A dividend is a distribution of a corporation’s profits. This case asks: Can you distribute the same profits twice, tax-free, despite the anti-avoidance rule in ITA s. 55? Justice Graham says: Yes, you can.
Income tax rules allow dividends to pass tax free from one Canadian corporation to another. Why? Because the paying corporation (or a company from which it got the money as a dividend) already paid income tax on its profits. So, there’s no need to tax the money again, until the corporation pays the dividend to an individual. The principle is based on the idea that we should tax business income at about the same rates, whether individuals earn it directly or, instead, through a corporation. So, we tax a corporation’s business income first at a lower rate when it earns the income and then we tax a little more again when it pays the money to its shareholders. The total of the tax the corporation pays on the business income and the tax the individual pays on the dividend is supposed to be close to the tax the individual would pay if he earned the money directly, without a corporation.
Some taxpayers abused this tax-free inter-corporate dividend rule to avoid capital gains tax when selling shares of their corporations to third parties. So, tax rules developed to stop the abuse. The rules are complicated but they do allow shareholders to sell their shares in a corporation without paying capital gains tax on the amount of its accumulated profits. You get this accumulated profit tax-free by having the corporation first pay part of the share value as a dividend, before the shareholder sells its shares. The reason for this capital gains tax exception is that a dividend paid from accumulated profits is the kind intended to benefit from the inter-corporate dividend rule; i.e., it’s a true dividend, not a disguised capital gain. These accumulated profits are called “safe income”.
In the complicated tax scheme of this case, the taxpayers took advantage of the principle that a corporation’s “safe income” (i.e., its accumulated profits) should include the accumulated profits of its subsidiaries.
RTI was the Appellant’s (D&D) subsidiary. RTI’s profits in this case were about $500,000. So, the Appellant D&D paid the equivalent of that $500,000 as a tax-free safe income dividend to its shareholder, HLL. But D&D didn’t really pay out RTI’s safe income; D&D paid its own money, based on the $500,000 value of RTI’s accumulated profit. Then, the Appellant D&D sold its subsidiary RTI to a newly formed corporation (“Newco3”) for shares in Newco3. So, D&D then owned Newco3 and Newco3 owned RTI. Relying on the fact that RTI still had its safe income, (i.e., its accumulated profits) Newco3 next paid a tax-free dividend to the Appellant D&D. In this way, the corporate group paid the value of RTI’s profits as a tax-free dividend twice. And so, the group avoided capital gains tax on $500,000 more of gain than the rules intend.
Had the rules demanded that a subsidiary (RTI) pay its profits to its parent (D&D) before the parent could use them as “safe income”, this scheme would have failed.
In justifying his decision, Justice Graham relied on the SCC’s repetition of the commonly offered reason for letting taxpayers use technical stratagems to avoid the spirit of the law:
“It would introduce intolerable uncertainty into the Income Tax Act if clear language in a detailed provision of the Act were to be qualified by unexpressed exceptions derived from a court’s view of the object and purpose of the provision.” [Para. 33.]
But would it produce “intolerable uncertainty” to interpret tax rules according to their purpose? In this case, “The Appellant admits that the same safe income is being used twice, but says there is nothing in the Act that prevents that double use.” (Para. 20; also at para. 22.)
D&D’s tax advisors spent a lot of effort to get around the intent of ITA s. 55, which is to prevent taxpayers from avoiding capital gains, while it lets them remove accumulated profits tax free. If you must go so far out of your way to avoid a target, can it be very hard to spot it? The spirit of the law is not hard to follow; but it is hard to avoid.
One shouldn’t rely too heavily on this decision. CRA did not rely on the General Anti-avoidance Rule to attack D&D’s scheme. But CRA might use that rule to attack similar transactions in the future. (Para. 34.)