Mady – Tax Court of Canada finds that the series of transactions can inform whether an included property transfer has a bad s. 74.5(11) purpose, and that the taxpayer is not responsible under s. 163(2) for the unbeknownst sharp practice of his tax advisor

As a result of Dental College requirements, the common shares of the professional corporation through which the taxpayer carried on his dental practice (“MDPC“) had to be transferred from a family trust to him. This was accomplished by those shares being distributed out of the trust to his wife qua capital beneficiary, followed by their immediate gifting to him. Dividends paid by MDPC to the taxpayer were reported as his wife’s income under s. 74.1(1).

In confirming CRA’s application of s. 74.5(11) (applicable where one of the main reasons for a transfer was to reduce Part I tax on income on the transferred property), Hogan rejected a submission that since s. 74.5(11) only referred to the purpose of the transfer, not of the series, and the wife was not accomplishing any reduction in her Part I tax by transferring her shares to her higher income husband:

[Lehigh Cement] accepts that, even in the absence of a “series of transactions” concept, the entire series of transactions may form part of the relevant circumstances in determining the purpose of the transfer of property.

Years later, the same dentist executed an agreement to sell all his MDPC shares for $4.5 million and then implemented tax planning. He did a s. 86 “estate freeze” transaction on the morning of the closing in which he exchanged all his common shares of MDPC for preference shares with a redemption value of $2 million and for new common shares. He then sold 85% of his new common shares to his wife and two children at a sale price of $0.01 per share, and they sold the same shares later in the day to the purchaser for $8,645 per share.

Hogan J found that the fair market value of the shares sold by the taxpayer to his wife and children was $8,645, not $0.01, per share, so that the taxpayer realized a corresponding capital gain under s. 69(1)(b)(i). However, he vacated the imposition of a gross negligence penalty on the taxpayer. The preferred shares’ redemption value equalled the $2 million equity value of MDPC as estimated by a colleague at the same accounting firm as the taxpayer’s tax advisor, who had not been informed by him that the purchaser had agreed to purchase that equity for $4.5 million. Hogan J stated:

While [the tax advisor] acted imprudently in failing to disclose the pending sale of MDPC to his colleague, I do not believe that the Appellant can be held accountable for his actions. … It is well established that a taxpayer is responsible for the actions of his agent only where the taxpayer is privy to the gross negligence of that agent or wilfully blind… .

Also of assistance to the taxpayer’s penalty defence:

• “the so-called freeze transaction had been discussed with his advisor well before the date of those [most recent financial] statements”
• CRA had assessed the taxpayer under the s. 86(2) conferral-of-benefit rule, which Hogan J had found to be inapplicable, and the alternative (successful) s. 69(1)(b)(i) ground was raised for the first time in the appeal – and “it is difficult to say that the Appellant, knew about, or was wilfully blind to, the application of a provision, i.e. subparagraph 69(1)(b)(i), that the CRA auditor overlooked during the assessment process.”
• “the transfer agreements between the Appellant and his wife and daughters all contained purchase price adjustments… [and] he believed that this type of clause allowed for greater leeway in setting the price paid by the related parties.”

Respecting the price adjustment clause, he indicated that he had no jurisdiction to comment on its application where the affected taxpayers (the wife and children) were not appellants.

Neal Armstrong. Summaries of Mady v. The Queen, 2017 TCC 112 under s. 74.5(11), General Concepts – FMV – Shares, General Concepts – Ownership, s. 86(2), s. 163(2) and General Concepts – Price Adjustment Clause.