Nassau Walnut Investments Inc. v. Her Majesty the Queen, [1995] 2 CTC 2057, 95 DTC 367

McArthur J.T.C.C.:-In computing its income for the taxation year ending January 31, 1989, the appellant included the amount of $699,000 as a deemed dividend from Westminster Transport Limited (’’Westminster”) pursuant to subsection 84(3) of the Income Tax Act, R.S.C. 1952, c. 148 (am. S.C. 1970-71-72, c. 63) (the ’’Act"). In computing its taxable income, the appellant deducted the whole of that amount under subsection 112(1) of the Act which permits a tax-free treatment of certain intercorporate dividends. Apparently subsections 55(2) to 55(5) of the Act were overlooked upon the completion and filing of its return. These subsections treat, as capital gains, certain intercorporate dividends which would otherwise be tax-free under section 112 of the Act.

Issue

The issues in this appeal are:

A. whether the whole dividend of $699,000 should be deemed as a capital gain (reduced by agreement to $660,531), or whether what is sometimes referred to as "safe income" of $270,978 should be deducted; and

B. whether the appellant should be permitted to file a designation of what is described herein to as "safe income" under paragraph 55(5)(f) of the Act.

Agreed statement of facts

1. The appellant was a corporation duly incorporated under the laws of the Province of Ontario.

2. On February 9, 1988, immediately before the series of transactions which are the subject of this appeal, Mrs. Diane Avery and her brother, Arthur Knowles, each owned 70,000 shares of a corporation called Westminster Transport Limited ("Westminster"). As there were no other issued shares in the corporation, the 70,000 shares owned by each of Mrs. Avery and her brother represented a 50 per cent interest. Mrs. Avery’s Westminster shares had a paid-up capital equal to $1,000, a fair market value equal to $700,000 and the income attributable to the shares that was earned or realized by any corporation after 1971 (safe income), within the meaning of subsection 55(2) of the Income Tax Act, was $270,978.

3. …

4. Prior to February 9, 1988, Mrs. Avery contacted her accounting and legal advisors in order to determine how to structure the transaction whereby she would relinquish her interest in Westminster to her brother. Mrs. Avery was advised that a direct sale would be the most suitable transaction, since she would benefit from the $500,000 capital gains exemption on any gains realized on the shares. Mr. Knowles, however, was financially unable to purchase the shares directly. Ultimately, it was agreed that Mrs. Avery should transfer her Westminster shares to the appellant and that Westminster would subsequently redeem those shares. After that redemption, Arthur Knowles would be left as the sole shareholder of Westminster.

5. Accordingly, on February 9, 1988, Mrs. Avery transferred her 70,000 shares of Westminster to the appellant in return for 99 common shares of the appellant. An election was made pursuant to subsection 85(1) of the Act for the transfer to take place at an elected amount of $39,469, being the adjusted cost base of Mrs. Avery’s 70,000 Westminster shares.

6. It was anticipated that on the redemption of the appellant’s 70,000 Westminster shares, there would be a tax deferral of an amount equal to the $270,978 of safe income relating to those shares. More specifically, it was anticipated that this $270,978 would be received as a tax-free intercorporate dividend by the appellant. The safe income of Westminster was calculated prior to the completion of the transactions so that a designation under paragraph 55(5)(f) of the Act could be made. The structure of the transaction contemplated the necessity of 55(5)(f) designation as may be seen in the planning memorandum dated December 1, 1987 ("planning memorandum"). The planning memorandum was prepared by an accounting firm which was acting for Mr. Knowles and Mrs. Avery to structure a transaction to which both parties could agree.

7. On February 9, 1988, immediately after the appellant’s acquisition of the Westminster shares, Westminster repurchased those shares for cancellation in a series of ten consecutive repurchase transactions as follows:

	No. of Common Shares	Aggregate
Order	Repurchased	Repurchase Price
1st	19,000.00	$190,000.00
2nd	1,000.00	10,000.00
3rd	1,000.00	10,000.00
4th	1,000.00	10,000.00
5th	1,000.00	10,000.00
6th	1,000.00	10,000.00
7th	1,000.00	10,000.00
8th	1,000.00	10,000.00
9th	1,000.00	10,000.00
10th	43.000,00	430.000.00
	70,00	$700,000.00

8. Soon after the closing of the transaction, the appellant appointed a new accounting firm. The new accountants had notice of the transaction and were advised to consult any of the participating advisors regarding compliance. It is not known whether any consultation took place.

9. In filing the appellant’s income tax return for its taxation year ending January 31, 1989, the new accountants mistakenly reported the difference between the aggregate repurchase price for the shares and their paid-up capital, $699,000, as a deemed dividend in accordance with subsection 84(3) of the Act. As noted above, this was contrary to the advice given by the accountants who structured the transaction to the effect that only an amount equal to the safe income attaching to the shares would be reported as a deemed dividend and that the balance of the redemption price would be reported as proceeds of disposition. In addition, the new accountants did not make a designation under paragraph 55(5)(f) of the Act with the appellant’s 1989 income tax return with respect to the deemed dividend arising on the redemption of the appellant’s Westminster shares as was recommended in the planning memorandum.

10. Mrs. Avery, the president of the appellant, is unsophisticated in tax matters and depends on the advice of professionals. She relied on the new accountants to complete the income tax return properly as contemplated in the planning memorandum. Once Mrs. Avery was informed by Revenue Canada that an error had been made and that federal and provincial tax was owing, both amounts were paid immediately.

11. The Minister of National Revenue reassessed the appellant on November 18, 1991 in respect of the purchase for cancellation of its Westminster shares, and has taken the position that the above-noted transaction resulted in a $660,531 capital gain relying on subsection 55(2) of the Act.

12. On February 3, 1992 the appellant filed a notice of objection to the Minister’s reassessment and requested permission to file a designation under paragraph 55(5)(f) of the Act. This designation stated that, of the $699,000 deemed dividend received by the appellant on the redemption of its Westminster shares, one increment of $190,000, eight increments of $10,000 and the balance of $429,000 each be deemed to be separate taxable dividends. The designation was not filed within the time set out in paragraph 55(5)(f) of the Act and the Minister refused to accept it.

13. In addition to the foregoing, for the purposes of subsection 55(2) of the Act the parties agree as follows:

(a) at the time immediately before the redemption of its Westminster shares, the appellant would have realized a capital gain of $660,531 upon a disposition of those shares at fair market value to an arm’s length party;

(b) the deemed dividend of $699,000 received by the appellant on the redemption of its Westminster shares was part of transaction or event, or a series of transactions or events, one of the results of which was to reduce the capital gain of $660,531, referred to in the preceding paragraph, to nil;

(c) of the capital gain of $660,531 referred to in paragraph 13(a) above, the amount of $270,978 could reasonably be attributable to safe income;

(d) of the capital gain of $660,531 referred to in paragraph 13(a) above, the amount of $389,553 could reasonably be attributable to anything other than safe income;

(e) the deemed dividend of $699,000 received by the appellant on the redemption of its Westminster shares was received as part of a transaction or event, or a series of transactions or events, that resulted in an increase in Arthur Knowles’ interest in Westminster from 50 per cent to 100 per cent; and

(f) at all material times, the appellant dealt with Arthur Knowles at arm’s length as defined in paragraph 55(5)(e) of the Act.

14. Notwithstanding paragraph 13(b), if the appellant’s tax return had been filed properly according to the instructions in the planning memorandum, a designation would have been made under paragraph 55(5)(f) which would have resulted in the realization of a capital gain of $389,553 (($700,000 (proceeds) -$270,978 (deemed dividend - safe income)) - $39,469 (acb) = $389,553).

The appellant's position

The appellant contends that the intention of the transactions which gave rise to the share redemption was to realize a taxable dividend equal to the safe income attributable to the appellant’s shares in Westminster, and to recognize the balance as a capital gain. The accountants, however, inadvertently reported the full $699,000 as a deemed dividend in accordance with subsection 84(3) of the Act. The appellant submits that it should not be prejudiced by reason of an inadvertent misunderstanding by its accountants as to the nature of the redemption proceeds.

The appellant submits that the shares were repurchased in a series of ten consecutive repurchase transactions, and the first nine repurchases of shares, which represented $270,000, was paid from safe income attributable to the Westminster shares owned by the appellant. Therefore, the appellant states that subsection 55(2) of the Act does not apply to the deemed dividend resulting from the repurchase of the first 27,000 shares owned by the appellant.

The appellant seeks permission to amend its 1989 tax return to show that a capital gain was realized on the transaction to the extent of the proceeds of redemption in excess of the safe income attributable to the Westminster shares. It also seeks permission to file a designation pursuant to paragraph 55(5)(f), designating an amount equal to the corporation’s safe income to be a separate taxable dividend. Alternatively, if a late-filed designation cannot be allowed, relief is sought to treat the deemed dividend otherwise arising on redemption be divided as if a designation had been made pursuant to paragraph 55(5)(f).

The Minister's position

Although at the time of redemption, the safe income attributable to the shares redeemed from the appellant was $270,978, the appellant made no designation under paragraph 55(5)(f) to treat the corporation’s safe income as a taxable dividend. The Minister argues that subsection 55(2) of the Act applies to treat the entire amount of the deemed dividend as "proceeds of disposition" of the appellant’s shares of Westminster in that the deemed dividend of $699,000 exceeds the amount of safe income on hand reasonably attributable to the appellant’s interest in Westminster.

Further, even if the redemption of the appellant’s 70,000 shares in Westminster were treated as ten separate redemptions as suggested by the appellant, the capital gain resulting from each of the redemptions exceeds the safe income on hand reasonably attributable to the shares redeemed in each redemption with the result that all of the "separate” deemed dividends would be treated as proceeds of disposition.

Included in the respondent’s written argument was the following:

In summary then, on the staged redemption of the first 27,000 Westminster shares owned by the appellant the resulting deemed dividend reduced the gain on those shares from $254,777 to nil. The issue then, in applying the provisions of subsection 55(2), is what is this reduced gain (or in other words, the gain that would otherwise have been realized) reasonably attributable to. Is it reasonable to attribute that reduced gain exclusively to the safe income of Westminster as the appellant suggests, or is it reasonable to say that, except for the $3.87 pro rata entitlement of safe income per share, the reduced gain is attributable to something other than safe income.

It is submitted that the later approach is clearly the more reasonable one.

At corporate law each share of a corporation shares in the net worth and earnings of a corporation proportionately. Why should the entitlement of a share to the safe income of a corporation be anything other than on a proportionate basis? Certainly, given the corporate law regarding entitlement of a share, pro rata sharing of safe income would, from a common sense perspective, seem more reasonable than the method proposed by the appellant.

Revenue Canada’s policy, since at least 1981, in sync with the corporate law, has been that safe income should be allocated to shares on a pro rata basis. Although this is clearly not binding on a Court, it at the very least has some persuasive value.

Other authorities in the field are of the view that safe income should be allocated on a pro rata basis. In the passages from Kellough and McQuillan: Taxation of Private Corporations and Their Shareholders, second edition, Canadian Tax Foundation, 1992, quoted above, that view is stated as a matter of fact without any mention of there being any controversy or debate on the issue.

If the Act really contemplated that taxpayers could allocate safe income in any matter that they chose, why would there need to be any need to include paragraph 55(5)(f) in the Act. Taxpayers could simply remove a corporation’s safe income in a staged series of redemptions as the appellant is seeking to do in this case. It is submitted that implicit in the existence of paragraph 55(5)(f), is a recognition that without that provision there would be no method of allowing a taxpayer, whose shares were being redeemed, to access the safe income attaching to those shares.

Lastly, it is submitted that the only reason that the appellant is suggesting this novel method of allocating safe income is because of the error of its accountant. If the appellant’s accountant had filed a designation under paragraph 55(5)(f), as he was supposed to, there would be no issue to appeal. The Minister should not be made to bear the consequences of the error of the appellant’s accountant.

In conclusion then, it is submitted that if the Act contemplated the late- filing of a paragraph 55(5)(f) designation it would state so specifically as is the case with other provisions of the Act. There are compelling policy reasons why some elective provisions of the Act have late-filing provisions and others do not. To allow a late-filed paragraph 55(5)(f) designation would open up the system for abuse by unscrupulous taxpayers.

Relevant sections of the Act

Subsection 55(2) of the Act reads as follows:

55(2) Where a corporation resident in Canada has after April 21, 1980 received a taxable dividend in respect of which it is entitled to a deduction under subsection 112(1) or 138(6) as part of a transaction or event or a series of transactions or events (other than as part of a series of transactions or events that commenced before April 22, 1980), one of the purposes of which (or, in the case of a dividend under subsection 84(3), one of the results of which) was to effect a significant reduction in the portion of the capital gain that, but for the dividend, would have been realized on a disposition at fair market value of any share of capital stock immediately before the dividend and that could reasonably be considered to be attributable to anything other than income earned or realized by any corporation after 1971 and before the transaction or event or the commencement of the series of transactions or events referred to in paragraph (3)(a), notwithstanding any other section of this Act, the amount of the dividend (other than the portion thereof, if any, subject to tax under Part IV that is not refunded as a consequence of the payment of a dividend to a corporation where the payment is part of the series of transactions or events)

(a) shall be deemed not to be a dividend received by the corporation;

(b) where a corporation has disposed of the share, shall be deemed to be proceeds of disposition of the share except to the extent that it is otherwise included in computing such proceeds; and

(c) where a corporation has not disposed of the share, shall be deemed to be a gain of the corporation for the year in which the dividend was received from the disposition of a capital property.

Paragraph 55(5)(f) provides as follows:

(f) where a corporation has received a dividend any portion of which is a taxable dividend,

(i) the corporation may designate in its return of income under this Part for the taxation year during which the dividend was received any portion of the taxable dividend to be a separate taxable dividend, and

(ii) the amount, if any, by which the portion of the dividend that is a taxable dividend exceeds the portion designated under subparagraph (i) shall be deemed to be a separate taxable dividend.

Analysis

The declaration of a significant dividend by a private corporation will often decrease the market value of its shares because, in a balance sheet sense, the shareholders’ equity is reduced. Since under the Income Tax Act, in certain circumstances, intercorporate dividends are effectively tax-free, if a parent corporation sells its shares in a subsidiary corporation after a dividend has been declared by the subsidiary, this would in effect convert the parent corporation’s taxable capital gains into non- taxable intercorporate dividends. Subsections 55(2) to 55(5) were enacted primarily to counter these transactions. These provisions were enacted to prevent the avoidance of tax on capital gains by taxpayers taking advantage of subsections 84(3) and 112(1) which results in the receipt of a tax-free dividend for tax purposes instead of proceeds of a disposition of shares. By virtue of subsections 55(2) to 55(5), an intercorporate dividend will be deemed generally to be proceeds of disposition of shares or a capital gain where the dividend would result in a significant reduction in the portion of the capital gain attributable to anything other than income earned or realized by any corporation after 1971. In practice, this latter amount that can be paid as a dividend without offending subsection 55(2) has been referred to as "safe income" as previously stated.

The method of calculating of "safe income" is described in paragraph 55(5)(b). In general terms "safe income" represents the taxed retained earnings of a corporation. Transitions can be structured so that "safe income" is not subject to double taxation.

In the present case, the appellant acknowledges that the February 8, 1988 transactions fall within the provisions of subsection 55(2) resulting in the dividend being deemed to be a capital gain. The parties further agree that the amount of $270,978 is "safe income" attributable to the appellant’s shares. The question, however, is whether the safe income of $270,978 which is attributable to the appellant’s shares should remain a dividend.

Whether the safe income can be deducted pursuant to subsection 55(2)

In addition to their plans to file a designation under paragraph 55(5)(f), the original tax advisors also recommended that the shares be redeemed in ten different transactions so as not to be caught by subsection 55(2) of the Act. By using ten different redemptions, because of section 84 of the Act, the advisors thought that as each redemption occurred, the safe income would be reduced eventually to equal the approximate amount of $270,000.

The Minister contends that safe income attaches to shares on a pro rata basis, and that it does not attach to shareholders. Thus, on each redemption, there is only a small portion that comes out of safe income, and the remaining amount attracts tax.

The taxpayer submits that the Minister’s position that safe income attaches to each share on a pro rata basis is only one reasonable interpretation of subsection 55(2). Counsel for the appellant submits that there is nothing in that subsection that indicates how you must attribute safe income, and it could be on a pro rata basis per share, per shareholder, first in first out (FIFO) method, etc. Both parties acknowledge that the key words in subsection 55(2) are:

that could reasonably be considered to be attributable to anything other than income earned or realized by any corporation after 1971 and before the transaction or event.

The appellant adds that since the method which "safe income" is to be attributable is not laid down in the statute, and the section only requires that the dividend "reasonably be considered" to be attributable to anything other than "safe income", the Minister’s method of attributing "safe income" may not be the only reasonable way. Counsel for the appellant continues that another way of attributing "safe income", which is equally reasonable, is attaching "safe income" to each shareholder. Under this method, each shareholder possesses a certain amount of "safe income", determined by the number of shares which he or she holds pro rata and if Parliament had intended that only the Minister’s method be used, then it would have stated SO.

In Highway Sawmills Ltd. v. M.N.R., [1966] S.C.R. 384, [1966] C.T.C. 150, 66 D.T.C. 5116, the Supreme Court stated at page 393 (C.T.C. 157-58; D.T.C. 5120):

The answer to the question what tax is payable in any given circumstances depends, of course, upon the words of the legislation imposing it. Where the meaning of those words is difficult to ascertain it may be of assistance to consider which of two constructions contended for brings about a result which conforms to the apparent scheme of the legislation.

Further, it is now well settled law that,

The words of an Act are to be read in their entire context and in their grammatical and ordinary sense harmoniously with the scheme of the Act, the object of the Act and the intention of Parliament.

(Dreidger, Construction of Statutes (2nd ed. 1983) at page 87)

The Supreme Court of Canada in two recent cases has looked at the intent of Parliament in interpreting taxing statutes Ant os ko v. Canada, [1994] 2 C.T.C. 25, 94 D.T.C. 6314; Corporation Notre Dame De Bon Secours v. Quebec (Communauté Urbaine), [1994] S.C.R. 78, [1995] 1 C.T.C. 241, 95 D.T.C. 5017. In Bon Secours, the Supreme Court of Canada summarized the rules for the interpretation of tax legislation as follows at C.T.C. page 252 (D.T.C. 5023):

-The interpretation of tax legislation should follow the ordinary rules of interpretation;

—A legislative provision should be given a strict or liberal interpretation depending on the purpose underlying it, and that purpose must be identified in light of the context of the statute, its objective and the legislative intent: this is the teleological approach;

—The teleological approach will favour the taxpayer or the tax department depending solely on the legislative provision in question, and not on the existence of predetermined presumptions;

—Substance should be given precedence over form to the extent that this is consistent with the wording and objective of the statute;

—Only a reasonable doubt, not resolved by the ordinary rules of interpretation, will be settled by recourse to the residual presumption in favour of the taxpayer.

Subsection 55(2) is an anti-avoidance provision to prevent artificial or undue reductions in capital gains. It was enacted to prevent the conversion of capital gains into tax-free intercorporate dividends on the disposition of a corporation’s shares, where the gain is not attributable to income earned or realized by a corporation after 1971. In other words, subsection 55(2) was enacted to ensure that only gains which reflect ’’safe income" can be converted to tax-free intercorporate dividends.

Both parties referred with favour, to a 1981 article quoted in part in Trico Industries Ltd. v. Canada, [1994] 2 C.T.C. 2053, 94 D.T.C. 1740 (T.C.C.), by John R. Robertson who was then Director General, Corporate Rulings Dictorate. Included in that article is the following:

..the application of subsection 55(2) is intended to be limited to cases of genuine tax avoidance and common sense should prevail.

The parties agree (paragraph 9 of agreed statement of facts) that "...the new accountants (for the appellant) mistakenly reported the difference between the aggregate repurchase price for the shares and their paid-up capital, $699,000, as a deemed dividend...." Having acknowledged that it was a mistake, this is not a case of "genuine tax avoidance".

It is clear that had the appellant’s accountants not made a mistake as Stated in paragraph 9 of the agreed statement of facts, the respondent would have allowed the appellant the benefit of the $270,000 tax-free dividend. Particularly given the complexity of section 55 of the Act, the consequences of this mistake, given the position of the respondent, appear particularly harsh. Should the appellant be permitted to attribute "safe income" on a pro rata basis per shareholder, it would be able to take advantage of all its "safe income" attached to its New Westminster shares, but no more. The appellant seeks to treat the $270,000 "safe income" for the relevant shares as a tax-free dividend, with the remaining $389,553 to be taxed as capital gain pursuant to subsection 55(2). The Court accepts the appellant’s contention that this is in keeping with the object and intent of subsection 55(2).

In interpreting subsection 55(2) substance should be given precedence over form to the extent that this is consistent with the wording and objective of legislature. In Bon-Secours, supra, the Supreme Court of Canada held at page 249 (D.T.C. 5021):

Such a rule also enabled the Court to direct its attention to the actual nature of the taxpayer’s operations, and so to give substance precedence over form, when so doing in appropriate cases would make it possible to achieve the purposes of the legislation in question. It is important, however, not to conclude too hastily that this latter rule (giving substance precedence over form) should be applied mechanically, as it only has real meaning if it is consistent with the analysis of legislative intent.

As stated above, the reasons why the appellant is involved in this litigation is because of a mistake made by its accountants and because the form of the transactions did not mirror the method recognized by Revenue. The appellant is not circumventing the intentions of subsection 55(2). The appellant is only seeking to receive what subsection 55(2) allows-i.e., to receive post-1971 tax retained earnings as tax-free dividends. By allowing the appellant’s appeal, substance is given precedence over form.

Finally, the Supreme Court of Canada held that where there is a reasonable doubt, not resolved by the ordinary rules of interpretation, this doubt is to be settled by recourse to the residual presumption in favour of the taxpayer (Bon Secours, supra, at page 5023). If there is a reasonable doubt as to whether the words ’’reasonably be considered" can include a method other than that recognized by Revenue, this doubt should be resolved in favour of the taxpayer. It is preferable to arrive at a decision that is in harmony with the intent of the legislation than a decision that does not provide the taxpayer the relief which is consistent with the analysis of legislative intent.

For these reasons the appeal is allowed with costs.

Appeal allowed.