SR&ED tax incentive regime is not sufficient to make Canada competitive globally

IP is an intangible asset and is as such moveable once you have the proper valuation  and proper transfer pricing documentation in place to a lower tax jurisdiction.  Of course proper structuring must be ensured so that the move does not trigger the Foreign Affiliate Passive Income (FAPI) rules of the Income Tax Act. The moveability of IP and the combination of  Canada's exempt surplus regime enables active foreign business income derived from the commercialization of the IP - to return to Canada on a tax-free basis.

However removing IP and commercializing it offshore however does not make for a viable economy.  This is why countries such as the United Kingdom, the Netherlands, China and Ireland have implemented what is referred to as "a patent box regime" to ensure that their IP does not go offshore and alternatively to attract IP to their shores.

The patent box regime was established in Ireland as early as 1973.  The patent box regime in essence taxes income derived from IP at a very low tax rate which can be as low as 2.4% (Ireland) if planned correctly. This is why names we are all familiar with are in Ireland (Dell, HP, Google to name a few easily recognizable names).  The United States similar to Canada has not adopted the patent box regime hence the easily recognizable American names.  

In Canada, our tax legislation (the Income Tax Act) encourages the development of IP through the SR&ED program.  A program not without flaws as highlighted in the Jenkins Report.  Some of the flaws pertain the difficulty in obtaining SR&ED credits.  CRA has listened and has undertaken steps to improve the SR&ED Investment tax credit process by implementing for 2013 a pre-approval process  so as to combat the difficulty in filing for SR&ED investment tax credits after R&D expenses have been incurred.  However the focus of the SR&ED program does little to encourage firms  here in Canada to maintain their IP here in Canada or to commercialize their IP here once developed resulting in transfer of the IP to a low tax jurisdiction and to the commercialization of the IP offshore.

Government Assistance or Loan?

Reproduced from the August 2013 edition of the Canadian Tax Highlights, a Canadian Tax Foundation publication

SR&ED activities are often funded by governmental programs such as the federal Industrial Assistance Research Program (IRAP). A successful SR&ED claim cannot be based on funds that were extended as government assistance and those funds cannot generate refundable investment tax credits. “Government assistance” is defined to mean assistance from a government, municipality or other public authority whether as a grant, subsidy, forgivable loan, deduction from tax, investment allowance or any other form of assistance other than” the federal investment tax credit (subsection 127(9)). A loan is government assistance only if it is a forgivable loan. The difference is considered by the TCC in Immunovaccine Technologies Inc. (2013 TCC 103), which concluded that funds extended by the Atlantic Canada Opportunities Agency (ACOA), a federal agency, constituted government assistance and not a bona fide loan. An appeal to the FCA was filed on May 10, 2013.

The decision sets out the contribution agreement between ACOA and the taxpayer on December 31, 2004, which specifies that the taxpayer must repay the ACOA contribution in annual installments calculated as a percentage of all gross revenues from any source. The first repayment was due on December 1, 2008 and repayment was to continue until the contribution was repaid in full. Each repayment was 2 percent if annual gross revenue in the immediately preceding year was less than $5,000,000 and 10 percent if gross revenue was more. No security was provided to ACOA if the contribution could not be repaid; no interest was charged. The agreement also further provided that if the taxpayer did not generate gross revenue, the agreement terminated upon the ACOA’s consent without any further repercussions to the taxpayer. The taxpayer acknowledged that it did not receive any other federal, provincial, or municipal financial assistance other from the ACOA. On numerous occasions, the agreement referred to the ACOA funding as a contribution.

The taxpayer said that the agreement’s reference to its termination if the taxpayer did not generate gross revenues merely reflected the business reality for all start-ups and business ventures: a loan or investment was not recoverable if the company was not successful. The taxpayer also argued that the contribution was a loan. Furthermore, the taxpayer said that the phrase “any other form of assistance” at the end of the government assistance definition should be read ejusdem generis with the preceding examples enumerated: the catch-all phrase only encompassed the extension of funds for which there was no expectation of repayment. Because on the facts the agreement provided for the funding’s repayment, it was not caught in the catch-all phrase “any other form of assistance” in the definition of government assistance.

The TCC disagreed, saying that the addition of the term “forgivable loan” in the enumerated items made it clear that the definition of government assistance extended beyond government acts that were purely gratuitous and unilateral. According to the court, the real test was set out in CCLC Technologies ([1996] FCJ No. 1226) in which the FCA focused on whether the contribution made by the government body was made “in exactly the same way for exactly the same reasons as payments made by private business, that is, for the purpose of advancing the interests of the payor”. In CCLC  the government of Alberta contributed funds in return for equity in the taxpayer`s technology development project.  The province agreed that if the technology became commercially successful, the province would sell back its equity for a price equal to the funds contributed plus interest. The FCA concluded that the funds extended by Alberta were government assistance: the agreement between the taxpayer and the province did not give the province any lasting property rights in the technology if the venture became commercially valuable. That was an arrangement, the court said, that an entity would not enter into to advance its business interests. On the facts in Immunovaccine Technologies, the TCC concluded that the fact that ACOA could not receive any net profit on the money invested in the appellant's ventures, combined with ACOA's objectives under the ACOA Act, made it clear that ACOA was not dealing with the taxpayer on basic commercial terms and was not acting in its own business interests. 

The TCC looked to the statutory context relating to the deductibility of SR&ED expenses and the related ITCs, under which the deductions and credits are deferred until the government assistance is repaid, This scheme, said the court, “reflect[s] Parliament's intention to restrict access to tax relief for SRED expenditures and to refundable investment tax credits (ITCs) where relief was provided in some other form. In other words, if another party has borne the economic cost of a taxpayer's participation in scientific research and experimental development, there is no need to allow deductions or credits as an incentive for that taxpayer to engage in SRED activities.” The scheme could only buttress the court’s conclusion that the funding was government assistance, because the rules outlined only operate in respect of government assistance.

The court also reviewed the ACOA legislation and concluded that although the ACOA was given a broad array of powers to enable it to achieve its objectives, it was not authorized to carry on business. ACOA’s  main objective was to strengthen the local economy in Atlantic Canada by “supporting the development of knowledge-based industry” and “help[ing to] increase the region’s capacity to carry out leading-edge research and development.” The court concluded that ACOA was not acting in its own business interest, a fact underscored because it could not receive any net profit on the contribution to the taxpayer’s ventures and also by the ACOA objectives as set out in the governing legislation.

Government assistance that is used in SR&ED activities and not repaid in the year of a SR&ED claim does not qualify as deductible SR&ED expenses or as refundable ITCs. However, if the assistance is repaid by the claimant, paragraph 37(1)(c) provides that the deductible expenditure pool for SR&ED activities in the year of repayment is increased by the amount by which the pool was previously reduced. Similarly paragraphs 127(9)(e.1) and (e.2) of the ITC definition allow the claimant to include an amount repaid in the year of repayment in order to calculate his ITC.

On the advice of its auditors and accountants the taxpayer sought unsuccessfully from ACOA an amendment to the agreement to require repayment on a fixed monthly repayment schedule instead of repayment based upon a percentage of gross revenues. The fixed monthly repayment amount would have been added under paragraph 37(1)(c) to the deductible expenditure pool for SR&ED activities and included in the ITC calculation under paragraph 127(9)(e.1) and (e.2).

Sunita Doobay

TaxChambers, Toronto

“Including GST” Does Not Mean GST Included

Reproduced from the September 2013 edition of the Canadian Tax Highlights, a Canadian Tax Foundation publication

In Global Learning Group Inc. v. Eskasoni First Nation (2013 ONCA 325), the Ontario Court of Appeal (ONCA) concluded that a fee described as “including GST” did not mean that it included  any GST. The purchaser had argued unsuccessfully that because it was tax-exempt, it should receive a discount from the stated fee.

Global provided fundraising services to the Eskasoni First Nation. The contract stated that Global’s fee was “15 percent (including GST)” of the gross funds raised. The Eskasoni First Nation is an Indian band under the Indian Act and is thus not subject to the imposition of the GST on goods or services provided to it. The band claimed that because GST was not chargeable on the services provided to it, the words “including GST” must be interpreted to mean that the band was entitled to a discount from the fees payable to Global in an amount equal to the GST that would have been collected from a taxable recipient of the fundraising activities.

The band argued that the words “including GST” imply that the actual fees are less than the 15 percent quoted because the 15 percent includes 5 percent GST. Thus, for an exempt client such as the Eskasoni First Nation, the band argued that the contract should be interpreted as requiring an equivalent discount to arrive at the amount that exempt client must pay.

A unanimous ONCA disagreed and dismissed the appeal. The court said that the phrase “including GST” meant that there was no GST in the fee because the band was tax-exempt: the contract’s wording did not mandate different treatment for exempt and non-exempt clients. The phrase did not imply that a discount should be allowed to the band: the amount payable to Global was referred to in the contract as a percentage of the funds raised, and the band was not being asked to pay more than it had agreed to pay. The contract also provided that the Eskasoni band was not responsible for remitting the GST.

We agree with the court that a discount should not be allowed to the band. However, it appears that the phrase “including GST” does not refer to the (nil) GST rate payable by the tax-exempt band; rather, it indicates that Global was collecting a fee that included GST at the regular 5 percent rate regardless of the band’s exempt status. The phrase “including GST” is not ambiguous and is understood by practitioners to include the 5 percent GST rate. The parties were unlikely to have considered band’s exempt status when arriving at the wording of the clause, which was probably standard in all of Global’s contracts. 

Instead of litigating to seek a discount, the band should have sought a GST rebate from the minister under subsection 261(1) of the Excise Tax Act. Global was contractually obliged to remit the GST on the fees collected. GST (or HST) that is shown on the documentation between the parties must be remitted by the supplier even if there was no tax payable by the purchasers. In Gastown Actors' Studio Ltd. (2000 CanLII 16656), the FCA said that “a taxpayer who has . . . collected GST, whether for services that are taxable or for services that are later determined to be exempt supplies, must remit those amounts and is liable to be assessed if they are not remitted.”

Sunita Doobay

TaxChambers, Toronto

Darcy L. MacPherson

Faculty of Law, University of Manitoba

Foreign Tax Credit for Franchise Tax

Reproduced from the June 2013 edition of the Canadian Tax Highlights, a Canadian Tax Foundation publication

Ruling 2011-0428791E5, dated May 11, 2012, concluded that a US state franchise tax – the name of the state was not disclosed - qualified for a foreign tax credit under the Act. The taxpayer did not have a US PE and was thus treaty exempt from US federal tax.

A Canco that expands into the United States is often subject to state tax despite structuring to avoid a US PE and thus US federal tax. Several US states – such as Florida and Michigan - voluntarily adhere to the treaty and do not impose a corporate income tax if the taxpayer is treaty exempt from federal taxation. Federal public Law 86-272 grants further protection against state corporate income tax: a state cannot levy an income tax on income derived by an independent agent who solicits orders for tangible goods warehoused outside the state if the contracts are concluded outside the state.  However, a state may impose a non-income tax or an income tax on income generated from sales within a state of tangible or intangible personal property.

To ensure that foreign income is not subject to double taxation, the foreign tax credit in section 126 of the Act allows a credit for income tax paid to foreign jurisdiction against Canadian income tax otherwise payable.  The foreign tax must be levied against income and paid to the government of a foreign country or its state, province, or other political subdivision.  The credit applies to a foreign tax levied on business and non-business income, and some exceptions are provided in the Act and in the Canada-US treaty for non-income taxes. Subsection 126(5), for example, allows a foreign tax credit for some oil and gas levies and the Canada–US treaty allows a credit for US estate tax.  A foreign tax that is not creditable may be deductible as an expense under subsection 9(1) if incurred for the purpose of earning income. 

In the ruling the CRA said that a foreign tax credit is available for a business-income tax on income or profits if the tax is paid to a foreign government (including a state) and can reasonably be regarded as being in respect of income from a business carried on by the taxpayer in the foreign country. To be creditable the foreign tax must be substantially similar to the income tax imposed under the Act and thus must be levied on net income or profits. The CRA is of the view that a state tax that is determined as a percentage of the Canco’s allocated net income is an income or profits tax and is thus eligible for the business-income foreign tax credit. This assumes that a business is carried on in the state and the ruling contains a list of relevant factors to determine whether a business is carried on in a particular place, such as the place where the contract is made – including decisions to purchase or sell – and where goods are delivered or payments made. In determining net foreign business income, the CRA notes that the determination is made under subsection 126(9) and is not the income allocated to the particular state using the three-factor formula.  The CRA went on to discuss the application of the treaty, whose primary purpose, it says, is the minimization of double taxation. The CRA noted that taxation of a corporation’s business profits in a place where no PE exists is contrary to the treaty source rules and article XXIV(7) provides that the treaty does not extend relief for a tax that is levied in a manner inconsistent with the treaty. However, relief from the particular state tax appears to be provided under the Act’s foreign tax credit system and thus treaty article XXIV generally does not reduce the foreign tax credit available under the Act.

US state franchise taxes are not structurally uniform and thus  care should be taken not to assume that a foreign tax credit is available for all franchise taxes. A franchise tax is generally based on the income earned within the state but in some instances is a flat fee or a capital tax.  For example, Delaware does not impose a corporate income tax but does levy a franchise tax on corporations incorporated in Delaware based on a corporation’s capital. The franchise tax in the ruling was calculated as a percentage of Canco`s allocated net income from the carrying on of a business in the state and thus qualified as a business income tax.    

Sunita Doobay

TaxChambers, Toronto

Intent in Service Contract

Reproduced from the May 2013 edition of the Canadian Tax Highlights:

Wiebe Doors (87 DTC 5025 (FCA)) sets out four factors to determine a service provider’s status as an independent contractor or an employee: control, ownership of tools, chance of profit or risk of loss, and integration. More recently the parties’ expressed intent has been added as a factor (Wolf, [2002] 4 FCA 96, and The Royal Winnipeg Ballet, 2006 FCA 87), but the evidentiary weight attached to intent has been unclear. The FCA decision in 1392644 Ontario Inc. O/A Connor Homes (2013 FCA 85) clarifies the impact of the parties’ expressed intent.

Connor Homes operated foster homes and group homes and provided care for children with serious behavioral and development disorders via child and youth workers, social workers, certified therapists, and psychologists. Written contracts stipulated that those individuals were independent contractors and not “entitled to any benefits” and were responsible for payments such as Canada pension, employment insurance, and taxes. Connor Homes unsuccessfully argued that the contract alone should determine the classification of an individual rendering services, without reference to the four factors of Wiebe Doors. 

The SCC in Sagaz Industries Canada Inc. ([2001] 2 SCR 983) upheld the four-prong test in Wiebe Doors and never considered the agreement’s expressed intent. However, several years later and after  intent had been established as a relevant consideration, Bowman, J. in Lang et al (2007 TCC 547) summarized four different approaches to the treatment of intent:  

(a)    Intent is determinative (Royal Winnipeg Ballet). (Bowman, J. himself said that the decision did not suggest that the matter was that simple.)

(b) Wiebe Door is all that is needed and intent need not be considered (Sagaz,

     Wiebe Door and Precision Gutters).

(c) The Wiebe Door test does not point conclusively in any direction and so

      intent is a tie-breaker (Wolf and City Water).

(d) Common sense, instinct and a consultation with the man 

     on the Clapham omnibus.

The characterization of an employee-employer relationship has far-reaching legal and practical ramifications as stated both by the full FCA in Connor Homes and by the FCA dissent in Royal Winnipeg Ballet. The latter pointed out that the parties’ statement in the contract can be viewed as self-serving and made with a view to achieve their ultimate objective such as an EI premium exemption.  However, the dissent went on to say:

… parties to contracts… are often not in equal bargaining positions. To attribute appreciable weight to a statement in the contractual document signed by the parties that the contract is one for the supply of services may disadvantage the more vulnerable party…[whose] contractual status and consequently her statutory rights may also be prejudiced by the stronger party’s legal characterization of the contract…[Moreover] the legal characterization of a contract may have an impact on third parties, such as the victim of a tort committed by a service provider in the course of performing the contract or, as in this case, Revenue Canada. Not to base legal characterization squarely on the terms of the contract, interpreted contextually, may jeopardize those interests and undermine non‑voluntary protective statutory programs, such as EI and CPP.

The FCA in Connor Homes clarifies that characterization of the relationship is very important in diverse areas such as tort law, social programs, labour relations, and taxation, and therefore the determination cannot be left to the sole subjective discretion of the parties. Thus intent is not determinative. The court summarizes a passage from its majority decision in Royal Winnipeg Ballet:

As a result, Royal Winnipeg Ballet stands for the proposition that what must first be considered is whether there is a mutual understanding or common intention between the parties regarding their relationship. Where such a common intention is found, be it as independent contractor or employee, the test set out in Wiebe Door is then to be applied by considering the relevant factors in light of that mutual intent for the purpose of determining if, on balance, the relevant facts support and are consistent with the common intent.

The FCA in Connor Homes sets out two steps to determine whether an individual is performing services as an employee or as an independent contractor. (1) Establish each party’s subjective intent, determined by the written contractual relationship or by their actual behaviour, such as invoices for services rendered, registration for GST purposes, and filing for income tax as an independent contractor. (2) Determine whether objective reality supports the parties’ subjective intent by applying the four factors in Wiebe Door.

On the facts in Connor Homes the FCA concluded that the parties’ subjective intent as expressed in the contracts was to enter into independent contractor relationships; however, application of the factors in Wiebe Door showed that employee-employer relationships had been established. The FCA found the taxpayer exerted significant control over the activities of the individuals rendering services. Service providers had to strictly adhere to a policy and procedures manual. Furthermore the taxpayer dictated the individuals’ duties daily and guided and instructed the service providers on managing difficult situations with clients. The use of a personal vehicle to transport some of the children was not an overweighing factor.

Sunita Doobay

TaxChambers, Toronto

Darcy L. MacPherson

Faculty of Law, University of Manitoba 

Tax Consequences of Carrying on Business through a Disregarded Entity in the United States

Reproduced from the April edition "Private Companies and Taxes"

It is common for Canadian corporations when expanding into the United States to conduct their U.S. operations through a Delaware Limited Liability Company (“LLC”) or through a Nevada LLC.  This article will discuss the tax consequences of utilizing an LLC.

An LLC is an American hybrid structure inspired by the Limited Liability Partnership structures of Central and South America which are often referred to as “Limitada”.  An LLC combines the characteristics of a corporation with that of a limited partnership. The LLC has similarities to a corporation or a limited liability partnership as it provides a shield for a member’s personal assets from creditors of the LLC.  Owners of an LLC are referred to as members and can be individuals, corporations or other LLCs.  Generally, members do not have to be residents of the U.S. and there is usually no limit on the number of members.  Most States also allow for a single member LLC.  LLC legislation differs from State to State with the result that each State may impose different eligibility requirements to form an LLC. State taxation of LLCs also differs from State to State.

An LLC with only one member will be treated as a disregarded entity for U.S. income tax purposes unless the LLC elects to be treated as a corporation on I.R.S. Form 8832.  An LLC with two or more members is treated as a partnership unless it elects otherwise on Form 8832.  A disregarded entity’s activities are treated in the same manner as a sole proprietorship, branch, or division of its owner (IRC Reg. 301-7701-2(a)).

Illustration

LLC carries on an active business selling widgets manufactured in Canada to arm length customers in the U.S. It also earns royalty income from a licensing agreement with U.S. widget manufacturers.  In 2012, LLC earned $100,000 net from selling widgets and LLC also earned $50,000 in royalty income.  For purposes of the illustration, it is assumed that Canada considers the LLC to be a U.S. corporation and that the LLC is not deemed to be Canadian Corporation under the mind and management rules.

  

Canadian Tax Treatment

For Canadian income tax purposes the LLC is deemed to be a U.S. corporation and a controlled foreign affiliate (“CFA”) of Canco. 

The characteristic of the income earned by the CFA will determine the tax treatment accorded to the income in Canada.  Under the Foreign Affiliate Rules contained in the Income Tax Act a foreign affiliate’s income can be from property, a business other than active business income or from the carrying on of an active business.  The first two sources of income are characterized as passive unless there are sufficient employees on the ground earning such income in the foreign jurisdiction to re-characterize the income as active.  The classification of passive versus active is important as this determines the treatment of the income in Canada.  Dividends from earnings of an active business carried on will be deemed to be from exempt surplus and will not be subject to Canadian income tax on repatriation.  Passive income, or as the Income Tax Act titles it, foreign accrual property income (“FAPI”) is taxed in the hands of the shareholder (which can be an individual or a corporation) when earned by the CFA.  In other words, one is taxed on FAPI income whether or not such income has been distributed.

In our example, CanCo will only need to include into income for its 2012 year end - $50,000 of the licensing income as this will be deemed FAPI income.  There is nothing in the facts that states that the licensing royalties are active business earnings.  Should LLC distribute the $100,000 as a dividend then the amount received in Canada will not need to be included into CanCo’s taxable income calculation, as it is traceable to earnings from an active business and is therefore derived from exempt surplus.

 

U.S. Tax Treatment

In the U.S. a non-U.S. person is subject to U.S. income tax where such person earns:

·         Income effectively connected to a U.S. trade or business;

·         Fixed or Determinable Annual or Periodical (“FDAP”) income which consists of passive income such as dividends, interest, rents, royalties.

The concept of “effectively connected” income, or ECI, is applicable only to a foreign (a Non-U.S.) corporation or a foreign (a Non-U.S.) individual engaged in a U.S. trade or business.  ECI is subject to the progressive tax rates of IRC §11 (corporate tax rates) or IRC §1 (individual tax rates).  Non-business income which is typically referred to as FDAP income is taxed at the flat rate of 30% under §881 (corporations) or under §871 where the taxpayer is an individual or at a lower tax treaty rate.  Under the Canada – U.S. Income Tax Convention (“Tax Treaty”) the 30% rate will be reduced to the Tax Treaty rate of 5% for dividends, 0% for interest and royalties for payments from a wholly owned subsidiary to its Canadian parent.

LLC as a branch will not only be subject to the graduated rates of IRC §11 on income earned in the US but it will also be subject to the branch profits tax which is imposed on its “dividend equivalent amount (“DEA”). The term DEA is a statutory defined term – see IRC §884(b) – and is intended to be equal to the amount that would have been distributed by the branch had it been a U.S. subsidiary. This article will not discuss the DEA calculation. LLC will be deemed to be remitting a dividend for each of its taxation years equal to the DEA even if it does not actually remit. The DEA is only levied on amounts surpassing $500,000 Canadian dollars (Treas. Reg. §1.884-1(g)(4)(iv)(B). Any amount over Cdn $500,000 will likely be subject to a 30% withholding tax pursuant to Article IV(7) which in essence denies treaty benefits to a Canadian owned LLC.

The royalty payment paid to U.S. LLC will, however, not be able to benefit from the reduced Tax Treaty rate pursuant to IRC §894(c) as such payments are deemed to not be to CanCo, but to a disregarded entity. See IRC Reg. §1.894-1(d)(1) which states:

The tax imposed by sections 871(a), 881(a), 1443, 1461, and 4948(a) on an item of income received by an entity, wherever organized, that is fiscally transparent under the laws of the United States and/or any other jurisdiction with respect to an item of income shall be eligible for reduction under the terms of an income tax treaty to which the United States is a party only if the item of income is derived by a resident of the applicable treaty jurisdiction.  …. An item of income paid to an entity shall be considered to be derived by the entity only if the entity is not fiscally transparent under the laws of the entity's jurisdiction ….

CanCo will therefore be subject to a 30% withholding tax on the $50,000 royalty income earned by LLC. 

The purpose of the above illustration is to outline the potential pitfalls when structuring operations through an LLC in the United States.  Practitioners often readily assume the LLC is a flow through for U.S. purposes but fail to take into consideration the punitive provision of IRC §894(c) and the CFA rules under the Income Tax Act where such LLC earns passive income.

Sunita Doobay

TaxChambers, Toronto

Sunita can be reached at sunita.doobay@taxchambers.ca

Interest Deduction Denied: Swirsky

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