Mcclurg v. Canada

Mcclurg v. Canada
Collection
Supreme Court Judgments
Date
1990-12-20
Report
[1990] 3 SCR 1020
Case number
20751
Judges
Dickson, Robert George Brian; Wilson, Bertha; La Forest, Gérard V.; L'Heureux-Dubé, Claire; Sopinka, John; Gonthier, Charles Doherty; Cory, Peter deCarteret
On appeal from
Federal Court of Appeal
Subjects
Commercial law
Taxation
Notes
SCC Case Information: 20751
Decision Content
McClurg v. Canada, [1990] 3 S.C.R. 1020
Her Majesty The Queen Appellant
v.
Jim A. McClurg Respondent
indexed as: mcclurg v. canada
File No.: 20751.
1989: November 29; 1990: December 20.
Present: Dickson C.J.* and Wilson, La Forest, L'Heureux‑Dubé, Sopinka, Gonthier and Cory JJ.
on appeal from the federal court of appeal
Income Tax ‑‑ Dividends ‑‑ Attribution ‑‑ Dividends declared and allocated to shareholders of a share class pursuant to discretion of directors -- Other classes of shares not participating in dividend ‑‑ Whether portion of dividend properly attributable to other classes of shares ‑‑ Income Tax Act, S.C. 1970‑71‑72, c. 63, s. 56(2).
Company law ‑‑ Dividends ‑‑ Discretionary dividend as declared and allocated at discretion of directors ‑‑ Whether derogation of common law with respect to nature of shares or directors' duties ‑‑ Whether permitted by Saskatchewan Business Corporations Act ‑‑ Business Corporations Act, R.S.S. 1978, c. B‑10, ss. 24(4), 40, 97, 234.
Respondent and his partner were the only directors of a closely held company incorporated under the Saskatchewan Business Corporations Act. The Articles of Incorporation provided for three categories of shares: Class A which are common, voting and participating shares; Class B which are common, non‑voting and participating where authorized by the directors; and Class C which are preferred, non‑voting shares. All three classes of shares carried "the distinction and right to receive dividends exclusive of other classes of shares in the said corporation". The two directors received no dividends on either their class A or class C shares during 1978, 1979 and 1980 but received salaries, bonuses, and bonus entitlements. Their wives, who held Class B shares, were voted a declaration and distribution of dividends amounting to $10,000 each in each of these three years. Mrs. McClurg had been actively involved in the firm's operations and had been paid a modest salary.
The Minister of National Revenue reassessed the respondent's income for 1978, 1979, and 1980 on the basis that $8,000 of the $10,000 in dividends attributed to Mrs. McClurg on her Class B shares was properly attributable instead to the respondent pursuant to ss. 56(2) of the Income Tax Act. The Minister's opinion was that the dividends declared in each of the years in question should be attributed equally to all of the common shares, no matter of what class and notwithstanding the express condition attaching to the Class B shares that they shall carry the right to receive dividends exclusive of other classes of shares in the company. The reallocation was made on the basis of the number of Class A shares owned by the respondent in relation to the number of Class B shares owned by Mrs. McClurg. The respondent's appeal to the Tax Court of Canada was dismissed. The respondent further appealed from the decision of the Tax Court judge by way of an action commenced in the Federal Court of Canada, Trial Division. The appeal was allowed. The Minister's appeal to the Federal Court of Appeal was dismissed.
At issue here was whether the dividends received by Mrs. McClurg in respect of her Class B common shares should be attributed in part to the respondent. A preliminary issue was whether the discretionary clause constituted a valid derogation to the common law rule of equality of distribution of dividends or whether it was permitted under the Saskatchewan Business Corporations Act.
Held (Wilson, La Forest and L'Heureux‑Dubé JJ. dissenting): The appeal should be dismissed.
Per Dickson C.J. and Sopinka, Gonthier and Cory JJ.: Discretionary dividend clauses may be validly used because they are not expressly prohibited by the Act and are not contrary to common law or corporate law principles.
The power to pay dividends is an integral component of the Act's broad grant of managerial power for directors and is expressly limited by restrictions in much the same way as at common law. It is also qualified in that the general managerial power, which rests in the directors of a company, is fiduciary in nature and so must be exercised in good faith and in the best interests of the company.
Shares have an equal right to receive a dividend unless the Articles of Incorporation provide otherwise. Their division into classes is a necessary condition to any derogation of this presumption of equality either with respect to dividends or to other shareholder entitlements. Section 24(4)(a) is to ensure that shareholders are fully aware of their entitlements and privileges to the extent that the presumption of equality is rendered inapplicable. The determination of whether or not the share class rebuts this presumption is a simple factual inquiry. The Articles of Incorporation rebutted the presumption of equality here.
The entitlement to be considered for a dividend is more properly characterized in terms of a "right". A dividend is no less a "right" because it is contingent upon the exercise of the discretion of the directors to allocate the declared dividend between classes of shares. The directors are bound by their fiduciary duty to act in good faith for the best interests of the company in declaring and allocating any dividend. That duty is not circumvented by the discretionary dividend clause. Many shareholder rights may be qualified and contingent and the mere fact that they are fettered does not render them anything less than shareholder rights.
A discretionary dividend clause does not give rise to any inherent conflict between the duty of the directors and their self‑interest. Their allocation of dividends pursuant to such a clause can be exercised in the best interests of the company. The fact that the directors may consider the identity of shareholders does not necessarily render the declaration invalid on the basis of a conflict of duty and self‑interest. The dividend allocation clause simply divides conceptually what has been traditionally one decision into two components ‑‑ declaration and allocation. The discretionary powers of the directors have always included both, subject to the provisions of the Articles of Incorporation.
Section 24(4)(b) of the Act recognizes that there must be shares entitled to receive a dividend if a dividend is declared. This principle is not defeated by a discretionary dividend clause because the identity of the class eligible for a dividend simply remains unknown until the allocation takes place. This conceptual division into declaration and allocation is not substantively different from any derogation from the presumption of equality in the payment of dividends.
It would be inappropriate for this Court to determine the validity of use of a discretionary dividend clause in the context of an income tax appeal. The Act is facilitative and allows parties to structure corporations as they wish subject to certain explicit exceptions. It also provides the means for a party aggrieved by the corporation ‑‑ security holder, creditor, director or officer ‑‑ to seek redress through the s. 234 oppression remedy. No interested party here lodged such complaint, presumably because all involved were satisfied with the way in which the directors were conducting its affairs. Furthermore, it is a well-established principle at common law that where shareholders are unanimously agreed to a transaction, inequality of treatment does not render it ultra vires the company.
The determination that the transaction occurred in the context of a director‑shareholder relationship is dispositive. While it is always open to the Courts to "pierce the corporate veil" in order to prevent parties from benefitting from increasingly complex and intricate tax avoidance techniques, a dividend payment does not fall within the scope of s. 56(2). 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. 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).
An allocation pursuant to a discretionary dividend clause is no different from the payment of a dividend generally. In both cases, but for the declaration (and allocation), the dividend remains part of the retained earnings of the company and is therefore not within the legitimate parameters of the legislative intent of s. 56(2).
The payments to Mrs. McClurg represented a legitimate quid pro quo and were not simply an attempt to avoid the payment of taxes. Her efforts expended in the firm's operation, while not dispositive of the issue, was further evidence that the dividend payment was the product of a bona fide business relationship. If a distinction is to be drawn in the application of s. 56(2) between arms' length and non arms' length transactions, it should be made between the exercise of a discretionary power to distribute dividends when the non arms' length shareholder has made no contribution to the company (in which case s. 56(1) may be applicable), and those cases in which a legitimate contribution has been made.
Per Wilson, La Forest and L'Heureux‑Dubé JJ. (dissenting): The separation of share ownership and control underlies many fundamental principles of corporate law. Among these are the principle that the directors and officers of a corporation owe a fiduciary duty to the corporation and the principle of equality of shares. More than just a mere contractual right, the principle of equality of shares developed as a measure of protection for the shareholder. Thus, when more than one class of shares was created, the directors were not free to discriminate arbitrarily between the classes when awarding a dividend.
Shareholder rights include the right to a dividend, the right to vote, and the right to participate in the distribution of assets upon dissolution of the corporation. These rights must attach to the corporation's shares and the shareholders may not agree to circumvent this principle.
A discretionary dividend clause that permits the directors of a corporation to choose which class is entitled to receive dividends to the exclusion of the other classes is invalid at common law. It contravenes the principle that the directors are not permitted to favour one class at the expense of the others. It also contravenes the principle that dividends attach to shares and not to shareholders because the directors would be making a discretionary allocation primarily on the basis of the identity of the shareholders. To allow discrimination on the basis of the identity of the shareholder ignores the separation that is supposed to exist between the corporation and its shareholders.
A discretionary dividend clause, if valid, would entail a number of problems. The shareholder would be completely dependent on the goodwill of the directors and the minority shareholder would be placed in a near impossible position if this goodwill were to be turned against that shareholder. It also places the director in a position where he cannot fulfill his fiduciary obligations to the corporation as a whole and so must be invalid at common law. The conflict of interest is heightened when the director happens to be a shareholder of a class to which dividends are awarded or from which some personal benefit is derived; the situation can be compared to the usurpation of a corporate opportunity properly belonging to the company.
Requiring the mode of distribution to be expressly set out in the Articles of Incorporation, which can only be amended by approval of the shareholders, is consistent with the fiduciary obligation. If the directors hold preferred shares, the common shareholders will have agreed to subordinate their dividend interest to the preferred class of shares based upon "full disclosure" of the maximum amount to which these preferred shares will enjoy priority. With a discretionary dividend clause, there is no such disclosure, since the amount and priority is left to be determined in the future, wholly at the directors' discretion.
If employees merit additional reward, the proper course to effect this is through some form of compensation other than a dividend. A dividend is a return on an investment. The directors, if they were to take into account the identity of shareholders when declaring a dividend, would be improperly exercising the discretionary dividend power.
The discretionary dividend clause, even if it were valid under the common law, would be insufficient to rebut the common law presumption of equality. All three classes of shares are defined in substantially the same manner with respect to their entitlement to dividends. Therefore, any difference between the shares concerning their right to receive dividends would clearly not derive from any differentiation between the shares; it would have to stem from the actions of the directors of the corporation. Such a right, therefore, would not derive from the share itself and would be invalid at common law.
Section 24(4)(a) of the Saskatchewan Business Corporations Act requires that the mode of distributing dividends be expressly provided for in the articles themselves. The section must be interpreted in accordance with the principles of the common law and, in particular, with the principle that shareholder rights be expressly provided for in the shares themselves. Any departure from this principle must be explicitly stated. Section 24(4)(a) does not clearly indicate an intent to provide corporate directors with a power which they did not otherwise have at common law. The use of the discretionary dividend clause is also inconsistent with the requirement in s. 24(3)(b) that at least one class of shares must be entitled "to receive any dividend declared by the corporation".
Even when the Act specifically provides that the directors may be given the discretion to determine the rights to be assigned to a series, this discretion is not unlimited. The shareholders can give the directors the power to issue series within a class and assign rights to those series but they may not agree to give the directors the discretion to interfere with their right to dividends or a return of capital by choosing to give another series priority. The rights assigned to series, unlike classes of shares, may be altered without amending the corporate constitution.
The statute contemplates that shareholders will be protected from changes being made to the rights attached to different classes of shares by virtue of the fact that such rights may only be amended by altering the corporate constitution. In theory, a shareholder can bring a suit if the directors are alleged to exercise their discretion improperly. This remedy, however, entails a significant burden and expense and is an inadequate means of protecting shareholders from the potential for abuse created by the presence of a discretionary dividend clause. The need for shareholder protection from abuse of the discretionary dividend clause becomes all the more apparent given the possibility that such a clause could be inserted in the Articles of Incorporation of a large, publicly held corporation.
The discretionary dividend clause has no socially useful purpose. Its only apparent purpose is to facilitate tax avoidance through "income‑splitting" and this purpose hardly supports the need to allow corporations to be structured in this manner.
It would be inappropriate to return the money paid out in dividends to the corporation because the directors must be taken to have declared dividends in the corporation's best interests. The dividends, therefore, should be redistributed amongst the various classes of shares which must, absent a valid differentiation between the shares, share equally in the dividend.
A dividend payment does not fall within the scope of s. 56(2) of the Income Tax Act in the typical situation where the dividend payment is within the powers of the corporation and the shareholder is bona fide entitled to the dividends. The contribution of a shareholder to the business is irrelevant, however, because a dividend is a return on capital attaching to a share and in no way dependent on the conduct of a particular shareholder.
The four elements of s. 56(2) were met here. The payment in question satisfied the requirement that there be a payment or transfer of property to a person other than the taxpayer; the term "payment" has acquired no technical meaning in the Income Tax Act and is to be interpreted in its popular sense. The payment was made pursuant to the direction of the taxpayer or with the concurrence of the taxpayer. An individual in control of a corporation can be said to have directed a payment within the meaning of s. 56(2) by exercising that control. The payment must be for the benefit of the taxpayer or recipient. Here the payment to Mrs. McClurg, which represented Mr. McClurg's dividend entitlement, amounted to a benefit to Mrs. McClurg under s. 56(2). Finally, this amount would have been included in Mr. McClurg's income had the allocation been properly made.
Cases Cited
By Dickson C.J.
Referred to: Burland v. Earle, [1902] A.C. 83; Bowater Canadian Ltd. v. R.L. Crain Inc. (1987), 62 O.R. (2d) 752; De Vall v. Wainwright Gas Co., [1932] 2 D.L.R. 145; Stubart Investments Ltd. v. The Queen, [1984] 1 S.C.R. 536; The Queen v. Golden, [1986] 1 S.C.R. 209; Bronfman Trust v. The Queen, [1987] 1 S.C.R. 32; Miller v. M.N.R., 62 D.T.C. 1139; Perrault v. The Queen, [1979] 1 F.C. 155.
By La Forest J. (dissenting)
Salomon v. Salomon and Co., [1897] A.C. 22; Farrar v. Farrars, Limited (1888), 40 Ch. D. 395; Borland's Trustee v. Steel Brothers & Co., [1901] 1 Ch. 279; Canadian Aero Service Ltd. v. O'Malley, [1974] S.C.R. 592; Henry v. Great Northern Ry. Co. (1857), 1 De G. & J. 606, 44 E.R. 858; Jacobsen v. United Canso Oil & Gas Ltd. (1980), 113 D.L.R. (3d) 427; Bowater Canadian Ltd. v. R. L. Crain Inc. (1987), 62 O.R. (2d) 752; Rondeau v. Poirier, [1980] C.A. 35; Birch v. Cropper, In re Bridgewater Navigation Co. (1889), 14 A.C. 525; Champ v. The Queen, 83 D.T.C. 5029; Stubart Investments Ltd. v. The Queen, [1984] 1 S.C.R. 536; Murphy v. The Queen (1980), 80 D.T.C. 6314; Bronfman, A. v. M.N.R., [1965] C.T.C. 378.
Statutes and Regulations Cited
Business Corporations Act, R.S.S. 1978, c. B‑10, ss. 6(1)(c)(i), 24(3)(b), (4), 27, 40, 97(1), 170(1)(c), 234.
Canada Business Corporations Act, S.C. 1974‑75, c. 33.
Companies Act, R.S.C. 1952, c. 53.
Income Tax Act, S.C. 1970‑71‑72, c. 63, ss. 56(2), 248(1).
Authors Cited
Boivin, Michelle. "Le droit aux dividendes et le dividende "discrétionnaire"" (1987), 47 R. du B. 73.
Bryden, R. M. "The Law of Dividends", in Jacob S. Ziegel, ed., Studies in Canadian Company Law. Toronto: Butterworths, 1967.
Eisenberg, Melvin A. "The Legal Roles of Shareholders and Management in Modern Corporate Decisionmaking" (1969), 57 Cal. L. Rev. 1.
Fraser, William Kaspar. Company Law of Canada, 5th ed. By J. L. Stewart and M. Laird Palmer. Toronto: Carswells, 1962.
Goodman, S. H. Comment. "The Last Bastion for Income‑Splitting? J.A. McClurg v. The Queen" (1986), 34 Can. Tax J. 404.
Martel, Maurice and Paul Martel. La compagnie au Québec, Les aspects juridiques, vol. I. Montréal: Wilson & Lafleur Ltée, 1987.
Quessy, Pierre. "Les aspects corporatifs et fiscaux des actions à dividende discrétionnaire", [1985] 7 R.P.F.S. 31.
Schmitthoff, Clive M. Palmer's Company Law, 23rd ed., vol. 1. London: Stevens & Sons, 1982.
Wegenast, F. W. The Law of Canadian Companies. Toronto: Carswells, 1979.
Welling, Bruce. Corporate Law in Canada. Toronto: Butterworths, 1984.
APPEAL from a judgment of the Federal Court of Appeal, [1988] 2 F.C. 356, 84 N.R. 214, [1988] 1 C.T.C. 75, 88 D.T.C. 6047, affirming a judgment of the Federal Court, Trial Division (1986), 2 F.T.R. 1, 86 D.T.C. 6128, reversing a decision of the Tax Court of Canada, [1984] C.T.C. 2469, 84 D.T.C. 1379, dismissing respondent's appeal from a notice of reassessment. Appeal dismissed (Wilson, La Forest and L'Heureux‑Dubé JJ. dissenting).
Ian S. MacGregor and Brent Paris, for the appellant.
Robert W. Thompson and Gordon Balon, for the respondent.
The judgment of Dickson C.J. and Sopinka, Gonthier and Cory JJ. was delivered by
//Dickson C.J.//
DICKSON C.J. -- This is an income tax case. The question in the appeal is whether certain dividends received by the wife of the respondent, Jim A. McClurg, in the years 1978, 1979, and 1980 in respect of Class B common shares of Northland Trucks (1978) Ltd. (hereinafter Northland Trucks) should be attributed in part to the respondent, an officer and director of Northland Trucks and the holder of the controlling Class A common shares in the capital stock of that company.
I. Background
1. Relevant Legislation
Income Tax Act, S.C. 1970-71-72, c. 63:
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.
Business Corporations Act, R.S.S. 1978, c. B-10:
24. ...
(4) The articles may provide for more than one class of shares and, if they so provide:
(a)the rights, privileges, restrictions and conditions attaching to the shares of each class shall be set out therein; and
(b)the rights set out in subsection (3) shall be attached to at least one class of shares but all such rights are not required to be attached to one class.
40. A corporation shall not declare or pay a dividend if there are reasonable grounds for believing that:
(a)the corporation is, or would after the payment be, unable to pay its liabilities as they become due; or
(b)the realizable value of the corporation's assets would thereby be less than the aggregate of its liabilities and stated capital of all classes.
97.--(1) Subject to any unanimous shareholder agreement, the directors of a corporation shall:
(a)exercise the powers of the corporation directly or indirectly through the employees and agents of the corporation; and
(b)direct the management of the business and affairs of the corporation.
234.--(1) A complainant may apply to a court for an order under this section.
(2) If, upon an application under subsection (1), the court is satisfied that in respect of a corporation or any of its affiliates:
(a)any act or omission of the corporation or any of its affiliates effects a result;
(b)the business or affairs of the corporation or any of its affiliates are or have been carried on or conducted in a manner; or
(c)the powers of the directors of the corporation or any of its affiliates are or have been exercised in a manner;
that is oppressive or unfairly prejudicial to or that unfairly disregards the interests of any security holder, creditor, director or officer, the court may make an order to rectify the matters complained of.
2. The Facts
The respondent is President of Northland Trucks, a company incorporated under the Saskatchewan Business Corporations Act. The company was established in 1978 upon purchase of an ongoing business, a dealership in International Harvester trucks. The respondent and his partner, Veryle Ellis, are the only directors of the company. The Articles of Incorporation provide for three categories of shares: Class A which are common, voting and participating shares; Class B which are common, non-voting and participating where authorized by the directors; and Class C which are preferred, non-voting shares. The Articles deal with the entitlement to dividends as follows:
Class A Common:
Common, voting and shall be participating shares carrying the distinction and right to receive dividends exclusive of the other classes of shares in the said corporation.
Class B Common:
Common, non-voting and shall be participating shares where authorized to be participating shares by unanimous consent of the Directors and the said shares shall carry the distinction and right to receive dividends exclusive of other classes of shares in the said corporation.
Class C Preferred:
Preferred, non-voting shares which carry the distinction and right to receive dividends exclusive of other classes of shares in the said corporation, if the said dividends are authorized by unanimous resolution of the directors.
Each class of shares has the right to receive dividends exclusive of other classes of shares in the company and the company is authorized to issue an unlimited number of shares in each class.
The clause "the distinction and right to receive dividends exclusive of other classes of shares in the said corporation" in the definition of the share classes is crucial to the analysis in this case; a primary question is whether the clause, which gives to the directors unfettered discretion as to the allocation of dividends among classes of shares, constitutes a valid derogation to the common law rule of equality of distribution of dividends. For the sake of simplicity, I will refer to it as the "discretionary dividend clause" throughout these reasons.
Shares in the company were issued at a price of $1.00 each, and the distribution of shares demonstrates the closely held nature of the company:
NAME
CLASS A
COMMON
CLASS B
COMMON
CLASS C
PREFERRED
Jim McClurg
400
-
37,500
Veryle Ellis
400
-
37,500
Wilma McClurg
(wife of Jim McClurg)
-
100
-
Suzanne Ellis
(wife of Veryle Ellis)
-
100
-
In the years 1978, 1979, and 1980, the directors, McClurg and Ellis, voted a declaration and distribution of dividends as follows:
NAME
1978
1979
1980
Jim McClurg
-
-
-
Veryle Ellis
-
-
-
Wilma McClurg
$10,000
$10,000
$10,000
Suzanne Ellis
$10,000
$10,000
$10,000
The form of resolution declaring the dividends was as follows:
It was noted and unanimously agreed by all the Directors that Class "B" Shareholders receive dividends in the amount of $100.00 per share for each issued share they hold.
BE IT RESOLVED
that payment of dividends to Class "B" Shareholders are made as follows:
CLASS "B" SHAREHOLDER
NUMBER OF ISSUED
SHARES
DIVIDEND
PER SHARE
TOTAL
PAID
Wilma McClurg
Suzanne Ellis
100
100
$100.00
$100.00
$10,000.00
$10,000.00
Although the two directors received no dividends on either their Class A or Class C shares during this three-year period, they did not go unrewarded. They received salaries, were paid bonuses, and bonus entitlements totalling, according to the trial judge, in the case of the respondent, $33,968 in 1978, $65,292 in 1979, and $57,900 in 1980. As well, the company's retained earnings as of October 31, 1980 were $312,611 and as of October 31, 1981 were $421,481. The directors of the company, as owners of the Class A shares (the only shares participating as of right), alone were entitled as of right to share in the accumulated profits of the company.
An analysis of the equity of the two classes of shares is shown below:
Class A Class B
Shares Shares
Shares Issued 800 200
Amount Paid 800 200
Dividends Received NIL 60,000
Growth Accruing to shares to Oct. 31, 1980312,611 NIL
Submissions attached with the Notice of Objection of Mr. McClurg for the 1978, 1979 and 1980 taxation years show that at the end of the 1981 taxation year, the equity (growth) per share stood at $527 per share for Class A common shareholders (an amount of 1.75 times that of Class B shares) whereas the total growth (equity) accruing to Class B common shares still remained at $300 per share.
Total
Reimbursement
to Oct. 31/81
Equity Growth
Retained to
Oct. 31/81
Total
Total $
Per Share
Owned
%
Jim McClurg
224,700
210,741
435,441
1,088.62
45
Veryle Ellis
224,700
210,741
435,441
1,088.62
45
Wilma McClurg
48,125
NIL
48,125
481.25
5
Suzanne Ellis
48,125
NIL
48,125
481.25
5
545,650
421,482
967,132
100
The financing of the formation of the company must also be reviewed. For the respondent's investment of 37,500 preferred shares, he borrowed $37,500 from the Toronto Dominion Bank on a note co-signed by his wife and his father-in-law. The latter provided further security in the form of a term deposit certificate totalling $40,000. The purchase of the business was partly financed by a loan from the vendor, security for which was provided, in part, by the respondent and his wife through the placing of a second mortgage on their jointly owned home in the amount of $25,000. Furthermore, Wilma McClurg co-signed with the respondent a personal guarantee to the International Harvester Company, the supplier of the company, with respect to a $500,000 debenture in connection with the business affairs of Northland Trucks. Finally, the company opened a line of credit with the Toronto Dominion Bank, initially for $50,000, and later increased to $200,000, which was guaranteed by all of the shareholders. It is worth noting that the trial judge found that Wilma McClurg had personal assets of between $15,000 and $20,000 during this time, which indicates that her personal guarantee was not without significance.
The role of Wilma McClurg in the business during the period in question also warrants examination. The evidence indicates that she carried the title of Administrative Assistant. As such, she assisted in the operation of the business, performing a variety of tasks as the need arose -- including stenography, bookkeeping, stocktaking, and driving a truck. For her efforts she received a salary of $625 in 1978, $5,000 in 1979, and $5,000 in 1980. Of the $30,000 received by Wilma McClurg in dividends during this period, $20,000 was reinvested by her in M.E. Investments Corporation, a company with a similar structure to that of Northland Trucks and which involved the same shareholders and directors. The purpose of M.E. Investments Corporation was the acquisition of land upon which the operations of Northland Trucks were located. In acquiring the land, a first mortgage was given. Wilma McClurg was a personal guarantor of the mortgage.
On January 14, 1982, by notices of reassessment, the Minister of National Revenue reassessed the respondent's income for 1978, 1979, and 1980. The basis for the reassessment was that in each of those years $8,000 of the $10,000 in dividends attributed to Wilma McClurg on her Class B shares was properly attributable instead to the respondent pursuant to ss. 56(2) of the Income Tax Act. The Minister made this reallocation on the basis of the number of Class A shares owned by the respondent in relation to the number of Class B shares owned by Wilma McClurg. The position of the Minister is that the dividends declared in each of the years in question should be attributed equally to all of the common shares, no matter of what class and notwithstanding the express condition attaching to the Class B shares that they shall carry the right to receive dividends exclusive of other classes of shares in the company. The respondent's appeal to the Tax Court of Canada was dismissed. The respondent further appealed from the decision of the Tax Court judge by way of an action commenced in the Federal Court of Canada, Trial Division. The appeal was allowed. The Minister's appeal to the Federal Court of Appeal was dismissed. Finally, leave to appeal was granted by this Court.
3. Judgments Below
Tax Court of Canada, 84 D.T.C. 1379
Goetz T.C.J. found no evidence suggesting that the investment of Wilma McClurg in the company was of any importance. He reasoned that the respondent and his partner had full control of the company and he concluded, at p. 1381, that the share structure was solely an income splitting device:
To my way of thinking the share set up and the establishment of the Class "B" shares was a channel of Northland to funnel payments of profits to the Appellant's wife and this was to the Appellant's tax benefit and is prohibited by section 56(2).
Goetz T.C.J. concluded, at p. 1381, that the dividends were a "blatant effort" at conferring a benefit on the wives of the directors and he further remarked, at p. 1382, that "the wives were the puppets of the Appellant and Ellis and did as they were told". Finally, he determined that the efforts expended by Wilma McClurg and her exposure under the guarantees had no relevance to the payment of dividends. He dismissed the appeal from the reassessment.
Federal Court of Canada - Trial Division 1986, 2 F.T.R. 1
Strayer J. began by considering the interpretation of s. 56(2), and he found, at p. 4, that its literal meaning could require that "every dividend paid to any shareholder of a company could be attributed to the income of directors participating in a decision to pay the dividend". He continued:
Such a dividend would be a "payment" "to some other person" with the "concurrence" of the director. It could also be described as a "benefit" that the director "desired to have conferred" on the shareholder, it surely being desirable from the viewpoint of directors that, where ever possible, dividends be paid to the shareholders of the company in order to enhance their satisfaction with the company.
Strayer J., reasoned, however, that the intention of the legislature could not have been such a broad reading and found the subsection qualified in that, to fall foul of s. 56(2), the taxpayer must seek to avoid receipt of funds that would otherwise be payable to him and that the concept of payment of a "benefit" is to be contrasted with payments for consideration.
In the opinion of Strayer J., it could not be said that money payable to the respondent was diverted to his wife so as to bring the situation within s. 56(2). He was not persuaded that the Articles of Incorporation must be regarded as void in so far as they permit differential payment of dividends to various classes of shareholders. Nor did he see any legal impediment to a contract between the shareholder and the company which allows the directors of the company to fix the amount of dividends payable in a given year to a given class of shareholders. Since no dividends were payable as a matter of right to holders of Class A shares, such as the respondent, without a resolution to that effect being adopted by the directors, it could not be said that money payable to him was diverted to his wife so as to bring the situation within s. 56(2).
Strayer J. also was satisfied that the dividends paid to Wilma McClurg were not a "benefit" within the contemplation of s. 56(2). The dividends were paid within the context of a legal relationship between the shareholder and the company pursuant to which she was entitled to receive dividends as declared from time to time by the directors. The surrounding circumstances suggested to him, at p. 5, that "this was a legitimate business relationship created by all the necessary legal instruments and should not be treated as a sham". Wilma McClurg had made a real contribution to the establishment of the business through her personal guarantee and the share of the mortgage she assumed on the house she owned jointly with the respondent. Furthermore, she had taken an active part in the operation of the business for which she was paid only a small salary. The appeal was allowed.
Federal Court of Appeal, [1988] 2 F.C. 356
The majority judgment at the Federal Court of Appeal was delivered by Urie J. and was concurred in by Heald J. Urie J. began by expressing a difficulty in appreciating how s. 56(2) could apply in a corporate context. A corporation provides to its shareholders, by way of dividends, such portion of its earnings as its directors deem advisable. Those directors do so in their capacities as directors and not in their personal capacities, no matter how closely held the corporation's shares. Urie J. had further difficulty understanding how "a taxpayer," when acting as a director, satisfies any of the conditions precedent for the application of s. 56(2). He reasoned, at p. 363, that:
Only the most explicit language, which is not present in subsection 56(2), would justify the notion that a director acting as such could be seen as directing a corporation to divert a transfer or payment for his own benefit or the benefit of another person, absent bad faith, breach of fiduciary duty or acting beyond the powers conferred by the share structure of the corporation, none of which bases have been alleged here.
Furthermore, Urie J. felt that applying s. 56(2) in a corporate context would make no distinction between arm's length and non-arm's length transactions, leaving all directors at risk of having dividends declared by them, and paid to shareholders who may be relatives, attributed to them for tax purposes. He concluded that the section was not intended to apply to the directors of corporations participating in the declaration of corporate dividends. He dismissed the appeal.
Desjardins J. dissented at the Court of Appeal. She began by observing that, unless otherwise provided in the Articles of Incorporation or by statute, the rights of the classes of shareholders to receive dividends are to be assessed on a basis of equality. She disagreed with Strayer J.'s conclusion that the description of the dividends found in the Articles of Incorporation constituted a "derogation from the principle of equality amongst shareholders recognized in the common law" (at p. 368), stating at p. 369:
What happens in the case at bar is that shareholders in each class are given "the distinction and right to receive dividends to the exclusion of other classes". From that perspective, they are all equal. Moreover, no mathematical formula is given if a distribution were to occur. . . . The directors obtain full control over the allocation if they declare dividends. . . .
I doubt that such a discretion to be exercised by way of a resolution of the directors, can be equated with a derogation specific and substantive enough to discard the common law rule of equality of distribution since there is no rule by which the directors are to carry out their discretion.
The moneys paid, in her opinion, ought to have been distributed equally amongst the shareholders and there should have been included in the respondent's income part of the dividends paid to his wife.
In rejecting the trial judge's conclusion that there was a legitimate business relationship between the respondent's wife and the company, Desjardins J. remarked that there is no relationship between the services that a shareholder brings to a company and his or her entitlement to a dividend. The dividends come as a return on investment and attach to the share, rather than to the shareholder.
Desjardins J. was not persuaded that s. 56(2), if interpreted widely, would cover every declaration of dividends. Once declared, the amount of the dividend received on each share is governed by a mathematical formula which the director must apply in accordance with the contract between the shareholders and the company.
II. Analysis
This appeal raises issues relating both to corporate law and the law of income taxation. In my view, it is useful to deal with the former first as the analysis is beneficial in the determination of the application of s. 56(2) of the Income Tax Act.
1. Corp