http://decision.tcc-cci.gc.ca/tcc-cci/decisions/en/item/232019/index.do
Mady v. The Queen (June 14, 2017 – 2017 TCC 112, Hogan J.).
Précis: The taxpayer entered into two sets of complex tax planning transactions.
The first involved a trust holding shares of his dental practice corporation which transferred shares to his wife who then transferred the shares to the taxpayer. The result, if it worked, was that dividends would be taxed in his wife’s hands because of the application of section 74.1 of the Income Tax Act (the “Act”). The Minister denied the application of section 74.1 and applied the avoidance rule contained in subsection 74.5(11) to tax the dividends in the hands of the taxpayer rather than at a lower rate in the hands of his wife.
The second transaction involved a reorganization of his dental corporation which involved three special classes of common shares which he then sold to his wife and two children, in trust, for one cent for each holder. On the same day all of the shares of the dental corporation were sold to an unrelated third party purchaser. The common shares issued to the taxpayer’s wife and children, in trust, were sold for roughly $735,000 for each holder. CRA reassessed on the basis that the shares were not transferred at fair market value by the taxpayer.
CRA levied gross negligence penalties on both sets of transactions.
The Tax Court affirmed CRA’s position on both sets of transactions but vacated the penalties, largely on the basis that the transactions were very complex and entered into after receiving expert advice.
If the parties were unable to agree on costs they were to file submissions of not more than 10 pages within 5 days.
Decision: The Court first turned to the application of subsection 74.5(11) of the Act:
Artificial transactions
(11) Notwithstanding any other provision of this Act, sections 74.1 to 74.4 do not apply to a transfer or loan of property where it may reasonably be concluded that one of the main reasons for the transfer or loan was to reduce the amount of tax that would, but for this subsection, be payable under this Part on the income and gains derived from the property or from property substituted therefor.
The Court rejected the careful arguments put forward by the taxpayer’s counsel:
[111] The Appellant disagrees with the Minister’s application of subsection 74.5(11). The Appellant observes that subsection 74.5(11) does not refer to a “series” of transactions, unlike, for example, the GAAR. The Appellant contends that the Minister, in making her decision to invoke subsection 74.5(11) in order to assess the Appellant on the dividend income, determined the purpose of the transfer of the shares from Mrs. Mady to Dr. Mady by considering the overall “series” of transfers starting with the transfer to Mrs. Mady from the Mady Family Trust and then from Mrs. Mady to Dr. Mady. In other words, according to the Appellant, the Minister applied subsection 74.5(11) because Mrs. Mady was made to be an intermediary transferee/transferor of the shares. The Appellant argues that subsection 74.5(11) dictates that the purpose of the transfer from Mrs. Mady to Dr. Mady must be determined solely by reference to that transaction. The Appellant contends that his interpretation of subsection 74.5(11) is consistent with the decision of the Federal Court of Appeal (“FCA”) in Lehigh Cement Limited. While that decision involved the interpretation of paragraph 95(6)(b) in the context of foreign affiliates, it also involved the interpretation of a specific anti-avoidance provision that the Court observed did not employ a “series of transactions” concept for the purpose of discerning a tax avoidance purpose.
[112] According to the Appellant, once Mrs. Mady owned the shares, she would be subject to tax on any dividend income received thereon. Therefore, the transfer of the shares from her to Dr. Mady could not have been intended to reduce tax payable on the dividends received on the shares. She was already the shareholder and the lower income earner. As a result, her tax rate was lower than the Appellant’s. If she had retained the shares rather than transfer them to her husband, the amount of tax due on the dividend income would have been less than that payable by Dr. Mady.
[113] In my opinion, the Appellant’s analysis of Lehigh Cement fails to take into account the FCA’s observations in paragraph 69 of that decision which are as follows:
69 The principal purpose of the acquisition or disposition of shares in the non-resident corporation is a question of fact to be determined on the basis of all relevant circumstances. An entire series of transactions may form part of the circumstances relevant to discerning the principal purpose of the acquisition or disposition of shares in the non-resident corporation. But it is not open to the Minister to look at an entire series of transactions to discern a tax avoidance purpose that is not the specific target of paragraph 95(6)(b).
[114] The FCA accepts that, even in the absence of a “series of transactions” concept, the entire series of transactions may form part of the relevant circumstances in determining the purpose of the transfer of property.
[115] The Appellant’s analysis of the underlying circumstances surrounding the transfer of shares to him fails for another reason. The parties agreed that Mrs. Mady could not own the shares of MDPC. The rules of the Royal College of Dental Surgeons prohibited Mrs. Mady from owning the shares. If she could not own the shares she could not receive dividend income thereon. Therefore, dividends could not be subject to tax in her hands at a lower tax rate than that which applied to Dr. Mady. In that context, it is only through the application of section 74.1 that the dividends paid on the shares could be taxed in the hands of Mrs. Mady. This was achieved by causing Mrs. Mady to transfer the shares that she could not own to Dr. Mady.
[116] As a final observation on the text of subsection 74.5(11), I note that the provision refers to “one of the main reasons” for the transfer of the property being to take advantage of the attribution rules so that the income from property is taxed in the hands of the lower-income earner. Paragraph 95(6)(b) considered in Lehigh Cement employs a narrower test, being the “principal purpose” for the acquisition or disposition of shares. In Groupe Honco, the FCA concluded that the phrase “one of the main purposes” which is in effect the same test as that employed in subsection 74.5(11), “is unambiguous and implies that a taxpayer may have more than one main motive in acquiring shares”. Even if I accept that one of the purposes of the transfer from Mrs. Mady to Dr. Mady was to ensure compliance with the new share ownership restriction discussed above, this does not override the fact that the other main purpose of structuring the transaction as it was in fact structured was to trigger the application of the distribution rules so that dividend income that Mrs. Mady was barred from receiving would be taxed in her hands at a lower rate. The Appellant conceded that his income tax rate was higher than that of his wife in the relevant taxation years. She paid of $180,000 tax on the dividend income attributed to her. The Appellant owes $199,000 of tax according to the Minister’s assessment, for a net difference of $19,000.
[Footnote omitted]
Similarly the taxpayer was unsuccessful on the fair market value of the common shares transferred to his wife and children, in trust, but on the basis of section 69, not section 86:
[140] In summary, for all of the reasons noted above, the price agreed to by the Appellant’s wife and two daughters on the one hand, and Dental Corporation on the other, satisfies the definition of the term “fair market value”, which is understood to mean “the highest price an asset might reasonably be expected to bring if sold by the owner in the normal method . . . in a market not exposed to any undue stresses and composed of willing buyers and sellers dealing at arm’s length and under no compulsion to buy or sell”.
[141] Therefore, I conclude that the Appellant under-reported taxable capital gains of $1,102,332. The reassessment is incorrect to the extent of $111,919 because the reassessment was issued on the basis that subsection 86(2) applied rather than subparagraph 69(1)(b)(i).
[Footnote omitted]
However the taxpayer did benefit from some fine lawyering that persuaded Justice Hogan that he should vacate the gross negligence penalties:
[156] Other aspects of the factual background shed a more favourable light on the Appellant’s conduct. The evidence shows that a proposal to implement the freeze was discussed by the Appellant and his tax advisor long before DCC appeared on the scene. On October 2, 2009, Mike Van Essen, in a letter sent to the Appellant, advised his client that it would be beneficial for him to exchange his common shares for fixed-value preferred shares to enable his wife and a trust set up for the benefit of his two daughters to acquire common shares of the corporation for a nominal consideration. The value of MDPC at the time was estimated by Mr. Van Essen to be $750,000. He advised his client that a formal valuation should be performed to avoid a challenge by the CRA. A follow-up letter was sent to the Appellant recommending that the estate freeze be implemented prior to the Appellant’s oldest daughter’s 18th birthday on February 23, 2012.
…
[158] While Mr. Van Essen acted imprudently in failing to disclose the pending sale of MDPC to his colleague, I do not believe that the Appellant can be held accountable for his actions. A valuation is a complex undertaking. Different methods may be used to determine the value of shares. I heard over two days of expert evidence on the determination of the fair market value of the shares. The Appellant and the Respondent felt it was necessary for me to hear that evidence. While I rejected the opinion of the Appellant’s experts to the effect that the fair market value of the shares should be based on the income approach, their opinions were not frivolous. It is well established that a taxpayer is responsible for the actions of his agent only where the taxpayer is privy to the gross negligence of that agent or wilfully blind to the fact of that negligence and the taxpayer acquiesces or participates in the false statements or omissions.
[159] Finally, I observe that the transfer agreements between the Appellant and his wife and daughters all contained purchase price adjustments designed to guard against a challenge by the CRA. From the Appellant’s testimony, I discerned that he believed that this type of clause allowed for greater leeway in setting the price paid by the related parties.
[160] Against this backdrop, I cannot conclude that the Appellant, knew, or, for that matter, was wilfully blind to the fact, that the valuation performed by Ms. King could not be relied upon to determine the fair market value of MDPC as at January 13, 2012 and be used to set the price for which the 85 Class B, C and D common shares were sold to the Appellant’s family members.
[161] Considering all of the above, I conclude that the Respondent has failed to satisfy her legal burden and, as a result, gross negligence penalties were improperly imposed by the Minister on the Appellant.
[Footnote omitted]
In the result, the Tax Court affirmed CRA’s position on both sets of transactions but vacated the penalties, largely on the basis that the transactions were very complex and entered into after receiving expert advice.
If the parties were unable to agree on costs they were to file submissions of not more than 10 pages within 5 days.