Date: 19990122
Docket: 96-541-IT-G
BETWEEN:
BRUCE N. SHEPP,
Appellant,
and
HER MAJESTY THE QUEEN,
Respondent.
Appeal heard on April 20, 1998, at Edmonton, Alberta, by the Honourable Judge Lucie Lamarre
Appearances
Counsel for the Appellant:
D.N. Cherniawsky
Counsel for the Respondent:
James Yaskowich
Counsel of record:
For the Respondent:
Morris Rosenberg
Deputy Attorney General of Canada
Ottawa, Canada
Judgment
The appeal from the assessment made under the Income Tax Act for the 1989 taxation year is allowed, with costs, and the assessment is referred back to the Minister for reconsideration and reassessment on the basis that the appellant did not have to increase the capital gain reported in his 1989 taxation year by an amount of $756,095.
Reasons for judgment
Lamarre, J.T.C.C.
[1] The appellant is appealing an assessment issued in accordance with the Income Tax Act (the "Act") in respect of his 1989 taxation year. In so assessing the appellant, the Minister of National Revenue (the "Minister") increased the capital gains reported by the appellant by $756,095 and increased his taxable income by $504,063 for that year on the basis that the appellant disposed of an economic interest in B.N. Shepp and Associates Ltd. ("Opco") that resulted in proceeds of disposition deemed to be equal to the fair market value of the property so disposed of, in accordance with subparagraph 69(1)(b)(ii) of the Act. That fair market value was assumed by the Minister to be $756,095.
Facts
[2] The parties filed a Statement of Agreed Facts , the relevant paragraphs of which read as follows:
[...]
2. The Appellant is an individual resident in Canada for the purposes of the Act.
3. The Appellant is a licensed actuary and received his actuarial designation in May, 1974 from the Society of Actuaries.
4. On or about November 28, 1975 the Appellant incorporated B.N. Shepp and Associates Ltd. ("Opco") to carry on the business of actuarial consulting. From 1975 until 1979 the Appellant and his wife Carol-Lynn Shepp owned all of the issued shares of Opco. At all relevant times the Appellant controlled Opco.
4.1 The fiscal year of Opco was December 1 to November 30.
5. In 1979 the authorized share capital of Opco was amended to include a class of Special Preferred Shares. Also in 1979 the Appellant and Carol-Lynn Shepp exchanged all of their Common Shares of Opco for 100 Special Preferred Shares having an aggregate redemption amount of $275,000 ($2,750 per share) pursuant to section 86 of the Act. After this share exchange Opco issued new Common Shares to the Appellant (79 Common Shares), his spouse Carol-Lynn Shepp (1 Common Share), Eric Manchester, a key employee (15 Common Shares) and William Keech, a key employee (5 Common Shares).
5.1 Opco was originally incorporated under the Companies Act (Alberta). On October 5, 1985, Opco was continued under the Business Corporations Act (Alberta).
6. Immediately prior to December 16, 1987 the authorized share capital of Opco consisted of one class of Common Shares and one class of Special Preferred Shares which were issued as follows.
# of Common Shares # of Special Preferred Shares
Appellant 79 99
Carol-Lynn Shepp 1 1
William Keech 5 -
(a key employee)
TOTAL 85 100
Some time before December 16, 1987 the 15 Common Shares owned by Eric Manchester were repurchased by Opco.
7. As part of the introduction of the capital gains deduction provisions in section 110.6 of the Act, subsection 73(5) (which allowed the transfer of shares of small business corporations to children and grandchildren), was repealed for dispositions after December 31, 1987.
...
9. On December 16, 1987 the Appellant settled the Bruce N. Shepp Family Trust No. 1 (the "Trust"). At all relevant times the Trustees of the Trust have been the Appellant and Carol-Lynn Shepp. At all relevant times the Appellant and Carol-Lynn Shepp dealt with the Trust on a non-arm's length basis.
10. The sole beneficiary of the Trust was Jeff Shepp, who was a 15-year-old student at the time that the Trust was settled.
11. On December 16, 1987 a Special Resolution was passed by the shareholders of Opco to amend the terms of its authorized share capital as follows:
a. To designate 17 Common Shares of Opco registered in the name of the Appellant as Class "B" Common shares;
b. To designate the remaining issued Common Shares and the unissued Common Shares of Opco as Class "A" Common Shares; and
c. To amend the rights, privileges, restrictions and conditions attached to the Class "A" Common Shares and the Class "B" Common Shares as follows:
(i) to provide that the holders of the Class "A" Common Shares and the Class "B" Common Shares shall share equally in the property of Opco on a dissolution, liquidation, winding-up or other distribution of assets on the winding-up of Opco's affairs;
(ii) to allow the payment of dividends on the Class "A" Common Shares to the exclusion of dividends on the Class "B" Common Shares;
(iii) to allow the payment of dividends on the Class "B" Common Shares in conjunction with the payment of dividends to the holders of Class "A" Common Shares;
(iv) to allow the holders of Class "A" Common Shares to vote at any meetings of shareholders; and
(v) to provide that the holders of the Class "B" Common Shares shall not have the right to vote at meetings of shareholders subject to any contrary provisions of the Business Corporations Act (Alberta).
These terms and conditions were supported by paragraphs 3.2 and 3.5 of the Special Resolution and the Articles of Amendment which provided as follows:
"3.2 the holders of the class "A" Common Shares shall have the right to receive such dividends as may be declared by the Corporation:
3.2.1 to the exclusion of the holders of the Class "B" Common Shares; or
3.2.2 together with the holders of the Class "B" Common Shares.
3.5 The holders of the Class "B" Common Shares shall not, subject to the provisions of the Business Corporations Act (Alberta), have the right to receive notice of or to attend any meetings of shareholders of the Corporation or to vote at any such meetings."
12. On December 17, 1987 the Appellant exchanged his 79 Common Shares of Opco for 62 Class "A" Common Shares and 17 Class "B" Common Shares in accordance with section 86 of the Act.
13. On December 17, 1987, the Appellant transferred his 17 class "B" Shares to the Trust and, in accordance with subsection 73(5) of the Income Tax Act, jointly elected with the Trust at an adjusted cost base of $1 per Class "B" Share and reported the fair market value of the Shares to be, in the aggregate, $200,000.
13.1 Opco had gross revenues in the following amounts for the years stated below:
1985 - $ l,l04,411
1986 - $ l,313,126
1987 - $ 1,712,197
1988 - $ 2,018,853
1989 - $ 1,519,322 (nine months ending August 31, 1989)
13.2 The Appellant received salary from Opco in the following amounts for the years stated below:
1987 - $ 382,977
1988 - $ 504,753
1989 - $ 445,535
13.3 Between 1979 and 1985, Opco paid dividends on the Special Preferred Shares. No dividends on those shares were paid for 1986 through August 31, 1989.
13.4 Between 1979 and 1985, Opco paid dividends on the Common Shares as follows for the years stated below:
1982 - $ 74,970
1983 - $ 136,000
1985 - $ 5,000
13.5 For the year ending November 30, 1988, the Retained Earnings of Opco were $l,027,169. For the period ending August 31, 1989, the retained earnings of Opco were $79,965.
14. On June 30, 1989 Opco repurchased its 5 class "A" Common Shares held by William Keech for a total consideration of $23,287. The consideration was determined by reference to a formula contained in an Agreement between Opco and William Keech dated October 12, 1978.
15. By the end of July, 1989 the Appellant reached an agreement with MLH & A Inc. ("MLH") for MLH to acquire all of the issued shares of Opco. On August 14, 1989, a written offer was made to [sic] MLH for the purchase of Opco, which offer was endorsed by the Appellant. At all relevant times the Appellant and MLH dealt with each other on an arm's length basis.
16. On August 28, 1989 the authorized share capital of Opco was amended as follows:
a. To increase the number of Class "B" Common Shares authorized to an unlimited number;
b. To split the issued Class "A" Common Shares and Class "B" Common Shares on a l,000 for 1 basis; and
c. To allow the holders of Class "B" Common Shares to convert their Class "B" Common Shares to Class "A" Common Shares on a one for one basis as provided by paragraph 3.7 of the Articles of Amendment:
"3.7 Any holder of Class "B" Common Shares shall be entitled at any time or from time to time at his option to have such number of Class "B" Common Shares held by him and designated by him for exchange, exchanged for an equal number of Class "A" Common Shares."
17. After the passage of the August 28, l989 Special Resolution the issued shares of Opco were as follows:
Class "A" Class "B" Special
Common Shares Common Shares Preferred Shares
Appellant 62,000 -- 99
Carol-Lynn Shepp 1,000 -- 1
The Trust -- 17,000 --
18. On August 28, 1989 the Trust exercised its right to exchange 4,800 class "B" Common Shares of Opco for 4,800 class "A" Common Shares of Opco.
19. On April 6, 1989 the Appellant incorporated 400367 Alberta Ltd. ("Newco"). On August 28, 1989 the Articles of Incorporation of Newco were amended to allow an unlimited number of First Preferred Shares to be issued in series. The First Preferred Shares were redeemable at the option of Newco, were retractable at the option of the shareholders and included the right to non-cumulative dividends at a rate not to exceed 8% per year.
20. On August 28, 1989 the Appellant transferred 99 Special Preferred Shares of Opco to Newco in exchange for 99 First Preferred Shares I having an aggregate redemption amount of $272,250 and having an aggregate paid-up capital of $99. The Appellant and Newco elected under subsection 85(1) of the Act in respect of this transfer for proceeds of disposition of $99 and filed Form T2057 with Revenue Canada on a timely basis.
21. On August 28, 1989 the Appellant transferred 49,592 Class "A" Common Shares of Opco to Newco in exchange for 49,592 First Preferred Shares II of Newco having an aggregate redemption amount of $2,461,746.88 and an aggregate paid-up capital of $49.60. The Appellant and Newco elected under subsection 85(1) of the Act in respect of this transfer for proceeds of disposition of $49.60. The Appellant and Newco filed Form T2057 with Revenue Canada on a timely basis.
22. On August 28, l989 the Trust transferred 4,800 Class "A" Common Shares of Opco to Newco in exchange for 4,800 First Preferred Shares II of Newco having an aggregate redemption amount of $238,272 and an aggregate paid-up capital of $4.80. The Trust and Newco elected under subsection 85(1) of the Act in respect of this transfer for proceeds of disposition of $4.80. The Trust and Newco filed Form T2057 with Revenue Canada on a timely basis.
23. On August 29, 1989 Opco redeemed its 99 Special Preferred Shares owned by Newco for aggregate consideration of $272,250. Newco reported the excess of the redemption amount over the paid-up capital of the Special Preferred Shares as a deemed dividend and applied the provisions of subsection 55(2) in segregating the deemed dividend into a taxable dividend of $168,290 and a capital gain of $103,960. Also on August 29, 1989 Opco redeemed l Special Preferred Share from Carol-Lynn Shepp.
24. On August 29, 1989 Opco declared a dividend of $9.90 per share on each of its Class "A" Common Shares. The total dividend paid was $671,220 and was allocated to the Opco shareholders as follows:
Appellant $122,839.20
Carol-Lynn Shepp 9,900.00
Newco 538,480.80
TOTAL $ 671,220.00
25. The Appellant and Carol-Lynn Shepp reported the dividends received from Opco on their 1989 personal income tax returns. Newco reported the taxable dividend of $538,480.80 in its l989 corporate income tax return and elected under paragraph 55(5)(f) to treat the dividend as a number of separate dividends even though all of the dividend was paid out of Opco's safe income.
26. On August 30, l989 the Trust sold 12,200 Class "B" Common Shares of Opco to the Appellant for proceeds of disposition of $41.25 per share or $503,250 in total. The 12,200 Class "B" Common Shares had a reported adjusted cost base in the aggregate of $12.20. As a result, the Trust reported a capital gain on its 1989 T3 return of $503,238 which resulted in a taxable capital gain of $335,492. In accordance with subsections 104(21), 104(21.1) and 104(21.2), the Trust allocated taxable capital gains of $335,492 to its sole beneficiary, Jeff Shepp and deducted the allocated capital gain in computing its taxable income.
27. On his 1989 personal income tax return Jeff Shepp reported a taxable capital gain of $335,492 which was allocated to him from the Trust. Jeff Shepp also claimed a capital gains deduction in total of $333,333 in accordance with subsection 110.6(2.1).
28. On August 30, 1989 Carol-Lynn Shepp sold l,000 Class "A" Common Shares of Opco to the Appellant for proceeds of disposition of $41.25 per share or $41,250 in total. The 1000 Class "A" Common Shares had a reported adjusted cost base in the aggregate of $l.00. On her 1989 personal income tax return she reported a capital gain of $41,249 which resulted in a taxable capital gain of $27,501. On her 1989 personal income tax return Carol-Lynn Shepp claimed a capital gains deduction of $27,501 in accordance with subsection 110.6(2.1).
29. On August 30, 1989 the Appellant converted the 12,200 Class "B" Common Shares of Opco which he had acquired from the Trust to 12,200 Class "A" Common Shares.
30. On August 30, 1989 the Appellant sold the 25,608 Class "A" Common Shares which he owned in Opco to MLH for $41.25 per share or $l,056,322.50 in total. This consideration was paid as follows:
Cash or Certified Cheque on Closing $1,047,750.00
50 Shares of MLH 8,572.50
TOTAL $1,056,322.50
30.1 On August 30, 1989 the Appellant entered into a contract of employment for a term of five years with MLH and Opco, now a wholly owned subsidiary of MLH. Among other things, that contract provided the Appellant with a salary of $125,000 per year and contained a non-competition clause.
31. On his 1989 personal income tax return the Appellant reported a capital gain of $503,237 in respect of the disposition of his shares of Opco to MLH. This resulted in a taxable capital gain of $335,491.86. The Appellant also claimed a capital gains deduction of $322,567 in accordance with subsection 110.6(2.1).
32. On August 30, 1989 Newco sold 54,392 Class "A" Common Shares of Opco to MLH for $41.25 per share or $2,243,677.50 in total. This consideration was paid as follows:
Cash or Certified Cheque on Closing $ 552,250.00
Promissory Note to be Paid in Monthly
Instalments of $29,166.67 Plus Interest at
Prime Plus 1% $ l,400,000.00
1,700 Shares of MLH 291,427.50
TOTAL $ 2,243,677.50
33. By Notice of Assessment dated June 27, 1990 the Appellant's 1989 personal income tax return was assessed substantially as filed.
34. By a Notice of Reassessment dated June 23, 1993 (the "Reassessment") the Minister of National Revenue (the "Minister") reassessed the Appellant's 1989 income tax return on the basis that the Appellant disposed of an economic interest in his Class "A" Common Shares to the Trust. Relying on paragraph 69(1)(b)(ii) of the Act, the Minister assessed the Appellant for proceeds of disposition deemed to have been received by the Appellant equal to the fair market value of the interest so disposed. This resulted in an increase to the capital gains reported by the Appellant of $756,095 and an increase to the Appellant's taxable income as reported of $504,063. This resulted in an increase to the Appellant's 1989 Federal and Provincial income tax of $229,685.29 and arrears interest of $104,094.28. The Federal tax portion of the Reassessment is approximately $154,000.
35. As a result of the Appellant's June 23, 1993 Reassessment and by Notices of Reassessment issued to Carol-Lynn Shepp, the Trust, Jeff Shepp and Newco on July 26, 1993, July 23, 1993, October 4, 1993 and August 9, 1993 respectively, the Respondent reassessed their 1989 income tax returns on the following basis.
a. Carol-Lynn Shepp
Carol-Lynn Shepp was "deemed to have disposed of part of an economic interest that resulted in proceeds of disposition totalling $12,195 in accordance with the provisions of subparagraph 69(1)(b)(ii) of the Act" which resulted in an increase to her capital gains of $12,195. The corresponding increase in taxable capital gains was offset by an increase in her capital gains deduction.
b. Jeff Shepp and the Trust
On August 28, 1989 the Trust was deemed to have acquired an economic interest in Opco at fair market value of not less than $768,290 in accordance with paragraph 69(1)(c) of the Act with the effect that the adjusted cost base of the 17,000 Class "B" Common Shares of Opco held by the Trust was revised to $768,307. This had the effect of eliminating the capital gains reported by the Trust in its 1989 T3 and eliminating the capital gain allocated to Jeff Shepp from the Trust which was reported in his 1989 personal income tax return.
c. Newco
Because the Trust was deemed to have acquired an economic interest in Opco with a fair market value of $768,290 on August 28, 1989, the adjusted cost base of the shares of Opco (which the Respondent incorrectly indicates on the Notice of Confirmation were transferred to Newco by the Trust) was revised from $47 to $216,976 pursuant to paragraph 85(1)(c.l) of the Act. As a result, the capital gain reported by Newco was reduced by $216,929.
36. The Appellant filed a Notice of Objection to the Reassessment on July 13, 1993.
37. By Notice of Confirmation dated November 23, 1995 the Respondent confirmed the Reassessment.
[3] In addition, the appellant called Mr. Bradley Tetz, C.A., as a witness. Mr. Tetz testified regarding the structure of Opco, the series of transactions leading up to the sale of Opco to MLH & A Inc. ("MLH") and the intended tax consequences of the transactions undertaken.
[4] Both Mr. Tetz and the appellant testified that the purpose behind the creation of the trust in 1987 was to allow some of Opco's growth to accrue to the appellant's son, Jeff Shepp. However, because Jeff Shepp was a minor, the appellant was advised that a trust was the most appropriate mechanism. The trust was therefore set up to hold 17 common shares of Opco until such time as the trustees of the trust decided to distribute the trust property to the beneficiary. In the meantime, the appellant felt it necessary to issue Class B common shares to the trust thereby allowing it to vote only on matters of significant corporate importance under the provisions of the Business Corporations Act (Alberta), but not on routine, day-to-day matters. The accountant also recommended that some flexibility be added by making the shares subject to a "dividend sprinkling" provision which would allow dividends to be paid on the Class A common shares to the possible exclusion of the Class B common shares.
[5] Mr. Tetz was more particularly involved in Opco's transactions from August 14, 1987, when a written offer ("Letter of Intent") was made by MLH for the purchase of Opco, which offer was endorsed by the appellant. At that time Opco did not qualify as a small business corporation as its investment assets were greater than 10 per cent of its total assets (Opco's financial statements showed approximately one million dollars in cash). Hence the capital gains exemption was not available to shareholders selling their shares in Opco.
[6] Furthermore, Opco had a large cash surplus that could be distributed tax-free out of its safe income to 400367 Alberta Ltd. ("Newco") a holding company with respect to Opco.
[7] Mr. Tetz testified that, between the date of the Letter of Intent and the date of closing of the transaction with MLH, two objectives had to be achieved in order to maximize the tax benefits of the transaction as specifically permitted by the Act. First, Opco had to be purified in order to become a small business corporation so as to allow the shareholders to receive the benefit of the capital gains exemption when they would sell their shares. Second, a substantial portion of the safe income was to be paid tax-free by way of dividends to Newco. This is why the appellant, Carol Lynn Shepp and the trust transferred part of their shares in Opco to Newco.
[8] As confirmed by Mr. Tetz, the Letter of Intent specifically allowed certain adjustments to be made in order for Opco to achieve these two objectives before closing. Indeed, there was a reference in the Letter of Intent to target retained earnings that were to be obtained by reducing the actual retained earnings (about $1,000,000 on August 14, 1989) by way of a share repurchase, dividends or bonuses.
[9] In fact, MLH purchased the Opco shares and what was left over after the purification of Opco for $3,300,000. The total dividends paid to the Class A shareholders in the purification process amounted to $671,220. It was not worth paying dividends to Class B shareholders as the trust would have been taxed at the highest marginal rate, or if the dividends were declared to the beneficiary, Jeff Shepp, they would have been attributed back to the appellant under the attribution rules.
[10] It was also decided that apart from the 4,800 common shares that were transferred to Newco by the trust, the appellant would acquire all common shares owned by Carol Lynn Shepp and the trust, and that the appellant would then resell them to MLH in one package. It was done this way for two reasons: first, it would be simpler to have only one closing with MLH; second, the appellant was to be paid partly in shares in MLH and MLH did not want inactive shareholders. All the Class B common shares were converted into Class A common shares before the sale to MLH. Mr. Tetz explained that this was done as part of the sale to MLH as they were cleaning up the share structure.
Basis of assessment
[11] The basis of assessment is summarized in the Respondent's Summary of Oral Argument as follows:
3. On August 18, [sic] 1989 the articles of B.N. Shepp and Associates Ltd. ("Opco") were amended to allow the holders of Class "B" shares to convert their shares to Class "A" shares on a one to one basis. At that time, and so long as the Class "B" shares remained issued and outstanding, the rights and privileges attached to the Class "B" shares were inferior to those possessed by the Class "A" shares.
4. As a result of the amendment to the articles, the value of the Appellant's aggregate Class "A" share holdings was considered to have been reduced by an amount equal to a proportionate increase in the value of the Class "B" shares. The simultaneous increase and decrease to the value of the Class "B" shares and Class "A" shares was considered to result from, in essence, a disposition of an economic interest from the Appellant to the holder of the Class "B" shares (the "Trust"). This disposition was considered to be a gift of property by the Appellant to the Class "B" shareholders.
5. The Appellant was not at arm's length to the Trust. Having concluded that a gift of property from the Appellant to the Trust had occurred, the Minister assessed the Appellant on the basis that the Appellant's proceeds of disposition arising from the disposition were deemed to be the fair market value of that property so disposed.
Income Tax Act, Subsection 69(1)(b)(ii) . . .
6. The fair market value of the proceeds was assumed to be $756,095, as follows:
a) At August 27 and 28, 1989, the total value of Opco, excluding the value of the preference shares and the redundant assets which were to be distributed to MLH & A Inc. ("MLH"), was $3,803,310;
b) Immediately prior to August 28, 1989, the aggregate value of all issued and outstanding Class "B" shares was $40,000, or $2,353 per share;
c) Immediately prior to August 28, 1989 the aggregate value of all 63 issued and outstanding Class "A" shares (62 held by the Appellant and l held by Carol-Lynn Shepp ) was $3,763,310, or $59,735 per share;
d) Immediately after the Special Resolution on August 28, 1989, which split the class "A" and Class "B" shares on a 1000 to 1 basis and allowed for the conversion of the Class "B" shares to Class "A" shares on a one to one basis, the value of each Class "A" and Class "B" share was equal at $47.54 (approximately $47,540 on a pre-split basis);
e) Immediately after the Special Resolution on August 28, 1989 the value of the 63,000 Class "A" shares (62,000 held by the Appellant and 1000 held by Carol-Lynn Shepp) was $2,995,020;
f) The fair market value of the economic interest disposed of by the Appellant and Carol-Lynn Shepp was equal to the reduction of the aggregate value of the Class "A" shares between August 27 and August 28, 1989, being $768,290 ($3,763,310 - $2,995,020) ...
Expert evidence
[12] The appellant and the respondent each called a business valuation expert to give evidence as to the value of the Opco shares before and after the August 28, 1989 Special Resolution ("Special Resolution").
Appellant's expert
[13] In valuing the Class A and Class B common shares before and after the Special Resolution the appellant's expert, Mr. Gordon Smith, considered both classes of shares to be equal in all regards except that the Class B common shares were non-voting and could be excluded from the declaration of dividends.
[14] In Mr. Smith's view there is no need to refer to a notional market to determine the fair market value of the shares since he has assumed that, at the valuation dates, namely August 27 and 28, 1989, an actual sale had occurred. Indeed, Mr. Smith testified that the relevant date for valuation of the shares was August 14, 1989, that is, the date of the signed Letter of Intent. According to Mr. Smith's evaluation, the MLH deal on August 14, 1989 had effectively crystallized the value of all the shares as at the date of the Special Resolution, or prior to that date, the reason being that there was no backing out of the deal once the Special Resolution was passed. Indeed, the conversion right Resolution was simply a mechanism to allow the sale to MLH to take place. It was not intended to create a difference in value amongst the various shares. The $671,220 dividend declared was the amount required to accomplish the objective of the Letter of Intent.
[15] Mr. Smith's opinion was that the Class B common shares' value prior to August 28, 1989 was equal to the Class B common shares' proportionate share of the proceeds of the sale to MLH, i.e. an aggregate amount of $701,250 (17,000 Class B common shares times $41.25—the purchase price per share offered by MLH). His opinion as to the Class B common shares' value immediately after August 27, 1989, was that it represented a proportionate amount of the sale proceeds ($701,250) plus a share in the distribution amounts that were scheduled to be paid by Opco as dividends, i.e. an additional aggregate amount of $47,250 (the trust's share of the total dividends of $671,220 declared on August 28, 1989). Accordingly, it is Mr. Smith's opinion that the Special Resolution only granted the Class B common shares an entitlement to share pro rata in the distribution amounts.
[16] Mr. Smith acknowledged it can be argued that, prior to MLH expressing interest in acquiring the shares of Opco, the Class B common shares were worth less than the Class A common shares, the primary reason being that they could be excluded from dividends. However, Mr. Smith was of the opinion that as long as William Keech (an employee-shareholder of Opco) continued to own Class A shares, it is reasonable to assume that Class B shares had a value equal to that of the Class A shares. According to Mr. Smith, it is unlikely that the appellant would have permitted the payment of dividends on Class A shares to the exclusion of Class B shares. To do otherwise would have caused Mr. Keech to receive 5/68 of the dividends rather than 5/85, which would not be to the appellant's advantage.
[17] As a matter of fact, Opco repurchased Mr. Keech's shares on June 30, 1989 for $23,287. This amount was calculated on the common share equity (determined by reference to a formula contained in an agreement between Opco and Mr. Keech dated October 12, 1978) divided by 85 common shares outstanding (including both Class A and Class B common shares) and not just by the 68 issued Class A common shares.
[18] Furthermore, Mr. Smith expressed the opinion that oppression remedies available to minority shareholders under the Business Corporations Act (Alberta) would have helped to prevent abuse by the Class A shareholders. However, he said that once the MLH deal was in place, oppression was no longer an issue.
[19] Also, the contractual arrangement with MLH restricted the quantum of dividends that Opco could declare (which eventually turned out to be $13,356 declared on August 23, 1989 as a capital dividend and $671,220 declared on August 29, 1989). Thus, even though dividends could be declared to the exclusion of Class B common shares, Opco had no authority to declare dividends in excess of those identified above. Any remaining value in Opco would be available for the common shareholders on a pro rata basis regardless of ability to restrict dividends on Class B shares. Mr. Smith noted that although Opco had the ability to distribute dividends to the exclusion of Class B shareholders, no dividends were in fact distributed from the date these Class B shares were issued in 1987 until August 23, 1989. Thus, the Class B shareholders continued to enjoy benefit from the growth in Opco.
[20] Moreover, although the Class B shares were non-voting, this alone did not make them worth less than the Class A shares. According to Mr. Smith even if the Class A common shares had voting rights, there was one Class A shareholder who was in a position of control and could control the voting decisions in any case. In other words, a minority Class A shareholder was no better off than the Class B shareholders.
[21] Finally, Mr. Smith suggested that giving a negligible value to the Class B common shares made no sense. He said that the Class B shareholders had the ability to prevent the sale to MLH from taking place. Had they chosen not to accept the MLH offer, they would have continued to own their pro rata share in Opco.
Respondent's expert
[22] The respondent's expert, Mr. Gerald Martin, premised his opinion on a notional market because of the absence of any sale of the Class A and Class B common shares on August 27 and 28, 1989, the valuation dates.
[23] According to Mr. Martin, the MLH offer in the Letter of Intent was for all Opco shares. Consequently, that offer, together with the value of redundant assets, could only serve to establish the full value of Opco. The offer did not allocate the value between the two classes of common shares.
[24] Mr. Martin defined fair market value based on a hypothetical market of all possible purchasers, who are knowledgeable and prudent and acting at arm's length in their own best interests and under no compulsion to transact.
[25] Mr. Martin then calculated the fair market value on August 27, 1989 of the Opco Class B common shares on the basis of the rights, privileges, restrictions and conditions attaching thereto. To Mr. Martin, the Class B common shares would have very little appeal to a purchaser because (a) they do not have voting rights; (b) they have no reasonable prospects of receiving dividends; (c) Opco is not likely to wind up; and (d) they are not transferable without the directors' consent, which may be withheld without reason. According to Mr. Martin, in the absence of the intended sale of Opco to MLH there would appear to have been no one interested in purchasing the Class B common shares.
[26] In Mr. Martin's opinion, the only right of any value associated with the Class B Common Shares was the right to a share in the assets upon the dissolution of Opco. But the Class B shares entailed no right to force a dissolution, nor any likely right to share in the growth of Opco reflected in an increase in its retained earnings. Indeed, according to Mr. Martin, the Class B shareholders' right to an equal per-share portion of the value of Opco when Opco would be wound up is rather speculative and would be very difficult to evaluate. The difficulty is due to the uncertainty as to what liquidation value might remain if and when the appellant should choose to liquidate Opco. The Class A shareholders, who elected the directors, would be within their rights in restricting to the Class A common shares all dividends declared after the preferred share dividend. Therefore, it is likely that the Class A shareholders would withdraw redundant assets - nearly equal in value to the retained earnings - prior to any voluntary liquidation they might choose, and use these funds to redeem the preferred shares and to pay a $671,220 dividend on the Class A common shares, which they did in fact do on August 29, 1989.
[27] Mr. Martin identified the Class B common shares as "special shares" and referred to Ian R. Campbell, Canada Valuation Service (Toronto: De Boo, August 1989) at 7-163, for the proper approach to valuing such shares:
Ultimately, the fair market value of such shares is a function of the rights, privileges, restrictions and conditions attaching to the shares coupled with the relevant statutory and common law relating to the degree of difficulty which a hypothetical purchaser would encounter in varying such rights, privileges, restrictions and conditions. The trend of the Canadian jurisprudence would appear to indicate that in general, the fair market value of special shares created for purposes of estate planning can be no more than the amount realizable by such shares in the event of a winding up or dissolution.
[28] To this Mr. Martin added at page 18 of his report:
The two most important factors in valuing minority shares are the expected return on investment by way of dividends or by sharing in a distribution of assets on liquidation. The class B common shares in this company cannot reasonably expect to either receive dividends or a distribution of assets due to the fact that a liquidation is not likely in the foreseeable future.
[29] Mr. Martin concluded that the fair market value of the Class B common shares on August 27, 1989, immediately before Opco's articles were changed to allow those shares to be exchanged for Class A common shares, was virtually nil. The only possibility, according to Mr. Martin, "appears to be a nuisance value which would be small, speculative and cannot be quantified with any degree of accuracy".
[30] It is Mr. Martin's opinion that the Special Resolution converted shares of no value into shares having a fully rateable value. Indeed, after the Special Resolution was adopted, a prudent Class B shareholder would immediately have converted all his Class B common shares to Class A common shares.
[31] Mr. Martin recognized that minority Class A shareholders did not control Opco and that a sale of their shares, as was the case for the Class B common shares, had to be approved by the directors. However, he is of the opinion that due to the intended sale to MLH, as well as the family relationship between the minority shareholders and the appellant, the minority shareholders appear to have had an opportunity to sell their shares either to the appellant or directly to MLH. If the sale to MLH was not closed, the minority Class A common shares would participate equally in future dividends. Therefore, Mr. Martin considered that the Class B common shares would not be subject to any material minority discount as of August 28, 1989. Accordingly, he has calculated the fair market value of the Class A and the Class B common shares as of August 28, 1989 based on the rateable portion of the en bloc common share value at page 14 of his report as follows:
FMV of all common shares in total $3,860,000
Value per common share (divide $3,860,000 by 80,000) $48.25
FMV of 63,000 class A common shares at $48.25 per share $3,039,750
FMV of 17,000 Class B common shares at $48.25 per share $820,250
[32] Mr. Martin's conclusion was the following as set out at p. 21 of his report:
In view of the foregoing, it is our view that the fair market value of the particular shares of B.N. Shepp and Associates Ltd. was as follows:
The FMV of the 63,000 class A common shares as of August 27, 1989 was $3,860,000 and as of August 28, 1989 was $3,039,750.
The FMV of the 17,000 class B common shares as of August 27, 1989 was nil and as of August 28, 1989 was $820,250.
Issues
[33] The issues are whether the change in share rights, effected by the Special Resolution to permit the conversion of Class B common shares to Class A common shares of Opco, constituted a disposal of an economic interest by the holders of Class A common shares (specifically the appellant) and if so, what was the fair market value of the interest disposed of.
Summary of appellant's argument
[34] It is the appellant's position that the Class B common shares of Opco had a fair market value equal to that of Class A common shares before and after the conversion right was added with respect to the authorized share capital of Opco on August 28, 1989. Thus, even if there were an economic interest disposed of, its value would be nil at the time of disposition and so section 69 of the Act would have no practical effect.
[35] Paragraph 69(1)(b) of the Act provides:
Section 69: Inadequate considerations
(1) Except as expressly otherwise provided in this Act,
. . .
(b) where a taxpayer has disposed of anything
(i) to a person with whom the taxpayer was not dealing at arm's length for no proceeds or for proceeds less than the fair market value thereof at the time the taxpayer so disposed of it, or
(ii) to any person by way of gift inter vivos,
the taxpayer shall be deemed to have received proceeds of disposition therefor equal to that fair market value; . . .
[36] Hence, the appellant concedes, the crux of his appeal concerns the value of the Class B common shares before and after August 28, 1989. Counsel for the appellant emphasized that the whole transaction involving the purchase of all shares in Opco by MLH needs to be considered in valuing the shares. The agreement between the appellant and MLH was for MLH to acquire all of the outstanding Opco shares from the appellant. The Special Resolution adopted on August 28, 1989 to permit the conversion of the Class B common shares into Class A common shares was part of a series of transactions leading up to the sale of the Opco shares to MLH on August 31,1989, all these transactions having been undertaken in order to minimize the tax burden resulting from this sale.
[37] According to counsel, it is important to note that the offer to purchase all of Opco's Class A and Class B common shares was made before the Special Resolution of August 28, 1989. He submits that the appellant and MLH had reached an agreement on August 14, 1989, date of MLH's Letter of Intent to purchase Opco, which offer was endorsed by the appellant. This Letter of Intent was more than an offer: it constituted a validly executed contract that would govern the conduct of the parties between August 14, 1989 and the date of closing on August 31, 1989. Accordingly, the Special Resolution should not have affected the value of either Class A or Class B common shares, which were always intended to be of same value.
[38] Furthermore, the appellant's counsel also questioned the methodology of the Minister in valuing the shares, observing that the Minister's valuation initially referred to the MLH transaction in valuing the Opco shares, but referred to a notional market in allocating that value between Class A and Class B common shares.
Summary of respondent's argument
[39] The Minister does not dispute that the appellant was entitled to arrange his affairs to take full advantage of the capital gains exemption and the tax-deferred inter-corporate dividend of safe income. The Minister challenges whether the law when applied to the facts, permits the desired tax effect. It was acknowledged that because the sale of the Opco shares to MLH was on an arm's length basis, the transaction provided a fair basis for determining the fair market value of Opco as at August 27 and 28, 1989. The transaction, it was argued, did not provide, however, a basis for allocating Opco's total value among the classes of shares existing at the relevant times.
[40] Counsel for the respondent submits that the effect of the Special Resolution was a reduction in value of the appellant's aggregate Class A common share holdings by an amount equal to a proportionate increase in the value of Class B common shares. This change represented a disposition of an economic interest by way of a gift of property from the appellant to the holder of the Class B common shares, the trust. According to counsel, the increase in value of the Class B common shares in the hands of the trust was not attributable to the rights, privileges or restrictions on those shares. While in the trust, the shares had negligible value. The increase in value of the Class B common shares arose solely, counsel submitted, through the Special Resolution. The effect of that Resolution was to transfer wealth from the Class A common shares to the Class B common shares. In other words, the Special Resolution converted shares of no value into shares of fully rateable value. This conclusion is founded on the fact that there was no sale on August 27 and 28, 1989, and therefore the value of the shares on those dates must be determined by reference to a notional market.
Analysis
[41] I have to determine if the adoption of the Special Resolution on August 28, 1989, had the effect of diluting the value of the appellant's Class A common shares or of divesting those shares of part of that value in favour of the trust's Class B common shares and if so, if it constituted a disposition of an economic interest in those shares giving rise to the application of paragraph 69(1)(b) of the Act.
[42] I first note that in assessing the appellant, the Minister assumed the aggregate value of the Class B common shares held by the trust to be $40,000 before the Special Resolution. The respondent's expert, Mr. Martin, assigned an even lower value to the Class B common shares, concluding that their value as of August 27, 1989 was nil.
[43] I would also point out that in December 1987 the appellant elected to transfer 17 Class B common shares that he owned to the trust at an adjusted cost base for the trust of $1.00 per share, pursuant to former subsection 73(5) of the Act (repealed by S.C. 1986, s. 36(1), applicable with respect to dispositions made after 1987). Former subsection 73(5) provided a rollover in respect of the transfer to a child of shares in a small business corporation. At the time of the transfer of the Class B common shares, the appellant reported the aggregate fair market value of the shares to be $200,000. This figure was not challenged by the Minister at that time and was accepted as an accurate determination of the fair market value of the Class B common shares as of December 1987 and was correctly used in calculating the amount of the deferral to which the appellant was entitled by virtue of subsection 73(5).
[44] I also realize that the respondent's expert based the allocation of value between the classes of shares upon the rights, privileges, conditions and restrictions attaching thereto. However, he was also of the opinion that the same Class B common shares with the same rights, privileges, conditions and restrictions had a different value when owned by the appellant or by the trust. A distinction was therefore also made on the basis of who owned the shares and not based strictly on the rights attached to the shares themselves.
[45] Likewise, Mr. Bradley Tetz, C.A., testified that once the Letter of Intent was executed on August 14, 1989, he was mandated to determine some way of reducing the retained earnings of Opco to the "target retained earnings" as specified in that Letter of Intent. In so doing, he had to work within the restrictions imposed by section 55 of the Act in order to benefit from the safe income of Opco. He also worked within the detailed technical requirements having to be met in order for the appellant, his wife Carol-Lynn and the trust to utilize their enhanced capital gain deduction as provided for in section 110.6 of the Act. It is noteworthy that the safe income was allocated equally for 1988 and 1989 between the Class A and Class B common shares. This safe income allocation was provided to the Minister and was not changed. The Minister did not see fit at the time to refuse the allocation of safe income to the Class B common shares on the basis of the remote possibility that the Class B common shares might not be entitled to dividends.
[46] I also note that the respondent's expert, Mr. Martin, determined the fair market value of the Class B common shares before the Special Resolution by reference to the notional market - that is, he determined a hypothetical fair market value - on the basis that there were no open-market transactions in the shares at that date, i.e. the Letter of Intent did not have contractual force. However, to determine the total value of Opco as well as the fair market value of the Class B common shares after the Special Resolution, Mr. Martin took into account the intended sale to MLH as being a good indicator although the Letter of Intent did not have contractual force.
[47] Similarly, the fact that the Class B common shares could not be sold without the approval of the directors of Opco had a negative impact on the value those shares were determined by him to have before the Special Resolution. The same fact was not considered to be an important factor by Mr. Martin in establishing the value of the Class B common shares after the Special Resolution. He did not apply a minority discount to those shares given the intended sale to MLH, as well as the family relationship of the minority shareholders to the appellant. In Mr. Martin's words, "the minorities appear to have an opportunity to sell their shares to Bruce Shepp or directly to MLH" (see Mr. Martin's report, Exhibit R-2, page 14).
[48] It is true that the appellant's expert, Mr. Smith, valued the shares before and after the Special Resolution on the assumption that the Letter of Intent had contractual force. Whether MLH and the appellant intended themselves to be bound until the execution of the further document is a question of construction. In G.H.L. Fridman, The Law of Contract, 3rd ed. (Toronto: Carswell, 1994) at p. 62, the author states:
. . . As it was put by Parker J. in an English case, Von Hatzfeldt-Wildenburg v. Alexander (which has been cited with approval in Canada),
if the documents or letters relied on as constituting a contract contemplate the execution of a further contract between the parties, it is a question of construction whether the execution of the further contract is a condition or term of the bargain or whether it is a mere expression of the desire of the parties as to the manner in which the transaction already agreed to will in fact go through. In the former case there is no enforceable contract either because the condition is unfulfilled or because the law does not recognise a contract to enter into a contract. In the latter case there is a binding contract and the reference to the more formal document may be ignored
. . .
Very different is the situation where there is uncertainty as to the terms of the contract, or, though there is no uncertainty as to the terms of the parties' agreement, their understanding and intention "is that their legal obligations are to be deferred until a formal contract has been approved and executed . . .". The original or preliminary agreement cannot constitute an enforceable contract. Such a "contract to make a contract" is not a contract at all.
[49] A careful reading of the Letter of Intent leads one to conclude that the parties did not intend that Letter to be a legally enforceable agreement or that it impose on either party any liability. Indeed, the agreement expressed in the Letter of Intent is qualified by the requirement of the execution of a formal agreement.
[50] Nevertheless, I do not find that Mr Smith's report is flawed for that reason. In my view, both experts relied on that Letter of Intent in expressing opposite opinions in their respective reports. In that context, I find that Mr. Smith's opinion should prevail. I do not believe that the Class A common shares had a greater value than the Class B common shares before and after the Special Resolution. We are dealing here with a going concern which is valuable only because of the goodwill of its controlling shareholder. Without the appellant, neither the Class A nor the Class B common shares would have much value. As a matter of fact, MLH was ready to purchase all the shares of Opco on condition only that the appellant agree to work for MLH for a certain period of time and that he sign a non-competition clause.
[51] Taking into account the actual serious offer made by MLH for all the shares of Opco, I do not find it necessary to resort to a notional market in determining the fair market value of the Class B common shares. Even if the Letter of Intent was qualified by the requirement of the execution of a formal agreement, negotiations between MLH and the appellant had started in February 1989 and had intensified in July 1989 with the signing of two previous letters of intent by the parties. Other letters followed outlining final changes before the signing of the last Letter of Intent. The appellant then mandated Mr. Tetz to finalize the transaction.
[52] I do not agree with Mr. Martin that there was no open market transaction. In fact, as I pointed out earlier, he had himself considered that such an open market transaction existed in determining the total value of Opco and the value of the Class B common shares after the Special Resolution. The offer was for all the shares of Opco and the fact that no allocation was made between the Class A and Class B common shares should not affect the pro rata attribution of the purchase price to each class of shares. MLH was aware of the existence of all the shares when it made its offer. It did not specify that it did not want to pay for the Class B common shares.
[53] The definition of fair market value is the highest price available in an open and unrestricted market between informed and prudent parties acting at arm's length and under no compulsion to act, expressed in terms of cash (see Canada Valuation Service,supra, p. 3-15). This definition encompasses the situation here as I am satisfied that the MLH offer is an indication sufficient to establish the fair market value of both the Class A and Class B common shares.
[54] No such indication existed in Winram Estate v. M.N.R., 72 DTC 6187 (F.C.T.D.), one of the cases referred to by counsel for the respondent. In that case, the issued capital of the company was virtually similar to that in the present case. The appeal was from an assessment for estate tax in respect of nine Class A voting common shares owned by the deceased. At the time of his death, the issued capital of the company consisted of 990 Class B non-voting shares, all owned by the wife of the deceased, and 10 Class A shares, one only of which was held by the widow. The Articles of Association provided that dividends might be declared by ordinary resolution and that "dividends so declared may be equal for each class of share or not equal and dividends may be declared on one class of share without dividends being declared on another class of share". In deciding that the value of the nine Class A shares which were held by the deceased was 9/10 of the company's value and not 9/1,000, Gibson J. said that the wife of the deceased could not have prevented the deceased from declaring dividends whereby the company would pay out 9/10 of the surplus to himself. According to Gibson J., such action would not have constituted an abuse of power in respect of the Class B shareholders as they did not have an inalienable right to any part of the dividends declared, nor would it have been a breach of the deceased's fiduciary duty as a director. Gibson J. also indicated that any dividends declared on Class A voting shares at a properly called directors' meeting would not have been an abuse by the majority of the Class A holders of the rights of the minority Class A holders (even though the deceased could have paid out all of the company's surplus by way of dividends).
[55] The decision in Winram presupposes that the Class B shares had no value and that the minority Class A holders could not do much to prevent the distribution of a surplus by way of dividends.
[56] I find though that the Winram case is distinguishable from the present case with regard to the value of the Class B shares. In Winram, the court had to determine the value of the shares for estate tax purposes. There was no pending offer from an arm's length purchaser to buy the shares as is the case here. The court implicitly had to resort to a notional market to establish the value of the shares which is not so in the case at bar.
[57] Furthermore, it is not true to say, as Mr. Martin implied, that the Class B common shares did not have any right to dividends before the Special Resolution. As was stated by the majority in the Supreme Court of Canada in The Queen v. McClurg, 91 DTC 5001, at pp. 5008 and 5009, "the fact that dividend rights are contingent upon the exercise of the discretion of the directors to allocate the declared dividend between classes of shares does not render entitlement to a dividend any less a 'right' . . . [T]he entitlement of a shareholder is 'to share in the profits of the company when these are declared as dividends in respect of the shares of the class of which his share forms a part': Bryden, 'The Law of Dividends', Studies in Canadian Company Law, Jacob S. Ziegel, ed., at p. 270. That right is in no way undermined by the presence of a discretionary dividend clause."
[58] Furthermore, if Mr. Martin is right in saying that the Class B common shares were special shares created for the purpose of having the appellant's son participate via a trust in the growth of Opco, it would also be fair to say that these non-voting shares were to share equally in the assets of Opco on a dissolution, liquidation, winding-up or other distribution of assets on the winding-up of Opco's affairs. The respondent's expert, Mr. Martin, did not take into account the liquidation value as Opco was a going concern which was not on the verge of winding up, as evidenced by the MLH offer. However, it has been generally established in Canadian jurisprudence that the fair market value of such shares can be calculated from the amount realizable on those shares in the event of a winding-up or dissolution (see Canada Valuation Service, supra,pp. 7-163). At the valuation dates, the financial statements of Opco showed current assets of considerable value which, if distributed, would have benefited the Class B shareholders. The document included at Tab 40 of the Joint Book of Exhibits illustrates after-tax proceeds to the shareholders of Opco based on a share sale at different values compared to an asset sale at different values. On the sale of goodwill at $3,000,000 or $3,500,000 the trust would receive between $460,000 and $513,000 after tax. Mr. Martin, who made reference to those figures in his report at page 6, testified that they represent what the Class B shareholders would receive in a situation where the goodwill was sold and Opco subsequently liquidated, as a Class B shareholder would participate equally in the winding-up.
[59] Counsel for the appellant added in his written argument that those amounts of $460,000 or $513,000 did not include the trust's share of the existing investment assets of $1,000,000 (it should be remembered that the offer by MLH did not include the investment assets worth $1,000,000 that were distributed to the shareholders before the final sale), of which the trust would receive $140,000. Hence, according to counsel for the appellant, with whom I agree, based on a liquidation of investment assets and a sale of goodwill at $3,000,000 to $3,500,000, the trust would receive $600,000 ($460,000 + $140,000) or $653,000 ($513,000 + $140,000). It is therefore not fair in my view to give a nil value to the Class B shares on the basis that Opco was not likely to be wound up.
[60] I therefore conclude that the Special Resolution did not significantly alter the value of the Class B common shares, and that no significant value was transferred from the appellant to the trust at the time the Special Resolution was adopted. This is sufficient to dispose of the appeal in favour of the appellant.
[61] I would however make some comments on the question of whether a dilution or divestment of part of the value of shares constitutes a disposition of property which would be caught by paragraph 69(1)(b) of the Act.
[62] As this point was not explicitly pleaded by the appellant in his written arguments, I will just indicate that I entertain some doubt as to the appropriateness of including in the terms "disposition of property" the disposition of an economic interest.
[63] Section 54 of the Act defines the word disposition mainly as being any transaction entitling a taxpayer to proceeds of disposition of property. I do not see how a taxpayer who has not disposed of his shares could be said to have disposed of property for proceeds of disposition when the value of those shares may fluctuate while he holds them. It seems to me that if this is the intent of Parliament it should be clearly included in the definition of "proceeds of disposition" as has been done in cases where proceeds of disposition are deemed to exist in cases where there is no parting with property as such (see, for example, those situations where a taxpayer is entitled to compensation for property injuriously affected, or has received insurance proceeds for damage to his property, as set out in section 54 of the Act.)
[64] It may be that the respondent's position is founded on Interpretation Bulletin IT-448, "Dispositions – Changes in Terms of Securities", June 6, 1980. This Bulletin discusses the factors that the Department of National Revenue considers in determining whether or not a disposition has taken place when alterations are made in the rights, preferences, terms, conditions, restrictions or limitations attaching to shares or other securities. According to this Bulletin, changes in the terms of shares will be regarded as a disposition if they are of sufficient substance. Some authors have argued that Revenue Canada's position with respect to alterations in the terms of shares and debt obligations is untenable in law.
[65] Bearing in mind the words of the Supreme Court of Canada in The Queen v. Compagnie Immobilière BCN Ltée, 79 DTC 5068, where that court said, at p. 5073, that the words "disposed of" in former subsection 20(5) of the Act (in the context of the scheme of the Act with respect to capital cost allowance) should be given their broadest possible meaning, Brian Arnold and David Ward, in their article "Dispositions – A Critique of Revenue Canada's Interpretation" (1980), 28 Canadian Tax Journal 559, said the following at p. 561:
Even with this broad approach to the interpretation of the term "disposition", the fundamental requirement is that there must be a cessation, divestiture, alienation, or transfer of the incidents of ownership of property. In other words, the taxpayer's interest in the property must be substantially, even if not completely, terminated whether or not such interest is acquired by any other person.
They went on to say at p. 569:
. . . It is clear from the jurisprudence concerning the term "disposition" that a disposition of property must involve the alienation or extinguishment of the property. There is no notion of alienation or extinguishment in Revenue Canada's concept that a disposition occurs whenever there is a substantial change in the holder's economic interest in the property. . . .
And they concluded at p. 576:
. . . The concept of a disposition is the statutory description of the realization requirement for income tax purposes. As stated earlier, it is a fundamental principle of income tax law that income must be "realized" before it is subject to tax. If property increases in value, the amount of the increase is not subject to tax until it is realized by means of a sale or some other similar transaction.
[66] In Friesen v. The Queen, 95 DTC 5551, the Supreme Court of Canada speaks of the realization principle according to which gains or losses must be realized in order for them to be included in the computation of income for tax purposes. The court states the following at pp. 5569-5570:
Professor B.J. Arnold, in Timing and Income Taxation: The Principles of Income Measurement for Tax Purposes (1983), remarks at p. 333:
One of the basic principles of income taxation is that appreciation or depreciation in the value of property is not taken into account in the computation of income until such appreciation or depreciation has been realized, usually by means of a sale.
The importance of this principle is reflected in the fact that, whenever the Income Tax Act permits deemed dispositions at fair market value without actual realizations, it does so narrowly and in a highly circumscribed manner: for example, when a taxpayer ceases to be a Canadian resident (s. 48 (now repealed)), or upon death (s. 70), or upon change of control (s. 111). Exceptions from the realization principle are thus clearly stipulated and explicitly codified, unlike the exception upon which the appellant seeks to rely. For the most part, the Act does not recognize "unrealized" or "paper" gains or losses: Krishna, supra, at pp. 278-79.
As a matter of fact, in The Queen v. Kieboom, 92 DTC 6382 (F.C.A.) referred to by counsel for the respondent in arguing that the appellant had disposed of an economic interest for proceeds of disposition deemed to be the fair market value, the court had to decide, among other things, whether the taxpayer was deemed to have disposed of an economic interest by way of gift to his children pursuant to paragraph 245(2)(c) (repealed in 1988) and subsection 69(1) of the Act. In this latter case, the taxpayer, formerly the owner of 90 per cent of the common shares of a corporation, implemented successive corporate transactions in which his wife subscribed for nominal consideration for sufficient additional shares to increase her shareholding to the same level as that of the taxpayer. Thereafter, additional shares were issued to each of the taxpayer's minor children, again for nominal consideration. It was argued first that there was a benefit conferred by the taxpayer on his children pursuant to former paragraph 245(2)(c) and second that the taxpayer transferred property to his wife by virtue of giving to her a portion of his ownership of the equity of his company, thereby bringing into play the attribution provisions of subsection 74(1).
[67] On the first argument, it was decided that subsection 69(1) and paragraph 245(2)(c) taken together deemed the transfers of equity which both Mr. and Mrs. Kieboom made to their children to be gifts, and that those transfers were deemed to have occurred at fair market value. It was held that former paragraph 245(2)(c) characterized a benefit conferred by a taxpayer by way of a transaction of any kind as a deemed disposition by way of gift, which disposition was deemed to have occurred at fair market value under subparagraph 69(1)(b)(ii). Former paragraph 245(2)(c) read as follows:
(2) Indirect payments or transfers. Where the result of one or more sales, exchanges, declarations of trust, or other transactions of any kind whatever 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
. . .
(c) deemed to be a disposition by way of gift.
Paragraph 245(2)(c) having been repealed, it must be stressed that a deemed disposition no longer exists under the Act in similar circumstances. Hence, paragraph 69(1)(b) which presupposes that a disposition has occurred, would not be applicable if a disposition has not actually taken place or has not been deemed by another provision of the Act to have taken place.
[68] On the second argument, it is true that the Federal Court of Appeal said the word property had to be widely interpreted, and that it considered the taxpayer to have transferred property to his wife by giving a portion of his ownership of the equity of his company to his wife. However, this was decided in the context of subsection 74(1), which covers transfers that are made "directly or indirectly" or "by any other means whatever".
[69] Some authors believe that the court enlarged inappropriately the meaning of "disposition of property". Douglas S. Ewens, Q.C., and Michael J. Flatters, in their acticle "Toward A More Coherent Theory of Dispositions", (1995), 43 Canadian Tax Journal 1377 provide a good overview of the question at pp. 1407-1411:
The relevance of dispositions in the context of the Act is to transactions in a taxpayer's "property". In other words, all situations in which a disposition is relevant to the computation of a taxpayer's income under the Act involve dispositions of property.
The concept of property enjoys remarkable breadth under the Act. In subsection 248(1) "property" is defined to mean
property of any kind whatever whether real or personal or corporeal or incorporeal and, without restricting the generality of the foregoing, includes:
(a) a right of any kind whatever, a share or a chose in action,
(b) unless a contrary intention is evident, money,
(c) a timber resource property, and
(d) the work in progress of a business that is a profession [emphasis added].
Paragraph (a) of this definition introduces the "bundle of rights" theory of "property" into all types of property. . . .
For the purposes of the Act, except where otherwise specifically provided, a disposition of property must entail a termination of the taxpayer's entire estate or interest in it, even in the case of property that is divisible. If it were otherwise, then every relinquishment of an interest in property would be a disposition because it results in the suspension or termination of that particular interest or right. . . .
Therefore, in order to make sense of the concept of the "disposition of property" and maintain the distinction between the realization of fixed amounts and the realization of and contingent amounts under the Income Tax Act, it is necessary to recognize that the concept of a "disposition of property" does not encompass every transaction or event in relation to property. . . . We submit that the problem with the decisions of the Federal Court of Appeal in Stursberg [93 DTC 5271], Kieboom, and Wiebe [87 DTC 5068] and with Revenue Canada's approach to dispositions in the context of the variation of the terms or conditions of debt and share instruments lies in the theory that all property is divisible and that any exploitation of property can result in a disposition of such property. In our view, only those transactions or events that result in the termination of a person's entire estate or interest can properly be considered a disposition of property under the Income Tax Act.
[70] In view of these comments, I find that there is an argument to be made for the non-existence of a disposition of property in a case where the value of shares might have fluctuated while in the possession of the owner to the benefit of a person with whom the owner is not at arm's length. This is certainly an argument that could be put forward and would require a more thorough analysis in a case where no third-party offer existed, and in such a case the fair market value of the shares could be an issue.
[71] The appeal is allowed with costs and the assessment is referred back to the Minister for reconsideration and reassessment on the basis that the appellant did not have to increase the capital gain reported in his 1989 taxation year by an amount of $756,095.
Signed at Ottawa, Canada, this 22nd day of January 1999.
"Lucie Lamarre"
J.T.C.C.