Brennan Educational Supply Ltd. (Formerly Brennan Supply (1978) Ltd.) v. Minister of National Revenue, [1990] 1 CTC 2376, 90 DTC 1306

Kempo, T.C.J.;—The appellant's appeal concerns its 1983 fiscal year ending October 31. The respondent assessed a Part II corporate distribution tax payable under subsection 181(1) of the Income Tax Act (the "Act"). A taxable dividend, when paid by the appellant, resulted in a substantial negative balance in its retained earnings account.

The issue was described as one of timing. The provisions of subsection 181(5) were crucial. The relevant parts read:

181. (5) Where a taxpayer has

(a) received an amount in a taxation year from a corporation

(i) [not applicable]

(ii) as a taxable dividend, other than a taxable dividend paid out of retained earnings of the corporation . . .

and the amount was received . . . as part of a transaction effected or to be effected after November 12,1981 or as part of a series of transactions each of which was or is to be effected after that day and it may reasonably be considered that one of the main purposes thereof was to avoid the tax that might otherwise have been or become payable under this Part by reason of a distribution of property of any particular corporation, the particular corporation shall, . . . pay a tax under this Part . . . equal to the amount of the tax that is or may be avoided by reason of the transaction or series of transactions.

Facts

Evidence was heard from Mr. William Brennan who has been the President and a director of the appellant since its incorporation under the laws of Saskatchewan in 1979. It was originally incorporated under the name of Brennan Supply (1978) Ltd. but it changed to its current name in 1984. The original common shareholders were Mr. Brennan as to 24 shares, Mr. Lloyd Rein as to 24 and Mr. Brennan's father as to 52. At the end of 1979 the appellant underwent a share reorganization and 432 class A preferred shares, redeemable at $1,000 per share, were issued to Brennan Management Ltd. which was owned by Mr. Brennan's father and mother.

During the next ensuing two years, 132 of these shares were redeemed, and 144 were redeemed within the two-year period after that. During the appellant's 1983 taxation year, 78 such shares were redeemed on June 2 and the last 78 were redeemed on October 29. The preferred share redemptions were made pursuant to a verbal understanding that they were to have been done on a regular and ongoing basis so long as the appellant was not made cash poor thereby.

Mr. Brennan has a Bachelors’ Degree in Arts and in Education. He was, throughout the material times, familiar with the workings of income statements and balance sheets, and that the latter encompassed a retained earnings entry which to him had meant “a figure on the balance sheet that had something to do with the business”. [T.10, 1.26, T.11 1.1] He said he became much more informed about its particulars and composition since the subject reassessment was made.

In October of 1983 Mr. Brennan and the other common shareholders of the appellant acted on the advice of their new accounting advisors in response to a change in fiscal laws regarding a Part Il tax on corporate distributions. A holding company was formed to hold the shares in the appellant and the shareholders transferred their shares to the holding company using the deferred tax rollover provisions of subsection 85(1) of the Act. This was followed by payment by the appellant of a taxable dividend to the holding company, on October 29, in an amount estimated to be the appellant's retained earnings.

Timing was said to be crucial. As explained by the appellant's accounting advisor, Mr. Thomas Robinson, the pre-October 31, 1983 retained earnings were to be crystallized and paid to the holding company prior to that date because the new fiscal provisions deemed that any dividend paid after that date applied firstly to any earnings that had been made thereafter. Put another way, the provisions mandated a last-in first-out regime with respect to the Part II tax and the retained earnings. As the appellant's business was healthy and growing, the planning was to avoid having to pay any Part II tax on its preOctober 31 earnings. The plan was that the dividends paid from the retained earnings were to be loaned back to the appellant.

On October 29 a meeting was held between Mr. Robinson, Mr. Brennan, another shareholder and the appellant's corporate solicitor. It was during this meeting that the retained earnings were estimated. The information known and relied upon at that meeting was as follows. The prior year-end retained earnings was approximately $42,000, dividend income from two related companies was estimated to total $150,000, the appellant's eleven-month statement to September 30 reflected earnings of $125,000 and the October's earnings were expected, on the basis of the performance of the preceding eleven months, to have been around $25,000. The rounded estimate was therefore taken at $320,000. The precise figure was $319,062. On the basis of the above, a taxable dividend of $265,000 was declared and paid on October 29.

Mr. Robinson's evidence was that this amount of dividends was predicated on the estimated retained earnings as of the date of the meeting, October 29, 1983. He said that as his accounting firm had not been the appellant's accounting advisors prior to October of 1983, they were not independently aware of, nor had they been told about, the June 2 preferred share redemption amounting to $77,922. Mr. Robinson had not asked for nor was he provided with the prior years' financial statements. If he had, the regular pattern of share redemptions would have been obvious. Mr. Brennan testified he did not raise this information at the meetings because he did not think that it was important and that to him it would not have affected what was going on at the time.

It was the evidence of Mr. Brennan that year-end inventory adjustments were discussed at the October 29 meeting but the system then in place precluded any reliable or meaningful forecasts to have been made as at that date. He further maintained that there were no discussions at that meeting of matters concerning either year-end management bonuses nor of the imminence of the final preferred share redemption of 78 shares. Historically, annual bonuses had been paid by the appellant to its employees in the range of one extra month's salary for regular staff and on a sliding scale for its purchasing agent. No management bonuses had been paid to its three shareholders; their remuneration was said to have been taken via salaries which were then often loaned back to the appellant.

The explanation advanced by Mr. Brennan as to why the amount of the declared dividend was $265,000 out of the estimated $320,000 in retained earnings was that it was to avoid an adverse fiscal impact on the appellant's cumulative deduction account.

Mr. Brennan acknowledged that up to October 29 he was fully aware, through the advice of his advisors, that the appellant could pay dividends from its earnings provided it did not create a negative retained earnings position, that there was a marked emphasis on the importance of estimating the net income for the fiscal year end, October 31, and that the dividend payment to the appellant from one of its related companies had created a negative balance in that company's retained earnings account. He also conceded his neglect in failing to have made any inquiries as to what constituted retained earnings and what was involved in share redemptions.

According to the minutes of two directors’ meetings, both held on October 29, not only was a resolution passed that dividends be declared on accumulated retained earnings to October 31 (Exhibit R-2) but also a further resolution was passed concerning redemption of the remaining 78 preferred shares held by Brennan Management Ltd. (Exhibit R-3). Mr. Brennan's explanation for this final redemption was vague and uncertain. The testimony in chief was:

Q. Mr. Brennan, in your earlier testimony when you were talking about redemption of shares there seemed to be a pattern developing that a block of shares would be redeemed each year, and yet, in 1983, there were two redemptions that year. Why was there a second redemption in 1983?

A. We, like the agreement with my father, was that we would redeem them at any point in time that was agreeable between Brennan Supply and Brennan Management. And it was just basic preference on our part that we redeem those last 78 shares, preferred shares, get them off the books in that form, and go on from there.

The money that was paid to Brennan Management was then loaned back to Brennan Supply because we still went with the idea that we were never going to make the company cash poor. And then we sat down and arranged with my father a payment of so much a month to pay off the money that was still owed to him in the company, Brennan Supply to Brennan Management.

Q. Was there anything else that you had in the back of your mind when you carried out this redemption in October of 1983?

A. Previous to all this happening, we were given some advice that I can't pinpoint right now that we should redeem the shares at that point time.

Now, Mr. Hopi had brought in an individual from Ontario to give us some advice named Clifford Plume, and this was related to a lot of the associations of all the companies that we had and what was going on with them. And, in the back of our mind there was something that he wanted us to do in regards to redeeming these shares.

Q. How many corporations were there that were connected with the Appellant in those years?

A. At that time?

Q. Yes.

A. It would be five, six. Five for sure, possibly six.

Q. How many are there today?

A. We boiled it down to three.

Q. Did you know at that time, this is October of 1983, how this redemption of the 78 Class A preferred shares would effect the retained earnings of the Appellant?

A. No. I wish I did.

Q. At that time, did you know how this redemption would effect the company's obligation or requirement to pay this new Part II tax?

A. No.

[T.31 1.2-26, T.32 1.1-23]

On cross-examination it was as follows:

Q. So, then you issued the shares in October, sorry, redeemed the shares in October. What was the basis for this information, if Mr. Robinson wasn't aware that you were doing this, that you were redeeming a third of [sic] 77 shares?

A. May I answer it this way; we are a family business, at that point in time four of the seven family members were in the business. We would sit down, we would discuss business at different times, and it was probably discussed by preference, and I say “probably” that we decided that we would like to pay, or redeem those preferred shares out then and loan the money back to the company.

Q. But if you had indicated earlier that the basis for issuing the, for redeeming the shares in June was the information provided by your old accountant—

A. I've told you, I've told you, because in June we redeemed 33 [sic] of them in June for some reason, I can't tell you why.

Q. How could you then, though, issue the subsequent October redemption without the benefit of some financial information from somebody, and presumably at that point was Peat Marwick?

A. I don't have total recollection of that. The only recollection I have is probably by preference that we wanted to get those off the books regarding being preferred shares to a loan. Just by preference.

As you've got to realize, this is a family run business, owned 76 per cent. And a lot of times what we do is by our preference, and that has occurred since these transactions occurred too. We still do things by our own preference. [T.46 1.9-26, T.47 1.1-15]

The upshot of Mr. Brennan's evidence was that at the time he was not cognizant of the fact that share redemptions reduced retained earnings, and that this was so regardless of the large cash amounts involved.

The further happening which transpired subsequent to the declaration of the dividends was that on December 21, 1983 a directors' meeting was held whereby Mr. Brennan had advised the others that as a result of accounting advice received it was feasible and beneficial to declare bonuses payable amongst themselves (save for a small sum in favour of the purchasing agent) effective as of October 31 for that fiscal year end in the aggregate amount of $106,200. Mr. Brennan's awareness of financial matters had by then included the knowledge that bonuses would reduce net earnings and therefore would reduce retained earnings. As noted earlier, there was no historical pattern of management bonus deferrals prior to October 29, 1983. Mr. Brennan's testimony was that the management bonuses were discussed in the context of, and for the sole purpose of, corporate tax deferral and that the matter of retained earnings was, to him, not even relevant.

As noted earlier, Mr. Robinson gave evidence for the appellant. He received his chartered accountant's designation in 1978 and in 1980 he enrolled in the C.I.C.A. in-depth tax course which he completed in 1981. He joined the tax practice of Peat Marwick in 1980 and practised full time in tax from 1980 until 1986 which was the date of his appointment as managing partner.

Mr. Robinson explained that the Part Il tax had been introduced in 1982 to apply to corporate distributions of income earned after taxation years commencing after 1982 on income subject to the small business deduction and to address matters of over-integration respecting the then dividend gross-up and dividend tax-credit rules. As to the appellant, these changes would have applied to its earnings that were earned on and after November 1, 1983 and not to earnings prior to that date. He and his firm became involved with the appellant about the middle of October 1983 on advising it about the implications of Part Il tax and subsection 181(5) of the Act.

The concern and planning directed by Mr. Robinson was to crystallize the appellant's pre-October 31,1983 earnings into a separate company so that when dividends were ultimately paid therefrom it would not attract Part II tax and it would avoid the last-in first-out principle. Mr. Robinson said it was common for corporations in Canada to go through this process and that everybody that he and the firm knew about was looking at it this way.

Mr. Robinson authored the planning letter dated October 17, 1983 (Exhibit R-1) encompassing matters of the formation of a holding company, the transfer of shares under subsection 85(1) of the Act, and the payment of a dividend prior to the end of the taxation year in an amount not to exceed retained earnings. He advised, therefore, that:

. . . [it was] important to estimate the net income for (the Appellant) for the fiscal year ending October 31, 1983 in order that the balance in retained earnings as at October 31, 1983 may be approximated.

In this planning letter he also formulated the reasons as to why the dividend “should not exceed A of the cumulative deduction account at the end of the year (October 31, 1983) plus . . . [not relevant]". In addressing possible cash flow concerns, Mr. Robinson's advice was that the dividend proceeds could be loaned back to the appellant.

Notwithstanding the emphasis placed in his letter as to the calculations having to be made as at October 31, at trial Mr. Robinson maintained that they were estimating the retained earnings as of October 29, 1983 being the date of the meeting. He gave his opinion that retained earnings were the "accumulated profits, losses, less any distribution of the retained earnings at a point in time" [T.89 1.25-26, T.90 1.1-2] and that generally accepted accounting principles (“GAAP”) regarding the preparation of interim financial statements envisioned use of the information available "at a point in time”. He said:

So, you have to use the best information that you have available at the time and you estimate that to be your retained earnings, and that's the basis that the dividends were declared on.

[T.91 1.12-15]

Mr. Robinson acknowledged that post-October 31 events are to be taken into account if they could be readily determined on [sic] estimated. Inventory adjustments were considered but then discarded because of the absence of any reliable system then in place. He said management bonuses were talked about, but it was then discarded also because of an inability to determine quantum. As noted earlier, Mr. Brennan said this subject was not discussed at the October 29 meeting.

Mr. Robinson said he had rendered his advice without having asked for nor having examined the appellant's corporate minute book, nor did he have or ask for the appellant's previous years' financial statements. He said he was not made aware of the appellant's corporate plan to redeem the final 78 preferred shares that very same day. Had he been so aware he acknowledged that both would have reduced the amount of retained earnings by approximately $155,000 with a concomitant reduction of the amount of the dividend. He did note that dividends are to be determined and paid at a point of time, and that they could not be determined or redetermined at a later date and then backdated to a prior point of time.

With respect to the bonus declaration of December 21, the evidence in chief of Mr. Robinson was to the following effect:

Q. Regarding these bonuses that were declared, how would the declaration and payment of bonuses effect Part II tax?

A. It would have no effect upon Part II tax.

Q. And why is that?

A. Part II tax was exigible upon dividends being paid, not on bonuses being declared.

[T.96 1.25-26, T.97 1.1-6]

And on cross-examination:

Q. So, earlier you had indicated that the bonus doesn't actually, payment of the bonus doesn't actually relate to, or wouldn't relate to the retained earnings?

I guess my question is this, when you saw the financial statements on December 21st you saw that there was substantial negative retained earnings at that point, why did you then go on to declare a bonus, substantial bonus? What was your rationale?

A. Well, the bonuses, once again, were determined for tax planning purposes. In the Income Tax Act, and I believe it’s section 78, I believe, there's provisions in there to actually declare a bonus and pay it out within the subsequent 12 month period, and that's what was done. That had the effect of reducing their earnings subject to tax.

Q. But surely you realized when you declared the bonus that it would subject more amount of money to the Part II tax as a result, isn't that true?

A. No, that's not true. Once again, there's two separate planning situations here, one happened on October 29th, 1983. Using the best information we had available to us at that point in time, certain things were done.

Q. The dividends were declared based on estimates?

A. Exactly right.

[T.111 1.26, 1.112 1.1-25]

Q. Okay. There was a fairly large bonus that was declared in '83 and in previous years. I mean, the reason that the bonus was large, it wasn't because of the financial improvement of the company, was it?

A. No, no. It was a bonus done for tax planning purposes. Once again, bonuses are allowed for tax planning purposes. And they were meant to be management bonuses, and they were meant to be equal to one year's salary for the three shareholders plus a reduced bonus for one of their employees. [T.114 1.9-18]

Mr. Robinson readily conceded that the year-end earnings figure would have had to include the bonuses declared in December. However, he maintained, that figure was neither known nor ascertainable on October 29 which was the meeting date at which the retained earnings were being calculated. Bonuses were normally determined after the year-end based upon income, the company situation and cash flow amongst other things. He said that the bonuses were meant to be management bonuses, and that it was done for tax planning purposes. The inventory adjustments, which amounted to a $27,387 write-down, were not known until the middle of November.

Both Mr. Brennan and Mr. Robinson emphasized in their testimony that none of the discussions at the end of October contemplated evasion or avoidance of the Part II tax on post-October 31 earnings.

A summation of the events that occurred in or in respect of, the 1983 fiscal year follows.

The respondent assessed a Part II tax of $29,421, purportedly pursuant to the provisions of subsections 181(1), 181(2) and 181(5) of the Act, on the amount dividended of $265,000. That the tax calculation was erroneous has been conceded in the respondent's pleadings in that the correct amount of tax payable is to be $19,614 being the lesser of:

(a) 12 /2% of $265,000 = $33,125

and

(b) / x /4 of $235,369 $19,614.

The respondent's assumption as stated in his reply to notice of appeal was that:

5. In so assessing the appellant in respect to the matters and issue herein, the respondent made, inter alia, the following assumptions of fact:

(a) the amount of the Appellant’s retained earnings at the time of the declaration of the taxable dividend of $265,000.00 was $29,631.00 and the dividend exceeded the retained earnings by $235,369.00;

(b) the amount of $235,369.00, referred to above, was paid as part of a transaction effected or to be effected after November 12th, 1981 or as part of a series of transactions each of which was to be effected after that day and which may reasonably be considered to have had as one of its main purposes the avoidance of tax that might otherwise have been or become payable under Part II of the Income Tax Act.

The Position of the Parties

The appellant's position was that the phrase "retained earnings" is not fiscally defined and that the respondent has administratively accepted its meaning as governed by GAAP. Here the important date was the date the dividend was declared, October 29, and not the date October 31 as determined by the financial statements. The former date was the critical accounting time, and the then estimation of the retained earnings was, according to GAAP, properly determined. The appellant's directors, at the critical accounting time, believed they were paying the dividend completely out of retained earnings and therefore the Part II tax would not apply. Mr. Brennan had no idea that retained earnings were reduced by share redemptions. The bonus declarations had nothing to do with Part II tax and there was no scheme to avoid Part II tax exigible on post-October 31 earnings. The appellant believed they were dealing only with pre-October 31 earnings.

The respondent's position was that, given each of the transactions and the sequence of events, it may reasonably be considered that one of their main purposes was to avoid Part II tax. The appellant and its advisors were well aware of the implications and consequences of the subsection 181(5) fiscal provision if negative retained earnings were created. The omission of the two share redemptions is of material concern. The planning letter, the minutes of the directors' meeting and the accounting evidence all clearly indicate the intent to calculate the retained earnings as at, or up to, October 31 and that is when it should have been done. A best or some reasonable estimate should have been made concerning inventory and bonuses; treating these as indeterminable is not satisfactory. The large bonuses were declared with full knowledge of a large deficit extant in the year-end retained earnings. In light of the situation as a whole, and the fact that the four transactions were all separate, each affecting the retained earnings, shows that one of the main purposes in declaring the subject dividend was to avoid the Part II tax.

Analysis

There is, in my opinion, little doubt that the planning perspective was not only recommended to be as at the year-end date of October 31, but that that is precisely what actually ensued on the occasion of the October 29 meeting. The accountant's letter and the discussions held during the meeting involving usual year-end matters of inventory write-downs and bonuses all serve to objectively confirm that year-end cumulated retained earnings were being deliberately calculated and that this was to be the amount employed. I do not see that appellant-counsel's submissions concerning interim financial statement matters, and its inherent difficulties, have much relevance to the facts of this case. It is true that subsection 181(5) of the Act exempts taxable dividends paid out of "retained earnings”, that this phrase has not been fiscally defined and that no time as to the calculation of the retained earnings has been provided. However this case is not one involving unexpected operational losses being suffered after a dividend had been bona fide declared and paid wherein the losses had reduced the year-end retained earnings to an amount below the amount of the dividend. Here, the year-end date was a scant two days away.

The focus of subsection 181(5) is one of anti-avoidance; it applies where it could reasonably be considered that one of the main purposes of the one or more transactions was to avoid the Part Il corporate distribution tax. In my view the crucial time to be examined is the time when the dividends were declared and paid, and that all aspects of the decision making process, prospectively and retrospectively, must be examined. This includes matters of omission as well as commission, and that a reasonable subjective and objective standard is to be applied. The Court is always faced with the obvious difficulties inherent in weighing subjectively reconstructed testimony with other kinds of evidence of a more objective nature. Ideally, the two should integrate in most respects.

Objectively, I am unable to reasonably] reconcile Mr. Brennan's failure to advise Mr. Robinson of the two 1983 share redemptions in view of the fact that so much attention was being paid to the topic of distribution of “earnings”. In the same vein it was unreasonable, given Mr. Robinson's experience in tax matters and the intense preoccupation with earnings, that he proceeded to finalize the retained earnings calculations in the absence of the corporate minute book or the prior years’ financial statements or of simple inquiry respecting share redemptions. The situation at bar is not one involving complex or obtuse concepts.

The retained earnings as at October 31 should have been $241,140, which is the estimated amount less $77,922 for the June 2 redemption. I also find that Mr. Brennan’s failure to advise of the imminence of the October 29 decision to redeem the remaining shares was without credible explanation and that it amounted to gross negligence on his part such that Part II tax avoidance on the part of the appellant may be objectively and reasonably inferred with respect to this transaction.

The effect of the above two transactions is that the retained earnings, as of October 31, have been overstated by $155,844.

With respect to the inventory, I am of the view that it was reasonable for the appellant and its advisors to have come to the decision not to make any adjustments. The appellant's historical performance was of little assistance, and its then record-keeping system was inadequate. Given the scope and purpose of subsection 181(5) as aforesaid, it would not be reasonable to infer that one of the main purposes of the November inventory write-down was to avoid the subject tax.

The remaining matter concerns the large bonuses declared on December 21 effective as at October 31. While simple tax-deferral planning was said to be its sole motivation, it cannot be ignored that the decision was made at the time that the year-end financial statements had disclosed a significantly large negative balance in its retained earnings account as of October 31 and that this decision served directly to make it worse. In my view it would be unreasonable to consider, objectively, that one of the main purposes of this transaction was not to avoid the Part II corporate distribution tax. Appellant-counsel’s submission that this kind of tax deferral planning has been acceptable goes no further than that. It does not act as a complete or total answer, as there may be dualpurpose motivations extant involving not only tax deferral but also Part II tax avoidance. Subsection 181(5) of the Act, supra, uses the phrase "one of the main purposes". Both purposes, in my view, were sought to be accomplished in this case.

Accordingly, the retained earnings of the appellant as of October 31 have been overstated by a further $106,200.

To summarize: the originally estimated retained earnings of $319,062 is to be reduced by $155,844 (the two share redemptions) and by $106,200 (the bonuses) leaving a net amount of $57,018. The dividend declared was in the amount of $265,000 resulting in a net negative balance in the appellant's retained earnings account as to October 31 in the amount of $207,982.

Decision

The appeal is allowed, in part, and the matter referred back to the Minister of National Revenue for reconsideration and reassessment on the basis that the provisions of subsection 181(5) of the Income Tax Act apply, and that the Part II tax leviable under subsections 181(1) and 181(2) is to be calculated on the basis that on October 29, 1983 the appellant had paid a taxable dividend to a taxpayer in the amount of $265,000 at a time when its retained earnings was in the amount of $57,018.

The appellant has failed to substantially succeed in this appeal. It is therefore not awarded costs.

Appeal allowed in part.