Neuman v. M.N.R., [1998] 1 S.C.R. 770

Melville Neuman Appellant

v.

Her Majesty The Queen Respondent

Indexed as: Neuman v. M.N.R.

File No.: 25565.

1998: January 28; 1998: May 21.

Present: L’Heureux‑Dubé, Gonthier, Cory, McLachlin, Iacobucci, Major and Bastarache JJ.

on appeal from the federal court of appeal

Income tax -- Dividends -- Attribution -- Taxpayer incorporating family holding company for tax planning and income splitting purposes -- Taxpayer’s wife elected sole director of company -- Wife declaring dividends on her own and on taxpayer’s shares -- Whether dividend income received by wife should be attributed to taxpayer for income tax purposes -- Income Tax Act, S.C. 1970-71-72, c. 63, s. 56(2).

The appellant N incorporated a family holding company and immediately sold all of his shares in another company to it on a tax-deferred basis for the same number of Class “G” voting shares in the holding company. N’s wife was issued 99 non-voting Class “F” shares at $1 per share. At the first annual meeting of shareholders N’s wife was elected sole director of the holding company and N and his wife were appointed as officers. In 1982, the holding company received $20,000 in dividends on the shares it owned. A board of directors meeting was held at which N’s wife, pursuant to a discretionary dividend clause in the company’s articles of incorporation, declared a dividend of $5,000 to be paid on N’s Class “G” shares and another dividend of $14,800 to be paid on her own Class “F” shares. N’s wife immediately loaned him $14,800 and received a demand promissory note as security in return. N’s wife died in 1988. The loan was not repaid. The dividend income paid to N’s wife in 1982 was attributed to N as being a payment or transfer of property made pursuant to the direction of or with the concurrence of N as described in s. 56(2) of the Income Tax Act (ITA) and he was assessed tax on this income. N appealed his 1982 assessment to the Tax Court of Canada and in 1992 that assessment was vacated. The respondent appealed to the Federal Court, Trial Division without success, but a further appeal to the Federal Court of Appeal was allowed.

Held: The appeal should be allowed.

Section 56(2) of the ITA does not apply to the dividend income received by N’s wife. While s. 56(2) strives to prevent tax avoidance through income splitting, it is a specific tax avoidance provision and not a general provision against income splitting. It can only operate to prevent income splitting where the following preconditions to its application are specifically met: (1) the payment must be to a person other than the reassessed taxpayer; (2) the allocation must be at the direction or with the concurrence of the reassessed taxpayer; (3) the payment must be for the benefit of the reassessed taxpayer or for the benefit of another person whom the reassessed taxpayer wished to benefit; and (4) the payment would have been included in the reassessed taxpayer’s income if it had been received by him or her. McClurg v. Canada provides that as a general rule, s. 56(2) does not apply to dividend income since, until a dividend is declared, the profits belong to the corporation as retained earnings. The declaration of a dividend therefore cannot be said to be a diversion of a benefit which the taxpayer otherwise would have received. Such an entitlement requirement is consistent with the purpose of s. 56(2), which is to capture and attribute to the reassessed taxpayer receipts which he or she otherwise would have obtained. Unless a reassessed taxpayer had a preexisting entitlement to the dividend income paid to the shareholder of a corporation, the fourth precondition cannot be satisfied and consequently s. 56(2) cannot operate to attribute the dividend income to that taxpayer for income tax purposes.

Assuming that proper consideration was given for the shares when issued, there is no exception to the rule that s. 56(2) does not apply to dividend income where the recipient of the dividend income in a non-arm’s length transaction has not made a legitimate contribution to the corporation. The fact that a company is closely held or that no contribution is made to the company by a shareholder benefiting from a dividend in no way changes the underlying nature of a dividend. Dividends are paid to shareholders as a return on their investment in the corporation. Since the distribution of the dividend is not determined by the quantum of a shareholder’s contribution to the corporation, it would be illogical to use contribution as the criterion that determines when dividend income will be subject to s. 56(2). Further, taxpayers are entitled to arrange their affairs for the sole purpose of achieving a favourable position regarding taxation and no distinction is to be made in the application of this principle between arm’s length and non-arm’s length transactions.

Cases Cited

Considered: McClurg v. Canada, 1990 CanLII 28 (SCC), [1990] 3 S.C.R. 1020, aff’g 1987 CanLII 8926 (FCA), [1988] 2 F.C. 356; distinguished: Winter v. Canada, 1990 CanLII 13033 (FCA), [1991] 1 F.C. 585; referred to: Stubart Investments Ltd. v. The Queen, 1984 CanLII 20 (SCC), [1984] 1 S.C.R. 536; Murphy v. The Queen, 1980 CanLII 4526 (FC), 80 D.T.C. 6314; Fraser Companies, Ltd. v. The Queen, 1981 CanLII 5000 (FC), 81 D.T.C. 5051.

Statutes and Regulations Cited

Income Tax Act, S.C. 1970-71-72, c. 63, ss. 12(1)(j), 56(2), 74.4 [ad. 1986, c. 6, s. 38], 82(1), 85(1), 245 [rep. & sub. 1988, c. 55, s. 185].

Authors Cited

Krishna, Vern. “Share Capital Structure of Closely-Held Private Corporations” (1996), 7 Can. Curr. Tax 7.

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

APPEAL from a judgment of the Federal Court of Appeal, 1996 CanLII 4085 (FCA), [1997] 1 F.C. 79, 201 N.R. 358, [1996] 3 C.T.C. 270, 96 D.T.C. 6464, [1996] F.C.J. No. 1108 (QL), allowing an appeal from a judgment of Rothstein J., 1993 CanLII 3023 (FC), [1994] 2 F.C. 154, 72 F.T.R. 17, [1994] 1 C.T.C. 354, 94 D.T.C. 6094, [1993] F.C.J. No. 1332 (QL), dismissing an appeal from a judgment of Sarchuk T.C.C.J., 1992 CanLII 15294 (TCC), [1992] 2 C.T.C. 2074, 92 D.T.C. 1652, [1992] T.C.J. No. 288 (QL), allowing an appeal from an assessment of income tax. Appeal allowed.

Joe E. Hershfield, Q.C., Ralph D. Neuman and Christopher M. Paterson, for the appellant.

Roger Taylor and Robert Gosman, for the respondent.

//Iacobucci J.//

The judgment of the Court was delivered by

1 Iacobucci J. -- The principal question raised by this appeal is whether dividend income, paid by a closely held family corporation to a non-arm’s length shareholder who has not contributed to or participated in the business of the corporation, in this case Ruby Neuman, should be attributed to the shareholder’s spouse, the appellant Melville Neuman, for income tax purposes in accordance with s. 56(2) of the Income Tax Act, S.C. 1970-71-72, c. 63 as amended (the “ITA”). I conclude that s. 56(2) does not apply to dividend income such that the dividend income received by Ruby Neuman cannot be attributed to the appellant for income tax purposes.

1. Facts

2 The appellant was at all material times a lawyer with the firm of Neuman, MacLean in Winnipeg. The appellant and his partners at the law firm each owned 1,285.714 common shares in Newmac Services (1973) Ltd. (“Newmac”), which owned commercial property in downtown Winnipeg, including the offices of Neuman, MacLean. The appellant acted as secretary of Newmac. The appellant’s wife, Ruby Neuman, had no involvement in the business of Newmac.

3 On April 29, 1981, the appellant incorporated Melru Ventures Inc. (“Melru”) as a family holding company. Rothstein J. of the Federal Court, Trial Division found that Melru was incorporated for tax planning and income splitting purposes and that it had no other independent business purpose (1993 CanLII 3023 (FC), [1994] 2 F.C. 154, at p. 160).

4 The capital structure of Melru provided for different classes of shares with different rights and privileges. The dividends were to be declared at the sole discretion of the directors; distributions could be done selectively among the various classes of shares. The rights and conditions of the Class “G” and “F” shares are as follows:

(a) the holders of Class “G” shares shall in each year, in the discretion of the directors, be entitled out of any or all profits or surplus available for dividends to non-cumulative dividends at such rate as may from time to time be declared on any such shares but not exceeding the equivalent of 1% per annum on “redemption price” above the maximum prime bank rates. . . .

(e) all dividends paid or declared and set aside for payment in any fiscal year, after making payments on Class “G” shares and preference shares of dividends declared shall be paid firstly on Class “F” shares until dividends aggregating 1¢ per share on the Class “F” shares then outstanding have been paid and then any additional dividends shall be set aside for payment on common shares until the common shares then outstanding shall have received 1¢ per share and any additional dividends shall be paid on Class “F” shares until they receive that fraction of profits properly available for payment of dividends as the number of Class “F” shares then outstanding bear to the total number of Class “F” shares and common shares then outstanding and the balance shall in the discretion of the directors be paid on common shares or set aside for future payment on common shares at the discretion of the board of directors.

5 Pursuant to an agreement dated April 29, 1981, the appellant sold his shares in Newmac to Melru for 1,285.714 Class “G” shares of Melru. The shares were sold on a tax-deferred basis pursuant to s. 85(1) of the ITA and they were described as having a fair market value of $120,000. On May 1, 1981, a meeting of the first director was held at which the appellant was appointed president and Ruby Neuman was appointed secretary. One voting common share of Melru was issued to the appellant for $1. A special general meeting of the shareholders was held that same day at which the appellant resigned as first director and was elected director of Melru until the first annual meeting of the corporation. Ruby Neuman acted as secretary at this meeting. That same day there was a meeting of the board of directors which the appellant chaired. A resolution was passed authorizing the issue of 1,285.714 Class “G” shares to the appellant in accordance with the agreement of sale. A second resolution was passed authorizing the issue of 99 non-voting Class “F” shares to Ruby Neuman at $1 per share.

6 The first annual meeting of shareholders was held on August 12, 1982. Ruby Neuman was elected sole director of Melru and the appellant and Ruby Neuman were appointed as officers.

7 In 1982, Melru received $20,000 in dividends on the Newmac shares. These were the first dividends paid on the Newmac shares. A board of directors meeting was held on September 8, 1982 at which time Ruby Neuman declared a dividend in the amount of $5,000 to be paid on the Class “G” shares and another dividend of $14,800 to be paid on the Class “F” shares. The minutes indicate that the holder of the common shares (i.e., the appellant) was prepared to have money set aside for future payment on his shares.

8 Ruby Neuman immediately loaned $14,800 to the appellant and she received in return a demand promissory note as security. Ruby Neuman died in 1988. The loan was not repaid.

9 Rothstein J. made the following relevant findings of fact (at pp.160-61):

1. The dividends declared by Ruby Neuman on her own Class “F” shares and the appellant’s Class “G” shares were declared pursuant to a discretionary dividend clause in the Articles of Incorporation of Melru. The dividends of $14,800 on the “F” shares and $5,000 on the “G” shares were arbitrary numbers.

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

3. The appellant’s evidence was that when his wife was elected director of Melru, he explained to her the duties of a director, that directors manage the corporation, that they have a duty to the corporation, and that they make the decisions. The appellant said that he made recommendations to his wife which she accepted but that the decision as to the declaration of dividends was hers.

10 The dividend income paid to Ruby Neuman in 1982 was attributed to the appellant as being a payment or transfer of property made pursuant to the direction of or with the concurrence of the appellant as described in s. 56(2) of the ITA and he was assessed tax on this income.

11 The appellant appealed his 1982 assessment to the Tax Court of Canada and in 1992 the assessment was vacated: 1992 CanLII 15294 (TCC), [1992] 2 C.T.C. 2074. (Proceedings had been delayed pending the final determination in McClurg v. Canada, 1990 CanLII 28 (SCC), [1990] 3 S.C.R. 1020.) The respondent appealed to the Federal Court, Trial Division without success, but a further appeal to the Federal Court of Appeal was successful: 1996 CanLII 4085 (FCA), [1997] 1 F.C. 79.

2. Judicial History

A. Tax Court of Canada

12 Sarchuk T.C.C.J. allowed the appellant’s appeal and referred the assessment back to the respondent for reconsideration on the basis that the dividend income received by Ruby Neuman was not to be included in the appellant’s income under s. 56(2). In reaching this conclusion, he relied on the opinion expressed by this Court in McClurg that as a general rule s. 56(2) does not apply to dividend income. Sarchuk T.C.C.J. acknowledged Dickson C.J.’s obiter dicta in McClurg (at p. 1054):

. . . 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.

13 However, Sarchuk T.C.C.J. was of the view that since this comment was obiter he was not bound by it. In his opinion, the Court had left open the question of the applicability of s. 56(2) to non-arm’s length transactions and the possibility of piercing the corporate veil to stop complex tax avoidance schemes. However, the case at bar, in his view, did not warrant this action. Although there were facts that would support the attribution of the income back to the appellant, the plan could not be described as a “blatant tax avoidance scheme” (p. 2085).

B. Federal Court of Canada, Trial Division

14 Rothstein J. dismissed the appeal from the decision of the Tax Court on the grounds that s. 56(2) was not designed to prevent income splitting in the context of the director-shareholder relationship.

15 He first considered whether Ruby Neuman, in declaring the dividend, was acting under the direction or with the concurrence of the appellant. Rothstein J. said he was “reluctant to presume that Ruby Neuman was acting pursuant to the direction of, or with the concurrence of, the [appellant] when she, as director, declared dividends on behalf of Melru” (p. 162). Although this would determine the appeal, this point was not pressed by the parties, and Rothstein J. did not decide the case on this point.

16 Rothstein J. went on to consider this Court’s holding in McClurg; the McClurg decision was critical to the outcome of the case at bar since the only material difference between the facts, in Rothstein J.’s view, is that Ruby Neuman made no contribution to Melru while Wilma McClurg did make contributions to the corporation from which she received dividend income.

17 Applying McClurg, Rothstein J. concluded that the declaration of dividends pursuant to the discretionary dividend clause was valid and he then went on to consider the tax law issue. Rothstein J. noted that in McClurg Dickson C.J. recognized two prerequisites to the application of s. 56(2): that the dividend income would otherwise have been obtained by the reassessed taxpayer, and that the payment must be a “benefit” for which there was no adequate consideration. Dickson C.J. concluded that s. 56(2) did not generally apply to dividends since the reassessed taxpayer would not have received the money if it had not been paid to the shareholder because it would have been retained as earnings by the company. Dickson C.J. also concluded that, on the facts in McClurg, the dividend income received by Wilma McClurg was consideration for the significant contribution which she made to the corporation; the dividend received by her was not, therefore, a “benefit”.

18 Rothstein J. concluded that Dickson C.J. had not intended to dispose of the McClurg case on the basis of Wilma McClurg’s contributions to the corporation; rather, his comments about her contributions were intended to address the third precondition to the application of s. 56(2) articulated in the provision itself, i.e., was the money “for the benefit of the taxpayer or as a benefit that the taxpayer desired to have conferred on the other person”?

19 Rothstein J. proceeded to consider Dickson C.J.’s suggested exception to the general rule that s. 56(2) does not apply to dividend income. Rothstein J. recognized that this Court did not determine in McClurg whether a distinction can be made between non-arm’s length and arm’s length transactions because in McClurg the recipient of the dividend made a legitimate contribution to the company; therefore the dividend did not constitute a benefit to Wilma McClurg and s. 56(2) could not apply for that reason.

20 The problem faced by Rothstein J. was whether, on the facts before him, where Ruby Neuman had made no contribution to the company and the receipt of the dividend was thus a “benefit” to her, a distinction must be drawn between non-arm’s length and arm’s length transactions. He concluded, relying on Urie J.’s ruling in the Federal Court of Appeal in McClurg, 1987 CanLII 8926 (FCA), [1988] 2 F.C. 356 (which ruling had not been overturned by the reasons of Dickson C.J.), that there is nothing in s. 56(2) which contemplates a distinction between non-arm’s length and arm’s length transactions. Rothstein J. noted that this Court found, in more general terms, that there was no distinction between arm’s length and non-arm’s length transactions (Stubart Investments Ltd. v. The Queen, 1984 CanLII 20 (SCC), [1984] 1 S.C.R. 536).

21 Having found that a distinction cannot be drawn between non-arm’s length and arm’s length transactions in the application of s. 56(2), Rothstein J. decided that he need not consider whether a dividend payment is a benefit for the purposes of s. 56(2) where the recipient did not make a contribution to the corporation.

22 Rothstein J. noted that there is nothing in the ITA which suggests an overall intention to prevent income splitting; an income splitting transaction must actually violate a section of the ITA in order for the Minister to challenge it.

23 In the absence of sham, and with all corporate formalities having been observed, Rothstein J. held that the transaction was valid and he dismissed the appeal.

C. Federal Court of Appeal

24 The Federal Court of Appeal allowed the respondent’s appeal and held that the appellant was taxable on the dividend income received by Ruby Neuman. The court held that the dictum of Dickson C.J. in McClurg regarding the possible application of s. 56(2) in non-arm’s length transactions was binding on the Trial Division. The court relied, in reaching its conclusion, on the fact that the incorporation of Melru and the declaration of the dividend to Ruby Neuman had no bona fide business purpose and lacked commercial reality. In reaching its conclusion, the court essentially pierced the corporate veil.

25 The court was of the view that the respondent had satisfied the four elements necessary to invoke s. 56(2): (1) payment or transfer made to a person other than the taxpayer; (2) made at the direction of or with the concurrence of the taxpayer; (3) for the taxpayer’s benefit; and (4) the payment would have otherwise been included in the taxpayer’s income.

26 More specifically, the court found that Ruby Neuman was acting with the concurrence of the appellant when she declared the dividends. The court also held that the payment of the dividend was “for the benefit of the taxpayer” as required by s. 56(2). The appellant benefited through a reduction in his own tax liability; he benefited a second time by having his wife lend him the money interest-free. In addition, the court found that the property would have been included in the appellant’s income had it been received by him and not Ruby Neuman by operation of ss. 12(1)(j) and 82(1) of the ITA.

27 Next the court had to deal with this Court’s ruling in McClurg that s. 56(2) does not generally apply to dividend income because the reassessed taxpayer would not have received that money had it not been paid to the shareholder. In order to overcome that general rule, the court invoked the exception to the rule recognized by Dickson C.J. in obiter in McClurg: that where a non-arm’s length shareholder does not make a legitimate contribution to the corporation, a person who directed or concurred in the payment of a dividend to that shareholder could be assessed for taxes on the amount of the dividend under s. 56(2). The court concluded (at p. 111) that the recognition by Dickson C.J. of this possible exception to the rule is binding on courts as it represents the “considered opinion of a majority” of the Supreme Court of Canada.

28 The court then found that the facts before them fit within the exception detailed in McClurg. Unlike Wilma McClurg, Ruby Neuman had made no contribution to Melru, a company which was incorporated solely for tax planning and income splitting purposes. The court found that applying s. 56(2) “would not be contrary to the commercial reality of the declaration of the dividend to Ruby Neuman, since there was none” (p. 105).

29 The appellant argued that the court should apply Winter v. Canada, 1990 CanLII 13033 (FCA), [1991] 1 F.C. 585 (C.A.), which stands for the proposition that there is a fifth precondition to the application of s. 56(2) which requires proof that the payee would not be subject to tax on the dividend income. The court declined to find that there was a fifth pre-condition to the application of s. 56(2).

30 As a result, the Federal Court of Appeal allowed the appeal and affirmed the Minister’s assessment attributing the dividend income received by Ruby Neuman to the appellant.

3. Issues

31 The central question raised by this appeal is whether the dividend income received by Ruby Neuman should be attributed to the appellant for tax purposes under s. 56(2) of the ITA. Section 56(2) provides:

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.

32 In order for s. 56(2) to apply, four preconditions, each of which is detailed in the language of the s. 56(2) itself, must be present:

(1) the payment must be to a person other than the reassessed taxpayer;

(2) the allocation must be at the direction or with the concurrence of the reassessed taxpayer;

(3) the payment must be for the benefit of the reassessed taxpayer or for the benefit of another person whom the reassessed taxpayer wished to benefit; and

(4) the payment would have been included in the reassessed taxpayer’s income if it had been received by him or her.

I agree that these four prerequisites to attribution are an appropriate analytical framework for the interpretation of s. 56(2) (see Cattanach J. in both Murphy v. The Queen, 1980 CanLII 4526 (FC), 80 D.T.C. 6314 (F.C.T.D.), at pp. 6317-18, and in Fraser Companies, Ltd. v. The Queen, 1981 CanLII 5000 (FC), 81 D.T.C. 5051 (F.C.T.D.), at p. 5058).

33 Because I conclude that s. 56(2) does not apply to dividend income since dividend income, by its very nature, cannot satisfy the fourth precondition absent a sham or other subterfuge, it is not necessary to discuss the other three prerequisites to the application of s. 56(2).

4. Analysis

A. Introduction.

34 As the judicial history of this appeal reveals, the interpretation of this Court’s majority decision in McClurg lies at the heart of the present case. This Court held in McClurg that generally s. 56(2) will not apply to dividend income. However, Dickson C.J. suggested in obiter in McClurg that s. 56(2) may apply where dividend income is distributed through the exercise of a discretionary power to a non-arm’s length shareholder who has made no legitimate contribution to the company (at p. 1054). The Federal Court of Appeal felt bound by the potential exception articulated by Dickson C.J. in obiter since the facts in the present case were similar to the facts in McClurg with the only material difference being that Ruby Neuman, unlike Wilma McClurg, had not made any contribution to the corporation.

35 A large part of my analysis will involve a review of the holdings in McClurg. Before I turn to McClurg, however, I wish to make some observations to place the present debate into its proper perspective. First, s. 56(2) strives to prevent tax avoidance through income splitting; however, it is a specific tax avoidance provision and not a general provision against income splitting. In fact, “there is no general scheme to prevent income splitting” in the ITA (V. Krishna and J. A. Van Duzer, “Corporate Share Capital Structures and Income Splitting: McClurg v. Canada” (1992-93), 21 Can. Bus. L.J. 335, at p. 367). Section 56(2) can only operate to prevent income splitting where the four preconditions to its application are specifically met.

36 Second, this case concerns income received by Ruby Neuman during the 1982 taxation year at which time the ITA did not provide specific guidelines to deal with corporate structures designed for the purposes of income splitting and tax minimization. Professor V. Krishna, in an article entitled “Share Capital Structure of Closely-Held Private Corporations” (1996), 7 Can. Curr. Tax 7, at p. 9, made the following comment with respect to income splitting in the corporate context:

Except when specifically curtailed by the Income Tax Act (for example, by the attribution rules), income splitting per se is not a sanctioned arrangement. Thus, corporate structures that facilitate income splitting in private companies should not be penalized without clear statutory language and intent. [Emphasis added.]

Parliament has since fashioned legislation to regulate corporate income splitting (s. 74.4 of the ITA, introduced in 1985), but this legislation does not apply to the present appeal.

37 Third, this appeal is limited to the interpretation and application of s. 56(2) of the ITA; the appeal is not based on the general anti-avoidance rule set out in s. 245 of the ITA (“GAAR”). GAAR came into force on September 13, 1988 and it applies only to transactions entered into on or after that date.

38 Fourth, the respondent has not argued that the appellant was involved in a sham or an artificial transaction and this was acknowledged by counsel for the respondent during the hearing.

39 Finally, it is important to remember that this Court held unanimously in Stubart, supra, at p. 575, that a transaction should not be disregarded for tax purposes because it has no independent or bona fide business purpose (Estey J. wrote for himself and Beetz and McIntyre JJ.; Wilson J. wrote concurring reasons for herself and Ritchie J.). Thus, taxpayers can arrange their affairs in a particular way for the sole purpose of deliberately availing themselves of tax reduction devices in the ITA. Estey J. rejected the suggestion that a distinction must be drawn between non-arm’s length and arm’s length transactions in the application of this principle (at pp. 570-72). According to Stubart, therefore, non-arm’s length arrangements can also be created for the sole purpose of taking advantage of tax reduction devices.

40 With these points in mind, I now turn to the decision of the Court in McClurg.

B. McClurg

41 McClurg involved a taxpayer and business associate who were the sole directors of a corporation which they had set up and in which they and their wives were shareholders. The corporation operated an International Harvester truck dealership. The capital structure of the corporation provided for three classes of shares with different rights and privileges: Class A shares were common, voting and participating shares; Class B shares were common, non-voting and participating where so authorized by the directors; and Class C shares were preferred non-voting shares. The dividends were to be declared at the sole discretion of the directors; distributions could be done selectively among the three classes of shares. Essentially, the capital structure was designed to permit income splitting.

42 Jim McClurg and his associate held Class A and C shares whereas their wives held Class B shares. In 1978, 1979, and 1980 the wives of the directors each received $100/share on their Class B shares: $10,000/year. These were the only dividends declared in those years.

43 Wilma McClurg made legitimate contributions to the business. She exposed herself to extensive liability by assisting in the financing of the business. She also worked as an administrative assistant, drove a truck when necessary, and generally fulfilled needs as they arose.

44 The Minister reassessed Jim McClurg’s income for 1978 to 1980 on the basis that $8000 of the $10,000 in dividends paid to his wife each year was attributable to him through the operation of s. 56(2). The Minister also challenged the validity of the discretionary dividend provision.

(i) The ratio in McClurg

45 Dickson C.J., writing for himself and Sopinka, Gonthier and Cory JJ. (Wilson, La Forest and L’Heureux-Dubé JJ. in dissent), first dealt with the issue of whether the discretionary dividend provision was valid as a matter of corporate law; he concluded that it was. He then turned to the tax issue and he held that the dividend income paid to Wilma McClurg was not attributable to her husband for income tax purposes through the operation of s. 56(2).

46 This Court concluded that, as a general rule, s. 56(2) does not apply to dividend income since, until a dividend is declared, the profits belong to the corporation as retained earnings. The declaration of a dividend cannot be said, therefore, to be a diversion of a benefit which the taxpayer would have otherwise received (at p. 1052). Dickson C.J. explained the ruling as follows (at p. 1052):

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, in my view 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: [B. Welling, Corporate Law in Canada (1984), 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). [Emphasis added.]

47 Although not explicitly stated, Dickson C.J.’s preceding comments concern the fourth precondition to the application of s. 56(2): that the payment would have been included in the reassessed taxpayer’s income if it had been received by him or her. In essence, dividend income does not satisfy this prerequisite to attribution since the reassessed taxpayer would not have received the income had it not been paid to the shareholder. In effect, this Court implicitly interpreted the fourth precondition to include an entitlement requirement; entitlement is used in the sense that the reassessed taxpayer would have otherwise received the payments in dispute. This was correctly noted by Rothstein J. at the Federal Court, Trial Division in similar terms where he acknowledged that Dickson C.J. qualified the application of s. 56(2) by requiring that the payment in issue “would otherwise have been obtained by the reassessed taxpayer” (p. 164).

48 An entitlement requirement in the sense I have described is consistent with the stated purpose of s. 56(2), which is to capture and attribute to the reassessed taxpayer “receipts which he or she otherwise would have obtained” (McClurg, at p. 1051). Dividend income cannot pass the fourth test because the dividend, if not paid to a shareholder, remains with the corporation as retained earnings; the reassessed taxpayer, as either director or shareholder of the corporation, has no entitlement to the money.

49 This is the only interpretation which makes sense and which avoids absurdity in the application of s. 56(2), as noted by Dickson C.J. (at p. 1053):

. . . 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. . . . 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.

50 I note that the decision in Winter, supra, which was rendered shortly before this Court’s ruling in McClurg, appears to challenge the view that where a taxpayer is not entitled to a payment that payment cannot be attributed to him or her under s. 56(2). Winter, however, did not involve the attribution of dividend income.

51 In Winter, the majority shareholder in an investment company caused the corporation to sell some of its shares to his son-in-law, who was also a shareholder in the corporation, for a price of $100 per share. The Minister calculated the fair market value of the shares at approximately $1,000 per share and reassessed the majority shareholder under s. 56(2) by adding as income the difference between what the son-in-law paid for the shares and their market value.

52 Marceau J.A., writing for the court, held that the fact that the taxpayer had no direct entitlement to the shares did not preclude attribution since there was no indication that s. 56(2) was intended to be so confined. Marceau J.A. concluded (at p. 593) that:

when the doctrine of “constructive receipt” is not clearly involved, because the taxpayer had no entitlement to the payment being made or the property being transferred, it is fair to infer that subsection 56(2) may receive application only if the benefit conferred is not directly taxable in the hands of the transferee. [Emphasis added.]

Marceau J.A. distinguished the Federal Court of Appeal’s ruling in McClurg where Urie J. held that s. 56(2) does not apply to dividend income, which holding was affirmed by this Court, as follows (at pp. 591-92):

the McClurg decision was concerned with a declaration of dividend in accordance (in the views of the majority) with the powers conferred by the share structure of the corporation, and I do not see it as having authority beyond the particular type of situation with which it was dealing.

53 I agree with Marceau J.A.: Winter concerned the conferral of a benefit which was not in the form of dividend income. The application of s. 56(2) to non-dividend income was not before this Court in McClurg and it is not before this Court in the present case. But the entitlement requirement implicitly read into the fourth precondition of s. 56(2) in McClurg clearly applies to dividend income.

54 I conclude that, unless a reassessed taxpayer had a preexisting entitlement to the dividend income paid to the shareholder of a corporation, the fourth precondition cannot be satisfied and consequently s. 56(2) cannot operate to attribute the dividend income to that taxpayer for income tax purposes.

(ii) The obiter dicta in McClurg and the exception to the general rule

55 The finding that dividend income cannot satisfy the fourth precondition to the application of s. 56(2), as modified by the implicit entitlement requirement, was dispositive of the McClurg case. La Forest J. agreed with the majority’s conclusion that bona fide dividend income does not fall within the scope of s. 56(2). However, he dissented on the finding under corporate law that the discretionary dividend clause was valid; therefore the dividend income at issue in McClurg was not, in his view, bona fide and s. 56(2) applied (see p. 1073).

56 Despite these conclusions, Dickson C.J. went on to consider the third precondition, that the payment must be for the benefit of the reassessed taxpayer or for the benefit of another person whom the reassessed taxpayer wished to benefit, and in so doing, he qualified his earlier interpretation of the fourth precondition. In his view, Wilma McClurg’s receipt of the funds was not a “benefit” as required by s. 56(2) (the third precondition) since her contributions to the corporate enterprise could be described as a “legitimate quid pro quo and were not simply an attempt to avoid the payment of taxes” (p. 1054). Since Wilma McClurg had made legitimate contributions to the corporation, the application of s. 56(2) “would be contrary to the commercial reality of this particular transaction” (p. 1053).

57 Dickson C.J. seemed to be of the view that the character of a shareholder’s dividend income is to be determined by that shareholder’s level of contribution to the corporation. This approach ignores the fundamental nature of dividends; a dividend is a payment which is related by way of entitlement to one’s capital or share interest in the corporation and not to any other consideration. Thus, the quantum of one’s contribution to a company, and any dividends received from that corporation, are mutually independent of one another. La Forest J. made the same observation in his dissenting reasons in McClurg (at p. 1073):

With respect, this fact is irrelevant to the issue before us. To relate dividend receipts to the amount of effort expended by the recipient on behalf of the payor corporation is to misconstrue the nature of a dividend. As discussed earlier, a dividend is received by virtue of ownership of the capital stock of a corporation. It is a fundamental principle of corporate law that a dividend is a return on capital which attaches to a share, and is in no way dependent on the conduct of a particular shareholder. [Emphasis added.]

58 Dickson C.J.’s finding that Wilma McClurg’s contributions to the corporation resulted in the dividend being consideration for her efforts rather than a “benefit” as required by s. 56(2) opened the door to his obiter comments which have led to some confusion (at p. 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.

59 Dickson C.J. is suggesting, it would seem, that where a non-arm’s length shareholder receives a dividend from a corporation to which he or she has made no contribution (the dividend income therefore constituting a “benefit” for the purposes of s. 56(2) in Dickson C.J.’s view), precondition four, interpreted by him to include an entitlement requirement, is automatically considered satisfied, or need not be satisfied, with the result that s. 56(2) applies.

60 In my view, it is wrong to suggest that there may be an exception to the rule that s. 56(2) does not apply to dividend income where the recipient of the dividend income in a non-arm’s length transaction has not made a “legitimate contribution” to the corporation. In so stating, I assume, of course, that proper consideration was given for the shares when issued. I am not aware of any principle of corporate law that requires in addition that a so-called “legitimate contribution” be made by a shareholder to entitle him or her to dividend income and it is well accepted that tax law embraces corporate law principles unless such principles are specifically set aside by the taxing statute.

61 Furthermore, there is no principled basis upon which this distinction can be drawn; the fact that a company is closely held or that no contribution is made to the company by a shareholder benefiting from a dividend in no way changes the underlying nature of a dividend. Neither the fact that the transaction is non-arm’s length nor the fact that the shareholder has not contributed to the corporation serves to overcome the conclusion that dividend income cannot satisfy the fourth precondition to attribution under s. 56(2).

62 Moreover, the obiter comments raise the difficult task of determining what constitutes a legitimate contribution. What will be the criteria upon which one can ascertain with any degree of precision or certainty that a contribution is legitimate?

63 Finally, the requirement of a legitimate contribution is in some ways an attempt to invite a review of the transactions in issue in accordance with the doctrines of sham or artificiality. Implicit in the distinction between non-arm’s length and arm’s length transactions is the assumption that non-arm’s length transactions lend themselves to the creation of corporate structures which exist for the sole purpose of avoiding tax and therefore should be caught by s. 56(2). However, as mentioned above, taxpayers are entitled to arrange their affairs for the sole purpose of achieving a favourable position regarding taxation and no distinction is to be made in the application of this principle between arm’s length and non-arm’s length transactions (see Stubart, supra). The ITA has many specific anti-avoidance provisions and rules governing the treatment of non-arm’s length transactions. We should not be quick to embellish the provision at issue here when it is open for the legislator to be precise and specific with respect to any mischief to be avoided.

64 To summarize, it is inappropriate to consider the contributions of a shareholder to a corporation when determining whether s. 56(2) applies. Dividends are paid to shareholders as a return on their investment in the corporation. Since the distribution of the dividend is not determined by the quantum of a shareholder’s contribution to the corporation, it would be illogical to use contribution as the criterion that determines when dividend income will be subject to s. 56(2). The same principles apply in the context of both non-arm’s length relationships such as often exist between small closely held corporations and their shareholders, and arm’s length relationships such as exist between publicly held corporations and their shareholders.

5. Conclusion

65 For the foregoing reasons, s. 56(2) does not apply to the dividend income received by Ruby Neuman. The appeal is therefore allowed, the decision of the Federal Court of Appeal is reversed, and that portion of the respondent’s assessment which attributes the dividend income received by Ruby Neuman to the appellant is set aside with costs throughout.

Appeal allowed with costs.

Solicitors for the appellant: Taylor, McCaffrey, Winnipeg.

Solicitor for the respondent: The Attorney General of Canada, Ottawa.