Introduction
The last year has provided no shortage of exciting and interesting tax cases that tax practitioners can learn from. Accordingly, the purpose of this paper is to review a select number of cases that we felt were important to highlight. Each case begins with a short summary followed by the facts, judicial reasoning and the take-away message.
Swirsky1
Summary
Owner-manager remuneration is important to many businesses, especially family businesses. Swirsky emphasizes the importance of distinguishing between different forms of owner-manager remuneration in certain circumstances. In a nutshell, this case involves a question of interest deductibility wherein the Federal Court of Appeal held that interest was not deductible as the shares were not acquired to earn income.
Facts
Due to a downturn in the real estate market and failing partnership relations, the taxpayer, Mr. Swirsky, became concerned about creditors seizing the family owned corporation, Torgan (the "Corporation"). At this time (1991), the Corporation was the main source of income for Mr. Swirsky and his family. Mr. Swirsky's accountant devised a plan whereby Mr. Swirsky would sell some of the shares in the Corporation to his wife who would borrow monies to acquire such shares. Mr. Swirsky used the proceeds from the sale of the shares to repay his outstanding shareholder's loan to the Corporation. By using the monies to repay the shareholder loans, Mr. Swirsky assured that such monies would not be available to creditors and he avoided subsection 15(2) of the Act as the shareholder loans were repaid within the requisite time limitation.
Subsequent to the transaction, a valuation was also obtained and the sale of the shares was adjusted so that only the amount of shares needed to fully repay Mr. Swirsky's outstanding shareholder loan were sold. Thus, the main goal of creditor-proofing was achieved with the plan. The credit-proofing transaction was repeated twice more in the next few years.
The Corporation used the cash to purchase a guaranteed investment certificate and the interest on this investment was used to partially off-set the interest payable by Ms. Swirsky on the loan that was used to fund her share purchase. The additional interest owed on the bank loan by Ms. Swirsky (and the guarantee fee for the loan) were charged to Mr. Swirsky's shareholder loan account. Due to the attribution rule in subsection 74.1(1) of the Act, the interest charges were claimed as losses by Mr. Swirsky. Subsection 74.1(1) of the Act attributes income and losses on property transferred between spouses to the spouse who actually transferred the property. The intended use of the attribution rule did not appear to affect the Court's decision in this case.
The Corporation did not pay taxable dividends for a number of years after the transactions but did pay a capital dividend of $2.5 million to Ms. Swirsky in 1999. The Corporation paid a taxable dividend in 2003 to Ms. Swirsky which was attributed to Mr. Swirsky. The Minister denied Mr. Swirksy's interest deduction for the 1996 through 2003 taxation years.
Judicial Reasoning
The Tax Court of Canada (the "TCC") upheld the Minister's denial of the interest and guarantee fees claimed by Mr. Swirsky. In order to obtain an interest deduction, the Supreme Court of Canada (the "SCC") noted four conditions in Shell Canada Ltd. v. R.:2 the amount must be paid or payable in the year; the amount is paid or payable pursuant to a legal obligation; the borrowed money is used to earn non-exempt income from business or property; and the amount must be reasonable. The SCC in Entreprises Ludco ltee c. Canada3 stated that the test for determining the purpose of interest deductibility is whether considering all of the circumstances, the taxpayer had a reasonable expectation of income at the time the investment was made.
The Court notes that there is no evidence, prior to 1999 that the Corporation had any history of paying dividends and that monies were extracted from the Corporation by way of bonuses and loans. Interestingly, Mr. Swirsky argued that the fact there was a creditor proofing transaction was evidence in and of itself of the belief that the Corporation had future earning potential. Mr. Swirsky's testimony did not help his case as he testified that income did not come from the shares in the Corporation but rather the Corporation itself. In reaching their decision, the Court noted that there was no evidence of discussion or consideration being given to an income earning purpose to the share acquisition. Further, the Court noted that Mr. Swirsky did not make any representations or promises to his wife that dividends would be paid on the shares.
The TCC briefly considered the Crown's argument made under subsection 74.5(11) of the Act noting that any inquiry under this provision would be factual and would focus on the main reasons for the transfer. However, the Court dismissed this argument because the Crown raised the argument late in the proceeding and thus pursuant to Anchor Pointe Energy Ltd. v. R.,4 the Crown bore the onus of proving that one of the main reasons for the transfer of the shares was to reduce tax – an onus the Crown did not meet. Further the TCC stated that the general anti-avoidance rule (the "GAAR") found in section 245 of the Act did not apply to the transaction as it was not shown that the primary purpose of the transaction was to obtain a tax benefit.
The Federal Court of Appeal (the "FCA") upheld the decision that Mr. Swirsky should not be allowed an interest deduction as his wife did not acquire the Corporation's shares for the purpose of earning income. In short, the FCA agreed with the TCC that Ms. Swirsky did not have a reasonable expectation of earning income when she acquired the shares. Mr. Swirsky challenged the TCC decision on the basis that the Court relied too heavily upon Ms. Swirsky's stated subjective intention with respect to the acquisition of the shares and not enough on the objective manifestations of that intention. The FCA responded by noting that there was no evidence of a dividend having been made prior to 1999, bonuses are not related to shareholdings; family expenses were paid by the Corporation and treated as loans regardless of whether the family members held shares; there was no dividend policy in place; the transaction was designed so that Ms. Swirsky would not have to pay interest out of her own pocket; and it could be inferred that Ms. Swirsky had a reasonable expectation of receiving a capital dividend. It should be noted that paragraph 20(1)(c) of the Act only allows interest to be deducted to the extent that it was incurred to earn taxable income and as such, a capital dividend does not qualify.
The Message
The taxpayer was not able to deduct his interest in this case due to incorrect legal form. In other words, future interest charges of the Corporation would have been deductible if the Corporation had previously paid the excess income in the form of dividends rather than paying salaries and bonuses. The Corporation was actually a good investment as it generated a consistent surplus. It is typical of many family owned Corporations to solve a negative shareholder loan balance at the end of the year by simply paying a bonus, however, caution to this approach should be exercised. In situations like this we recommend that practitioners establish their intention clearly in the documents that implement the transaction.
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