In Demers c. La Reine, 2006 CCI 504, the taxpayer tried to split income with his minor daughters. The Court ruled against the taxpayer, in part because it considered artificial the payment of thousands of dollars of dividends on shares that were issued for only $1.
Opco issued one Class D share to each of the taxpayer’s minor daughters (aged 6 and 2) for $1 each. The daughters did not pay for their shares; rather Opco deducted the price of the shares as an expense. Opco then paid dividends of $72,000 in total on the Class D shares in 1999. The dividends received by the daughters were deposited in the taxpayer’s bank account, allegedly because the daughters loaned him the money. He claimed to repay the loans later by making contributions to their RESPs. The taxpayer used the money deposited to his account to repay amounts he owed to Opco. The daughters reported the dividends in their income for tax purposes and presumably did not pay tax on them (the kiddie tax was not yet in force).
In another agreement, the daughters offered to sell the shares back to the taxpayer for $1 each as of December 31, 1999, which offer the taxpayer accepted.
The taxpayer’s lawyer—who apparently is not afraid of an uphill battle—argued that the reassessed transactions represented legitimate tax planning of a kind that had been approved in Neuman v. M.N.R., [1998] 1 S.C.R. 770, [1998] 3 C.T.C. 177, 98 D.T.C. 6297.
The Crown replied by pointing out the many deficiencies in the execution of the plan, not the least of which was that the shares were not validly issued because the daughters did not pay for them as required by subsection 25(3) of the Canada Business Corporations Act. That subsection provides as follows:
A share shall not be issued until the consideration for the share is fully paid in money or in property or past services that are not less in value than the fair equivalent of the money that the corporation would have received if the share had been issued for money.
The Crown also argued that, even if the daughters did pay $1 per share, that purchase price was well below the true fair market value of the shares given the dividends to which they were entitled. The Crown argued that the artificial purchase price supported its contention that the entire set of transactions was a sham.
The Tax Court did not hesitate to dismiss the taxpayer’s appeal. The Tax Court pointed out that Neuman, while it had approved dividend sprinkling, nevertheless required that the planning be based on legally effective transactions. If the transactions are legally ineffective, or if they amount to a sham, then the tax consequences proposed for the transactions will not follow. The Court held that the shares were not validly issued as required by the CBCA because the daughters had not paid for them.
The Court, however, went on to hold that, even if the shares had been validly issued, the transactions were artificial (or a sham) because, among other things, the shares were issued for little or no consideration although they were entitled to significant dividends (which were in fact paid) (see ¶30).
The latter conclusion is somewhat troubling for professional corporations. The Ontario Business Corporations Act does not permit an adult child to hold shares through a trust. Clients, however, are often reluctant to allow their children to hold fully participating shares of their professional practice. The solution sometimes proposed is to issue shares for a nominal amount that can be redeemed for the same amount but that are entitled to unlimited dividends. The concern with such shares is that their value is not nominal, given their dividend entitlement, especially if hindsight will show that significant dividends are paid in respect of the shares. The Court’s comments in Demers, while they appear to be obiter, suggest another concern: the lack of commercial reality associated with such shares could help support an argument that the shares are part of a sham.
Demers is no reason to panic, however. The scheme under consideration was so abusive that another court would likely be slow to apply its conclusions to a case where the tax planning is executed by means of legally effective transactions.
Hi John
In follow up to your summary the Ontario Medical Association assists physicians through the process of setting up a PC. They charge a mere $1,000 for this less than helpful support. I was referred a doc who had attempted to set up a PC through the OMA service and the way it works is the doc answers some questions and the OMA program spits out articles of incorp and all other documents. For instance they ask for the names of the doc’s family and based on the answer the program sets up the classes of shares. The shares were common shares with voting rights and a number of different classes of special shares. The number of seperate class of shares were based on the answers to the question “please provide the names of your family members”.
In light of the Demers case the problem I can see is with the special shares in that the shares are issued for nominal consideration, do not participate in growth and have a discretionary dividend right. Also, there was not menitioned anywhere in the documents from the OMA that the shareholders needed to pay for the shares they were issued. Something that could prove problematic in light of Demers.
As an aside the doc in question answered the question of the names of family members with son, Mum, Dad and brother. The correct answer to the ambiguous question. The problem was that the OMA program added incorrectly the brother as a shareholder.
In the end the doc went to a lawyer and got the articles corrected and came to us for the tax advice and CPSO filings.
The OMA assisted set up process is like the will kits and should be avoided.