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A-15-74
Nathan Bernstein (Appellant)
v.
Minister of National Revenue (Respondent)
Court of Appeal, Ryan and Le Dain JJ. and Hyde D.J.—Montreal, March 9; Ottawa, May 16, 1977.
Income tax — Calculation of income — Companies —
Stock option benefits to employees Election re averaging Whether scheme for appropriating undistributed profits — Income Tax Act, R.S.C. 1952, c. 148, s. 85A.
The Minister, in re-assessing the income of the appellant, president of a corporation, denied him the right to apply the provisions of section 85A of the Income Tax Act, concerning stock benefits to the appellant as an employee of the company. The sum of $99,800 was thereby added to the appellant's income for the taxation year 1964. The Trial Division dismissed the appellant's appeal from this assessment.
Held, the appeal is dismissed. Although the judgment of the Trial Division might imply that an employee who was a con trolling shareholder could not qualify for the election provided in section 85A(2), this is not the case. All the factors surround ing the granting of the benefit by the corporation must be taken into consideration. When it is evident that the options were granted because the employees were shareholders, they cannot qualify.
INCOME tax appeal. COUNSEL:
Bruce Verchère and S. Sweibel for appellant. Alban Garon, Q.C., and Jean Paul Fortin, Q.C., for respondent.
SOLICITORS:
Verchère & Gauthier, Montreal, for appel lant.
Deputy Attorney General of Canada for respondent.
The following are the reasons for judgment rendered in English by
HYDE D.J.: Appellant (Bernstein) has appealed from a judgment of the Trial Division [[1973] F.C. 1305] which dismissed his appeal from his assessment for the year 1964 under the Income Tax Act, R.S.C. 1952, c. 148.
The dispute arises from the election by Bern- stein as to the manner in which a stock option benefit, amounting to $99,800, received by him in 1964 should be taxed as provided in section 85A of the Act. The arithmetic by which the contested tax is arrived at is not in question but only the right of Bernstein to make the election provided for in subsection (2) of section 85A.
Bernstein was both an employee and a share holder of Highland Knitting Mills Inc. (High-
land) in fact he was the President of the Com pany and beneficial owner of fifty per cent of its capital stock, the other fifty per cent being benefi cially owned by one Kamichik its Vice-President and Secretary-Treasurer.' Bernstein and Kamichik incorporated Highland in 1956 to take over their unincorporated partnership business of manufac turing and distributing knitted clothing—a suc cessful operation as indicated from its increase in sales from $350,000 in 1956 to $1,100,000 in 1964.
By a complicated series of transactions High land acquired 20,000 5% non-cumulative non-vot ing redeemable preferred shares of a wholly owned subsidiary corporation, Berkam Investments Lim ited (Berkam), at the par value of $10 each in October 1964. 2 On November 23, 1964 Highland gave Bernstein and Kamichik each the option to purchase 10,000 of Berkam preferred shares for the sum of $200 which option they each exercised on December 11, 1964.
' The record only shows Kamichik as Secretary-Treasurer but Stanley S. Rosan C.A., the auditor of Highland Knitting Mills Inc. and principal witness called by Bernstein at trial, during cross-examination on being asked what office he held in 1960 replied "I would imagine he was Vice-President, I think he was also Vice-President and Treasurer" (transcript p. 172).
2 As the various steps in this series are material to this case I give the Trial Judge's account [[1973] F.C. 1305 at pp. 1307-08]:
Some time in September 1964 they acquired the charter of a company known as Salbron Investments Limited which had been incorporated under a Quebec charter on December 2, 1963 but which had never commenced operations. Its author ized capital consisted at the time of 9,900 5% non-cumulative non-voting redeemable preferred shares of the par value of $10 each. They obtained supplementary letters patent dated September 11, 1964 increasing the capital by creating an additional 11,000 5% non-cumulative non-voting redeemable preferred shares of the par value of $10 each and changing
On December 14, 1964 Berkam redeemed these preferred shares so that Bernstein received $100,- 000 for an outlay of $200 or the substantial benefit of $99,800—the basis of the disputed assessment.
The issue on appeal is whether the stock option benefit received by the appellant is one contem plated by section 85A, and the appellant is, there fore, entitled to elect the special calculation of tax provided for by subsection 85A(2) ' .
the name of the company to Berkam Investments Limited, hereinafter referred to as "Berkam". At a meeting of High land on October 28, 1964 it undertook to subscribe for 94 common shares and 20,000 of the said preferred shares of Berkam at their par value of $10 a share and to pay for all these shares so subscribed for, as well as for the six common shares which had been allotted and issued to the three original applicants for incorporation. The company borrowed the money from its bank to pay for these shares, a cheque for $201,000 being issued by Highland in favour of Berkam, which cheque was dated October 26, 1964 but not date- stamped by the bank until December 4, 1964.
On November 23, 1964 Highland gave an option to each of Messrs. Bernstein and Kamichik to purchase from it 10,000 of the said preferred shares for the price of $200 and by letters dated December 11, 1964 they each took up this option and the same day a meeting of Berkam approved the transfer from Highland to them of the said shares. On December 14, 1964 Berkam approved a by-law providing for the redemption and cancellation of 20,000 of its said pre ferred shares. This was duly approved at a special general meeting of shareholders the same date and supplementary letters patent were obtained on December 16, 1964 confirm ing the reduction of the capital of Berkam by the cancella tion of the said shares so that the capital would thenceforth consist of 900 preferred shares and 100 common shares of the par value of $10 each. At all meetings of both companies from the time Highland acquired the shares in Berkam it was Messrs. Kamichik and Bernstein who attended and formed the quorum of directors or shareholders as the case may be. '85A....
(2) Where a benefit is deemed by paragraph (a), (b), (c) or (d) of subsection (I) to have been received by an employee by virtue of his employment in a taxation year, the employee shall, if he so elects, pay as tax for the year under this Part, in lieu of the amount that would otherwise be payable, an amount equal to the aggregate of
(a) the tax that would be payable by the employee for the year under this Part if no benefit were so deemed to have been received by him in the year, and
(b) the amount, if any, by which
(i) the proportion of the benefit so deemed to have been received that the aggregate of the taxes that would have been payable by the employee under this Part for the 3 years immediately preceding the taxation year (before making any deduction under section 33, 38 or 41), if no
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His original assessment of June 28, 1965 was made on the basis of this election but by notice of re-assessment dated June 25, 1969 he was re assessed and denied the right to make such elec tion so that the sum of $99,800 was added to his ordinary taxable income for 1964. He filed an objection but the re-assessment was confirmed and his appeal to the Federal Court was dismissed in the Trial Division—hence the present appeal.
The re-assessment was based on subsection (7)
of section 85A which reads:
85A....
(7) This section does not apply if the benefit conferred by the agreement was not received in respect of, in the course of or by virtue of the employment.
Appellant's principal attack on the judgment appealed from is directed against the reasoning [at page 1325] that:
... appellant and Mr. Kamichik were the sole shareholders as well as being bona fide employees and that in their capacity as sole shareholders of Highland they caused it to so act as to confer a benefit on them which, although stated to be conferred by virtue of their employment, was in actual fact received by them in consequence of their being able as sole shareholders of the company to so control its actions as to cause this benefit to be paid. It was not, therefore, received by virtue of their employment within the meaning of section 85A(7) but rather by virtue of their being shareholders of the company with the result that section 85A cannot be used in the case of appellant as an exception preventing the application of section 137(2) and section 8(1)(c) of the Act. The appeal is therefore dis missed with costs. [Underlining mine.]
Read out of context this might imply that an employee who was a controlling shareholder could not qualify for the election provided in subsection 85A(2) which I do not consider to be so. All the factors surrounding the granting of the benefit by the corporation must be taken into consideration.
One of these factors is certainly that Bernstein and Kamichik were the sole shareholders, each for one half. But that is not enough by itself given the
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benefit were deemed by paragraph (a), (b), (c) or (d) of subsection (1) to have been received by him in those years, is of the aggregate of the employee's incomes for those years minus the benefit deemed by paragraph (a), (b), (c) or (d) of subsection (1) to have been received by him in those years,
exceeds
(ii) 20% of the amount of the benefit so deemed to have been received.
fact that they were also the most important employees.
For reasons not explained while Bernstein and Kamichik each received salaries of $17,000 in 1963, in 1964 Bernstein's was $34,000 while Kamichik's was only $18,000, and still the stock option benefit was conferred on them equally.
Moreover, this transaction required the appro priation of a substantial part of Highland's earned surplus on which tax had been paid. Compared with a salary or bonus adjustment, which would have been a deductible expense to the company, it was from that point of view not in the company's interest but designed, taxwise, particularly tc favour the recipients. While it is true that Bern- stein and Kamichik had rendered most valuable services there were other employees who, if there had been no share control, might reasonably have been expected to participate in such an important employee benefit arrangement. For example Mr. Rosan (transcript p. 223) testified that there were three long-term employees who had been with Messrs. Bernstein and Kamichik since 1950 or earlier, before the business was incorporated, who in 1964 were receiving comparatively modest sal aries of $7,000 a year.
Furthermore, Highland was obliged to borrow from its bankers to provide the $200,000 it paid Berkam for its preferred shares which loan was repaid on January 8, 1965 with loans from Bern- stein and Kamichik of an equal amount against which they each received from Highland promisso ry notes of $100,000. Although these notes bore interest at 6% per annum, Mr. Rosan testified that this interest was waived by Messrs. Bernstein and Kamichik.
As subsection (7) of section 85A indicates, the exception provided for stock option benefits is that they be received as employees not as shareholders. That an employee may incidentally be a share holder does not disqualify him but when it is evident, as 1 believe it has been shown to be the case in this instance, that the options were granted because these employees were shareholders—in
fact the only ones they cannot qualify.
Obviously, the self-serving statement in the option agreement (Ex. Mc vol. I, p. 70) that the benefit is conferred on Bernstein "in respect of and by virtue of his employment" does not establish that as a fact. When one reads Rosan's testimony (particularly pp. 183 to 232) it is clear that the two partners did not want to take the surplus earnings out of the company through dividends in the normal way because of the tax impact and that this scheme was devised by Mr. Rosan, with legal advice, to accomplish indirectly what they did not wish to do directly.
I believe that the factors I have noted are suffi cient to show that appellant Bernstein does not escape the proviso of subsection (7) of section 85A.
I would dismiss this appeal with costs.
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RYAN J.: I concur.
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LE DAIN J.: I concur.
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