written on behalf of Feigenbaum Law
Business owners, especially those who own 100% of their business, might not spend considerable time worrying about how they will pay themselves. Some might think that money flowing from the company to the owner is the same no matter what the mechanism is behind it. However, even those experienced in the world of tax and finance may be unaware of the pitfalls that await if a business owner pays themself in a way that allows their business to avoid tax liability. This was the situation in a decision recently issued by the Tax Court of Canada, Murphy v. The King, in which a business owner’s payment of dividends to himself was seen as a way to reduce his corporation’s tax burden. The case is an example of why working with a trusted tax and legal professional is crucial for your personal and corporate tax planning and compliance.
Business owner pays himself dividends
The taxpayer in Murphy v. The King was the sole shareholder of a corporation. The corporation owned a subsidiary through which the taxpayer operated an accounting firm. For simplicity’s sake, we’ll collectively refer to these entities as “the corporation.”
On December 21, 2015, the corporation transferred property (specifically dividends) in the amount of $140,500 to the taxpayer and $1,000 to his family trust. The transfer of these dividends was declared by a written resolution (by the taxpayer, as the sole director and shareholder of the corporation). When the transfer of dividends was made, the corporation had a tax liability owing to the Canada Revenue Agency (CRA). The amount due as of June 7, 2017, was $109,460.96.
The CRA took the position that the transfer of dividends was used to eliminate the corporation’s tax liability. The case’s central issue was the distinction between salary and dividends and the laws around non-arm’s-length dealings between parties.
Joint liability rule of the Income Tax Act restricts some types of transfers
The CRA took issue with the transfers, stating that they were in contravention of section 160 of the Income Tax Act (the Act). Section 160 sets out the joint liability rule, which extends tax liability to someone who receives a transfer of property (“the transferee”) if the transferor of the property has a non-arm’s-length relationship with the transferee and the transfer was seemingly done to avoid tax liabilities.
For joint liability to exist under section 160, the CRA must establish three criteria (in addition to showing that a transfer occurred). They are:
- The corporation has a liability under the Income Tax Act that remains unpaid;
- The corporation transferred property without adequate consideration; and
- The transferor and transferee are not dealing at arm’s length, which means there is a connection between the parties, such as family members, friends, or a corporation and its shareholders.
Taxpayer says dividends were provided in exchange for services
The Tax Court did not have to spend a significant amount of time to determine that a transfer did occur, that the corporation had a tax liability under the Income Tax Act that remained unpaid, and that there was not an arm’s length relationship between the taxpayer and the corporation. The only element subject to analysis was whether or not any consideration was provided for the transfer.
The taxpayer told the Court that the dividends he received were paid to him personally for the corporation to retain his services as an accountant. He further argued that in the modern business world, dividends are a “legitimate and valid form of remuneration for executives, key personnel and principals of a company.”
Dividends cannot be exchanged for consideration
The Tax Court explained that despite how dividends may be understood in common parlance, that definition cannot be extended in a legal situation. Even if the Court was to entertain the idea that the taxpayer provided consideration to the corporation in exchange for his dividends, and even if the services provided were equal to the fair market value of the dividends, the Supreme Court of Canada has ruled that dividends cannot be exchanged for consideration at all.
In its 1998 decision in Newman v. Minister of National Revenue, the Supreme Court of Canada wrote that a dividend is related to shareholding and cannot be given in exchange for any other consideration the shareholder may have provided. Instead, a dividend is an allocation of a company’s “undistributed profits” that are given out to shareholders. The conduct of a shareholder has nothing to do with their distribution. Canadian courts, including the Tax Court of Canada, have repeatedly affirmed this decision.
Given this established law, the Court found that the fact the taxpayer declared the dividends on his personal income tax return and paid tax on them had no bearing on whether they were paid in exchange for his services. Since the taxpayer gave no consideration for his dividends, he was declared jointly and severally liable for the corporation’s tax liability.
Feigenbaum Consulting Helps Toronto Business Owners Avoid Tax Pitfalls
Feigenbaum Consulting offers an unparalleled, multi-disciplinary approach to business and personal tax planning, including the creation of cross-border tax solutions for clients conducting business in Canada and the United States. Led by Mark Feigenbaum, a Canadian and U.S.-licensed lawyer and accountant, the firm helps clients lower their tax burdens, ensure compliance with tax laws, and avoid financial penalties. The firm’s skilled advocates also represent clients in tax litigation. Feigenbaum Consulting is located just north of Toronto in Thornhill and proudly serves clients across Canada, the U.S., and worldwide. To schedule a confidential consultation, contact the firm online or by phone at 905-695-1269 (toll-free at 877-275-4792).