The Tax Court of Canada recently released its decision in Twomey v. The Queen (2012 TCC 310) which addressed whether the taxpayer could claim the lifetime capital gains exemption on his sale of small business shares; in particular, the issue was whether he held those shares for at least 24 months as required under the definition of “qualifying small business corporation share”.
At its core, however, Twomey was more fundamentally about whether corporate records could be corrected ad hoc to be binding on third parties, such as the CRA, without the need for a rectification order.
Starting in 1994, the taxpayer and three other individuals were in the Heating, Ventilating, and Air Conditioning parts business and were operating through a corporation called Fortress Group Inc. All of the shares of Fortress were owned by a separate corporation (HoldCo) which was owned equally by the four individuals. In 1995, the taxpayer and another shareholder (D.K.) bought out the other two shareholders interest in HoldCo. For tax purposes, the transaction was accomplished by incorporating a new company (NewCo) that purchased the shares of the other two.
At that time, the taxpayer`s accountant instructed their lawyer to incorporate and organize a new corporation and to have the taxpayer and D.K., as equal owners, subscribe for 100 shares each for a total price of $200. During the course of the transaction, the acting lawyer decided that he was under a conflict of interest by acting for all four shareholders and engaged another lawyer, T.H., to organize the new corporation for the taxpayer and D.K. In organizing the new corporation, T.H. was unaware of the accountant`s instructions and issued only one share apiece to the taxpayer and D.K., not 100. The taxpayer and his accountants were always under the impression that he held 100 shares in NewCo.
Several years later, the taxpayer and D.K. had a falling out and the taxpayer triggered a buy-sell clause pursuant to their shareholders agreement which resulted in D.K. buying out the taxpayer`s shares in NewCo. The taxpayer was advised to use his lifetime capital gains exemption on the gains from 77 shares he owned, which saved him $182,638 in his 2005 taxation year. It was at this point that the taxpayer’s advisors noticed that the taxpayer’s had been issued only one share in NewCo and not 100 shares. This was an obvious problem for claiming the lifetime capital gains exemption on the 77 shares sold to D.K.
Rather than seek a rectification order to retroactively correct such errors, which is the normal procedure, their lawyer, T.H, passed a simple resolution on February 5, 2005 to amend the corporate records to provide that each shareholder held 100 shares each and not a share each.
The Minister disallowed the taxpayer`s claim for his lifetime capital gains exemption on the basis that he only owned one qualified small business corporation shares; or more specifically, that the taxpayer did not hold 76 of the 77 shares for at least 24 months prior to disposition. In other words, the Minister found that the resolution had the effect of issuing 99 newshares instead of correcting the previous error and, accordingly, determined that the taxpayer only owned one share for at least 24 months. Their view was that, if accepted, the resolution would amount to retroactive tax planning.
Taxpayer’s appeal was allowed – No Rectification Required
Pizzitelli, J. allowed the taxpayer`s appeal and held that the taxpayer was entitled to claim the lifetime capital gains exemption on gains realized on the sale of his shares. Pizzittelli, J. also held that the taxpayer was not guilty of any retroactive tax planning and that he was not required to seek a rectification order to correct an error in the corporate records.
The analysis began with s. 110.6(1) of the ITA and the definition of a “qualified small business corporation share” and, in particular, clause (b) – the 24 month rule. Pizzitelli, J. proceeded quickly to s. 110.6(14)(f) which requires that the shares were issued to the particular person. The ITA does not define “issue” or “issuance” and so the court looked to the Ontario Business Corporation Act (“OBCA”), where again there is no definition. However, what was relevant to the analysis was found in s. 139(3) of the OBCA which addressed the admissibility of records of a corporation into evidence, and read:
(3) The bound or looseleaf book or, where the record is not kept in a bound or looseleaf book, the information in the form in which it is made available under clause (2)(b) is admissible in evidence as proof, in the absence of evidence to the contrary (emphasis added), of all facts stated therein, before and after dissolution of the corporation.
The taxpayer argued that while the corporate records stated that he owned only one share, there was an abundance ofevidence to the contrary to rebut the record. In other words, while the share certificate said he owned one share, there was plenty of evidence that stated he owned 100 shares. The Minister argued that there was no “evidence to the contrary” without further corporate acts to substantiate the taxpayer’s intention. Pizzitelli, J. agreed with the taxpayer that the existence of a share certificate was not conclusive proof as to the veracity of the certificate in the presence of evidence to the contrary.
There was strong evidence that the taxpayer had always intended to own 100 shares. The taxpayer’s accountants had recorded consideration of $100 received for 100 shares in the corporation’s general ledger and recorded the issuance of 200 common shares in the financial statements under shareholder’s equity right from the very beginning. Furthermore, the corporation had consistently reported that each shareholder held 100 shares on the corporation’s tax returns.
Pizzitelli, J. went on to deride the Minister for proceeding with the appeal despite such overwhelming evidence. In his view, the corporate record was correctable by a simple resolution and that the February 5, 2005 resolution was a corporate act that reflected the intention of the corporation and its shareholders. He did not consider this to be retroactive tax planning.
The decision in Twomey is a fairly unique outcome. The Minister’s position in this case was consistent with its general approach in such matters, that in order to make a correction to a corporate record that is binding on third parties, such as the CRA, a rectification order issued by a Provincial superior court is required.
The Minister is currently within the 30 day limit to consider an appeal. It will be quite interesting to see whether the Minister decides to limit the implications of this case to the facts or proceed to the Federal Court of Appeal to ensure such amendments are done only by rectification order. Until more direction is provided, we would caution against using a simple resolution to correct corporate errors that have retroactive tax implications.
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