes of the Act. Such a fine distinction between characteristics for income tax purposes, as contrasted with those for solely corporate purposes, is not a simple concept, and it is for that reason I have placed stress on the application of section 85 of the Act in these circumstances. If indeed it can be shown by the appellant that the utilization of section 85 of the Act did not leave any distinguishing marks on the second 1,000 shares of 551360 issued to Mr. Sullivan, then there would be no valid reason to reject the appellant's proposition. Counsel for the appellant agreed (argument supra,) that there had been value added to the original 1,000 shares and apparently the increase in the value of $450,000 was not disputed. Counsel at the same time took the position that since none of thee attributes had changed in those particular 1,000 shares, they remained identical to the second 1,000 shares issued and therefore could be treated no differently. I am not quite sure that answers the point at issue. It appears to me that the appellant and his advisors now wish to utilize the protection they see in section 74 of the Act— saying in effect that the income from the original 1,000 shares must be considered for income tax purposes as if they remained the property of Mrs. Sullivan, while ignoring also for income tax purposes, any direct consequences which- arose out of the use of the section 85 rollover. That is at the heart of the matter. It was agreed that there was little, if anything, in the case law touching directly on point. The significant part of the Income Tax Act to be addressed in my view is subsection 85(1) which reads as it is relevant to this appeal:

Where a taxpayer has, after May 6, 1974, disposed of any of his property that was a capital property (other than real property, an interest therein or an option in respect thereof, owned by a non-resident), a property referred to in subsection 59(2), an eligible capital property or an inventory (other than real property) to a taxable Canadian corporation for consideration that includes shares of the capital stock of the corporation, if the taxpayer and the corporation have jointly so elected in prescribed form and within the time referred to in subsection (6), the following rules apply:

(a) the amount that the taxpayer and the corporation have agreed upon in their election in respect of the property shall be deemed to be the taxpayer's proceeds of disposition of the property and the corporation's cost of the property;

While assets of some form (capital property, inventory, etc.) are the subject of the transfer or disposal under section 85 of the Act—when one speaks of a section 85 "rollover", the reference is to the rolling into the transferee corporation of any potential tax liability inherent in the asset which is the subject of the disposal. The potential tax liability would become a question of immediate consideration except for the "election" provisions under section 85. That "election" does nothing more than to formally notify Revenue Canada that both the transferor and the transferee acknowledge the continued existence of the potential liability and that the "consideration that includes shares of the capital stock of the corporation" (see subsection 85(1)) now is the repository of that potential liability rather than the former shares in Drugs held by the transferor. In addition, certain amounts which can be used in the eventual calculation of that liability are determined—and these amounts relate to “fair market value”, and "cost amount". In the instant appeal, the significance of this analysis is that the "earned surplus” of $744,037 in Drugs at the time of transfer was the major reference point for the determination of the $900,000 “fair market value" figure used in the "election form". There was no evidence which would show that the 5,001 shares of Drugs transferred by Mr. Sullivan could have a value much different than the nominal $53, without taking into account the “earned surplus” above. The appellant recognized the inclusion of the "retained earnings” in the calculation of the $900,000—see Exhibit A-6 above. The "retained earnings" which had formed the basis for the “fair market value” calculation of the 5,001 shares of Drugs when they were owned by Mr. Sullivan, now formed the basis for any capital gain built into the specific shares of 551360 received by the transferor as consideration.

The transfer by Mr. Sullivan of his shares in Drugs to 551360 in exchange for the issue by 551360 of 1,000 treasury shares of its own stock to him, did not of itself transfer any of the assets of Drugs to 551360. But it did transfer to 551360 any claim formerly held by the transferor against the equity or earned surplus in Drugs to that point, to the corporation 551360. Mr. Sullivan accepted as full consideration for the value of the 5,001 shares in Drugs, including such equity, the 1,000 new shares of 551360 but the exchange itself did not alter or dilute in any way the “equity” or “net worth" of Drugs. As noted earlier in the exhibits referenced, there were no "assets acquired” by 551360 from Drugs as part of the section 85 rollover. The section 85 rollover being examined here was not from Drugs to 551360, but from the appellant Mr. Sullivan personally to 551360. It covered shares of Drugs, owned by the appellant, not assets of the corporation.

I do not want to suggest that there is anything odious about the events under review in these appeals by referring to a more “normal” section 85 transaction. But I believe it is fair to say that in a normal section 85 use, some different shares (often preference shares) would be taken back by the transferor, which shares at some future time might be sold or redeemed to provide him with the realization of the capital gain contained in the shares. As the respondent sees it, the dividends from Drugs were used as a direct "flow- through" using 551360 to Mr. Sullivan. As noted earlier, even that in principle the respondent does not seem to regard as improper. It is only the splitting of the dividends from 551360 to which the Minister objects. I recognize that since Mr. Sullivan no longer personally owned the shares of Drugs, he would have been in a very vulnerable position financially without the ownership or control of 551360, but that is not in issue.

The legal and physical characteristics of the second 1,000 shares of 551360, including entitlement to dividends from the "retained earnings" or "earned surplus" of that company are the same as the legal and physical characteristics of the first 1,000 shares issued. The question is, however, do the dividends from Drugs “flow through" to 551360 unimpaired by the provisions of the Act and reach the "earned surplus” of 551360 so as to make them available for such equivalent distribution. I am not persuaded that the dividends received from Drugs can be reflected in the accounts of 551360 without recognizing and highlighting the special nature of the dividends which arise out of the use of section 85 of the Act. No segregation was necessary until the dividends were paid from Drugs—which dividends effectively depleted the "earned surplus" of Drugs. That "earned surplus" in Drugs had attached to it, by virtue of the section 85 rollover certain characteristics which were recognized in the notice of appeal of Mr. Sullivan as follows:

That any difference between the purchase price of the shares of Hugh Sullivan Drugs Ltd. and the specified consideration of $52.98 in shares of 551360 Ontario Ltd. was to be recorded on the books of 551360 Ontario Ltd. as contributed surplus.

[Emphasis added.]

Whether the term "contributed surplus" should be regarded as anatomically correct, was not argued at the trial, and some other identification could be just as descriptive. The term “contributed surplus" may however be quite appropriate, since it does at least indicate that the source of the funds has some particular identity. However characterized, the point is that the dividends received by 551360 do not become “surplus on hand" for equal distribution to all shareholders, even all common shareholders, and not necessarily just because the common shares are all held by one party. The critical fact is that the full consideration for the 5,001 shares of Drugs transferred by Mr. Sullivan to 551360 must be accounted for in his hands, under whatever scheme for payment he has selected. A very crude analogy would be to look at (or through) the transactions as similar to items of "accrued interest", “interest payable”, and "interest paid”, to make the matter somewhat less complex. Obviously, one does not extinguish the "accrued interest" on one set of obligations by paying a part of it to the holder of another set of obligations or to a party holding no obligations at all. It is my view that 551360 because it was used as a vehicle in this section 85 rollover and election in these circumstances, could only use the dividends received from Drugs for the benefit of the second 1,000 shares issued. Drugs declared dividends of $660,000 to 551360 in fiscal 1983, and a further amount of $132,000 in fiscal 1984—thereby directly reducing the "retained earnings” of Drugs which was the support for the “capital gain" inherent in Mr. Sullivan’s second 1,000 shares of 551360.

I am satisfied that the evidence and testimony lead to this result, but as some form of support for this conclusion I would make reference to the following extracts from noted material on the subject.

A. The Taxation of Corporate Reorganizations

CTJ, Vol. 36, no. 5, Sept./Oct. 1988

“Limitations to Section 85—General Rule"

(Douglas S. Ewens, David Y. Timbrell and Richard C. Rohde)

- Subsection 85(1) of the Act is intended as a mechanism to allow for the deferral of tax on the conveyance of property to a taxable Canadian corporation, provided that an appropriate election is promptly filed and that the consideration received for the property transferred includes shares of the transferee corporation.

- To accomplish a so-called rollover of the inherent tax liability under section 85, both parties must agree to an elected amount within a permitted range for each property that will be the transferor's proceeds of disposition, and the transferee's

cost. The cost of the consideration received by the transferor will be deemed to be equal to the aggregate elected amounts for the properties transferred. If both shares and non-share consideration are received (that is cash and debt), the nonshare consideration will take on a tax cost equal to its fair value at the time of the transfer.

- It is important to note that, since the accrued gain on the transferred property is built into the shares received by the transferor with no corresponding adjustment to the cost base for the property acquired by the transferee corporation, an

element of double taxation can result; once on the disposition of the asset by the transferee corporation and again on the disposition of the shares by the transferor.

- The above comments are intended as a summary of some of the limitations to section 85 and some of the traps to be considered; this summary, however, is by no means exhaustive. In addition, it is always important to consider the sales tax' capital tax, and accounting implications before proceeding.

B. "The Pitfalls of Section 85"

CA Magazine, Vol. 117, no. 12, Dec. 1984 (Clifford R. Plume)

- Because shares must be received for assets transferred under Section 85. the determination of the number and type will depend on whether the transferor is the sole shareholder, or whether the indirect gift rule could apply to the transaction. A major pitfall can occur in the situation where a transferor transfers property having accrued gains, to a corporation that has only common shares authorized at a time when other family members own some of the common shares. As stated earlier, where Section 85(1) (e.2) is of concern, fair market value of the total consideration becomes important. Usually, non-share consideration is received by the transferor up to the amount of the adjusted cost base of the assets transferred to the corporation, and preference shares are received for the difference between the fair market value of the property transferred and the adjusted cost base, which is the elected amount.

- As mentioned earlier, a major problem arises if the company's only authorized shares are common shares and assets are transferred to the company at a time when other family members own some of the common shares. In my view, the transaction timing becomes crucial. The articles of incorporation must be amended before the asset transfer to provide for a class or classes of preference shares that will have attached to them sufficient rights and conditions to provide the required fair market value. Careful drafting of the rights and conditions attaching to those preference shares is mandatory to ensure that problems will not arise relating to the indirect gift rule.

- One of the down-side risks in using Section 85 is the inherent double taxation of the same gain - once in the hands of the transferor and again in that of the corporation. Consideration should, therefore, be given to what future steps could be taken to eliminate, or at least minimize, the double taxation.

- The solution to that situation is to take back on the transfer a different class of shares or to take back a sufficient number of shares of the same class that bring about the appropriate results when dispositions occur in stages.

C. “Accounting Section 85”

CA Magazine, Vol. 114, no. 7, July 1981

(James M. Sylph, and Eric G. Percival)

- Most income tax systems that tax capital gains and allow the deduction of capital losses permit share exchanges and transfers of property between corporations and their shareholders or between related corporations without immediate recognition of the resulting gains or losses for income tax purposes. The rationale is to prevent undue tax burdens on corporate reorganizations, takeovers, intercorporate transfers of assets and other transactions that occur frequently between corporations and their shareholders in the course of furthering their business activities. This is the way it works in Canada as well.

- The now infamous tax reform of January 1, 1972, introduced a provision in the Income Tax Act, under the rules of Section 85, to enable a deferral of tax that might otherwise be payable on sales or transfers of various assets that must normally be reported at fair market value. The rollover is available when a taxpayer (an individual, partnership or corporation) transfers the qualifying property to a Canadian corporation for a consideration (including shares of that corporation) and both parties jointly elect that, for tax purposes the transaction takes place at an agreed amount. Section 85 provides a range within which such an election may take place. Generally, the untaxed gain must be represented wholly or in part by shares of the purchasing corporation, with the non-share consideration (cash, demand note, etc.) normally equal to the tax value of the assets to the vendor.

D. "Transferring shares of private corporations need not be so taxing"

CA Magazine, Vol. 113, no. 5, May 1980

(Alan M. Schwartz)

- Enough time has now passed since Valuation Day for taxpayers to begin considering whether a substantial capital gain and resulting tax liability may arise when they transfer shares of a non-public corporation. To many, this will be a distasteful thought because their capital gains are partly a reflection of the inflationary increases in value that have occurred since 1971. The thought becomes positively abhorrent where the transfer involves transferring a family business from one generation to another.

- Under a typical Section 85 freeze, a parent transfers his or her shares of an operating corporation ("Opco") to a new holding corporation ("Holdco") and takes back preference shares equal in value to the transferred Opco shares. The children subscribe for the common shares of Holdco, paying for them a nominal price. To ensure the rollover benefits to the parent, however, it is imperative that the Holdco preference shares taken back have a fair market value equal to the shares of Opco.

- Also, if the parent is elderly, a Section 85 freeze may give rise to double taxation. It happens this way. First. at the time of death, the parent is deemed to receive proceeds of disposition equal to the fair market value of Holdco's preference shares. This will trigger a capital gain equal to the difference between such proceeds and the cost base to the parent of the preference shares— generally the cost base to the parent of the Opco common shares transferred to Holdco. Then the second level of tax occurs, when Holdco sells the Opco shares, realizing a capital gain equal to the difference between the sale price and the cost to Holdco under Section 85 - which is generally the cost base to the parent of the Opco shares he or she transferred to Holdco.

- Specifically, the taxpayer transfers shares of a family business (Opco) to a holding company (Holdco). This is done pursuant to Section 85 of the Income Tax Act so that no capital gain will arise on the transfer. Opco would then pay a dividend equal to its retained earnings to Holdco, which would receive it tax-free as an intercorporate dividend. Holdco would then sell the Opco shares to the child or third party.

- The result of such a procedure is that the capital gain is replaced by an intercorporate dividend which is, as mentioned above, received tax-free by Holdco. Revenue

Canada has stated that, as long as the amount of the dividend does not exceed Opco's “post-1971 taxed retained earnings,” it will not invoke Section 55 (i.e., the section dealing with artificial reduction of capital gains). Tax retained earnings is defined by Revenue Canada to be retained earnings computed in accordance with generally accepted accounting principles (GAAP).

- Thus, flushing out dividends should continue to be available as a means of reducing capital gains, but only to the extent that a dividend does not exceed post-1971 taxed retained earnings or Part IV tax.

- For example, if the Opco shares have a paid-up capital of $100 and a fair market value of $100,000, Holdco shares would be issued with an aggregate par value of $100. The difference between $100,000 and the $100 ($99,900) will be shown as contributed surplus.

- The dividend paid to Holdco can, as mentioned, be lent to Opco. As the loan is paid off, the money may be invested by Holdco and used as a source of retirement income for the parent and his or her family.

E. Canadian Tax Foundation

Corporate Tax Management Conference 1978, page 200

(Howard J. Kellough)

- The ability to split income is one of the natural consequences of owning shares in a corporation. Reference has been made above to the attribution problems associated with this concept. It was also observed that the $1,000 interest and dividend deduction under section 110.1 will be lost where dividends are received from a non-arm's length holding company as opposed to being received directly from an operating corporation with which the individual may otherwise be at arm's length.

- The labyrinth of problems confronting the non-arm's length taxpayer suggests that he should probably consider acquiring the shares in a holding corporation, effect the financing through the holding corporation, then proceed with either an amalgamation or a winding-up.

- This arrangement is similar to the direct corporate buy-out, except that the shares owned by Father are first transferred to a holding company and the corporate purchase is between the holding company and Opco. In order to put this arrangement in place, Father would transfer his shares in Opco to either an existing or a newly incorporated corporation under subsection 85(1). Common shareholders of Holdco could be either Father alone, or Father and other members of his family, such as his wife. The common shares of Opco could be converted into fixed value preference shares under section 86. The intended common shareholders would subscribe, either directly or through their own holding companies, for common shares of a new class in Opco. Father would cause his preference shares to be redeemed from time to time from the earnings of Opco. Finally, the proceeds of redemption either could be re-invested by Holdco in Opco or elsewhere or used to pay taxable dividends to Holdco's shareholders.

- Where section 84.1 does not apply, the consideration given by Holdco on the subsection 85(1) transfer by Father of his Opco shares can be represented by nonshare consideration and can be repaid to Father as a return of capital before dividends of the shares (representing the consideration given for the deferred gain element of the Opco shares) are redeemed.

- The ability to return capital in this manner would not be available if the consideration received by Father comprised only one class of shares. This is because the adjusted cost base would be distributed pro rata among all shares and the redemption thereof would give rise to a partial return of capital and either a capital gain or deemed dividend, depending on the extent of the paid-up capital of the shares. A

pure return of capital could be effected, however, if two classes of shares are issued by Holdco and the class of preference shares represent consideration equal in value to the adjusted cost base of the Opco shares (and have an equivalent paid- up capital) and the common shares constituted consideration for the gain deferred.

[Emphasis added.]

I do not suggest that everything in the above quotations can be applied directly to this case, but the general parameters, and risks are outlined. I would make particular reference to the following:

From A.

- the accrued gain on the transferred property is built into the shares received by the transferor. . .

From B.

- one of the downside risks in using section 85 is the inherent double taxation of the same gain—once in the hands of the transferor and again in that of the corporation. Consideration should, therefore, be given to what future steps could be taken to eliminate, or at least minimize, the double taxation.

- The solution to that situation is to take back on the transfer a different class of shares or to take back a sufficient number of shares of the same class that bring about the appropriate results when dispositions occur in stages.

From D.

- Specifically, the taxpayer transfers shares of a family business (Opco) to a holding company (Holdco). This is done pursuant to Section 85 of the Income Tax Act so that no capital gain will arise on the transfer. Opco would then pay a dividend equal to its retained earnings to Holdco, which would receive it tax-free as an intercorporate dividend. Holdco would then sell the Opco shares to the child or third party.

- The result of such a procedure is that the capital gain is replaced by an intercorporate dividend which is, as mentioned above, received tax-free by Holdco.

- Thus, flushing out dividends should continue to be available as a means of reducing capital gains, but only to the extent that a dividend does not exceed post-1971 taxed retained earnings or Part IV tax.

- For example, if the Opco shares have a paid-up capital of $100 and a fair market value of $100,000, Holdco shares would be issued with an aggregate par value of $100. The difference between $100,000 and the $100 ($99,900) will be shown as contributed surplus.

[Emphasis added.]

Summary

It is my appreciation of the testimony that the appellant and his advisors did not take into account fully the importance of the phrase from "A" above—the Taxation of Corporate Reorganizations, that "accrued gain on the transferred property is built into the shares received by the transferor" which I believe to be quite an accurate representation of the effect of the section 85 rollover and which is consistent with the analysis of the matter above. No provision was made by any other shares or class of shares for the required fair market value (See "B" above—CA Magazine, Vol. 117, no. 12, December 1984). As I see it the critical 1,000 new shares therefore became axiomatically a form of common shares distinct and different from the original 1,000 shares. As at least further partial support for this conclusion I would again refer to section 84 of the Act— specifically subsection 84(4)—wherein the term "a dividend on a separate class of shares comprising the shares so redeemed" is used. I know that reference is to a different type of transaction, and deals with a "deeming provision". However, I do not find it unrealistic that in the circumstances of this case, the appellant has accomplished that which I contend in this judgment, rather than managing to subordinate the provisions of section 85 of the Act to the provisions of section 74 of the Act, as he asserts. I have certainly not heard from the appellant a cogent argument which would move the funds at issue from "contributed surplus" (as it was termed above) with the attendant restrictions, to some form of "earned surplus" for unlimited utilization by 551360.

It might well be argued that some questions might have been raised by Revenue Canada at the time of filing of Exhibit A-7 (the election form), rather than at the assessment stage, but that is not the issue here. In what manner this conundrum, set up by the appellant's advisors, could or should be finally resolved is not for me to decide. The sole issue for this Court is whether any of the dividends declared and paid by 551360 out of the funds received by dividend from Drugs, come under the attribution rules of section 74 of the Act, and they do not. The attribution rules from section 74 do not even arise, the matter resting at the stage of the results of the section 85 rollover.

The appeals are dismissed.

Appeals dismissed.