McClurg v. Canada, [1990] 3 S.C.R. 1020
Her Majesty The Queen Appellant
v.
Jim A. McClurg Respondent
indexed as: mcclurg v. canada
File No.: 20751.
1989: November 29; 1990: December 20.
Present: Dickson C.J.* and Wilson, La Forest, L'Heureux‑Dubé, Sopinka, Gonthier and Cory JJ.
on appeal from the federal court of appeal
Income Tax ‑‑ Dividends ‑‑ Attribution ‑‑ Dividends declared and allocated to shareholders of a share class pursuant to discretion of directors -- Other classes of shares not participating in dividend ‑‑ Whether portion of dividend properly attributable to other classes of shares ‑‑ Income Tax Act, S.C. 1970‑71‑72, c. 63, s. 56(2).
Company law ‑‑ Dividends ‑‑ Discretionary dividend as declared and allocated at discretion of directors ‑‑ Whether derogation of common law with respect to nature of shares or directors' duties ‑‑ Whether permitted by Saskatchewan Business Corporations Act ‑‑ Business Corporations Act, R.S.S. 1978, c. B‑10, ss. 24(4), 40, 97, 234.
Respondent and his partner were the only directors of a closely held company incorporated under the Saskatchewan Business Corporations Act. The Articles of Incorporation provided for three categories of shares: Class A which are common, voting and participating shares; Class B which are common, non‑voting and participating where authorized by the directors; and Class C which are preferred, non‑voting shares. All three classes of shares carried "the distinction and right to receive dividends exclusive of other classes of shares in the said corporation". The two directors received no dividends on either their class A or class C shares during 1978, 1979 and 1980 but received salaries, bonuses, and bonus entitlements. Their wives, who held Class B shares, were voted a declaration and distribution of dividends amounting to $10,000 each in each of these three years. Mrs. McClurg had been actively involved in the firm's operations and had been paid a modest salary.
The Minister of National Revenue reassessed the respondent's income for 1978, 1979, and 1980 on the basis that $8,000 of the $10,000 in dividends attributed to Mrs. McClurg on her Class B shares was properly attributable instead to the respondent pursuant to ss. 56(2) of the Income Tax Act. The Minister's opinion was that the dividends declared in each of the years in question should be attributed equally to all of the common shares, no matter of what class and notwithstanding the express condition attaching to the Class B shares that they shall carry the right to receive dividends exclusive of other classes of shares in the company. The reallocation was made on the basis of the number of Class A shares owned by the respondent in relation to the number of Class B shares owned by Mrs. McClurg. The respondent's appeal to the Tax Court of Canada was dismissed. The respondent further appealed from the decision of the Tax Court judge by way of an action commenced in the Federal Court of Canada, Trial Division. The appeal was allowed. The Minister's appeal to the Federal Court of Appeal was dismissed.
At issue here was whether the dividends received by Mrs. McClurg in respect of her Class B common shares should be attributed in part to the respondent. A preliminary issue was whether the discretionary clause constituted a valid derogation to the common law rule of equality of distribution of dividends or whether it was permitted under the Saskatchewan Business Corporations Act.
Held (Wilson, La Forest and L'Heureux‑Dubé JJ. dissenting): The appeal should be dismissed.
Per Dickson C.J. and Sopinka, Gonthier and Cory JJ.: Discretionary dividend clauses may be validly used because they are not expressly prohibited by the Act and are not contrary to common law or corporate law principles.
The power to pay dividends is an integral component of the Act's broad grant of managerial power for directors and is expressly limited by restrictions in much the same way as at common law. It is also qualified in that the general managerial power, which rests in the directors of a company, is fiduciary in nature and so must be exercised in good faith and in the best interests of the company.
Shares have an equal right to receive a dividend unless the Articles of Incorporation provide otherwise. Their division into classes is a necessary condition to any derogation of this presumption of equality either with respect to dividends or to other shareholder entitlements. Section 24(4)(a) is to ensure that shareholders are fully aware of their entitlements and privileges to the extent that the presumption of equality is rendered inapplicable. The determination of whether or not the share class rebuts this presumption is a simple factual inquiry. The Articles of Incorporation rebutted the presumption of equality here.
The entitlement to be considered for a dividend is more properly characterized in terms of a "right". A dividend is no less a "right" because it is contingent upon the exercise of the discretion of the directors to allocate the declared dividend between classes of shares. The directors are bound by their fiduciary duty to act in good faith for the best interests of the company in declaring and allocating any dividend. That duty is not circumvented by the discretionary dividend clause. Many shareholder rights may be qualified and contingent and the mere fact that they are fettered does not render them anything less than shareholder rights.
A discretionary dividend clause does not give rise to any inherent conflict between the duty of the directors and their self‑interest. Their allocation of dividends pursuant to such a clause can be exercised in the best interests of the company. The fact that the directors may consider the identity of shareholders does not necessarily render the declaration invalid on the basis of a conflict of duty and self‑interest. The dividend allocation clause simply divides conceptually what has been traditionally one decision into two components ‑‑ declaration and allocation. The discretionary powers of the directors have always included both, subject to the provisions of the Articles of Incorporation.
Section 24(4)(b) of the Act recognizes that there must be shares entitled to receive a dividend if a dividend is declared. This principle is not defeated by a discretionary dividend clause because the identity of the class eligible for a dividend simply remains unknown until the allocation takes place. This conceptual division into declaration and allocation is not substantively different from any derogation from the presumption of equality in the payment of dividends.
It would be inappropriate for this Court to determine the validity of use of a discretionary dividend clause in the context of an income tax appeal. The Act is facilitative and allows parties to structure corporations as they wish subject to certain explicit exceptions. It also provides the means for a party aggrieved by the corporation ‑‑ security holder, creditor, director or officer ‑‑ to seek redress through the s. 234 oppression remedy. No interested party here lodged such complaint, presumably because all involved were satisfied with the way in which the directors were conducting its affairs. Furthermore, it is a well-established principle at common law that where shareholders are unanimously agreed to a transaction, inequality of treatment does not render it ultra vires the company.
The determination that the transaction occurred in the context of a director‑shareholder relationship is dispositive. While it is always open to the Courts to "pierce the corporate veil" in order to prevent parties from benefitting from increasingly complex and intricate tax avoidance techniques, a dividend payment does not fall within the scope of s. 56(2). The purpose of s. 56(2) is to ensure that payments which otherwise would have been received by the taxpayer are not diverted to a third party as an anti‑avoidance technique. This purpose is not frustrated because, in the corporate law context, until a dividend is declared the profits belong to a corporation as a juridical person. Had a dividend not been declared and paid to a third party, it would not otherwise have been received by the taxpayer. Rather, the amount simply would have been retained as earnings by the company. Consequently, as a general rule, a dividend payment cannot reasonably be considered a benefit diverted from a taxpayer to a third party within the contemplation of s. 56(2).
An allocation pursuant to a discretionary dividend clause is no different from the payment of a dividend generally. In both cases, but for the declaration (and allocation), the dividend remains part of the retained earnings of the company and is therefore not within the legitimate parameters of the legislative intent of s. 56(2).
The payments to Mrs. McClurg represented a legitimate quid pro quo and were not simply an attempt to avoid the payment of taxes. Her efforts expended in the firm's operation, while not dispositive of the issue, was further evidence that the dividend payment was the product of a bona fide business relationship. If a distinction is to be drawn in the application of s. 56(2) between arms' length and non arms' length transactions, it should be made between the exercise of a discretionary power to distribute dividends when the non arms' length shareholder has made no contribution to the company (in which case s. 56(1) may be applicable), and those cases in which a legitimate contribution has been made.
Per Wilson, La Forest and L'Heureux‑Dubé JJ. (dissenting): The separation of share ownership and control underlies many fundamental principles of corporate law. Among these are the principle that the directors and officers of a corporation owe a fiduciary duty to the corporation and the principle of equality of shares. More than just a mere contractual right, the principle of equality of shares developed as a measure of protection for the shareholder. Thus, when more than one class of shares was created, the directors were not free to discriminate arbitrarily between the classes when awarding a dividend.
Shareholder rights include the right to a dividend, the right to vote, and the right to participate in the distribution of assets upon dissolution of the corporation. These rights must attach to the corporation's shares and the shareholders may not agree to circumvent this principle.
A discretionary dividend clause that permits the directors of a corporation to choose which class is entitled to receive dividends to the exclusion of the other classes is invalid at common law. It contravenes the principle that the directors are not permitted to favour one class at the expense of the others. It also contravenes the principle that dividends attach to shares and not to shareholders because the directors would be making a discretionary allocation primarily on the basis of the identity of the shareholders. To allow discrimination on the basis of the identity of the shareholder ignores the separation that is supposed to exist between the corporation and its shareholders.
A discretionary dividend clause, if valid, would entail a number of problems. The shareholder would be completely dependent on the goodwill of the directors and the minority shareholder would be placed in a near impossible position if this goodwill were to be turned against that shareholder. It also places the director in a position where he cannot fulfill his fiduciary obligations to the corporation as a whole and so must be invalid at common law. The conflict of interest is heightened when the director happens to be a shareholder of a class to which dividends are awarded or from which some personal benefit is derived; the situation can be compared to the usurpation of a corporate opportunity properly belonging to the company.
Requiring the mode of distribution to be expressly set out in the Articles of Incorporation, which can only be amended by approval of the shareholders, is consistent with the fiduciary obligation. If the directors hold preferred shares, the common shareholders will have agreed to subordinate their dividend interest to the preferred class of shares based upon "full disclosure" of the maximum amount to which these preferred shares will enjoy priority. With a discretionary dividend clause, there is no such disclosure, since the amount and priority is left to be determined in the future, wholly at the directors' discretion.
If employees merit additional reward, the proper course to effect this is through some form of compensation other than a dividend. A dividend is a return on an investment. The directors, if they were to take into account the identity of shareholders when declaring a dividend, would be improperly exercising the discretionary dividend power.
The discretionary dividend clause, even if it were valid under the common law, would be insufficient to rebut the common law presumption of equality. All three classes of shares are defined in substantially the same manner with respect to their entitlement to dividends. Therefore, any difference between the shares concerning their right to receive dividends would clearly not derive from any differentiation between the shares; it would have to stem from the actions of the directors of the corporation. Such a right, therefore, would not derive from the share itself and would be invalid at common law.
Section 24(4)(a) of the Saskatchewan Business Corporations Act requires that the mode of distributing dividends be expressly provided for in the articles themselves. The section must be interpreted in accordance with the principles of the common law and, in particular, with the principle that shareholder rights be expressly provided for in the shares themselves. Any departure from this principle must be explicitly stated. Section 24(4)(a) does not clearly indicate an intent to provide corporate directors with a power which they did not otherwise have at common law. The use of the discretionary dividend clause is also inconsistent with the requirement in s. 24(3)(b) that at least one class of shares must be entitled "to receive any dividend declared by the corporation".
Even when the Act specifically provides that the directors may be given the discretion to determine the rights to be assigned to a series, this discretion is not unlimited. The shareholders can give the directors the power to issue series within a class and assign rights to those series but they may not agree to give the directors the discretion to interfere with their right to dividends or a return of capital by choosing to give another series priority. The rights assigned to series, unlike classes of shares, may be altered without amending the corporate constitution.
The statute contemplates that shareholders will be protected from changes being made to the rights attached to different classes of shares by virtue of the fact that such rights may only be amended by altering the corporate constitution. In theory, a shareholder can bring a suit if the directors are alleged to exercise their discretion improperly. This remedy, however, entails a significant burden and expense and is an inadequate means of protecting shareholders from the potential for abuse created by the presence of a discretionary dividend clause. The need for shareholder protection from abuse of the discretionary dividend clause becomes all the more apparent given the possibility that such a clause could be inserted in the Articles of Incorporation of a large, publicly held corporation.
The discretionary dividend clause has no socially useful purpose. Its only apparent purpose is to facilitate tax avoidance through "income‑splitting" and this purpose hardly supports the need to allow corporations to be structured in this manner.
It would be inappropriate to return the money paid out in dividends to the corporation because the directors must be taken to have declared dividends in the corporation's best interests. The dividends, therefore, should be redistributed amongst the various classes of shares which must, absent a valid differentiation between the shares, share equally in the dividend.
A dividend payment does not fall within the scope of s. 56(2) of the Income Tax Act in the typical situation where the dividend payment is within the powers of the corporation and the shareholder is bona fide entitled to the dividends. The contribution of a shareholder to the business is irrelevant, however, because a dividend is a return on capital attaching to a share and in no way dependent on the conduct of a particular shareholder.
The four elements of s. 56(2) were met here. The payment in question satisfied the requirement that there be a payment or transfer of property to a person other than the taxpayer; the term "payment" has acquired no technical meaning in the Income Tax Act and is to be interpreted in its popular sense. The payment was made pursuant to the direction of the taxpayer or with the concurrence of the taxpayer. An individual in control of a corporation can be said to have directed a payment within the meaning of s. 56(2) by exercising that control. The payment must be for the benefit of the taxpayer or recipient. Here the payment to Mrs. McClurg, which represented Mr. McClurg's dividend entitlement, amounted to a benefit to Mrs. McClurg under s. 56(2). Finally, this amount would have been included in Mr. McClurg's income had the allocation been properly made.
Cases Cited
By Dickson C.J.
Referred to: Burland v. Earle, [1902] A.C. 83; Bowater Canadian Ltd. v. R.L. Crain Inc. (1987), 62 O.R. (2d) 752; De Vall v. Wainwright Gas Co., [1932] 2 D.L.R. 145; Stubart Investments Ltd. v. The Queen, [1984] 1 S.C.R. 536; The Queen v. Golden, [1986] 1 S.C.R. 209; Bronfman Trust v. The Queen, [1987] 1 S.C.R. 32; Miller v. M.N.R., 62 D.T.C. 1139; Perrault v. The Queen, [1979] 1 F.C. 155.
By La Forest J. (dissenting)
Salomon v. Salomon and Co., [1897] A.C. 22; Farrar v. Farrars, Limited (1888), 40 Ch. D. 395; Borland's Trustee v. Steel Brothers & Co., [1901] 1 Ch. 279; Canadian Aero Service Ltd. v. O'Malley, [1974] S.C.R. 592; Henry v. Great Northern Ry. Co. (1857), 1 De G. & J. 606, 44 E.R. 858; Jacobsen v. United Canso Oil & Gas Ltd. (1980), 113 D.L.R. (3d) 427; Bowater Canadian Ltd. v. R. L. Crain Inc. (1987), 62 O.R. (2d) 752; Rondeau v. Poirier, [1980] C.A. 35; Birch v. Cropper, In re Bridgewater Navigation Co. (1889), 14 A.C. 525; Champ v. The Queen, 83 D.T.C. 5029; Stubart Investments Ltd. v. The Queen, [1984] 1 S.C.R. 536; Murphy v. The Queen (1980), 80 D.T.C. 6314; Bronfman, A. v. M.N.R., [1965] C.T.C. 378.
Statutes and Regulations Cited
Business Corporations Act, R.S.S. 1978, c. B‑10, ss. 6(1)(c)(i), 24(3)(b), (4), 27, 40, 97(1), 170(1)(c), 234.
Canada Business Corporations Act, S.C. 1974‑75, c. 33.
Companies Act, R.S.C. 1952, c. 53.
Income Tax Act, S.C. 1970‑71‑72, c. 63, ss. 56(2), 248(1).
Authors Cited
Boivin, Michelle. "Le droit aux dividendes et le dividende "discrétionnaire"" (1987), 47 R. du B. 73.
Bryden, R. M. "The Law of Dividends", in Jacob S. Ziegel, ed., Studies in Canadian Company Law. Toronto: Butterworths, 1967.
Eisenberg, Melvin A. "The Legal Roles of Shareholders and Management in Modern Corporate Decisionmaking" (1969), 57 Cal. L. Rev. 1.
Fraser, William Kaspar. Company Law of Canada, 5th ed. By J. L. Stewart and M. Laird Palmer. Toronto: Carswells, 1962.
Goodman, S. H. Comment. "The Last Bastion for Income‑Splitting? J.A. McClurg v. The Queen" (1986), 34 Can. Tax J. 404.
Martel, Maurice and Paul Martel. La compagnie au Québec, Les aspects juridiques, vol. I. Montréal: Wilson & Lafleur Ltée, 1987.
Quessy, Pierre. "Les aspects corporatifs et fiscaux des actions à dividende discrétionnaire", [1985] 7 R.P.F.S. 31.
Schmitthoff, Clive M. Palmer's Company Law, 23rd ed., vol. 1. London: Stevens & Sons, 1982.
Wegenast, F. W. The Law of Canadian Companies. Toronto: Carswells, 1979.
Welling, Bruce. Corporate Law in Canada. Toronto: Butterworths, 1984.
APPEAL from a judgment of the Federal Court of Appeal, [1988] 2 F.C. 356, 84 N.R. 214, [1988] 1 C.T.C. 75, 88 D.T.C. 6047, affirming a judgment of the Federal Court, Trial Division (1986), 2 F.T.R. 1, 86 D.T.C. 6128, reversing a decision of the Tax Court of Canada, [1984] C.T.C. 2469, 84 D.T.C. 1379, dismissing respondent's appeal from a notice of reassessment. Appeal dismissed (Wilson, La Forest and L'Heureux‑Dubé JJ. dissenting).
Ian S. MacGregor and Brent Paris, for the appellant.
Robert W. Thompson and Gordon Balon, for the respondent.
The judgment of Dickson C.J. and Sopinka, Gonthier and Cory JJ. was delivered by
//Dickson C.J.//
DICKSON C.J. -- This is an income tax case. The question in the appeal is whether certain dividends received by the wife of the respondent, Jim A. McClurg, in the years 1978, 1979, and 1980 in respect of Class B common shares of Northland Trucks (1978) Ltd. (hereinafter Northland Trucks) should be attributed in part to the respondent, an officer and director of Northland Trucks and the holder of the controlling Class A common shares in the capital stock of that company.
I. Background
1. Relevant Legislation
Income Tax Act, S.C. 1970-71-72, c. 63:
56. ...
(2) A payment or transfer of property made pursuant to the direction of, or with the concurrence of, a taxpayer to some other person for the benefit of the taxpayer or as a benefit that the taxpayer desired to have conferred on the other person shall be included in computing the taxpayer's income to the extent that it would be if the payment or transfer had been made to him.
Business Corporations Act, R.S.S. 1978, c. B-10:
24. ...
(4) The articles may provide for more than one class of shares and, if they so provide:
(a)the rights, privileges, restrictions and conditions attaching to the shares of each class shall be set out therein; and
(b)the rights set out in subsection (3) shall be attached to at least one class of shares but all such rights are not required to be attached to one class.
40. A corporation shall not declare or pay a dividend if there are reasonable grounds for believing that:
(a)the corporation is, or would after the payment be, unable to pay its liabilities as they become due; or
(b)the realizable value of the corporation's assets would thereby be less than the aggregate of its liabilities and stated capital of all classes.
97.--(1) Subject to any unanimous shareholder agreement, the directors of a corporation shall:
(a)exercise the powers of the corporation directly or indirectly through the employees and agents of the corporation; and
(b)direct the management of the business and affairs of the corporation.
234.--(1) A complainant may apply to a court for an order under this section.
(2) If, upon an application under subsection (1), the court is satisfied that in respect of a corporation or any of its affiliates:
(a)any act or omission of the corporation or any of its affiliates effects a result;
(b)the business or affairs of the corporation or any of its affiliates are or have been carried on or conducted in a manner; or
(c)the powers of the directors of the corporation or any of its affiliates are or have been exercised in a manner;
that is oppressive or unfairly prejudicial to or that unfairly disregards the interests of any security holder, creditor, director or officer, the court may make an order to rectify the matters complained of.
2. The Facts
The respondent is President of Northland Trucks, a company incorporated under the Saskatchewan Business Corporations Act. The company was established in 1978 upon purchase of an ongoing business, a dealership in International Harvester trucks. The respondent and his partner, Veryle Ellis, are the only directors of the company. The Articles of Incorporation provide for three categories of shares: Class A which are common, voting and participating shares; Class B which are common, non-voting and participating where authorized by the directors; and Class C which are preferred, non-voting shares. The Articles deal with the entitlement to dividends as follows:
Class A Common:
Common, voting and shall be participating shares carrying the distinction and right to receive dividends exclusive of the other classes of shares in the said corporation.
Class B Common:
Common, non-voting and shall be participating shares where authorized to be participating shares by unanimous consent of the Directors and the said shares shall carry the distinction and right to receive dividends exclusive of other classes of shares in the said corporation.
Class C Preferred:
Preferred, non-voting shares which carry the distinction and right to receive dividends exclusive of other classes of shares in the said corporation, if the said dividends are authorized by unanimous resolution of the directors.
Each class of shares has the right to receive dividends exclusive of other classes of shares in the company and the company is authorized to issue an unlimited number of shares in each class.
The clause "the distinction and right to receive dividends exclusive of other classes of shares in the said corporation" in the definition of the share classes is crucial to the analysis in this case; a primary question is whether the clause, which gives to the directors unfettered discretion as to the allocation of dividends among classes of shares, constitutes a valid derogation to the common law rule of equality of distribution of dividends. For the sake of simplicity, I will refer to it as the "discretionary dividend clause" throughout these reasons.
Shares in the company were issued at a price of $1.00 each, and the distribution of shares demonstrates the closely held nature of the company:
|
NAME |
CLASS A COMMON |
CLASS B COMMON |
CLASS C PREFERRED |
| Jim McClurg |
400 |
- |
37,500 |
| Veryle Ellis |
400 |
- |
37,500 |
| Wilma McClurg (wife of Jim McClurg) |
- |
100 |
- |
| Suzanne Ellis (wife of Veryle Ellis) |
- |
100 |
- |
|
|
|
|
|
In the years 1978, 1979, and 1980, the directors, McClurg and Ellis, voted a declaration and distribution of dividends as follows:
| NAME |
1978 |
1979 |
1980 |
| Jim McClurg |
- |
- |
- |
| Veryle Ellis |
- |
- |
- |
| Wilma McClurg |
$10,000 |
$10,000 |
$10,000 |
| Suzanne Ellis |
$10,000 |
$10,000 |
$10,000 |
|
|
|
|
|
The form of resolution declaring the dividends was as follows:
It was noted and unanimously agreed by all the Directors that Class "B" Shareholders receive dividends in the amount of $100.00 per share for each issued share they hold.
BE IT RESOLVED
that payment of dividends to Class "B" Shareholders are made as follows:
| CLASS "B" SHAREHOLDER |
NUMBER OF ISSUED SHARES |
DIVIDEND PER SHARE |
TOTAL PAID |
| Wilma McClurg Suzanne Ellis |
100 100 |
$100.00 $100.00 |
$10,000.00 $10,000.00 |
|
|
|
|
|
Although the two directors received no dividends on either their Class A or Class C shares during this three-year period, they did not go unrewarded. They received salaries, were paid bonuses, and bonus entitlements totalling, according to the trial judge, in the case of the respondent, $33,968 in 1978, $65,292 in 1979, and $57,900 in 1980. As well, the company's retained earnings as of October 31, 1980 were $312,611 and as of October 31, 1981 were $421,481. The directors of the company, as owners of the Class A shares (the only shares participating as of right), alone were entitled as of right to share in the accumulated profits of the company.
An analysis of the equity of the two classes of shares is shown below:
Class A Class B
Shares Shares
Shares Issued 800 200
Amount Paid 800 200
Dividends Received NIL 60,000
Growth Accruing to shares to Oct. 31, 1980312,611 NIL
Submissions attached with the Notice of Objection of Mr. McClurg for the 1978, 1979 and 1980 taxation years show that at the end of the 1981 taxation year, the equity (growth) per share stood at $527 per share for Class A common shareholders (an amount of 1.75 times that of Class B shares) whereas the total growth (equity) accruing to Class B common shares still remained at $300 per share.
|
|
Total Reimbursement to Oct. 31/81 |
Equity Growth Retained to Oct. 31/81 |
Total |
Total $ Per Share Owned |
% |
| Jim McClurg |
224,700 |
210,741 |
435,441 |
1,088.62 |
45 |
| Veryle Ellis |
224,700 |
210,741 |
435,441 |
1,088.62 |
45 |
| Wilma McClurg |
48,125 |
NIL |
48,125 |
481.25 |
5 |
| Suzanne Ellis |
48,125 |
NIL |
48,125 |
481.25 |
5 |
|
|
545,650 |
421,482 |
967,132 |
|
100 |
|
|
|
|
|
|
|
The financing of the formation of the company must also be reviewed. For the respondent's investment of 37,500 preferred shares, he borrowed $37,500 from the Toronto Dominion Bank on a note co-signed by his wife and his father-in-law. The latter provided further security in the form of a term deposit certificate totalling $40,000. The purchase of the business was partly financed by a loan from the vendor, security for which was provided, in part, by the respondent and his wife through the placing of a second mortgage on their jointly owned home in the amount of $25,000. Furthermore, Wilma McClurg co-signed with the respondent a personal guarantee to the International Harvester Company, the supplier of the company, with respect to a $500,000 debenture in connection with the business affairs of Northland Trucks. Finally, the company opened a line of credit with the Toronto Dominion Bank, initially for $50,000, and later increased to $200,000, which was guaranteed by all of the shareholders. It is worth noting that the trial judge found that Wilma McClurg had personal assets of between $15,000 and $20,000 during this time, which indicates that her personal guarantee was not without significance.
The role of Wilma McClurg in the business during the period in question also warrants examination. The evidence indicates that she carried the title of Administrative Assistant. As such, she assisted in the operation of the business, performing a variety of tasks as the need arose -- including stenography, bookkeeping, stocktaking, and driving a truck. For her efforts she received a salary of $625 in 1978, $5,000 in 1979, and $5,000 in 1980. Of the $30,000 received by Wilma McClurg in dividends during this period, $20,000 was reinvested by her in M.E. Investments Corporation, a company with a similar structure to that of Northland Trucks and which involved the same shareholders and directors. The purpose of M.E. Investments Corporation was the acquisition of land upon which the operations of Northland Trucks were located. In acquiring the land, a first mortgage was given. Wilma McClurg was a personal guarantor of the mortgage.
On January 14, 1982, by notices of reassessment, the Minister of National Revenue reassessed the respondent's income for 1978, 1979, and 1980. The basis for the reassessment was that in each of those years $8,000 of the $10,000 in dividends attributed to Wilma McClurg on her Class B shares was properly attributable instead to the respondent pursuant to ss. 56(2) of the Income Tax Act. The Minister made this reallocation on the basis of the number of Class A shares owned by the respondent in relation to the number of Class B shares owned by Wilma McClurg. The position of the Minister is that the dividends declared in each of the years in question should be attributed equally to all of the common shares, no matter of what class and notwithstanding the express condition attaching to the Class B shares that they shall carry the right to receive dividends exclusive of other classes of shares in the company. The respondent's appeal to the Tax Court of Canada was dismissed. The respondent further appealed from the decision of the Tax Court judge by way of an action commenced in the Federal Court of Canada, Trial Division. The appeal was allowed. The Minister's appeal to the Federal Court of Appeal was dismissed. Finally, leave to appeal was granted by this Court.
3. Judgments Below
Tax Court of Canada, 84 D.T.C. 1379
Goetz T.C.J. found no evidence suggesting that the investment of Wilma McClurg in the company was of any importance. He reasoned that the respondent and his partner had full control of the company and he concluded, at p. 1381, that the share structure was solely an income splitting device:
To my way of thinking the share set up and the establishment of the Class "B" shares was a channel of Northland to funnel payments of profits to the Appellant's wife and this was to the Appellant's tax benefit and is prohibited by section 56(2).
Goetz T.C.J. concluded, at p. 1381, that the dividends were a "blatant effort" at conferring a benefit on the wives of the directors and he further remarked, at p. 1382, that "the wives were the puppets of the Appellant and Ellis and did as they were told". Finally, he determined that the efforts expended by Wilma McClurg and her exposure under the guarantees had no relevance to the payment of dividends. He dismissed the appeal from the reassessment.
Federal Court of Canada - Trial Division 1986, 2 F.T.R. 1
Strayer J. began by considering the interpretation of s. 56(2), and he found, at p. 4, that its literal meaning could require that "every dividend paid to any shareholder of a company could be attributed to the income of directors participating in a decision to pay the dividend". He continued:
Such a dividend would be a "payment" "to some other person" with the "concurrence" of the director. It could also be described as a "benefit" that the director "desired to have conferred" on the shareholder, it surely being desirable from the viewpoint of directors that, where ever possible, dividends be paid to the shareholders of the company in order to enhance their satisfaction with the company.
Strayer J., reasoned, however, that the intention of the legislature could not have been such a broad reading and found the subsection qualified in that, to fall foul of s. 56(2), the taxpayer must seek to avoid receipt of funds that would otherwise be payable to him and that the concept of payment of a "benefit" is to be contrasted with payments for consideration.
In the opinion of Strayer J., it could not be said that money payable to the respondent was diverted to his wife so as to bring the situation within s. 56(2). He was not persuaded that the Articles of Incorporation must be regarded as void in so far as they permit differential payment of dividends to various classes of shareholders. Nor did he see any legal impediment to a contract between the shareholder and the company which allows the directors of the company to fix the amount of dividends payable in a given year to a given class of shareholders. Since no dividends were payable as a matter of right to holders of Class A shares, such as the respondent, without a resolution to that effect being adopted by the directors, it could not be said that money payable to him was diverted to his wife so as to bring the situation within s. 56(2).
Strayer J. also was satisfied that the dividends paid to Wilma McClurg were not a "benefit" within the contemplation of s. 56(2). The dividends were paid within the context of a legal relationship between the shareholder and the company pursuant to which she was entitled to receive dividends as declared from time to time by the directors. The surrounding circumstances suggested to him, at p. 5, that "this was a legitimate business relationship created by all the necessary legal instruments and should not be treated as a sham". Wilma McClurg had made a real contribution to the establishment of the business through her personal guarantee and the share of the mortgage she assumed on the house she owned jointly with the respondent. Furthermore, she had taken an active part in the operation of the business for which she was paid only a small salary. The appeal was allowed.
Federal Court of Appeal, [1988] 2 F.C. 356
The majority judgment at the Federal Court of Appeal was delivered by Urie J. and was concurred in by Heald J. Urie J. began by expressing a difficulty in appreciating how s. 56(2) could apply in a corporate context. A corporation provides to its shareholders, by way of dividends, such portion of its earnings as its directors deem advisable. Those directors do so in their capacities as directors and not in their personal capacities, no matter how closely held the corporation's shares. Urie J. had further difficulty understanding how "a taxpayer," when acting as a director, satisfies any of the conditions precedent for the application of s. 56(2). He reasoned, at p. 363, that:
Only the most explicit language, which is not present in subsection 56(2), would justify the notion that a director acting as such could be seen as directing a corporation to divert a transfer or payment for his own benefit or the benefit of another person, absent bad faith, breach of fiduciary duty or acting beyond the powers conferred by the share structure of the corporation, none of which bases have been alleged here.
Furthermore, Urie J. felt that applying s. 56(2) in a corporate context would make no distinction between arm's length and non-arm's length transactions, leaving all directors at risk of having dividends declared by them, and paid to shareholders who may be relatives, attributed to them for tax purposes. He concluded that the section was not intended to apply to the directors of corporations participating in the declaration of corporate dividends. He dismissed the appeal.
Desjardins J. dissented at the Court of Appeal. She began by observing that, unless otherwise provided in the Articles of Incorporation or by statute, the rights of the classes of shareholders to receive dividends are to be assessed on a basis of equality. She disagreed with Strayer J.'s conclusion that the description of the dividends found in the Articles of Incorporation constituted a "derogation from the principle of equality amongst shareholders recognized in the common law" (at p. 368), stating at p. 369:
What happens in the case at bar is that shareholders in each class are given "the distinction and right to receive dividends to the exclusion of other classes". From that perspective, they are all equal. Moreover, no mathematical formula is given if a distribution were to occur. . . . The directors obtain full control over the allocation if they declare dividends. . . .
I doubt that such a discretion to be exercised by way of a resolution of the directors, can be equated with a derogation specific and substantive enough to discard the common law rule of equality of distribution since there is no rule by which the directors are to carry out their discretion.
The moneys paid, in her opinion, ought to have been distributed equally amongst the shareholders and there should have been included in the respondent's income part of the dividends paid to his wife.
In rejecting the trial judge's conclusion that there was a legitimate business relationship between the respondent's wife and the company, Desjardins J. remarked that there is no relationship between the services that a shareholder brings to a company and his or her entitlement to a dividend. The dividends come as a return on investment and attach to the share, rather than to the shareholder.
Desjardins J. was not persuaded that s. 56(2), if interpreted widely, would cover every declaration of dividends. Once declared, the amount of the dividend received on each share is governed by a mathematical formula which the director must apply in accordance with the contract between the shareholders and the company.
II. Analysis
This appeal raises issues relating both to corporate law and the law of income taxation. In my view, it is useful to deal with the former first as the analysis is beneficial in the determination of the application of s. 56(2) of the Income Tax Act.
1. Corporate Law Issues
I begin the analysis with a statement of the obvious. The decision to declare a dividend lies within the discretion of the directors of a company, subject to any restrictions which have been included in the Articles of Incorporation. This principle has long been accepted at common law and was explicitly recognized by Lord Davey, speaking for the Judicial Committee of the Privy Council, in Burland v. Earle, [1902] A.C. 83, at p. 95, wherein the principle was described in terms of the "internal management" of the company:
Their Lordships are not aware of any principle which compels a joint stock company while a going concern to divide the whole of its profits amongst its shareholders. Whether the whole or any part should be divided, or what portion should be divided and what portion retained, are entirely questions of internal management which the shareholders must decide for themselves, and the Court has no jurisdiction to control or review their decision, or to say what is a "fair" or "reasonable" sum to retain undivided, or what reserve fund may be "properly" required.
With the advent of statutory regulation of corporations, the authority to pay dividends, recognized at common law as part of the internal management of the company, has been given statutory recognition. In the case at bar, the governing legislation is the Saskatchewan Business Corporations Act, (hereinafter S.B.C.A.). In my view, it cannot be disputed that the power to pay dividends is an in tegral component of the broad grant of managerial power for directors found in s. 97(1) of the Act, cited earlier. I take it, both from an observation of the workings of corporations, and from other provisions in the statute, that the section embraces the common law power of directors. The power to declare dividends is expressly limited in the Act, in much the same way as it was at common law. For example, s. 40 of the S.B.C.A., also cited earlier, prohibits the declaration of a dividend if there exist reasonable grounds to believe that to do so would leave the corporation unable to pay its debts (s. 40(a)); or, if the payment of a dividend would render the realizable value of the assets of the corporation less than the aggregate of its liabilities and stated capital of all classes of shares (s. 40(b)). Although these restrictions are not brought into play by the declarations of dividends in issue in this appeal, the presence of those limitations in the Act suggests that the power to declare dividends is statutorily limited only by restrictions expressly stated.
Of course, the power to declare dividends is further qualified by the fact that the law has for many years recognized that the general managerial power which rests in the directors of a company is fiduciary in nature. The declaration of dividends, which is subsumed within that power, therefore is limited legally in that it must be exercised in good faith and in the best interests of the company. As Professor Welling recognized in his treatise Corporate Law in Canada (1984), at p. 614, this limitation exists when any disbursement is made by the directors of a company:
The directors' general managerial power is a fiduciary one, owed to the corporation. It must always be exercised in what the directors' from time to time think is likely to serve the best interests of the corporation. It has been consistently urged throughout this book that "the corporation", as referred to in that context, means the legal and economic entity, not some vague aggregation of the shareholders' wants. This means that dividends should be seen as basically what they seem to be on a narrow, legalistic view: corporate gifts. . . . giving it is permissible only to the extent that the directors think that it will serve the corporate entity's best interest, as they then perceive those interests; beyond this, the declaration of any dividend, like any other unauthorized gift of corporate property, is a breach of directors' duty.
In my opinion, this is an accurate statement of the legal basis of the declaration of a dividend in the context of the modern corporation.
Having reviewed the legal basis for the payment of a dividend by a company, another fundamental principle of corporate law can be restated. The appellant argues, and it is conceded by the respondent, that the rights carried by all shares to receive a dividend declared by a company are equal unless otherwise provided in the Articles of Incorporation. This principle, like the managerial power to declare dividends, has been well accepted at common law. The principle, or more accurately, the presumption of equality amongst shares and the prerequisites required to rebut that presumption, are described in Schmitthoff, Palmer's Company Law, 23rd ed., vol. 1, at p. 387, para. 33-06:
Prima facie the rights carried by the shares rank pari passu, i.e. the shareholders participate in the benefits of membership equally. It is only when a company divides its share capital into different classes with different rights attached to them that the prima facie presumption of equality of shares may be displaced.
In my view, a precondition to the derogation from the presumption of equality, both with respect to entitlement to dividends and other shareholder entitlements, is the division of shares into different "classes". The rationale for this rule can be traced to the principle that shareholder rights attach to the shares themselves and not to shareholders. The division of shares into separate classes, then, is the means by which shares (as opposed to shareholders) are distinguished, and in turn allows for the derogation from the presumption of equality: Bowater Canadian Ltd. v. R.L. Crain Inc. (1987), 62 O.R. (2d) 752 (C.A.), at p. 754 (per Houlden J.A.).
The concept of share "classes" is not technical in nature, but rather is simply the accepted means by which differential treatment of shares is recognized in the Articles of Incorporation of a company. As Professor Welling, supra, succinctly explains, at p. 583, "a class is simply a sub-group of shares with rights and conditions in common which distinguish them from other shares". Indeed, the use of the share class is recognized in the S.B.C.A.as the means by which derogation from the principle of equality is to be achieved. The statute thus explicitly requires that "the rights, privileges, restrictions and conditions attaching to the shares of each class" must be expressly stated in the Articles of Incorporation: s. 24(4)(a).
Having outlined the underlying principles of corporate law relevant to the issues raised on this appeal, the application of those principles to the facts can be attempted. The appellant, the Minister of National Revenue, argues that the discretionary dividend clause in the Articles of Incorporation of Northland Trucks does not create discrete classes of shares with different rights to dividends. Furthermore, the Minister contends that the clause creates no right to dividends at all and, therefore, does not comply with the statutory requirement in s. 24(4)(a). Consequently, the allocation of a dividend made pursuant to the discretionary dividend clause must be disregarded because of its failure to comply with the S.B.C.A. and with the principles of corporate and common law. As a result, the presumption of equality has not been rebutted and equality of distribution amongst the share classes prevails. As I have earlier noted, Desjardins J. in her dissenting reasons at the Court of Appeal accepted this argument, and held that the clause permits the directors to create differences in dividend allocation "at whim". She thus expressed doubts, at p. 369, as to whether:
. . . such a discretion to be exercised by way of a resolution of the directors, can be equated with a derogation specific and substantive enough to discard the common law rule of equality of distribution since there is no rule by which the directors are to carry out their discretion.
The respondent argues, on the other hand, that the discretionary dividend clause is a valid exercise of contractual rights between the company and its shareholders in accordance with the common law and statute. Moreover, the right to receive dividends in potentially unique amounts gives each share class different rights. It is argued that this is a material distinction sufficient to create separate share classes with differentiated dividend entitlements which, in turn, validly derogates from the principle of equality.
I agree with the arguments which the respondent has raised in this regard. In my opinion, the discretionary dividend clause is both a valid means of allocating declared dividends and is sufficient to rebut the presumption of equality amongst shares. I find this determination, with respect to the presumption of equality, to be a simple factual inquiry. In my view, the presence of a discretionary dividend clause can only be interpreted as creating differences between share classes, since that is the rationale for the clause. As far as the statutory requirements are concerned, the purpose of s. 24(4)(a) is to ensure that shareholders are fully aware of their entitlements and privileges to the extent that the presumption of equality is rendered inapplicable. To my mind, that purpose has been met since the dividend entitlements are clearly set out in the description of the share classes. In this regard, I find the argument of Quessy in his article "Les aspects corporatifs et fiscaux des actions à dividende discrétionnaire", [1985] 7 R.P.F.S. 31, at p. 45 to be persuasive:
[TRANSLATION] . . . the inclusion in the articles of a discretionary dividend clause expressly establishes that the corporation intends to derogate from the principle of equality among shareholders. The provision included in the articles alters the division of profits, which in the absence of such a provision would have to be made in accordance with the principle of equality among shareholders.
I am in full agreement with Strayer J. (at p. 5) that, with respect to the presumption of equality, "the Articles of Incorporation specifically provide to the contrary". In my view, then, the presumption of equality manifestly has been rebutted.
I find the appellant's arguments, as they relate to the validity of a discretionary dividend clause in terms of general corporate law and the requirements of the S.B.C.A., to be equally unpersuasive. Counsel for the appellant placed considerable emphasis in his arguments upon the nature of a shareholder "right", arguing that for the purposes of the statute and common law, a right to a dividend comprises a right to a portion of the total dividend declared, calculated according to the terms set out in the share description if and when the directors decide to make a distribution of the profits of the company. The appellant argues that the insertion of a discretionary dividend clause in the Articles of Incorporation is insufficient to confer a "right" since no corresponding "duty" is imposed on the company to pay dividends on that class once a dividend has been declared. Implicitly, Desjardins J. accepted this argument when she referred to the ability of the directors to allocate dividends "at whim". The appellant argues that this unconstrained discretion cannot be considered a "right" which is conferred by the shares.
I disagree with this analysis. In my opinion, 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". Rather, it is the entitlement to be considered for a dividend which is more properly characterized in those terms. I agree with the respondent that the Class B common shareholders of the company have an entitlement comparable to that of a fixed dividend holder to receive a dividend if the company's directors declare one. As well, the appellant's argument that there is no corresponding "duty" on directors as regards the "right" of shareholders is, in my view, specious. The directors are bound by their fiduciary duty to act in good faith for the best interests of the company in the declaration and allocation of any dividend. That duty is in no way circumvented by the presence of a discretionary dividend clause. Finally, I think that it should be borne in mind that many shareholder rights may be qualified and contingent (voting rights, the right to transfer shares, preferential rights to dividends, participation rights); yet the mere fact that these rights are fettered does not render them anything less than shareholder rights.
In a similar vein, I do not agree that the absence of a mathematical formula for the allocation of declared dividends in the Articles of Incorporation of the company is dispositive of the issue of the validity of the discretionary dividend clause. As the decision to declare a dividend and the determination of the funds available for a dividend are already within the discretion of the directors, it seems to me that a discretionary dividend clause is not a significant departure or extension of that discretion: De Vall v. Wainwright Gas Co., [1932] 2 D.L.R. 145 (Alta. C.A.). If shares are divided into separate classes, one of which contains a preferred entitlement to dividends declared by the company, the directors effectively have the discretion to allocate dividends only to that preferred class. Thus, the respondent could have achieved precisely the same allocation of dividends by structuring the company so that Wilma McClurg and Suzanne Ellis constituted a preferred class of shareholders with first entitlement to dividends. Such a structure would be unimpeachable in terms of the principles of corporate law.
Furthermore, it cannot reasonably be maintained that the presence of a discretionary dividend clause inherently leads to a conflict of the duty of directors and their self-interest any more than does the discretion to declare a dividend in any company. Consequently, I cannot agree with those authors who take the position that the allocation of dividends by directors, pursuant to a discretionary dividend clause, inherently cannot be exercised in the best interests of the company: see Martel and Martel, La compagnie au Québec, Les aspects juridiques, vol. I, at pp. 18-10 through p. 18-14C; Boivin, "Le droit aux dividendes et le dividende "discrétionnaire"" (1987), 47 R. du B. 73. I agree with the argument of the respondent that it is unrealistic to think that directors will not pay heed to the identity of shareholders and the contribution to the company of those shareholders any time a decision is made as to whether dividends of any sort should be declared. The fact that directors may consider the identity of shareholders does not necessarily render the declaration invalid on the basis of a conflict of duty and self-interest. For example, the discretion could be exercised for the purpose of rewarding a group of employees who comprise a preferred class of shareholders and who have been encouraged to invest in a company. Surely the fact that the identity of the holders of that class of shares was considered in the decision to declare a dividend and in the determination of the quantum of the dividend would not render the decision invalid. To reiterate, the limitation on the decision is purely a fiduciary one and the 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" [emphasis added]: Bryden, "The Law of Dividends", in Jacob S. Ziegel, ed., Studies in Canadian Company Law, at p. 270. That right is in no way undermined by the presence of a discretionary dividend clause.
In other words, the clause simply divides conceptually into two components -- declaration and allocation -- what has been, traditionally, one decision. In substance, though, the discretion which lies in the hands of the directors has always included both, subject to the provisions of the Articles of Incorporation. In this regard, the only other limitation upon the directors of which I am aware is that "if a dividend is declared by [a] corporation . . . there must be some shares entitled to receive the dividend": Welling, supra, at pp. 588-89. The principle has been given statutory recognition in s. 24(4)(b) of the S.B.C.A. In my view, this rule is not defeated by the presence of the discretionary dividend clause because the identity of the class eligible for a dividend simply remains unknown until the allocation takes place. This conceptual division into declaration and allocation is not substantively different from any derogation from the presumption of equality in the payment of dividends. Consequently, for this Court to find that the use of a discretionary dividend clause on these facts was an invalid exercise of the discretion of the directors would be to defeat the substance of what was achieved solely on the basis of its form.
Finally, I question whether it would be appropriate for this Court to determine that the use of a discretionary dividend clause is invalid in the context of an income tax appeal. The purpose of the governing statute, the S.B.C.A., is facilitative -- that is, it allows parties, with certain explicit restrictions, to structure bodies corporate as they wish. As well, the Act provides the means for an aggrieved party -- security holder, creditor, director or officer -- whose interests have not been regarded fairly by the corporation, to seek redress through the oppression remedy in s. 234 of the Act. No such complaint has been lodged by any interested party in this case, presumably because all those involved in this company are satisfied with the way in which the directors are conducting its affairs. Furthermore, at common law it is a well established principle that where shareholders are unanimously agreed to a transaction, inequality of treatment does not render it ultra vires the company: Wegenast, The Law of Canadian Companies, at pp. 321-22. As I have found that the use of a discretionary dividend clause is not prohibited expressly by the Act, nor contrary to common law or corporate law principles, I think the permissive spirit of the Act demands that a conclusion be reached that the use of the clause is valid. As Quessy, supra, explained, at p. 48, the use of the clause represents a legitimate exercise of the contractual rights between shareholders and a company:
[TRANSLATION] . . . the declaration and payment of a dividend by the directors on discretionary dividend shares is a legal act under the Corporations Acts when the articles contain a provision conferring greater discretion on them. We then have shares of the capital stock carrying the right to receive any dividend declared. Moreover, the articles contain an express provision indicating that the parties intend to derogate from the principle of equality among shareholders. Accordingly, as the parties to the contract are not acting contrary to public order and not infringing the law, we are of the view that the terms of the agreement concluded by them should be observed.
I agree with this conclusion. Professor Eisenberg, more than two decades ago, in his work on modern corporate law, "The Legal Roles of Shareholders and Management in Modern Corporate Decisionmaking" (1969), 57 Cal. L. Rev. 1, at p. 180, reasoned that "[i]n the case of the privately held corporation, legal rules governing internal decisionmaking should be suppletory in nature and based on the shareholders' probable expectations". Given that the legislature has not chosen to disallow the discretionary dividend clause, and no shareholder has taken remedial action against its use (presumably because shareholder expectations have been realized by its exercise), it would be paternalistic in the extreme for this Court to invalidate the clause at the behest of the appellant Minister of National Revenue. If the legislature determines that the use of the discretionary dividend clause undermines the reasonable expectations of shareholders or is in some way unfair to an interested party, then it is up to the legislature to limit the use of this means of structuring corporate affairs.
In conclusion, then, I find nothing untoward in the use of the discretionary dividend clause in the allocation of corporate dividends. There is nothing in the S.B.C.A. or at common law that prohibits this dividend allocation technique.
2. Income Tax Implications
Having dealt with the corporate law issues raised by the use of a discretionary dividend clause, I now turn to the primary issue raised in this appeal, namely, the tax consequences of the allocation of dividends made pursuant to the clause. This analysis entails an examination of s. 56(2) of the Income Tax Act and its application to the facts at bar. Before proceeding with that analysis, though, I would like to review briefly the method of interpretation to be followed in applying the section.
Interpretation of Taxing Statutes
In recent years this Court, in an income tax appeal, has found it beneficial to engage explicitly in the development of an interpretative approach to the Income Tax Act, an approach which is wedded neither to a rule of "strict construction" nor to an all-encompassing test of "independent business purpose". This trend began with the judgment of Estey J. in his majority reasons in Stubart Investments Ltd. v. The Queen, [1984] 1 S.C.R. 536. In that case, Estey J. undertook an extensive discussion of interpretative techniques, and he drew a conclusion as to the preferred approach to be taken by the Courts, at p. 576:
It seems more appropriate to turn to an interpretation test which would provide a means of applying the Act so as to affect only the conduct of a taxpayer which has the designed effect of defeating the expressed intention of Parliament. In short, the tax statute, by this interpretative technique, is extended to reach conduct of the taxpayer which clearly falls within "the object and spirit" of the taxing provisions.
Estey J. expanded upon this test of "object and spirit" in his majority judgment in The Queen v. Golden, [1986] 1 S.C.R. 209, at pp. 214-15:
. . . the law is not confined to a literal and virtually meaningless interpretation of the Act where the words will support on a broader construction a conclusion which is workable and in harmony with the evident purposes of the Act in question. Strict construction in the historic sense no longer finds a place in the canons of interpretation applicable to taxation statutes in an era such as the present . . . .
More recently, in Bronfman Trust v. The Queen, [1987] 1 S.C.R. 32, I described the approach in terms of the need to discern the commercial reality of a taxpayer's transaction, at pp. 52-53:
I acknowledge, however, that just as there has been a recent trend away from strict construction of taxation statutes ... so too has the recent trend in tax cases been towards attempting to ascertain the true commercial and practical nature of the taxpayer's transactions. There has been, in this country and elsewhere, a movement away from tests based on the form of transactions and towards tests based on ... a "common sense appreciation of all the guiding features" of the events in question. . . .
This is, I believe, a laudable trend provided it is consistent with the text and purposes of the taxation statute. Assessment of taxpayers' transactions with an eye to commercial and economic realities, rather than juristic classification of form, may help to avoid the inequity of tax liability being dependent upon the taxpayer's sophistication at manipulating a sequence of events to achieve a patina of compliance with the apparent prerequisites for a tax deduction.
Thus, in proceeding to analyze the tax consequences of the application of the discretionary dividend clause, it is necessary to determine both the purpose of the legislative provision and the economic and commercial reality of the taxpayer's actions. To a certain extent, the latter inquiry in the case at bar already has been answered by my determination that the use of the discretionary dividend clause is a valid means whereby directors of a company can distribute dividends. The question also is answered, in part, by the fact that it was not argued by the appellant that the payment of dividends to Wilma McClurg was a "sham". Therefore, to use the words of Estey J. in Stubart Investments Ltd., supra, at p. 572, it cannot be said that the transaction was "constructed as to create a false impression in the eyes of a third party, specifically the taxing authority". Having determined these preliminary issues, the purpose of s. 56(2) can be examined.
Subsection 56(2) of the Income Tax Act
In attempting to discern the purpose of s. 56(2), it is helpful to refer to the body of jurisprudence dealing with the subsection. A useful starting point is an early case dealing with the predecessor section to s. 56(2): Miller v. M.N.R., 62 D.T.C. 1139 (Ex. Ct.). In that case, Thurlow J., as he then was, in examining s. 16(1) of the Act, made some general comments, at p. 1147, as to the anti-avoidance purpose of the provision which remain relevant today:
In my opinion, s. 16(1) is intended to cover cases where a taxpayer seeks to avoid receipt of what in his hands would be income by arranging to have the amount received by some other person whom he wishes to benefit or by some other person for his own benefit. The scope of the subsection is not obscure for one does not speak of benefitting a person in the sense of the subsection by making a business contract with him for adequate consideration.
Strayer J. noted, at p. 4, in respect of the Miller case:
Two important qualifications are noted here: the first is that the taxpayer seek "to avoid receipt" of funds, presumably funds that would otherwise be payable to him; and the second is that the concept of payment of a "benefit" is contrasted to payments for adequate consideration.
In my opinion, the views of Thurlow J. and Strayer J. provide a sound foundation for the interpretation of s. 56(2). The subsection obviously is designed to prevent avoidance by the taxpayer, through the direction to a third party, of receipts which he or she otherwise would have obtained. I agree with both Thurlow J. and Strayer J. in their characterization of the purpose of the section and, specifically, I concur with their view that the section reasonably cannot have been intended to cover benefits conferred for adequate consideration in the context of a legitimate business relationship.
Application to the Facts
Having discerned the purpose of the section and the proper approach in interpretation, the next step in the analysis is apparent: a determination of the commercial reality and practical nature of the respondent's transactions which were the subject of reassessment by the Department of National Revenue. Urie J. in the Court of Appeal found the determination that the transaction occurred in the context of a director-shareholder relationship to be dispositive. I agree with that conclusion, and with the skepticism expressed by Le Dain J. in Perrault v. The Queen, [1979] 1 F.C. 155 (C.A.), at pp. 165-66, where he questioned whether the words of s. 56(2) "were intended to apply to the payment of a dividend". While it is always open to the Courts to "pierce the corporate veil" in order to prevent parties from benefitting from increasingly complex and intricate tax avoidance techniques, in my view a dividend payment does not fall within the scope of s. 56(2). The purpose of s. 56(2) is to ensure that payments which otherwise would have been received by the taxpayer are not diverted to a third party as an anti-avoidance technique. This purpose is not frustrated because, in the corporate law context, until a dividend is declared, the profits belong to a corporation as a juridical person: Welling, supra, at pp. 609-10. Had a dividend not been declared and paid to a third party, it would not otherwise have been received by the taxpayer. Rather, the amount simply would have been retained as earnings by the company. Consequently, as a general rule, a dividend payment cannot reasonably be considered a benefit diverted from a taxpayer to a third party within the contemplation of s. 56(2).
The appellant argues, and Desjardins J. accepted in dissent in the Court of Appeal, that s. 56(2) may be invoked at the point when the allocation is made of a dividend declared by the directors pursuant to the discretionary dividend clause. It is submitted that because, once declared, a dividend must be receivable by one class of shares pursuant to s. 24(4)(b) of the S.B.C.A., a portion of the dividend would have been received by the respondent in his capacity as shareholder had the payments not been directed to Wilma McClurg by him in his capacity as director. However, in discussing the use of the discretionary dividend clause, I have already concluded that its validity rests, in part, on the fact that allocations made pursuant to the clause are substantively no different from allocations made pursuant to a mathematical formula in the articles of incorporation of a company. Given that determination, it would be formalistic in the extreme to reach the conclusion that but for the payment to a third party shareholder, a director-shareholder would be the recipient of a portion of the payment. Instead, my view is that an allocation pursuant to a discretionary dividend clause is no different from the payment of a dividend generally. In both cases, but for the declaration (and allocation), the dividend would remain part of the retained earnings of the company. That cannot legitimately be considered as within the parameters of the legislative intent of s. 56(2). If this Court were to find otherwise, corporate directors potentially could be found liable for the tax consequences of any declaration of dividends made to a third party. I agree with both Urie J. and Strayer J. in the courts below that this would be an unrealistic interpretation of the subsection consistent with neither its object nor its spirit. It would violate fundamental principles of corporate law and the realities of commercial practice and would "overshoot" the legislative purpose of the section.
Although I have concluded that s. 56(2) does not apply to the declaration of dividends generally, its application also would be contrary to the commercial reality of this particular transaction. Strayer J. reviewed the evidence and reached the conclusion that the background and context of the transaction could be described as a "legitimate business relationship" (at p. 5), and he found that:
. . . the plaintiff's wife had made a real contribution to the establishment of the company and business through the personal guarantee she gave and the share of the mortgage she assumed on their jointly-owned home. The evidence presented before me also satisfied me that she had taken an active part in the operation of the business to the extent of her abilities and the requirements of the situation.
I find this conclusion to be completely supported by the evidence. Wilma McClurg played a vital role in the financing of the formation of the company. Although I agree with Desjardins J., at p. 370 that, with respect to a shareholder, "dividends come as a return on his or her investment", in my view there is no question that the payments to Wilma McClurg represented a legitimate quid pro quo and were not simply an attempt to avoid the payment of taxes. In my opinion, Goetz T.C.J. erred when he found that the dividends were a blatant attempt at tax avoidance. Indeed, his dismissal of the relevance of Wilma McClurg's contribution to the company and his description of her and Suzanne Ellis as "puppets" pay no regard to the very real contributions, financial and operational, made by Wilma McClurg. Furthermore, the efforts expended by Wilma McClurg in the operation of Northland Trucks, while not dispositive of the issue raised in this appeal, do provide further evidence that the dividend payment was the product of a bona fide business relationship.
In my opinion, if a distinction is to be drawn in the application of s. 56(2) between arm's length and non-arm's length transactions, it should be made between the exercise of a discretionary power to distribute dividends when the non-arm's length shareholder has made no contribution to the company (in which case s. 56(2) may be applicable), and those cases in which a legitimate contribution has been made. In the case of the latter, of which this appeal is an example, I do not think it can be said that there was no legitimate purpose to the dividend distribution.
III. Disposition
In conclusion, I have found that: (i) the discretionary dividend clause is valid in terms of the principles of corporate law and the provisions of the Saskatchewan Business Corporations Act; (ii) the declaration of a dividend is normally beyond the scope of s. 56(2) of the Income Tax Act; and, (iii) the facts at bar provide no evidence that the business arrangement was an attempt at tax avoidance, but rather that it was the product of a business contract made for adequate consideration. As a result, I would dismiss the appeal. Pursuant to the order of this Court granting leave to appeal in this case, costs of the appeal will be payable by the appellant on a solicitor-client basis.
The reasons of Wilson, La Forest and L'Heureux-Dubé JJ. were delivered by
//La Forest J.//
LA FOREST J. (dissenting) -- This appeal is concerned with whether money received by Wilma McClurg, wife of the respondent Jim A. McClurg, by virtue of a "discretionary dividend" clause, may properly be attributed to the respondent pursuant to s. 56(2) of the Income Tax Act, S.C. 1970-71-72, c. 63. The facts and the judgments of the courts below have been set out at length in Chief Justice Dickson's reasons, and I do not propose to repeat them. Rather, I will proceed directly to the legal analysis. Following the basic framework of the opinion of the Chief Justice, the discussion is divided into issues of corporate and tax law.
Corporate Law Issues
Simply put, the corporate law question raised by this appeal is whether the clause in Northland Trucks (1978) Ltd.'s Articles of Incorporation purporting to give each class of shares the "right to receive dividends exclusive of other classes of shares in the said corporation" is a valid allocation of power to the directors of the corporation under the Saskatchewan Business Corporations Act, R.S.S. 1978, c. B-10. The clause is referred to as a "discretionary dividend" clause because the mode of distribution of dividends is not determined by the Articles of Incorporation themselves, but is left to the "discretion" of the directors of the company.
In a certain sense, the term "discretionary dividend" is a misnomer, since it is a well-accepted principle of common law that the directors of a corporation have the discretion to determine if and when a dividend should be declared, and in what amount. This discretion is, of course, subject to certain reasonable limitations. For example, s. 40(a) of the Saskatchewan Business Corporations Act provides that a dividend may not be declared if there are reasonable grounds to believe such declaration would render the corporation unable to pay its debts. As well, there is the overriding principle that the discretion must always be exercised in a manner which is in the best interests of the corporation; see Welling, Corporate Law in Canada (1984), at p. 614.
Although the term "discretionary dividend" may be somewhat misleading, it is nonetheless not difficult to understand how the label itself was first chosen. Clauses such as the one contained in the Articles of Incorporation of Northland Trucks give directors a power of discretion that they never previously had: the power to discriminate between different classes of shares when determining how a dividend should be distributed. Is this allocation of power to the directors valid under the Saskatchewan Business Corporations Act? To answer this question, it is necessary to examine both the principles at common law and the statute itself.
The Common Law
Since the famous decision of the House of Lords in Salomon v. Salomon and Co., [1897] A.C. 22, it has been a settled proposition of law that a corporation has a separate legal existence, independent from that of its shareholders. Even before Salomon, it had been said that it was this proposition that lay at the "root" of corporate law: Farrar v. Farrars, Limited (1888), 40 Ch. D. 395, at pp. 409-10.
The independent legal existence of the corporation means that, while the shareholder remains a proportionate owner of the corporation, he does not actually own its assets. These assets belong to the corporation itself, as a separate legal entity; Schmitthoff, Palmer's Company Law (23rd ed. 1982), vol. 1, at p. 384, para. 33-01. Management of the corporation is entrusted to its officers and directors with the shareholder's interest protected through the distribution of shareholder votes. Thus, the corporate entity is unique in that it allows the shareholder to alienate ownership of property by placing it in a structure where the ownership of the property is separated from the effective control over that property; see Welling, supra, at p. 81. The sole link between the shareholder and the company is the share, which provides both a measure of the shareholder's interest in the company, as well as of the extent of the shareholder's liability for the actions of that company: see Borland's Trustee v. Steel Brothers & Co., [1901] 1 Ch. 279, at p. 288.
This separation of ownership and control provides the basis for many of the fundamental principles of corporate law. One example is the principle that the directors and officers of a corporation owe a fiduciary duty to the corporation: see Canadian Aero Service Ltd. v. O'Malley, [1974] S.C.R. 592. In recognizing for the first time that the fiduciary duty owed by directors to the corporation should be extended to senior officers of the corporation as well, this Court focused upon the degree of control that the officers were in a position to exercise in that case. Laskin J., as he then was, speaking for the Court, there stated, at p. 610:
Strict application against directors and senior management officials is simply recognition of the degree of control which their positions give them in corporate operations, a control which rises above day-to-day accountability to owning shareholders and which comes under some scrutiny only at annual general or at special meetings. It is a necessary supplement, in the public interest, of statutory regulation and accountability which themselves are, at one and the same time, an acknowledgment of the importance of the corporation in the life of the community and of the need to compel obedience by it and by its promoters, directors and managers to norms of exemplary behaviour.
Another principle that I believe also stems logically from the separation of ownership and control inherent in the corporation is the principle of equality of shares. Since the shareholders are only proportionate owners of the company, if their interest is to be adequately and fairly protected, those in the position of control must treat all the shareholders, or more accurately, all the shares, equally. Thus see Schmitthoff, supra, at p. 387, para. 33-06:
Prima facie the rights carried by the shares rank pari passu, i.e. the shareholders participate in the benefits of membership equally. It is only when a company divides its share capital into different classes with different rights attached to them that the prima facie presumption of equality of shares may be displaced.
In my opinion, the principle of equality of shares, like the principle of fiduciary duty, developed as more than just a mere contractual right -‑ it was a measure of protection for the shareholder that arose as a practical consequence of the unique nature of the corporate structure itself. This is so even though the parties could contract out of it to the extent that shares could be created that did not themselves have equal rights. In such a situation, the shareholder was still protected by virtue of the common law rule that shareholder rights had to be attached to the share itself, and not to the individual shareholder. Thus, while the shares had differentiated rights depending upon the particular class to which they belonged, the shareholder himself could not be discriminated against. For example, even when different classes of shares were created, the shares within the various classes themselves still had to be treated on an equal basis. It is thus put by Wegenast, The Law of Canadian Companies (1979), at pp. 320-21:
Apart from provisions, duly adopted, for preferences as between different classes of shares, and, where there are such preferences, then as amongst the members in each respective class, shareholders are entitled to be treated on a basis of equality. Shareholders may differ as to the wisdom of a particular course of action, but once adopted it must be carried out without discrimination amongst the shareholders or, as it is said in some of the cases, "for the benefit of the company as a whole." [Emphasis added.]
More significantly, even when more than one class of shares was created, the directors were not free to discriminate arbitrarily between the classes when awarding a dividend. As Fraser states in Company Law of Canada (5th ed. 1962), at p. 532, quoting Lord Cranworth L.C. in Henry v. Great Northern Ry. Co. (1857), 1 De G. & J. 606, at p. 638, 44 E.R. 858, at p. 871:
[Where there is more than one class of shareholders] it will [. . .] be the duty of the directors to fix the amount of the fund retained with reference to the general interest of all classes of shareholders, and not to favour any one class at the expense of the other.
The few Canadian cases that appear to have considered the issue have all held that, even when the shareholders agree to do so, a company may not validly be structured so as to derogate from the common law principle that shareholder rights must attach to the shares themselves. When I speak of shareholder rights, I include at least those three categories of rights that are considered to be fundamental: the right to a dividend, the right to vote, and the right to participate in the distribution of assets upon dissolution of the corporation.
In Jacobsen v. United Canso Oil & Gas Ltd. (1980), 113 D.L.R. (3d) 427 (Alta. Q.B.), the defendant company passed a by-law to the effect that no one person was entitled to vote more than 1000 shares, notwithstanding the number of shares actually held by that person. The company had originally been incorporated under the Companies Act, R.S.C. 1952, c. 53. The court found the by-law invalid since the Companies Act recognized the common law presumption of equality "that all shares confer equal rights and impose equal liabilities and that if voting rights are to vary separate classes of shares must be created so that the different numbers of votes can be attached to the shares themselves and not to the holder" (at p. 433) (emphasis added). The court also held that the by-law was invalid under the Canada Business Corporations Act, S.C. 1974-75, c. 33, which superseded the Companies Act, the Act upon which the Saskatchewan Business Corporations Act is based.
In Bowater Canadian Ltd. v. R.L. Crain Inc. (1987), 62 O.R. (2d) 752, the Ontario Court of Appeal held invalid a "step-down" provision contained in the respondent R.L. Crain Inc.'s Articles of Incorporation. The provision provided for a special class of common shares that carried ten votes per share while in the possession of the original shareholder, but that would carry only one vote per share if transferred to another. The Court of Appeal followed the reasoning of McRae J. in the court below, who, at p. 754, held that:
. . . although there was no express prohibition in the CBCA against a step-down provision, s. 24(4) of the Act should be interpreted in accordance with the general principles of corporation law with the result that the rights which are attached to a class of shares must be provided equally to all shares of that class, this interpretation being founded on the principle that rights, including votes, attach to the share and not to the shareholder. [Emphasis added.]
Both Jacobsen and Bowater recognize that the principle that shareholder rights must attach to the corporation's shares is more than a mere contractual right: even the shareholders themselves may not agree to circumvent this principle.
Another case holding that rights attach to the share rather than the shareholder, albeit in a different context, is Rondeau v. Poirier, [1980] C.A. 35. In that case, the respondent claimed he was entitled to receive a portion of the cumulative dividends paid on shares that were given by him to his former wife as part of their divorce settlement. The respondent argued that he should receive the dividends that were paid retroactively for the years during which he possessed the shares. This argument was rejected by the Court of Appeal, which held that the right to receive dividends is a contingent right that does not actually arise until the dividends have been declared by the corporation. Although the respondent had been the shareholder during the years when most of these dividends were accumulated, any right to these dividends passed with the shares when they were transferred (at p. 39).
Writing for the majority of the Court of Appeal in Rondeau, Lamer J., as he then was, noted at p. 37 that the shareholder's right to a dividend encompasses the right to a particular mode of distribution once a dividend has been declared:
[TRANSLATION] [The shareholder] is entitled not to the profits, since the directors are not obliged to distribute them, but to a portion and to certain modes of distribution of profits if and when the directors decide on a distribution, in other words, declare a dividend. [Emphasis added.]
In my view, a discretionary dividend clause such as the one in this case, that permits the directors of a corporation to choose which class is entitled to receive dividends to the exclusion of the other classes, would be invalid at common law. It contravenes the principle that the directors are not permitted to favour one class at the expense of the others: see Fraser and Stewart, supra, at p. 532. Further, and the respondent does not dispute this point, if dividends are allocated to the different classes on a discretionary basis, then the directors will be making this allocation primarily on the basis of the identity of the shareholders in the various classes. While the respondent contends that this does not represent a significant departure from the existing state of the law, I disagree, for it means, in effect, that the right to the dividend attaches not to the shares, but to the shareholder: see Boivin, "Le droit aux dividendes et le dividende `discrétionnaire'" (1987), 47 R. du B. 73, at p. 92.
Again, in my view, the rule that shareholder rights must attach to the shares themselves is a principle which has its roots in the very nature of the corporate structure. When the Articles of Incorporation create classes of shares that have different rights, this normally does not require the directors to discriminate between the shareholders ‑- the mode of distribution is set out in the shares themselves. To allow discrimination on the basis of the identity of those possessing the shares ignores the separation that is supposed to exist between the corporation and its shareholders: see Martel and Martel, La compagnie au Québec, Les aspects juridiques (1987), vol. I, at p. 18-14B.
The respondent, however, contends that, even in a situation where no discretionary dividend clause exists, in a corporation with at least one class of preferred share, the directors of a corporation effectively have the power to choose which classes will receive dividends. They can do so by declaring dividends in an amount small enough that only the preferred shares will partake. This, however, is a discretion that is expressly limited by the terms of the Articles of Incorporation. The need for protection is not as great, for the common shareholder is not placed in a position where the director can award dividends of any amount to a class other than his or her own. That shareholder knows that if dividends are declared in excess of a specified amount, then his or her class of shares will participate. If dividends are never declared in excess of that amount, then at least the money is retained by the corporation. Where there is a discretionary dividend clause, however, the shareholder is completely dependent on the goodwill of the directors. The minority shareholder is placed in a near impossible position if this goodwill turns against him or her; see Martel and Martel, supra, at p. 18-14A. It is interesting to note that at least one commentator who writes in favour of the discretionary dividend clause suggests that each shareholder's "informed" consent to this sort of arrangement be obtained in advance in writing, presumably to guard against just such an eventuality: see Quessy, "Les aspects corporatifs et fiscaux des actions à dividende discrétionnaire", [1985] 7 R.P.F.S. 31, at pp. 42-43.
In my opinion, a second reason why the discretionary dividend clause is invalid at common law is because it places the director in a position where he cannot fulfill his fiduciary obligations to the corporation as a whole. The interests of different classes of shareholders, where a discretionary declaration of dividends is concerned, are necessarily divergent, since a dividend will be declared for the benefit of one class of shareholders at the expense of the others. As put by Martel and Martel, supra, at pp. 18-14 and 18-14A:
[TRANSLATION] It would be impossible for him to justify this preference, since it is surely not made in good faith in the interests of the company. In using their discretion to favour certain shareholders, the directors are in an obvious conflict of interest, particularly if they are themselves those shareholders or associated with them. . . . The situation created by discretionary dividend clauses is unprecedented, and places the directors in an impossible position: if they favour certain shareholders by departing from the rule of equality, they are breaching their obligations as agents or quasi-fiduciaries of the company, and in fact are acting as agents of the shareholders they are favouring, or at least of those who control the company.
The conflict of interest is heightened when the director happens to be a shareholder himself. When the discretionary dividend clause is utilized to award dividends to a class in which the director holds shares, or from which he derives some personal benefit, the situation can be compared to the usurpation of a corporate opportunity properly belonging to the company. As Laskin J. observed in the Canadian Aero Service Ltd. v. O'Malley, supra, at pp. 606-607, the fiduciary duty, at the very least, precludes the director
. . . from obtaining for himself, either secretly or without the approval of the company (which would have to be properly manifested upon full disclosure of the facts), any property or business advantage either belonging to the company or for which it has been negotiating; and especially is this so where the director or officer is a participant in the negotiations on behalf of the company.
A discretionary dividend clause gives the director a licence to secure, by virtue of his position, a personal benefit at the expense of the corporation and its shareholders without having to seek shareholder approval. By contrast, requiring the mode of distribution to be expressly set out in the Articles of Incorporation, which can only be amended by approval of the shareholders, is consistent with the fiduciary obligation as described in the Canadian Aero case. I note that, in the usual case, if the directors themselves hold preferred shares, this does not present a problem, for the common shareholders will have agreed to subordinate their dividend interest to the preferred class of shares based upon "full disclosure" of the maximum amount to which these preferred shares will enjoy priority. With a discretionary dividend clause, there is no such disclosure, since the amount and priority is left to be determined in the future, wholly at the directors' discretion.
The Chief Justice states that the fact that the directors take into account the identity of shareholders when declaring a dividend does not necessarily create a conflict of duty. As an example, he suggests that the directors could validly exercise their discretion to allocate dividends so as to reward a group of employees who comprise a class of preferred shareholders. With respect, it seems to me that even this would constitute an improper exercise of the discretionary dividend power. If the employees truly merit some additional reward, the proper course would be to achieve this through some other form of compensation, for example a bonus. A dividend is supposed to be a return on an investment. On this point, I adopt the words of Desjardins J. of the Federal Court of Appeal ([1988] 2 F.C. 356), at p. 370:
But surely, there is no relationship, in company law, between the work and services a shareholder brings to a company and his or her entitlement to a dividend if declared. The dividends come as a return on his or her investment and not on account of work and services he or she may render to the company. The dividend attaches to the share and not to the shareholder.
In any event, even if I did not find that the discretionary dividend clause was itself invalid under the common law, I would find that the clause, at least as designed in the present case, is insufficient to rebut the common law presumption of equality. As earlier noted, it is well accepted that in the absence of some differentiation between the shares, all shares must be treated equally: see Birch v. Cropper, In re Bridgewater Navigation Co. (1889), 14 A.C. 525 (H.L.). The respondent contends that the fact that the classes of shares have the potential to receive dividends in potentially different amounts is sufficient to differentiate them. The fact remains, however, that all three classes of Northland Trucks' shares are defined in substantially the same manner with respect to their entitlement to dividends. Each class carries "the distinction and right to receive dividends exclusive of other classes of shares in the said corporation". As Professor Boivin, supra, notes, at p. 94:
[TRANSLATION] . . . if all the shares have a discretionary dividend clause, they are all on an equal footing as regards dividends, even if there are certain distinctive characteristics with respect to other rights or privileges. Far from breaching the principle of equality, the clause thus used confirms it.
Any difference between the shares concerning their right to receive dividends that does exist clearly does not derive from any differentiation between the shares, but would have to stem from the actions of the directors of the corporation. This would, however, be a right that does not derive from the share itself, and as such would be invalid at common law.
Having found that the discretionary dividend clause contained in the Articles of Incorporation of Northland Trucks was an invalid allocation of power at common law, it remains to examine the Saskatchewan Business Corporations Act to see if the statute changes this result.
The Saskatchewan Business Corporations Act
Section 24(4)(a) of the Saskatchewan Business Corporations Act provides that the corporation may derogate from the common law rule of equality, by creating more than one class of shares:
24. . . .
(4) The articles may provide for more than one class of shares and, if they so provide:
(a)the rights, privileges, restrictions and conditions attaching to the shares of each class shall be set out therein;
See also s. 6(1)(c)(i).
The question becomes whether the allocation of power to the directors of a corporation to determine each class of shares' right to a dividend, once one has been declared, is consistent with s. 24(4)(a), which provides that such rights must be "set out" in the Articles of Incorporation. There are two possible interpretations. The first is that it is sufficient if the articles "set out" that the different classes of shares have the "right" to receive a dividend that has been declared, wholly at the discretion of the directors. The second is that the requirement that the rights be "set out" requires that the mode of distribution of the dividends be expressly provided for in the articles themselves.
I start from the premise that s. 24(4)(a) must, of course, be interpreted in accordance with the principles of the common law: see Bowater, supra, at p. 754. It should be apparent from the preceding analysis that, in my opinion, this would inevitably lead one towards the second interpretation, since, at common law, shareholder rights had to be expressly provided for in the shares themselves. If the Saskatchewan legislature intended to depart from this principle, it could have stated so explicitly. In my view, s. 24(4)(a) falls far short of providing the clear expression necessary to indicate an intent to provide the directors of a corporation with a power which they did not otherwise have at common law.
I note that this interpretation of s. 24(4)(a) appears to be the most consistent with other provisions of the Act as well. For example, s. 27 provides for the possibility of creating different "series" within a class of shares, which may themselves be structured so as to possess different rights. In contrast to its treatment of classes of shares, the Act expressly provides that the directors of a corporation may be given the discretion to determine the rights attaching to these series. Section 27(1) reads:
27.--(1) The articles may authorize the issue of any class of shares in one or more series and may authorize the directors to fix the number of shares in and to determine the designation, rights, privileges, restrictions and conditions attaching to the shares of each series, subject to the limitations set out in the articles.
It is significant that, even when the Act specifically provides that the directors may be given the discretion to determine the rights to be assigned to a series, this discretion is not unlimited: see s. 27(2), (3), (4). In particular, the directors may not assign to a series a higher priority in respect of dividends or return of capital over any other series of the class that are still outstanding (s. 27(3)). Thus, even though under the Act the shareholders can give the directors the power to issue series within a class and assign rights to those series, the shareholders may not agree to give the directors the discretion to interfere with their right to dividends or a return of capital by choosing to give another series priority. Why would the legislature find it necessary to protect the shareholders by restricting the directors' discretion in this manner? In my view, the answer lies in the fact that the rights assigned to series, unlike classes of shares, may be altered without amending the corporate constitution. As Professor Welling, supra, notes, at p. 584, this distinction leads to a potential for abuse of power by the directors:
The result is clear although, from the point of view of shareholder protection, it is initially astounding. The statute requires that discrimination between different classes be strictly regulated by the corporate constitution, subject to the remedies protecting adherence to the corporate constitution and changeable only by the usual shareholder approvals. Strangely, discrimination within a particular class need only be pre-meditated in the articles: the details can be supplied from time to time by ordinary directors' resolutions, without any shareholder participation at all. [Emphasis in original.]
Because s. 27 allows the shareholders to give directors the power to discriminate between series of shares, while leaving the directors with the ability to "supply the details" of this discrimination themselves at a later date, the legislature apparently found it necessary to limit this power, by preventing the directors from discriminating in certain areas, specifically with respect to priority over dividends. This attempt at protection would be rendered futile if it were permissible for shareholders to give to directors the same power to discriminate with respect to priority over dividends where shareholder classes are concerned, through the use of a discretionary dividend clause.
A more reasonable interpretation of the statute is that it contemplates that shareholders will be protected from changes being made to the rights attached to different classes of shares by virtue of the fact that such rights may only be amended by altering the corporate constitution. Section 170(1)(c) of the Saskatchewan Business Corporations Act provides that:
170 (1) . . . the holders of shares of a class or . . . of a series are entitled to vote separately as a class or series upon a proposal to amend the articles to:
. . .
(c) add, change or remove the rights, privileges, restrictions or conditions attached to the shares of such class . . . .
The protection afforded by s. 170 for dividend rights can only be meaningful if the mode of distribution must itself be set out in the Articles of Incorporation. Otherwise, the section can effectively be circumvented because the directors will have the power to change each class' allocation of dividends at will, without the need for a shareholder vote. The importance of s. 170(1) as a mechanism for protecting shareholder interests is evidenced by the fact that each class of shares is entitled to vote, regardless of whether the shares normally carry this right or not (s. 170(3)).
I also find the use of the discretionary dividend clause in the present case to be inconsistent with the requirement of the Act that at least one class of shares must be entitled "to receive any dividend declared by the corporation" (s. 24(3)(b)). On this point, I agree with the following remarks of Professor Boivin, supra, at p. 93:
[TRANSLATION] Assuming that the capital consists of a single class of shares and that these shares carry a discretionary dividend, they do not confer, in our view, any right to any dividends, which is not surprising since that is precisely the aim. Even assuming that the share confers a right to a dividend, that right cannot be interpreted as a right to receive "any dividend declared".
In essence, the argument of the respondent distills down to a single point: the Saskatchewan Business Corporations Act does not appear to specifically prohibit the use of a discretionary dividend clause, and in the absence of such explicit prohibition, the parties must be left free to contract at will. If one were to carry this argument to its logical conclusion, there would be nothing to prevent shareholders from passing a "discretionary voting" clause, giving the directors the power to exercise all of their votes as they see fit. Indeed, during the oral argument, counsel for the respondent appeared to suggest that this, too, would be a permissible allocation of power. I find that such an arrangement, which would leave the directors in complete control of the corporation, with the power to prolong their tenure indefinitely, to be completely unacceptable in that it would undermine virtually all of the protection afforded to shareholders by the Act.
It is true, of course, that the actions of the directors will always be subject to the qualification that they are acting as fiduciaries for the corporation. Thus, in theory, it is always open for a shareholder to bring a suit if he feels the directors are exercising their discretion improperly. In reality, however, one cannot overlook the significant burden and expense that this remedy entails. In my view, placing the onus on shareholders to bring a suit to vindicate their rights is an inadequate means of protecting them from the potential for abuse created by the presence of a discretionary dividend clause.
If this protectionist view seems somewhat patronizing, I would point out that other provisions of the Saskatchewan Business Corporations Act provide, in a similar manner, for the protection of shareholders from arrangements to which they might otherwise agree. One example already referred to is s. 27, which restricts the power that can validly be allocated to directors to determine the rights and privileges of future series of shares. I also note that the protection of the individual shareholder was one of the major driving forces behind the extensive statutory reform that took place in Canadian corporate law in the 1970s; see Welling, supra, at p. 502. The Saskatchewan Business Corporations Act is a product of that reform, as is the Canada Business Corporations Act upon which the Saskatchewan Business Corporations Act is modeled. Corporate law has not yet evolved to the point where the freedom to contract at any cost has become paramount to all other concerns.
The need for shareholder protection from abuse of the discretionary dividend clause becomes all the more apparent when one considers the possibility that such a clause could be inserted in the articles of incorporation of a large, publicly held corporation. I recognize that in this case we are dealing with a closely held corporation, where there has been no allegation of a breach of fiduciary duty by the directors, but the Saskatchewan Business Corporations Act applies to large and small corporations equally. One rule of law must stand for both. I hasten to add that, in my view, the primary reason that the discretionary dividend clause is invalid is that it offends the principle that the corporation has a separate legal existence from the shareholder. Since the shareholders of closely held corporations are given preferential treatment, such as limited liability, based upon the notion of this separation between corporation and shareholder, it is not unreasonable for the state to require them to respect this separation by structuring their corporation accordingly.
Against the weight of these arguments, I can think of no socially useful purpose, and counsel for the respondent could point to none, behind the employment of a discretionary dividend clause. The only apparent purpose of such a clause is to facilitate tax avoidance through "income-splitting", which does little to persuade me of the need to allow corporations to be structured in this manner: see Boivin, supra, at p. 106; see also comment, "The Last Bastion for Income-Splitting? J.A. McClurg v. The Queen" (1986), 34 Can. Tax J., at p. 404.
Having found that the discretionary dividend clause used in the Articles of Incorporation of Northland Trucks was invalid, it remains to determine how the money distributed pursuant to that clause should be allocated. Since the directors of Northland Trucks must be taken to have made the decision that the declaration of the amount of dividends that were distributed was in the best interests of the corporation, it would be inappropriate to now return this money to the corporation. The proper solution, in my view, is to redistribute the dividends amongst the various classes of shares. As previously discussed, in the absence of a valid differentiation between the shares to the contrary, all of the classes will share in the dividend equally. In the present case, that means that the money will be allocated equally to the shares in classes A, B, and C.
I turn then to a consideration of the income tax consequences of the dividend payments.
Income Tax Consequences
General
I am in agreement with the Chief Justice as to the proper approach to the interpretation of the Income Tax Act generally, and s. 56(2) specifically, as well as the necessity of ascertaining the true nature of the transaction in question. With deference, however, I am unable to agree with him as to the application of s. 56(2) in the present case. Our differences arise as a result of the interdependence of the corporate law and income taxation issues in this case, and my finding that the discretionary dividend clause is invalid.
Any tax planning technique is open to challenge on the basis that the underlying legal construct is invalid. This follows from the fundamental principle of taxation law that the actual legal result of a transaction, rather than its form, is relevant to tax liability. In Champ v. The Queen, 83 D.T.C. 5029 (F.C.T.D.), for example, a dividend payment was found to be invalid in law, and the form of the payment was disregarded for tax purposes. In that case, the taxpayer and his wife held two-thirds and one-third of the shares of the corporation respectively. While the Articles of Association of the company specifically stated that "dividends may be declared and paid according to . . . the number of shares held", dividends were paid to only one class of shares, which were held exclusively by the wife. The court found that the taxpayer diverted his pro rata share of the dividends, and included this indirect payment in his income by way of s. 56(2). The approach adopted by the Federal Court in Champ is in keeping with the "ineffective transaction" test for denying a taxpayer the benefit of a particular transaction, which was articulated by this Court in Stubart Investments Ltd. v. The Queen, [1984] 1 S.C.R. 536.
In the present case, Mrs. McClurg received a dividend payment of $10,000 on the basis of the discretionary dividend clause that has been found to be invalid. Therefore, the taxpayer's characterization of the true nature of the payment cannot stand. Instead, the analysis must proceed on the basis that the dividend declared in each of the three years in question should have been allocated equally to the shares in classes A and B. Of the $10,000 dividend declared, then, $8,000 was payable to Mr. McClurg, and only $2,000 was payable to Mrs. McClurg.
Before turning to the specifics of the application of s. 56(2) to the facts at hand, it is necessary to comment on two points raised by the Chief Justice. First, he states that a dividend payment does not fall within the scope of s. 56(2). I agree with this view so far as it refers to the typical situation where the dividend payment is within the powers of the corporation and the shareholder is bona fide entitled to the dividends. It must be emphasized, however, that $8,000 of the dividend payment to Mrs. McClurg was not a bona fide dividend payment, but a receipt of dividend income otherwise payable to her husband. As was the case in Champ v. The Queen, supra, a payment which is not in law a dividend payment cannot serve as a bar to the application of s. 56(2).
Secondly, I must comment on the relevance of Mrs. McClurg's contribution to the business. At trial, it was found as a fact that Wilma McClurg contributed to the establishment and operation of the business. The Chief Justice considers this fact to be of relevance to the resolution of the matter before this Court, because it indicates that the dividend payment was not the product of a blatant tax avoidance scheme, but rather a benefit conferred for adequate consideration in the context of a legitimate business relationship. In other words, the dividend payment can be justified because of the efforts made by Mrs. McClurg on behalf of the company.
With respect, this fact is irrelevant to the issue before us. To relate dividend receipts to the amount of effort expended by the recipient on behalf of the payor corporation is to misconstrue the nature of a dividend. As discussed earlier, a dividend is received by virtue of ownership of the capital stock of a corporation. It is a fundamental principle of corporate law that a dividend is a return on capital which attaches to a share, and is in no way dependent on the conduct of a particular shareholder.
In the present case, a $10,000 dividend was declared by the directors of Northland Trucks and was allocated in its entirety to Mrs. McClurg, ostensibly in return for work and services rendered to the company. Regardless of what motivated the directors to allocate the dividends to Mrs. McClurg, if she were somehow bona fide entitled to the dividends, it would be an entitlement based solely on her ownership of shares of the corporation, and s. 56(2) would not apply. In other words, s. 56(2) clearly is inapplicable to a transaction wherein a shareholder is in receipt of a dividend properly allocated to his or her shares.
Application of Section 56(2)
Turning to the application of s. 56(2) to the instant case, I find it useful as a starting point to break the provision down into its constituent parts. Such an analytical framework was adopted by Cattanach J. in Murphy v. The Queen, 80 D.T.C. 6314 (F.C.T.D.), where he stated, at pp. 6317-18:
To fall within subsection 56(2) each essential ingredient to taxability in the hands of the taxpayer therein specified must be present.
Those four ingredients are:
(1)that there must be a payment or transfer of property to a person other than the taxpayer;
(2)that the payment or transfer is pursuant to the direction of or with the concurrence of the taxpayer;
(3)that the payment or transfer be for the taxpayer's own benefit or for the benefit of some other person on whom the taxpayer wished to have the benefit conferred, and
(4)that the payment or transfer would have been included in computing the taxpayer's income if it had been received by him instead of the other person.
It must be determined, then, whether these four elements or prerequisites to the application of s. 56(2) are present in the transaction at hand.
With regard to the first element, the term "payment" has acquired no technical meaning in the Income Tax Act and is to be interpreted in its popular sense: see Murphy, supra, at p. 6320. Furthermore, "property" is defined in very broad terms in s. 248(1) of the Income Tax Act, and specifically includes money. It is also noteworthy that s. 16(1), the predecessor to s. 56(2), originally referred to a transfer of "money, rights or things". Therefore, it appears that the payment in question satisfies the first prerequisite to the operation of s. 56(2). This is confirmed by Champ v. The Queen, supra, where it was held that the taxpayer effected a "transfer of property" by directing the payment of dividends.
The second element provides that the payment or transfer be pursuant to the direction of the taxpayer or with the concurrence of the taxpayer. The respondent argued that the payment was made by the company, a legal entity separate from the taxpayer, and to the extent that the taxpayer directed or concurred in the payment of the dividend, this was done in his capacity as a director of the corporation, and not in any personal capacity.
Under s. 56(2), however, it is sufficient that such a payment be made with the concurrence of the taxpayer. The facts indicate that the respondent, in his capacity as a shareholder, did not object to the distribution of dividends. The appellant argued that Mr. McClurg's failure to object to the payment to Mrs. McClurg constituted implied concurrence. In other words, since Mr. McClurg did not demand his share of the dividends, he implicitly accepted that the company make an $8,000 payment to his wife. To this end, the appellant relied on Bronfman, A. v. M.N.R., [1965] C.T.C. 378 (Ex. Ct.), at p. 385, in which Dumoulin J. held that the "abstention or indifference" of shareholders who had the power to object to the actions of directors was "tantamount to an approval" and sufficient to invoke s. 16(1), the predecessor to s. 56(2).
In my view, an individual in control of a corporation can be said to have directed a payment or transfer of property within the meaning of s. 56(2) by exercising that control. Furthermore, even if one accepts the contrary view that the taxpayer did not direct the payment, the payment nevertheless was made with the concurrence of Mr. McClurg in his personal capacity as a shareholder of the company. Thus, the second precondition to the operation of s. 56(2) is met.
The third precondition requires that the payment be for the benefit of the taxpayer or recipient. Since Mrs. McClurg was entitled to only $2,000 in dividends, the $8,000 portion of the payment representing Mr. McClurg's dividend entitlement amounts to a benefit to her under s. 56(2). In addition, Mr. McClurg himself obtained a benefit from the transaction by way of a reduction in income tax. As explained by Cattanach J. in Murphy v. The Queen, supra, at p. 6318, this type of benefit goes to the very purpose of s. 56(2):
Subsection 56(2) is to impute receipt of income to the taxpayer that was diverted at his instance to someone else. It is to cover cases where the taxpayer seeks to avoid the receipt of what in his hands would be income by arranging to transfer that amount to some other person he wishes to benefit or for his own benefit in doing so. Apart from any moral satisfaction the practical benefit to the taxpayer is the reduction in his income tax.
Finally, it is obvious that the $8,000 dividend would have been included in Mr. McClurg's income had the allocation been properly made.
Therefore, the four prerequisites to the application of s. 56(2) have been met. Since $8,000 of the $10,000 in dividends attributed to Wilma McClurg on her class B shares was properly attributable to Mr. McClurg, this amount should be included in the computation of his income.
Disposition
In the result, I would allow the appeal and uphold the Minister's reassessment.
Appeal dismissed with costs, WILSON, LA FOREST and L'HEUREUX‑DUBÉ JJ. dissenting.
Solicitor for the appellant: John C. Tait, Ottawa.
Solicitors for the respondent: Bennett Jones, Calgary.