Case Commentary: Pitfalls When Paying Shareholder Dividends – Schonberger v. HMK, Section 160 Of The Income Tax Act

Introduction: Appeals to assessments under section 160 of the Income Tax Act

Helen Schonberger v. HMK was an appeal to the Tax Court of Canada ("Tax Court") heard jointly with the appeal of Tommy Schonberger. The two appeals were made in respect of the Notice of Assessments from the Canada Revenue Agency dated October 18, 2017. The CRA had assessed dividends received by Mrs. and Mr. Schonberger (collectively the "Taxpayers") from the corporation the Appellants jointly owned, Graycove Developments Inc. (the "Corporation") under section 160 of the Income Tax Act ("Tax Act"). The tax assessments found that the corporation owed $245,398, for which the CRA held the Appellants personally liable. The Appellants' appeal challenged the amount for which they were being held liable. Unfortunately, the Tax Court agreed with the CRA and dismissed the tax appeal with costs payable by the Taxpayers to the CRA.

Background: The dividends and liability

Each Appellant was a 50% shareholder in the Corporation, and they were the only officers and directors of the Corporation. The Corporation's income tax return for the taxation year ending February 28, 2014, showing a loss, was ultimately filed after January 5, 2016. The Corporation's loss from the 2014 taxation year was subsequently carried back to its 2011, 2012 and 2013 taxation years. Mrs. and Mr. Schonberger both received annual dividends from the Corporation. During the Corporation's 2010, 2011, 2012 and 2013 financial years, the Corporation declared and paid each shareholder a dividend of $107,500, $113,000, $113,250, and $65,500, respectively.

According to each Notice of Assessment dated October 18, 2017, the Corporation owed $245,398 for the Corporation's 2010, 2011, 2012 and 2013 taxation years. Additionally, from the tax assessments made by the CRA, Mrs. and Mr. Schonberger were liable under section 160 of the Tax Act because of dividends received during the relevant period from the Corporation. Thus, leading the two to appeal their reassessments.

The two appeals were heard at the same time and under common evidence.

The Issue in Dispute: Were the appellants correctly assessed under section 160

The core issue for the appeals was whether the CRA had correctly assessed the Appellants under section 160 of the Tax Act. Subsection 160(1) of the Tax Act provides as follows:

"Tax liability re property transferred not at arm's length

1. Where a person has, on or after May 1, 1951, transferred property, either directly or indirectly, by means of a trust or by any other means whatever, to
2. 1. the person's spouse or common-law partner or a person who has since become the person's spouse or common-law partner,
   2. a person who was under 18 years of age, or
   3. a person with whom the person was not dealing at arm's length,
      the following rules apply:
   4. the transferee and transferor are jointly and severally, or solidarily, liable to pay a part of the transferor's tax under this Part for each taxation year equal to the amount by which the tax for the year is greater than it would have been if it were not for the operation of sections 74.1 to 75.1 of this Act and section 74 of the Income Tax Act, chapter 148 of the Revised Statutes of Canada, 1952, in respect of any income from, or gain from the disposition of, the property so transferred or property substituted for it, and
   5. the transferee and transferor are jointly and severally, or solidarily, liable to pay under this Act an amount equal to the lesser of
   6. 1. the amount, if any, by which the fair market value of the property at the time it was transferred exceeds the fair market value at that time of the consideration given for the property, and
      2. the total of all amounts each of which is an amount that the transferor is liable to pay under this Act (including, for greater certainty, an amount that the transferor is liable to pay under this section, regardless of whether the Minister has made an assessment under subsection (2) for that amount) in or in respect of the taxation year in which the property was transferred or any preceding taxation year, but nothing in this subsection limits the liability of the transferor under any other provision of this Act or of the transferee for the interest that the transferee is liable to pay under this Act on an assessment in respect of the amount that the transferee is liable to pay because of this subsection."

There was no dispute in this case about whether the Corporation transferred property directly to each Appellant or whether the chronological sequence of dividends was sufficient to cover the Corporation's tax liability in or in respect of the taxation year in which the dividend was paid or any preceding taxation year. Nor was there any dispute about whether the Appellants were dealing at arm's length, as they were the sole shareholders of the Corporation. Thus, they were not dealing at arm's length for purposes of the Tax Act.

Position of the Parties: Correctness of the reassessments and caselaw

The Appellants put forth two arguments. First, that the underlying Corporation's reassessments were too high and that there ought not to have been a tax liability for which the Appellants were liable. Second, the Appellants argued that the ceded dividends, in the absence of the payment of any salary, was consideration that should not be considered a gratuitous transfer.

The CRA argued that the Appellants were correctly assessed for $245,398 according to section 160 of the Tax Act. As shareholders, each appellant received dividends from the Corporation totalling $399,250, for which the Corporation received no consideration. At the time each dividend was paid, the Corporation had tax liability arising under the Tax Act in respect of the relevant period totalling at least $245,398 for its 2010, 2011, 2012, and 2013 taxation years. Thus, considering the annual tax liability incurred in each given year that the annual dividend was paid, and the amount of the dividends paid, the Appellants were liable under section 160 for the $245,398 amount.

Evidence: Issues with the records and testimonies

During the appeal hearing there was testimony from three witnesses: Mrs. Schonberger, Mr. Schonberger, and the appeals officer for the CRA, Ms. Parry.

Mrs. Schonberger testified that she was a housewife with neither tax nor accounting training. Her role in the corporation was limited to assisting with decorations and fabric choices for model homes while handling family and home responsibilities to allow Mr. Schonberger to focus on their businesses. Her financial knowledge was limited, and she was unaware of the Corporation's financial details or dividends paid.

Mr. Schonberger confirmed through his testimony that he had over 40 years of experience in the construction business, building over 300 houses, and had been retired for 6-7 years. He confirmed that his role in the Corporation was to manage land development, construction, and sales. He acted as director, president, and secretary. Additionally, he and his wife took draws as needed, which were allocated as dividends by the accountant at year-end. He did not believe he was personally liable for corporate taxes as he considered dividends as payment for his work.

For financial management, Mr. Schonberger confirmed that he lacked accounting knowledge and instead relied on a bookkeeper and an accounting firm for the Corporation's bookkeeping and financial matters. Thus, the bookkeeper managed the books and accounting entries, and the accounting firm handled the financial statements and tax returns.

Furthermore, Mr. Schonberger claimed that the Corporation did not pay some suppliers and that the accounts examined in the reassessment were carried as payables for years until advised to take them into income. While Mr. Schonberger could confirm figures in statements, he provided no explanations for the numbers.

Ms. Parry's testimony confirmed that changes were made to the Corporation's 2010, 2011, and 2013 tax years to reduce overstated debts. She confirmed that these adjustments were related to accounts payable for suppliers and were made based on sufficient documentation for two suppliers. However, she received no additional documentation to support further adjustments related to other suppliers. Additionally, she confirmed that the reassessment recognized a loss from the Corporation's 2014 tax return, which was applied to the Corporation's 2011, 2012, and 2013 tax years, though with delays.

On cross-examination, Ms. Parry confirmed she reviewed specific amounts raised by the appellants, but not all of the taxpayer's information. She addressed objections raised by the taxpayer, relying on provided documentation, and did not review beyond specific objections. The Canadian litigation tax lawyer for the Appellants claimed that the final reassessments in the Appellants' or Respondent's Book of Documents, were not the actual final reassessments. Ms. Parry, however, asserted that they were the final reassessments.

Burden of Proof: The Taxpayers or CRA's onus?

The Tax Court briefly discussed where the burden of proof lies for showing that the underlying tax assessments are incorrect. Relying on the case of Manna v. The Queen, the Tax Court reiterated that the general rule is that a taxpayer bears the onus of establishing that an assessment or reassessment is incorrect, subject to an exception where the facts concerning the underlying assessments are exclusively within the knowledge of the CRA. In the latter situation, the onus will then be shifted to the CRA to show the correctness of the underlying assessment.

The Appellants failed to show that the burden was on the CRA. The Corporation was originally assessed tax under the Tax Act as filed and was reassessed following objections filed. The Tax Court found that the reasons raised by the Appellants for reconsidering the Corporation's reassessments under the Tax Act were closely linked to the position adopted by the Corporation on its income tax returns. The Tax Court found that this situation was not exclusively within the knowledge of the CRA. Thus, the burden remained with the Appellants to show that the underlying tax reassessments were incorrect.

The First Argument: Incorrect reassessments

Concerning the Taxpayers' first point, the Court accepted that the Taxpayers were allowed to legitimately challenge the underlying Corporation's reassessments for the 2010, 2011, 2012 and 2013 taxation years. The Corporation's action, or inaction, would not preclude the Taxpayers from doing so. The Tax Court clarified that the assessment must be challenged if a taxpayer believes the tax liability under the Tax Act is incorrect.

The Tax Court noted that the Corporation's income tax filing for the 2010, 2011, 2012 and 2013 taxation years was late. Income tax returns for all these years were filed after the financial statements for such years were prepared. The Corporation's position in the notice of objections it filed stated that each year the Corporation's income was overstated by amounts of accounts payable which were included in income which were not income received in the year.

The notices of objection were followed by discussions with the Appeals Division and written representations. The Corporation's representations essentially referred to a mistake in filing the returns for those years. That the accounts were originally liabilities of the Corporation which should have remained as such for financial and income tax purposes. The Tax Court found that the incorrect situation claimed by the Corporation then and the Taxpayers now originated from the Corporation's filing.

The Corporation's representations confirmed that it obtained verbal confirmation from several suppliers of the existence of their accounts payable. However, the Appellants only provided written evidence supporting two suppliers. The Corporation during the objection stage concluded that it would be reasonable to resolve the objection by reducing its income by $107,044.42, which was the amount linked to the two suppliers. The Appeals Division accepted that sufficient proof supported a review on that basis. Reassessments for the Corporation's 2010, 2011, and 2013, tax years would then be issued in 2014 to reflect the change with additional reassessments for the years being issued in 2016 and 2017 to reflect a carry-back loss from 2014.

The Tax Court was satisfied that the evidence supported the tax reassessments, and that no sufficient evidence from the Taxpayers was provided that could allow this result to be changed. The Tax Court was not convinced that the evidence introduced by the Taxpayers allowed it to conclude that the underlying reassessments or the total amount for which the Corporation was liable, were incorrect. The Taxpayers' arguments supporting the attack of the underlying reassessments largely relied on general statements and lacked evidence, facts, circumstances, details, information, and corroboration relating to each account payable. The Tax Court noted that Mr. Schonberger lacked the knowledge on this issue and the capabilities for him to elaborate on this issue before the Court was significant. Additionally, neither the Corporation's accountants responsible for preparing the financial statements, nor the Corporation's bookkeeper responsible for the Corporation's accounting entries, testified. The Tax Court concluded that no one involved in the treatment of the accounts payable of the Corporation testified.

The Taxpayers were unable to reverse the CRA's assumptions of facts that confirmed the Corporation's liabilities under the Tax Act and the 2010, 2011, 2012 and 2013 taxation years were reassessed on October 28, 2014 (for 2010), February 5, 2016 (for 2011) and April 20, 2017 (for 2012 and 2013). These reassessments were the final assessments for these taxation years and Taxpayers' inability to disprove them was fatal to their argument.

The Second Argument: Departing from precedence

The Appellants' second argument was based on asking the Tax Court to reconsider, for section 160 of the Tax Act, the absence of a salary for services performed as consideration given for the dividends. If accepted by the Tax Court, there would be no liability to the extent that the dividends were no less than the fair market value of the services rendered to the Corporation.

The knowledgeable Canadian tax litigation lawyer for the taxpayers recognized that this was a break away from a long line of cases about how the courts determined that the absence of a salary for services rendered was not consideration for section 160 of the Tax Act. The courts in previous cases have viewed the legal nature of entitlement to a dividend, and corresponding deprivation to the corporate payor, as a reason for determining that there was no consideration payable.

The Taxpayers argued that it might be time to revisit the question in light of the COVID-19 pandemic and the reaction of governments to the consequences of the pandemic which implemented supportive economic measures. Specifically, the Appellants referred to publications about the Canada Emergency Response Benefit and the Canada Emergency Business Account loans. The CRA expressly considered what qualifies as income for the benefits and recognized that amounts paid by a corporation to its owner-manager could include non-eligible dividends and considered employment or self-employment income. Additionally, in the Canada Emergency Business Account loans document "sole proprietors receiving business income directly, as well as family-owned corporations remuneration in the form of dividends rather than a payroll." The Taxpayers believed that this was recognition by the Government of Canada that, in small businesses, owner-managers remunerated themselves with dividends and payroll. The Taxpayers asked the Tax Court to find that the Government's recognition was a reason for departing from the long-established case authorities.

The Tax Court did not believe that the reasons submitted by the Taxpayers were sufficient to reconsider the long-standing position on dividends for purposes of section 160 of the Tax Act. The Tax Court does not see a change of position or policy from the legislature that could impact the existing wording of section 160 or the interpretation by the courts. Furthermore, under the doctrine of stare decisis, the decision of a higher court within the same jurisdiction acts as binding authority on a lower court within that same jurisdiction. Thus, the Tax Court was bound to the previous cases, which were made by the Supreme Court of Canada.

Additionally, the Tax Court recognized that the Taxpayers decided to receive income under a specific mechanism – the dividends. Different mechanisms may lead to the same result, but each mechanism has its own legal implications. Thus, the legal consequences must be applied because the Taxpayers chose to receive dividends. Therefore, the second argument failed too.

PRO TAX TIPS: Assembling a strong appeal

The Tax Court at several points throughout Schonberger v The King highlighted the inadequacy of records and testimony provided by the Appellants. Proper documentation and the ability to convey the appropriate information are essential for a strong tax appeal. An expert Canadian tax litigation lawyer would be able to advise you on these elements and highlight where the testimony of others would be beneficial to your appeal and of course, provide effective representation in your tax litigation case.

FAQ

Why is section 160 of the Tax Act significant?

Section 160 prevents taxpayers from avoiding tax liabilities by transferring assets to related parties. It ensures that tax debts are recoverable by holding both the transferor and transferee accountable for the tax owing on the transferred property. The tax liability incurred on the transferee from the section may occur in various situations. If a transferee is assessed under the section, then he or she should reach out to a Canadian tax lawyer for advice on challenging the tax assessment and underlying tax liability.

I currently receive dividends from a non-arm's length party, should I be concerned about liability under section 160 of the Tax Act?

Section 160 of the Tax Act should be considered before choosing to structure remuneration by way of dividends from a non-arm's length party, as it could result in tax liability. However, the risk of liability in any individual situation varies. It would be prudent to have a consultation with an expert Canadian tax lawyer to examine the risk in your situation and explore other possibilities to avoid unwanted legal implications.

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.