Why a business owner who paid himself dividends got into trouble with the CRA

National Post


Many retail investors are certainly familiar with the concept of dividend income, having received it either via direct ownership of publicly traded shares or, indirectly, through the ownership of mutual funds that flow dividends out to them. In these cases, dividends represent the investor’s share of corporate after-tax profits that a corporation has decided to distribute to its shareholders rather than retain for its own use.

But if you’re a business owner who owns an incorporated business, including a professional corporation, dividends are sometimes thought of as a form of remuneration. Consider a business owner who owns 100 per cent of the shares of their corporation. To extract funds from their business to live on, they can choose to pay themselves a salary or, as the sole shareholder, have the corporation pay them a dividend.

But a dividend is not legally considered remuneration, which can have severe implications for a business owner, as one Delta, B.C., taxpayer recently found out. The taxpayer, a chartered professional accountant and licensed insolvency trustee, was in Tax Court in September to challenge a Canada Revenue Agencyassessment under section 160 of the Income Tax Act.

Section 160, also known as the “joint liability rule,” gives the CRA the power to hold an individual liable for the tax debts of someone with whom they have a non-arm’s length relationship if they’ve been involved in a transaction seen to avoid tax.

“Non-arm’s length” refers to individuals who are related, typically blood relatives, spouses or common-law partners, as well as a corporation and its shareholders, and anyone else the CRA believes is factually not at arm’s length with each other.

Four criteria must be met for the CRA to successfully win a joint-liability assessment: there must have been a transfer of property; the transferor and the transferee must not have been dealing at arm’s length; there must not have been adequate consideration paid by the transferee to the transferor; and the transferor must have had an outstanding tax liability at the time of the transfer.

In the recent case, the taxpayer was reassessed in 2017 under section 160 for a transfer of property from his corporation to him in December 2015 at a time when the corporation had a tax liability owing. In this case, the transfer of property was in the form of dividends in the amounts of $140,500 paid to the taxpayer and $1,000 paid to his family trust. Both dividends were declared and authorized by a written resolution of the taxpayer, who was the corporation’s sole director and controlling shareholder.

At the time of the transfer, the corporation had a tax liability outstanding of nearly $110,000, representing the total federal and provincial tax owing, plus accrued interest. The issue to be decided by the Tax Court was whether the taxpayer should be held jointly and severally liable for the $110,000 of tax owed by the corporation pursuant to section 160.

In court, the taxpayer argued the dividends paid to him were in consideration for services he provided to the corporation as an individual licensed insolvency trustee. He maintained the dividends were paid to him personally to retain his services. “In today’s business world, dividends are a legitimate and valid form of remuneration for executives, key personnel and principals of a company,” the taxpayer testified.

Three of the four section 160 criteria listed above were clearly met, but the taxpayer and the CRA disagreed as to whether or not the taxpayer provided consideration (his services) for the property (the dividends) transferred to him by the corporation and, if so, whether the fair market value of that consideration exceeded the fair market value of the property transferred to him.

The taxpayer said the professional services he provided to the corporation were the consideration he provided to the corporation in return for the dividends. But this argument has failed in the past due to the inherent nature of dividends.

The Tax Court referred to a seminal 1998 decision of the Supreme Court of Canada that determined a dividend is related to shareholding and not to any other consideration the shareholder might have provided.

“A dividend is a payment which is related by way of entitlement to one’s capital or share interest in the corporation and not to any other consideration,” the Supreme Court wrote. “Thus, the quantum of one’s contribution to a company, and any dividends received from that corporation, are mutually independent of one another.”

In a prior case, the Supreme Court wrote, “To relate dividend receipts to the amount of effort expended by the recipient on behalf of the payor corporation is to misconstrue the nature of a dividend … (A) dividend is received by virtue of ownership of the capital stock of a corporation. It is a fundamental principle of corporate law that a dividend is a return on capital which attaches to a share, and is in no way dependent on the conduct of a particular shareholder.”

The taxpayer also attempted to argue that he reported the dividends on his personal income tax return and paid taxes on them, thus the dividends were akin to payment for his services. But the Tax Court judge disagreed, concluding the “declaration of a dividend is, in corporate law, an allocation of a company’s undistributed profits to its shareholders and does not depend on the conduct of a given shareholder.”

Since no consideration was given by the taxpayer for the dividends, the judge found the taxpayer to be jointly and severally liable for the tax owing under section 160 of the Income Tax Act.