Does no death mean no inheritance?: Case involves 'pre-humous' sum of $3-million

National Post

2005-06-25


Just received an inheritance? Congratulations -- the bequest in your hands is
tax-free. But what if the inheritance is directed to you in advance of the
benefactor's death; would such an inheritance still be tax-free? That was the
question before the Tax Court of Canada in a recent case involving the
relationship between Peter Au and Paul Johnson, and an "inheritance" of more
than $3-million.

While a partner at the national accounting firm of Clarkson Gordon, Mr. Au
provided accounting services and tax advice to the Insurance Group, an insurance
company controlled by Mr. Johnson. The two men developed a "strong bond, a close
personal and business relationship" from 1980 through 1987.

In 1986, Mr. Johnson had serious concerns about his health and, according to
the testimony: "He was in need of a friend and confidant, competent in the
business world, who was likely to survive him and upon whom he could rely to
take care of his estate and family concerns after his death." Mr. Au fit the
bill.

After several requests by Mr. Johnson, Mr. Au left Clarkson Gordon in 1987 to
work full-time as an employee of the Insurance Group. In March, 1987, the two
men signed an agreement that later became the subject of the tax dispute between
Mr. Au and the Canada Revenue Agency.

The agreement provided for an annual salary, guaranteed bonus and car
allowance totalling more than $93,000, which was more than Mr. Au was drawing as
a partner of Clarkson Gordon. It also provided for a one-ninth interest in Mr.
Johnson's estate after both Mr. Johnson and his wife had passed away.

Mr. Au testified the promised one-ninth of the estate "was not a benefit he
considered in accepting the offer of employment" since at no time did he ask for
such a bequest, and he was already well-compensated for his services by the
salary package.

In 1996, the Insurance Group was sold to Royal Insurance for $78-million, at
which point Mr. Au was informed that his services were no longer required. Mr.
Au then contacted Mr. Johnson's lawyer, who advised him "that he had no claim
upon Mr. Johnson's estate."

After consulting a labour lawyer, Mr. Au then sued the Insurance Group for
wrongful dismissal, seeking damages for loss of employment and for breach of the
agreement to provide a one-ninth interest in the estate.

The parties agreed to mediation and settled the matter with two payments. The
first totalled just over $1-million plus costs, and Mr. Au proceeded to report
that amount in his 1998 personal tax return as employment income.

The second payment was just over $3-million, which Mr. Au did not report on
his return. This amount represented approximately 10% of the net value of Mr.
Johnson's estate in 1997 and was in lieu of Mr. Au being included as a
beneficiary under Mr. Johnson's will.

Mr. Au stated he did not report the $3-million on his return since it was
neither employment income nor business income, and therefore was essentially
akin to a tax-free inheritance, albeit received in advance.

The question before the court, therefore, was whether or not the March, 1987,
agreement, which stipulated the bequest from the estate, was a legally binding
contract of employment. If so, the $3-million settlement would be considered
akin to employment income and should be fully taxable. If not, it was more like
a tax-free inheritance.

After a detailed review and analysis of all the facts and evidence, the judge
rejected the CRA's argument that the $3-million bequest was paid to Mr. Au in
his capacity as an employee. Rather, the judge concluded, it "evolved from the
personal relationship between the two men and Mr. Johnson's desire to cultivate
their friendship and continued business relationship."

The judge concluded that since the interest in the estate existed
independently of Mr. Au's employment, the settlement amount was paid in lieu of
Mr. Johnson's bequest and was therefore tax-free.

The lesson to be learned from this case is to ensure any promises of future
inheritances are kept out of all employment and business documents. As the judge
wrote: "It is perhaps unfortunate that the communication from Mr. Johnson to
[Mr. Au] regarding his interest in the estate was often included in letters
about his employment." If they had been separate, the matter may never have
ended up in court.