The decision of the Tax Court in MacDonald earlier this year (2012 TCC 123) has prompted quite a lot of discussion among tax professionals. The case seems to take the debate about the legitimacy of dividend stripping to a new level. Specifically, the decision seems to say that steps taken to remove corporate surplus at less than taxable dividend rates are acceptable, provided the steps taken are legally effective and the tax provisions relied on are literally complied with. The current version of the Income Tax Act does not use the phrase “dividend stripping” and no section of the Act specifically defines it, or attaches adverse consequences to it when it does occur (however defined). Nonetheless, it is the CRA’s stated administrative position that dividend stripping is an unacceptable practice and may be countered by one or more of subsections 84.1, 84(2) and 245(2). (See Technical Interpretation 2012-0443421E5 (F) for a very recent example.)What is going on here? Quite a lot, actually.
In the days before the 1972 tax reform (yes that’s nineteen hundred and seventy-two, it’s not a typo), capital gains were not taxed at all, but corporate distributions (usually dividends) were. Tax professionals spent a good deal of time devising plans to realize on undistributed corporate income as capital gains rather than as dividends. In a paper to the 1961 Annual Conference of the Canadian Tax Foundation, H. Heward Stikeman outlined 12 ways in which this might be accomplished. In the face of this the Department of Finance had little choice but to amend the then Act, and amend it they did in 1963 by adding section 138A to give the Minister broad discretionary power to counter dividend stripping. The section was carried into the tax reform legislation of 1972 as former section 247, where it continued until its repeal in 1988 consequent upon the enactment of section 245, the general anti-avoidance rule (GAAR).
In the Department of Finance notes to the introduction of the GAAR, the point was made that the new rule made a number of the then anti-avoidance provisions redundant. Former section 247 was repealed on this basis. It was believed that abusive dividend strips could be handled under the new rule. It is worth noting that the heading to former sections 138A/247 was “Dividend Stripping.” To my knowledge, this is the only place in the tax legislation since the introduction of the 1948 version of the Act that the phrase has been used. It was not defined then, but generally was understood to mean the extraction of corporate surplus at less than the normal personal rates of tax. So, if one asked the question: “Is there a policy in the Act against dividend stripping” at any time up to the enactment of the GAAR in 1988, the answer would be: “Yes, see section 247.” This suggests the GAAR was intended, inter alia, to catch dividend strips that would have been caught under former section 247.
The MacDonald decision is provocative when viewed from this perspective. The court did not trace the history of the dividend stripping provisions as I have done here. It based its conclusions on the current wording of subsection 84(2) and section 245, and the observation that the Act offers taxpayers choices in the manner in which corporate surplus might be taxed. It inferred that if capital gains realized on the non-arm’s length sale of shares are to be taxed as dividends, more specific statutory language is required. It remains to be seen what the Court of Appeal will have to say about this. Pending that, it is interesting (to me, anyway) to speculate whether another specific anti-avoidance rule of some sort may be proposed to deal with dividend strips in pipeline-type transactions. Haven’t we been down this road before?