729658 Alberta Ltd. and 729656 Alberta Ltd. (Appellants) v. Her Majesty the Queen (Respondent)

2004 DTC 2909

Tax Court of Canada

June 29, 2004

Neutral Citation 2004 TCC 474

Court File Nos. 2003-194(IT)G and 2003-195(IT)G (General Procedure)

Subsection 55(2) avoidance assessments — Attribution of “safe income” — Whether “safe income” should be attributed to corporations pro rata in line with share of capital gains allocated to them under subsection 85(1) rollover — Income Tax Act, R.S.C. 1985 (5th Supp.), c.1, as amended, ss.55(2), 85(1), 112(1).

Lewis Nickerson and Ronald Lauterstein each owned 50% of the shares of a Canadian-controlled private corporation, Comcare Ltd. These shares had an adjusted cost base (“ACB”) of $37,600, a fair market value of $12,429,037, and an inherent capital gain of $12,391,437. The safe income attributable to Lauterstein's shares was $1,932,802 and to Nickerson's shares was $1,834,065. During the week prior to May28, 1997, Lauterstein and Nickerson each sold their common shares of Comcare to the numbered companies that they incorporated, respectively, 729658 Alberta Ltd. and 729656 Alberta Ltd. (“the taxpayers”). The consideration for each sale was a promissory note in the amount of $10,393,335 and 2,035,702 common shares of the respective numbered company. Subsection 85(1) elections for “agreed amounts” of $10,393,335 were made. As a result, both Lauterstein and Nickerson realized taxable dividends in the amount of $10,355,735, and the ACB of the Comcare shares to each of the taxpayers was $10,393,335. Comcare paid dividends of $2,035,702 to each of the taxpayers comprising taxable dividends of $1,932,802 and a non-taxable capital dividend of $102,900. On May 28, 1997, the taxpayers sold their Comcare shares to an arm's length third party. In reassessing the taxpayers for 1997, under subsection 55(2) of the Act, the Minister re-characterized approximately five-sixths of the dividends they received from Comcare as capital gains. The Minister's position was that the accrued gain rolled to the holding companies ($1,932,802) represented approximately one-sixth of the entire accrued capital gain of $12,391,437, so that only one-sixth of Comcare's safe income ($1,932,802) should be attributed to the taxpayers. In support of this position, the Minister alleged that it was in line with CRA practice, that it was recognized in the tax literature, and that it accorded with the object and spirit of the subsection 55(2) avoidance legislation. The taxpayers, 729658 Alberta Ltd. and 729656 Alberta Ltd., appealed to the Tax Court of Canada.

Held: The taxpayers' appeals were allowed. In interpreting the phrase “reasonably be attributable” in subsection 55(2) of the Act, it has never been suggested that any accrued gain should be apportioned on a pro rata basis between “income earned or realized by any corporation after 1971” and any “unrealized appreciation in the value of underlying assets”. The approach has been to allocate gain first to “income earned or realized” and, only if dividends exceed this amount, to allocate the excess to “unrealized appreciation in the value of underlying assets”. This approach is essential if subsection 55(2) is to achieve its legislative purpose. The taxpayers were correct in pointing out that no tax was avoided in this case and the dividends they received did not exceed what was contemplated by subsection 55(2). Tax was paid on the untaxed appreciation in the value of Comcare's underlying assets by Lauterstein and Nickerson in the form of taxable dividends deemed to have been received by them under section 84.1 of the Act. In conclusion, tax was paid in the amount that Parliament intended, and the Minister at no time suggested that there had been any “tax leakage”. The Minister was ordered to reassess on the basis that the taxable dividend of $1,932,802 received by the taxpayers was fully deductible under subsection 112(1) of the Act.

Before: Woods, J.

WOODS, J.:

[1] The appellants, 729656 Alberta Ltd. and 729658 Alberta Ltd., have been reassessed pursuant to subsection55(2) of the Income Tax Act in respect of dividends that they received as part of a series of transactions designed to extract so-called “safe income” on a tax-deferred basis prior to an arm's length sale of shares. “Safe income” is the term commonly used to describe the amount of corporate income that can be extracted by way of tax-free intercorporate dividends without being recharacterized as capital gains under subsection55(2).

[2] The specific issue in these appeals is how “safe income” should be determined if dividends are received by a corporation on shares that were acquired on a partial rollover under subsection85(1) of the Act. The Crown submits that safe income should be apportioned on a pro rata basis if an accrued gain is partly realized by a transferor under subsection85(1). The appellants submit that it is not reasonable to apportion safe income on a pro rata basis on their particular facts because the transactions do not offend the object and spirit of subsection55(2).

Overview of subsection55(2)

[3] Subsection55(2) is an anti-avoidance provision that was introduced in the 1979 federal budget. At the time of its introduction, the government was concerned that taxpayers were engaging in transactions that unduly reduced capital gains on a sale of shares by converting proceeds of disposition into tax-free intercorporate dividends.

[4] The relevant part of subsection55(2) reads:

… one of the purposes 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 be reasonably be attributable to anything other than income earned or realized by any corporation after 1971 and before the safe-income determination time for the transaction, event or series … (emphasis added)

[5] The legislative scheme is not apparent from subsection55(2). However, it was described by the government at the time the section was introduced. The scheme was succinctly described by Noël, J.A. in Kruco Inc. v. R., [2003 DTC 5506] [2003] 4 C.T.C. 185 (F.C.A.):

The goal was to ensure that the capital gain inherent in the shares of a corporation that is attributable to an unrealized appreciation since 1971 in the value of the underlying assets of the corporation was not avoided by the use of intercorporate tax-free dividends (subsection112(1)). At the same time, Parliament did not want to impede the tax-free flow of dividends that were attributable to income which had already been taxed.

…

Conceptually, this approach captures the tax applicable to the portion of the notional gain attributable to an increase in value of the underlying assets while maintaining the tax-free treatment of that part of this gain attributable to “income earned or realized” since 1971.

Facts

[6] The facts are not in dispute and were provided by way of agreed statements. A summary of the relevant facts, based on a written submission on behalf of the appellants, is attached as an appendix to these reasons.

[7] Prior to the transactions at issue, Ronald Lauterstein and Lewis Nickerson each owned 50percent of the shares of Comcare Ltd., a Canadian-controlled private corporation. On May28, 1997, the shares of Comcare were sold to an arm's length buyer. In the week leading up to the share sale, Messrs. Lauterstein and Nickerson undertook a series of transactions that was designed in part to defer tax on the amount of “safe income” attributable to their shares.

[8] Prior to the series of transactions, the shares of Comcare owned by each individual had a fair market value of $12,429,037 and an adjusted cost base of $37,600. Most of the value, then, represented accrued gain. The safe income on the Comcare shares at that time was estimated to be $1,932,802 and this calculation is not in dispute in these appeals.

[9] The relevant transactions undertaken during the week prior to the share sale were:

(a) a transfer by Messrs. Lauterstein and Nickerson of the shares of Comcare to their holding companies (the appellants);

(b) the payment of taxable dividends by Comcare to the holding companies aggregating $1,932,802; and

(c) the sale of the shares of Comcare by each of the holding companies to an arm's length buyer for cash consideration of $10,393,335. The consideration was equal to the fair market value of the shares of Comcare before the series of transactions less the amount of dividends paid to the holding companies.

[10] These steps are typical of transactions that are designed to access safe income and would not have been controversial if the shares of Comcare had been transferred to the holding companies at their adjusted cost base so that the holding companies had inherited the entire accrued gain ($12,391,437). What has led to these transactions being reassessed is that most of the accrued gain was realized by Messrs. Lauterstein and Nickerson on the transfer. Only a small portion of the accrued gain, an amount equal to the estimated safe income ($1,932,802), was transferred to the holding companies. This was effected by making elections under subsection85(1) such that the deemed proceeds of disposition of the shares of Comcare to Messrs. Lauterstein and Nickerson, and the deemed cost of the shares of Comcare to the holding companies, was $10,393,335.

[11] The tax result that Messrs. Lauterstein and Nickerson intended by this series of transactions was for them to realize taxable dividends of $10,393,335 (on the transfer of the shares of Comcare to the holding companies) and for the holding companies to realize tax-free dividends from Comcare and no gain on the sale of the Comcare shares. The Crown has not suggested that this resulted in less tax than would be payable if the transactions had been implemented in a more conventional manner, with the holding companies inheriting the entire accrued gain. If the holding companies had inherited the entire gain, the individuals would not have realized any income and the holding companies would have realized capital gains of $10,393,335.

[12] The Minister of National Revenue reassessed tax for the 1997 taxation years of the holding companies pursuant to subsection55(2). A portion of the dividends received by the holding companies was recharacterized as proceeds of disposition and taxed as capital gains. The Minister took the position that the safe income that was attributable to the Comcare shares in the hands of the individuals, which was admitted to be $1,932,802, should be prorated when the shares were transferred to the holding companies. The accrued gain that was rolled to the holding companies ($1,932,802) represented approximately one-sixth of the entire accrued gain ($12,391,437) and the Minister reasoned that only one-sixth of the safe income should be inherited by the holding companies. Therefore approximately five-sixths of the dividends were recharacterized as proceeds of disposition pursuant to subsection55(2).

Issue

[13] The question to be determined is whether a pro rata portion of the dividends received by the holding companies should be recharacterized as proceeds of disposition pursuant to subsection55(2).

Positions of parties

[14] The position of the Crown is that, on the subsection85(1) transfer, the safe income should be prorated on the same basis that the accrued gain is prorated. The specific arguments made in support of this position are:

(a) because the safe income that was attributable to the portion of the capital gain realized on the transfer to the holding companies is reflected in the adjusted cost base of the shares to the holding companies, it should not continue to be double-counted as safe income;

(b) requiring proration of the safe income is a reasonable extension of generally accepted principles of interpretation of subsection55(2);

(c) the position is in accordance with the object and spirit of the legislation which is reflected in the phrase “reasonably be attributed;”

(d) the position accords with the administrative practice of the Canada Revenue Agency; and

(e) it has been recognized in the tax literature.

[15] The appellants, on the other hand, submit that since the transactions were intended to defer tax on income that had been subject to tax in Comcare, there is no reasonable basis to deny this result since it is in accordance with the scheme of the Act.

[16] The parties also made submissions as to which position should take precedence if I were to determine that both positions were reasonable. The Crown submits that its position trumps the position of the appellants and that subsection55(2) should be applied in this case: Nassau Walnut Investments Inc. v. R., [97 DTC 5051] [1998] 1. C.T.C. 33 (F.C.A.) and Brelco Drilling Ltd. v. R., [99 DTC 5253] [1999] 3 C.T.C. 95 (F.C.A.). The appellants submit that these cases are not relevant on these facts and that any ambiguity should be resolved in favour of the taxpayer: Johns-Manville Canada Inc. v. R., [85 DTC 5373] [1985] 2 C.T.C. 111 #2 (S.C.C.).

Analysis

[17] These appeals concern how an accrued gain should be apportioned between “income earned or realized” and “unrealized appreciation in the value of underlying assets.” The answer turns on the meaning of the phrase “reasonably be attributable.”

[18] Often when a provision of the Act requires something to be allocated on a reasonable basis, an averaging or proration is the most logical basis for the allocation. I am not satisfied that this is appropriate in this case. In my view, the word “reasonably” in the context of this anti-avoidance provision implies that the accrued gain should be allocated based on the particular circumstances of the case to counter the mischief that was sought to be addressed. That is the approach that has generally be adopted in interpreting this section.