Nathan Bernstein (Appellant)
d.
Minister of National Revenue (Respondent)
Trial Division, Walsh J.—Montreal, November
26; Ottawa, December 17, 1973.
Income tax—Companies—Stock option benefits to
employees—Election re averaging—Whether scheme for
appropriating undistributed profits—Income Tax Act, ss.
8(1)(c), 81, 85A, and 137(2).
The Minister, in re-assessing the income of the appellant,
president of a corporation, denied him the right to apply the
provisions of section 85A of the Income Tax Act, concern
ing stock benefits to the appellant as an employee of the
company. The sum of $99,800 was thereby added to the
appellant's income for the taxation year 1964.
Held, affirming the Minister's decision, section 85A was
designed to enable a corporation to afford its employees an
opportunity to acquire shares of its stock or the stock of its
subsidiary, on terms conferring a benefit on them in order to
reward their services and retain their interest in the compa-
ny's progress, without the obligation to pay regular tax rates
on the amount of this benefit. It was not intended to be used
as a means of compensating employees who may have been
underpaid for some years, by conferring a benefit in a
taxation year at a very advantageous tax rate, when, had
they been paid the salary to which they claim to have been
entitled, they would have had to pay tax on it each year at
the regular tax rate. Neither was it intended to be used as a
means of transferring all the company's surplus to share
holders who, between them, own or control all of the
company's stock, at the same advantageous tax rate, where
as payment to them by way of increased salary, bonus,
regular dividend or even by the use of section 105 (tax on
undistributed income, corporate election) would have result
ed in substantially higher taxes.
INCOME tax appeal.
COUNSEL:
Bruce Verchère and André Primeau for
appellant.
André P. Gauthier for respondent.
SOLICITORS:
Verchère and Primeau, Montreal, for
appellant.
Deputy Attorney General of Canada for
respondent.
WALSH J:—This case deals with the attempt
of appellant to apply section 85A of the Income
Tax Act, R.S.C. 1952, c. 148 which was enacted
as section 75A in 1952-53, c. 40, section 28,
substituted in 1955, c. 54, section 25, with sub
section (7) added in 1953-54 by c. 57, section
21(2), as it existed in the taxation year 1964
prior to the further substitution of 1966-67, c.
47, section 9. Without quoting the section in
question in extenso, it can be said that in 1964 it
provided in paragraph (1)(a) as follows:
85A. (1) Where a corporation has agreed to sell or issue
shares of the corporation or of a corporation with which it
does not deal at arm's length to an employee of the corpora
tion or of a corporation with which it does not deal at arm's
length,
(a) if the employee has acquired shares under the agree
ment, a benefit equal to the amount by which the value of
the shares at the time he acquired them exceeds the
amount paid or to be paid to the corporation therefor by
him shall be deemed to have been received by the
employee by virtue of his employment in the taxation year
in which he acquired the shares;
and paragraphs (2)(a) and (b) provide in effect
that when an employee is deemed to have
received such a benefit by virtue of his employ
ment in a taxation year he may elect to pay the
tax that he would normally pay for the year on
his other income without this benefit plus the
amount by which the proportion of this benefit
that the aggregate of his taxes for the three
preceding years bears to the aggregate of his
income for those years exceeds 20% of the
amount of the benefit so deemed to have been
received. In the case of the present taxpayer,
the calculation of the tax to be paid on the
$99,800 which the stock option benefit he
received amounted to was worked out by adding
his net income of $10,970.71 for 1961,
$13,643.56 for 1962, and $18,550.18 for 1963
making a total of $43,164.45. The tax paid was
$1,997.75 in 1961, $2,925.90 in 1962 and
$4,967.83 in 1963 making a total of $9,891.48
which represents 22.91% of his net income for
the three years in question. Applying this tax
rate to $99,800 results in a tax of $22,864.18
from which 20% of the $99,800 benefit is
deducted in the amount of $19,960 leaving a
sum of $2,904.18 as tax adjustment payable on
this stock option benefit in addition to his
normal taxes on his other income for the year.
The background of his business operations
leading to his receipt of this benefit can be set
out as follows. In January 1956 he and one
Hyman Kamichik incorporated Highland Knit
ting Mills Inc., hereinafter referred to as "High-
land", to carry on the business of manufacturing
and distributing knitted clothing, and transferred
to it the similar business which they had former
ly carried on together in partnership. They were
the principal shareholders, officers and most
valuable employees of the company from its
incorporation to the death of Mr. Kamichik in
1969. The company was very successful as can
be seen from its increase of sales from $350,-
000 in 1956 to $1,100,000 in 1964 and $2,500,-
000 in 1968. Some time in September 1964 they
acquired the charter of a company known as
Salbron Investments Limited which had been
incorporated under a Quebec charter on
December 2, 1963 but which had never com
menced operations. Its authorized capital con
sisted at the time of 9,900 5% non-cumulative
non-voting redeemable preferred shares of the
par value of $10 each. They obtained supple
mentary letters patent dated September 11,
1964 increasing the capital by creating an ad
ditional 11,000 5% non-cumulative non-voting
redeemable preferred shares of the par value of
$10 each and changing the name of the com
pany to Berkam Investments Limited, herein-
after referred to as "Berkam". At a meeting of
Highland on October 28, 1964 it undertook to
subscribe for 94 common shares and 20,000 of
the said preferred shares of Berkam at their par
value of $10 a share and to pay for all these
shares so subscribed for, as well as for the six
common shares which had been allotted and
issued to the three original applicants for incor
poration. The company borrowed the money
from its bank to pay for these shares, a cheque
for $201,000 being issued by Highland in favour
of Berkam, which cheque was dated October
26, 1964 but not date-stamped by the bank until
December 4, 1964.
On November 23, 1964 Highland gave an
option to each of Messrs. Bernstein and Kami-
chik to purchase from it 10,000 of the said
preferred shares for the price of $200 and by
letters dated December 11, 1964 they each took
up this option and the same day a meeting of
Berkam approved the transfer from Highland to
them of the said shares. On December 14, 1964
Berkam approved a by-law providing for the
redemption and cancellation of 20,000 of its
said preferred shares. This was duly approved
at a special general meeting of shareholders the
same date and supplementary letters patent
were obtained on December 16, 1964 confirm
ing the reduction of the capital of Berkam by
the cancellation of the said shares so that the
capital would thenceforth consist of 900 pre
ferred shares and 100 common shares of the par
value of $10 each. At all meetings of both
companies from the time Highland acquired the
shares in Berkam it was Messrs. Kamichik and
Bernstein who attended and formed the quorum
of directors or shareholders as the case may be.
As a result of this series of transactions
appellant received the sum of $100,000 on
redemption of his said preferred shares for
which he had paid $200 or a benefit of $99,800.
Appellant relies on the terms of the agreement
giving him (and the same agreement was made
with Mr. Kamichik) the right to buy the said
shares from Highland for $200, which sets out
that he is an employee of the company and "the
latter desires to confer a benefit upon him in
respect of and by virtue of his employment",
and in the next paragraph states:
... in consideration of such employment the Company
hereby grants unto Bernstein the exclusive right to purchase
from the Company 10,000 5% Non-Cumulative Non-Voting
Redeemable Preferred Shares of the par value of $10 each
of the capital stock of BERKAM INVESTMENTS LIMITED for the
sum of $200, during the period and upon and subject to the
terms and conditions hereinafter respectively specified and
set forth, namely:-
1. Bernstein's rights hereunder may be exercised in the
manner hereinafter specified, at any time during two (2)
years from the date hereof provided that at the time of the
exercise of such rights Bernstein is in the employ of the
Company.
The original assessment of June 28, 1965
assessed appellant's 1964 tax in the amount
estimated by him on the basis of the election he
made under section 85A but by notice of re
assessment dated June 25, 1969 he was re
assessed by being denied the right to apply the
provisions of section 85A so that the sum of
$99,800 was added to his income for the 1964
taxation year. He objected to the re-assessment
which was confirmed and in due course institut
ed the present appeal.
Respondent contends that appellant and Mr.
Kamichik did not receive the benefit in consid
eration of their employment but rather as share
holders of Highland, that this was a scheme for
appropriation by the shareholders of Highland's
funds or for distribution to the shareholders of
most of the accumulated surplus of Highland
which, as of January 1, 1964, stood at $209,-
022.94, for the sole purpose of diminishing the
amount of income tax payable. Respondent
relies on subsection (7) of section 85A of the
Act which reads as follows:
85A. (7) This section does not apply if the benefit con
ferred by the agreement was not received in respect of, in
the course of or by virtue of the employment.
and on section 8(1)(c) which reads:
8. (1) Where, in a taxation year,
(c) a benefit or advantage has been conferred on a share
holder by a corporation,
otherwise than
(i) on the reduction of capital, the redemption of shares
or the winding-up, discontinuance or reorganization of
its business,
(ii) by payment of a stock dividend, or
(iii) by conferring on all holders of common shares in
the capital of the corporation a right to buy additional
common shares therein,
the amount or value thereof shall be included in computing
the income of the shareholder for the year.
Alternatively, respondent submits that the ben
efit conferred on the appellant was received in
his capacity as a shareholder on account or in
lieu of payment of or in satisfaction of divi
dends within the meaning of section 6(1)(a)(î) of
the Act which reads:
6. (1) Without restricting the generality of section 3,
there shall be included in computing the income of a taxpay
er for a taxation year
(a) amounts received in the year as, on account or in lieu
of payment of, or in satisfaction of
(i) dividends,
Respondent further submits that the result of
the interdependent and interconnected transac
tions referred to was that Highland and/or
Berkam conferred on the appellant a benefit of
$99,800 which by virtue of the provisions of
subsection (2) of section 137 of the Income Tax
Act was required to be included in the computa
tion of appellant's income. Section 137(2) reads
as follows:
137. (2) Where the result of one or more sales,
exchanges, declarations of trust, or other transactions of any
kind whatsoever is that a person confers a benefit on a
taxpayer, that person shall be deemed to have made a
payment to the taxpayer equal to the amount of the benefit
conferred notwithstanding the form or legal effect of the
transactions or that one or more other persons were also
parties thereto; and, whether or not there was an intention
to avoid or evade taxes under this Act, the payment shall,
depending upon the circumstances, be
(a) included in computing the taxpayer's income for the
purpose of Part I,
(b) deemed to be a payment to a non-resident person to
which Part III applies, or
(e) deemed to be a disposition by way of gift to which
Part IV applies.
Finally, respondent submits that the transac
tions referred to were part of a reorganization
of the business of Highland whereby property
of Highland was distributed or otherwise appro
priated to or for the benefit of appellant at a
time when Highland had undistributed income
on hand, which should therefore be included in
appellant's income by virtue of section 81(1) of
the Income Tax Act which reads as follows:
81. (1) Where funds or property of a corporation have, at
a time when the corporation had undistributed income on
hand, been distributed or otherwise appropriated in any
manner whatsoever to or for the benefit of one or more of
its shareholders on the winding-up, discontinuance or reor
ganization of its business, a dividend shall be deemed to
have been received at that time by each shareholder equal to
the lesser of
(a) the amount or value of the funds or property so
distributed or appropriated to him, or
(b) his portion of the undistributed income then on hand.
After several conferences between counsel
and the Court the following agreement was
reached so as to eliminate what would apparent
ly have been lengthy and repetitive evidence:
The parties, by their respective counsel, hereby agree that
the following evidence would be given as to facts by Nathan
Bernstein, Emilien Tanguay, Marcel Leduc and Françoise
Paquette all employees of Highland Knitting Mills if they
had given evidence:
a) such agreement is made for the purpose of this appeal
only and may not be used against either party on any
other occasion or by any other party; and
b) the parties reserve their right to object to the relevancy
of any of the facts hereby admitted.
1. Messrs. Kamichik and Bernstein were bona fide
employees of Highland Knitting Mills Inc. (Highland) during
the period 1956-1969 and were during this period officers,
directors and sole shareholders of the company.
2. Mr. Bernstein has continued to the present day to be a
bona fide employee of Highland.
3. During the period 1956-1969 Messrs. Bernstein and
Kamichik, being officers, employees, directors and share
holders of Highland, performed their duties in an exception
al manner. Specifically, they worked extraordinary hours,
that is, approximately ten hours a day, six days a week, fifty
weeks a year in the case of Mr. Kamichik and approximate
ly fifteen hours a day, six days a week, fifty weeks a year in
the case of Mr. Bernstein.
4. Messrs. Kamichik and Bernstein worked substantially
longer hours than the other "key" employees of Highland.
5. The contribution made by Messrs. Kamichik and Bern-
stein as outlined above was substantially greater than the
contribution made by the other "key" employees.
6. The duties performed by Messrs. Kamichik and Bern-
stein, as outlined above, were essential to the welfare and
growth of the business of Highland.
In view of the agreement it was only necessary
to hear one witness, Stanley Rosen, C.A., High
land's auditor since 1960. He testified that Mr.
Kamichik's work was primarily on the financial
side of the business while Mr. Bernstein was the
salesman, stylist and production expert. Both
worked extremely hard in building up the busi
ness and for salaries which he considered were
grossly inadequate. The business grew very rap
idly, sales increasing from $403,245 in 1960 to
$1,538,785 in 1965 and gross profits from
$70,881 in 1960 to $388,087 in 1965 with net
profit before income taxes increasing from
$13,651 in 1960 to $197,978 in 1965. The busi
ness continued to expand thereafter until 1969
when control of it was sold by Messrs. Bern-
stein and Kamichik to Kambern Diversified
Industries Limited as a result of which the out
standing loans of Highland payable to Mr. Bern-
stein and the estate of Mr. Kamichik in the
amount of $71,676.28 and $73,481.85 respec
tively were paid in October 1969. Mr. Bernstein
continued to remain in the company's employ as
President and to devote his full time and atten
tion to the business whose sales had by 1969
grown to $2,387,328 on which the gross profit
was $744,441 and the net profit before taxes
$424,624. This period does not directly concern
the present case save to the extent that it shows
the continued progress of the business in the
years following 1964. According to Mr. Rosen's
evidence, during the period from 1956 to 1962
their salaries had only been in the nature of
$8,000 to $10,000 each. Mr. Bernstein received
a salary of $17,450 in 1963, however, and
$35,000 in 1964 in which year Mr. Kamichik's
salary was $18,000. Although the company had
123 employees in 1964, three of whom were
long-term employees who had been with the
business since the late 1940's before it was
incorporated, Mr. Rosen felt that the entire
growth of the company was due to the excep
tionally hard work and successful management
of Messrs. Bernstein and Kamichik and when it
became apparent in 1962 and 1963 that the net
profits were accelerating rapidly he urged them
to take more money out of it, which he consid
ered should include compensation for their past
services. A pension plan was established in
1965 for Messrs. Bernstein and Kamichik only
and large sums paid for their past services pen
sions. He conceded on cross-examination that
taking the company's taxation and the personal
tax of Messrs. Bernstein and Kamichik to
gether, the tax burden would be less onerous by
using the stock option plan which was adopted
than by paying them increased salaries or divi
dends. He did not consider it bad administration
of the company on their part to have the com
pany incur a loss of $199,600 in 1964 by selling
them for $400 shares of Berkam for which it
had paid $200,000 although this loss on invest
ment reduced the earned surplus account which
stood at $148,817.49 on January 1, 1964 to
$9,422.94 by December 31, 1964 despite the
addition to earned surplus of net profit of
$60,205.45 for the year 1964. He considered
that the benefit was justified to motivate them
to continue to make the company prosper, and
the company's ability to easily overcome this
loss was shown by its continued prosperity in
the succeeding years.
Messrs. Bernstein and Kamichik each had
$40,000 invested in the company's capital
stock, $25,000 being in $1 par value preferred
shares and $15,000 in $1 par value common
shares, the preferred shares carrying a 5% non-
cumulative dividend which dividend was only
paid once, in 1962, in which year a dividend of
25¢ a share was also paid on the common stock
making total dividend payments of $2,500 on
the preferred stock and $7,500 on the common
stock in that year which they shared equally.
Berkam, although incorporated as an investment
company, never did any business. Mr. Rosen
further testified that Highland's acquisition of
shares in Berkam was not the result of a "day-
light" loan which he defined as one incurred and
repaid the same day. Highland had a good line
of credit with the bank and in 1964 it amounted
to $250,000. After the borrowing to buy the
shares of Berkam, Highland only owed the bank
$213,000, as it normally has only a small bank
loan outstanding during December when most
of its receipts come in. Although its cheque to
Berkam in the amount of $201,000 in payment
of the shares subscribed for is dated October
26, 1964, it was only date-stamped by the bank
on December 4, 1964, but this is of no great
significance save for the fact that interest on
this increase in its outstanding bank loan would
only run from that date. The loan was repaid to
the bank on January 8, 1965 on the same date
that Messrs. Bernstein and Kamichik loaned
$200,000 to the company, taking its promissory
notes for same in the amount of $100,000 each.
Although these notes bore interest at 6%, Mr.
Rosen testified that this interest was waived by
Messrs. Bernstein and Kamichik.
In laying great stress on the value of services
rendered to Highland by Messrs. Bernstein and
Kamichik compared to the remuneration they
had received from it in the years preceding
1964, appellant contends that the benefit con
ferred on them was "received in respect of, in
the course of or by virtue of the employment"
and hence the exclusion in section 85A(7)
(supra) does not apply. While conceding that the
end result of the method adopted was that most
of Highland's surplus which had been
accumulated to the end of 1964 was distributed
to Messrs. Bernstein and Kamichik, reliance
was placed on the well-established principle in
tax law that a taxpayer is not obliged to so
arrange his affairs as to attract maximum taxa
tion and that, provided he can bring himself
squarely within the provisions of sections of the
taxing statute and regulations which have the
result of minimizing his taxation, he is entitled
to do so. It was further contended that section
137(2) dealing with tax evasion cannot take
effect so as to negate the provisions of another
section of the Act which the taxpayer is entitled
to use, even if the consequence of this use is to
reduce his tax liability.
While some of the jurisprudence to which I
was referred by counsel for both parties was
helpful, there does not appear to be any case
which is directly in point. Counsel for appellant
referred to paragraph 8 of Tax Interpretation
Bulletin IT 23 of August 6, 1971 issued by the
Department of National Revenue which would,
of course, not be binding on the Court, as auth
ority for the proposition that an option under
section 85A may be conferred on a person who
is at the same time an employee and a share
holder. I would have assumed this to be the case
in any event since section 139(1)(1a) of the Act
states:
139. (1) In this Act,
(la) "employee" includes officer;
and, while an officer is not necessarily a direc
tor and hence a shareholder, he usually is. I do
not believe that respondent's argument goes so
far as to contend that section 85A can only be
applied to an employee who does not also
happen to own some shares in the corporation,
but the contention is that the benefit must have
been conferred on him "in respect of, in the
course of or by virtue of the employment" and
not in his capacity as a shareholder of the
corporation. The difficulty in the present case
arises from the fact that Messrs. Bernstein and
Kamichik were not merely minor shareholders
of Highland but that between them they owned
or controlled all of its shares and could direct
and govern the conduct of the corporation as
they saw fit. I am not unmindful of the fact that
the corporation has an existence separate and
apart from its shareholders and that in the
present case Highland, at least, was an actively
operating corporation and not a sham or simula-
crum, nor am I unmindful of the jurisprudence
which has held that a corporation cannot be
considered as an agent of its shareholders nor
are the shareholders owners of the property of
the corporation'. With respect to Berkam, how
ever, although it filed the necessary annual
returns and continued to do so in the years
following 1964, ownership of it was clearly
acquired by Messrs. Bernstein and Kamichik
for the purpose of completing the carrying out
of this scheme, the end result of which was to
greatly diminish their income tax liability for the
year in question, and it has never at any time
been used for any other purpose or carried on
any business whatsoever. However, it was
Highland which conferred the benefit on them
and not Berkam, the benefit consisting of their
being given the right to purchase from it shares
of Berkam worth $200,000 for $400, Berkam
being merely the vehicle by which the cash
benefit of this transaction eventually found its
way into their hands.
Appellant invokes the case of Crosbie Estate
v. M.N.R. [1967] 1 Ex.C.R. 297 which case,
however, did not depend on an interpretation of
section 85A of the Income Tax Act but was an
estate tax case. In it a corporation controlled by
the deceased gave two of its employees, one of
whom was related by blood relationship to the
deceased, the right to buy shares of its capital
stock at a substantial discount in recognition of
"long and faithful service ... and as a further
incentive to continue to render such service".
When the deceased died within three years the
Minister added the value of the benefit back to
his estate as being in the nature of a gift or a
disposition for partial consideration. The Court
ruled that the benefit was conferred upon a
relative as an employee of the company for
legitimate business reasons and not as a blood
relation of the deceased. In rendering judgment,
however, Jackett P., as he then was, made refer
ence to section 85A, stating at page 304:
One further point needs to be developed in considering
the neat point that has to be decided on this appeal. In my
view, what was done here falls into a not uncommon catego
ry of business transactions, namely, payments made in the
ordinary course of business without legal liability. A busi
ness is operated to make a profit. No disbursement is a
proper business disbursement unless it is made directly or
indirectly to attain that end. Generally speaking, business
payments are made pursuant to contracts whereby the busi
ness man receives a quid pro quo for that payment—e.g.,
contracts for services, purchase contracts, construction con
tracts, etc. Nevertheless, good business can dictate, depend
ing on the circumstances, disbursements over and above the
amounts legally owing for what the business man has
received or is to receive. A special payment to a good
contractor in unforeseen difficulties so that he will be avail
able for future work, is one example. Bonuses to employees
over and above any requirement of the contracts of employ
ment, so as to maintain their goodwill and keep employee
morale high is another. Still another is the very type of
benefit conferred on senior executives that we find in this
appeal. That it is a very common type of benefit conferred
on senior executives is evidenced by the special provision
made in section 85A of the Income Tax Act for their income
tax treatment.
In the preceding paragraph, however, a conclu
sion of fact on which this statement is based is
set out as follows:
There is no suggestion that the transaction was a mere
subterfuge for conferring a benefit on Andrew C. Crosbie as
a blood relation of the deceased and there is no suggestion
that any part of the amount of the benefit is for anything
other than the benefit that "legitimate business reasons"
dictated that it was in the commercial interest of the com
pany that it should confer on this employee. This aspect of
the case is underlined by the otherwise irrelevant fact that a
similar arrangement was made for a fellow employee on
very similar terms at the same time.
The facts in that case are evidently quite differ
ent from the present where, despite the great
stress laid by appellant's counsel in argument of
the value to a corporation of offering stock
option benefits to senior employees in lieu of
increases in salary in order to retain their ser
vices and prevent their leaving to work for a
competitor, it was quite evident that neither Mr.
Bernstein nor Mr. Kamichik had any such
thought or intention. The business was, in fact,
theirs, had been founded by them long before
they incorporated, and they were for all practi
cal purposes the only shareholders of Highland.
It might perhaps be contended that the stock
option benefit was conferred on them as a
reward for past services, but certainly it was not
required as an incentive to maintain their good
will and continued devotion to the company's
service. Looked at in this light it cannot be
compared with stock option benefit plans which
are frequently given to senior executives of
large corporations in the interests of encourag
ing them and retaining their services. It is not
without significance that three other employees
who had been with the business since the late
1940's, and while admittedly not as valuable to
Highland as Messrs. Bernstein and Kamichik,
were only receiving $7,000 to $8,000 in 1964,
were not given the opportunity to participate to
even a very limited extent in the stock option
benefit nor were they included in the company's
pension plan established in 1965. It is also not
without significance that in 1964, the very year
in which the stock option benefit was conferred
on appellant (and on Mr. Kamichik with whom
we are not here concerned) his salary had been
increased to $35,000 from the $17,450 he had
received in 1963 and $8,000 in 1962, so it can
hardly be successfully contended that the stock
option benefit was necessary "for legitimate
business reasons" to reward him for his excep
tionally hard work and ability and to retain his
interest in continuing on the same basis in the
company's service.
Appellant also referred to the Tax Appeal
Board judgment in the case of Smith v. M.N.R.
69 DTC 192 which permitted the application of
section 85A to a share option benefit conferred
on appellant by a company in which he and his
wife owned the controlling interest. The case
seems to have been decided, however, on the
basis that it was not necessary to have a formal
written agreement between the company and
appellant respecting the issue of the shares to
him, a mere verbal agreement being sufficient,
and no consideration seems to have been given
to the possible application of section 85A(7) nor
did the Minister invoke the provisions of section
137(2).
Appellant also referred to the case of Mars-
land v. M.N.R. [1970] Tax A.B.C. 49 in which
appellants, husband and wife, were assessed for
gift tax as the result of the issuance to their son
at a substantial discount of shares in a corpora
tion of which they owned 47 of the 50 issued
shares, the son owning the other three. The
finding was to the effect that it was clearly a
benefit conferred on an employee by virtue of
section 85A(1)(a) so that tax should be calculat
ed in accordance with the provisions of section
85A(2) and that section 137(2) could not be
applied. The reasoning in the judgment was to
the effect that, since under section 85A such a
payment is deemed to be income and under
section 137(2) it can either be included in com
puting taxpayer's income under paragraph (a) or
deemed to be a disposition by way of gift under
paragraph (c) and since the recipient, the son,
was prepared to pay whatever tax was payable
by section 85A(2), it should not be treated as a
gift. Again in this case there was no discussion
of section 85A(7) and as already pointed out the
question was not one of income tax but rather
of gift tax which is not the issue in the case
before me. Furthermore, the appellants' son was
only a minority shareholder of the corporation
although he had been for some time its most
valued employee, his father having retired some
time previously. It is clearly distinguishable
from the present case therefore.
Appellant also relies on the case of M.N.R. v.
Pillsbury Holdings Limited [1965] 1 Ex.C.R.
676, in which the respondent company bor
rowed a large sum of money from two of its
subsidiaries. Subsequently interest was waived
on the loan. The contention was that this was
the conferral of a benefit by the subsidiary
corporations on the parent corporation, being a
shareholder. In refusing to apply section 8(1)(c)
of the Act (supra), Cattanach J., in rendering
judgment, found that the benefit or advantage
was not conferred on the parent company qua
shareholder and in so finding he states at page
687:
The Minister does not allege that he assumed, in making the
assessments, that the waiver was an arrangement or device
adopted by the corporation to confer a benefit or advantage
on the respondent as a shareholder. There was no onus on
the respondent to disprove that fact, which is essential to its
being taxable, unless the Minister assumed that fact when
assessing. It may be that the Minister's appeal should be
dismissed on that ground.
In the present case there is a clear invoking of
the provisions of section 8(1)(c) and section
137(2) by respondent. The significance of this is
emphasized when Cattanach J. states again at
page 688:
I have more difficulty, as far as the first round of waivers
is concerned, inasmuch as it does seem improbable that the
lender would have cancelled the interest outright, instead of
merely giving time for payment, on a claim by the borrower
that it was in difficulties, were it not for the fact that the
borrower owned practically all the shares in the lender
corporation. However, there was no allegation that the
waiver was anything other than what it purported to be, that
is, a lender granting relief to a borrower in difficulties. Had
the transactions been attacked in the Notice of Appeal and
at the trial as being a device or arrangement for conferring a
benefit on the respondent qua shareholder, it might well
have been difficult for the respondent to have resisted the
attack. However no such attack was made and the assess
ments cannot therefore stand.
I believe that two of respondent's contentions
can readily be disposed of. In support of its
contention that the benefit should be treated as
a dividend under the provisions of section
6(1)(a)(î) of the Act (supra) respondent relies on
the case of Hill v. Permanent Trustee Company
of New South Wales, Limited [1930] A.C. 720
in which it is stated at page 731:
A limited company not in liquidation can make no pay
ment by way of return of capital to its shareholders except
as a step in an authorized reduction of capital. Any other
payment made by it by means of which it parts with moneys
to its shareholders must and can only be made by way of
dividing profits. Whether the payment is called "dividend"
or "bonus," or any other name, it still must remain a
payment on division of profits.
This case was referred to in the Exchequer
Court in the case of Northern Securities Com
pany v. The King [1935] Ex.C.R. 156 where,
after quoting this passage, Maclean P. stated at
pages 160-61:
This means that any distribution of money, except on a
reduction of capital, by which assets are released to the
shareholders, can only be a distribution of profits, by what
ever method it is made.
Another finding to the same effect was made in
the case of McConkey v. M.N.R. [1937] Ex.C.R.
209. None of these cases has any application to
the present situation, however, unless it is con
cluded that the benefit was conferred on
Messrs. Bernstein and Kamichik qua sharehold
ers and not qua employees as otherwise section
85A, which was not of course an issue in the
Hill case (supra) in Britain, nor in existence at
the time of the two Canadian judgments, does
provide an alternative method of distributing
surplus by interest means. In any event, even if
the conclusion were reached that this was a
benefit conferred on Messrs. Bernstein and
Kamichik qua shareholders, I believe it would
be section 8(1)(c) which should apply to it
rather than section 6(1)(a)(i). Section 6(1)(a)(i)
merely uses the word "dividends" and the word
"dividend" is defined in section 139(1)(k) as
follows:
139. (1) In this Act,
(k) "dividend" does not include a stock dividend;
There was no meeting of directors at which any
dividend was declared and the elaborate scheme
which was adopted to eventually get cash from
the company's surplus into the hands of Messrs.
Bernstein and Kamichik could hardly be consid
ered as the payment of a dividend. If it were to
be considered as a dividend at all, and I do not
so find, it would be more in the nature of a
stock dividend dealt with in section 8(1)(c)(ii).
However, some consideration, however slight,
was paid for the stock and surely in a normal
stock dividend no consideration would be paid
for same and, moreover, it was not stock of
Highland which was distributed to them but
stock of Berkam which was sold at a discount.
If it is found, therefore, that the transaction
resulted in a benefit or advantage being con
ferred on a shareholder qua shareholder within
the meaning of section 8(1)(c) of the Act, the
exceptions in subparagraphs (i), (ii) and (iii) of
paragraph (c) would not apply since it would not
be an advantage or benefit conferred either "on
the reduction of capital, redemption of shares or
winding-up, discontinuance or reorganization of
the business", the "payment of a stock divi
dend", or "by conferring on all holders of
common shares in the capital of the corporation
the right to buy additional common shares
therein", as what was conferred was not a right
to buy additional shares of Highland but rather
the sale by Highland to Messrs. Bernstein and
Kamichik of the shares which Highland owned
in Berkam. The amount or value of the benefit
would therefore be included in computing appel
lant's income for the year.
I believe also that respondent's contention
that the benefit should be taxed under the provi
sions of section 81(1) of the Act must fail since
it only applies "on the winding-up, discontinu
ance or reorganization" of the corporation's
business and there was no reorganization what
soever of Highland's capital structure or busi
ness, the reorganization having taken place with
respect to Berkam. As I have already concluded
that the benefit was conferred not by Berkam
but by Highland, this section can have no
application.
This brings us to the main question in issue,
namely whether the benefit was not received
"in respect of, in the course of or by virtue of
the employment" of appellant within the mean
ing of section 85A(7) in which event the applica
tion of section 85A can have no effect.
Appellant contends that section 85A(1) is
intended to apply to a transaction such as that in
issue in the present case in that Highland sold
shares of Berkam, a corporation with which it
did not deal at arm's length, he and Mr. Kami-
chik being employees of Highland, and that the
benefit must be deemed to have been received
by them by virtue of their employment in
accordance with section 85A(1)(a) and the tax
calculated in accordance with section 85A(2).
He points out that there is no requirement in the
section that the same benefit be extended to all
employees and that there is no limitation on the
amount of the benefit which can be so given.
Certain indicia point to the fact, however, that
the benefit was not conferred on them by virtue
of their employment. Although they worked
unequal time in the course of their employment
by the company and in the years 1963 and
1964, in any event, Mr. Bernstein received sub
stantially higher salary than Mr. Kamichik, at all
times each owned 50% of the company's shares
and had the same investment in the company,
and the benefit was conferred on them equally.
It was not merely a relatively small benefit
which was conferred on them but one which
absorbed practically all of the company's earned
surplus at the end of 1964. It was not offered to
any other employee, even three others with long
service. It was not beneficial to the company
tax-wise but, on the contrary, was detrimental in
that had it been paid by way of a bonus or
increase in salary, this would have been a
deductible expense to the company in its tax
return. In its consequences it amounted to a
distribution of Highland's profits, which profits
are normally only distributed to shareholders as
such and not to employees unless by virtue of
some profit-sharing plan. Finally, the amounts
received were, after the redemption of the
shares, immediately loaned back to Highland by
appellant and Mr. Kamichik, and it would be
most unusual for employees as such to immedi
ately loan back to the company a benefit
received from it. When one looks at the intent
of section 85A, it was evidently designed to
enable a corporation to afford its employees (or
its senior employees if it desires to restrict the
offer to them) an opportunity to acquire shares
of its stock or of the stock of a controlled
subsidiary on terms which confer a benefit on
them in order to reward their services and retain
a personal interest by them in the company's
progress without their being obliged to pay regu
lar tax rates on the amount of this benefit. It can
hardly have been intended to be used as a
means of compensating an employee or
employees, who may have been underpaid for
some years, by conferring on them a benefit in a
subsequent year at a very advantageous tax
rate, in an amount sufficient to compensate
them for all the alleged underpayment of salary
which they have suffered in preceding years,
when, had they been paid the salary to which
they claim to have been entitled in those years,
they would have had to pay tax on it each year
at the regular tax rate. Neither could it have
been intended that it should be used as a means
of transferring nearly all of the company's
earned surplus to shareholders who, between
them, own or control all the shares of the com-
pany's stock at the same advantageous tax rate,
whereas had it been paid to them by way of
increased salary, bonus, regular dividend (which
would have been subject to the dividend credit)
or even by use of section 105, the taxes payable
would have been substantially higher 2 .
In the case of Smythe v. M.N.R. [1968] 2
Ex.C.R. 189, Gibson J. considered the applica
tion of section 137(2) to the involved transac
tion involved in that case at some length. He
concluded that there was no business reason for
entering into the various transactions and that
the result of the series of transactions was that
the company conferred a benefit on the appel
lants qua shareholders, which benefit, because
of section 137(2), is deemed to be a payment
which must be included in computing the tax
payer's income. The assessor had included it as
a deemed dividend under section 81(2) of the
Act, but Gibson J. concluded, as I have conclud
ed in the present case, that there was no wind-
ing-up, discontinuance or reorganization of the
business and as a consequence he would have
assessed the benefit as income received by the
appellant within the purview of section 8(1) of
the Act. This judgment was upheld in the
Supreme Court ([1970] S.C.R. 64) but in that
Court it was found that the case was plainly
covered by section 81(1) of the Act and that it
was therefore unnecessary to express any opin
ion on the scope of section 137(2).
In the case of Craddock v. M.N.R. [1969] 1
Ex.C.R. 23, Gibson J. went into further detail as
to his understanding of the application of sec-
tion 137(2) of the Act to a surplus stripping
operation having no legitimate business purpose
and resulting in a benefit being conferred on the
appellants. In rendering judgment he states at
page 31:
When the circumstances of the inter-related transactions
are such that it is correct to include such "benefit" "in
computing the taxpayer's income for the purpose of Part I",
then the total of it is included in such taxpayer's income as
one of the sources of such taxpayer's income within the
meaning of section 3 of the Act in the same manner as if
section 137(2) was in one of the series of sections in Part I
such as section 6, section 8(1), section 16(1) and section
81(1). But section 137(2) of the Act in any such case is not
dependent upon for its efficacy on or connected with any
other section or sections in Part I, such as sections 6, 8(1),
16(1) and 81(1) and therefore none of these latter sections
are relevant in the adjudication of any case in which section
137(2) is applicable.
On this basis, section 137(2) may not even have
to be linked with another section in order to be
applied, but since, in the present case, I have
concluded that it would also come within sec
tion 8(1)(c), it is not necessary to conclude that
the transaction would be taxable by the provi
sions of section 137(2) alone. I am satisfied on
the facts before me that the series of transac
tions commencing with the acquisition of
Berkam by Highland, the reorganization of its
capital structure to provide for additional pre
ferred shares, the purchase of these shares at
their par value by Highland, the subsequent sale
of these shares for a nominal price by Highland
to appellant and Mr. Kamichik, the subsequent
supplementary letters patent of Berkam result
ing in the cancellation and redemption of its
preferred shares and payment of the par value
of them to appellant and Mr. Kamichik, and the
immediate loan by them to Highland of the
amounts so received to enable Highland to
repay the bank indebtedness it had incurred for
the purchase of these shares in the first place,
were all carried out in order to confer a benefit
on appellant and Mr. Kamichik within the mean
ing of section 137(2) of the Act with the inten
tion of diminishing the taxes payable by them
under the Act and that the benefit received
should therefore be included in computing the
taxpayer's income for the purpose of Part I.
Section 8(1)(c) in Part I applies in that the
benefit or advantage was conferred on them as
shareholders of Highland. This finding depends
on the facts of this case, which should not be
construed as holding that section 85A cannot
properly be applied to an employee who is also
a shareholder, but is based on the fact that in
the present case appellant and Mr. Kamichik
were the sole shareholders as well as being bona
fide employees and that in their capacity as sole
shareholders of Highland they caused it to so
act as to confer a benefit on them which,
although stated to be conferred by virtue of
their employment, was in actual fact received
by them in consequence of their being able as
sole shareholders of the company to so control
its actions as to cause this benefit to be paid. It
was not, therefore, received by virtue of their
employment within the meaning of section
85A(7) but rather by virtue of their being share
holders of the company with the result that
section 85A cannot be used in the case of appel
lant as an exception preventing the application
of section 137(2) and section 8(1)(c) of the Act.
The appeal is therefore dismissed with costs.
' See for example Salomon v. Salomon [1897] A.C. 22;
The Gramophone and Typewriter, Limited v. Stanley [1908]
2 K.B. 89; Army and Navy Department Store Limited v.
M.N.R. [1953] 2 S.C.R. 496; Denison Mines Limited v.
M.N.R. [1971] F.C. 295 at p. 320 and Sazio v. M.N.R.
[1969] 1 Ex.C.R. 373.
2 I am strengthened in this view by the amendment made
to section 85A(2)(b) in 1966-67, c. 47, s. 9(1) whereby the
tax, instead of being based on the difference between the
proportion of the benefit, calculated in accordance with
section 85A(2)(b)(i) and 20% of the benefit so received is
now calculated on the difference between the proportion so
calculated and the lesser of 20% of the benefit so deemed to
have been received or $200. If the $200 provision had been
in effect in 1964, the tax payable by appellant would have
been very substantially larger and the benefit would have
been of far less tax advantage to him.
You are being directed to the most recent version of the statute which may not be the version considered at the time of the judgment.