Bernstein v. MNR, 74 DTC 6041, [1974] CTC 4 (FCTD), aff'd 77 DTC 5187, [1977] CTC 328 (FCA)

Walsh, J:—This case deals with the attempt of appellant to apply section 85A of the Income Tax Act, RSC 1952, c 148, which was enacted as section 75A in 1952-53, c 40, section 28, substituted in 1955, c 54, section 25, with subsection (7) added in 1953-54 by c 57, subsection 21(2), as it existed in the taxation year 1964 prior to the further substitution of 1966-67, c 47, section 9. Without quoting the section in question in extenso, it can be said that in 1964 it provided in paragraph (1)(a) as follows:

85A. (1) Where a corporation has agreed to sell or issue shares of the corporation or of a corporation with which it does not deal at arm’s length to an employee of the corporation or of a corporation with which it does not deal at arm’s length,

(a) if the employee has acquired shares under the agreement, a benefit equal to the amount by which the value of the shares at the time he acquired them exceeds the amount paid or to be paid to the corporation therefor by him shall be deemed to have been received by the employee by virtue of his employment in the taxation year in which he acquired the shares;

and paragraphs (2)(a) and (b) provide in effect that when an employee is deemed to have received such a benefit by virtue of his employment in a taxation year he may elect to pay the tax that he would normally pay for the year on his other income without this benefit plus the amount by which the proportion of this benefit that the aggregate of his taxes for the three preceding years bears to the aggregate of his income for those years exceeds 20% of the amount of the benefit so deemed to have been received. in the case of the present taxpayer, the calculation of the tax to be paid on the $99,800 which the stock option benefit he received amounted to was worked out by adding his net income of $10,970.71 for 1961, $13,643.56 for 1962, and $18,550.18 for 1963 making a total of $43,164.45. The tax paid was $1,997.75 in 1961, $2,925.90 in 1962 and $4,967.83 in 1963 making a total of $9,891.48 which represents 22.91% of his net income for the three years in question. Applying this tax rate to $99,800 results in a tax of $22,864.18 from which 20% of the $99,800 benefit is deducted in the amount of $19,960 leaving a sum of $2,904.18 as tax adjustment payable on this stock option benefit in addition to his normal taxes on his other income for the year.

The background of his business operations leading to his receipt of this benefit can be set out as follows. In January 1956 he and one Hyman Kamichik incorporated Highland Knitting Mills Inc, hereinafter referred to as “Highland”, to carry on the business of manufacturing and distributing knitted clothing, and transferred to it the similar business which they had formerly carried on together in partnership. They were the principal shareholders, officers and most valuable employees of the company from its incorporation to the death of Mr Kamichik in 1969. The company was very successful as can be seen from its increase of sales from $350,000 in 1956 to $1,100,000 in 1964 and $2,500,000 in 1968. Some time in September 1964 they acquired the charter of a company known as Salbron Investments Limited which had been incorporated under a Quebec charter on December 2, 1963 but which had never commenced operations. Its authorized capital consisted at the time of 9,900 5% non-cumulative non-voting redeemable preferred shares of the par value of $10 each. They obtained supplementary letters patent dated September 11, 1964 increasing the capital by creating an additional 11,000 5% non-cumulative non-voting redeemable preferred shares of the par value of $10 each, and changing the name of the company to Berkam Investments Limited, hereinafter referred to as “Berkam”. At a meeting of Highland on October 28, 1964 it undertook to subscribe for 94 common shares and 20,000 of the said preferred shares of Berkam at their par value of $10 a share and to pay for all these shares so subscribed for, as well as for the six common shares which had been allotted and issued to the three original applicants for incorporation. The company borrowed the money from its bank to pay for these shares, a cheque for $201,000 being issued by Highland in favour of Berkam, which cheque was dated October 26, 1964 but not date-stamped by the bank until December 4, 1964.

On November 23, 1964 Highland gave an option to each of Messrs Bernstein and Kamichik to purchase from it 10,000 of the said preferred shares for the price of $200 and by letters dated December 11, 1964 they each took up this option and the same day a meeting of Berkam approved the transfer from Highland to them of the said shares. On December 14, 1964 Berkam approved a by-law providing for the redemption and cancellation of 20,000 of its said preferred shares. This was duly approved at a special general meeting of shareholders the same date and supplementary letters patent were obtained on December 16, 1964 confirming the reduction of the capital of Berkam by the cancellation of the said shares so that the capital would thenceforth consist of 900 preferred shares and 100 common shares of the par value of $10 each. At all meetings of both companies from the time Highland acquired the shares in Berkam it was Messrs Kamichik and Bernstein who attended and formed the quorum of directors or shareholders, as the case might be.

As a result of this series of transactions appellant received the sum of $100,000 on redemption of his said preferred shares for which he had paid $200 or a benefit of $99,800. Appellant relies on the terms of the agreement giving him (and the same agreement was made with Mr Kamichik) the right to buy the said shares from Highland for $200, which sets out that he is an employee of the company and “the latter desires to confer a benefit upon him in respect of and by virtue of his employment”, and in the next paragraph states:

... in consideration of such employment the Company hereby grants unto Bernstein the exclusive right to purchase from the Company 10,000 5% Non- Cumulative Non-Voting Redeemable Preferred Shares of the par value of $10 each of the capital stock of BERKAM INVESTMENTS LIMITED for the sum of $200, during the period and upon and subject to the terms and conditions hereinafter respectively specified and set forth, namely:—

1. Bernstein’s rights hereunder may be exercised in the manner hereinafter specified, at any time during two (2) years from the date hereof provided that at the time of the exercise of such rights Bernstein is in the employ of the Company.

The original assessment of June 28, 1965 assessed appellant’s 1964 tax in the amount estimated by him on the basis of the election he made under section 85A but by notice of reassessment dated June 25, 1969 he was reassessed by being denied the right to apply the provisions of section 85A so that the sum of $99,800 was added to his income for the 1964 taxation year. He objected to the reassessment which was confirmed and in due course instituted the present appeal.

Respondent contends that appellant and Mr Kamichik did not receive the benefit in consideration of their employment but rather as shareholders of Highland, that this was a scheme for appropriation by the shareholders of Highland’s funds or for distribution to the shareholders of most of the accumulated surplus of Highland which, as of January 1, 1964, stood at $209,022.94, for the sole purpose of diminishing the amount of income tax payable. Respondent relies on subsection (7) of section 85A of the Act which reads as follows:

85A. (7) This section does not apply if the benefit conferred by the agreement was not received in respect of, in the course of or by virtue of the employment.

and on paragraph 8(1 )((c) which reads:

8. (1) Where, in a taxation year,

(c) a benefit or advantage has been conferred on a shareholder by a corporation

otherwise than

(i) on the reduction of capital, the redemption of shares or the winding- up, discontinuance or reorganization of its business,

(il) by payment of a stock dividend, or

(iii) by conferring on all holders of common shares in the capital of the corporation a right to buy additional common shares therein,

the amount or value thereof shall be included in computing the income of the shareholder for the year.

Alternatively, respondent submits that the benefit conferred on the appellant was received in his capacity as a shareholder on account or in lieu of payment of or in satisfaction of dividends within the meaning of subparagraph 6(1)(a)(i) of the Act which reads:

6. (1) Without restricting the generality of section 3, there shall be included In computing the income of a taxpayer for a taxation year

(a) amounts received in the year as, on account or in lieu of payment of, or in satisfaction of

(i) dividends,

Respondent further submits that the result of the interdependent and interconnected transactions referred to was that Highland and/or Berkam conferred on the appellant a benefit of $99,800 which by virtue of the provisions of subsection (2) of section 137 of the Income Tax Act was required to be included in the computation of appellant’s income. Subsection 137(2) reads as follows:

137. (2) Where the result of one or more sales, exchanges, declarations of trust, or other transactions of any kind whatsoever is that a person confers a benefit on a taxpayer, that person shall be deemed to have made a payment to the taxpayer equal to the amount of the benefit conferred notwithstanding the form or legal effect of the transactions or that one or more other persons were also parties thereto; and, whether or not there was an intention to avoid or evade taxes under this Act, the payment shall, depending upon the circumstances, be

(a) included in computing the taxpayer’s income for the purpose of Part I,

(b) deemed to be a payment to a non-resident person to which Part lll applies, or

(c) deemed to be a disposition by way of gift to which Part IV applies.

Finally, respondent submits that the transactions referred to were part of a reorganization of the business of Highland whereby property of Highland was distributed or otherwise appropriated to or for the benefit of appellant at a time when Highland had undistributed income on hand, which should therefore be included in appellant’s income by virtue of subsection 81(1) of the Income Tax Act which reads as follows:

81. (1) Where funds or property of a corporation have, at a time when the corporation had undistributed income on hand, been distributed or otherwise appropriated in any manner whatsoever to or for the benefit of one or more of its shareholders on the winding-up, discontinuance or reorganization of its business, a dividend shall be deemed to have been received at that time by each shareholder equal to the lesser of

(a) the amount or value of the funds or property so distributed or appropriated to him, or

(b) his portion of the undistributed income then on hand.

After several conferences between counsel and the Court the following agreement was reached so as to eliminate what would apparently have been lengthy and repetitive evidence:

The parties, by their respective counsel, hereby agree that the following evidence would be given as to facts by Nathan Bernstein, Emilien Tanguay, Marcel Leduc and Françoise Paquette all employees of Highland Knitting Mills if they had given evidence:

a) such agreement is made for the purpose of this appeal only and may not be used against either party on any other occasion or by any other party; and

b) the parties reserve their right to object to the relevancy of any of the facts hereby admitted.

1. Messrs Kamichik and Bernstein were bona fide employees of Highland Knitting Mills Inc (Highland) during the period 1956-1969 and were during this period officers, directors and sole shareholders of the company.

2. Mr Bernstein has continued to the present day to be a bona fide employee of Highland.

3. During the period 1956-1969 Messrs Bernstein and Kamichik, being officers, employees, directors and shareholders of Highland, performed their duties in an exceptional manner. Specifically, they worked extraordinary hours, that is, approximately ten hours a day, six days a week, fifty weeks a year in the case of Mr Kamichik and approximately fifteen hours a day, six days a week, fifty weeks a year in the case of Mr Bernstein.

4. Messrs Kamichik and Bernstein worked substantially longer hours than the other “key” employees of Highland.

5. The contribution made by Messrs Kamichik and Bernstein as outlined above was substantially greater than the contribution made by the other “key” employees.

6. The duties performed by Messrs Kamichik and Bernstein, as outlined above, were essential to the welfare and growth of the business of Highland.

In view of the agreement it was only necessary to hear one witness, Stanley Rosen, CA, Highland’s auditor since 1960. He testified that Mr Kamichik’s work was primarily on the financial side of the business while Mr Bernstein was the salesman, stylist and production expert. Both worked extremely hard in building up the business and for salaries which he considered were grossly inadequate. The business grew very rapidly, sales increasing from $403,245 in 1960 to $1,538,785 in 1965 and gross profits from $70,881 in 1960 to $388,087 in 1965 with net profit before income taxes increasing from $13,651 in 1960 to $197,978 in 1965. The business continued to expand thereafter until 1969 when control of it was sold by Messrs Bernstein and Kamichik to Kambern Diversified Industries Limited as a result of which the outstanding loans of Highland payable to Mr Bernstein and the estate of Mr Kamichik in the amount of $71,676.28 and $73,481.85 respectively were paid in October 1969. Mr Bernstein continued to remain in the company’s employ as president and to devote his full time and attention to the business whose sales had by 1969 grown to $2,387,328 on which the gross profit was $744,441 and the net profit before taxes $424,624. This period does not directly concern the present case save to the extent that it shows the continued progress of the business in the years fol- lowing 1964. According to Mr Rosen’s evidence, during the period from 1956 to 1962 their salaries had only been in the nature of $8,000 to $10,000 each. Mr Bernstein received a salary of $17,450 in 1963, however, and $35,000 in 1964 in which year Mr Kamichik’s salary was $18,000. Although the company had 123 employees in 1964, three of whom were long-term employees who had been with the business since the late 1940’s before it was incorporated, Mr Rosen felt that the entire growth of the company was due to the exceptionally hard work and successful management of Messrs Bernstein and Kamichik and when it became apparent in 1962 and 1963 that the net profits were accelerating rapidly he urged them to take more money out of it, which he considered should include compensation for their past services. A pension plan was established in 1965 for Messrs Bernstein and Kamichik only and large sums paid for their past services pensions. He conceded on cross-examination that taking the company’s taxation and the personal tax of Messrs Bernstein and Kamichik together, the tax burden would be less onerous by using the stock option plan which was adopted than by paying them increased salaries or dividends. He did not consider it bad administration of the company on their part to have the company incur a loss of $199,600 in 1964 by selling them for $400 shares of Berkam for which*it had paid $200,000 although this loss on investment reduced the earned surplus account which stood at $148,817.49 on January 1, 1964 to $9,422.94 by December 31, 1964 despite the addition to earned surplus of net profit of $60,205.45 for the year 1964. He considered that the benefit was justified to motivate them to continue to make the company prosper, and the company’s ability to easily overcome this loss was shown by its continued prosperity in the succeeding years.

Messrs Bernstein and Kamichik each had $40,000 invested in the company’s capital stock, $25,000 being in $1 par value preferred shares and $15,000 in $1 par value common shares, the preferred shares carrying a 5% non-cumulative dividend which dividend was only paid once, in 1962, in which year a dividend of 250 a share was also paid on the common stock making total dividend payments of $2,500 on the preferred stock and $7,500 on the common stock in that year which they shared equally. Berkam, although incorporated as an investment company, never did any business. Mr Rosen further testified that Highland’s acquisition of shares in Berkam was not the result of a “daylight” loan which he defined as one incurred and repaid the same day. Highland had a good line of credit with the bank and in 1964 it amounted to $250,000. After the borrowing to buy the shares of Berkam, Highland only owed the bank $213,000, as it normally has only a small bank loan outstanding during December when most of its receipts come in. Although its cheque to Berkam in the amount of $201,000 in payment of the shares subscribed for is dated October 26, 1964, it was only date-stamped by the bank on December 4, 1964, but this is of no great significance save for the fact that interest on this increase in its outstanding bank loan would only run from that date. The loan was repaid to the bank on January 8, 1965 on the same date that Messrs Bernstein and Kamichik loaned $200,000 to the company, taking its promissory notes for same in the amount of $100,000 each. Although these notes bore interest at 6%, Mr Rosen testified that this interest was waived by Messrs Bernstein and Kamichik.

In laying great stress on the value of services rendered to Highland by Messrs Bernstein and Kamichik compared to the remuneration they had received from it in the years preceding 1964, appellant contends that the benefit conferred on them was “received in respect of, in the course of or by virtue of the employment” and hence the exclusion in subsection 85A(7) (supra) does not apply. While conceding that the end result of the method adopted was that most of Highland’s surplus which had been accumulated to the end of 1964 was distributed to Messrs Bernstein and Kamichik, reliance was placed on the well- established principle in tax law that a taxpayer is not obliged to so arrange his affairs as to attract maximum taxation and that, provided he can bring himself squarely within the provisions of sections of the taxing statute and regulations which’ have the result of minimizing his taxation, he is entitled to do so. It was further contended that subsection 137(2) dealing with tax evasion cannot take effect so as to negate the provisions of another section of the Act which the taxpayer is entitled to use, even if the consequence of this use is to reduce his tax liability.

While some of the jurisprudence to which I was referred by counsel for both parties was helpful, there does not appear to be any case which is directly in point. Counsel for appellant referred to paragraph 8 of Tax Interpretation Bulletin IT-23 of August 6, 1971 issued by the Department of National Revenue which would, of course, not be binding on the Court, as authority for the proposition that an option under section 85A may be conferred on a person who is at the same time an employee and a shareholder. I would have assumed this to be the case in any event since paragraph 139 (1)(la) of the Act states:

139. (1) In this Act,

(la) “employee” includes officer;

and, while an officer is not necessarily a director and hence a shareholder, he usually is. I do not believe that respondent’s argument goes so far as to contend that section 85A can only be applied to an employee who does not also happen to own some shares in the corporation, but the contention is that the benefit must have been conferred on him “in respect of, in the course of or by virtue of the employment” and not in his capacity as a shareholder of the corporation. The difficulty in the present case arises from the fact that Messrs Bernstein and Kamichik were not merely minor shareholders of Highland but that between them they owned or controlled all of its shares and could direct and govern the conduct of the corporation as they saw fit. I am not unmindful of the fact that the corporation has an existence separate and apart from its shareholders and that in the present case Highland, at least, was an actively operating corporation and not a sham or simulacrum, nor am I unmindful of the jurisprudence which has held that a corporation cannot be considered as an agent of its shareholders nor are the shareholders owners of the property of the corporation.* [1] With respect to Berkam, however, although it filed the necessary annual returns and continued to do so in the years following 1964, ownership of it was clearly acquired by Messrs Bernstein and Kamichik for the purpose of completing the carrying out of this scheme, the end result of which was to greatly diminish their income tax liability for the year in question, and it has never at any time been used for any other purpose or carried on any business whatsoever. However, it was Highland which conferred the benefit on them and not Berkam, the benefit consisting of their being given the right to purchase from it shares of Berkam worth $200,000 for $400, Berkam being merely the vehicle by which the cash benefit of this transaction eventually found its way into their hands.

Appellant invokes the case of Montreal Trust Co, Executors of Estate of Chesley Arthur Crosbie v MNR, [1966] CTC 648; 66 DTC 5424, which case, however, did not depend on an interpretation of section 85A of the Income Tax Act but was an estate tax case. In it a corporation controlled by the deceased gave two of its employees, one of whom was related by blood relationship to the deceased, the right to buy shares of its capital stock at a substantial discount in recognition of “long and faithful service . . . and as a further incentive to continue to render such service”. When the deceased died within three years the Minister added the value of the benefit back to his estate as being in the nature of a gift or a disposition for partial consideration. The Court ruled that the benefit was conferred upon a relative as an employee of the company for legitimate business reasons and not as a blood relation of the deceased. In rendering judgment, however, Jackett, P, as he then was, made reference to section 85A, stating at page 655 [5428]:

One further point needs to be developed in considering the neat point that has to be decided on this appeal. In my view, what was done here falls into a not uncommon category of business transactions, namely, payments made in the ordinary course of business without legal liability. A business is operated to make a profit. No disbursement is a proper business disbursement unless it is made directly or indirectly to attain that end. Generally speaking, business payments are made pursuant to contracts whereby the businessman receives a quid pro quo for that payment—eg, contracts for services, purchase contracts, construction contracts, etc. Nevertheless, good business can dictate, depending on the circumstances, disbursements over and above the amounts legally owing for what the business man has received or is to receive. A special payment to a good contractor in unforeseen difficulties so that he will be available for future work, is one example. Bonuses to employees over and above any requirement of the contracts of employment, so as to maintain their goodwill and keep employee morale high is another. Still another is the very type of benefit conferred on senior executives that we find in this appeal. That it is a very common type of benefit conferred on senior executives is evidenced by the special provision made in section 85A of the Income Tax Act for their income tax treatment.

In the preceding paragraph, however, a conclusion of fact on which this statement is based is set out as follows:

There is no suggestion that the transaction was a mere subterfuge for conferring a benefit on Andrew C Crosbie as a blood relation of the deceased and there is no suggestion that any part of the amount of the benefit is for anything other than the benefit that “legitimate business reasons” dictated that it was in the commercial interest of the company that it should confer on this employee. This aspect of the case is underlined by the otherwise irrelevant fact that a similar arrangement was made for a fellow employee on very similar terms at the same time.

The facts in that case are evidently quite different from the present where, despite the great stress laid by appellant’s counsel in argument of the value to a corporation of offering stock option benefits to senior employees in lieu of increases in salary in order to retain their services and prevent their leaving to work for a competitor, it was quite evident that neither Mr Bernstein nor Mr Kamichik had any such thought or intention. The business was, in fact, theirs, had been founded by them long before they incorporated, and they were for all practical purposes the only shareholders of Highland. It might perhaps be contended that the stock option benefit was conferred on them as a reward for past services, but certainly it was not required as an incentive to maintain their goodwill and continued devotion to the company’s service. Looked at in this light it cannot be compared with stock option benefit plans which are frequently given to senior executives of large corporations in the interests of encouraging them and retaining their services. It is not without significance that three other employees who had been with the business since the late 1940’s, and while admittedly not as valuable to Highland as Messrs Bernstein and Kamichik, were only receiving $7,000 to $8,000 in 1964, were not given the opportunity to participate to even a very limited extent in the stock option benefit nor were they included in the company’s pension plan established in 1965. It is also not without significance that in 1954, the very year in which the stock option benefit was conferred on appellant (and on Mr Kamichik with whom we are not here concerned) his salary had been increased to $35,000 from the $17,450 he had received in 1963 and $8,000 in 1962, so it can hardly be successfully contended that the stock option benefit was necessary “for legitimate business reasons” to reward him for his exceptionally hard work and ability and to retain his interest in continuing on the same basis in the company’s service.

Appellant also referred to the Tax Appeal Board judgment in the case of Gordon G Smith v MNR, [1969] Tax ABC 217; 69 DTC 192, which permitted the application of section 85A to a share option benefit conferred on appellant by a company in which he and his wife owned the controlling interest. The case seems to have been decided, however, on the basis that it was not necessary to have a formal written agreement between the company and appellant respecting the issue of the shares to him, a mere verbal agreement being sufficient, and-no consideration seems to have been given to the possible application of subsection 85A(7) nor did the Minister invoke the provisions of subsection 137(2).

Appellant also referred to the case of Stanley Marsland and Florence L Marsland v MNR, [1970] Tax ABC 49; 70 DTC 1047, in which appellants, husband and wife, were assessed for gift tax as the result of the issuance to their son at a substantial discount of shares in a corporation of which they owned 47 of the 50 issued shares, the son owning the other three. The finding was to the effect that it was clearly a benefit conferred on an employee by virtue of paragraph 85A(1)(a) so that tax should be calculated in accordance with the provisions of subsection 85A(2) and that subsection 137(2) could not be applied. The reasoning in the judgment was to the effect that, since under section 85A such a payment is deemed to be income and under section 137(2) it can either be included in computing taxpayer’s income under paragraph (a) or deemed to be a disposition by way of gift under paragraph (c) and since the recipient, the son, was prepared to pay whatever tax was payable by subsection 85A(2), it should not be treated as a gift. Again in this case there was no discussion of subsection 85A(7) and as already pointed out the question was not one of income tax but rather of gift tax which is not the issue in the case before me. Furthermore, the appellant’s son was only a minority shareholder of the corporation although he had been for some time its most valued employee, his father having retired some time previously. It is clearly distinguishable from the present case therefore.

Appellant also relies on the case of MNR v Pillsbury Holdings Limited, [1964] CTC 294; 64 DTC 5184, in which the respondent company borrowed a large sum of money from two of its subsidiaries. Subsequently interest was waived on the loan. The contention was that this was the conferral of a benefit by the subsidiary corporations on the parent corporation, being a shareholder. In refusing to apply paragraph 8(1 )(c) of the Act (supra), Cattanach, J, in rendering judgment, found that the benefit or advantage was not conferred on the parent company qua shareholder and in so finding he states at page 303 [5189]:

The Minister does not allege that he assumed, in making the assessments, that the waiver was an arrangement or device adopted by the corporation to confer a benefit or advantage on the respondent as a shareholder. There was no onus on the respondent to disprove that fact, which is essential to its being taxable, unless the Minister assumed that fact when assessing. It may be that the Minister’s appeal should be dismissed on that ground.

In the present case there is a clear invoking of the provisions of paragraph 8(1)(c) and subsection 137(2) by respondent. The significance of this is emphasized when Cattanach, J states again at page 303 [5189]:

I have more difficulty, as far as the first round of waivers is concerned, inasmuch as it does seem improbable that the lender would have cancelled the interest outright, instead of merely giving time for payment, on a claim by the borrower that it was in difficulties, were it not for the fact that the borrower owned practically all the shares in the lender corporation. However, there was no allegation that the waiver was anything other than what it purported to be, that is, a lender granting relief to a borrower in difficulties. Had the transactions been attacked in the Notice of Appeal and at the trial as being a device or arrangement for conferring a benefit on the respondent qua shareholder, it might well have been difficult for the respondent to have resisted the attack. However no such attack was made and the assessments cannot therefore stand.

I believe that two of respondent’s contentions can readily be disposed of. In support of its contention that the benefit should be treated as a dividend under the provisions of subparagraph 6(1)(a)(i) of the Act (supra) respondent relies on the case of R A Hill and Others v Permanent Trustee Company of New South Wales, Limited, and Others, [1930] AC 720 at 731, in which it is stated:

A limited company not in liquidation can make no payment by way of return of capital to its shareholders except as a step in an authorized reduction of capital. Any other payment made by it by means of which it parts with moneys to its shareholders must and can only be made by way of dividing profits. Whether the payment is called “dividend” or “bonus,” or any other name, it still must remain a payment on division of profits.

This case was referred to in the Exchequer Court in the case of Northern Securities Company v His Majesty the King, [1935] Ex CR 156, where, after quoting this passage, Maclean, P stated at pages 160-61:

This means that any distribution of money, except on a reduction of capital, by which assets are released to the shareholders, can only be a distribution of profits, by whatever method it is made.

Another finding to the same effect was made in the case of Hilliard C McConkey v MNR, [1937] Ex CR 209; [1935-37] CTC 24; 1 DTC 394. None of these cases has any application to the present situation, however, unless it is concluded that the benefit was conferred on Messrs Bernstein and Kamichik qua shareholders and not qua employees, as otherwise section 85A, which was not of course an issue in the R A Hill case (supra) in Britain, nor in existence at the time of the two Canadian judgments, does provide an alternative method of distributing surplus by interest means. In any event, even if the conclusion were reached that this was a benefit conferred on Messrs Bernstein and Kamichik qua shareholders, I believe it would be paragraph 8(1)((c) which should apply to it rather than subparagraph 6(1)(a)(i). Subparagraph 6(1)(a)(i) merely uses the word “dividends” and the word “dividend” is defined in paragraph 139(1)(k) as follows:

139. (1) In this Act,

(k) “dividend” does not include a stock dividend;

There was no meeting of directors at which any dividend was declared and the elaborate scheme which was adopted to eventually get cash from the company’s surplus into the hands of Messrs Bernstein and Kamichik could hardly be considered as the payment of a dividend. If it were to be considered as a dividend at all, and I do not so find, it would be more in the nature of a stock dividend dealt with in subparagraph 8(1 )(c)(ii). However, some consideration, however slight, was paid for the stock and surely in a normal stock dividend no consideration would be paid for same and, moreover, it was not stock of Highland which was distributed to them but stock of Berkam which was sold at a discount. If it is found, therefore, that the transaction resulted in a benefit or advantage being conferred on a shareholder qua shareholder within the meaning of paragraph 8(1 )(c) of the Act, the exceptions in subparagraphs (i), (ii) and (iii) of paragraph (c) would not apply since it would not be an advantage or benefit conferred either “on the reduction of capital, redemption of shares or winding-up, discontinuance or re- organization of the business”, the “payment of a stock dividend”, or “by conferring on all holders of common shares in the capital of the corporation the right to buy additional common shares therein”, as what was conferred was not a right to buy additional shares of Highland but rather the sale by Highland to Messrs Bernstein and Kamichik of the shares which Highland owned in Berkam. The amount or value of the benefit would therefore be included in computing appellant’s income for the year.

I believe also that respondent’s contention that the benefit should be taxed under the provisions of subsection 81(1) of the Act must fail since it only applies “on the winding-up, discontinuance or reorganization” of the corporation’s business and there was no reorganization whatsoever of Highland’s capital structure or business, the reorganization having taken place with respect to Berkam. As I have already concluded that the benefit was conferred not by Berkam but by Highland, this section can have no application.

This brings us to the main question in issue, namely whether the benefit was not received “in respect of, in the course of or by virtue of the employment” of appellant within the meaning of subsection 85A(7) in which event the application of section 85A can have no effect.

Appellant contends that subsection 85A(1) is intended to apply to a transaction such as that in issue in the present case in that Highland sold shares of Berkam, a corporation with which it did not deal at arm’s length, he and Mr Kamichik being employees of Highland, and that the benefit must be deemed to have been received by them by virtue of their employment in accordance with paragraph 85A(1)(a) and the tax calculated in accordance with subsection 85A(2). He points out that there is no requirement in the section that the same benefit be extended to all employees and that there is no limitation on the amount of the benefit which can be so given. Certain indicia point to the fact, however, that the benefit was not conferred on them by virtue of their employment. Although they worked unequal time in the course of their employment by the company and in the years 1963 and 1964, in any event, Mr Bernstein received substantially higher salary than Mr Kamichik, at all times each owned 50% of the company’s shares and had the same investment in the company, and the benefit was conferred on them equally. It was not merely a relatively small benefit which was conferred on them but one which absorbed practically all of the company’s earned surplus at the end of 1964. It was not offered to any other employee, even three others with long service. It was not beneficial to the company tax-wise but, on the contrary, was detrimental in that had it been paid by way of a bonus or increase in salary, this would have been a deductible expense to the company in its tax return. In its consequences it amounted to a distribution of Highland’s profits, which profits are normally only distributed to shareholders as such and not to employees unless by virtue of some profit-sharing plan. Finally, the amounts received were, after the redemption of the shares, immediately loaned back to Highland by appellant and Mr Kamichik, and it would be most unusual for employees as such to immediately loan back to the company a benefit received from it. When one looks at the intent of section 85A, it was evidently designed to enable a corporation to afford its employees (or its senior employees if it desires to restrict the offer to them) an opportunity to acquire shares of its stock or of the stock of a controlled subsidiary on terms which confer a benefit on them in order to reward their services and retain a personal interest by them in the company’s progress without their being obliged to pay regular tax rates on the amount of this benefit. It can hardly have been intended to be used as a means of compensating an employee or employees, who may have been underpaid for some years, by conferring on them a benefit in a subsequent year at a very advantageous tax rate, in an amount sufficient to compensate them for all the alleged underpayment of salary which they have suffered in preceding years, when, had they been paid the salary to which they claim to have been entitled in those years, they would have had to pay tax on it each year at the regular tax rate. Neither could it have been intended that it should be used as a means of transferring nearly all of the company’s earned surplus to shareholders who, between them, own or control all the shares of the company’s stock at the same advantageous tax rate, whereas had it been paid to them by way of increased salary, bonus, regular dividend (which would have been subject to the dividend credit) or even by use of section 105, the taxes payable would have been substantially higher.* [2]

In the case of Conn Stafford Smythe, Conn Smythe and Clarence H Day v MNR, [1967] CTC 498; 67 DTC 5334, Gibson, J considered the application of subsection 137(2) to the involved transaction involved in that case at some length. He concluded that there was no business reason for entering into the various transactions and that the result of the series of transactions was that the company conferred a benefit on the appellants qua shareholders, which benefit, because of subsection 137(2), is deemed to be a payment which must be included in computing the taxpayer’s income. The assessor had included it as a deemed dividend under subsection 81(2) of the Act, but Gibson, J concluded, as I have concluded in the present case, that there was no winding-up, discontinuance or reorganization of the business and as a consequence he would have assessed the benefit as income received by the appellant within the purview of subsection 8(1) of the Act. This judgment was upheld in the Supreme Court ([1970] SCR 64; [1969] CTC 558; 69 DTC 5361), but in that Court it was found that the case was plainly covered by subsection 81(1) of the Act and that it was therefore unnecessary to express any opinion on the scope of subsection 137(2).

In the case of Wilbour Lee Craddock and Stanley Curtis Atkinson v MNR, [1968] CTC 379; 68 DTC 5254, Gibson, J went into further detail as to his understanding of the application of subsection 137(2) of the Act to a surplus stripping operation having no legitimate business purpose and resulting in a benefit being conferred on the appellants. In rendering judgment he states at page 386 [5258]:

When the circumstances of the inter-related transactions are such that it is correct to include such “benefit” “‘in computing the taxpayer’s income for the purpose of Part I’’, then the total of it is included in such taxpayer’s income as one of the sources of such taxpayer’s income within the meaning of Section 3 of the Act in the same manner as if Section 137(2) was in one of the series of sections in Part I such as Section 6, Section 8(1), Section 16(1) and Section 81(1). But Section 137(2) of the Act in any such case is not dependent upon for its efficacy on or connected with any other section or sections in Part I, such as Sections 6, 8(1), 16(1) and 81(1) and therefore none of these latter sections are relevant in the adjudication of any case in which Section 137(2) is applicable.

On this basis, subsection 137(2) may not even have to be linked with another section in order to be applied, but since, in the present case, I have concluded that it would also come within paragraph 8(1 )(c), it is not necessary to conclude that the transaction would be taxable by the provisions of subsection 137(2) alone. I am satisfied on the facts before me that the series of transactions commencing with the acquisition of Berkam by Highland, the reorganization of its capital structure to provide for additional preferred shares, the purchase of these shares at their par value by Highland, the subsequent sale of these shares for a nominal price by Highland to appellant and Mr Kamichik, the subsequent supplementary letters patent of Berkam resulting in the cancellation and redemption of its preferred shares and payment of the par value of them to appellant and Mr Kamichik, and the immediate loan by them to Highland of the amounts so received to enable Highland to repay the bank indebtedness it had incurred for the purchase of these shares in the first place, were all carried out in order to confer a benefit on appellant and Mr Kamichik within the meaning of subsection 137(2) of the Act with the intention of diminishing the taxes payable by them under the Act and that the benefit received should therefore be included in computing the taxpayer’s income for the purpose of Part I. Paragraph 8(1 )(c) in Part I applies in that the benefit or advantage was conferred on them as shareholders of Highland. This finding depends on the facts of this case, which should not be construed as holding that section 85A cannot properly be applied to an employee who is also a shareholder, but is based on the fact that in the present case appellant and Mr Kamichik were the sole shareholders as well as being bona fide employees and that in their capacity as sole shareholders of Highland they caused it to so act as to confer a benefit on them which, although stated to be conferred by virtue of their employment, was in actual fact received by them in consequence of their being able as sole shareholders of the company to so control its actions as to cause this benefit to be paid. It was not, therefore, received by virtue of their employment within the meaning of subsection 85A(7) but rather by virtue of their being shareholders of the company with the result that section 85A cannot be used in the case of appellant as an exception preventing the application of subsection 137(2) and paragraph 8(1)(c) of the Act. The appeal is therefore dismissed with costs.