David v Prentice, Edward a Prentice and Robert T Prentice v. Minister of National Revenue, [1976] CTC 2364, 76 DTC 1252

A J Frost:—These appeals are in respect of the appellants’ 1969 taxation year from Notices of Assessment dated August 7, 1974, where in an amount of $30,220 was deemed to have been received by each of the appellants under subsections (3) and (8) of section 81 of the Income Tax Act, RSC 1952, c 148 (and amendments thereto), from E V Prentice Co Ltd (hereinafter referred to as “the company”), a company incorporated in British Columbia and doing business in that province. The appeals were heard on common evidence and the decision will apply equally to all three.

The appellant and his three brothers, Thomas, David and Edward, all non-residents, were equal owners of the company, except for one insignificant share. In 1969 the brothers had a falling out, and it was agreed that Thomas had to leave the company.

To secure Thomas’s departure, it was decided to cause the company to pay him the value of his interest and reduce its capital account accordingly. The paid-up capital of the company was $40.01 and the balance of undistributed income amounted to $421,500.96, one-quarter of which amounted to $105,375.24.

On November 13, 1969, the capital structure and the shareholders of the company were as follows:

To effect Thomas’s withdrawal from the company, the shareholders passed a special resolution on November 14, 1969, converting the 1,000 npv common shares with a book value of $10 to 1,000 redeemable preferred shares with a par value of $120.89 each. The special resolution provided that:

(1) The capital of E V Prentice Co Ltd be altered by converting the ONE THOUSAND (1,000) issued shares without nominal or par value with a maximum selling price of ONE DOLLAR ($1.00), beneficially owned by Thomas H Prentice, into ONE THOUSAND (1,000) issued shares with a nominal or par value of ONE HUNDRED TWENTY DOLLARS AND EIGHTY- NINE CENTS ($120.89) each.

(2) The said ONE THOUSAND (1,000) converted shares with a nominal or par value of ONE HUNDRED TWENTY DOLLARS AND EIGHTY-NINE CENTS ($120.89) each be called Preferred Shares and the remaining NINE THOUSAND (9,000) shares without par value of which THREE THOUSAND AND ONE (3,001) remain issued, be called Common Shares, so that the authorized capital of the Company is ONE HUNDRED TWENTY THOUSAND, EIGHT HUNDRED NINETY DOLLARS ($120,890.00), divided into ONE THOUSAND (1,000) Preferred Shares with nominal or par value of ONE HUNDRED TWENTY DOLLARS AND EIGHTY-NINE CENTS ($120.89) each, and the Company is also authorized to issue NINE THOUSAND (9,000) Common Shares without nominal or par value, with a maximum selling price of ONE DOLLAR ($1.00) each.

(3) In compliance with subsection (2) of section 25 of the Companies Act, there be attached to the ONE THOUSAND (1,000) issued Preferred Shares, the following rights and restrictions as set out in paragraph (5) below.

(4) There be deleted from the Memorandum of Association the clauses numbered 6th and 7th.

(5) There be added to the Memorandum the following clauses to be numbered 6th, 7th and 8th:

“6. The authorized capital of the Company is ONE HUNDRED TWENTY THOUSAND, EIGHT HUNDRED NINETY DOLLARS ($120,890.00) divided into ONE THOUSAND (1,000) Preferred Shares with a nominal or par value of ONE HUNDRED TWENTY DOLLARS AND EIGHTY-NINE CENTS ($120.89) each and with the following special rights and restrictions attached thereto:

(a) The said preferred shares shall not confer the right to vote or attend meetings;

(b) the said preferred shares shall not confer the right to dividends or interest;

(c) the said preferred shares may be redeemed by the Company by the payment of ONE HUNDRED TWENTY DOLLARS AND EIGHTY-NINE CENTS ($120.89) per share.”

(7) The Company is also authorized to issue NINE THOUSAND (9,000) Common Shares without nominal or par value and the Capital of the Company shall with respect to those shares be at least equal to the aggregate amount paid to the Company on or for such of those shares as are issued, together with such amounts as may from time to time be added by ordinary resolution to such capital.

(8) The maximum price or consideration at or for which the shares without nominal or par value may be sold is ONE DOLLAR ($1.00) each.

By resolution of the company’s directors dated December 31, 1969, the 1,000 common shares in the name of Thomas H Prentice were cancelled and 1,000 redeemable preferred shares were issued in his name. Immediately thereafter the preferred shares were redeemed by the issue of serial debentures to Thomas H Prentice with an aggregate face value of $120,890. On January 14, 1970 the debentures were redeemed in cash and $15,806.28 was then remitted to the Receiver General of Canada for non-resident tax under Part III of the Income Tax Act.

It is clear from the above that the aim, object and purpose of all this corporate fuss was to reorganize the corporate structure of the company so as to eliminate the total interest of one particular shareholder without disturbing the interest of any of the others.

The company’s change in its financial structure was intended to result in a conversion of its common shares into preferred shares pursuant to paragraph 81 (2)(b) of the Income Tax Act, RSC 1952, c 148, as amended, under which the deemed dividend would be the lesser of

(i) amount or value of preferred shares received by Thomas H Prentice pursuant to the conversion $1,000 preferred shares at

redemption price of $120.89 per share	$120,890.00
or
(ii) Thomas H Prentice’s share (25%) of undistributed income
of $421,500.96 then on hand	$105,375.24

The Minister, however, viewed the position of the appellants in a different light and confirmed his assessments of August 7, 1974 on the ground that “the undistributed income of E V Prentice Co Ltd was capitalized in 1969 and, accordingly, the amount of $30,220 is deemed to have been received by [each] appellant within the meaning of subsections (3) and (8) of Section 81 of the Act”.

Counsel for the Minister submitted written arguments which read as follows:

1. The Respondent submits that on the facts alleged by the Appellants and admitted, either expressly or by operation of Rules 7 and 8 of the Board’s Rules of Practice and Procedure, E V Prentice Co Ltd increased its paid-up capital by $120,880.00.

2. Immediately prior to the corporate transactions described in the Notices of Appeal, the paid-up capital of the Company was $40.01, being 4001 common shares, no par value, issued as fully paid for $.01 per share.

3. By virtue of the corporate transactions described in the Notices of Appeal, the paid-up capital was increased by $120,880.00 in that the paid-up capital of the Company now totalled $120,920.01, comprised of the following elements:

$30.01 3001 common shares npv issued at $.01 per share

$120,890.00 1000 redeemable preference shares having a par value of

$120.89 per share

$120,920.01

The Respondent points out that the paid-up capital

(a) on account of par value shares is the total nominal amount of those shares by virtue of Section 27 of the Companies Act, RSBC 1960, c 27 as amended;

(b) on account of no par value shares is the total amount paid on account of those shares by virtue of Section 28(1).

4. As the Company increased its paid-up capital, a certain amount of undistributed income on hand was DEEMED to have been capitalized by virtue of Section 81(8), Income Tax Act, RSC 1952, c 148, the relevant portions of which read as follows:

“81. (8) Where a corporation has at any time increased its paid-up capital . . . the corporation shall, for the purposes of subsection (3), be deemed to have capitalized at that time undistributed income on hand equal to the lesser of

(c) undistributed income then on hand, or

(d) the amount by which the corporation’s capital was so increased . . .”

(underscoring provided).

5. The Respondent submits also that on the facts alleged the assets of the corporation were not increased nor the liabilities reduced, rather that one form of liability, share capital was increased and another liability, surplus, correspondingly decreased.

6. The Respondent therefore made the calculation of the amount deemed to have been capitalized as set out in Appendix A to the Notice of Appeal:

“81. (3) Where the whole or any part of a corporation’s undistributed income on hand has been capitalized a dividend shall be deemed to have been received by each of the persons who held any of its shares immediately before the capitalization equal to the shareholder’s portion of the undistributed income that was capitalized.”

Undistributed Income deemed to have been
capitalized—lesser of	(c) $421,500.96
	(d) $120,880.00
7. Section 81(3) read as follows:

(underscoring provided).

with the result that each of the Appellants and Thomas H Prentice, as holders of 1,000 common shares prior to the deemed capitalization are DEEMED to have received one quarter of $120,880.00, or $30,220.00.

8. Each Appellant and Thomas H Prentice was accordingly assessed a tax of 15% upon an amount deemed by Part I of the Income Tax Act to have been paid as a dividend to each shareholder.

9, The Respondent suggests that the effect of a “deeming provision” is that a result or state so deemed to be is irrebuttably concluded to be so.

10. The relevant portions of Section 81(2) read as follows:

“81 . (2) Where a corporation, at a time when it had undistributed income on hand, has

(a) . . .

(b) converted any of its common shares into shares other than common shares . . .,

a dividend shall be deemed to have been received at that time by each of the persons who held any of the shares at that time equal to the lesser of

(i) the amount received or the value of that which was received by him for or in respect of the shares . . . or the conversion, or,

(ii) his portion of the undistributed income on hand.”

11, The Respondent submits that by virtue of Section 81(5)

(a) the deemed dividends aforesaid were deductible from undistributed income on hand with the result that, following the dividends deemed by Section 81(3), the undistributed income on hand of the Company was $300,620.96.

(b) The portion of undistributed income on hand for Thomas H Prentice calculated in accordance with Section 82(1)(c) was one-quarter of $300,620.96, or $75,155.24.

12. Therefore, the dividend deemed to have been received by Thomas H Prentice was equal to the lesser of

(i) $120,890.00

(ii) $75,155.24

13. Thomas H Prentice thus paid tax of 15% on $105,375.24 in total, comprised of deemed dividends of $30,220.00 and $75,155.24 from Sections 81(3) and 81(2) respectively.

One can almost sense counsel for the appellants’ indignation when he says, "the assessment herein objected to proceeds on a false and distorted view of the transaction in question and is not in accordance with either the letter or the spirit of the Income Tax Act’. It is strange indeed how such a simple transaction could become such a complicated matter. One would have thought that an intelligent bookkeeper and a competent tax clerk could have speedily handled the whole affair. No wonder businessmen often become frustrated with legal and tax matters.

The amount of undistributed income on hand is $421,500.96 and Thomas H Prentice’s share (25%) is $105,375.24. This is the amount by which undistributed income was reduced and is the amount which would have been paid out of earned surplus if an ordinary cash divi- dend could have been paid to Thomas H Prentice to return his interest in the company’s undistributed income. The Minister has assumed that he is entitled to collect two deemed dividends: one under subsection 81(8) by allocating the increase in paid-up capital ($120,890 in new preferred shares less $10 paid-up capital, or $120,880) as follows:

and the other—a deemed dividend under subsection 81(2) on 25% of the difference between

To assess income taxes on $196,035.24 as the amount that went to Thomas H Prentice, is to levy a tax on an amount greater than his interest in the company.

It is not likely that Parliament intended to give the Minister the power to levy two deemed dividends under circumstances such as are described here. The company’s intention was to release earnings and to pass them to the credit of the account of Thomas H Prentice so that he could be paid in full for his one-quarter interest in the company. This conversion transaction resulted in a distribution of assets and an authorized elimination of the share capital account of a particular shareholder.

In the case at bar, conversion and capitalization are two aspects of a single transaction. Surplus account (earnings on the books of the company or undistributed income under the Income Tax Act) must be reduced and capital account increased by the following bookkeeping entry:

Subsequent entries required to redeem preferred capital by issuing debentures and the redemption of debentures are capital transactions only, and do not affect Income Account. Conversion lies, not in the capital aspects of this case, but in the capitalization of income as per the above entry. As income is capitalized in one transaction (it could hardly be otherwise) and authorized by a single resolution, the Minister’s position, in my opinion, untenable.

in the Supreme Court of Canada decision, Colonel D M Waters (in the Matter of the Estate of Stella Maud Waters), [1956] CTC 217; 56 DTC 1113, Rand, J J said at page 222 [1116]:

When earnings are “capitalized”, they cease, at that moment to be “earnings”;

As capital account is represented by shares and shares are not ordinarily income, the moment earnings on capitalized income are converted to capital they become capital. Subsection 81(2) fits the situation perfectly, in my opinion.

The Minister’s multi-assessment of a single transaction, with its side effects of levying taxes against shareholders whose equity interest remains constant, Is rot, in my opinion, in accordance with the spirit of the Act or with sound administration of the Act.

As subsection 81(3) does not fit the circumstances of this case— and by no stretch of my imagination can l come to the conclusion that Parliament ever intended that it should—I allow the appeals.

Appeals allowed.