Canada v. VIH Logging Ltd., 2005 DTC 5095, 2005 FCA 36

Date: 20050131

Docket: A-26-04

Citation: 2005 FCA 36

CORAM:        LINDEN J.A.

LÉTOURNEAU J.A.

SHARLOW J.A.

BETWEEN:

                                                    HER MAJESTY THE QUEEN

                                                                                                                                            Appellant

                                                                           and

                                                            VIH LOGGING LTD.

                                                                                                                                        Respondent

                              Heard at Vancouver, British Columbia, on November 29, 2004.

                                Judgment delivered at Ottawa, Ontario, on January 31, 2005.

REASONS FOR JUDGMENT BY:                                                                           SHARLOW J.A.

CONCURRED IN BY:                                                                                                   LINDEN J.A.

                                                                                                                           LÉTOURNEAU J.A.

Date: 20050131

Docket: A-26-04

Citation: 2005 FCA 36

CORAM:        LINDEN J.A.

LÉTOURNEAU J.A.

SHARLOW J.A.

BETWEEN:

                                                    HER MAJESTY THE QUEEN

                                                                                                                                            Appellant

                                                                           and

                                                            VIH LOGGING LTD.

                                                                                                                                        Respondent

                                                    REASONS FOR JUDGMENT

SHARLOW J.A.

[1]                This is an appeal by the Crown and a cross-appeal by VIH Logging Ltd. (VIH) from the judgment of the Tax Court of Canada dated December 19, 2003, allowing an appeal of a 1994 reassessment made under the Income Tax Act, R.S.C. 1985 (5^th Supp.), c. 1. The reasons for judgment are reported as VIH Logging Ltd. v. Canada, 2004 D.T.C. 2090, [2004] 2 C.T.C. 2149. The reassessment was based on subsection 55(2) of the Income Tax Act, and taxed dividends received by VIH in the amount of $1,624,959 as though they were proceeds of disposition of a capital property.

[2]                VIH presented two alternative arguments in the Tax Court. One argument was that subsection 55(2) does not apply to the facts. That argument succeeded. The Crown appeals on that issue. The other argument was that the reassessment was made outside the time limit in subsection 152(4) of the Income Tax Act. That argument did not succeed. VIH cross-appeals on that issue.

1. Facts

[3]                From 1991 until February 23, 1993, Mr. Kenneth Norie owned the only issued share of 401277 B.C. Ltd. I will refer to 401277 B.C. Ltd. as "Old VIH" because its former name is VIH Logging Ltd. Mr. Norie's adjusted cost base of his share of Old VIH (that is, his cost of the share as determined for income tax purposes) was $1. Old VIH carried on a profitable helicopter logging business. It had retained earnings of approximately $60,000 as of the end of its 1992 fiscal year, which ended on February 28, 1992.

[4]                During the period March 1, 1992 to February 23, 1993, Old VIH earned income of approximately $2.3 million. If Old VIH had undertaken no transactions before its taxation year end on February 28, 1993, it would have been liable for income tax of approximately $900,000, and its after-tax retained earnings would have been approximately $1.4 million. According to expert valuation evidence presented at trial, which the Judge accepted, the fair market value of the share of Old VIH on February 23, 1993 was $1,443,000.

[5]                Three transactions occurred on February 23, 1993. First, the authorized capital of Old VIH was amended to create two classes of preferred shares to facilitate the remaining transactions. Then, VIH was incorporated as 441584 B.C. Ltd. Finally, Mr. Norie exchanged his share of Old VIH for shares of VIH. By the end of February 23, 1993, Mr. Norie was the sole shareholder of VIH, and VIH was the sole shareholder of Old VIH. A subsequent statutory election ensured that Mr. Norie had no taxable capital gain on the share, and that VIH inherited Mr. Norie's adjusted cost base of the share of Old VIH ($1).

[6]                On February 24, 1993, Old VIH sold to VIH all of the assets comprising the helicopter logging business, retaining only enough funds to pay its then estimated income tax liability. The purchase price, $1,850,403, was the then estimated fair market value of the assets sold, net of liabilities except for the estimated income tax liability. The sale of the business assets resulted in a gain to Old VIH in the amount of $84,807, reflecting a gain on the sale of inventory. There was no taxable gain resulting from the sale of the goodwill of the business, because the business had no goodwill.

[7]                On February 24 and 25, 1993, Old VIH paid the following dividends to VIH, keeping enough funds to pay its then estimated income tax liability of $938,080:

[8]                The stock dividend increased the adjusted cost base of the share of Old VIH from $1 to $366,080 but did not result in a change to the fair market value of the share of Old VIH. The fair market value of the share of Old VIH would have been reduced as follows with the payment of each of the cash dividends:

[9]                On February 27, 1993, Old VIH purchased seismic data for $2,200,000. The purchase price was paid by a promissory note in the amount of $938,080, and the issuance of a preferred share with a par value of $1 and a redemption value of $1,261,919 (shown on the balance sheet of Old VIH as contributed surplus). The acquisition of the seismic data entitled Old VIH to a deduction of $2,200,000 for its 1993 taxation year. That reduced the taxable income of Old VIH for that year, and thus also its income tax liability for that year. However, as the income tax liability was only deferred, the balance sheet of Old VIH continued to reflected a deferred income tax liability, then estimated at $975,491.

[10]            On March 2, 1994, VIH sold all of the shares of Old VIH to Senergy, Inc., a corporation with which it dealt at arm's length, for $366,080. VIH did not realize a capital gain on this sale because the purchase price was equal to the adjusted cost base of its shares (which had been increased by $366,079 by the February 25, 1993 stock dividend).

[11]            The transactions described above, beginning with the reorganization of the capital of Old VIH on February 23, 1993 and ending with the sale of the shares of Old VIH to Senergy Inc. on March 2,1993, were intended to defer the income tax liability of Old VIH on the income it had earned as of February 23, 1993, in a manner that would leave Mr. Norie in control of the helicopter logging business, while ensuring that the transactions did not result in any other income tax liability to Mr. Norie or VIH.

[12]            When the income tax return of VIH for its fiscal year ended January 31, 1994 was filed, the dividends paid by Old VIH on February 24 and February 25, 1993 were included in income, and an offsetting deduction was claimed under subsection 112(1) of the Income Tax Act. The deduction was allowed.

[13]            The 1994 income tax return of VIH was first assessed on November 14, 1994. Therefore, the normal reassessment period ended on Friday, November 14, 1997.

[14]            After an investigation, the Minister concluded that the dividends totalling $1,763,508 received by VIH in its 1994 taxation year should have been treated as deemed capital gains pursuant to subsection 55(2) of the Income Tax Act. The adjustments required to make that change are reflected on a reassessment notice bearing the date November 13, 1997.

[15]            The reassessment notice was not mailed to VIH. Rather, on Thursday, November 13,1997, it was given to Dan Foss Couriers with instructions to deliver it the next day. The Judge concluded that delivery was attempted on Friday, November 14, 1997, perhaps twice, but without success.

[16]            The assessment notice was delivered on the following Tuesday, November 18, 1997. It appears that the reassessment notice remained in the custody of Dan Foss Couriers from the time it was picked up on Thursday, November 13, 1997 until it was delivered the following Tuesday. There is no evidence that the Crown attempted to recall the package, although the terms governing the courier service would have permitted that to be done.

2. Procedural History

[17]            VIH filed a notice of objection, as a result of which the Minister concluded that subsection 55(2) of the Income Tax Act should have been applied to $1,624,959 of the dividends, rather than the full $1,763,508. A notice of reassessment making that change was issued to VIH on June 13, 2001.

[18]            VIH appealed the reassessment to the Tax Court of Canada, challenging not only the correctness of the application of subsection 55(2) of the Income Tax Act, but also arguing that the reassessment was not made within the statutory time limit. That appeal resulted in the judgment that is now before this Court.

3. Subsection 55(2)

A. Statute

[19]            The portions of subsection 55(2) of the Income Tax Act that are most relevant to this case read as follows in 1994:

B. Discussion

(1) Uncontroversial questions relating to the application of subsection 55(2)

[20]            Subsection 55(2) of the Income Tax Act was enacted in 1980 to deter transactions known as "capital gains strips", that are designed to avoid capital gains tax on the sale of corporate shares. The common element in all capital gains strips is a tax-free intercorporate dividend paid on shares before they are sold. A dividend may reduce a capital gain by reducing the fair market value of the shares (and thus the proceeds of disposition, assuming the purchaser will not pay more than the shares are worth). A stock dividend may also reduce a capital gain by increasing the adjusted cost base of the shares.

[21]            Subsection 55(2) of the Income Tax Act does not apply to a dividend unless (1) the corporation that received the dividend was a corporation resident in Canada, (2) the recipient corporation was entitled to a deduction under subsection 112(1) for the dividend, (3) the dividend was received as part of a series of transactions that resulted in a disposition of property to a person who did not deal at arm's length with the recipient of the dividend, and (4) a fair market value sale of the share immediately before the dividend would have resulted in a capital gain.

[22]            It is undisputed that all of these conditions were met. Specifically, VIH was a corporation resident in Canada that received dividends from Old VIH in respect of which it was entitled to a deduction under subsection 112(1). The dividends were received as part of a series of transactions that began with the reorganization of the capital of Old VIH on February 23, 1993 and ended with the sale of the shares of Old VIH to Senergy Inc., which did not deal at arm's length with VIH.

[23]            The controversial questions are whether the "safe income" rules in subsection 55(2) preclude the application of subsection 55(2) to the cash dividends, and whether the purpose test in subsection 55(2) is met with respect to the stock dividend.

(2) The determination of safe income

[24]            It is not the object of subsection 55(2) of the Income Tax Act to impose capital gains tax on all dividends paid on shares in contemplation of their sale. One limitation, stated broadly, is that subsection 55(2) is not intended to deter the payment of tax-free intercorporate dividends out of post-1971 corporate earnings. The reason for that limitation is explained as follows in a document issued by the Department of Finance as part of the 1979 budget papers relating to the proposed enactment of subsection 55(2) (reproduced in David M. Sherman, Income Tax Act and Regulations Department of Finance Technical Notes, 7^th ed., page 442):

[25]            This statement suggests that subsection 55(2) should not apply to a dividend paid out of "post-1971 taxed retained earnings". However, despite the language of the Department of Finance explanation, the language of subsection 55(2) does not ask directly about the source of the dividend. Rather, subsection 55(2) of the Income Tax Act requires a hypothetical determination of the capital gain that would have resulted from a fair market value sale of the shares immediately before the dividend. The hypothetical capital gain must then be analyzed to determine its source. If the hypothetical capital gain is attributable to what has come to be called "safe income" or, in the words of subsection 55(2):

the dividend is presumed to have the same economic source and, consistent with the fiscal policy behind subsection 55(2), should be treated as a tax-free intercorporate dividend. If the hypothetical capital gain is attributable to anything other than safe income (it is not necessary to determine what), the dividend is treated as a capital gain.

[26]            It is undisputed that the series of transactions in this case includes the transactions that occurred on February 23, 1993, the payment by Old VIH of the two cash dividends and the stock dividend, the acquisition of the seismic data, and the sale of the shares of Old VIH to Senergy Inc.

[27]            If, as the Judge found, the safe income of Old VIH ought to be determined for the period ending on February 23, 1993, then the two cash dividends would not be caught by subsection 55(2). That is because, if the share of Old VIH had been sold for its fair market value of $1,443,000 on February 23, 1993, immediately before the payment of the cash dividends, the resulting capital gain of $1,442,999 would have been attributable entirely to safe income (that is, the income earned by Old VIH from its helicopter logging business up to February 23, 1993). However, the same could not be said of the stock dividend, because, by February 25, 1993 when the stock dividend was paid, the income earned by Old VIH up to February 23, 1993 was almost entirely depleted by the cash dividends.

[28]            The Crown argues that the Judge was not correct to include in the safe income of Old VIH any of the earnings of Old VIH for the period from March 1, 1992 to February 23, 1993 (I will refer to this as the "stub period" because it represents an incomplete part of the 1993 fiscal year of Old VIH which ended on February 28, 1993). If this argument is valid and income earned during the stub period is excluded from safe income, then the cash dividends would be caught by subsection 55(2). That is because the safe income of Old VIH prior to March 1,1992 was only approximately $60,000.

[29]            The Crown concedes that this argument is not consistent with the safe income guidelines, sometimes called the "Robertson Rules", written by a Revenue Canada official in 1981 and frequently consulted by tax practitioners and tax assessors (John R. Robertson, F.C.A., "Capital Gains Strips: A Revenue Canada Perspective on the Provisions of Section 55", Report of Proceedings of the Thirty-Third Tax Conference, 1981 Conference Report (Toronto: Canadian Tax Foundation, 1982) 81, as further explained by Robert J.L. Read, C.A., in "Section 55: A Review of Current Issues", Report of Proceedings of the Fortieth Tax Conference, 1988 Conference Report (Toronto: Canadian Tax Foundation, 1989) 18:1). The most relevant comment about stub periods is that of Mr. Read, who wrote this at page 18:5:

[30]            The Crown argues that, although the Robertson Rules countenance the existence of a stub period ending immediately before the series of transactions that includes the dividend, that is not consistent with the language of the statute and is merely an instance of "administrative relief" which is not binding. As support for this argument, the Crown cites an article by Jake E. Harms which suggests that it may be technically incorrect to recognize such a stub period (see "Section 55: A Primer", 1992 Prairie Provinces Tax Conference Report (Toronto: Canadian Tax Foundation, 1992) 5:1, under the heading "holding periods"), and the following statement by Rip J. in 943963 Ontario Inc. v. Canada, [1999] 4 C.T.C. 2119, (1999) 99 D.T.C. 802 (T.C.C.), at paragraph 33:

[31]            The argument of the Crown, as I understand it, is that there can be no "income for the year" for a stub period because "income for the year" must be computed under section 3 of the Income Tax Act, which always requires income to be determined for an entire taxation year, not for part of a taxation year. One difficulty with this argument is that the phrase "income for the year" is not used in subsection 55(2). Another difficulty is that it seems to attribute more meaning to the comment of Rip J. than is warranted. I do not read his comment as an attempt to somehow impute the words "income for the year" into subsection 55(2) so as to exclude the possibility that safe income may include income for a stub period. Rip J. was not even addressing a debate about a stub period. (Indeed, it appears from the statement of facts in the 943963 Ontario Inc. case that safe income had been computed on the basis of a stub period; that aspect of the safe income determination was not challenged.)

[32]            The Crown argues that its proposed interpretation is supported by paragraph 55(5)(c) of the Income Tax Act, which is one of the many specific rules for the computation of safe income (none of which are applicable to the facts of this case). I reproduce paragraph 55(5)(c) here for ease of reference:

[33]            However, this provision merely requires that the computation of the safe income of a private corporation, for whatever period is mandated by subsection 55(2), must conform to the computation of income under the Income Tax Act, disregarding two specific statutory deductions. Paragraph 55(5)(c) says nothing about how to determine what the period is, or when it ends.

[34]            The Judge rejected the Crown's argument because an interpretation of subsection 55(2) that permits stub period income to be included in safe income is not only consistent with the language of subsection 55(2), it is also more consistent with the purpose of subsection 55(2) than the Crown's interpretation. I agree with the Judge.

[35]            The Crown's principal argument is that safe income is intended to include only income on which tax has actually been paid. The only evidence offered for the existence of this supposed purpose of subsection 55(2) is the 1979 explanation from the Department of Finance, quoted above, which I reproduce here for ease of reference (emphasis added):

[36]            Despite what the Department of Finance said in 1979, subsection 55(2) of the Income Tax Act as finally enacted does not ask whether tax was actually paid on the post-1971 income. That is not surprising. On the contrary, it is consistent with the scheme of the Income Tax Act that permits tax-free intercorporate dividends whether or not the dividends are paid out of income on which tax has actually been paid.

[37]            Most intercorporate dividends are "tax-free" in the sense that, although they are required to be included in the income of the receiving corporation, they are not deductible in computing the income of the paying corporation. The recipient corporation is permitted a deduction to offset the income inclusion so that, in effect, the underlying income is not taxed except in the hands of the corporation that earns it.

[38]            However, the availability to the recipient corporation of an offsetting dividend deduction does not depend upon the paying corporation having actually paid any tax. The reason may be that there are numerous legitimate reasons why a corporation may have the capacity to pay a dividend out of current earnings, while having no current tax liability by the time the year ends. That could happen, for example, if the corporation suffers unanticipated business losses after paying the dividend. It could also happen if the corporation is entitled to take advantage of certain incentives in the Income Tax Act, as occurred in this case when Old VIH acquired seismic data which entitled it to a deduction that deferred its 1993 tax liability. I conclude that the Crown's principal argument is based on a false premise. It is simply not true that subsection 55(2) is intended to ensure that tax-free intercorporate dividends are limited to post-1971 earnings on which tax has actually been paid.

[39]            The Crown also argues that the interpretation adopted by the Judge requires words to be added to the statute. I do not agree. In my view, including stub period income in the calculation of safe income is consistent with the language of subsection 55(2). The question asked by subsection 55(2) is this: how much income did the corporation earn or realize after 1971 and before the commencement of the series of transactions that included the dividend? That question is being asked in order to determine, hypothetically, the source of any capital gain that would have arisen if the share had been sold at its fair market value before the dividend. The word "before" means "earlier in time". In the context of the question asked, it does no violence to the language of subsection 55(2) to interpret the phrase "before the commencement of the series of transactions" to mean "immediately before the commencement of the series of transactions", rather than "as of the end of the fiscal year ending before the commencement of the series of transactions", as the Crown contends.

[40]            Finally, the Crown suggests an alternative interpretation which would reduce safe income by an amount equal or almost equal to the $2.2 million deduction resulting from the February 27, 1993 acquisition of seismic data. Support for the Crown's alternative interpretation is said to be found in the Robertson Rules. Again, it is convenient to refer to the article of Mr. Read, at page 18:5-6 (emphasis added):

[41]            In my view, the Crown is misreading the point being made in this excerpt. Mr. Read is obviously addressing a situation where circumstances exist prior to the commencement of the series of transactions that are likely to generate a loss within the same fiscal year, but not until after the series of transactions has commenced. This does not mean that safe income ought to be reduced by a deduction that will arise only as part of the series of transactions that includes the dividend, such as the acquisition of the seismic data in this case.

[42]            It bears repeating that subsection 55(2) requires a determination as to the source of the hypothetical capital gain that would have arisen if the share had been sold prior to the dividend and before the commencement of the series of transactions. It is axiomatic that income earned or realized as part of the series of transactions, and that would not exist but for the series of transactions, must be excluded from safe income. By the same reasoning, losses or deductions arising from the series of transactions must also be excluded from the computation of safe income.

[43]            I conclude that the Judge was correct to find that the period for which safe income is to be determined ends immediately before the commencement of the series of transactions that includes the dividend. As explained also in paragraph 27, it follows that the two cash dividends are not caught by subsection 55(2). However, the stock dividend would be caught if the purpose test was met with respect to the stock dividend. That is the issue discussed next.

(3) The purpose test

[44]            Subsection 55(2) would apply to a stock dividend if one of the purposes of the stock dividend was to "significantly reduce" the capital gain that would have resulted on a sale of the share of Old VIH at fair market value immediately before the payment of the stock dividend. The Judge found that the purpose test was not met for the stock dividend, and therefore it was not caught by subsection 55(2).

[45]            The adjusted cost base of the share of Old VIH before February 23, 1993 was $1. The fair market value of the share of Old VIH on February 23, 1993, before the payment of the first dividend, was $1,443,000. The cash dividends paid on February 24 and 25, 1993 reduced that fair market value, dollar for dollar. Thus, the capital gain that would have been realized on a fair market value sale of the share of Old VIH immediately before each dividend is determined as illustrated in the following table:

[46]            The result of the stock dividend of $366,079 was to increase the adjusted cost base of the share of Old VIH from $1 to $366,080. When VIH sold the shares to Senergy Inc. for $366,080, there was no capital gain. If the shares had been sold at fair market value immediately before the stock dividend, there would have been a capital gain of $45,570. Therefore, the stock dividend resulted in a $45,570 reduction in the capital gain that would have arisen on the fair market value sale of the shares of Old VIH immediately before the stock dividend. The Crown argues that a 100% reduction in the capital gain is significant, and that the purpose of the stock dividend was to effect that reduction.

[47]            It was not argued, nor did the Judge find, that the purpose test was not met with respect to the stock dividend because the reduction in the capital gain was accidental or unintended, as opposed to intentional. The evidence is to the contrary. Rather, as I read the reasons (particularly footnote 17 at paragraph 65), the Judge concluded that the stock dividend reduced the hypothetical capital gain by an amount that, in the context of the case, was so small that it could not be considered significant.

[48]            Counsel for VIH did not defend the Judge's conclusion as to the purpose of the stock dividend, but indicated that VIH could make a "designation" under paragraph 55(5)(f) of the Income Tax Act, the effect of which would be to limit the application of subsection 55(2) to $45,570 of the stock dividend. The Crown agreed at trial that such a designation would be permissible (see Tax Court judgment, footnote 17, and Canada v. Nassau Walnut Investments Inc. (C.A.), [1997] 2 F.C. 279, 206 N.R. 386, 97 D.T.C. 5051, [1998] 1 C.T.C. 33). Thus, even if the Crown's appeal is allowed on this point, the result will be a reassessment to impose a tax on a capital gain of $45,570, assuming a designation is made.

[49]            Whether a dividend causes a reduction in a capital gain that is "significant" must be determined contextually, taking into account all of the relevant facts and circumstances. The amount of the reduction in this case was approximately $45,000, in the context of a series of transactions involving dividends totalling over $1.7 million. In my view, it was open to the Judge in the circumstances of this case to characterize the $45,000 capital gain reduction as not "significant". It follows that she was correct to conclude that the purpose test in subsection 55(2) was not met for the stock dividend.

4. Disposition

[50]            For these reasons, I would dismiss the appeal. As the result is to require the reassessment to be vacated, I would also dismiss the cross-appeal, without expressing an opinion on the correctness of the Judge's conclusion that the reassessment was issued within the statutory limitation period. The respondent should be granted costs.

             (s) "K. Sharlow"                

J.A.

"I agree.

     A.M. Linden J.A."

"I agree.

     Gilles Létourneau J.A."

                                                  FEDERAL COURT OF APPEAL

                            NAMES OF COUNSEL AND SOLICITORS OF RECORD

DOCKET:                                           A-26-04

APPEAL FROM DECISION OF TAX COURT OF CANADA, WOODS J.,

DATED DECEMBER 19, 2003.

STYLE OF CAUSE:               HER MAJESTY THE QUEEN v. VIH LOGGING LTD.

PLACE OF HEARING:                     Vancouver, British Columbia

DATE OF HEARING:                       29-30 November, 2004

REASONS FOR JUDGMENT:        LINDEN J.A.

LÉTOURNEAU J.A.

SHARLOW J.A.          

DATED:                                              31 January, 2005

APPEARANCES:

SOLICITORS OF RECORD: