J. A. McClurg v. Her Majesty the Queen, [1986] 1 CTC 355, 86 DTC 6128

Strayer, J.:—This is an appeal from the Tax Court of Canada with respect to its decision upholding reassessments by the Minister of National Revenue of the plaintiff’s income tax for 1978, 1979 and 1980.

Facts

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 I.H.C. 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.

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

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 and financing of this company and business, the plaintiffs wife took an active part. For the plaintiff’s initial investment of $37,500 preferred shares, the plaintiff borrowed this amount from the Toronto- Dominion Bank by a note co-signed 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 I.H.C. covering future indebtedness to I.H.C. of up to $500,000. Further, the plaintiffs 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 plaintiffs wife had personal assets of $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 company 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 personal guarantor.

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

The plaintiffs 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 notice 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 plaintiffs 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.

Conclusions

It is necessary first to consider what interpretation should be given to subsection 56(2). Taken quite literally in its broadest possible meaning it could require, in the context of distribution of corporate dividends, that every such dividend paid to any shareholder of a company could be attributed to the income of directors participating in a decision to pay the dividend. Such a dividend would be a “payment” “to some other person" with the “concurrence" of the director. It could also be described as a “benefit" that the director “desired to have conferred" on the shareholder, it surely being desirable from the viewpoint of directors that, wherever possible, dividends be paid to the shareholders of the company in order to enhance their satisfaction with the company. Obviously, the section cannot be read this broadly.

I would respectfully adopt two important qualifications referred to in a judgment of Thurlow, J. in Miller v. M.N.R., [1962] C.T.C. 199 at 212; 62 D.T.C. 1139 at 1147 where he said, in reference to subsection 16(1), the forerunner of subsection 56(2):

In my opinion, subsection 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.

Two important qualifications are noted here: the first is that the taxpayer seek “to avoid receipt" of funds, presumably funds that would otherwise be payable to him; and the second is that the concept of payment of a “benefit" is contrasted to payments for adequate consideration.

With respect to the first qualification, it has not been demonstrated to my satisfaction that $8,000 of the $10,000 paid to the plaintiffs wife in each of the taxation years in question was really, as a matter of law, payable to the plaintiff instead. Certainly the Articles of Incorporation do not prescribe that dividends must be paid equally to holders of all classes of shares. Indeed, as noted above, the Articles specify quite the contrary: that dividends may be paid on each class of shares exclusive of other classes of shares. Nor does the Business Corporations Act, R.S.S. 1976-77, c. 10, under which this company was incorporated, so prescribe. The only kind of provision which is directly pertinent is one such as subsection 24(3) of the Act which provides as follows:

(3) The articles may provide for more than one class of shares and, if they so provide, there shall be set out therein the rights, privileges, restrictions and conditions attaching to the shares of each class.

Of a similar nature is subparagraph 6(1)(c)(i). These provisions do not appear to require that the Articles specify the privileges of each class of shares with respect to distribution of dividends, however, if it is not the intention to create any such privileges. In the present case, the Articles specify no particular privileges with respect to dividends and one must therefore assume that, as decisions concerning the distribution of dividends are normally a matter left to the directors, the directors of this company are authorized not only to fix the general level of dividends but also to determine as among the various classes of shares in respect of which class dividends will be paid.

Authority was cited to me by counsel for the defendant to the effect that, according to the general principles of company law, in the absence of a provision to the contrary, dividends are to be paid equally on all classes of shares. In the present case the Articles of Incorporation specifically provide to the contrary. It was further contended that such Articles contravene sound principles of company law and possibly the Business Corporations Act of Saskatchewan as well. I am not satisfied on the authorities cited, none of which, apart from the Business Corporations Act, deal specifically with the company law of Saskatchewan, that these Articles of Incorporation must be regarded by me as void and of no legal effect in so far as they permit differential payment of dividends to various classes of shareholders.

It was also contended by counsel for the defendant that as the Articles of Incorporation of a company form a contract between shareholder and company, that contract must provide for some specific entitlement (presumably, equality with all other shareholders) to dividends. I see no legal impediment to a contract that allows a particular body — here the company directors — to fix the amount of dividends payable in a given year to a given class of shareholders, if shareholders willingly purchase shares on that basis as prescribed in the contract (i.e. the Articles).

Therefore as no dividends were payable as a matter of right to the holders of Class A shares such as the plaintiff without a resolution to that effect being adopted by the directors, it cannot be said that money payable to him was diverted to his wife so as to bring the situation within subsection 56(2).

This case is distinguishable from Warren Champ v. The Queen, [1983] C.T.C. 1; 83 D.T.C. 5029 (F.C.T.D.) where the Articles of Incorporation of the company required that dividends be distributed among all shareholders on the basis of the number of shares held. It is also distinguishable from cases such as Murphy v. The Queen, [1980] C.T.C. 386; 80 D.T.C. 6314 (F.C.T.D.) and M.N.R. v. Bronfman, [1965] C.T.C. 378; 65 D.T.C. 5235 (Ex. Ct.), where the taxpayers in question would have been legally entitled to the money had they not taken steps to divert it to other persons.

I am also satisfied that the dividends paid to the plaintiff’s wife were not a "benefit" within the contemplation of subsection 56(2). As noted above, in the Miller case it was said that the concept of "benefit" in this subsection did not include advantages conferred under a contract for adequate consideration. While that may not precisely contemplate the circumstances of the present case under which dividends were paid to the plaintiff’s wife, they were paid within the context of a legal relationship between the plaintiffs wife and the company pursuant to which she was entitled to receive dividends as declared from time to time by the directors. The surrounding circumstances suggest to me that this was a legitimate business relationship created by all the necessary legal instruments and should not be treated as a sham. See, for example,The Queen v. Parsons and Vivian, [1984] 2 F.C. 909; [1984] C.T.C. 354; 84 D.T.C. 6447 (C.A.). While, strictly speaking, the dividends were paid to the plaintiff’s wife as a shareholder and none were paid to the plaintiff who is also a shareholder, the facts are such that it is not possible to say that this was an artificial device with no purpose but the avoidance of taxation. First, it may be noted that the plaintiff and Mr. Ellis, the Class A shareholders, while not receiving any dividends in cash at this time were not denied substantial benefits from the company. They were both being paid a good salary and, as the only holders of shares which were participating as of right, they were accumulating a potential benefit represented by the growing value of the company as indicated by its financial statements. Secondly, the plaintiffs wife had made a real contribution to the establishment of the company and business through the personal guarantee she gave and the share of the mortgage she assumed on their jointly- owned home. The evidence presented before me also satisfied me that she had taken an active part in the operation of the business to the extent of her abilities and the requirements of the situation. She was paid only a small salary in respect of this work, some $625 in 1978, and $5,000 in each of 1979 and 1980. It is not unusual, I think, that shareholders working in their own company withdraw a small salary and, depending on the success of the business year, receive further remuneration at the end of the year in the form of dividends. In such circumstances, I cannot characterize such dividends as “benefits” within the meaning of subsection 56(2).

The learned trial judge in the Tax Court of Canada, in rendering judgment on December 15, 1983, laid considerable stress on the decision of Titeley v. M.N.R., [1977] C.T.C. 2045; 77 D.T.C. 36 (T.R.B.). The evidence presented before me discloses some differences between the facts of that case and the present case. In that case the wives apparently took no part in the business but received all the dividends. Their shares were participating shares whereas their husbands (who did all the work) held non-participating shares. This meant that, when dividends were paid to the wives only, the husbands were obtaining no benefits real or potential through their own shareholding. Also, since the decision of the Tax Court in the present case there have been further decisions of higher courts which I must take into account, including Stubart Investments Ltd. v. The Queen, [1984] 1 S.C.R. 536; [1984] C.T.C. 294; 84 D.T.C. 6305 and the Parsons and Vivian case, supra.

I will therefore allow the appeal.

Appeal allowed.