In
Swirsky (2013 TCC 73) the TCC
concluded that interest paid on a loan incurred for the purpose of a share purchase
was not deductible under subparagraph 20(1)(c)(i). The decision touches upon the
issue of whether the gross expected dividend return on shares places a limit on
the deductibility of interest expense related to their purchase.
Mr.
Swirsky, the taxpayer, held shares in Torgan Construction Limited, a
corporation actively engaged in real estate development. The taxpayer incorporated
Torgan in 1974 and his wife became an equal shareholder a few years after their
marriage. The 1989 decline in the real estate market created the very real
possibility of bankruptcy to the taxpayer. Just before the market peaked, the
taxpayer and Mr. Cohen embarked on an ambitious development and each provided joint
and several personal guarantees to a bank. The project was cancelled and when the
taxpayer learned from Mr. Cohen that he was creditor proof, he had reasonable concerns
that the bank would seek to collect the entire loan amount under his personal
guarantee. The taxpayer sought to place the Torgan shares out of the lender’s
reach by selling them to his wife and by using the sale proceeds to pay down shareholder
loans that he owed to Torgan.
Torgan
had not made a practice of paying dividends and instead paid bonuses and
extended significant shareholder loans to the taxpayer to achieve the deductibility
of amounts paid out of its income. Arguably on the facts a preference existed,
because Mr. Swirsky knew that he was potentially facing bankruptcy, his wife believed
that bankruptcy was imminent, and the transaction was entered into to preserve
family income, but the court concluded that the transaction was an effective creditor-proofing
measure.
In Shell ([1999] 3 SCR 622) the SCC concluded that four requirements support
an interest deduction under paragraph 20(1)(c): (1) the amount must be paid in
the year or be payable in respect of the year of deduction; (2) the amount must
be paid pursuant to a legal obligation to pay interest on borrowed money; (3) the
borrowed money must be used for the purpose of earning non-exempt income from a
business or property; and (4) the amount must be reasonable in light of the
first three requirements.
The
TCC in Swirsky focused on the third
requirement: whether the borrowed money was used for the purposes of earning
non-exempt income. Based on Ludco, although
personal intention is not determinative, the TCC in Swirsky said that clearly the wife purchased the shares without any understanding
of their potential for income. And there was little objective history of the
payment of dividends on those shares before their transfer to the wife.
Interestingly, dividends were paid on the shares after their transfer. The TCC largely
ignored the post-transfer conduct, but pointed out that the first dividend paid
was a non-taxable capital dividend, and the first taxable income after the
shares’ transfer occurred in 2003, over seven years after the transfer’s final
stage. (The accountants advised to transfer the shares in three tranches in
order to match the shareholder loans outstanding.) According to the TCC, Ludco required that there must be a
reasonable expectation of income at the time that the investment was made.
On
the facts presented, there is a strong implication that the wife agreed to purchase
the shares in order to facilitate a creditor-proofing transaction, independent
of any desire to earn income. The TCC also concluded that the spouses agreed
between themselves that the wife would not be responsible for the loan costs.
The court concluded that thus it was more likely than not that the wife was not
concerned with the shares’ income-earning potential at the time of their
purchase.
The
TCC appears to be correct in concluding that based on a lack of dividend
history, a reasonable buyer could not anticipate income, and thus the wife had
no reasonable expectation of earning income from the shares acquired with the
loan. The wife’s lack of understanding of the economic consequences augments
the conclusion that there was no reasonable expectation of earning income from
the shares. Arguably a history of dividend payments prior to the transfer might
have resulted in a different conclusion because it would justify an objectively
supported and reasonable belief that the shares would earn income. However, the
focus on dividend payments as the predominant source of income from shares may
seem too narrow in the context or a personally held corporation, because many
taxpayers earn different types of income from a corporation, such as salary, bonuses,
loans, and dividends. Salary and bonuses are generally used to entice employees
to reach their top performance.
In
our view the TCC in Swirsky was correct to focus on dividends. The CBCA
provides two economic rights that must be allotted to classes of shares: the
right to receive any dividend declared by the
corporation and to receive the remaining property of the corporation on
dissolution. Other rights, such as a conversion right or a right of redemption,
attach to the share, not the shareholder (Bowater
Canada Ltd v RL Crain Inc (1987), 62 O.R. (2d) 752, 46 D.L.R. (4th) 161, 26 O.A.C. 348, 39 BLR 34). Thus while most other forms of
compensation, such as salary and bonuses, are tied to acts done on the
corporation’s behalf, dividends are the product of two factors. First, the
directors must decide to declare a dividend, further to their obligation to
manage the business and affairs of the corporation. Second, the shareholder
must own a share that has the right to participate in the dividend declared. If
both elements are present, the principle of equality demands that the share
receive the dividend (McClurg, [1990]
3 SCR 1020) and no further acts by the shareholder on the corporation’s behalf are
required to justify the payment of the dividend (Neuman, [1998] 1 SCR 770).
Sunita
Doobay
TaxChambers,
Toronto
Darcy L. MacPherson
Faculty of Law, University of Manitoba
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