Her Majesty the Queen v. Jim A. McClurg, [1988] 1 CTC 75, 88 DTC 6047

Urie, J. (Heald, J. concurring):— In this appeal from a judgment of the trial division rendered by Strayer, J. in which he allowed the appeal of the respondent from reassessments for income tax made by the appellant for the respondent's 1978,1979 and 1980 taxation years. I have had the advantage of reading a draft copy of the reasons for judgment of Desjardins, J. with which I respectfully disagree.

The facts as found by the learned trial judge are not in dispute but due to their importance for a proper appreciation of the case, it would be convenient to set forth hereunder the complete text thereof:* [1]

The plaintiff is president and general manager, as well as being a director, of Northland Trucks (1978) Ltd. which carries on business in Prince Albert, Saskatchewan as a dealer in IHC trucks. The company was established in 1978 and the business purchased at that time. The Articles of Incorporation provide for three categories of shares: Class A which are common, voting, and participating shares; Class B which are common, non-voting, and participating where so authorized by unanimous consent of the directors; and Class C which are preferred, non-voting shares. According to the Articles, each of these categories of shares carries "the distinction and right to receive dividends exclusive of the other classes of shares".

The following shares were issued in the company at a paid price of $1 per share.

	CLASS A	CLASS B	CLASS C
NAME	COMMON	COMMON	PREFERRED
Jim McClurg	400	—	37,500
Veryle Ellis	400	—	37,500
Wilma McClurg
(wife of Jim McClurg)	—	100	—
Suzanne Ellis
(wife of Veryle Ellis)	—	100	—

(Veryle Ellis was the other principal owner of the company and major participant in the business as sales and service manager).

Messrs. McClurg and Ellis as holders of the only voting shares were at all material times the only directors of the company In 1978, 1979, and 1980 they voted a distribution of dividends as follows:

	1978	1979	1980 1980
Jim McClurg	—	—	—
Veryle Ellis	—	—	—
Wilma McClurg	$10,000	$10,000	$10,000
Suzanne Ellis	$10,000	$10,000	$10,000

While it will be noted that no dividends were paid on either the Class A or Class C shares — the only ones owned by the two directors — they earned substantial amounts in salaries, paid bonuses, and bonus entitlements, totalling in the case of the taxpayer $33,968 in 1978, $65, 292 in 1979, and $57,900 in 1980. As the owners of the Class A shares, the only participating shares as of right, the two directors would also be entitled to share in the accumulated profits of the company. According to the financial statements of the company, its retained earnings as of October 31, 1980 were $312,611, and as of October 31, 1981 were $421,481.

In the formation of financing of this company and business, the plaintiff's wife took an active part. For the plaintiffs initial investment of $37,500 preferred shares, the plaintiff borrowed this amount from the Toronto-Dominion Bank by a note cosigned by his wife and his father-in-law. His father-in-law provided further security in the form of a term deposit certificate in the amount of $40,000. The purchase of the business was partly financed by a loan from the vendor in the amount of $50,000, security for which was provided by the two directors. For his part, the taxpayer and his wife provided security in the amount of $25,000 by putting a second mortgage on their jointly-owned home. The plaintiffs wife also co-signed with him a personal guarantee to the International Harvester Company, the supplier of Northland Trucks (1978) Ltd,, with respect to a debenture given by Northland Trucks (1978) Ltd. to IHC covering future indebtedness to IHC of up to $500,000. Further, the plaintiff’s wife co-signed another personal guarantee to the Toronto-Dominion Bank with respect to the line of credit to be made available by the bank to Northland Trucks (1978) Ltd. The evidence advanced before me indicated that at that time the plaintiff's wife had personal assets of from $15,000 to $20,000, so that these guarantees were not empty gestures.

Of the $30,000 dividends paid to the plaintiff's wife during the three years in question, $20,000 was reinvested by her in M.E. Investments Corporation, a com- pany with a structure and control similar to that of Northland Trucks (1978) Ltd. involving the same shareholders and directors. M.E. Investments Corporation acquired land to which the business of Northland Trucks (1978) Ltd. was moved. For acquiring this land a first mortgage was assumed of which the plaintiff's wife was also a guarantor personally.

According to the plaintiff's wife, she used the remainder of her dividends from Northland Trucks (1978) Ltd. for personal purposes.

The plaintiff's wife worked in the business from time to time during the three years in question. The nature and extent of this work varied. Although her participation was only part-time and somewhat sporadic depending on need, the evidence satisfied me that it was significant notwithstanding that she had young children to care for during this period.

By notices of reassessment dated January 14, 1982 the Minister of National Revenue reassessed the plaintiff’s income for 1978, 1979, and 1980, on the basis that in each year $8,000 of the $10,000 in dividends attributed to the plaintiff's wife as dividends on her Class B shares should be attributed to the plaintiff instead. This allocation of the $10,000 was made on the basis of the number of Class A shares

(400) owned by the plaintiff in relation to the number of Class B shares (100) owned by his wife. That is, the Minister takes the position that the dividends declared in each of these years should be attributed equally to all of the common shares, no matter of what class. At the hearing, he relied principally on subsection 56(2) of the Income Tax Act which provides as follows:

56(2) A payment or transfer of property made pursuant to the direction of, or with the concurrence of, a taxpayer to some other person for the benefit of the taxpayer or as a benefit that the taxpayer desired to have conferred on the other person shall be included in computing the taxpayer's income to the extent that it would be if the payment or transfer had been made to him.

The learned trial judge reached the conclusion that in the circumstances of this case the dividends received by the respondent's wife were not properly attributable to the respondent pursuant to subsection 56(2) of the Income Tax Act and allowed the respondent's appeal from the reassessments for the taxation years in issue.

The sole issue in the appeal is whether or not the trial judge erred in concluding that the dividends declared in each of the 1978, 1979 and 1980 taxation years should not have been attributed equally to all of the common shares of the company, no matter what class, pursuant to subsection 56(2).

The basis upon which counsel for the appellant argued the appeal was two-fold. First, he said, subsection 56(2) operates to tax the income received by Mrs. McClurg by way of dividends declared on the Class B shares of the company, in the hands of her husband, the respondent, because of the share structure of the company and because of his powers as a director. To support this submission he relied upon Murphy v. The Queen, [1980] C.T.C. 386; 80 D.T.C. 6314 and Champ v. The Queen, [1983] C.T.C. 1; 83 D.T.C. 5029. The latter case, in his view, was indistinguishable from this case on the facts.

Secondly, in the alternative, it was counsel's submission that discretionary dividends (which dividends on Class B shares were, he said) are illegal because, in law, all shareholders are entitled to dividends equally, pro rata, once they have been declared.

Subsection 56(2) reads as follows:

A payment or transfer of property made pursuant to the direction of, or with the concurrence of, a taxpayer to some other person for the benefit of the taxpayer or as a benefit the taxpayer desired to have conferred on the other person shall be included in computing the taxpayer's income to the extent that it would be if the payment or transfer had been made to him.

Before dealing with the principal and alternative submissions of appellant's counsel, I perceive a preliminary problem which arises from my basic difficulty in appreciating how subsection 56(2) can apply in the context of a corporate situation. While the applicability of the subsection was not raised by counsel for the respondent, the Court alluded to it during the presentations of each counsel, questioned them and received responses from each.

I start from the premise that it would indeed be unusual for an individual to declare a dividend payable to others, in the sense that a corporation can on the proportion of ownership of the company to which each share entitles a holder. A corporation provides to its shareholders by way of dividends, such portion of its earnings as its directors deem advisable. This is one of the benefits accruing from ownership of shares of a corporation. That is accomplished by the directors, as the directing minds of the corporation, passing resolutions from time to time, declaring dividends within the restrictions imposed by law and its articles of incorporation. Those directors do so in their capacities as directors not in their personal capacities no matter how closely held or widely held the corporation's shares may be. That being so, I have difficulty in understanding how it can be said that “a taxpayer", when acting as a director of a company satisfies any of the conditions precedent for the application of subsection 56(2). In Murphy v. The Queen, supra, Cattanach, J. identified the elements required to be present for the subsection to apply, in the following way:

To fall within subsection 56(2) each essential ingredient to taxability in the hands of the taxpayer therein specified must be present.

Those four ingredients are:

(1) that there must be a payment or transfer of property to a person other than the taxpayer;

(2) that the payment or transfer is pursuant to the direction of or with the concurrence of the taxpayer;

(3) that the payment or transfer be for the taxpayer's own benefit or for the benefit of some other person on whom the taxpayer wished to have the benefit conferred, and

(4) that the payment or transfer would have been included in computing the taxpayer's income if it had been received by him instead of the other person.

At page 390 (D.T.C. 6318) of the report, Justice Cattanach set forth what was, in his view, the purpose for which the subsection was enacted:

As I appreciate this difference in language between the two subsections it follows from the purpose to be accomplished by each. Subsection 56(2) is to impute receipt of income to the taxpayer that was diverted at his instance to someone else. It is to cover cases where the taxpayer seeks to avoid the receipt of what in his hands would be income by arranging to transfer that amount to some other person he wishes to benefit or for his own benefit in doing so. Apart from any moral satisfaction the practical benefit to the taxpayer is the reduction in his income tax.

The language of the subsection creating the essential ingredients required in its application, viewed in light of its purpose, is simply not apt, in my opinion, to encompass the acts of a director when he participates in the declaration of a corporate dividend unless it is read in its most literal sense. To do so ignores the existence of the corporate entity. Only the most explicit language, which is not present in subsection 56(2), would justify the notion that a director acting as such could be seen as directing a corporation to divert a transfer or payment for his own benefit or the benefit of another person, absent bad faith, breach of fiduciary duty or acting beyond the powers conferred by the share structure of the corporation, none of which bases have been alleged here.

It is noteworthy, furthermore, that the subsection, if it is to apply to corporate situations, makes no distinction between arm's length and nonarm's length transfers. Literally construed, then, all directors, whether of large or small public or private corporations among whose shareholders may be relatives, would risk having dividends declared by them and paid to such shareholders, attributed to them for tax purposes.

In fact, as observed by Strayer, J., a strict, literal construction of the subsection would inhibit directors from declaring dividends at all, no matter the relationship of any of the shareholders to them, because of the possibility of the attribution thereof to them.

Such a construction is, of course, absurd but if the appellant's application of the subsection in cases such as the one at bar is to be accepted where is the line to be drawn? To find where it is to be drawn is it either proper or practical in each factual situation to examine all extraneous circumstances? For example, would it be necessary to ascertain the individual relationship of the directors to any of the shareholders for the closeness of that relationship? Is the wideness of the distribution of shares an element? Is the fact that a company is a public one and not a private one a relevant fact?

Posing the questions appears to demonstrate cogently, it seems to me, that the subsection was never intended to permit the attribution of corporate dividends to the directors participating in the declaration thereof. Consistency and uniformity in applying it would lead to absurd results. If it had been intended by the legislators that it might apply to directors of small, closely held family corporations only, apt language could have been employed to achieve the desired result. But to utilize the general language of subsection 56(2) to achieve the result desired by the taxing authorities, as exemplified in this case, is not, in my view, justifiable. Undoubtedly, other provisions in the Income Tax Act may be employed to prevent improper income splitting without recourse to this subsection which patently does not apply.

I would, accordingly, dismiss the appeal for those reasons.

It is unnecessary for me, then, to discuss in any detail the attacks of the appellant on the impugned judgment. Suffice it to say that I agree substantially with the reasons and conclusions of the learned trial judge and, in particular, in his distinguishing previous cases in the manner in which he did.

In leaving the matter, I should observe I find it incongruous or ironic that in both of his attacks on the judgment, counsel for the appellant relied heavily on corporate law principles for support while, at the same time ignoring the existence of the corporation in the application of subsection 56(2) as the basis for the reassessments at issue. In doing so he obviously overlooked the statements of principle in Stubart Investments Ltd. v. The Queen, [1984] 1 S.C.R. 536, in particular at 570-71; [1984] C.T.C. 294 at 312, as applied in this Court in such cases as The Queen v. Parsons and Vivian, [1984] 2 F.C. 909; [1984] C.T.C. 354, to which Strayer, J. referred in his reasons.

I would dismiss the appeal with costs.

Desjardins, J. (dissenting): —This is an appeal by Her Majesty The Queen from a judgment of the Honourable Mr. Justice Barry L. Strayer rendered on February 20, 1986, allowing the appeal of the respondent from reassessments raised by the Minister of National Revenue with respect to the respondent's 1978, 1979 and 1980 taxation years.

The findings of fact made by the trial judge are not in dispute. They are set forth in the reasons for judgment by Urie, J. They can also be found in the trial judge's decision reported at [1986] 1 C.T.C. 355; 86 D.T.C 6128; [1986] 2 F.T.R. 1.

The sole issue for determination, both before the Trial Division, and before this Court, is whether the respondent was, pursuant to the provisions of subsection 56(2) of the Income Tax Act, R.S.C. 1952, c. 148 as amended by section 1 of S.C. 1970-71-72, c. 63, under an obligation to include in the computation of his income the amount of $8,000 of the total amount of $10,000 paid by Northland Trucks (1978) Ltd. to his spouse in each of the taxation years 1978, 1979 and 1980.

The articles of incorporation give the respondent, as director, complete discretion to decide whether a dividend should be declared and if so, which of the holders of Class A, B or C shares would receive the dividend. In fact, the classes of shares contained the following description with respect to dividends:

Class A

(1) Common, voting and shall be participating shares carrying the distinction and right to receive dividends exclusive of the other classes of shares in the said corporation.

(. . .)

Class B

(i) Common, non-voting and shall be participating shares where authorized to be participating shares by unanimous consent of the Directors and the said shares shall carry the distinction and right to receive dividends exclusive of other classes of shares in the said corporation.

(. . .)

Class C

(i) Preferred, non-voting shares which carry the distinction and right to receive dividends exclusive of other classes of shares in the said corporation, if the said dividends are authorized by unanimous resolution of the directors . . .

As will be noted, there are some slight variations in the drafting with regard to dividends. Class A makes no reference to the unanimous consent of the directors with regard to the distinction and right to receive dividends. Class B refers to the unanimous consent of the directors but only with regard to the participating shares and not with regard to dividends. Class C makes reference to the unanimous resolution of the directors with regard to the distinction and right to receive dividends. These variations are however not pertinent to the issue since, at all relevant times, two directors were in office.

What is contended by the appellant is that by exercising a discretion in the attribution of the dividends to either of the classes of shares, the respondent met the four essential criteria that have to be satisfied before subsection 56(2) establishes tax liability in the hands of the taxpayer. In Murphy, G.A. v. The Queen, [1980] C.T.C. 386; 80 D.T.C. 6314 (F.C.T.D.), Mr. Justice Cat- tanach listed these criteria in the following manner:

(1) that there must be a payment or transfer of property to a person other than the taxpayer;

(2) that the payment or transfer is pursuant to the direction of or with the concurrence of the taxpayer;

(3) that the payment or transfer be for the taxpayer's own benefit or for the benefit of some other person on whom the taxpayer wished to have the benefit conferred,

and

(4) that the payment or transfer would have been included in computing the taxpayer's income if it had been received by him instead of the other person.

The forerunner of subsection 56(2) (i.e. subsection 16(1)) was commented [on] by Thurlow, J., as he then was, in Miller v. M.N.R., [1962] C.T.C. 199 at 212; 62 D.T.C. 1139 at 1147, when he said:

In my opinion, section 16(1) is intended to cover cases where a taxpayer seeks to avoid receipt of what in his hands would be income by arranging to have the amount received by some other person whom he wishes to benefit or by some other person for his own benefit. The scope of the subsection is not obscure for one does not speak of benefitting a person in the sense of the subsection by making a business contract with him for adequate consideration.

These comments were adopted by the trial judge who referred to them as two important qualifications, namely,

(1) ”. . that the taxpayer seek 'to avoid receipt’ of funds, presumably funds that would otherwise be payable to him,"

(2) ”. . . that the concept of payment of a ‘benefit’ is contrasted to payments for adequate consideration.”

It is trite law that the directors have full discretion to declare dividends and that if they do, the dividends so declared must not represent a part of the capital. It is also trite law that unless otherwise provided in the Articles of Incorporation or in the statute, the rights of all classes of shareholders to dividends are to be assessed on a basis of equality: L.C.B. Gower, Principles of Modern Company Law, 4th ed. (London: Stevens & Sons, 1979) at 403; International Power Co. Ltd v. McMaster University et al., [1946] S.C.R. 178, at 203; Rondeau v. Poirier, [1980] C.A. 35 at 38. This prima facie equality arises "by implication which the law raises as between partners, unless their contract has provided to the contrary" (V.E. Mitchell, A Treatise on the Law Relating to Canadian Commercial Corporations (1916), at 429-30).

When does such an intention to the contrary appear?

F.W. Wegenast, The Law of Canadian Companies, (Toronto: Carswell, 1979) at 320 notes:

Apart from provisions, duly adopted, for preferences as between different classes of shares, and, where there are such preferences, then as amongst the members in each respective class, shareholders are entitled to be treated on a basis of equality. [Emphasis added.]

C.M. Schmitthoff, Palmer's Company Law, vol. 1, 23rd ed. (London: Stevens & Sons, 1982) c. 33, no. 33-06 at 387 states in brief:

. . . It is only when a company divides its share capital into different classes with different rights attached to them that the prima facie presumption of equality of shares may be displaced.

Speaking generally, a separate class of shares is constituted when the principal rights carried by the shares differ from those carried by other shares; e.g. some shares carry preferential or deferred rights as to dividend or capital, or more votes than other shares. But differentiation between other rights may suffice to create a different class of shares, e.g. differences as to freedom of transferability, or redeemability under the 1981 Act. [Emphasis added.]

In view of the conclusion the trial judge has arrived at, he had to be convinced that the description with respect to dividends found in the articles of incorporation constituted a derogation to the principle of equality amongst shareholders recognized in the common law. The trial judge states, at page 357 of the Appeal Book, C.T.C. 358, (D.T.C. 6131), that "the Articles of Incorporation specifically provide to the contrary". Further down he says "they permit differential payment of dividends to various classes of shareholders".

With respect, I do not share his conviction on this matter. Nowhere do I find a reference specific enough to overturn the common law rule of equality of dividends.

What happens in the case at bar is that shareholders in each class are given "the distinction and right to receive dividends to the exclusion of other classes". From that perspective, they are all equal. Moreover, no mathematical formula is given if a distribution were to occur. (See Gower, supra, pages 412-25 for a description of the classes of shares generally encountered). The directors obtain full control over the allocation if they declare dividends. On what basis do they then allot? What criteria do they follow? If they create differences at whim, are they necessarily benefiting some classes and not others? If they are also shareholders, as in the case at bar, why should they not seek also a return on their money? Is not their decision not to receive a return on their money for their class of shares the equivalent, for the other classes of shares, of a “receipt of funds, presumably funds that would otherwise be payable to" them (the directors) as shareholders? If, consequently, they give more to other classes because they take nothing for themselves, is there not a benefit for the others?

I doubt that such a discretion to be exercised by way of a resolution of the directors, can be equated with a derogation specific and substantive enough to discard the common law rule of equality of distribution since there is no rule by which the directors are to carry their discretion.

Having come to the conclusion that the dividend clause does not constitute a valid derogation to the common law rule of equality amongst shareholders, I am of the opinion that the moneys paid in the case at bar should have been distributed equally between all the shareholders of Northland Trucks (1978) Ltd. Thus, it is manifest that part of the dividends paid to Mrs. McClurg should have been included in the appellant’s income. What Mr. McClurg has done was "to avoid receipt” of funds that would otherwise have come to him as a Class A shareholder.

Does such a payment represent a “benefit” by contrast to payments for adequate consideration? The trial judge was satisfied that the dividends paid to the plaintiff's wife were not a “benefit” within the contemplation of subsection 56(2). He clearly discarded the possibility of a sham. The surrounding circumstances, as shown in the evidence, suggested to him that there had been, between the plaintiff and his wife, a legitimate business relationship created by all the necessary legal instruments.

But surely, there is no relationship, in company law, between the work and services a shareholder brings to a company and his or her entitlement to a dividend if declared. The dividends come as a return on his or her investment and not on account of work and services he or she may render to the company. The dividend attaches to the share and not to the shareholder. The return on the capital is proportionate to the capital invested by the shareholder as represented by the number of shares. It has nothing to do with the individual who owns the shares.

The trial judge's concern that subsection 56(2), if it were to be interpreted too widely, would cover every declaration of dividends, does not arise since, generally, once declared, the amount of dividend received on each share is governed by a mathematical formula which the director is called upon to apply in virtue of the contract between the shareholders and the company. There is no direction by him at whim.

In reaching the conclusion I have arrived at, I am mindful and respectful of the corporate veil. What I am saying, essentially, is that because the share structure of Northland Trucks (1978) Ltd. does not, in my view, reverse the common law presumption of equality of dividends, Mr. McClurg, as a shareholder, is deemed to have received money equally to the other shareholders and that money is taxable in his hands, as a shareholder.

I would therefore set aside the decision of the trial judge.

Appeal dismissed.