Northern Hot Oil Services Ltd. v. R., [1997] 2 CTC 2543, 97 DTC 1210

Bonner T.C J .:

The appellant appeals from assessments of income tax for the 1986 and 1987 taxation years. The appeals were heard by Judge Kempo who resigned before rendering a decision. By agreement of the parties this decision is given on a transcript of the testimony, the documentary evidence and additional argument.

The issue is whether paragraph 55(3)(b) of the Income Tax Act (“Act’) applies to render subsection 55(2) inapplicable to a taxable dividend deemed by subsection 84(3) to have been received by the appellant from Swan Production Equipment and Rentals Ltd. (“Swan”) as a consequence of the acquisition by Swan from the appellant of common shares of Swan.

In the beginning the issued capital of Swan consisted of 100 common shares half of which were held by Jim Wallace and half by Niel Brown. The two individuals decided to go their separate ways and to divide Swan between them. Brown, who held 100 per cent of the issued shares of the appellant, rolled his Swan shares into the appellant on a tax free basis under section 85 of the Act and he received shares of the appellant in exchange. The appellant then sold its Swan shares to Swan in exchange for equipment and cash. No conscious attempt was made to plan the transaction as a “butterfly” under paragraph 55(3)(b) of the Act but the appellant contends that the transaction nevertheless falls within that exception to subsection 55(2).

Subsection 55(2) reads:

(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)(«), 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...

The paragraph 55(3)(b) reorganization rule upon which the appellant relies was enacted to

mitigate the effect of the wide net cast by subsection 55(2) and give recognition to the notion that shareholders of a corporation should be able to divide the underlying corporate assets on a tax-deferred basis as a means of separating business activities [1] .

The provision reads in part:

Subsection (2) does not apply to any dividend received by a corporation,

(b) if the dividend was received in the course of a reorganization in which property of a particular corporation was transferred, directly or indirectly, to one or more corporations (each of which is in this paragraph referred to as a “transferee”) and, in respect of each type of property so transferred, the fair market value of the property so received by each transferee was equal to or approximated the proportion of the fair market value of all property of that type owned by the particular corporation immediately before the transfer that

(i) the aggregate of the fair market value immediately before the transfer of all shares of the capital stock of the particular corporation owned by the transferee at that time

is of

(ii) the fair market value immediately before the transfer of all the issued shares of the capital stock of the particular corporation at that time,

except that...

The central issue is whether the fair market value of the property received by the appellant was equal to or approximated 50 per cent of the fair market value of property of that type owned by Swan immediately before the transfer to the appellant.

The legislative framework in which section 55 is found is described by Robertson J.A. in Placer Dome Inc. v. R. [2] as follows:

...Subsections 55(2) to (5) form a set of anti-avoidance provisions which prevent a Canadian-resident shareholder from converting a taxable capital gain on the disposition of shares held in another corporation into a dividend that would not be taxable under Part I of the Act. When subsection 55(2) applies it deems tax- free inter-corporate dividends not to be dividends but rather proceeds of disposition of a capital property or, ...

Swan was incorporated in July 1978. It carried on the business of renting oil field equipment. During the summer of 1985 the relationship be- tween Brown and Wallace degenerated to the point that they could no longer work together. In August of 1985 they decided to separate. Evidence was given regarding the reasons for the dispute but it was irrelevant.

The property of Swan, in the main, consisted of equipment rented to Swan’s clients for use in the business of extracting oil. It owned tanks, separators, pop tanks, pipe racks and pipe used for rental purposes. As well it owned a small aircraft which Mr. Wallace said was used to “hustle parts”. Swan did not have any investments such as term deposits or marketable securities.

Late in 1985 Brown and Wallace met. They reviewed a list of Swan’s equipment and evaluated each item. The valuation was, of necessity, approximate. The equipment was not new. Much was in the possession of lessees who were using it and it was therefore not practical to examine it. Wallace observed that the value of such equipment tended to fluctuate. They reached an oral agreement to divide the equipment (including the aircraft) equally between them on the basis of value. I am satisfied that, at that time, the total value of the equipment was approximately $300,000. In this regard I note that I prefer the testimony of Mr. Wallace to that of Mr. Brown. The evidence of Mr. Brown was riddled with inconsistencies in relation to the value of the equipment. At times he acknowledged that the value was $300,000. At other times he gave other figures, none of which could rationally be supported.

Swan’s normal year end was July 31. Swan’s accountant was directed to prepare financial statements as at September 30, 1985. The statements were completed in November of that year. They were the most recent statements available at the time of the reorganization [3] . The Balance Sheet was as follows:

SWAN PRODUCTION EQUIPMENT & RENTALS LTD.

BALANCE SHEET AS AT SEPTEMBER 30, 1985 (Unaudited)

Swan Production Equipment & Rentals Ltd. Balance Sheet as at September 30, 1985 (Unaudited)

Assets

			Sept. 30	July 31
			1985	1985
			$	$
Current
Bank			7,598	5,400
Accounts re-			48,804	40,053
ceivable
Deposits				5,000
Due from Re			1,993
ceiver General
			58,395	50,453
Fixed - Note 1
			Accumu
			lated
	Cost	Deprecia
		tion
	$	$
Rental equip	603,041	438,348	164,693	164,693
ment
Automotive
equipment	51,401	51,401		50,067
Shop equip	15,203	4,800	10,403	10,403
ment
Office equip	1,919	860	1,059	1,059
ment
Aircraft	60,000	49,321	10,679	10,679
	731,564	544,730	186,834	236,901
Other
Deferred fi				1,101
nance charges
			245,229	288,455
SWAN PRODUCTION EQUIPMENT & RENTALS LTD.
BALANCE SHEET AT SEPTEMBER 30, 1985 (Unaudited)
Swan Production Equipment & Rentals Ltd.

Balance Sheet as at September 30, 1985 (unaudited)

Liabilities

	Sept 30	July 31
	1985	1985
	$	$
Current
Accounts payable	61,660	93,968
Corporate tax payable	607	-
Advance due to shareholders	3,483	3,483
Current portion of long-term debt	-	13,953
	65,750	111,404
Long-Term
Finance contracts	-	13,953
Less: current portion		13,953
	65,750	111,404
Shareholders’ Equity
Share Capital
Authorized: 20,000 shares of no
par value
Issued and fully paid: 100 shares	2	2
Retained Earnings	179,477	177,049
	179,479	177,051
	245,229	288,455

The first formal step in the reorganization was taken on January 2, 1986 when Brown transferred his shares of Swan to the appellant and received, as consideration, 50 common shares of the appellant. The value at that time of the shares so transferred was $181,803. The stage was then set for the purchase by Swan from the appellant of its shares with the resultant dividend being tax free under section 112 of the Act.

On January 14, 1986 a meeting was held to finalize the division of Swan. It was attended by Wallace, Brown and their professional advisors. Brown and Wallace had agreed that Swan would redeem the Swan shares held by the appellant for a consideration of $153,586. of which $150,000. was to be payable by way of transfer to the appellant of Swan equipment and the balance by cash. During the meeting, Brown requested a private session with Wallace at which Brown demanded that a further payment of $50,000. be made to the appellant. Wallace, wishing to avoid a dispute, agreed. Later he stipulated that the additional payment take the form of $30,000. in cash and $20,000. by transfer of one additional piece of Swan’s equipment, a separator.

An informal memorandum signed by Brown and Wallace reflecting the agreement as initially amended was entered in evidence. It read:

SWAN PRODUCTION EQUIPMENT & RENTALS LTD.

Swan Production Equipment & Rentals Ltd.
Agreement - January 14, 1986
1.	Payment to Norwest Trucking -	$ 20,000
	Management Fee
2.	Payment to Niel Brown - Share	1,783
	holder Loan
3.	Redemption of 50 common shares	181,803
		203,586
To be settled by
1.	Equipment valued at	$ 150,000
2.	Cash	3,586
3.	Cash by monthly payment over	50,000
	two years without interest
		203,586
Agreed:
Jim Wallace		Niel
		Brown

The agreement as further amended to divide the payment of the extra $50,000. between equipment and cash is reflected in paragraph 2 of a formal agreement made “as of” January 14, 1986 among Wallace, Brown, the appellant and Swan as follows:

2. In accordance with the provisions of Schedule 1 (which is modified as set out in this Agreement), the Corporation [Swan] agrees to pay to Northern the sum of $203,586.00 in the following manner:

Equipment:	$170,000.00
Cash:	3,586.00
By monthly installments as set out	30,000.00
below:
TOTAL:	$203,586.00

Other relevant provisions of the formal agreement included:

5. In consideration of the foregoing, Northern agrees to sell and transfer unto the Corporation the 50 Common Shares (“Shares”) held by it and to ensure that the resignations of its appointees as officers and directors of the Corporation at the closing.

13. The closing shall take place at the offices of Messrs. Cleall, Pahl, Sussman, St Pierre & Veylan, Barristers and Solicitors, # 404, 10240-124 Street, Edmonton, Alberta, at which time Northern shall deliver up Share Certificates representing the Shares, properly endorsed for transfer to the Corporation, and together with the resignations of Brown as Officer and Director of the Corporation, and in return, the Corporation shall provide Northern with post dated cheques for said balance, a chattel mortgage as hereinbefore referred to, a Promissory Note for the balance, a Bill of Sale for the equipment, and an assignment of the life insurance policies it currently holds on Brown’s life.

14. The parties acknowledge that the equipment referred to in paragraph 2 of this Agreement has already been delivered to Northern or otherwise dealt with to its satisfaction and the cash referred to in paragraph 2 has been paid to Northern.

The agreement was executed on March 18, 1986.

An attempt was made to treat the reorganization as a transaction or series of transactions completed on January 14, 1986. It is clear that completion did not occur until March 18, 1986. The minute of the corporate resolution of Swan authorizing entry into the agreement and the cancellation of the shares acquired from the appellant is made “as of” January 14, 1986. The formal agreement was apparently attached to the resolution and thus the resolution cannot have been passed before March 18, 1986. The bill of sale transferring the equipment from Swan to the appellant although dated January 14, 1986 was, I assume, delivered at the closing. The affidavit of bonafides was sworn on March 18, 1986. It may be noted that the aircraft is included in the listing of property attached to the bill of sale opposite the notation “sold to Red Ram Sales”. A bill of sale of the aircraft from the appellant as grantor to Red Ram Towing Ltd. as grantee is dated February 26, 1986. The affidavit of bona fides attached to that document appears to have been sworn on that same day.

The evidence thus supports a conclusion that the final agreement called for a division of equipment which, at least in the view of Brown and Wallace, was unequal, the total value being $300,000., a quantity thought to be worth $130,000. to remain in Swan and a quantity thought to be worth $170,000. to be transferred to the appellant.

Paragraph 55(3)(b) can apply only if the dividend from Swan to the appellant was received in the course of a reorganization in which property of Swan was transferred to the appellant and if,, in respect of each type of property so transferred, the fair market value of property received by the appellant was equal to or approximated the proportion of the fair market value of property of that type owned by Swan immediately before the transfer that the subparagraph 55(3)(b)(i) figure is of the subparagraph 55(3)(£>)(ii) figure (in short 50-50).

The purpose of paragraph 55(3)(b) is not immediately apparent from the language of the provision but it must be identified so far as possible in order to attempt to determine what is meant by the enigmatic reference to “...each type of property so transferred...”. It is in cases such as this that the “teleological approach” prescribed by the Supreme Court of Canada in Québec (Communauté Urbaine) v. Notre-Dame de Bonsecours (Corp.)^ [4] is most useful.

Counsel for the appellant submitted that the purpose of paragraph 55(3)(b) is to allow the shareholders of a corporation to divide underlying corporate assets on a tax deferred basis to facilitate the continuation of business by each corporate shareholder independently. Counsel referred to a technical note in which the Finance Department states that butterfly reorganizations should not be subject to the application of subsection 55(2) because there is not, in essence, a sale of property by one person to another but rather a division of assets held by corporate intermediaries. Thus far I agree. Counsel argued further that paragraph 55(3)(b) ought to apply in circumstances where taxpayers are legitimately attempting to divide the assets of a business proportionately to their shareholdings and where there is no attempt to “cash-out” one of the shareholders. Here I disagree for reasons set out below.

Counsel argued further that here the division of assets between the appellant and Swan was proportionate to shareholdings since all of Swan assets were “business assets” immediately before the transfer to the appellant. In this regard he relied on evidence which, he submitted, showed that Swan used all of its assets in its equipment rental business and did not hold surplus cash or investment assets. He took the position that the terms “type of property” and “equal to or approximated” were used in paragraph 55(3)(b) to assist taxpayers and to make the provision workable in accordance with business reality. All of this coupled with financial statements of Swan prepared as of January 14, 1986 led counsel to assert that the proportionate distribution requirement of paragraph 55(3)(b) is met as illustrated by the following table:

There are several flaws in the argument. Generally I agree with counsel’s description of the purpose underlying paragraph 55(3)(b) and the requirement therein that each type of property transferred be received by each transferee in proportion to shareholdings. However I disagree with the argument that working capital is a “type of property” for purposes of paragraph 55(3)(b). Working capital is, quite simply not property either within the ordinary meaning of the word or within the meaning laid down in subsection 248(1) of the Act. Working capital is a concept, the result of a calculation of assets minus liabilities, and nothing more. Next, I observe that cash and equipment cannot be regarded as a single type of property for purposes of paragraph 55(3)(&) without giving the words “type of property” a strained and unnatural meaning. If, as counsel submits, cash and equipment can be so regarded then the legislative intention to exclude from paragraph 55(3)(b) transactions whereby a shareholder is “cashed-out” would be greatly impaired.

Counsel sought to derive comfort from the teleological approach to construction. He noted that the paragraph 55(3)(b) proportionate distribution of property by type requirement is intended to prevent application of the provision in circumstances where a shareholder is “cashed-out”. He noted that the appellant was not cashed-out and suggested that the provision should therefore apply to the reorganization now in issue. I do not agree. The teleo- logical approach referred to in the Bon Secours case [5] is to be utilized in the process of construing statutory language. It is not a justification for the reconstruction of paragraph 55(3)(ft) in such a way as to eradicate the “type of property” test and to substitute a “cash-out or not” test.

The appellant called Denis Harvey to testify as an expert and business valuator to testify as an expert on value. He recast Swan’s January 14, 1986 balance sheet to reflect fair market value of shares, fixed assets, tax liability arising on disposition and deferred tax liability (discounted for the time value of money) and thereby arrive at conclusions on value. I found that this theoretical exercise was of no assistance whatever in determining the fair market value of property owned by Swan at any time and, in particular, immediately before the transfer.

It is not necessary in order to dispose of this appeal to attempt to define all the categories of property which might be regarded as a separate or distinct “type of property” for purposes of paragraph 55(3)(b). It is sufficient to note that in my view there were two different types of property transferred by Swan to the appellant, cash and equipment. The initial agreement to divide the equipment equally was abandoned. There was substituted an agreement to divide the equipment on a basis which, at least in the view of Brown and Wallace, was unequal. Apart from the evidence of Mr. Harvey which, as already explained, is unhelpful, the only evidence touching on fair market value is that of Brown and Wallace. Wallace’s view on the fair market value of the equipment is, I think, entitled to much weight by reason of his experience gained in the operation of Swan. Brown’s experience would, I assume, qualify him equally but his evidence on the subject was, as already noted, inconsistent. I assume it was greatly affected by his interest in the outcome of the appeals. I therefore rely on Wallace’s testimony and conclude that the division of the equipment was so unequal in relation to market value that the “equal to or approximated” test in paragraph 55(3)(b) is not met. The appeals must therefore fail.

I need only add that the parties approached this case on the assumption that the aircraft and equipment were property of one type. The bill of sale between the appellant to Red Ram suggests that ownership of the aircraft did in some way reach the appellant before the completion of the reorgani- zation of March 18, 1986. If it did not, and the evidence in this area is a muddle, I remain unable to conclude that the appellant discharged the onus of establishing that property was transferred in appropriate proportions.

For the foregoing reasons, the appeals will be dismissed with costs.

Appeal dismissed.