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TaxMatters@EY - November 2012 - Amendment of corporate records saves capital gains exemption claim - EY - Canada

TaxMatters@EY - November 2012

Amendment of corporate records saves capital gains exemption claim

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TransAlta Corporation v The Queen, 2012 TCC 86
Jennifer Smith, Ottawa

This recent Tax Court of Canada (TCC) decision demonstrates that it is not always necessary to go to the expense of obtaining a rectification order where the relevant corporate documents do not reflect the intentions of the parties. Here, a simple corporate resolution correcting an error was sufficient to “save” the taxpayer’s ability to claim the capital gains exemption. Unfortunately, however, the taxpayer was forced to go to the expense of litigating the matter before the TCC.

Facts

In 1995, the taxpayer and another individual (D.K.) agreed to acquire a heating, ventilating and air conditioning parts supply business in which they each had previously held a 25% interest. Their accountant recommended that the purchase be made through a newly incorporated company, the common shares of which would be held 50/50 by the taxpayer and D.K. More specifically, the accountant provided written instructions to the lawyer representing all the parties at the time, to incorporate a new numbered company, on the basis that each of the taxpayer and D.K would be owners of 100 common shares of such corporation for a total price of $1.00 per share or $200 in the aggregate.

The lawyer became concerned that he was in a conflict of interest since he was acting for both the purchasers and the vendors and referred the taxpayer and D.K. to a new lawyer. He forwarded draft articles of incorporation to the new lawyer, but it appeared from the evidence that the new lawyer was not made aware of the accountant’s instructions with respect to the number of shares to be issued. The new lawyer proceeded to incorporate 115447 Ontario Ltd. (115) and set up the shareholdings of 115 so as to issue only one common share to each of the taxpayer and D.K.

Commencing with the first fiscal year end of 115 ending 29 February 1996, and thereafter, the accountants prepared the financial statements for 115 on the basis 200 common shares were the issued stock with a paid-up capital of $200, based on the instructions they had given in the first place. The initial Notice of Shareholders attached as a schedule to the corporation's first filed tax return indicated that each of the taxpayer and D.K. owned 100 common shares issued at $1 per share.

Later, in 2005, the taxpayer and D.K. were not getting along, and the taxpayer triggered a buy-sell clause under the shareholders agreement that resulted in D.K. buying out the taxpayer’s interest. It was discovered that the minute book of 115 did not accord with the shareholdings of 115 as evidenced by the financial statements and ledgers of 115 and the corporate tax return information as filed.

The taxpayer’s lawyer considered that the minute book contained a clerical error and decided the easiest way to remedy it was to have the directors of 115 pass a resolution acknowledging the initial intent of the parties and issue additional share certificates totalling 99 common shares of 115 to each of the taxpayer and D.K. to correct the error. He testified on cross-examination that he did not seek a rectification order from a court having regard to the high cost of obtaining one, when all that had to be done was pass a simple resolution, which was done on 5 February 2005.

Reassessment

The taxpayer was reassessed to disallow the capital gains exemption of $182,638 claimed in his 2005 taxation year with respect to the sale of 77 of his common shares in 115 to D.K. The Minister took the view that 77 of the 78 shares sold by the taxpayer were not held for a period of 24 months prior to their disposition as required to qualify as qualified small business corporation shares under ss. 110.6(1) of the Income Tax Act.

TCC decision

The TCC judge, Pizzitelli J. allowed the taxpayer’s appeal, expressing “surprise” that the Crown pursued this case.

The Crown took a hard line, arguing that the minute book of 115 created in 28 November 1995, on its incorporation showed that only one common share was subscribed for by each of the taxpayer and D.K. As such, the additional 99 common shares issued to each of the taxpayer and D.K. on 5 February 2005 were not held for two years prior to the sale of the taxpayer’s shares to D.K. on the same date.

The definition of "qualified small business corporation share" is found in subsection 110.6 (1) of the Income Tax Act, the relevant portions of which reads as follows:


110.6(1) “...qualified small business corporation share" of an individual ... means a share of the capital stock of a corporation that ...”

(b)   “throughout the 24 months immediately preceding the determination time, was not owned by anyone other than the individual or a person or partnership related to the individual, and ...”

[12]   Paragraph 110.6(14)(f) of the Income Tax Act reads:

(f)   “shares issued after June 13, 1988 by a corporation to a particular person or partnership shall be deemed to have been owned immediately before their issue by a person who was not related to the particular person or partnership unless the shares were issued ...”

There is no definition in the Income Tax Act of what constitutes an issuance of shares for the purposes of paragraph (f) above. The TCC looked to the Ontario Business Corporations Act (OBCA) under which 115 was incorporated. Although there is no definition in the OBCA, ss. 139(3) creates a presumption that corporate records that exist at a particular time are proof of shareholdings. The TCC judge found that the taxpayer had successfully overcome this presumption, based on the following evidence:

  • 115 recorded the consideration received for 100 shares in the general accounting ledger of the corporation as testified by the accountant, whom the judge found highly credible;
  • 115 recorded the issuance of 200 common shares in its financial statements under shareholders’ equity beginning with its first financial year end; and
  • A schedule to the corporation's first filed tax return for the fiscal year ending 29 February 1996 stated that each of the taxpayer and D.K. had been issued 100 common shares.

In the TCC’s view, these were “substantial and sufficient corporate acts” to evidence the existence of the 100 shares right from the date of incorporation. The TCC went on to express “difficulty” with the Crown’s argument that the corporate records dealing with the initial issuance of one share to each of the taxpayer and D.K. were corporate records that spoke for themselves while the correcting resolution of 5 February 2005, should be ignored.

Conclusion

It is suspected that the Crown’s real concern in this case was to prevent what it considered to be retroactive tax planning (see, for example cases such as Steven Adam v. The Minister of National Revenue, 85 DTC 667). However, as the TCC judge pointed out, this was not a case of retroactive tax planning, given the clear evidence that of the intention to issue the 100 common shares upon incorporation.

This case demonstrates that where there is an error in corporate records, a rectification order may not be necessary, provided there is clear and consistent evidence of the parties’ intentions.


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