Judgments

[1994] 2 F.C. 154

T-2281-92

Her Majesty the Queen (Plaintiff)

v.

Melville Neuman (Defendant)

Indexed as: M.N.R. v. Neuman (T.D.)

Trial Division, Rothstein J.—Winnipeg, October 21; Ottawa, December 14, 1993.

Income tax — Income calculation — Dividends — Appeal from Tax Court decision dividends received by defendant’s wife should not be attributed to defendant — Defendant incorporating company, making wife sole director to split income from another company — Defendant having sole voting share — Based upon defendant’s recommendation, wife directing company to pay dividend — MNR reassessed defendant, pursuant to s. 56(2), by including in his income dividends received by wife — Two qualifications to application of s. 56(2): dividend payments would otherwise have been obtained by reassessed taxpayer; payment “benefit” for which no adequate consideration — S. 56(2) not applicable to dividends generally because first condition not met as, until declared, dividends belonging to company — No distinction between arm’s-length and non-arm’s length transactions in application of s. 56(2) — Condition precedent to application of s. 56(2) that payee not be subject to tax on amount received when reassessed taxpayer had no entitlement to payment not satisfied. — ITA containing no general scheme to prevent income splitting.

This was an appeal from a Tax Court decision that dividends received by the defendant’s wife in 1982 should not be attributed to the defendant. In 1981 the defendant incorporated and became the first director of Melru Ventures Inc., established as a tax planning vehicle to split any income received from another company in which he owned shares, with his wife, and to let any increase in his equity in the other company accrue to his wife. The defendant received one common voting share and Class “G” shares in exchange for an equal number of shares in the other company. He thus rolled over his interest in the other company to Melru. His wife paid for 99 Class “F” non-voting shares of Melru with her own money, but neither made any other contribution to the company nor assumed any risk. The defendant, the sole voting shareholder, resigned as director and elected his wife as the sole director of the corporation. Melru received $20,000 in dividends during 1982. Based on the defendant’s recommendation, and pursuant to discretionary dividend provisions in the articles of incorporation, his wife declared and had Melru pay to her $14,800 in dividends on her Class “F” shares and $5,000 in dividends to the defendant on his Class “G” shares”. The defendant immediately borrowed the $14,800 from his wife, which he had not repaid at the time of her death in 1988. The Minister reassessed the defendant by including in his income the $14,800 of dividends received by his wife. Income Tax Act, subsection 56(2) provides that a payment made pursuant to the direction 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 it would be if the payment or transfer had been made to him.

Held, the appeal should be dismissed.

There are two qualifications to the application of subsection 56(2): (1) that a dividend payment would otherwise have been obtained by the reassessed taxpayer; and, (2) that the payment is a “benefit” for which there was no adequate consideration. If either qualification is not met, subsection 56(2) does not apply.

The Supreme Court of Canada held in McClurg v. Canada that subsection 56(2) does not apply to dividends generally because, until declared, dividends belong to the company, not to another shareholder. Thus the first qualification for the application of subsection 56(2) was not met. The Chief Justice’s comments in McClurg as to the commercial reality of the transaction were intended as an additional, independent reason consistent with the conclusion he had already reached. Irrespective of the director-shareholder relationship that was dispositive of the issue, the payment to the wife in that case was not a benefit and the second qualification also was not met.

Where, as here, a dividend declaration was an attempt at income splitting, and the payment was a “benefit” and not a payment for adequate consideration, it is necessary to address the threshold question of whether a distinction is to be made between arm’s length and non-arm’s length transactions in the application of subsection 56(2). The Federal Court of Appeal held in McClurg that there was nothing in subsection 56(2) to suggest that it contemplated a distinction between arm’s length and non-arm’s length transactions. That finding was consistent with the Supreme Court’s dictum in Stubart Investments Ltd. v. The Queen that taxpayers in non-arm’s length, as well as in arm’s length, relationships could utilize whatever legal means were available to minimize tax obligations. McClurg did not change the law from that set out in Stubart. Therefore, no distinction should be drawn between an arm’s length and a non-arm’s length transaction in the application of subsection 56(2). There was no basis for investigating whether a shareholder, in a non-arm’s length situation, made a contribution to a company such that a dividend payment would not be considered a “benefit” as contemplated by subsection 56(2).

It is a condition precedent to the application of subsection 56(2) that the payee not be subject to tax on the amount she received when the reassessed taxpayer had no entitlement to the payment. The defendant’s wife received the payment as a shareholder, not as his wife. There was no allegation that the dividend payment was the result of a sham. All corporate formalities were followed. She was liable to tax on the dividend payment she received. The defendant had no entitlement to the payment made to his wife. The condition precedent was not satisfied.

The Income Tax Act contains no general scheme to prevent income splitting. For an income splitting transaction to be successfully challenged by the Minister, it must contravene an applicable section of the Act. Subsection 56(2) was not designed to prevent the type of income splitting engaged in by the defendant’s wife and the defendant.

This does not mean that subsection 56(2) could never be applied in the context of a director-shareholder relationship and the declaration of dividends. It could well apply if a transaction giving rise to payment of dividends was a sham, in which case the appearance of the director-shareholder relationship would be different from the actual relationship between the parties. It could also apply where the declaration of a dividend to one class of shares was properly attributable to other classes of shares as well, or where the intended recipient of a declared dividend redirected the dividend to another person. Apart from these narrow exceptions, subsection 56(2) is not the appropriate provision for the Minister to invoke to challenge income splitting in the context of the director-shareholder relationship and the declaration of dividends.

STATUTES AND REGULATIONS JUDICIALLY CONSIDERED

Business Corporations Act, R.S.S. 1978, c. B-10.

Income Tax Act, S.C. 1970-71-72, c. 63, ss. 56(2) (as am. by S.C. 1987, c. 46, s. 15), 86 (as am. by S.C. 1974-75-76, c. 26, s. 50; 1980-81-82-83, c. 48, s. 46).

CASES JUDICIALLY CONSIDERED

APPLIED:

McClurg v. Canada, [1990] 3 S.C.R. 1020; (1990), 76 D.L.R. (4th) 217; [1991] 2 W.W.R. 244; [1991] 1 C.T.C. 169; 91 DTC 5001; 119 N.R. 101; Stubart Investments Ltd. v. The Queen, [1984] 1 S.C.R. 536; [1984] CTC 294; (1984), 84 DTC 6305; 53 N.R. 241; Canada v. McClurg, [1988] 2 F.C. 356; [1988] 1 C.T.C. 75; (1987), 18 F.T.R. 80; 88 DTC 6047; 84 N.R. 214 (C.A.); affg [1986] 1 C.T.C. 355; [1986], 86 DTC 6128; 2 F.T.R. 1 (F.C.T.D.); Winter v. Canada, [1991] 1 F.C. 585 (C.A.); Smith, D.N. v. The Queen (1993), 93 DTC 5351 (F.C.A.); Snook v. London & West Riding Investments, Ltd., [1967] 1 All E.R. 518 (C.A.).

CONSIDERED:

Champ (W) v. The Queen, [1983] CTC 1; (1982), 83 DTC 5029 (F.C.T.D.).

REFERRED TO:

Miller, Alex v. Minister of National Revenue, [1962] Ex. C.R. 400; [1962] C.T.C. 199; (1962), 62 DTC 1139.

AUTHORS CITED

Gower, L. C. B. Gower’s Principles of Modern Company Law, 4th ed. London: Stevens & Sons, 1979.

Krishna, Vern and J. Anthony VanDuzer, “Corporate Share Capital Structures and Income Splitting: McClurg v. Canada” (1992-93), 21 Can. Bus. L.J. 335.

Welling, Bruce. Corporate Law in Canada: The Governing Principles, 2nd ed. Toronto: Butterworths, 1991.

APPEAL from the Tax Court decision (Neuman (M.) v. M.N.R., [1992] 2 C.T.C. 2074; (1992), 92 DTC 1652) that dividends received by the defendant’s wife in 1982 should not be attributed to the defendant. Appeal dismissed.

COUNSEL:

Robert W. McMechan and Robert M. Gosman for plaintiff.

Ralph D. Neuman for defendant.

SOLICITORS:

Deputy Attorney General of Canada for plaintiff.

Taylor, McCaffrey, Winnipeg, for defendant.

The following are the reasons for judgment rendered in English by

Rothstein J.: This case comes to this Court by way of appeal from the Tax Court of Canada [[1992] 2 C.T.C. 2074]. By decision dated May 19, 1992, Sarchuk T.C.C.J. found in favour of the defendant and the plaintiff appeals that decision.

The issue in this case is whether $14,800 in dividends received by the defendant’s wife in 1982 should be attributed to the defendant by virtue of subsection 56(2) of the Income Tax Act, S.C. 1970-71-72, c. 63, as amended. In 1982, subsection 56(2) stated:[1]

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.

The defendant is a lawyer and was, at the relevant time, a member of the Winnipeg law firm of Newman, MacLean. He, along with his partners, owned the shares of Newmac Services (1973) Ltd. Newmac had a management contract with Newman, MacLean and owned some commercial property in downtown Winnipeg.

On April 29, 1981, the defendant incorporated and became the first director of Melru Ventures Inc., established by him as a tax planning vehicle specifically to split any income received from Newmac with his wife Ruby Neuman and to freeze his equity in Newmac and let the increase accrue to her.[2] The defendant subscribed for and received one common voting share and 1,285.714 Class “G” shares in Melru in exchange for the same number of shares of Newmac. He thus rolled over his interest in Newmac to Melru. Ruby Neuman, who was not involved in Newmac, subscribed for and received 99 Class “F” non-voting shares of Melru, paying for them with $99 of her own money.

At the first annual shareholders’ meeting of Melru on August 12, 1982, the defendant, who was Melru’s sole voting shareholder, resigned as a director of Melru and elected his wife as the sole director of the corporation. One of the motivating reasons for doing so was to distance himself from the decision-making of Melru and therefore to have a better argument should income splitting arrangements be disallowed by the Minister of National Revenue.

During the calendar year 1982, Melru received $20,000 in dividends from Newmac. The defendant said that he gave his wife expert advice as to what dividends Melru should declare, advice which she took. Based on the defendant’s recommendation, Ruby Neuman, a sole director of Melru, declared and had Melru pay to her $14,800[3] in dividends on her Class “F” shares and declared and had Melru pay to the defendant $5,000 in dividends on his Class “G” shares. The $14,800 received by Ruby Neuman was immediately borrowed by the defendant on the strength of a demand note with interest payable only if demanded. Ruby Neuman died on October 2, 1988. The demand for repayment was never exercised.

By notice of reassessment dated October 1, 1984, the Minister reassessed the defendant by including in his income the $14,800 of dividends received by Ruby Neuman from Melru.

Counsel for the plaintiff argues that the dividend payment to Ruby Neuman was an attempt at tax avoidance (income splitting) and not the product of a business arrangement made for adequate consideration. He submits that McClurg v. Canada, [1990] 3 S.C.R. 1020, stands for the proposition that subsection 56(2) of the Income Tax Act applies to dividends paid pursuant to the power of directors to make discretionary dividend payments when a non-arm’s length shareholder has made no contribution to the company. In this case, plaintiff’s counsel says that Ruby Neuman, who, as the defendant’s wife, was in a non-arm’s length relationship with him, made no contribution to Melru. Therefore, subsection 56(2) should properly be applicable so as to have the dividends paid to her included in the income of the defendant for tax purposes.

Defendant’s counsel says that Ruby Neuman made the decision to declare the dividends on her own and not pursuant to the direction of, or with the concurrence of, the defendant. Moreover, defendant’s counsel invokes Stubart Investments Ltd. v. The Queen, [1984] 1 S.C.R. 536, in support of the proposition that a taxpayer may arrange his or her affairs in such a way as to minimize his or her tax consequences. He submits that Melru was incorporated for tax planning and income splitting purposes but cites Stubart to support the argument that a transaction may be entered into solely for tax purposes and that an independent business purpose need not be demonstrated. Defendant’s counsel also relies on McClurg, (supra), for the proposition that dividends, generally, do not fall within the scope of subsection 56(2) of the Income Tax Act.

The evidence in this case leads me to the following conclusions of, and observations on, the facts:

(1) Melru was incorporated for tax planning and income splitting purposes. It had no other independent business purpose.

(2) The dividends declared by Ruby Neuman on her own Class “F” shares and the defendant’s Class “G” shares were declared pursuant to discretionary dividend provisions in the Articles of Incorporation of Melru.[4] The dividends of $14,800 on her Class “F” shares and $5,000 on the defendant’s Class “G” shares were arbitrary numbers having regard only to the fact that Melru had earnings by way of dividends from Newmac of $20,000 available for distribution. But the allocation of $14,800 to the Class “F” shares and $5,000 to the Class “G” shares was arbitrary.

(3) Ruby Neuman made no contribution to Melru, nor did she assume any risks for the company.

(4) In declaring the dividends, was Ruby Neuman acting “pursuant to the direction of, or with the concurrence of,” the defendant, as those terms are used in subsection 56(2) of the Income Tax Act? The defendant’s evidence was that when his wife was elected director of Melru, he explained to her the duties of director, that directors manage the corporation, that they have a duty to the corporation, and that they make the decisions. The defendant said that he made recommendations to his wife which she accepted but that the decision as to the declaration of dividends was hers.

Counsel for the plaintiff points out that this is a family corporation in which the shareholders are husband and wife. Further, the husband in this case held the sole voting share and could remove his wife as a director if she did not declare dividends in accordance with his wishes.

As a corporate director, Ruby Neuman was a fiduciary and as such, owed a duty to act in the best interests of the corporation. Her fiduciary obligation as a director was to the corporation and not to the shareholders (see B. Welling, Corporate Law in Canada: The Governing Principles (2nd ed.), at pages 381 and 442). Part of the fiduciary obligation of a director is the necessity to exercise independent and unfettered judgment. This doctrine has been variously stated (see for example L.C.B. Gower, Gower’s Principles of Modern Company Law (4th ed.), at page 582).

It seems to me that a finding that Ruby Neuman was acting pursuant to the direction of, or with the concurrence of, the defendant would imply, notwithstanding the defendant’s evidence, that in the husband and wife context, there is a presumption that the director (wife in this case) is breaching her fiduciary obligation owed to the corporation by acting pursuant to the direction of her spouse and not acting independently.

I think it is obvious that in many cases of large and small corporations, directors take the advice or recommendations of management or professional advisers when making decisions as to the declaration of dividends. By accepting such advice or recommendations, are such directors acting pursuant to the direction of, or with the concurrence of, those who provided the recommendations or advice, thereby placing them in breach of their fiduciary obligations owed to their corporations? I think not. Similarly, I do not see why a director, who accepts a recommendation as to the declaration of dividends from his or her spouse, should be presumed, in the absence of evidence to the contrary, to be acting pursuant to the direction of, or with the concurrence of, his or her spouse.

As to the issue of the defendant holding the sole voting share and being able to remove Ruby Neuman as director, a finding that, for this reason, she was acting pursuant to his direction or with his concurrence, would blur the distinction between the corporation and the voting shareholder. I have not been provided with authority to the effect that when specific shareholders control the election to the board of directors, that the directors are presumed to act pursuant to the direction of, or with the concurrence of, the controlling shareholders in declaring dividends.

For these reasons, I would be reluctant to presume that Ruby Neuman was acting pursuant to the direction of, or with the concurrence of, the defendant when she, as director, declared dividends on behalf of Melru. A finding that Ruby Neuman was not acting pursuant to the direction of, or with the concurrence of, the defendant would be determinative in this case. However, because this issue was not addressed in depth by counsel, I do not propose to decide the case on this issue and my comments should be considered as obiter only. Without deciding this issue therefore, I proceed with an analysis of McClurg, (supra), and its application to the case at bar.

Similar facts to those in the case at bar were present in McClurg, (supra), with one material exception being that Ruby Neuman made no contribution to Melru while Mrs. McClurg did make a contribution to the company from which she received dividends. In fact, the processing of this case had been delayed by agreement of counsel to allow McClurg to first proceed through the courts. The determination of law applicable to the case at bar requires a consideration of the findings of the Supreme Court in McClurg.

In McClurg, Wilma McClurg, the wife of the reassessed taxpayer Jim McClurg, had received dividends from a trucking company, Northland Trucks (1978) Ltd., owned by the McClurgs and one other family. The Minister unsuccessfully attempted to invoke subsection 56(2) to tax Jim McClurg as if he had received a portion of the dividends paid to Wilma McClurg.

The decision of the majority of the Supreme Court of Canada dealt with two issues, one corporate and the other tax related. The corporate issue was the question of the validity of a discretionary dividend clause in the Articles of Incorporation of Northland. The tax issue was whether subsection 56(2) applied to dividends generally or to dividends in that case specifically.

As to the corporate issue, the Minister argued that as both Wilma and Jim McClurg held common shares of the company, albeit of different classes, there was a common law presumption of equality of treatment of those shares. Under such presumption, as Jim McClurg had 400 Class “A” common shares and Wilma McClurg had 100 Class “B” common shares, a $10,000 dividend to Wilma McClurg should have been attributable, $8,000 to Jim McClurg and $2,000 to Wilma McClurg.

Dickson C.J. found that the Articles of Incorporation of Northland gave the directors unfettered discretion as to the allocation of dividends among classes of shares and was a valid derogation from the common law presumption of equality of distribution of dividends. Moreover, nothing in the Saskatchewan Business Corporations Act, R.S.S. 1978, c. B-10, as amended, precluded a discretionary dividend clause in the Articles of the corporation.

La Forest J., writing for the minority in the Supreme Court, was of the view that a discretionary dividend clause was invalid at common law because of the principle that directors are not permitted to favour one class of shareholders at the expense of others.

The law as it stands as a result of McClurg, (supra), is that discretionary dividend clauses in Articles of Incorporation are valid (presumably unless precluded by statute) and rebut the common law presumption of equality of treatment among shareholder classes.

In the case at bar therefore, the declaration of dividends by Ruby Neuman as director of Melru, pursuant to the discretionary dividend provisions in the Articles of Melru, was a valid and effective allocation of dividends between her Class “F” shares and the defendant’s Class “G” shares.

As to the tax issue, Dickson C.J., for the majority of the Supreme Court, discussed the object and purpose of subsection 56(2) which he derived from prior judgments, specifically the dicta of Thurlow J. (as he then was) in Miller, Alex v. Minister of National Revenue, [1962] Ex. C.R. 400 and Strayer J. in McClurg, [1986] 1 C.T.C. 355 (F.C.T.D.). Dickson C.J. stated, at page 1051:

The subsection obviously is designed to prevent avoidance by the taxpayer, through the direction to a third party, of receipts which he or she otherwise would have obtained … the section reasonably cannot have been intended to cover benefits conferred for adequate consideration in the context of a legitimate business relationship.

It appears to me that these two qualifications to the application of subsection 56(2)—that a dividend payment would otherwise have been obtained by the reassessed taxpayer and that the payment is a “benefit” for which there was no adequate consideration, are central to Dickson C.J.’s analysis of the commercial reality and practical nature of the transaction in McClurg. In my view each qualification is independent of the other. Thus, if a taxpayer can demonstrate that either qualification is not met, subsection 56(2) would not apply.

The initial finding of Dickson C.J. with respect to the tax issue was that subsection 56(2) did not apply to dividends generally. At page 1052 he stated:

While it is always open to the Courts to “pierce the corporate veil” in order to prevent parties from benefiting from increasingly complex and intricate tax avoidance techniques, in my view a dividend payment does not fall within the scope of s. 56(2).

He continued:

The purpose of s. 56(2) is to ensure that payments which otherwise would have been received by the taxpayer are not diverted to a third party as an anti-avoidance technique. This purpose is not frustrated because, in the corporate law context, until a dividend is declared, the profits belong to a corporation as a juridical person: Welling, supra, at pp. 609-10. Had a dividend not been declared and paid to a third party, it would not otherwise have been received by the taxpayer. Rather, the amount simply would have been retained as earnings by the company. Consequently, as a general rule, a dividend payment cannot reasonably be considered a benefit diverted from a taxpayer to a third party within the contemplation of s. 56(2).

Later, on the next page, rejecting the notion that, but for the payment of a dividend to a third party, a director-shareholder would be the recipient of the payment, he stated:

… but for the declaration (and allocation), the dividend would remain part of the retained earnings of the company. That cannot legitimately be considered as within the parameters of the legislative intent of s. 56(2). If this Court were to find otherwise, corporate directors potentially could be found liable for the tax consequences of any declaration of dividends made to a third party. I agree with both Urie J. and Strayer J. in the courts below that this would be an unrealistic interpretation of the subsection consistent with neither its object nor its spirit. It would violate fundamental principles of corporate law and the realities of commercial practice and would “overshoot” the legislative purpose of the section.

Part of the rationale of the Chief Justice was that subsection 56(2) applied to payments that otherwise would have belonged to the reassessed taxpayer. In the context of dividends however, if they were not paid to a shareholder, they would remain part of the retained earnings of the company. They would not automatically belong to another shareholder. The words “[i]t would violate fundamental principles of corporate law” make it abundantly clear that the Chief Justice was emphatic that subsection 56(2) did not apply to dividends.

This finding disposed of the tax issue in McClurg since the payment to Wilma McClurg was not a receipt which Jim McClurg would have otherwise obtained. If the payment had not been made to Wilma McClurg, the dividends would have remained as retained earnings in Northland. Thus the first qualification for the application of subsection 56(2) noted by Dickson C.J. was not met.

Dickson C.J., however, then looked at what he termed “the commercial reality of this particular transaction”.[5] At pages 1053-1054 he agreed with the finding of Strayer J. in the Federal Court, Trial Division that Wilma McClurg made a real contribution to the establishment of Northland Trucks and took an active part in the operation of the business. He found that dividend payments to her represented a legitimate quid pro quo and were not simply an attempt to avoid taxes.[6]

The question is, what meaning is to be given to the observations of the Chief Justice regarding the commercial reality of the circumstances in McClurg? This question is particularly relevant to the case at bar because, contrasted with Wilma McClurg, Ruby Neuman made no contribution to Melru and the declaration of dividends to her on her class “F” shares was solely to her as shareholder of Melru for the purpose of income splitting.

In my opinion, the comments of the Chief Justice, at page 1053 as to the commercial reality of the transaction in McClurg addressed the second qualification for the application of subsection 56(2)—whether or not a “benefit” as contemplated by the subsection was conferred on Wilma McClurg. These comments were intended as an additional independent reason consistent with the conclusion he had already reached; that subsection 56(2) generally did not apply in the context of the director-shareholder relationship and that this was dispositive of the issue. Moreover, I doubt that he intended his comments about the commercial reality of the transaction to be determinative of the issue. I come to these conclusions for the following reasons:

(1) The Chief Justice stated, at page 1053:

… its [s. 56(2)] application also would be contrary to the commercial reality of this particular transaction. [Underlining mine.]

His use of the word “also” suggests to me that his conclusion that subsection 56(2) did not apply to the declaration of dividends generally was sufficient to determine the issue in the case.

(2) The Chief Justice stated that he agreed with Desjardins J.A. (writing a minority opinion in the Federal Court of Appeal reported as Canada v. McClurg, [1988] 2 F.C. 356, at page 370) that “dividends come as a return on his or her investment”. However, he added that, in that case, they “represented a legitimate quid pro quo and were not simply an attempt to avoid the payment of taxes” (at page 1054). In my view, the reference to “quid pro quo” is related to the qualification that for subsection 56(2) to be applicable, a payment made must be a “benefit” and not a payment for adequate consideration. It appears to me that the Chief Justice was saying that although he acknowledged that dividends were paid for no other reason than as a return on investment in shares of a company, and that the director-shareholder relationship was dispositive of the issue, even if dividends were contemplated by subsection 56(2), there was clearly no “benefit” as required by that subsection in the McClurg case as there was adequate consideration for the payment to Mrs. McClurg. Thus, the second qualification for application of subsection 56(2) had not been met.

(3) The Chief Justice acknowledged that Wilma McClurg’s efforts in the operation of Northland Trucks were “not dispositive of the issue raised in this appeal” (at page 1054).

In my view, the comments of the Chief Justice in McClurg, relating to the commercial reality of the transaction, were intended to demonstrate that, irrespective of the director-shareholder relationship that he had already determined was dispositive of the issue, the payment to Wilma McClurg was not a “benefit” under subsection 56(2). Thus, neither of the two independent qualifications that are essential for the application of subsection 56(2) were present in McClurg.

I now come to the passage in the reasons of Dickson C.J. relied upon by the Minister found, at page 1054.

In my opinion, if a distinction is to be drawn in the application of s. 56(2) between arm’s length and non-arm’s length transactions, it should be made between the exercise of a discretionary power to distribute dividends when the non-arm’s length shareholder has made no contribution to the company (in which case s. 56(2) may be applicable), and those cases in which a legitimate contribution has been made. In the case of the latter, of which this appeal is an example, I do not think it can be said that there was no legitimate purpose to the dividend distribution.

I must admit to having some difficulty reconciling this passage with the preceding words of the Chief Justice that to consider dividends within subsection 56(2) “would violate fundamental principles of corporate law and the realities of commercial practice and would overshoot the legislative purpose of the section” [at page 1053]. In any event, the passage raises three questions for decision. The first is whether, in the application of subsection 56(2), a distinction is to be made between arm’s length and non-arm’s length transactions. The second is, within the scope of non-arm’s length situations, where a dividend has been declared pursuant to a discretionary dividend clause, whether or not the shareholder has made a contribution to the company. The third is whether, if no contribution has been made by the shareholder, subsection 56(2) is applicable.

Looked at in this way, it is quite clear that the threshold question, whether a distinction is to be made between arm’s length and non-arm’s length transactions in the application of subsection 56(2), has not been answered by the Supreme Court of Canada. Without answering that question, the Chief Justice had no difficulty concluding that on the facts in McClurg, Wilma McClurg did make a contribution to the company. I interpret the words of the Chief Justice as meaning that even if a distinction was to be drawn between arm’s length and non-arm’s length transactions in the application of subsection 56(2) (which issue he was not deciding), the facts of McClurg were such that there was no “benefit” and subsection 56(2) would not be applicable on that ground, even if the Minister could invoke subsection 56(2) to attack dividend payments in non-arm’s length situations.

However, where, as in the case at bar, the evidence is that a dividend declaration was an attempt at income splitting, and that the payment to Ruby Neuman was a “benefit” and not a payment for adequate consideration, in the McClurg sense, it is necessary to address the threshold question of whether a distinction is to be drawn between arm’s length and non-arm’s length transactions in the application of subsection 56(2). While this specific question was not answered by the Supreme Court of Canada in McClurg, it has been answered by the Federal Court of Appeal in the judgment of Urie J.A. in Canada v. McClurg, [1988] 2 F.C. 356. In his reasons, Dickson C.J. did not disturb this finding of the Federal Court of Appeal. The determination by the Federal Court of Appeal as to whether a distinction is to be drawn between arm’s length and non-arm’s length transactions in the application of subsection 56(2) is, of course, binding on the Trial Division of this Court.

In his reasons in the Federal Court of Appeal, Urie J.A. found there was nothing in subsection 56(2) to suggest that it contemplated a distinction between arm’s length and non-arm’s length transactions. At pages 363-364 he stated:

It is noteworthy, furthermore, that the subsection, if it is to apply to corporate situations, makes no distinction between arm’s length and non-arm’s length transfers.

…

If it had been intended by the legislators that it might apply to directors of small, closely held family corporations only, apt language could have been employed to achieve the desired result. But to utilize the general language of subsection 56(2) to achieve the result desired by the taxing authorities, as exemplified in this case, is not, in my view, justifiable.

In more general terms, the Supreme Court has looked at the issue of whether the Income Tax Act contemplates a distinction between arm’s length and non-arm’s length transactions in the well-known case of Stubart Investments Ltd. v. The Queen, (supra). In that case Estey J. rejected such a distinction. That case decided that taxpayers in non-arm’s length relationships, as well as in arm’s length relationships, could utilize whatever legal means were available to minimize tax obligations. At pages 570-572 he stated:

In light of this general background, a further subsidiary question must be considered: Is the transaction affected as to tax consequences where the vendor and purchaser are not at arm’s length? There are, of course, many pragmatic and philosophical answers. In considering this issue, one must take cognizance of the many examples in the Act and its application by the Department which belie the distinction. For example, inter-spousal loans, which effectively allow income splitting with the consequential tax reduction, are approved under the present Act. See Interpretation Bulletin No IT-258R2, Department of National Revenue. There are other examples, including the transfer of invested surpluses by a corporation from bonds to stocks where the corporation moves from deficit to profit on its commercial operations. In neither of these examples is there any bona fide business purpose for the transfer or exchange of assets, both being done exclusively or avowedly to reduce or eliminate taxation.

Other sections of the Income Tax Act enable a corporation or its shareholders to reduce income upon the distribution of accumulated surplus, as for example under s. 85 of the old Act. By conforming with the terms of the statute, this income, which, when otherwise withdrawn by the shareholders would be taxable at full personal rates, can be transferred to the shareholders at reduced rates, even “artificially” reduced tax rates when one considers the artifice prescribed by Parliament in these sections.

There are many other examples in the Act of tax reduction devices, most of which, by axiom, are founded upon non-arm’s length relationships. The taxpayer may acquire the marital deduction in toto for the entire calendar year by marrying on December 31 instead of January 1 in the following year. If the choice is made solely for tax reasons, surely the taxpayer’s entitlement is not thereby placed in jeopardy. The same applies to persons who deliberately avail themselves of registered home ownership savings plans whether or not the taxpayer does so because of the tax deduction or because of a long-term, bona fide intent to establish a fund to be used to purchase a home; and to businesses combining by way of joint venture rather than by minority shareholding in a project. Motive would nowhere appear to be a precondition of eligibility. The same applies to the decision of a taxpayer to incorporate or to carry on business in partnership with a corporation. Whether or not these choices are made solely on the basis of tax advantage, whenever the Income Tax Act prescribes different tax rates for different forms of business, the taxpayer must surely be free to choose whichever mode fits his plans.

I think the finding of Urie J.A. in McClurg, that subsection 56(2) makes no distinction between arm’s length and non-arm’s length transactions, is consistent with the dictum of Estey J. in Stubart.

In deciding McClurg, the Chief Justice did not overlook Stubart because he made reference to it himself in setting forth his framework for his analysis in that case (at pages 1049-1050). Stubart dealt directly with the issue of tax avoidance and found that per se, tax avoidance in the non-arm’s length context was not offensive or abusive so as to be judicially curtailed. I do not think the observations of the Chief Justice in McClurg were intended, by implication, to change the law from what a unanimous Supreme Court had set out in Stubart. Had it been his intention to do so, it is reasonable to assume that he would have used clear and direct language.[7]

Based on the decisions of the Federal Court of Appeal in McClurg and the Supreme Court in Stubart, I must conclude that the threshold question, whether a distinction is to be drawn between an arm’s length and a non-arm’s length transaction in the application of subsection 56(2), must be answered in the negative. Having come to this conclusion, there is no basis upon which to embark upon an investigation of whether or not a shareholder, in a non-arm’s length situation, made a contribution to a company such that a dividend payment would not be considered a “benefit” as contemplated by subsection 56(2).

Although it is not essential for my decision in this case, I would add that counsel for the plaintiff was good enough to draw to my attention a condition precedent to the application of subsection 56(2) established by the Federal Court of Appeal in Winter v. Canada, [1991] 1 F.C. 585, page 594. That condition precedent is that when a reassessed taxpayer himself or herself has no entitlement to the payment made to the recipient, the validity of the assessment under subsection 56(2) of the Act is subject to the condition that the recipient of the benefit not be subject to tax on the benefit received. This principle was applied in Smith, D.N. v. The Queen (1993), 93 DTC 5351 (F.C.A.).

Counsel for the plaintiff argued that this condition was not referred to by the Chief Justice in McClurg, but I do not think this invalidates the principle, especially since the decision in Winter was issued on November 20, 1990, after the argument in McClurg in the Supreme Court but only one month before the Supreme Court issued its decision in McClurg on December 20, 1990.

Plaintiff’s counsel also argued that Ruby Neuman was not subject to tax on her dividend payment as it was not as shareholder, but as wife, that she was paid. This type of distinction was made by Marceau J.A. in Winter, (supra). However, in my view, in the case at bar, the payment received by Ruby Neuman was indeed received by her as shareholder and not as wife. There was no allegation that the dividend payment was the result of a sham. According to the evidence before me, all corporate formalities were followed. Ruby Neuman was liable for tax on the dividend payment she received. The defendant had no entitlement to the payment made to Ruby Neuman. Following Winter and Smith, (supra), the condition precedent for the application of subsection 56(2), that the payee not be subject to tax on the amount she received when the reassessed taxpayer had no entitlement to the payment made to her, has not been satisfied in the case at bar.

It may also be appropriate for me to observe that nothing in the scheme of the Income Tax Act as a whole suggests an overall intention to prevent income splitting. In a paper by Vern Krishna and J. Anthony VanDuzer, “Corporate Share Capital Structures and Income Splitting: McClurg v. Canada” (1992-93), 21 The Canadian Business Law Journal 335,[8] the learned authors state, at page 367:

The Canadian income tax system is structured on the premise that each taxpayer, including corporations, is a separate tax entity and, apart from specific provisions such as s. 56(2) which prevent the diversion of income, there is no general scheme to prevent income splitting. To be sure, both s. 56(2) and s. 74.1 do reflect an underlying philosophy that a taxpayer should not be able to divert income to another taxpayer for the purposes of reducing his or her marginal rate of tax. Those provisions are, however, extremely technical and specific in their ambit and do not reflect any general overall philosophy that can be ascribed to the Act “read as a whole”.

For an income-splitting transaction to be successfully challenged by the Minister it must contravene an applicable section of the Income Tax Act. Based on the decision of the Supreme Court in McClurg, I have found that subsection 56(2) is not designed to prevent the type of income splitting engaged in by Ruby Neuman and Melville Neuman in the case at bar.

My conclusion does not imply that subsection 56(2) can never be applied in the context of a director-shareholder relationship and the declaration of dividends. If a transaction giving rise to the payment of dividends was a sham within the definition of that term as set out by Diplock L.J. in Snook v. London & West Riding Investments, Ltd., [1967] 1 All E.R. 518 (C.A.), at page 528:

… which are intended by them to give to third parties or to the court the appearance of creating between the parties legal rights and obligations different from the actual legal rights and obligations (if any) which the parties intend to create.

I think subsection 56(2) could well apply. In such circumstances, the appearance of the director-shareholder relationship would be different from the actual relationship between the parties. In the case at bar, counsel for the plaintiff expressly stipulated that there was no allegation or suggestion by the Minister that the transaction pursuant to which Ruby Neuman received her dividends was a sham.

Subsection 56(2) could also apply in circumstances in which the declaration of a dividend to one class of shares was properly attributable to other classes of shares as well. Subsection 56(2) was applied in Champ (W) v. The Queen, [1983] CTC 1 (F.C.T.D.) in which a dividend payment to one class of shares was, according to the Articles, attributable also to another class of shares. In that case, subsection 56(2) was invoked to attribute dividends to both classes of shares in accordance with the requirements of the Articles. In the case at bar, dividends were declared pursuant to a valid discretionary dividend clause in the Articles and the presumption as to equality of treatment of shares was rebutted.

Subsection 56(2) might also apply to a case in which the intended recipient of a declared dividend redirected the dividend to another person. This did not occur in the case at bar.

Apart from these narrow types of exceptions, subsection 56(2) is not, in my opinion, the appropriate provision for the Minister to invoke to challenge income splitting in the context of the director-shareholder relationship and the declaration of dividends.

The appeal is dismissed with costs.

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