The Trojan Tax Horse:

The Canadian Shareholder Benefits Regime and Building

Structures to Expatriate Retained Earnings with Minimal Tax

Consequence.

By: Aaron Grinhaus

August 6, 2012

Table of Contents

I. Crashing the Party...................................................................................................... 1

II. Spoiling the Fun – Restrictions on Shareholder Benefits......................................... 3

a. The Prophecy............................................................................................ 3

b. The Learned Scholars................................................................................... 5

c. Cheating your Fate..................................................................................... 12

III. Laying Siege to the ITA............................................................................................ 13

a. Building the Walls..................................................................................... 13

b. Planning the Invasion................................................................................. 17

c. Venturing Across the Sea............................................................................... 27

III. Using Horse Sense.................................................................................................... 29

a. Basic Construction................................................................................. 29

b. In for the Kill........................................................................................ 31

c. Shooting the Arrow............................................................................... 35

IV. Journey’s End............................................................................................................ 37

Bibliography.......................................................................................................................... 39

Appendix A: Brief Synopsis of the Iliad

1

I. Crashing the Party

The greatest and most contrived tax planning strategies and structures are the ones that

are most vulnerable to attack from within. Individuals charged with the protection and

administration of such structures must ensure that its walls are high, the coffers are stocked with

provisions and adequate finances, and that all the right people are informed of its dealings in

order to avoid an invitation of discord. Unfortunately though, no one likes being left off a guest

list, especially the Canada Revenue Agency (the “CRA”).

Nothing makes the CRA more vindictive than when it makes an appearance at your party

uninvited. When the CRA assesses a taxpayer it is an expression of mistrust; audit, enforcement

and investigation are functions exercised by the CRA when taxpayers fail to, or are suspected of

having failed to, report the correct taxable income in their returns. In addition to the obligation to

self-assess and file a return “without notice or demand” under the Income Tax Act (“ITA”)1, the

CRA has “fairness” policies to alleviate penalties and to encourage delinquent taxpayers to

disclose errors in their returns. Occasionally tax planners discover that a Golden Apple was

tossed into the crowd of shareholders when they find a loop-hole in the law.

The purpose of this paper is to explore the shareholder benefit provisions of the ITA and

identify where the legislation fails in its attempt to curb the minimization of tax by shareholder-

taxpayers funnelling funds to themselves through the use of tax structures. Many CRA Income

Tax Bulletins (“IT Bulletins”) have attempted to address the proper uses of devices such as

shareholder loans and stock options in order to prevent the use of aggressive planning strategies

which circumvent the protective provisions of the legislation. The response to these strategies

has been increased restrictions on shareholder benefit and increased audit power, while

1 Income Tax Act, R.S.C. 1985, (5th Supp) c.1, s. 150(1) [“The ITA”].

2

simultaneously granting protections and rights to taxpayers through alternate legislation, internal

CRA policies and through the common-law.

The courts have played an influential role in the development of exceptions to

shareholder benefit provisions under the ITA. Although the courts are often hesitant to interfere

with the contrived language of the ITA, they have been successful in carving-out enclaves and

niches in favour of aggressive tax planning structures, allowing for creative tax planners to craft

strategies that allow for the build up of loaned and repayable funds in corporate capital accounts.

The goal is to create an arrangement whereby the taxpayer can minimize the tax payable on

money withdrawn from the corporation by either deferring or eliminating the attribution of

capital to the individual.

This paper will describe how, given the state of the shareholder benefit regime in Canada,

different strategies can be used to effect tax minimization and deferral arrangements without

incurring the wrath of the all powerful CRA. There are many different ways that shareholders

can create debts within a corporation in order to extricate money on a tax free or tax deferred

basis that were not intended or foreseen by the legislature, or for which the legislature created a

specific exemption to the benefit of the shareholder-taxpayer. There are also many creative ways

that debt can be shifted in order to create loans for repayment. In other words, shareholders

have the ability to extract money from the retained earnings of corporations with minimal

tax consequence if they plan their tax affairs aggressively and creatively.

The paper will begin by examining the shareholder benefits provisions and how they

have been interpreted by the courts. The courts have been both merciful and brutal to

shareholders who have tried creative structures, and some leeway has been given to shareholders

attempting aggressive structures. The paper will go on to look at how the statutory rules have

3

been interpreted by the CRA in its IT Bulletins, and will examine how the courts have applied

the law in various planning contexts. The paper will address the scholarly commentary on

various tax planning strategies involving shareholder benefits and the extrication of retained

earnings, and will conclude by exploring a number of tax planning strategies that can be used to

exploit those fissures evident in the tax law in order to craft strategies and fabricate structures

that can be used to conceal funds from the wary and prying eyes of the CRA.

II. Spoiling the Fun – Restrictions on Shareholder Benefits

a. The Prophecy

Devising a tax structure for clients requires a prediction of their future activity: will they

sell their business in the near future? Will their families grow, or will an asset protection strategy

be required for impending divorce? Is there a succession plan in place? Often times the

recommendations begin with financial advisors, who approach their client’s accountant or lawyer

with a cryptic, oracle like prophecy of using corporations and trusts as investment vehicles

without fully appreciating their use, impact or tax benefit, if any. We as professionals must be

cognizant of these instructions coming from clients who are spun yarns of invulnerable

investments and infinitely useful insurance products. Even more promising is the prospect of pre-

tax dollars being spent from the corporation’s coffers to pay for these investments and insurance

products, the cost of which can be deducted from the taxable income of the corporation and paid

for with pre-tax dollars. It is the accountant and lawyer’s role to filter out and decipher the

specific application of these structures for the full benefit of the client without running afoul of

the income tax scheme.

The ITA is a contrived labyrinth of rules designed to capture benefits conferred by

corporations on a number of interested individuals in order to attribute those benefits to the

4

taxable income of the respective individual. Two of such specified individuals are employees

under section 6 of the ITA2, and shareholders under section 15

3, for whom special provisions

have been made.

Section 15 of the ITA reads (in part) as follows:

15(1) Where at any time in a taxation year a benefit is conferred on a

shareholder ... otherwise than by

(a) the reduction of the paid-up capital, the redemption, cancellation or

acquisition by the corporation of shares of its capital stock or on the

winding-up, discontinuance or reorganization of its business, or otherwise

by way of a transaction to which section 88 applies,

(b) the payment of a dividend or a stock dividend,

(c) conferring, on all owners of common shares ... [a right] to acquire

additional shares of the capital stock of the corporation [where voting

rights differ from other classes of shares and the fair market value does

not differ from other classes] ... and [the cost of acquiring the new

shares is different from the other classes], or

(d) an action described in [the deemed dividend rules],

the amount or value thereof shall, except to the extent that it is deemed by

section 84 to be a dividend, be included in computing the income of the

shareholder for the year.4

This is a broad, dispositive subsection which states that, other than as explicitly enumerated; any

benefit conferred on a shareholder must “be included in computing the income of the shareholder

for the year”.5 The section continues by stating that:

2 The ITA, s. 6.

3 Ibid.

4 Ibid., s. 15.

5 Ibid., s. 15(1).

5

(1.2) For the purpose of subsection 15(1), the value of the benefit

where an obligation issued by a debtor is settled or extinguished at

any time shall be deemed to be the forgiven amount at that time in

respect of the obligation.

...

(2) Where a person ... is (a) a shareholder of a particular corporation,

(b) connected with a shareholder of a particular corporation, or (c) a

member of a partnership, or a beneficiary of a trust, that is a

shareholder of a particular corporation and the person or partnership

has in a taxation year received a loan from or has become indebted to

the particular corporation ... the amount of the loan or indebtedness is

included in computing the income for the year of the person or

partnership.6

Other than the explicitly enumerated exceptions, section 15 lays the basic groundwork for the

shareholder benefit provisions of the ITA.

b. The Learned Scholars

Individuals seeking to take full advantage of tax minimization structures depend heavily

on the creativity of their learned advisors. The complexity of these structures, often dressed-up to

camouflage the tax savings, varies depending on how far the professional advisors are willing to

set sail, and what justifications they use, to lay claim to the riches they wish to acquire. The CRA

Aggressive Tax Planning Division is specifically designed to ferret out any attempts at creating

structures that result in a taxpayer benefit which is precluded by the ITA or the General Anti-

Avoidance Rule (“GAAR”) more generally.7

When the CRA Aggressive Tax Planning Division identifies a suspicious structure and

hands the file to its auditors, it is scrutinized on the facts and could ultimately lead to litigation.

The courts have applied the provisions of the shareholder benefit provisions of the ITA fairly

consistently, despite the varied and creative ways in which taxpayers have attempted to justify

the use of corporate money. Several cases help demonstrate how the rules have been fleshed-out

6 Ibid., ss. 15(1.2), (2).

7 Ibid., s. 245.

6

over the years in accordance with the language of the statute and the policy of the CRA to

disallow the use of corporate money for personal shareholder benefit.

Varcoe v. Canada8

In Varcoe, a taxpayer attempted to disguise expenditures made with corporate money as

advertising expenses for the business. The Tax Court of Canada (the “TCC”) engaged in a

focussed analysis of whether the taxpayer’s use of the funds did in fact constitute a legitimate

personal expense or whether it was in fact a veiled conduit used to finance a hobby.

Donald Varcoe was a sole proprietor of a truck repair business in Sault Ste. Marie,

Ontario. Due to its proximity to the Canada-USA border his services extended to customers in

Michigan, USA. Mr. Varcoe was also an avid stock-car racing enthusiast. He regularly competed

in races since the early 1980s and was a very successful competitor, having won his 200th

race by

1998. In 1994 he purchased a truck dealership and incorporated a company to hold its assets

(“Lakeway”), to which he charged many of his business expenses. In 1996 Mr. Varcoe decided

to incorporate his business and sold all the sole proprietorship’s assets to a corporation he

incorporated for that purpose. His focus was to expand his operations into neighbouring

Michigan and proceeded to do so with success.9

His strategy for expanding into the USA allegedly included advertising in the form of

competitive racing in Michigan. This was the main focus of the assessment, as Mr. Varcoe’s

stated use of corporate advertising dollars was “to develop a racing team to race cars at amateur,

non-NASCAR tracks in Michigan so as to advertise Lakeway by signs on the cars”.10

The

maintenance and construction of the cars used to race were both financed by the corporation and

8 Varcoe v. Canada, 2005 TCC 620.

9 Ibid. at para. 10.

10 Ibid. at para. 7.

7

the expenses for which were deducted as advertising and marketing business expenses.11

Any

prize money claimed as a result of any winning races in which the team competed was not

“deposited as income into Lakeway’s account ... [and part] ... of this money was treated as a

shareholder’s loan from Mr. Varcoe to Lakeway”.12

Despite the fact that Mr. Varcoe did successfully obtain business in Michigan, which

suffered a substantial reduction upon the termination of the racing program13

, the Court

dismissed the appeal, identifying the following factors in the reasons for its decision:

[] Mr. Varcoe was the sole shareholder of Lakeway and he was

devoted to car racing as a fan and a performer. With Lakeway’s

money, he saw a way to build cars with parts purchased by Lakeway

in Mr. Varcoe’s personal name, assembled at his personal home shop

and for the most part, driven by him personally. Mr. Varcoe won his

200th car race in 1998, the year Lakeway terminated the alleged

racing programme. Mr. Varcoe testified that he kept the racing

trophies in his home, not at Lakeway. The only forms of title to the

remaining cars and trailer are the invoices and customs records which

are all in Mr. Varcoe’s personal name. The monies paid by Lakeway

... were properly assessed under subsection 15(1) ....14

The Court’s analysis of the facts in this case revealed that the actions from within, such as

characterizing the prize money as a shareholder loan and effecting all repairs of the vehicles in

his name and in his own residence, are what brought the downfall of the taxpayer. Other cases

demonstrate that, although the taxpayer may successfully argue that the shareholder benefits

provisions do not apply, the courts will ensure that money drawn from corporate entities by

shareholders are captured in the taxpayers income regardless.

11

Ibid. at para. 13. 12

Ibid. at para. 15. 13

Ibid. at para. 11. 14

Ibid. at para. 16.

8

Erb v. Canada15

A fine line between applicable sections of the ITA forms when other business vehicles

are used in conjunction with corporations; however, looking at the ITA as a whole and applying

its basic principles, as did the Court in Erb, allows one to extrapolate the intention of the

legislature and avoid an absurd result. Erb dealt with two major issues: whether the value of a

parcel of land which was transferred from a corporation to a shareholder should be included the

shareholder’s income; and whether amounts drawn by the shareholder of a partner corporation,

in excess of the allocated share of partnership income, resulted in a deficit in the partner’s capital

account, thus giving rise to indebtedness that should be treated as a taxable benefit under section

15(2) of the ITA.16

The former issue is irrelevant to this paper and so the latter issue will be the

focus of this analysis.

The Court summarized the relevant portions of section 15(2) as follows:

Where a person is .... a shareholder of a particular corporation ... and

the person ... has in a taxation year ... become indebted to ... [a

corporation or] a partnership of which the particular corporation is a

member ... the amount of the ... indebtedness is included in computing

the income for the year of the person ...17

The issue in this case was the result of a distinction which was illustrated as follows: scenario

one is presented as “A, B and C are shareholders of a corporation and the corporation is a

member of a partnership of which the corporation and E, F and G are partners”, in which case

15(2) would apply.18

Scenario two would be where “A, B and C are shareholders of a

corporation and the corporation and A, B and C are members of a partnership”, in which case the

appellant argued that section 15(2) should not apply, since, it was argued, “a partner cannot be

15

Erb v. Canada, 2000 DTC 1401. 16

Ibid. 17

Ibid. at para. 62. 18

Ibid. at para. 63.

9

indebted to the partnership of which he is a member”.19

The Court reverted to basic principles

within the ITA in order to resolve whether such a line existed.

In its analysis the Court astutely identified that the attribution of a draw on a partnership

resulting in indebtedness to the shareholder of a partner-corporation would result in double

taxation. This is because the “over-draw” amount to be added to the income of the partner in

accordance with subsection 15(2) “is not recognized until the partnership ceases to exist or the

partnership interest is disposed of”, thus deferring the tax consequence.20

The Court explained

how this works by reciting a litany of the sections which impact how the assessment should be

gauged:

The position taken by the Minister on assessing would result in

taxation under subsection 15(2) and again under subsections 98(1) or

100(2). Such double taxation is prohibited by subsection 4(4). Since,

as a practical matter, subsections 98(1) or 100(2) would apply later

than subsection 15(2) (if it applied at all), it would mean that by

assuming an indebtedness and consequent taxation under 15(2) in

circumstances where paragraph 40(3) would otherwise apply, the

Minister could render the provisions of subsections 53(1), 53(2),

40(3), 98(1) and 100(2) inoperative. Such a result could not have been

in accordance with the intention of Parliament. A result that is more

consonant with the intent of Parliament would be to allow those

provisions to operate according to their terms without having that

operation interfered with by what seems to me to be a highly

questionable application of subsection 15(2).21

In this case the shareholder benefit was side-stepped where a different vehicle intervened in the

relationship between the corporation and the shareholder: a partnership. The Court ordered a

reassessment and essentially determined that sections 40(3) and 15(2) of the ITA are mutually

exclusive in the situation where indebtedness in created by a shareholder utilizing excessive

draws of a corporation-partner. While this determination focussed on how indebtedness to the

19

Ibid. at para. 63. 20

Ibid. at para. 82. 21

Ibid. at para. 86.

10

corporation should be treated in special circumstances, the Court has also opined on the more

troubling, and interesting, attempts to create corporate indebtedness to the shareholder.

Roth v. The Queen22

Roth is an interesting case in which a shareholder attempted to create loans from the

contribution of intangible property. Ray Roth was a shareholder of a corporation which was a

partner in a joint-venture designed to form a purchasing group for liquefied natural gas in South-

East Asia (the “Project”).23

Prior to entering into the joint venture, Mr. Roth spent $370,000 of

his own personal money in order to travel to Asia and explore the feasibility of engaging in such

business. Mr. Roth then transferred his “ownership of the Project” to a corporation he

incorporated to deliver his consulting services (“Tri Pacific”). The consideration for the transfer

took the form of his expedition to explore the feasibility of the Project equal to the amount that

he spent on the expedition, in order to create a shareholder loan, evidenced by a promissory

note.24

The Court’s analysis focussed on two issues: whether the expenditures made by Mr. Roth

were deductable to a corporation which subsequently hired Tri Pacific to advise on the Project;

and whether Mr. Roth was required to include $370,000 in his income in the taxation year that

the promissory note was repaid. This paper will not address the former issue, though suffice it to

say that the court disallowed the deduction on the rationale that the subsequent corporation did

not incur those expenses and so it could not deduct those particular expenses claimed by Mr.

Roth.25

22

Roth v. The Queen, 2005 TCC 484. 23

Ibid. at para. 5. 24

Ibid. at para. 10. 25

Ibid. at para. 25.

11

With respect to the latter issue, the analysis focussed on whether any “property” was

transferred to the corporation, or whether the amount paid to Mr. Roth was an amount to be

considered a shareholder benefit under section 15(1) and to be included in income. Mr. Roth

argued:

I had expenses to the tune of approximately three hundred and seventy

thousand dollars ($370,000). It was for transportation,

accommodation, entertainment, intellectual proprietary knowledge,

engineering, designing consulting I had access to knowledge about the

cryogenics.26

The Court subsequently attempted to excavate from Mr. Roth’s testimony some artefact

evidencing a relationship between him and the entity from which he sought to claim

indebtedness. Despite its heroic effort the Court was unable to establish such a connection and

came to the following conclusion:

No evidence of any document of conveyance was proffered. Roth

described some of the expenditures making up the total of some

$370,000. They included personal expenditures. ... The evidence also

indicated that a promissory note was prepared by Earnst & Young,

and that it was not signed but was initialled in the upper corner. That

note evidently remained with Earnst & Young, Roth having testified

that he did not attempt to obtain same from that firm. An accounting

entry cannot create legal relationships. It can only reflect same. The journal entry, without evidence of Roth having, in law, conveyed

something to Tri Pacific did not create a legally enforceable right ....27

The Court identified that, since no “document of conveyance” evidencing the transfer of

property to the corporation existed, the indebtedness was essentially fabricated.28

Mr. Roth subsequently argued that, despite the lack of documentation, the Project itself

was the property being transferred to the corporation. The Project consisted of Mr. Roth’s

exploration into the feasibility of the Project and the expenses he incurred as a result. The Court

26

Ibid. at para. 6. 27

Ibid. at para. 35 (emphasis added). 28

Ibid. at para. 35.

12

once again attempted to excavate some nuggets of value from the historical record with which it

was provided; however, in the end it was not able to justify “knowledge” as “property”:

My conclusion is that information, ideas, knowledge and or know-

how, do not fall within the meaning of the word “property” [within the

meaning of the ITA]. They are not exclusive to one person and are

not, in that simple form, capable of being described as property. It

follows that no property was conveyed by Roth to Tri Pacific. It is to

be noted that the Joint Venture’s Management Agreement with Tri

Pacific required that the services of Roth on a full-time and exclusive

basis be provided. He was to be paid for his services. This is, apart

from the formalization of know-how into some marketable form, the

manner in which know-how produces economic reward. In these

circumstances, the provisions of section 15(1) of the Act ... apply to

Roth....29

The Court flat out refused to let the tail wag the dog, and clearly explained that an accounting

note attributing indebtedness to a corporation, without an actual conveyance of property for

which the indebtedness was incurred, will not on its own create a debt to the shareholder. Thus

section 15(1) of the ITA operated to deem any amounts drawn against this phantom fabricated

debt a dividend to the shareholder.

c. Cheating your Fate

Roth effectively demonstrated the dangers of attempting to siphon money out of a

corporation in the guise of a shareholder loan. Paid-Up Capital (“PUC”) is an equally effective

way for shareholders to extract money from the corporation tax free.30

Any amount forming the

PUC at the time the share is acquired may be drawn-down against its value as though it were a

loan. Section 84 of the ITA thus vigilantly guards against the artificial inflation of PUC for this

reason by declaring that any amounts drawn over and above the PUC become a deemed dividend

to be included in the shareholder’s taxable income immediately:

29

Ibid. at para. 41. 30

The ITA, s. 15(1)(a).

13

84(1) Where a corporation resident in Canada ... increased the paid-up

capital in respect of the shares of any particular class of its capital

stock, otherwise than by [a number of exceptions] ... the corporation

shall be deemed to have paid at that time a dividend ... and a dividend

shall be deemed to have been received at that time by each person

who held any of the issued shares....31

This subsection qualifies section 15(1)(a) which allows the return of capital up to the PUC

amount to be drawn by the shareholder tax free by contemplating what would happen if the

shareholder drew amounts in excess of the PUC. The subsection imposes a deemed dividend

which must be included in the income of the shareholder, thus guarding against the artificial

inflation of PUC and snapping-shut a potential trap door for taxpayers to extract capital from the

corporation tax-free.

III. Laying Siege to the ITA

The ITA is an elaborately constructed fortress of rules designed to keep as much tax

money within its walls as possible. Finding cracks in its walls is not easy, but not impossible.

Some of those cracks are placed there intentionally; Tax-Free Savings Accounts, for example,

allow individuals to reap the gains from investment income tax-free, as long as they are using

after-tax dollars as the principal.32

These and other contrived vulnerabilities open the gates just

enough for tax planners to create schemes as elaborate as the walls which have been created to

defend against them. As the weaknesses are exposed and the courts either stem their growth or

stretch their application, the CRA’s struggles are illustrated by its interpretation bulletins to

restore the walls to their original fortitude.

a. Building the Walls

The CRA frequently uses Interpretation Bulletins (“ITs”) to elaborate on its enforcement

practices and its interpretation of the rules in the ITA. They are used to buttress the rules and

31

Ibid., s. 84(1). 32

Ibid., s. 146.2.

14

practices of CRA staff, always beginning with the ominous (and ironic) disclaimer that they do

not carry the force of law. Regardless of their “technical” nature, they provide insight into how

these and other rules are interpreted by the very people on the inside of the city walls who have

their hands on the levers of the audit and enforcement regime. The following ITs address the

issues discussed above:

IT-119R4: Debts of Shareholders and Certain Persons Connected With Shareholders.33

This IT attempts to flesh-out subsection 15(2) and related provisions of the ITA, which

specifically provide for the inclusion “in a shareholder’s income amounts received from a

corporation in the guise of loans or other indebtedness, with specific exceptions provided in the

law.”34

The exceptions, as described in subsection 15(2.4), include:

(a) an individual who is an employee of the lender ... pursuant to

paragraph 15(2.4)(a);

(b) an individual who is an employee of the lender or is the spouse of

an employee of the lender to acquire a dwelling ... pursuant to

paragraph 15(2.4)(b);

(c) an employee to acquire previously unissued fully paid shares of a

corporation ... pursuant to paragraph 15(2.4)(c); or

(d) an employee to acquire a motor vehicle to be used in the

performance of the employee’s job ... pursuant to paragraph

15(2.4)(d);

where

(e) for loans made after April 25, 1995, it was reasonable to conclude

that the employee or the employee’s spouse received the loan because

of the employee’s employment and not because of any person’s

shareholdings, and

(f) at the time the loan was made, bona fide arrangements were made

for repayment of the loan within a reasonable time... 35

33

Canada Revenue Agency, Interpretation Bulletin IT-119R4, “Debts of Shareholders and Certain Persons Connected With Shareholders.” (7 August 1998). 34

Ibid. 35

Ibid. at para. 9.

15

The IT emphasizes, inter alia, that, in order to avoid accruing a shareholder benefit, the

shareholder must be cognizant of: the shareholder’s relationship to the company (the shareholder

should hold less than 10% of the shares in order to avoid being a “Specified Shareholder” and

thus a non-exempt “Specified Employee”);36

whether the loan was made for the purchase of real

property;37

whether the loan was offered to the shareholder-employee on the same terms as it

was to other employees or whether there was a preference;38

and whether a loan was made for

the purchase of shares in the corporation.39

The exemptions provided for in the section, as

described in more detail in the IT, are limited; but, as will be discussed below, expose some

weaknesses in the seemingly invulnerable ITA.

IT-239R2: Deductibility of Capital Losses from Guaranteeing Loans for Inadequate

Consideration and from Loaning Funds at less than a Reasonable Rate of Interest in

Non-arm’s Length Circumstances.40

This IT explains the consequences under subsection 40(2)(g)(ii) of the ITA, when a

shareholder (or partner in a partnership) has incurred a capital loss, where the shareholder or

partner has been forced to pay a loan by virtue of having been a guarantor of that loan, or where

a loan made to the company by the shareholder or partner is not paid back. The IT states that “a

taxpayer’s loss arising from the disposition of a debt is nil unless the debt had been acquired by

the taxpayer for the purpose of gaining or producing income from a business or property.”41

Generally then these types of loans will not result in a capital loss; however, the IT explains that:

36

Ibid. at para. 22. 37

Ibid. at para. 18. 38

Ibid. at para. 11. 39

Ibid. at para. 20. 40

Canada Revenue Agency, Interpretation Bulletin IT-239R2, “Deductibility of Capital Losses from Guaranteeing Loans for Inadequate Consideration and from Loaning Funds at less than a Reasonable Rate of Interest in Non-arm’s Length Circumstances.” (9 February 1981). 41

Ibid. at para. 3.

16

any loss arising from a payment required of the guarantor under that

guarantee will be considered to be a deductible capital loss ....

Similarly, money which had been loaned at a reasonable rate of

interest generally constitutes a debt acquired for the purpose of

gaining or producing income, and any capital loss which arises

because it has become uncollectible is generally not deemed to be nil

by virtue of subparagraph 40(2)(g)(ii).42

This means that, as long as the loan terms were commercially reasonable, a capital loss may be

reaped by the shareholder who loaned the money.

The IT enumerates a number of conditions under which loans that may be made with less

than reasonable rates of interest, the most relevant for the purposes of this paper being “[a]

minority shareholder may borrow money at interest to lend to, or make good on a guarantee in

respect of the debts of, a Canadian corporation controlled by him and members of his family or

its Canadian subsidiary.”43

As long as none of the other shareholders benefit from the payment of

such debt (which is a question of fact), the individual taxpayer-shareholder can claim a capital

loss; though caution must be taken in order to avoid the application of the GAAR.

IT-421R2: Benefits to Individuals, Corporations and Shareholders from Loans or Debt.44

This IT addresses generally the provisions of section 80.4 and related provisions of the

ITA with respect to how loans and debts are to be treated when granted by a business to its

employees. The section states generally that:

Where a person or partnership receives a loan or otherwise incurs a

debt because of or as a consequence of a previous, the current or an

intended office or employment of an individual, or because of the

services performed or to be performed by a corporation carrying on a

personal services business, the individual or corporation, as the case

may be, shall be deemed to have received a benefit in a taxation year

equal to the amount ....45

42

Ibid. at paras. 4-5. 43

Ibid. at para. 11. 44

Canada Revenue Agency, Interpretation Bulletin IT-421R2, “Benefits to individuals, corporations and shareholders from loans or debt.” (9 September 1992). 45

The ITA, s. 80.4(1).

17

The IT described three conditions, the satisfaction of which requires that the loan or debt be

included in income such that: a loan or debt must be incurred, the recipient must be a shareholder

(or related as described in the section) and the receipt of said loan or debt was “by virtue” of

being a shareholder.46

As always, some exceptions are subsequently enumerated.

Subsection 80.4(3) of the ITA exempts the debts and loans described above from being

included in income under certain circumstances. The exceptions are very narrow: subsection

80.4(a) provides an exception where the corporation is in the business of loaning money. This

will be a question of fact as to whether any of the purposes of the business is to loan money; the

second is an exception where the amount has already been included in income by operation of

another provision of the ITA, such as subsection 15(2).47

Proving whether someone received the

loan “by virtue of an office or employment or the shareholding of a person or partnership” can be

tricky if it is a small business with few, or only one, employees, officers and directors.48

These

questions of fact and technical requirements (such as being in the business of lending) are fairly

malleable concepts which, as will be demonstrated below, can be manipulated in order to

produce a favourable tax position for the taxpayers involved. As a result, much academic and

professional commentary has been written on the sections referenced and discussed above.

b. Planning the Invasion

Although taxpayers and the CRA are not “enemies”, they are adverse parties, and the

ramparts created by Parliament and enforced by the CRA are designed to defend against

aggressive tax planning strategies which allow taxpayers to, in some cases, substantially reduce

46

Canada Revenue Agency, Interpretation Bulletin IT-421R2, “Benefits to individuals, corporations and shareholders from loans or debt.” (9 September 1992) at para. 6. 47

Ibid. at para. 10. 48

Ibid.

18

their tax burden. There is a fine line to be walked when planning aggressively; the distinction has

been described as follows:

[T]he term “tax evasion” can be reserved for conduct that entails

deception, concealment, destruction of records or the like, while “tax

avoidance” refers to behavior [sic] that the taxpayer hopes will serve

to reduce his tax liability but that he is prepared to disclose fully to the

[tax authorities].49

It is incumbent on the tax planning professional to be cognizant of this distinction in order to

avoid a detrimental assessment by the CRA.

One of the challenges tax advisors face is the inconstant nature of the ITA. It has been

noted that “[l]ike the movement of water down a stream, tax is an ever changing system of rules

and interpretations that is constantly evolving based on new legislation or new interpretations of

current legislation.”50

This makes tax planning a moving target to a certain extent; however, the

target moves in response to the structures and methods devised by tax planners who create

strategies to minimize, defer and split the tax burden. One such method is the issuance of shares

to individuals for the purpose of income splitting.

The most important part in the implementation of a tax strategy is the preliminary steps

leading-up to the structure itself. Sections 15 and 80.4 of the ITA are penalties that attribute

amounts to a taxpayer’s income after the taxpayer has been issued shares. It is important for tax

planners to realize that “the professional fees [clients] are paying is [] insurance that things will

be done correctly and the risk of unforeseen tax consequences is eliminated or minimized. ...

Most tax professionals know that there are certain procedures and steps necessary to properly

set-up a family trust to eliminate the possibility of 75(2) ‘reversionary trust’ or other attribution

49

Boris Bittker and Martin McMahon, Federal Income Taxation of Individuals (Boston and New York: Warren, Gorham & Lamont, 1988) at 1-25. 50

John F. Oakey, "Estate Planning – Hot Topics" (Paper presented to the Canadian Tax Foundation Atlantic Provinces Tax Conference, 2011) 3B:2.

19

rules from applying.”51

The “Reversionary Trust” rules state that “where ... property is held on

condition”:

(a) that it or property substituted therefor may (i) revert to the person

from whom the property or property for which it was substituted was

directly or indirectly received (in this subsection referred to as “the

person”), or (ii) pass to persons to be determined by the person at a

time subsequent to the creation of the trust, or

(b) that, during the existence of the person, the property shall not be

disposed of except with the person’s consent or in accordance with the

person’s direction,

any income or loss from the property ... and any taxable capital gain ...

shall ... be deemed to be income ... of the person.52

As trusts are now regularly used as part of estate freeze and various other tax mitigating

transactions this section acts as a restraint on the reckless use of trusts without properly preparing

by attributing assets distributed through the trust to the table income of an individual. It has been

observed and noted that simple preliminary steps, such as performing valuations, can help avoid

undue scrutiny of these transactions by the CRA. In one case the individual attracted attribution

under subsection 75(2) by transferring new common shares into a trust at less than fair market

value; thus because “[t]he trust indirectly received property from the individual due to the fact

that the individual transferred property by way of giving up a portion of his ownership interest in

the equity of the operating company as a consequence of issuing new common shares at an

amount below fair market value”, the individual fell victim to the attribution rules of subsection

75(2).53

The effect of the attribution provisions underscores the importance of meticulous

preparation in creating a tax plan for clients. The rules themselves may change frequently;

51

Ibid. at 3B:8. 52

The ITA, s. 75(2). 53

John F. Oakey, "Estate Planning – Hot Topics" (Paper presented to the Canadian Tax Foundation Atlantic Provinces Tax Conference, 2011) 3B:9.

20

however, in structuring a complex group of entities and the assets of parties, tax planners must be

mindful of the possibility that the lack of preliminary, rudimentary activities, such as a valuation,

could expose the structure and the professionals themselves to scrutiny and subsequent liability.

Once the shares are in the hands of the people for which they are intended there are a

number of ways that corporate income can be split. As discussed above, section 15(2) is driven

by fact analysis; in an assessment the CRA must determine the intentions and relationships of the

parties involved in order to determine whether the transaction was arm’s length and whether,

beyond section 15(2), the section 245 GAAR principles apply. As a result, “[m]ost appeals

involving the application of section 15 are often fact specific and credibility based”.54

Further to

this point, and as will be discussed in more detail below, the courts have determined that “a

benefit is not conferred without an element of knowledge or intent, or in circumstances where

the shareholder or corporation ought to have known that a benefit was conferred and did nothing

to reverse the benefit if it was not intended.”55

The case law suggests that, though the courts are now more willing to look towards the

intent of the parties in these transactions, they are also more willing to enforce harsher penalties.

One author surveyed the recent case law addressing section 15 of the ITA and determined that

the courts have grown accustomed to accepting and enforcing harsh penalty provisions, whereas

in the past such penalties were often not imposed or were forgiven:

the Court is taking a harder or stricter line with taxpayers. This is

typified by the Court’s upholding of gross negligence penalties. There

was a time, not long ago, when penalties were fairly routinely vacated

and the Crown could only uphold penalties in the most egregious of

circumstances. Now, the Courts appear to be much less willing to give

the taxpayers the benefit of seemingly plausible explanations.56

54

Elizabeth Junkin, "Section 15 – Shareholder Benefits Update" (Paper presented to the Canadian Tax Foundation British Columbia Tax Conference, 2009) 12:4/5. 55

Ibid. at 12:5/6 [emphasis added]. 56

Ibid. at 12:4/5.

21

The phrase “seemingly plausible explanations” implies that the courts have been imposing a

high-level burden of proof on taxpayers when it has come to proving intention of the taxpayers in

the tax-avoidance transaction under scrutiny.

A high level of transaction scrutiny is understandable given the probability of a contrived

tax avoidance structure being in fact a veiled evasion scheme or sham transaction to effect a tax

saving. Using the “Nuremburg Defence”, namely that the taxpayers did not know that what they

were doing was “wrong”, or that they were blindly following the advice of their tax advisors,

will come down, as the author had noted, to a question of credibility. This has evidently led the

courts to err on the side of caution by implementing a fact driven analysis tailored to ferret-out

sham transactions which extricate money from a corporation and thwart section 15. There are,

however, a number of well established and recognized ways of siphoning money out of a

corporation and into the hands of taxpayers which result in favourable treatment of those funds

under the ITA.

Income splitting is a popularly used, though often misused and misunderstood,

mechanism for reducing the taxable income of a corporation and for taking money out of a

corporation and putting it into the hands of the shareholders. The three main conduits for

accomplishing this goal are paying salaries, issuing dividends, and investing corporate funds for

the ultimate benefit of the shareholder. The first two methods are fairly straight forward, whereas

the last, if not carefully considered and executed, could result in a taxable benefit under section

15 of the ITA.

Income splitting is not a new concept; however, the rules governing its taxability are an

ever shifting sea of sand. Salaries may be given to shareholder-managers so long as they actually

participate in the business, whereas dividends may be issued regardless of involvement in the

22

corporation, so long as the individual is the holder of a dividend-bearing share and the issuance

of the dividend will not cause “the corporation ... [to] be, unable to pay its liabilities as they

become due; or [cause] the realizable value of the corporation’s assets ... [to] be less than the

aggregate of its liabilities and stated capital of all classes.”57

In other words: the issuance of a

dividend cannot render the corporation insolvent.

The decision whether to squeeze money out of a corporation in the form of a salary or a

dividend depends heavily on the circumstances as they both have pros and cons. The benefits of

paying a salary include “creation of RRSP contribution room ... ; reduction of the corporation’s

taxable income ... ; a deferral of cash outflow, since a bonus need not be paid for 179 days

following year-end; entitlement to Canada Pension Plan (CPP) benefits ... ; the ability to

establish and make contributions to an individual pension plan ... ; and the ability to claim the

Canada employment amount tax credit.”58

On the other hand, dividends can only be issued after tax has already been paid on the

money used to fund them. This is not necessarily a bad thing though since it effectively passes

part of the individual taxpayer’s tax burden onto the corporation, for which retained earnings can

be used and a dividend tax credit is offered to the individual.59

Some additional benefits of

paying dividends are: “avoidance of payroll taxes; avoidance of problems with debt covenants

that can arise when paying salary or bonuses; deductibility of interest where money has been

borrowed to purchase shares; a refund of taxes paid by the corporation to the extent that there is

refundable dividend tax on hand (RDTOH); ... ability to create greater charitable donation room

as a result of the dividend gross-up; ... ; and prevention of denial of the capital gains deduction

57

Canada Business Corporations Act, RSC 1985, c C-44, s. 44 (note: the respective Provincial business corporation statutes contain similar provisions, or “solvency tests”, as conditions precedent to issuing a dividend). 58

Tim J. Cestnick, "Tax Issues and Opportunities for the Family Office: Family Harmony and Wealth Distribution" (2011) 2 CTJ (Personal Tax Planning) 353 at 371/372. 59

The ITA, at s. 12(1)(j).

23

when insufficient dividends have been paid by the corporation.”60

The decision of whether to use

salary or dividends will depend on the circumstances.

It has been noted that “[t]he decision as to whether a shareholder-manager should be paid

salary or dividends is a never-ending discussion that must, by necessity, be revisited every time

there is a change in personal or corporate tax rates. Further, the decision will change depending

on whether the corporation earns active business income or strictly investment income.”61

As a

result there is no easy answer except to review the situation and determine where the money is

best taxed: in the hands of the individual or in the hands of the corporation. In many cases, such

as when an investment corporation or a corporation incorporated strictly for the purpose of

managing and distributing personal investments, taxpayers will endeavour to retain earnings in

the corporation in order to use the funds for “personal” gain.

As noted above, money can be used in a limited capacity for “personal”, but only with

caution in order not to offend the shareholder benefit provisions. Where a shareholder is loaned

money, for example, for one of the permissible enumerated purposes, tax must be paid in

accordance with section 15(2) of the ITA if the loan is not repaid within a specified period.

Taxpayers should be apprehensive about structuring these types of loans, for “if the loan is not

actually repaid within the mitigating time frame, a tax liability with arrears interest will

retroactively exist; additionally, the CRA has relied on subsection 152(4.3) [of the ITA] to

consequentially reassess statute-barred tax years when adjustments to 15(2) and 20(1)(j)

60

Tim J. Cestnick, "Tax Issues and Opportunities for the Family Office: Family Harmony and Wealth Distribution" (2011) 2 CTJ (Personal Tax Planning) 353 at 372/373 (internal citations omitted). 61

Ibid. at 373/374.

24

reassessments cross in and out of closed filing periods.”62

These and other penalties reflect the

ostensibly punitive nature of the provisions themselves.

Furthermore, tax planners must be highly cognizant of the relationships of the parties

involved in an income splitting scheme as the ITA does guard against such transactions through

its ramparts of attribution. Commentary on the subject of income splitting suggests that “[t]here

are various attribution provisions in the [ITA], the objective of which is to prevent the splitting

of income and capital gains when property is loaned or transferred to certain non-arm’s-length

parties.”63

In addition, splitting income by paying salaries to non-arm’s length parties can land

the taxpayer in hot water. The author goes on to explain that “in order to be deductible, salaries

paid to family members, or to other related individuals who are not shareholders, must be

reasonable on the basis of the service provided, they must be commensurate with the value of the

responsibilities assumed, and the service must assist the business in earning income.”64

The

courts have also helped fortify these types of transactions by applying the GAAR to these

situations.

As an added barrier to income-splitting tactics, the Supreme Court of Canada (the

“SCC”) is of the opinion that the CRA may view certain income splitting transactions as an

abusive avoidance transaction under the GAAR. In Lipson, very generally, a husband and wife

attempted to make interest on the funds used to purchase their principle residence deductable by

having the wife borrow money to purchase shares in the husband’s corporation from the

husband, after which the husband used the money to buy the house and both spouses secured a

62

Gabriel Brown, "Practical Approaches to Planning for Owner-Manager Remuneration" (Paper presented to the Canadian Tax Foundation Ontario Tax Conference, 2009) 8:9/10 (emphasis added; internal citations omitted). 63

Irene Jacob and Evelyn Lee, “Income-Splitting Strategies: Selected Aspects” 2010 CTJ 4 at 1005. 64

Ibid. at 1019.

25

mortgage to pay back the share purchase loan originally obtained by the wife.65

The result of this

was that the interest on the debt used to purchase the shares became deductible in accordance

with subsection 20(1)(c) of the ITA.66

The SCC was content with the transaction “until the point

in the series of transactions that triggered the attribution of Mrs. Lipson’s loss (generated by the

interest deduction) to her husband. The court disallowed the attribution of the interest deduction

to Mr. Lipson, leaving the deduction in the hands of Mrs. Lipson; therefore, only the revenue

component remained to be attributed to Mr. Lipson.”67

In reaching its decision, the SCC held:

It has long been a principle of tax law that taxpayers may order their

affairs so as to minimize the amount of tax payable .... However, the

Duke of Westminster principle has never been absolute, and

Parliament enacted s. 245 of the ITA, known as the GAAR, to limit

the scope of allowable avoidance transactions while maintaining

certainty for taxpayers ....68

This statement clearly illustrates the struggle between certainty and vagueness with respect to

structuring: although one may order his or her affairs to minimize the tax burden within the legal

language of the ITA, the CRA may always use GAAR as a back-up if that minimization is

“abusive” within the meaning of the GAAR.

The GAAR has also been a useful tool in ensuring that shareholders do not convert

capital and business losses of a corporation into each other by using the Allowable Business

Investment Loss (“ABIL”) rules, which state that:

65

Lipson v. Canada, 2009 SCC 1. 66

The ITA, s. 20(1)(c) (“20(1)...there may be deducted such of the following amounts ... (c) an amount paid ... pursuant to a legal obligation to pay interest on (i) borrowed money used for the purpose of earning income from a business or property ....) 67

Irene Jacob and Evelyn Lee, “Income-Splitting Strategies: Selected Aspects” 2010 CTJ 4 at 1009. 68

2009 SCC 1 at para. 21 (internal citations omitted).

26

[a]n “allowable business investment loss” is defined as in paragraph

38(c) [of the ITA] as [1/2] of a “business investment loss” defined in

paragraph 39(1)(c) [of the ITA]. To qualify as a business investment

loss, an amount must first be a capital loss. Thus when a transaction

does not give rise to a capital loss, or when a capital loss is deemed to

be nil (e.g., under paragraph 40(2)(g) [of the ITA]), no business

investment loss can result. ... A taxpayer’s business investment loss

may arise from the disposition of: (a) a share of a corporation that is a

small business corporation, or (b) a debt owing to the taxpayer ... by a

Canadian-controlled private corporation.69

The advantage of an ABIL is that it can be deducted from all sources of income, not just capital

gains, making it a valuable tool for reducing taxable income. This can be very useful for

shareholders who plan to use business investment losses to minimize taxes; however, the courts

have placed limitations on how “bad debts” can be established.

If “bad debts” meet the requirements of subsection 39(1)(c) of the ITA, they will qualify

as an ABIL. The treatment of “bad debts” is found under subsection 50(1) of the ITA, and is

explained as follows:

where (a) a debt owing to a taxpayer at the end of a taxation year ... is

established by the taxpayer to have become a bad debt in the year ...

and the taxpayer elects in the taxpayer’s return of income for the year

to have this subsection apply ... the taxpayer shall be deemed to have

disposed of the debt ... at the end of the year for proceeds equal to nil

and to have reacquired it immediately after the end of the year at a

cost equal to nil.70

By operation of law, the deemed disposition and reacquisition described in subsection 50(1)(a),

“results in a bad debt being a capital loss for the year with any recovery of the debt being a

capital gain.”71

The cases illustrate that, in order for shareholders to generate an ABIL, they must

exercise caution and due diligence in the administration of the loans they give and in the way

they attempt to collect.

69

Canada Revenue Agency, Interpretation Bulletin IT-484R2, “Business Investment Losses” (28 November 1996) at paras. 1,3. 70

The ITA, s. 50(1)(a). 71

Canada Revenue Agency, Interpretation Bulletin IT-159R3, “Business Investment Losses” (1 May 1989) at para. 1.

27

One such case demonstrates the requirement to exercise due diligence in attempts to

satisfy the debt. In Sunatori, the sole shareholder-employee of an unprofitable corporation would

draw a salary cheque once per year throughout the period of assessment and immediately write a

cheque for a loan equal to the amount of the salary back to the corporation and claiming it as an

ABIL for each respective year.72

The shareholder-taxpayer did not cash either cheque, nor did he

make any attempts to collect the debt created by these so-called “transactions”, arguing that “the

nominal revenues of the company [] evidence[d] that the company was insolvent and had no

money to repay the loans.”73

The TCC disagreed, holding that:

just because the Appellant was satisfied that the loans could not be

repaid at the end of the years in question, does not mean it was

reasonable to consider that they were bad. ... As I stated at the outset

of this analysis the proven facts of this case have caused me to

concede that the Appellant has succeeded in creating a reality out of

transactions that common sense suggests never actually happened.74

In other words, the mere action of writing cheques, without cashing them or exercising a right to

collect an outstanding debt, is not enough to create a “bad debt” within the meaning of

subsection 50(1)(a) of the ITA.

The Canadian tax law with respect to the treatment of shareholder loans is not unique

though it does differ from the law in distant, and not-so-distant, lands.

c. Venturing Across the Sea

Agreements with foreign jurisdictions circumvent or replace provisions of the ITA in

certain circumstances, which may result in an unintended tax benefit to shareholders. The treaty

Canada has with the United States is one example. The treaty seeks to avoid double taxation

72

Sunatori v. The Queen, 2010 TCC 346. 73

Ibid. at para. 16. 74

Ibid. at paras. 55, 58.

28

between the two countries by implementing a tax credit regime.75

US taxpayers have a flexible

system of foreign tax payment which allows individual shareholder-taxpayers to benefit from

taxes payable by a subsidiary of a corporation in another jurisdiction.

One such example of the flexibility of the US foreign tax credit regime is the ability to

either deduct foreign taxes paid as current expenses or opt to use a foreign tax credit.76

The

interchange-ability of this treatment with respect to individuals involved in corporations or

certain partnerships can result in a disproportionate benefit to the taxpayer-shareholder in the

USA:

forgoing the foreign tax credit and claiming the deduction can result

in greater tax benefits in certain situations. The foreign tax credit

allows US persons to credit foreign income taxes directly paid or

incurred against their US tax obligation. Thus, a US person who is a

member of an S corporation, LLC, or partnership can claim a foreign

tax credit for income taxes incurred by a Canadian branch or a

disregarded entity such as a Canadian [corporation] or limited

partnership formed under provincial law. Similarly, a C corporation

can claim a foreign tax credit for the taxes paid on the profits of a

Canadian branch and on its share of the profits of a fiscally

transparent [corporation] or limited partnership. US persons also can

claim a foreign tax credit in respect of withholding tax on dividends,

interest, and royalties they receive from Canadian entities.77

In this respect the American tax regime allows for flexibility with respect to deriving a tax

benefit from foreign source corporate dividend income.

The preceding subsections (a), (b) and (c) of this paper all demonstrate the limitations

and potential benefits to shareholders or partners with respect to their income tax obligations

created by virtue of their ownership\share interests. While the courts have been fairly consistent

in their application of these sections, the ITA itself, perhaps as a result of its contrived defences

75

Canada-United States Tax Convention Act, 1984, SC 1984, c 20. 76

United States Internal Revenue Code, 26 USC §§ 164(a); 901(a). 77

Mathieu Ouellette, “US Owner-Managed Enterprises Conducting Business in Canada: An Integrated Approach”, International Tax Planning, 2012 CTJ 2 at 424-425.

29

and complexity, has nevertheless become vulnerable to creative and aggressive tax planning

strategies which have been able to slip stealthily through its battlements to establish creative and

aggressive tax planning structures from within its borders.

IV. Using Horse Sense

Not every transaction between a corporation and a shareholder where the shareholder

extracts money from the retained earnings of the corporation results in a taxable benefit. There

are a number of typical ways in which to create or recognize a debt owing to the shareholder,

thus allowing the shareholder to remove retained earnings from the corporation without

triggering a taxable event. In addition, there are other, more creative ways, to create situations

where retained earnings can be extracted from the corporation in a tax-free or deferred manner.

This final section will survey the basic methods of extracting corporate retained earnings while

incurring the minimum tax consequence, and will explore some of the more creative methods of

doing so.

a. Basic Construction

There are a number of commonly used methods for drawing retained earnings from a

corporation either tax-free, deferred or at a preferential tax rate. These methods are used in some

form or combination in almost every reorganization and are utilized commonly in various

commercial transactions.

Repayment of Shareholder Loan

Generally speaking, any amounts advanced to a corporation are characterized as a loan,

the principle amount of which is repayable tax-free from the retained earnings of a corporation.

The amount, when loaned, does not form part of the income of the corporation, unless the debt is

30

forgiven, in which case, as noted above, the loss may be deductable to the lender as a bad debt.78

The courts have upheld the proposition that shareholder loans are tax-free when repaid to the

shareholder, and that this tax-free status is a question of fact which transcends bookkeeping and

accounting methods and records.79

In Chopp, a shareholder-officer advanced nearly $30,000 to a legal advisor pursuant to

the purchase of a personal asset, planning on drawing on the shareholder loan account which

exceeded $150,000.80

The shareholder recorded this advance as a legal expense rather than a

repayment of loan and was subsequently assessed personally for the amount.81

In holding that the

section 15 taxpayer benefit provisions should not apply to the amount in question, the Federal

Court of Appeal held that “a bookkeeping error of which the sole shareholder was not aware and

which he did not sanction and that was not in accordance with the company’s established

practices [does not] constitute in reality a method, arrangement or device for conferring a benefit

or advantage on the shareholder”.82

The courts have protected legitimately loaned amounts from

these types of errors, though they will not condone any artificial inflation of amounts drawn on

the paid-up capital of shares.

Don’t Muck with PUC

As discussed above in section II(c), the PUC of a share is the amount actually paid for it

upon issuance.83

Although the stated capital of the share can shift based on, inter alia, fair

market value, director determination and reduction for discounts or unpaid amounts, the PUC

78

The ITA, s. 39(1)(c). 79

The Queen v. Chopp, (1997) 98 DTC 6014. 80

Ibid. 81

Ibid. at 6015. 82

Ibid. at 6015 (citing Long v. Canada, [1997] T.C.J. No. 722). 83

The ITA, s. 89(1).

31

must not change.84

Since shareholders can draw up to the amount of the PUC tax-free from the

retained earnings of the corporation the ITA does not permit the change in the amount of the

PUC without additional capital contributions from the shareholder.85

An artificial increase in the

PUC will result in a deemed dividend to the shareholder in the amount of the increase in value

immediately at the moment of increase as though the shareholder had instantaneously received

the benefit.86

This applies even to a non-artificial increase in PUC; for example, the conversion

of retained earnings into PUC by capitalizing retained earnings will result in a deemed dividend

to the shareholder of the subject shares.87

Dividends

Dividends are surplus income paid to the holders of eligible dividend bearing shares.

Although they come in many forms they are always paid after the corporation has already paid

income tax on the funds used for the distribution. Since the shareholder is granted a dividend tax

credit for the amount paid when the dividend funds come into the shareholder’s hands

(theoretically in accordance with the principles of integration), the corporation has effectively

paid part of the shareholder’s tax burden on that money.88

b. In for the Kill

The ITA attempts to prevent preferable tax treatment of shareholders through the

provisions discussed above; however, several exceptions and interesting strategies are available

to shareholders which allow them to defer, split and minimize tax payable in ways not forestalled

by the ITA. The risks, in addition to the GAAR, are not entirely evident due to the lack of cases

which specifically address these strategies.

84

Canada Revenue Agency, Interpretation Bulletin IT-463R2, “Paid-up Capital.” (8 September 1995) at para. 3. 85

Ibid. at para. 9. 86

The ITA, s. 84(1). 87

Ibid., s. 84(1)(c.3). 88

Ibid., s. 121.

32

Deferring Shareholder Loans

Under section 15 of the ITA, a loan from a corporation to one of its shareholders will

generally be included in the income of the shareholder unless the loan is “repaid within one year

after the end of the taxation year of the lender.”89

However, an additional exception exists where

a loan is made “in the ordinary course of the lender’s ordinary business of lending money where,

at the time the indebtedness arose or the loan was made, bona fide arrangements were made for

repayment of the debt or loan within a reasonable time.”90

In this respect if a subsidiary

corporation is incorporated with the shareholders of the parent also being issued shares, and the

subsidiary grants several micro, interest bearing loans evidenced by promissory notes using

money which is transferred tax-free to the subsidiary by dividend, then presumably any money

borrowed by the shareholders for more than one year would not result in the attribution of

income to the shareholders. The only other requirements in the section are not onerous:

In considering whether any arrangements for repayment were bona

fide, the extent to which the arrangements have been carried out by

the borrower is reviewed and, if the borrower is in default, any

unusual circumstances that might have hindered them from being

carried out. Whether or not the period allowed for repayment is

"within a reasonable time" is a question of fact. In a given situation,

one of the factors considered in determining what is a reasonable time

is the normal commercial practice which would prevail in a similar

situation. For example, for a housing loan, normal commercial

practice requires the borrower, among other things, to give the lender

some security (not necessarily a mortgage) and to repay any balance

on the loan should the property be sold while an amount is still

owing.91

This method will help defer any tax consequence on money borrowed from the retained earnings

of the corporation.

89

Ibid., s. 15(2.6). 90

Ibid., s. 15(2.3). 91

Canada Revenue Agency, Interpretation Bulletin IT-119R4, “Debts of Shareholders and Certain Persons Connected With Shareholders.” (8 September 1995) at para. 12.

33

Using Property

Loaning money to a corporation will allow a shareholder to draw retained earnings out of

the corporation tax free and will allow the shareholder to charge interest which will be taxed,

though preferentially treated, as a capital gain. In addition to a direct loan, the shareholder may

create debts in the corporation in exchange for various assets and services. If the shareholder has

property, the value of which has been or is able to be objectively proven, the shareholder can roll

the property (other than real property, which can be rolled in under section 51 of the ITA) into

the corporation in exchange for shares which will have PUC equal to the value of the property.92

The rollover can consist of both tangible and intangible property, so long as a valuation is

performed to evidence the value. Money can then be drawn from the corporation tax-free up to

the amount of the PUC.

In addition, where shareholder loans and debts exist within a group of related

corporations, and the shareholder has registered general security agreements in the Ontario

Personal Property Security Act (“PPSA”) electronic registration system in order to secure its

debts as against other creditors, the shareholder may be able to “shift” debts and capital between

corporations to repay the loans through the use of an intercompany loan agreement. This type of

agreement causes all corporations which become party to such agreement to become liable for

the debts of the others, thus allowing the shareholder to extract retained earnings tax free from

corporation with retained earnings. The intercompany loan agreement acts as a multiple guaranty

for the acts of the debtor corporations in the group by the corporations generating profits. This

type of agreement could also be used to shift the responsibility of repayment between

92

The ITA, s. 85.

34

corporations in the event of an acquisition, where this would otherwise be prevented by the

ITA.93

Stock Options

Normally options to acquire shares in a corporation are a taxable benefit, the values of

which come into income when they are received.94

The ITA provides an exception to this

inclusion when an option is received by non-arm’s length employee-shareholders of Canadian

Controlled Private Corporations (“CCPC”).95

A CCPC as defined at subsection 125(7) of the

ITA is, inter alia, “a Canadian [private] corporation other than a corporation controlled ... by one

or more non-resident persons, by one or more public corporations ..., by one or more

corporations [a class of shares of which is listed on a stock exchange], or by any combination of

them”.96

Under section 7(1.1) of the ITA, “the benefit [of a stock option], if any, under paragraph

7(1)(a) will not be included in the employee’s income until the year in which the employee

disposes of or exchanges the share. Any gain accruing on the share after it is acquired by the

employee is subject to the capital gains rules.”97

The non-inclusion of the option in income is a

good way for a shareholder-employee to build a reserve with the company to be exercised when

it is beneficial for tax purposes, and even then the inclusion is preferentially treated as a capital

gain.

ABIL

As discussed in III(b) above, ABIL can be used to reduce any form of taxable income.

These losses can be carried-back three years and forward seven years, and can be carried-

93

Ibid., s. 111. 94

Ibid., s. 7(1)(a). 95

Ibid., s. 7(1.1). 96

Ibid., s. 125(7). 97

Canada Revenue Agency, Interpretation Bulletin IT-113R4, “Benefits to Employees - Stock Options.” (7 August 1996) at para. 13.

35

forward as capital losses after the seventh year, which makes them very useful and versatile. As

long as a non-arm’s length shareholder makes an attempt to collect on a bad debt, it can generate

losses in a corporation and realize an ABIL in accordance with subsection 50(1) of the ITA. In

addition, “[i]f a shareholder is dealing at arm’s length with a small business corporation, a

business investment loss may arise when the shares of that corporation are redeemed or

purchased for cancellation.98

In utilizing the above mentioned strategies tax planners must be wary of the risks which

may expose the Achilles Heel of the tax plan.

c. Shooting the Arrow

Some final considerations are the risks associated with aggressive tax plans, including the

use of various vehicles and common transactions outside of the normal context.

Trusts

Many tax planners enjoy using family trusts to move property around and split income.

Trusts are good vehicles for doing so; however, as discussed in subsection III(b) above, they

carry with them the risk of attribution under certain circumstances. For example, many structures

require that the person transferring property into a trust retain de facto control of the property in

order to administer the assets in a tax efficient way. Tax planners should be cognizant of section

75(2)(b) of the ITA which states that if the deed of trust provides “that, during the existence of

the person, the property shall not be disposed of except with the person’s consent or in

accordance with the person’s direction”, then “any income or loss from the property ... shall ... be

98

Canada Revenue Agency, Interpretation Bulletin IT-484R2, “Business Investment Losses” (28 November 1996) at para. 13.

36

deemed to be income ... of the person.”99

This attribution rule would mortally injure any

structure based on distributions from a trust.

Sweat Equity

Attempting to create shareholder debts through the use of “sweat equity” or contributed

labour just does not work. In short, any compensation for actual work done for a corporation

must be in one of two forms: as a contractor, where the shareholder would have to not be an

employee of the company providing services, billing the corporation and charging excise tax

(Harmonized Sales Tax); or as an employee on payroll subject to source deductions. Where the

shareholder receives shares or shareholder loans as compensation for work, such compensation

will be assessed as employment income and/or as a taxable benefit to the shareholder, and the

corporation will be responsible for remitting source deductions on those amounts as salary.

Can’t Stress Enough: Don’t Muck with PUC

As was discussed in subsection IV(a) above, PUC is a useful way of extracting money tax

free from a corporation; however, increasing PUC after the share is issued will result in a

deemed dividend. Attempting to increase PUC through justifications such as an exchange of

labour or adding to the value by contributing property of less than fair market value or property

which was not subject to a proper valuation, even a price adjustment clause will not save the

taxpayer from a detrimental assessment. If relying on a price adjustment clause it is important to

ensure that “[t]he [transfer] agreement reflects a bona fide intention of the parties to transfer the

property at fair market value and [it] arrive[d] at that value for the purposes of the agreement by

a fair and reasonable method.”100

99

Ibid., s. 75(2)(b). 100

Canada Revenue Agency, Interpretation Bulletin IT-169, “Price Adjustment Clauses.” (6 August 1974) at para. 1.

37

V. Journey’s End

The sojourn of creative tax planners searching for tax planning structures designed to

reduce taxes payable and extract retained earnings from corporations is often a battle against a

seemingly impenetrable fortress of a contrived tax system, protected by vigilant CRA guards and

investigators. The goal of extracting wealth from corporations in a tax efficient manner is a

difficult one requiring more than just brawn; it requires strength of mind, stealth and foresight.

This paper began by examining the provisions which comprise the shareholder benefit regime

and the jurisprudence which elaborated on and expounded those rules. The paper then explored

scholarly commentary on the subject, including how other parts of the ITA succeed and fail in

protecting against aggressive tax mitigation strategies, as well as how foreign jurisdictions

manage shareholder benefits.

In addition, the paper illustrated how the jurisprudence bolstered, and in some cases

weakened, the ITA, and explored the various strategies available to tax planners for the

mitigation of tax liability in extracting retained earnings and preventing shareholder attribution.

It was demonstrated that shareholders have the ability to extract money from the retained

earnings of corporations with minimal tax consequence if they plan their tax affairs

aggressively and creatively. Although the paper ended by providing a number of caveats to the

tax planner to heed when attempting aggressive structuring.

As tax planners continue their struggle to balance tax efficiency with the provisions of the

ITA and the GAAR, they are continually seeking to construct their Trojan Horses to move assets

through the wary eyes of Parliament and the CRA undetected. In the end, the decade-long Trojan

War ended with an invasion borne of a large wooden horse; the difference here is that no matter

38

how many wooden horses tax planners construct, Parliament will keep changing the location of

the city, and so the siege is bound to continue for decades to come.

39

Bibliography Legislation, Treaties and Regulations

1. Canada-United States Tax Convention Act, 1984, SC 1984, c 20.

2. Canada Business Corporations Act, RSC 1985, c C-44.

3. Income Tax Act, R.S.C. 1985, (5th Supp) c.1.

4. United States Internal Revenue Code, 26 USC.

Case Law

1. Lipson v. Canada, 2009 SCC 1.

2. Erb v. Canada, 2000 DTC 1401.

3. The Queen v. Chopp, (1997) 98 DTC 6014.

4. Roth v. The Queen, 2005 TCC 484.

5. Sunatori v. The Queen, 2010 TCC 346.

6. Varcoe v. Canada, 2005 TCC 620.

CRA Publications

1. Canada Revenue Agency, Interpretation Bulletin IT-113R4, “Benefits to Employees - Stock Options.” (7

August 1996).

2. Canada Revenue Agency, Interpretation Bulletin IT-119R4, “Debts of Shareholders and Certain Persons

Connected With Shareholders.” (7 August 1998).

3. Canada Revenue Agency, Interpretation Bulletin IT-159R3, “Business Investment Losses” (1 May 1989).

4. Canada Revenue Agency, Interpretation Bulletin IT-169, “Price Adjustment Clauses.” (6 August 1974).

5. Canada Revenue Agency, Interpretation Bulletin IT-239R2, “Deductibility of Capital Losses from

Guaranteeing Loans for Inadequate Consideration and from Loaning Funds at less than a Reasonable Rate

of Interest in Non-arm’s Length Circumstances.” (9 February 1981).

6. Canada Revenue Agency, Interpretation Bulletin IT-421R2, “Benefits to individuals, corporations and

shareholders from loans or debt.” (9 September 1992).

7. Canada Revenue Agency, Interpretation Bulletin IT-463R2, “Paid-up Capital.” (8 September 1995).

8. Canada Revenue Agency, Interpretation Bulletin IT-484R2, “Business Investment Losses” (28 November

1996).

Secondary Sources

1. Boris Bittker and Martin McMahon, Federal Income Taxation of Individuals (Boston and New York:

Warren, Gorham & Lamont, 1988).

2. Gabriel Brown, “Practical Approaches to Planning for Owner-Manager Remuneration” (Paper presented to

the Canadian Tax Foundation Ontario Tax Conference, 2009).

3. Tim J. Cestnick, “Tax Issues and Opportunities for the Family Office: Family Harmony and Wealth

Distribution” (2011) 2 CTJ (Personal Tax Planning) 353.

4. Irene Jacob and Evelyn Lee, “Income-Splitting Strategies: Selected Aspects” 2010 CTJ 4.

5. Elizabeth Junkin, “Section 15 – Shareholder Benefits Update” (Paper presented to the Canadian Tax

Foundation British Columbia Tax Conference, 2009).

6. John F. Oakey, “Estate Planning – Hot Topics” (Paper presented to the Canadian Tax Foundation Atlantic

Provinces Tax Conference, 2011).

7. Mathieu Ouellette, “US Owner-Managed Enterprises Conducting Business in Canada: An Integrated

Approach”, International Tax Planning, 2012 CTJ 2.

40

Appendix A

Iliad Synopsis*

It was the face that launched a thousand ships, the face of Helen, the woman who started a ten-year war. But how

could one woman start a war, you ask? To answer that I have to take you back to a time, many sunrises and sunsets

before blood was shed over the soil of Troy…

The Golden Apple

It was the wedding-feast of King Peleus and the Sea-goddess, Thetis, and all the gods were invited, them, along with

the other mortal guests, all except Eris, the goddess of discord. (After all, Thetis knew that wherever Eris went

trouble followed, and who would have wanted such a disruption at such a joyful event as a wedding-feast?) But

nothing got past Eris. She knew she was being excluded, and she was furious! So she came to the wedding,

uninvited and unannounced, and threw a golden apple into the circle of guests. On the apple was inscribed the

words: “For the fairest one”. Athena, Aphrodite and Hera, all claimed the golden fruit and fought over the prize, so

Zeus chose Paris, Prince of Troy, to make the decision as to who was to get the apple. Hence, each goddess offered

him a bribe: Athena promised him supreme wisdom, and Hera offered to give him great wealth and unlimited

power. However it was Aphrodite who made him the most irresistible offer of them all, promising to give him the

fairest mortal woman alive—Helen of Sparta. But there was one problem: Helen was already married to Menelaus,

King of Sparta. Therefore, in order to keep her promise, Aphrodite seduced Helen with an arrow of love and helped

Paris abduct her. It was then that the furious Menelaus asked for the help of his brother, Agamemnon, King of

Mycenae, and other fellow kings so that they, together, could redeem Helen and conquer one of the finest cities in

the land. It was the start of a ten-year war.

Book 1: The Quarrel of Achilles and Agamemnon

Many years later, well into the war, the Achaeans, under King Agamemnon’s command was losing many of its

comrades in battle. Apollo was furious at Agamemnon for dishonoring Chryses, a priest of Apollo, when he had

come to the Achaean King with gifts aplenty to ask for the return of his daughter, Chryseis, and Agamemnon

refused, wanting her as a mistress and seeing her as a prize of his after stealing her from the city of Troy. So

distressed with being denied his beloved daughter, Chryses prayed to Apollo. Phoibos Apollo, hearing his priest’s

prayer, brought a plague and more destruction to the Achaeans. Finally, after ten days passed, Achilles of the swift

feet, Agamemnon’s greatest warrior, called a meeting of the people and questioned a prophet about the means of the

Achaeans’ devastation. And the seer spoke, in fear, instructing Agamemnon to return Chryseis without accepting the

ransom and lead a sacrificial offering to her father, Chryses—only then would the plague be removed from the

Achaeans.

The king of Mycenae was furious at the seer for speaking such news, and he still refused to return the girl.

Nonetheless, after arguing tirelessly with Achilles over the matter, he finally agreed to return Chryseis, but wanted

compensation for his loss of booty. He ordered Odysseus to return Chryseis and in turn stole Achilles’ prize, Briseis.

Dishonored and angered, Achilles sat by his ship, refusing to fight; and on the twelfth day of his strike, Thetis went

to Zeus on Mount Olympus and requested that he, King of the gods, give the Trojans strength and help them win the

war until her son’s honor was redeemed.

* Available at: < http://library.thinkquest.org/04oct/00018/Cosmic%20Odyssey/TMorikawa/IliadSummary.html >.

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Book 18: The Arming of Achilles

For days on end, Achilles refused to fight and the Achaeans suffered. With the loss of their greatest warrior and the

devastation that plagued them, they were trapped. Desperate, Agamemnon sent Aias and Odysseus to beg Achilles

to return, offering him gifts and treasures aplenty, but Achilles refused. Upon this refusal, the Achaeans’ plight

worsened and Achilles remained relentless. But hearing of the Achaeans’ desperate need, he finally agreed to allow

his dear friend, Patroklos, to take his armor and fight. Disguised as Achilles, Patroklos pushed the Trojans back to

the walls of Troy. However, Apollo interceded and helped the Trojan prince, Hektor, kill Patroklos. Hektor then

took Achilles’ armor into his possession while a huge fight arose over Patroklos’ body. At the end of the brutal fight,

the Achaeans obtained Patroklos’ body and performed the appropriate burial rites.

Hearing of his beloved companion’s death, Achilles was deeply saddened and mourned endlessly for his dear friend.

Then the great goddess, Thetis, came to him, her son, and filled Achilles’ heart with courage. Achilles was now

ready to fight and avenge his friend’s death. At that time, the great warrior also learned that after Hektor’s death, his

own death would soon follow. With that, Thetis, goddess of the sea, went to Hephaistos and requested that he make

a most beautiful armor to protect her son.

Book 22: The Death of Hektor

Armed in his new armor and filled with renewed courage and anger, Achilles returned to the battlefields of Troy.

Meanwhile, Priam and Hekabe were trying desperately to convince their son, Hektor, to remain within the walls of

Troy, safe from Achilles. Alas they failed. Hektor stayed outside the gates and waited and waited. When he finally

saw the Achilles coming toward him, Achilles’ spear shaking above his shoulder, terror swept over the Trojan prince

and he fled. Achilles raced with rage, chasing Hektor around and around the walls of Troy. And the gods looked

down on them and counseled, trying to decide who should be the one to die. It was the fourth time that the two

warriors had come racing around the side wall. Apollo had been keeping Hektor’s knees light, driving him forward,

but Zeus balanced his golden scales and set two measures of death, one on each end. Hektor’s weight was heavier. It

was done. It was decided. Apollo retreated and the gray-eyed Athena came swooping down, transforming herself

into Deiphobos, Hektor’s brother. She stopped Hektor’s swift feet and convinced him to face up to Achilles in

combat, telling him that he (Deiphobos) would indeed be there to help Hektor finish Achilles off. This deceiving act

brought great courage to Hektor as he turned toward Achilles, declared his newfound spirit and fought. Eventually,

Hektor realized that he was fighting alone and fought to his death.

After Hektor gasped his last breath, Achilles pulled the spear out from Hektor’s body, stripped him of his armor,

stabbed a hole by the tendons in his ankles, threaded ox-hide through the holes, and tied the Trojan prince to the

chariot letting his head drag. Achilles rose onto the chariot, and lifting the golden armor high, he started the horses

running and dragged Hektor in a cloud of dust that trailed around the walls of Troy. Appalled, the people of Troy,

and especially Hektor’s wife, father and mother, who loved him the most, looked down at Hektor’s lifeless body

being dragged in the dust and mourned for the death of their most favored prince.

Book 24: Achilles and Priam

While the Trojans wept for Hektor, the Achaeans held funeral games for their beloved warrior, Patroklos, and were

showered with joy, all of them that is, but Achilles. He would not eat, and his sleep was restless. Tossing and

turning, he was plagued by his companion’s death. Every night Achilles would weep, and every day he would rise

with the sun, tie Hektor to his chariot and drag him three times around Patroklos’ tomb. However, Apollo had pity

on Hektor and protected his body from destruction. On the twelfth day, Phoibos Apollo spoke before the gods,

convincing them that they should persuade Achilles to return the lifeless body. Thus, Zeus ordered Thetis to tell her

son to return Hektor’s body to Priam. Then the king of the gods commanded Iris to tell Priam to offer gifts to

Achilles and secure the release of his son.

42

Hermes was sent to guide the Trojan king and keep him safe from harm. When they reached the dwelling of

Achilles, they found him sitting and dining with his fellow companions. Priam entered inconspicuously, knelt down

by Achilles, took the warrior’s knees in his arms and kissed the hands that had caused blood to flow from his son.

The two heroic men looked into each other’s eyes, each in marvel of the other, and finally the Trojan King spoke

and humbly asked that Achilles take pity on him and return his son to him. Finishing his request, Priam huddled at

Achilles’ feet and wept; and Achilles wept with him—for his own father and once again, for his dear friend

Patroklos. Then the swift-footed warrior led the Trojan king to the side and ordered his serving-maids to wash

Hektor’s body, anoint it with olive oil and cover him with a cloak and tunic. When this was done, Achilles himself

helped to lift the body into a beautifully polished mule wagon and took his supper with Priam. The two enemies

feasted on roasted meat, bread and wine, and when they had eaten to their heart’s content, they took pleasure in

sleep—their first sweet sleep in many days.

The next morning Priam departed with his son’s body, and Achilles ordered a twelve-day truce so that the Trojans

could perform the proper burial rites for their prince. The Trojans mourned over his body, each woman coming to

pay her respects, and on the tenth day, they burned his body. When Dawn rose again the next day, they gathered up

what remained of his lifeless body and placed it in a golden casket, and wrapping it with soft purple robes, they

placed it in a hollow grave. After they had finished this task, they gathered at house of Priam and rejoiced with a

glorious feast.

But that was not really “The End”. The war went on for many more months. As you probably know, it ended with

the wooden horse—a gift to the Trojans—that concealed the hiding Achaean warriors, led by the command of

Odysseus. There was a great slaughter within the walls of Troy, and when it was over, there was nothing but

destruction. The Trojans were devastated; the Achaeans were victorious; and the woman with the face that launched

the thousand ships ten years earlier was returned to her homeland.