Tax Matters is a regular feature appearing every other month which is written by Brian Nichols of Goldman Sloan Nash & Haber LLP, Toronto. Brian Nichols practices law through Brian Nichols Professional Corporation
Michelle Kufsky ("Michelle") and her husband Allan Kufsky ("Allan") had a 35-year relationship with their accountant—until they sued him. The recent decision of the Federal Court of Appeal in Kufsky v. Canada, 2022 DTC 5046, sheds some light on Michelle's tax problems and why Mr. and Mrs. Kufsky sued their accountant.1
It started out as a common situation. Michelle owned all of the shares of Mon Refuge Décor Inc. (the "Corporation"). The Corporation carried on an active business which became insolvent.
Michelle testified that Allan was responsible for the accounting and tax matters. She did not work with the accountant. Allan testified that the accountant made many errors leading them to have the financial statements redone.
Michelle and Allan testified that they used the corporate credit card to pay for personal expenditures as well as business expenditures. The bookkeeper and the accountant would allocate the amounts charged to the corporate credit card between personal expenditures and business expenditures. This resulted in Michelle's owing amounts to the Corporation.
Michelle reported the following amounts in her tax returns:
2009 – nil
2010 – business income: $20,000
Interest income: $4
2011 – interest income: $4.13
As a result of the use of the corporate credit card to pay her personal expenses, Michelle became indebted to the Corporation. Subsections 15(2) and 15(2.6) of the Income Tax Act (the "ITA") provide in general that if an individual, who is a shareholder of a corporation, becomes indebted to the corporation in a particular taxation year, the amount of the indebtedness is added to the individual's income for the year unless the indebtedness is repaid within one year after the end of the year.2 One tried and true way for accountants to deal with subsection 15(2) exposure is to use dividends to repay the indebtedness of the individual shareholder to the corporation.
In July 2012, the accountant chose to deal with the subsection 15(2) exposure by late issuing T5's and by filing T1 Adjustments which purported to reflect the following dividends paid by the Corporation to Michelle:
2009 – $35,000
2010 – $15,000
2011 – $35,000
The Corporation did not prepare directors' resolutions authorizing the declaration of the dividends. The CRA reassessed Michelle in accordance with the late filed T5s. Michelle did not object to the reassessments and paid the additional personal taxes.
The Corporation filed amended T2 tax returns which resulted in a revised tax liability of the Corporation of $68,616.
On June 7, 2013, the CRA reassessed Michelle pursuant to section 160 of the ITA for this revised tax liability.3 The CRA applied section 160 on the basis that the Corporation had tax liabilities at the time it transferred property to Michelle in the form of dividends. The effect of section 160 was to make Michelle personally liable for the tax liabilities of the Corporation.
Michelle appealed to the Tax Court of Canada. When that appeal was unsuccessful, she appealed to the Federal Court of Appeal.4
At the Federal Court of Appeal, Michelle relied upon the following arguments:
- The dividends were invalid and void because:
- The Corporation was insolvent at the time the dividends were declared. Accordingly, subsection 38(3) of the Ontario Business Corporations Act prohibited the dividends; or
- The directors of the Corporation never declared the dividends.
- The amounts in issue were never paid to Michelle.
- Even if the Corporation paid the amounts at issue to Michelle, they were, in part, the repayment of an amount owed by the Corporation to Michelle for salary or management fees.
All three judges on the Federal Court of Appeal panel ruled against Michelle. Two of the judges (the "Majority') gave one opinion. The third judge (the "Minority") gave a second opinion which agreed with most of the first opinion, but differed in one important respect.
The Majority noted that Michelle had not objected to the reassessments of her 2009, 2010, and 2011 taxation years to include the dividends in her income. The Majority held that this precluded Michelle from taking the position, in contesting her section 160 assessment, that the amounts at issue were not dividends. I shall refer to this as the "Estoppel Argument". The Majority did not consider the consequences of the declaration of the dividends being prohibited by corporate law.
The Minority indicated that a dividend declared and paid contrary to applicable corporate law may still be a dividend for both corporate law purposes and for tax purposes. The Minority indicated that section 130 of the Ontario Business Corporations Act stipulates that directors who authorize a dividend contrary to the solvency test may be jointly and severally liable to repay the amount of the dividend to the corporation. Section 130 does not stipulate that the dividend is void or invalid.5
The Minority indicated that Michelle's failure to object to the 2009, 2010, and 2011 reassessments did not preclude her from challenging the section 160 assessment on the basis that the amounts in question were not dividends. However, the Minority found that Michelle did not meet the burden of proof to successfully challenge the Minister's section 160 assessment.
The Majority dealt with the second and third arguments raised by Michelle:
- Michelle argued that the dividends were not paid to her. The Majority ruled that the reduction in the amounts owed by Michelle constituted payment of the dividends to her.
- Michelle argued that the amounts in issue were not received by her as dividends, but instead were actually amounts payable to her as salary or management fees. The Majority held that the Estoppel Argument precluded her from taking this position. In any event, the facts did not support this argument.
This case is a reminder of the danger of using a corporate credit card to pay personal expenses and that tax advisors need to take the possibility of a section 160 assessment into account when doing subsection 15(2) planning.
It does raise an intriguing question as well. Suppose a corporation is insolvent but has met its tax obligations. Could it then use a prohibited dividend to deal with subsection 15 (2) issues?
There is one final unanswered question. The amount of the section 160 assessment was $68,616 plus interest. The cost of appealing to the Tax Court of Canada and then to the Federal Court of Appeal is many times this amount. Why did Michelle pursue her appeal all the way to the Federal Court of Appeal?
1. The lawsuit against the accountant has been settled.
2. A full discussion of subsection 15(2) of the ITA is complex and beyond the scope of this article.
3. Section 160 has been subject to recent litigation which has resulted in proposed statutory amendments. A discussion of section 160 and the proposed amendments is complex and beyond the scope of this article. I am assuming that the reader has a basic familiarity with section 160.
4. The decision of the Federal Court of Appeal refers to a voluntary disclosure which may have been made in an effort to reclassify the dividends as salary and management fees. It appears that Michelle did not achieve that result through the voluntary disclosure. A discussion of the voluntary disclosure is beyond the scope of this article.
5. The tax consequences of an action prohibited by corporate law is currently a live issue. In Mandel v. 1909975 Ontario Inc., 2020 DTC 5086 (ONSC), the taxpayer implemented an estate freeze. The taxpayer was concerned about possible future issues with the spouses of his children should his children encounter marital difficulties. Accordingly, the taxpayer purported to acquire a class of shares which could be converted into common shares in a way that would dilute the shares held by his children. When this resulted in reassessments pursuant to subsection 15(1) and paragraph 85(1)(e.2), the taxpayer took the position that his shares were never validly issued because subsection 23(3) of the Ontario Business Corporations Act required that the shares must be fully paid for. The taxpayer had not paid for the shares. The taxpayer applied to the Ontario Courts for a declaration that the shares had never been validly issued. Both the applications judge and the three-judge panel of the Ontario Court of Appeal declined to accept jurisdiction, holding that this matter ought to be resolved in the Tax Court of Canada.
A version of this article originally appeared in Tax Topics published by Wolters Kluwer.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.