The Queen v MacDonald, 2013 FCA 110

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Surplus Stripping

The Queen v MacDonald, 2013 FCA 110

At issue was whether the payment on a debt instrument to a former shareholder, part of a series of transactions to wind up the corporation, is caught by subsection 84(2), so as to deem the capital gain to be a dividend.

The FCA held that The application of 84(2) is wide and looks past legal form of transactions to see if funds or property of a corporation find their way into a shareholder’s hands, even if they happen to pass through intermediary third parties and change in character to a debt repayment on a share sale.


This conclusion is entirely appropriate so as to prevent tax evasion by means of turning what would have to be taxable corporate distributions included as income (dividends) into capital gains.  However, this provision and this decision are not entirely satisfactory and better means exist so as to allow appropriate taxation of retained earnings of a corporation on share sales in circumstances where tax avoidance is foreseeable and probable.

For example, in case of closely held private corporations, a rule could be introduced to require a pro rata inclusion in income as dividends the portion of proceeds of a share sale that reasonably represent retained earnings of a corporation during the time a particular shareholder was a shareholder.  This rule would not differentiate between an arm’s length and a non-arm’s length purchaser, and would ensure that capital gains on share sales do not include retained earnings components.  Out tax system gives preferences to corporations so that they may operate to produce income and create jobs (in the form of lower tax rates and so on), but there is no reason to allow a shareholder to escape appropriate tax liability on corporate earnings that find their way to the shareholder, funded and made possible by the tax benefits granted by society to a corporation.


Dr. Mac Donald wanted to retire and wind up his professional corporation (“PC” of which he was sole shareholder, director, and officer) so as to gain access to the about $500,000 in cash it held.  On advice of his accountant, MacDonald initiated a series of transaction that involved the sale of the shares to MacDonald’s bother in law.

The bother in law first bought the shares from MacDonald personally (paying with a promissory note), then sold them to a numbered company he was sole shareholder of (in exchange for shares). The PC issued a dividend to the numbered company, and these funds were eventually used to pay off the note held by MacDonald for the original share sale.

The Crown reassessed MacDonald’s return, and applied subsection 84(2) so that the capital gain was deemed to be a dividend.

The TCC allowed MacDonald’s appeal and determined that subsection 84(2) did not apply because MacDonald received the funds in the capacity of a creditor and not shareholder. The TCC held that the subsection was not meant to cover payments arising as consideration for a share sale, but only applies to payments to persons who are shareholders at the time of the distribution.  The Court stated that the words “in any manner whatever” did not have the effect of altering to whom the dividend was paid.


The Crown argued that subsection 84(2) applies irrespective of the manner in which the Corporate funds find their way into the hands of a shareholder on the winding up of the Corporation.

Subsection 84(2) reads:

84. (2) Where funds or property of a corporation resident in Canada have at any time after March 31, 1977 been distributed or otherwise appropriated in any  manner whatever to or for the benefit of the shareholders of any class of shares in its capital stock, on the winding-up, discontinuance or reorganization of its business, the corporation shall be deemed to have paid at that time a dividend on the shares of that class equal to the amount, if any, by which

(a) the amount or value of the funds or property distributed or appropriated, as the case may be,


(b) the amount, if any, by which the paid-up capital in respect of the shares of that class is reduced on the distribution or appropriation, as the case may be,

and a dividend shall be deemed to have been received at that time by each person who held any of the issued shares at that time equal to that proportion of the amount of the excess that the number of the shares of that class held by the person immediately before that time is of the number of the issued shares of that class outstanding immediately before that time.

The Court took a purposive, contextual, and textual analysis of subsection 84(2), and determined that the relevant considerations include:

(i)               who initiated the winding-up, discontinuance or reorganization of the business;

(ii)             who received the funds or property of the corporation at the end of that winding-up, discontinuance or reorganization; and

(iii)           the circumstances in which the purported distributions took place.

The FCA looked at the decisions in Merritt v. Canada (Minister of National Revenue), [1941] Ex. C.R. 175, rev’d on other grounds [1942] 2 D.L.R. 465 (doesn’t matter that undistributed surplus of a corporation reached a former shareholder indirectly through a third party) and Smythe v. Canada (Minister of National Revenue), [1970] S.C.R. 64 (can’t use artificial transactions to distribute or appropriate to shareholder undistributed income of an old company), and distinguished it from McNichol v. Canada, [1997] T.C.J. No. 5  because in the latter case a bank loan was used to pay for the shares purchased (could not be said that any of the old companies funds found their way back to the shareholders).  However, in RMM Canadian Enterprises Inc. and Equilease Corporation v. Her Majesty the Queen, 97 D.T.C. 302, Justice Bowman recognized that the words “distributed or otherwise appropriate in any manner whatever on the winding-up, discontinuance or reorganization” the business of a corporation, are meant to cover a wide variety of ways that corporate funds can end up in a shareholder’s hands.  Bowman J stated that one must take a realistic view and not be fooled by the intervention of a Bank and another company (para 27).

The phrase “on winding-up” refers not only to a direct winding-up, but also to a course of events and transactions that are part of the winding-up process.  The FCA stated that it is an error to only look at the legal character of the various transactions in the series, and ignore that the series were transactions each of which were completed in contemplation of the other (all part of the winding-up) – this wide approach is required by the words “in any manner whatever”.

The Court concluded at paragraph 29 by stating:

[29]          In this case, at the end of the winding up, all of PC’s money (net of the $10,000 compensation to the accommodating brother-in-law) ended up through circuitous means in the hands of Dr. MacDonald, the original and sole shareholder of PC who was both the driving force behind, and the beneficiary of, the transactions. In my view, the only reasonable conclusion is that subsection 84(2) applies, as the Crown contends.

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