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UBC Theses and Dissertations

The small business deduction and a Canadian tax on unreasonable accumulations Dent, Douglas Edward 1985

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THE  S M A L L B U S I N E S S D E D U C T I O N AND A C A N A D I A N UNREASONABLE ACCUMULATIONS  TAX  ON  By DOUGLAS B.A., LL.B.,  The  University  The  A THESIS  of  University  SUBMITTED  THE  EDWARD  DENT  B r i t i s h  of  IN  REQUIREMENTS MASTER  Columbia,  B r i t i s h  Columbia,  PARTIAL  FULFILLMENT  FOR  DEGREE  OF  THE  OF  LAWS  in THE  FACULTY  OF  GRADUATE  (FACULTY  We  accept to  THE  this  the  thesis  required  UNIVERSITY  OF  October (c)  OF  Douglas  STUDIES  LAW)  as  conforming  standard  BRITISH  COLUMBIA  1985  Edward  Dent,  1985  1972 1975  OF  In presenting  this  thesis i n partial  f u l f i l m e n t of the  r e q u i r e m e n t s f o r an a d v a n c e d d e g r e e a t t h e U n i v e r s i t y o f B r i t i s h C o l u m b i a , I a g r e e t h a t t h e L i b r a r y s h a l l make it  freely  a v a i l a b l e f o r r e f e r e n c e and s t u d y .  agree t h a t p e r m i s s i o n f o r extensive for  s c h o l a r l y p u r p o s e s may  for  financial  of  *\.AoU  The U n i v e r s i t y o f B r i t i s h 1956 Main M a l l V a n c o u v e r , Canada V6T 1Y3 Date  DE-6  n/fin  Oct *s  -  i j. *  Columbia  my  It is thesis  s h a l l n o t be a l l o w e d w i t h o u t my  permission.  Department  thesis  be g r a n t e d by t h e h e a d o f  copying or p u b l i c a t i o n of t h i s  gain  further  copying of t h i s  d e p a r t m e n t o r by h i s o r h e r r e p r e s e n t a t i v e s . understood that  I  written  i i  ABSTRACT  In  its  treatment  of  Reform,  the  government  achieve  the  ephemeral  such  neutrality  in  as  implementing  controlled provide  such  a  the  theory  (or  other  the  in  the  ability  thesis  validity  business fact  of  through  exist)  of  to  entrepreneurial  the  funding  but  this  role  a  there  is  presently  funds  made  the  one  no  available business  purported  goal  of  of  control to  to  this  only  to  justifies on  concessions  to  f u l f i l  what  its  in  reduce  business,  would  is  seen  traditional  economy.  not  attempt  a  to  assistance  (assuming  that  potential  (apparent)  mechanism  tax  to  imperfections  be  does  are  was  business  tax  small  to  on  but  alleged  to  incorporated  deduction" of  special  providing  its  small  business  measures  —  wisdom  to  are  focuses  aspect  intention  bu s i n e s s  Canadian  policy  rather  Canadian-  of  herein  concepts  for  business  the  f i s c a l  in  "small  in  to  to  deduction"  Conventional  theory  proposed  inherent  the  small  attempt  contrary,  stated  available  Tax  the  small  which  of  On  its  small  time  to  adherence  assistance  for  the  not  equity.  business  absence  markets,  adherents  The  the  assistance)  the  strict  to  at  chose  horizontal  providing  that  day  business.  of  significantly  by  of  assistance  capital  limit  goal  business  corporations  small  policy  the  "small  private  incorporated  of  and  the  "direct  "small"  to  small used  it  credit,  to  small  does  in  inefficiency  implementation: ensure business  in  assess  that  through  furtherance i.e.  the  of  "direct  i i i  assistance thesis  to  small  that  the  unreasonable tax  would  restoration  accumulations  of  to  is  suggested  some  replace  form  the  pressure  upon  private  corporation  in  of  benefits  deduction  towards  have  their  the  corporations  available stated  failed  to  of  small  object.  Such  a  reinvest  the  Part  guiding  of  on V  Canadian-  the  function  this  tax  the  through  complementary  which  terms  in  departed  appropriate  deferral  of  It  provide  controlled  course,  business."  the  tax  business  tax  would,  depriving deferral  of  those  benefits  same.  Chapter defines  one  its  basic  foundation  for  unreasonable reviews would the  the  have  of  exploring  relevant to  be  such  lessons  chapters  four,  five  tax  which form:  experiences  in  American  to  the  form  in  fact  take  chapter  eight  as  were  contains  offer  found  this  chapter  five  looking  seven on  to  be  some  reviewing  analyses  the  unreasonable instituted  conclusions.  of  on in  at  its  the  British  p o s s i b i l i t i e s  Canada.  of  Canadian  accumulations in  tax  realm,  expression  area,  six  a  variations  with  chapter  two  interest  in  a on  aspects  dealing  tax  it  the  specific  already  such  considers  might  tax  chapter  four  Chapter a  a  which  In  and  laying  chapter  and  which  three  examine  of  that  into  tax.  history six  means  topic  desirable,  context  a  have  this  example  manifestation.  such  and  be  Chapter  for  a  the  suggestion  may  statutory  placed.  legislative  introduces As  the  accumulations  learning  a  thesis  parameters.  justification  such  the  as  might  Finally,  iv  TABLE  OF  CONTENTS  Chapter  1. 2. 3. 4. 5. 6. 7. 8.  S t a t e m e n t of the P r o b l e m The S t a t u t o r y Context The R a t i o n a l e f o r a Tax on U n r e a s o n a b l e The C a n a d i a n E x p e r i e n c e The A m e r i c a n E x p e r i e n c e The B r i t i s h E x p e r i e n c e A Tax on U n r e a s o n a b l e A c c u m u l a t i o n s f o r The Form I t M i g h t T a k e Conclusions Bibliography  Page  Accumulations  1 10 26 51 61 85  Canada: 115 136 141  1  SMALL BUSINESS D E D U C T I O N A N D A C A N A D I A N  TBI  UNREASONABLE  "Once the decision is made to tax a separate entity, the virtually insoluble achieve total neutrality ... is posed."^  Chapter  Statement  In  this  thesis,  accumulation" of  that  rate  by  a  portion  w i l l  be  of  the  context  of  becomes  "unreasonable"  business  the  of  Reference concepts  of While  varying  shades to  the  profits It  when  it  corporation as problem of how  a to  Problem  problem  taxed  w i l l  business  the  corporation  small  suggested  deduction, is  "unreasonable  private at  be  of  not  business  that  an  in  the  accumulation  reinvested  in  the  corporation.  w i l l  be  made  neutrality,  equity.  ascribed  small  the  of  potential  examined.  ON  1  Canadian-controlled its  TAX  ACCUMULATIONS  these of  them  herein  horizontal  to  equity  terms  are  obviously  meaning,  for  present  in  the  Report  of  the  the  very and  capable purposes Royal  basic vertical  of  carrying  the  meanings  Commission  on  1. J.E. Hershfield, "Is a Small Business Credit a Tax Expenditure," Canadian Taxation (Winter, 1979), pp. 51-53 at p. 5 2 .  2  Taxation used. does  2  chaired  Thus, not  sector  the  compared  place  Neutrality  is  the  taxation  change  as  market  a  by  system  to  to  the  of  said  in  desirable  LeM. to  be  Carter  w i l l  be  neutral  when  it  resources  allocation  produce be  Kenneth is  allocation  would said  late  which  the  in  the  absence  the forces of  private of  taxes.  equity  exists  equity  exists  to the and of  when:  ... individuals circumstances bear Vertical  3  because:  the allocation of resources in response free market forces w i l l in general give in short run the best u t i l i z a t i o n of resources, in the long run the most satisfactory rate i n c r e a s e i n the o u t p u t of the economy.^ Horizontal  the  and families t h e same t a x e s . r  in  similar  when:  . . . those in different circumstances bear appropriately different taxes. . . . . vertical equity is achieved when i n d i v i d u a l s and families pay t a x e s t h a t a r e a c o n s t a n t p r o p o r t i o n of their d i s c r e t i o n a r y economic power.^ In  the  view  fundamental from  the  of  the  importance  Commission's  Carter -  as  Commission, seen  in  the  equity following  was  of  passage  Report:  If e q u i t y w e r e n o t o f v i t a l c o n c e r n t a x e s w o u l d be unnecessary. The state could simply commandeer what it needed. . . . . Unless the allocation of the burden is generally accepted as fair, the social and p o l i t i c a l fabric of a country is w e a k e n e d a n d c a n be destroyed.-,  2. This paper w i l l f o l l o w t h e common p r a c t i c e of referring to the Commission i t s e l f as the Carter C o m m i s s i o n and the r e p o r t of the Commission as the C a r t e r Report. 3. Canada, Report of the Royal Commission on Taxation (Ottawa, Queen s P r i n t e r , 1 9 6 6 ) , v o l . 2 , c h a p t e r T~, p~! 8~T 4. Loc. c i t . 5. Op. c i t . , v o l . 1 , p. 4 . 6. Op. c i t . , v o l . 1 , p. 5 . 7. Loc . c i t .  3  When  using  equity,"  terras  the  context  immediately  obvious  that  If  of  the  in  the  use  income  source  insofar  as  -  providing other  one  a  manifestation  where  of  in  incentive  of  a  source  shareholders  and  disadvantage  concerned income  when  source  or  an  policy  insofar  as to  compared  source  which  the  of  does  i n the  of  result  provided  the  of the  taxation  of  course,  would  occur  between  shareholder  neither  incidence ownership  individuals.  of of  by  business;  in a  neutrality  would  taxes  a  Conversely,  the  not  private  the forces  absence  owner,  an  circumstances"  a s an i n t e r m e d i a r y  or  by  "inequity" i n turn resources  direct  by a n i n d i v i d u a l  advantage  when  "similar  neutral.  corporation,  compared  shareholder  for incorporating  i t s indirect  of that  an  income  " i n e q u i t y " would  n o t be  intertwined.  horizontal equity  allocation  t h e use of a c o r p o r a t i o n  income  nor  then  produce  would  the  i t i s  between  provides  same  This  this  taxation,  intermediary  to the a l l o c a t i o n  fiscal  which  that  "horizontal  closely  owner,  taxes."  would  words,  an  in essentially  the  as compared  as  and  of tax i s concerned  of  t h e same  place  are very  corporation,  individuals,  change  market  system  that  individuals  to  sector  in  or  corporate  i t s indirect  ownership  not "bear  tend  they  the incidence  individual  do  of  direct  exist  of  corporation  and  shareholders  to  a  "neutrality"  an or  advantage tax that  was same  4  In g  its  treatment  of  Reform  the  government  achieve  the  ephemeral  such  neutrality  in  as  implementing  controlled "direct  the  private  assistance  and  "small"  of  the  goal  of  day  chose  strict  horizontal  "small  small  its  at  the  not  time  to  adherence  equity.  business  corporations to  business  of  attempt to  Tax  to  concepts  On  the  contrary,  deduction"  for  Canadian-  intention  business"  -  was but  to  provide only  to  9 incorporated assistance only  in  to  small small  public  business. business  This -  pronouncements  policy  assuming but  also  that in  of it  providing exists  not  substance  (as  8. This paper w i l l f o l l o w the common p r a c t i c e of referring t o t h e p r o c e s s c o m m e n c i n g w i t h t h e c r e a t i o n of t h e The Royal C o m m i s s i o n on T a x a t i o n and t e r m i n a t i n g w i t h the passage of t h e Income Tax A c t of C a n a d a , S . C . 1 9 7 0 - 7 1 - 7 2 , c . 6 3 , as Tax Reform. 9. Honourable E.J. Benson, M i n i s t e r of Finance, Summary of 1971 Tax R e f o r m L e g i s l a t i o n , O t t a w a , Queen's Printer, 1971, p. 3 7 . T h i s r e s t r i c t i o n of the s m a l l b u s i n e s s d e d u c t i o n to incorporated small business was apparently based upon the f a c t t h a t the f i n a n c e s of the c o r p o r a t i o n are (or should be) clearly segregated from those of its shareholders whereas t h o s e of the s o l e p r o p r i e t o r would not n e c e s s a r i l y be. The advantage from the government's perspective of segregated finances was apparently that this state of affairs would f a c i l i t a t e the use of the c u m u l a t i v e d e d u c t i o n a c c o u n t as a device for t a r g e t i n g the small business deduction to "small" business. (See on this point: Kathleen A. Lahey, "The Small Business Credit: A Tax Expenditure Analysis," Canadian Taxation (Summer, 1979) pp. 29-34 at p. 30.) In h i s budget s p e e c h , the M i n i s t e r of F i n a n c e commented t h a t it had been h i s "hope t h a t a s y s t e m m i g h t be d e v e l o p e d t o aid unincorporated as well as incorporated business" but that " a l l the proposals were found to be unworkable. (See: Canada, Parliament, House of Commons, O f f i c i a l Report of Debates, 3rd Session, 28th Parliament, Ottawa, Queen's P r i n t e r , v o l . VII, 1 9 7 1 , p. 6897.)  5  appears this  to  be  the  country.  regime  which  Honourable  belief  In the  -  not  a  the  Minister  implementation  wisdom  that  absence  in  the  assistance)  for  corporate  tax  deduction"  replaced,  the  of  as  i.e.  in  established  large small  of  Finance  being  biases  the  a b i l i t y  adherents  special  towards firms  at  that  motivated  time, by  the  to  a  this  policy  tax  away  low  from  biases to  to  theory  (or  other capital  investment risk  alleged  in  to  i t s  what  new  reduce  business,  f u l f i l be  the  the  risk  small  to  in  greater  are  business theory  on  concessions  imperfections  available  small  be e n c o u r a g e d and . . . to lower the tax and they need for growth  relatively  and  which  funding of  such  business  businesses,  significantly the  j u s t i f i e s  small  markets,  by  in  that:  Conventional  limit  development  rate  . . . small businesses should a useful way to do t h i s is take less out of the funds and expansion.JJ  and  recent  dual  business  Abbott,  its  is  announcing "small  D.C.  described  case)  is  would seen  traditional  12 entrepreneurial  role  in  the  Canadian  economy.  10. See below at pp. 31 36 f o r discussion regarding the evidence, as manifested in the small business deduction, tending to establish that such a policy does, in fact, exist. It should be n o t e d a l s o , h o w e v e r , t h a t the contrary has been asserted by, inter a l i a , J.E. Hershfield in an a r t i c l e entitled "Is an U n i n t e g r a t e d Corporate Tax Regime a Small Business Subsidy?" which appeared in Canadian Taxation (Winter, 1979) at pages 5 1 - 5 3 and W o l f e D. Goodman in an a r t i c l e entitled "The Small Business Credit: A Critique of the Proposed Changes" which appeared in Canadian Taxation (Summer, 1979) at pages 38-39. 1 1 . C a n a d a , P a r l i a m e n t , House of Commons, O f f i c i a l R e p o r t of Debates, Ottawa, Queen's P r i n t e r , vol. 2 , 1 9 4 9 , p. 1 7 9 8 . 12. This view is most clearly articulated in the Carter Report, vol. 4, pp. 271-272, but is implicit in the s t a t e m e n t s of M e s s r s . A b b o t t and Benson found above.  6 The the  thesis  validity  proposed  of  the  business  through  does  fact  in  inefficiency  exist)  it  the  assistance  When 1972,  of  the  the  there  towards  its  made  to  business goal  small  control  goal.  These  1. Part V ineligible  of  it  potential  its  (apparent) mechanism  incorporated  deduction" this  small  that  a  control to  of  to  assuming on  assess  are  tax  to  small  used  credit,  in i.e.  business."  business  two  aspect no  to  assistance  focuses  available  purported  attempt  (again,  presently  "small  small  were  one  is  not  providing  rather  in  funds  through  furtherance "direct  but  there  the  of  does  measures  inherent  that  business  policy  f i s c a l  implementation: ensure  herein  deduction devices  came  which  into  force  sought  to  in  direct  were:  tax a refundable investments; and  tax  in  respect  of  2. the "total business limit" which terminated e l i g i b l i t y for the " s m a l l business d e d u c t i o n " when "retained e a r n i n g s " ^ reached $400,000. The  Part  V  tax  was  repealed  shortly  after  coming  into  force 14  with It  its  was  limit  never remained  1984. size  repeal  At to  the  having  application  replaced. a  part  time  of of  The the its  retroactively  concept small  of  the  business  disappearance,  to  total tax it  1972. business  system had  until  grown  in  $1,000,000.  13. Retained earnings that i s as d e t e r m i n e d by t h e formula prescribed by the Income Tax Act of Canada (paragraph 1 2 5 ( 6 ) ( b ) ) d e f i n i n g the c o n t e n t of the " c u m u l a t i v e deduction account". To equate the cumulative deduction account to r e t a i n e d e a r n i n g s i s , of c o u r s e , to s i m p l i f y i n the extreme, but f o r p r e s e n t p u r p o s e s such a d e f i n i t i o n seems a d e q u a t e . 14. S . C . 1973-1974, c. 14, s. 6 0 .  7  It  is  explored of  the  for  in  fiscal  it  -  as  new  suggested,  opposed  the  be  of  is  certain  that  need.  accumulations  target  of  to  replace  the  small  of that  and,  if  corporate  such  method,  some the  source  gains  in  the  business  submitted  capital  of  need  assisting  potential  One  a  guiding  small  reduction  restoration  of  further  be  elimination  the  a  w i l l  created  method  providing It  that  has  through  proposed  the  i t s e l f ,  alternate  tax  intensify  would  in  which  thesis)  intended  to  from  reasons  this  investment.  law,  unreasonable  an  their  exemption  greatly  of  available  passive  becomes  (for  limit,  of  towards  for  rates  business  advantages  business  herein  three  development  deduction  the  chapter  total  the  funds  submitted  form  of  departed  tax it  is  tax  on  Part  V  tax .  From has  been  "small  the  inception  the  intention  business"  reinvested appears the  to  small  of  the  of  a  in have  its  deduction  business  funds  made  through  corporation's  business  measure  that  corporation  retained  business  total new  the  of  status  available this  business. as  the  to  ensure  enactment that  the  device  be  That  the  it  to  policy  justification  notwithstanding  l i m i t . T h e  designed  deduction,  for  elimination at  only  this  time  businesses  15. Statements to t h i s effect c a n be f o u n d i n t h e two most recent federal budgets. See: Honourable Marc Lalonde, Minister of Finance, S i m p l i f y i n g Taxes For Small Business, Canada, Department of Finance, Ottawa, Queen s Printer, 1 9 8 4 , a t p. 1 and The H o n o u r a b l e M i c h a e l H. W i l s o n , Minister of F i n a n c e , The C o r p o r a t e Income Tax System A D i r e c t i o n for Change. Canada, Department of Finance, Ottawa, Queen s Printer, 1 9 8 5 , a t p. 2 5 .  8  f i t t i n g be  within  given  the  deduction its  mere  in  of  to  prove  view  the  of  "another"  definition  benefit  to  of  total  restoration  merely  arbitrary  right  might  form,  concept  some  be  the  this  latter  of  of  l i m i t ,  a  the  term  small  the  it  be  and,  government  Whatever  repeal  could  device  "small" business  d i f f i c u l t .  recentness  business  example  from  p o l i t i c a l l y  the  of  of  the  seen  as  thereby,  "retreating"  a as  on  its  16 policy the  i n i t i a t i v e s  other  designed for  hand, to  policy  presumably  such  ensure  business  legislative  no  -  device  would  seem  complaint  that  purposes  a  policy  was  designed to  be  an  in  unpalatable could of  be  made  making  successfully to  As  of  a  funds  On measure  available  implemented.  encourage  order.  option.  one  attainment  of  author  put  has  A that the  matter: ... as the total business limit increased [sic], the application of a low rate of corporate tax becomes less acceptable without further target controls, such a a Part V-type tax.^j If of  an  increase  some  form  acceptable," whatsoever  in of a  makes  the tax  total on  f o r t i o r i , the  case  business  limit  unreasonable the for  absence such  a  makes  the  accumulations of tax  any very  such  absence "less limit  compelling  indeed. 16. "Another" in the sense that the government was recently a c c u s e d of "retreating" when i t decided to drop its budget proposal of "de-indexing" pensions. See f o r example: The Financial Times (Canada), vol. 74, no. 2, July 1, 1985, p. 1. W h i l e t h e e l i m i n a t i o n of t h e t o t a l b u s i n e s s l i m i t was originally suggested i n the 1984 Budget of Mr. Lalonde, in the final analysis it was the new C o n s e r v a t i v e government w h i c h a c t u a l l y p a s s e d t h e l e g i s l a t i o n d o i n g away w i t h i t . 17. J.E. Hershfield, "Is a Small Business Credit a Tax Expenditure," Canadian Taxation ( W i n t e r , 1979), pp. 5 1 - 5 3 at p. 5 3 .  9 As  a  means  of  suggestion  that  a  desirable,  chapter  tax two  context  into  Chapter  three  such  tax.  In  might  offer  a  history six  w i l l  which w i l l  examine  have  already  found  four  dealing  with  five  looking  reviewing analyse  its the  unreasonable instituted some  in  laying  at  on  a  unreasonable  w i l l  such  review  a  consider the  foundation  tax  interest in  this  specific  the  British  of  as  accumulations  might  conclusions.  to  Finally,  be  such  and  a  fact  chapter  five tax  take eight  and which  chapter  chapter  six  seven  which  as  chapter  area,  Chapter form  for  lessons  form:  example  be  placed.  four,  this  in  may  statutory  such  in  the  the  justification  on  manifestation.  p o s s i b i l i t i e s  Canada.  the  to  legislative  experiences  American  have  chapters  variations in  relevant  learning  realm,  expression Canadian  the  of  exploring  accumulations  would  aspects  for  a  were w i l l  w i l l  tax it  to  on be  contain  10  Chapter  The  As would  a  prelude  seem  upon  which  to  -  at  the  build least  that  As  a  of  the the  significantly  Tax  Act  of  of  force  on  a  statutory  The the  summary  w i l l  be  amendment,  providing of  that  fashion  -  a  the  it  foundation  amendment, context  inserted.  activities canvassing  of  its  modified  of  our  1,  of  into  Act  the  This  the  the  to into  chapter  As  these  private  point  of  which  of  be  for  is  which  taxation  the  taxing  came  form  the  corporation,  proposed  Income  finally  amendments  for  regime  corporation to  Reform  departure it  opinion  amendments  system  Commission  private  Tax  present  Carter  public  from  1972.  accumulations  Tax  of  report,  when  resulting  January  context  Income "Act."  of  Canadian-controlled  convenient  unreasonable  1. as  means  Canadian-controlled  provides  legislative  structure  a  the  Canada^  framework  the  of  the  was  basic  in  release  to  a  the  extensive  applicable  into  as  a  foundation.  result  followed  Context  proposing  amendment  constitutes  and  Statutory  appropriate,  which  describe  to  2  income  this  describing that  a  the  date the  tax  on  referred  to  placed.  Canada  is  hereinafter  11  The  taxation  corporation  which  independent  without  rather  was  but  Thus,  whatever first  gains  the  of  half  50%  declining  when  it  reached  At envisaged  its four  source,  the  its  one  so per  present  cent rate  the  seemingly  distinct  private  1.  active  2.  business  3.  property;  4.  capital  3  -  each of  46%.  "new"  was  those  in  rate  year  to 2  an  of  the  tax  in  (capital  that  i n i t i a l l y  not  provisions.  assessed  exception  inception,  Canadian-controlled  to was  private  provisions  corporate  taxed)  the  1972  other  it  f u l l an  was  at  to  to  in  supplementary  at  thereof  effect  relation  course,  taxable  applicable  into  income  instance  being,  but  came  code  Act,  the  scheme  only pegged  through  to  the at 1976  4  legislative  "income"  sources^  scheme for  the  corporation:  business; other  than  active  business;  and gains.  2 . The A c t , s . 1 2 3 . 3. Technically and l e g a l l y , of c o u r s e , i t i s not a c c u r a t e in the Canadian context to call a capital gain a "source" of "income" but for present purposes the technical and legal distinction between a capital gain and income w i l l be ignored. 4. This thesis w i l l adopt the common p r a c t i c e of assuming the combined f e d e r a l and p r o v i n c i a l t a x r a t e t o be e q u a l to the federal rate as it would be were it not for the abatement in respect of t a x a b l e income earned i n a province provided f o r i n s u b - s e c t i o n 124(1) of the Act. 5 . As a r e s u l t of t h e i n t e r a c t i o n of s e c t i o n s 125 and 129 of the Act.  12  In  keeping  of  corporate  feature  with  of  In  and  this  this  controlled  principle  personal  new  system,  would  accurately, deduction"  of  neutrality,  income  tax  was  "integration"^  to  be  an  important  the  Canadian-  scheme.  private  business"  The  the  only  of  its  from  an  "assistance"  provided  reduced  which  derived  the  credit)  which  income  corporation receive  tax  principle  the  by  the  effective  integration  (or,  "small  tax  was  "active more business  rate  preserved  to  25%.7  in  this  g situation  in  corporation tax  paid  that  to  by  its  both  essentially  equal  payable  the  rather As the other  had than of  a  upon  shareholders the to  the  the  active  been  of  its  total  and  amount  business  corporation.  1972,  the  corporation  amount  its  by  by  of  would a  sole  the  income  shareholders  which  owned  income  have  was been  proprietor  9  income  Canadian-controlled than  distribution  (other  private  business  than  dividend  corporation  would  be  taxed  income)  from at  of  sources the  f u l l  6 . W h i l e i t i s p r o b a b l y u n n e c e s s a r y t o do s o i n l i g h t o f the extensive use of the t e r m , the purpose of this footnote is to confirm, in the interest of eliminating possible a m b i g u i t y , that the term " i n t e g r a t i o n " i s used h e r e i n i n the sense a t t r i b u t e d to i t in the Carter Report: " . . . a f u l l credit . . . for the underlying corporation tax, the integration of corporation and personal income taxes." (vol. 1 , p. 7.) 7. S u b s e c t i o n 125(1). 8 . The s t a t e m e n t t h a t " i n t e g r a t i o n was p r e s e r v e d " overlooks, of c o u r s e , the p o t e n t i a l l y s i g n i f i c a n t advantage of deferral a b o u t w h i c h m o r e w i l l be s a i d i n t h e f o l l o w i n g chapter. 9. Assuming as i s the custom i n t h i s sort of analysis that the marginal rate of the sole proprietor in question was 5 0 % .  13  corporate  rate  would  eligible  under  be  Section  mechanism  with  Deferral  was  f u l l  was  paid  prevented paid  by  of  the  upon rate  r a t e . ^  double  essentially  to  to  (in its  equal  theory)  rather  effective  the -  the  the  total and  amount  or  provisions.  fact  the  that  tax  dividend amount its  which  at  lower  corporation of  of  an  to  when  system  income  have  the  amount  25%  tax  the  small  shareholders would  tax  double  corporation  at  rate  refundable  corporation to  the  dividend  its  the  the  than to  to  company treatment  deferral  by  by  the  tax  refundable  subject  receipt  taxation the  dividend  prevent  income  its  dividends,^  dividends,  The  refunding  reduce  both  Act.  -  By  of  refundable  prevented  to  payment  for  respect  taxed  sufficient  upon  designed  corporate  business  it  129  was  taxation  income  and,  tax was been  10. In fact, of course, given that for the f i r s t decade of the e x i s t e n c e of the r e f u n d a b l e d i v i d e n d tax system the top marginal rates a p p l i c a b l e to individuals exceeded the f u l l corporate rate, the refundable d i v i d e n d tax did not totally eliminate the deferral advantage during that period. When the 1981 Budget decreased the top marginal rate applicable to individuals to approximately the level of the f u l l corporate rate, the a b i l i t y of the refundable dividend tax t o f u l f i l i t s i n t e n d e d r o l e was g r e a t l y improved. 11. In fact: [t]he basic federal corporate rate ... was 50 per cent in 1972. A refundable tax at 25% of investment income therefore resulted in an effective corporate r a t e of 25 p e r c e n t , and this was f u l l y o f f s e t by t h e d i v i d e n d t a x c r e d i t . The f e d e r a l r a t e , however, was r e d u c e d . . . t o a 46 p e r c e n t r a t e by 1 9 7 6 . No c o r r e s p o n d i n g r e d u c t i o n wa made in the rate at which refundable tax was earned. In t h e o r y , o v e r i n t e g r a t i o n resulted. (Thomas E. M c D o n n e l l , "The Taxation of Investment Income of Private Corporations and Personal Services Business Income," Report of Proceedings of the Thirty-Fourth Tax Conference, Toronto, Canadian Tax Foundation, 1982, pp. 103-147 at p. 112.)  14  payable rather  had  t h e income  than  Under  source  by a  corporation.  Part  IV  of  the  private  dividends  from  generally a  speaking  refundable  33  make t h e t o t a l of  were 1/3%  the dividend)  derived both  on  equivalent  payer  and  individual refundable  Part  refundable  effect  (by both  t h e income  at  a  dividend  the  marginal  I V t a x was tax  than which to  t a x was t o  and t h e r e c i p i e n t the dividend  would  rate  of  t o form  hand  of  was s u b j e c t e d  have  recipient  considered on  (other  which  t a x which  had  income  of t h i s  the payer from  individual  corporations  tax free)  The  to the t o t a l  taxable  an  corporations  received  recipient  by  dividend  controlled  tax.  tax paid  owned  Act, the  Canadian-controlled received  been  of  paid been  was by an  50%.  This  part  of the  the  recipient  corporation.  It  was  intended,  incorporated  businesses  available  virtue  this  by  context,  annual  profits  business  -  of be  of  "small"  course, eligible  the small  was  derived  i t s"business  by  the  limit"  only  f o r the  business  defined by  that  reference  and  "assistance"  deduction.  corporation -  "small"  In  t o both the from  the t o t a l  active  "retained  12 earnings" -  derived  the "total  by t h e c o r p o r a t i o n  business  limit."  from  Initially,  active the  business "business  12. As m e n t i o n e d i n c h a p t e r one, the a c t u a l formula f o r measuring the " r e t a i n e d earnings" of the c o r p o r a t i o n , found in the statutory d e f i n i t i o n of the "cumulative deduction a c c o u n t " w a s s u c h a s t o make t h e t e r m " r e t a i n e d e a r n i n g s " a n i n a c c u r a t e one i n t h i s c o n t e x t . T h i s q u e s t i o n w i l l be d e a l t with below.  15  limit"  of  the  Canadian-controlled  private  corporation 13  carrying  on  intervening it  is  active  years,  currently,  originally the  an  this  decision  business  deduction  inclusion  and  1 5  disappeared  The  active  amount  $200,000.  $400,000  concept  business  business in  the  measurement "cumulative  of  the  The  had  terms  of  the of  gradually "total  the  Act  been  to  the  account"  for  "retained  which  mechanism 18  1. The taxation  was when  1 6  the  small  earnings"  from  necessitated  the  would  permit  adopted  was  the the  which:  originally introduced was The b a l a n c e i n t h e a c c o u n t  aggregate  limit"  1984."''^  corporation  The  the  increased;  $1,000,000  e l i g i b i l i t y  of  Over  business  in  provisions  same.  $50,000.  increased  limit  in  deduction  has  4  from  to  Act  ... as simple. as:  1  was  comparatively was d e t e r m i n e d  of: corporation's taxable income y e a r s commencing a f t e r 1971 p l u s  for  2. 4/3 of taxable dividends received from C a n a d i a n c o r p o r a t i o n s and f o r e i g n a f f i l i a t e s , deducted in computing such taxable incomes; less  the  aggregate  3. 4/3 of corporation  13. 14. 15. 16. 17. 18.  of:  taxable in those  Subsection 125(2). SC 1 9 8 0 - 8 1 - 8 2 - 8 3 , c. 140, Subsection 125(2). SC 1 9 8 0 - 8 1 - 8 2 - 8 3 , c. 140, SC 1 9 8 4 , c . 4 5 , s . 4 0 . Paragraph 125(6)(B).  dividends years and  subsec.  86(1).  subsec.  86(1).  paid  by  the  16  4. 4 times the amount by corporation's refundable dividend exceeded i t s dividend refund. In  essence  the  constituted, income  consisted  of  the  Dividend  this  of  be  that,  where  business year,  were  reduced  had  the  exceeded  corporation  account  by  an  business  amount  equal  that  tax  rate  exceeded out"  tax  to  amount for  to  year  payable  its  after  to  addition  to  the  tax  by  derived  the  on  that  portion  limit  would  year's  account  profits  would  have  of leave  been  deduction  earnings to  completely thus,  a  an  hand,  business  the  unable  from in  other  active  its it  after  derived  limit,  account and  particular  funds  the  from  business  deduction  a  was  active  dividends  On  three  account  from  in  profits  profits.  amounts  procedure  cumulative  paying  from  every  sufficient  its  exceeded  business  that  year  this  limit  the  to  profits  cumulative  respect  reduce  for  derived  business have  as  deduction  of  earnings  equal that  its  had  its  effect  would  corporation's  the  The  not  income  for  four.  cumulative  made  time  Thereafter,  business  corporation.  been  such  the hand  i n i t i a l l y  active  have  until  the  as  private  to  exhausted.  corporation's  active  account,  undistributed  hand  the  of  the  on  payment  by  payment  where  the  deemed  tax  dividend  would  of  were  dividend  account  dollars  deduction  Canadian-controlled  payments  refundable in  cumulative  which t a x on  higher which "clean with  permanent  made.  19. William J. Strain, "'Capping' Provisions: The Annual and Total Business Limits and the Cumulative Deduction Account," text of a paper delivered a t a S y m p o s i u m on the Simplification of the Small Business Provisions of the Income Tax Act in Toronto, Ontario on July 11-13, 1983 s p o n s o r e d by t h e C a n a d i a n Tax Foundation.  17  Aside as  from  "small"  "total  tax  the  credit to  upon  the  the  in  l i m i t , "  of  rate  of  "superintegration."  the  21  came  cent.  to  In this  as  other  and  and  amendments  in of  defined  limit"  significant  enriching  deduction,  In  "business  thirty-three  per  referred  statutorily  deduction  was  f i f t y  of  f i r s t  former  business  amounts  concepts the  these its  variously  the  business  from  small  to  the  small  important  cent  is  found  business  affecting most  increases  1977. the  The  dividend  one-third  terms change  of  its  per  effect  produced  "overintegration"  what  20  and  words:  [Bjecause of the increased dividend tax credit, taxpayers earning active business income in a C a n a d i a n - c o n t r o l l e d p r i v a t e c o r p o r a t i o n were about 8 percentage points ahead a f t e r tax on dividends paid to them out of that active business income than they would have been had they earned an equivalent amount of active business income directly.22 This  change  changes the  in  would later  complexity  Two method account.  of  play years  of  the  important measuring The  f i r s t  a  major  -  each  small  changes the of  intended participation enterprises. 25 per cent  of  in  which  business  were  value  these  role  the  changes  would  other  contribute  to  rules.  also of  necessitating  made  in  1977  cumulative  to  the  deduction  was:  to  encourage substantial minority corporations in Canadian To accomplish this, the refundable Part IV tax on dividend income by  2 0 . M c D o n n e l l , o p . c i t . a t p. 1 1 7 . 21. David Jones, "Is the Small Business Credit Expenditure?", Canadian Taxation (Winter, 1979), pp. 22. McDonnell, l o c . c i t .  a Tax 53-57.  18  received by shareholdings This  "waiver"  dividend subject short  was to  Part  IV  tax  to  w i l l  be  when  the  the  payer  recipient  restrictions  (as  was waived per cent.23  which,  discussed  was,  given  for  of  the  however,  their  below),  need  very not  be  here.  The  other  calculating  the  1977  a  enactment  in  the  deduction  required  amendment  amount  formerly  cumulative  after  corporations e x c e s s o f 10  "connected"  life-span  Whereas  the  certain  mentioned  year  of  in  fresh of  the  affected  cumulative  determination account  at  calculation  this  by  method  deduction  of  the  the  the  end  account.  amount  of  reference  each back  of  in  the  taxation to  1972,  amendment:  [T]he c l o s i n g b a l a n c e i n the a c c o u n t at the end of one y e a r w o u l d become t h e o p e n i n g b a l a n c e f o r the subsequent year and a l l r e l e v a n t changes for that year would then be r e f l e c t e d . These amendments, while perhaps intended to simplify the ongoing record keeping for the [cumulative deduction account,] further complicated the planning considerations for the [Canadian-controlled private corporation.] . . . . Where there are timing differences in the recognition of income f o r a c c o u n t i n g and t a x p u r p o s e s . . . care has to be taken not to pay out the after-tax accounting income to shareholders before such income is recognized for tax purposes.24 As  w i l l  of  the  be  discussed  statutory  deduction  account"  factor  the  23. Hist Toro pp. 24.  to  in  chapter  definition was  demise  of  cited the  as  total  3, of a  the  mounting  the  complexity  term  "cumulative  significant  contributing  business  limit.  Bernard Shinder, "The Taxation of Small Business: An orical and Technical Overview," Canadian Tax Journal, nto, Canadian Tax Foundation (Jan.-Feb., 1984), 1 - 5 3 a t p. 17. S t r a i n , op. c i t . , pp. 19-20.  19  By  1978,  it  to  the  attached  had  been  f i r s t  interfering  with  Thus,  restrictions  pay  these a  which  tax it  its  free  was  of  on  dividend  it  the  1977  achieve  its  the  ability  of  to  a  felt  to  intended a  recipient  In  be  were goals.  corporation  corporation  eliminated.  was  restrictions  amendments  to  were  however,  that  the  ability  connected  restrictions,  decided  to with  removing  these  necessary:  . . . to prevent such 'exempt' dividends from increasing the amount of b u s i n e s s income eligible for the low rate [and so] amendments were also made to prevent the deduction by the payer corporation in determining its [cumulative deduction account] for dividends paid to other non-associated private corporations unless Part IV t a x was p a i d i n r e s p e c t of these dividends. The a d o p t i o n of t h i s p r o v i s i o n p e r m i t t i n g o n l y certain so called "qualifying dividends" to reduce the [cumulative deduction account] meant that the concept of the [ c u m u l a t i v e d e d u c t i o n a c c o u n t ] as a measurement of the r e t a i n e d b u s i n e s s e a r n i n g s of a corporation had been abandoned. . . . . These provisions raised a whole new set of problems 25 As  the  these  last  few  changes By  fiscal  sources benefits taking  to  become  clear,  at  view,  that  further  changes  were  the  Strain,  op.  applicable it  had  small  advantage  the  quotation  had  which  only  above  it  professionals  25.  the  s t i l l  regime  of  of  were  1978,  government's the  words  of  were  c i t . ,  not  this  small  been  tax  20-21.  least  intended  to  the  Alberta  to  Income  extend  were  credit. in  in  necessary  business.  deduction  incorporating  pp.  suggest,  beginning.  to  business  might  the  nonetheless  For and  example, making  20  extensive were be  use  of  resigning engaged  controlled  their  as and  services  to  Department by  one  the  stating  promptly former  with  respect was  regarded  Minister  of  as  as  elsewhere.  salaried  employees  their  business"  companies  positions  which  jurisprudence "active  management  of  employees  companies  contracted  to  employers. to  not the  the  desired  Finance,  The  only  which  to they  provide  their  Furthermore, meaning  evolving  Others  in  of  what  fashion  Honourable  the  the  as  terra  Finance  was  J.  the  confirmed  Chretien,  in  that: Court rulings have also entitled investment and rental income to this reduced rate. As I have said i n my b u d g e t speech, it would be u n f a i r to a l l o w s u c h p r a c t i c e s t o go on ••••26  While  B i l l  problems were  C-37,  did  made  not  in  business" any  of  business  the  particular  the  terms  other  relatively passage B i l l  a  of The  at  B i l l  three  definition  paraphrased  as  defined  of  27  to  the  Given  business as  an  definitions the  Act  "non-qualifying  business."  was  these  amendments  C-17.  added  business,"  these  remedying  similar  non-qualifying  business two  of  C-17  investment  than  latter  been  the  attempt  "active  "specified  importance.  has  law,  things,  investment  business,  business  become  other  and  specified  Chretien's  1979 t h r o u g h  Amongst definitions  Mr.  that and  a  active were  of  non-qualifying  follows:  26. Honourable J . C h r e t i e n as quoted i n Canada, P a r l i a m e n t , House of Commons, O f f i c i a l Report of Debates, Ottawa, Queen's P r i n t e r , v o l . 3 , 1 9 7 8 - 1 9 7 9 , p. 3245. 2 7 . SC 1 9 7 9 , c . 5.  21  1) the professional professionals;  practice  of  certain  defined  2) t h e b u s i n e s s of p r o v i d i n g s e r v i c e s i f more 66 2/3[%] of the gross revenue for the year derived from s e r v i c e s provided t o one e n t i t y and 3) the related time in The  concept  apply  to  above. as  of  The  business of providing managerial services to a business connected at the year with the corporation.2g  the  the  non-qualifying  professionals  term  than was . . .;  and  "specified  business former  investment  was  and any  intended  employees business"  to  mentioned was  defined  follows: ... a i s to  This  business . . . the p r i n c i p a l derive income from property  definition  "investment  As their  was  from  rental"  the  case  only  for  a  not  129  of  prior  to  eligible the  Act  it  a  any  tax  was  to  from  an  by  credit for  following  deduction." a  investment  although  was  Income lesser  business"  under  refundable  of  Chretien.  business"  received  "specified  which  sources  Mr.  "active  business  eligible  those  of  1979 amendments,  business"  from  for  the  "small  "non-qualifying  encompass  referred  income  f u l l  Income  to  income  the  the  "deduction." was  intended  and  passage  eligible  was  purpose . . . .  section  dividend  tax  treatment.  These  new  necessitated  sources  further  of  income,  changes  the  cumulative  deduction  28.  McDonnell,  loc.  c i t .  in  account.  taxable the As  at  method a  differing of  result:  rates  calculating  22  [K]eeping track of account] for small become a n i g h t m a r e .  the [cumulative deduction business corporations had  On t o p o f t h e e a r l i e r c o m p l e x i t i e s o f segregating qualifying from non-qualifying dividends, a different gross-up function (3/2) was introduced in the calculation of the [cumulative deduction account] to be a p p l i e d to d i v i d e n d s received and paid by corporations carrying on non-qualifying businesses p r o v i s i o n s were a l s o introduced in 1979 to increase the [cumulative deduction account] of non-qualifying business corporations by a f a c t o r of 1/8 of the balance i n the account at the end of the t a x a t i o n year prior to the new rules becoming effective. This 'specified addition' was intended to compensate for the larger gross-up. T h i s a d j u s t m e n t was a l s o t o be made in circumstances where the status of a c o r p o r a t i o n changed from a c t i v e to non-qualifying business. Should the status of a corporation change from n o n - q u a l i f y i n g to active business ... a deduction i n the [cumulative deduction account] was made a t the end of the year in which the corporation c e a s e d t o c a r r y on a n o n - q u a l i f y i n g b u s i n e s s equal to 1/9 of the balance in the account at that date.2Q The  small  of  the  business cumulative  becoming  the  complexity  of  of  Next the  Budget  -  prior 29.  to  its  Strain,  would  come  demise op.  the  measurement  particular  took  the  pp.  to  in  demands  Canada for  brought  in  the  were  -  has total  Budget,  the  which  the  reached  its  simplification.  about  $1,000,000.  25-26.  1981  within  operated  changes  it  the  regime  increase  c i t . ,  in  by  straightforward  final  and  account  introduced  business  most  the  general  fiscal  significant the  already:  the  small  in  complicated.  amendments  incorporated apogee.  system  deduction  increasingly  With  One  tax  by  been  the  1981  mentioned  business  limit  23  The This  1981  new  the  tax  Act:  income  that  The  dividends tax  1981  the  after  was  "  tax from  a  a  the new  at  retained  per  being  cent  on  amount.  deferral  the  on  benefits 30  business. resulting  of  into  overintegration  amendment  introduction  tax.  business  earnings  tax  in  small  12.5  eliminate  continued  II  amount,"  the  of  Part  definition  earnings  preferred  to  it  income  the  of  tax  the  "housekeeping"  was  about  taxed  is  [but]  business  Budget  and  designed  income,  further  insertion  1982  II  . . .  brought  "preferred  originating  active A  of  part  distributed for  also  necessitated  earned  rate.  This  Budget  from  the  concept  the  creation  the  of  the  31 "personal  services  non-qualifying incorporated business  business employee  to  offer  possibilities the and  were  incorporated taxing  rates  the  while  normally The amend, 30. 31.  his  final  once  to  change  again,  the  eliminated  denying  available  to  employee  the  high  advantage  income a  of  "employee"  corporation.  a  personal  services  business  deductions  at  small  deferral  the  a  the the  the  defining  such  of  deprived  by  any  an  had  significant  through  as  from it  f u l l left  services  income  1979  the it  available  While  in  of  deduction,  possibilities chose  business."  who These  "business"  f u l l  other  of  business corporate  than  those  employee.  resulting method  Shinder, op. c i t . , p. 20. SC 1 9 8 0 - 8 1 - 8 2 - 8 3 , c . 1 4 0 ,  of  from  the  1981  calculating  subsec.  86(9).  Budget the  was  to  cumulative  24  deduction view  account.  that  created  the  by  documents  This  original  Tax  change,  in  taxation  Reform  was  accompanying  the  effect,  scheme  flawed. 1981  for  This  Budget  reflected small  view  and  is  the  business  appears  in  expressed  as  follows: The purpose of the [total business limit] is to confine the tax a s s i s t a n c e during early years when t h e b u s i n e s s i s b e i n g e s t a b l i s h e d and when i t may have difficulty in obtaining debt or equity financing from external sources. Businesses can, however, avoid the cumulative retained earnings l i m i t by p a y i n g o u t d i v i d e n d s . As a r e s u l t , they can remain eligible for the low corporate rates l o n g a f t e r t h e y h a v e c e a s e d t o be s m a l l and obtain benefits even though the funds are not used for business expansion. In order to retarget the incentive where it is most needed, dividends d i s t r i b u t e d a f t e r D e c e m b e r 3 1 , 1 9 8 1 w i l l no longer be deductible in computing the cumulative d e d u c t i o n l i m i t of a b u s i n e s s . ^ This in  amendment  permitting  deduction  was  apparently  dividend  account,  "encouraging With  the  Budget,  the  reached  such  Foundation  small  a  payments  the  to  small  business  amendments  response  to  to  remain  the  Act  relating  a  complexity  felt  it  of  necessary  to  the  "refresh"  business  provisions level  to  the  tax  small."  sponsor  from  the a  cumulative system  small that  that,  was  33  resulting to  claim  the  1981  business  had  Canadian  symposium  Tax  of  the  clearly  in  34 topic  of  simplification.  The  climate  was  favour of making changes to reduce the complexity of the 32. Honourable A l l a n J . MacEachen, Deputy Prime M i n i s t e r and Minister of Finance, The Budget in More Detail, Canada, Department of F i n a n c e , O t t a w a , Queen's P r i n t e r , 1~981, p . 4 5 . 33. Shinder, op. c i t . , p. 20. 3 4 . The symposium e n t i t l e d " S y m p o s i u m on t h e Simplification of t h e S m a l l B u s i n e s s P r o v i s i o n s of t h e Income Tax A c t " took p l a c e i n T o r o n t o , O n t a r i o on J u l y 1 1 - 1 3 , 1 9 8 3 .  25  relevant the  portions  1984 Budget  of  the  Act.  Thus,  a  paper  accompanying  stated:  A number of business tax section puts system. ...  causes of complexity in the system have been identified. forward a proposal to simplify e l e m e n t s of the p r o p o s a l are:  small This that  elimination of the $1,000,000 limit on t o t a l cumulative income e l i g i b l e for low tax rate benefits, which eliminates the requirement for the cumulative deduction account; - e l i m i n a t i o n of the d i s t i n c t i o n between nonqualifying business income and active business income subject to the low tax rate, thus reducing the number of types of income receiving different tax treatment;  ••••35  Legislation  embodying  Conservative As  was  investments force  with  government  a  to  small  its  after  mentioned, business  refundable which  proposals  shortly  previously  "assistance" included  these  was  repeal  first  tax  in  repealed having  the  was it  passed  by  assumed  the  office.  new 36  legislative  scheme  enacted  1972  respect shortly  in of  after  application  of also  ineligible coming  into  retroactively  to  37 1972. below.  This 3  tax  w i l l  be  discussed  in  greater  detail  8  35. Honourable Marc Lalonde, Minister of Finance, S i m p l i f y i n g Taxes For Small B u s i n e s s , Canada, Department of Finance, Ottawa, Queen's P r i n t e r , 1 9 8 4 , p. 15. 3 6 . SC 1 9 8 4 , c . 4 5 . 37. S.C. 1973-1974, c. 14, s. 60. 3 8 . See C h a p t e r 4 , The C a n a d i a n Experience.  26  Chapter  The  Rationale  To tax  on  advance the  private  This  the  Tax  i s ,  of  seem  Unreasonable  that  eligible  to  to  such  needs  to  appropriate,  as  the  is  the  In  preliminary  perspective, whether  applies in  turn  Income made  this  that  continue  review  Act  has  that  beneficiaries with  an  w i l l  in  by  is  only.  analysis  This the  small made  the  this  rationale  it  its  historical question  achieving  w i l l  be  through the  to  of same  legislation  chapter for  so,  achieve  which  followed  which  the  "assistance"  deduction  available  do  consider:  the  of  control  business  Finally, of  to  to  an  discussion  mechanisms  incomplete.  to  to  examine  f i s c a l  f i s c a l  motivated the deduction; and  from  manner  the  attempted  the  it  of  then  the  business.  a  possible  matters  and  factors  small  Tax  ensure  chapter  be  by  these  purpose  to to  at  or  step,  2. the manner i n which i t sought p u r p o s e when f i r s t enacted. looked  a  business  present  order  1. the purpose which o r i g i n a l l y enactment of the s m a l l b u s i n e s s  Having  impose  small  flawed  explored. a  should  Canadian-controlled  that  entities be  of  for  suggest  Accumulations  Canada  accumulations  course,  applicable  on  proposition  corporations  suggestion  would  a  unreasonable  deduction regime  for  3  in  order  to  its  intended  w i l l  conclude  adding  a  tax  on  27  unreasonable  accumulations  to  the  present  small  business  tax  regime.  In  describing  business," stated  The  that  the  1972  Honourable  the  version  E.J.  government  of  "assistance  Benson,  sought  Minister  to  of  small  Finance,  to:  limit the incentive to smaller private Canadiancontrolled corporations that require, and i n fact use, the tax savings to invest in t h e i r businesses or t o pay d i v i d e n d s t o shareholders.... Although,  as  the  favourable  above  tax  unincorporated  rate  was  the  scheme  adopted  at  least  resulting  payment inequity (ignoring deferral)  a  of  of  -  or  so  that,  neither  by  again  neutrality  only  company situation  in  the  1972 to  the  being  in  the words  1. Honourable E.J. Benson, Minister 1971 Tax R e f o r m L e g i s l a t i o n , O t t a w a , p. 3 7 .  income  to  one  important of  Mr.  appeared, the  temporary;  taxes  of  to  neutral,  render  apparently  a  business  nor  examination,  personal  not  "small  equitable  and  the  time  of  providing  but  the  implementation  loss  corporate  the  be  its  in  incorporated  superficial  returning for  to  for  dividends  suggests,  businesses  intended  inequity  integration  to  small  deduction"  upon  quotation  upon  the  removed  the  neutrality  advantage  of  Benson:  of Finance, Summary of Queen's Printer, 1971,  28  "the net corporate r a t e s of  The E.J.  two  Benson  was  effect income tax.  created  with  attributed  indicate a  [would be] . . . to tax the the individual shareholders'  0  quotations would  ... at  view  to  that  above  the  to  small  f u l f i l l i n g  The  Honourable  business  two  deduction  goals:  1. p r o v i d i n g for the i n t e g r a t i o n of the corporate and personal income taxes payable by the shareholder of the Canadian-controlled private c o r p o r a t i o n c a r r y i n g on an a c t i v e b u s i n e s s ; and 2. providing businesses. No  other  goals  Does  the  1972  provide  intended  small  to  In  were  explicitly  business  any  to  for  corporation  deduction scheme would  but  which appear  available  to  analyse  the  for  came  into  helpful the  articulated  this  (incorporated)  by  the  Minister.  originally that  it  question,  practical  its  to  as  confirm  eligible  also  small  enacted  was,  in  in  fact,  would  seem  goals?  answer  to  the  to  these  necessary  to  deduction  evidence  f u l f i l l  order  assistance  implications,  for  the  shareholders,  force  in  compare  shareholder  1972. the of  it  net a  of  not  small the  only  business legislative  Specifically, after  tax  it  return  Canadian-controlled  2. Honourable E.J. Benson, Minister of Finance, Summary of 1971 Tax Reform L e g i s l a t i o n , Ottawa, Queen's Printer, 1971, p. 38. When the deferral advantage is taken into consideration, it readily becomes apparent that the small business deduction is not merely a tool for preventing double taxation. Even i g n o r i n g the deferral advantage, it is obvious that the "net e f f e c t " referred t o by M r . Benson w i l l only occur where the mechanism through which "integration" is implemented i s effective in achieving its purpose. T h i s a s p e c t o f t h e p r o b l e m w i l l be d i s c u s s e d more f u l l y below at pages 31-35.  29  private  corporation  deduction  from  corporation by  the  that  with  active  the  made  (which  to  as  as  a  which an  the  the  small  carried  would  had In  below),  several  analysis;  these  1. that the combined m a r g i n a l tax r a t e of the fifty percent;  by  been  he  proprietor.  business  on  have  individual,  sole  appears  f a c i l i t a t e  for  business  return  if,  business  comparison be  an  shareholder  same  eligible  that  received  carried  on  making  this  assumptions  w i l l  are:  federal and individual in  provincial question is  2. that the combined federal and provincial tax rate for a Canadian-controlled private corporation earning income from an active business and eligible for the small business deduction is twenty-five per c e n t ; ^ and 3. that the a f t e r - t a x are d i s t r i b u t e d i n the are earned. The  f i r s t  element  of  analysing this  two  the  element  small  of  business  but  it  to  of  inaccuracy  third  and the  three  Act  The  cases  analysis  these  inaccuracy  analysis. some  of  make  fact  assumptions is  these in  assumption  untrue that  deduction  in not pay  profits of the corporation same c a l e n d a r y e a r a s they  somewhat two  out  of  w i l l  to  the  of  a  slight  convention and  effect  be  their  true  upon  eligible profits  in  accept  f a c i l i t a t e  obviously  companies a l l  a  assumptions  order  others; a l l  introduces  the in this  for  the  in  the  3. As m e n t i o n e d i n c h a p t e r two, t h i s t h e s i s w i l l adopt the common p r a c t i c e of assuming that the combined f e d e r a l and p r o v i n c i a l tax r a t e i s equal to the f e d e r a l r a t e as i t would be were it not for the abatement in respect of taxable income earned in a province provided for in sub-section 124(1) of the Act.  30  calendar  year  in  which  they  are  earned  w i l l  would  have  be  discussed  below.^  The  individual  on  $400  of  In  1972,  earned  tax  active  had  by  account  then  by  the  dividend  credit  have  been  $200  have  been  $100  small tax  have  -  business payable  integration absence  of  system  that  of  described one  of  business corporate 4.  At  the  These  was  personal  31-35.  to  upon  the  would  also  the  shareholder  would  circumstances, no would  at  in of  a  be  would  the  total -  to  taxes  for of  if  the  corporate of  the  payable  by in  proprietor confirm  of  the  integration the  the  obviously  sole  seem  total  In  use  tax  the  provide  f u l l  implementation  provide  to  i.e.  the  the  in  taxes.  $266.67 by  then,  reduction  occurred;  payable  income  into  by  have  behind  (taking  would  taxed  figures  total  corporation  resulted  tax  the  time)  deduction  shareholder  business  based  shareholder  been  been  the  business  have  and  that  involve  and  income  by  effect  would  total  deduction  pages  would  had  and  at  these  only  purposes  and  In  small  above. the  payable  $100.  would  force  him.  dividends,  above  payable  corporate  corporation  excess  in  tax  taxation  both  described  tax  by  small  shareholder  rates,  form  the  and  revenue  double  for  corporation  its  the  business  of  corporation's  corporate  out  deduction  of  active  $200  directly  way  and  -  of  earned  paid  by  the  been  income  eligible  paid  both  above  $400  assumptions  tax  likewise  same  corporation  and  payable  business  that  a  deduction  described  that small  of  shareholder  the of  a  31  Canadian-controlled active  however,  deduction,  in  paragraph,  was  taxes,  in  two  are  place  at  portion profits  in  on  an  the  in  the  much.  constitute  the of  after  active  a  business  intermediary amount  proprietor Does  the  the  in  of  mere  "assistance?"  upon  situation  to  25%  example  deferral  in  of  of would  of  to  did  the  those of  the  -  tax  its  many -  the  of  the  profits  l i a b i l i t y  than  corporation  profits  have  was  individual rather  the  the  these  in  receipt  as  took  which  directly  corporation  equal this  -  year  profits  certainly  income  a  corporation  things,  year  upon  small  assumption  calendar of  of  business to  the  corporate  portion  dividend  with  of  income  second  third  same  most  shareholder  of  small  the  calendar  a  personal  the  scheme  by form  an  the  of  preceding  the  profits  payment the  to  after-tax  it  the  assistance  back  1972  the  as  comparison  taxes  sole  Under  business  f u l f i l  Did  any  in  in  and  credit  lead  small  described  after-tax  earned,  the  earning  that  carrying  the  above?  dividends  time  payable  by  through  the  as  then  tax  provide  distribution  were  deferred  the  that  any  instances,  this  questions  of  corporate  mentioned  earned.  that  profits  did  fact,  distributed  extent  integrate  way  These  above:  they  paid  to  in  effect  circumstances  purposes  business?  are  the  the  what  deduction,  made  corporation  business.  If,  the  private  paid to  pay  while twice tax  32 Common deferral  is  retained, on  sense of  over  the  value and  same  intermediary  without  be  to  course,  benefits  of  tax  method  in  of  the  are  as  a  reduced some  income  conclusion  which  suggest  that  the  the  of be  one  of  corporate  used  within  In the  thus  carrying  a  income.  are  the  funds  individual  can  generate  that  the  use  retain,  deferral  this  tax  Thus,  the  must  the basis  occur, of or  to as  tax  rate  the  fact,  basic  tax  of  goals  when tax  Prior  rate; which  it  tax  revenues  treatment to  tax  given  reaching  the  one  is  deviation  w i l l  only  a  constitute or  enacted force  A  a  foregone,  whether  in  provides  deferral.  been  originally rate  analysis  course,  have  determine  at  not  the  constituted the  time  must  a  tax  "small a of  tax its  identified.  circumstances of  of  a  preferential  revenues  tax  of  taxpayer.^  "normal"  be  expenditure  value  "normal"  deduction,"  enactment  In  to  "normal"  expenditure,  tax  the  source  the  expenditure. business  of  result  that  identify  the  to  to  of  measuring said  as  able  area  is  from  extent  without  continue  expenditure  f i r s t  would  planning."'  Work  to  the those  business  corporation the  to  above  would  more  comparison  described was  the  above, tax  rate  the of  "norm" an  chosen  individual  5. The Canadian Taxpayer, Revised Supplement (Toronto, R i c h a r d De B o o L i m i t e d A u g u s t , 1 9 8 0 ) , p. v i . 6. T h i s d e f i n i t i o n of the concept of a " t a x e x p e n d i t u r e " is t a k e n f r o m Roger S . S m i t h , Tax Expenditures: An Examination of Tax Incentives and Tax Preferences in the Canadian F e d e r a l Income Tax S y s t e m ( T o r o n t o , C a n a d i a n Tax Foundation, 1979) at pp. 1-6.  33  carrying  on  an  conclusion  drawn  proprietor private ideally  -  the  in  its  deferral  Is  of  it  i s , ^  is  on  an  of  through  Tax  Professor  The  the  sole  business  the  benefitted  to  the  Reform,  extent  of  business  expenditure?  on is  who  (and,  business  small  tax  work  Smith  small  the  a  seminal  to  with  active  advantage  his  proprietor.  Canadian-controlled  goals  available  in  sole  the  stated  Pathways  as  of  deferral  a  comparison  business)  Surrey  expenditures,  that  the  active  this  Professor  by  carrying  advantage  deduction.  tax  that  as  shareholder  terms  -  business  was  corporation  deduction the  active  the of  has  topic  the  of  opinion  attempted  to g  apply If  the  the  In  its  theory,  present  fact reduce  that its  otherwise  reduction  the  to  is  expenditure,  value  value over it  of  the  was  a  have  the  in  the  setting  off  the  able  been  of  tax  the  the  of  to  making  paid  out  income the  of tax  the  avoid  by  cost  tax  Canadian  deferral  interest  period  borrowing  calculating  upon  advantage  analysis  context.  how  does  is  equal  one  value?  corporation  in  expenditure  deferral  measure  the  tax  use in  the  cost  deferral  by  of  the  taxes  -  interest  expense  the  of  the  altogether  or  moneys taking thus  by  reason  borrowing  otherwise  interest  avoided  to  which into  avoided  payable against  would the  might  account that  a  follow revenue  7. (Cambridge, Massachusetts, Harvard University Press, 1 9 7 3 ) , at pp. 108-111 and 120-125. 8. Roger S. Smith, Tax E x p e n d i t u r e s : An E x a m i n a t i o n o f Tax Incentives and Tax Preferences in the Canadian Federal Income Tax System (Toronto, C a n a d i a n Tax Foundation, 1979) a t p. 9 8 .  34  derived  from  illustrates  the this  funds.  An  example  from  Professor  Surrey  phenomenon:  Suppose an i n d i v i d u a l , A, in the 60 p e r c e n t tax bracket, invests $100 i n an a s s e t . Assume that business, accounting and normal tax rules would require the cost of the asset t o be capitalized, but that a tax expenditure provision permits the cost to be e x p e n s e d in the year of acquisition, thus deferring tax l i a b i l i t y on the amount of i n c o m e o f f s e t by t h e s p e c i a l d e d u c t i o n The immediate deduction of $100 gives A an immediate tax s a v i n g of $60. The $60 t a x w i l l be postponed until the asset is sold. One way to d e s c r i b e the r e s u l t i s to say t h a t the Government h a s made a l o a n of $60 to A without asking for interest, c o l l a t e r a l , or a definite time for payment of the loan, since it w i l l wait until A decides to s e l l the asset. The higher A's tax b r a c k e t , the l a r g e r the i n t e r e s t - f r e e loan. What is this loan worth to A? Assume that borrowing $60 from a bank would cost him 10 percent interest. A t h u s s a v e s p a y i n g 10 percent a year on $60 or $6 l e s s the b e n e f i t of the income tax d e d u c t i o n of $6 i n t e r e s t a year, or a net saving of $2.40 per year, for a total of $6 interest a year, or a net saving of $2.40 per year, f o r a t o t a l o f $ 2 4 i f he s e l l s i n t e n years. The s a v i n g f r o m d e d u c t i n g t h e c o s t of t h e a s s e t in the f i r s t year instead of the tenth year, e x p r e s s e d i n terms of the present v a l u e 'of money, would be worth $19.46 to A (using an after-tax d i s c o u n t r a t e of 4 p e r c e n t i f A can f r e e l y borrow a t a 10 p e r c e n t b e f o r e - t a x r a t e ) g While  this  valuation  determining  the  technique  value  of  business  deduction  makes  business  deduction  would  attempt it  to  overlooks  unavailable  9.  place  Surrey,  at  a the  any  Pathways  value  the  suggests deferral  possible, argue on  the  cost  to  to  Tax  the  it  deferral  type  Reform,  at  is in  that  method  which  proponents  that  possibility  a  the  of  small  misleading  this  way  corporation  pp.  small  the  financing  of  for  120-121.  in  to that  may  be  which  is  35  eligible this  for  the  small  perspective,  being  invaluable  In  any  business  one and  event,  would  it  can  in  constitute  "assistance"  it  1972,  allowed  for  taxation  its  eligible  constant  feature  present  day.  constant  of  at  25%  50%''"''"  Additionally,  of  period  deduction  beyond  integration  "superintegration."  for  of  the  dividend  a  tax  and  an  In  business  credit  tax  no  the  respect  10. See, for example, the f i n a n c i n g found i n the Carter 11. See subsection 117(5.2) 81-82-83, c. 140, subsec. 75(  do  so?  affected  down has  and  to  the  by  an  60%  25% t h a n two of  to that.  during  the  small  credit  went  "overintegration"  or  of  the  private  tax  a  remained  payable  chapter  dividend  private  remained  combination  deduction, a  to  did  deduction  has  rate  in  its  extent  have  rate  closer  produce  produced  to  approximately  enriched  to  of  the  deduction  mentioned  inclusive,  time  to  which  marginal  come  as  -  advantage  from  Canadian-controlled  small  as  deduction  business  business  top  has  course,  business  income  but  Act  business  the  the  continued  small  small  small  1978-1981  from  advantage  Canadian-controlled  deferral  the  it  the  the  the  dropped  approximately  business  Has  in  at  business  small  by  for  while  has  deferral  that,  small  to  the  The  individual  the  the  faced  shareholders,  the  seen  changes  regime  corporation  be  deferral.  Notwithstanding the  see  Viewed  irreplaceable.  inception  that  deduction.^  active  corporation this  situation  change  whereby  the  business eligible in $400  the of  discussion on small business Report, v o l . 4, pp. 271-272. of the Act added by SC 1 9 8 0 2).  36  income  used  only  as  $175  the  of  to  the  directly  by  an  remained the  the  deferral  method provided  small  inception, the  tax  its  II  in  any  suggest  it  of  the  a  which to  and  as  with  of  the  leaving  the  small  those  the  corporation  disappeared  the  not, to  result  above  as  earned  did  period  as  i t s e l f  deduction, to  then,  constitute, business  small  other  that  income  available  this  tax  advantage  small the  tax  only  business  who  chose  to  provisions.  continues  Does  same  rate  discussed  tax  business  and  deferral.  would  of  that  during  through a  incorporated  assistance  the  attract  individual  assistance  Part  advantage  themselves  The  of  constant the  would  "Superintegration"  business;  of  above  and  on  "superintegration"  significant deduction  tax  amount  essentially  Budget  to  the  implementation  avail  of  individual.  small  1981  comparison  corporate  $200  increase  incorporated  of  combined  compared  however,  basis  a  form  through  business  way? does  constituted  A not  as  the  of is  its  assistance  mechanism  deduction  review -  of  at  the  of  provide  legislation  confirmed  in  the  12 literature.  The  "assistance" that  the  controlled this within  and  constitutes  shareholder private  favourable the  favourable  tax  or  tax  is  assistance shareholders  corporation rate  rate  can  eligible afford  to  the  sole  only  to  of  the  to  the  of  extent  Canadian-  avail  leave  form  i t s e l f  its  of  profits  corporation.  12. See f o r example: J.E. Hershfield, "Is an Unintegrated Corporate Tax Regime a Small Business Subsidy?" Canadian Taxation ( W i n t e r , 1 9 7 9 ) , p p . 5 3 - 5 7 a t p. 5 3 .  37  The  fact  providing  that  implementation  assistance  to  of  business  relies  end  confirms  the  to  achieve  that  device.  The  size  the  resulting  is  a  suggests  that  deferral to  to  the  such  there  its  1985  intended  federal  figures  are  oft-stated  small  deferral  of  the  need  tax  to  beneficiaries the  most  available,  the  amount  solely  value  -  the in  of  upon this  strongly  benefits  1980,  recent  of  of  expenditure  limit  Budget  goal  according  year  tax  of  for  thus  which  deferred  13 was an  estimated  at  "assistance"  direct  grants  $1,305,000,000. program  rather  created  without  control  to  of  than  including  ensure  this  that  as  It size  a  tax  within  the  -  unlikely  implemented  expenditure  its  aims  seems  of  structure the  by  -  way  of  would  be  form  of  some  program  that  were  being  met. The  question  this  assistance  the  small  to  Canadian thus  between  from  f u l f i l  its  arises: tax  who  deferral uses  himself  stated  what  the and  purpose  of  business  role  mechanism  the  corporation  suggests,  that  would  ensures -  a  that  sum  exceed  by  that  owner  form  entrepreneurial  What  above  corporate  the  small  economy?  found  to  ensure  assisting  traditional  in  mechanisms  available  its  accumulated  analysis  the  business  intermediary diverted  -  then  as  -  is  of an not  business in the  which,  the funds  as  the  approximately  13. The Honourable M i c h a e l H. Wilson, Minister of The Corporate Income Tax System A Direction for Canada, Department of Finance, Ottawa, Queen s 1985, pp. 7-8.  Finance, Change. Printer,  38  fifty  per  cent  the  after  tax  proceeds  available  to  the  sole  -  simply  left  14 proprietor there  to  invested In  from shelter  in  deduction.  c r i t e r i a  be  2.  reinvest  3.  use  that,  31),  where  integration (ignoring  in  tax  tax  to  it  (as  the  f i r s t  advantage  to  incorporated  indeed for  established  the  small  these  to  from  as  the  business  businesses:  to  and  d i v i d e n d s . ^  used equity, of  involve equity  a  only  remained  there and  or  pay  advantage  provided then  depart  discussed  were  seemed  even  to  savings;  restore  neutrality  being  made  that  savings  important  and  s a t i s i f i e d :  the  while  either  savings  policy of  and  not  taxation  was  were  were  system  appeared  which  corporation  the  tax  the  principles  small;  this  the  fiscal  e l i g i b i l i t y  1.  Given  a  are  investments?  decision  c r i t e r i a  for  These  immediate  "passive" the  certain  business  from  providing  preconditions  be  them  when  by  businesses,  savings  active  so-called  1972,  neutrality  above),  his  were  second  in two of  above  at  pages  28-  to  pay  dividends,  and  thus  neutrality  deferral  discussed  departure  from  the  the  tax  of  the  insofar the  hands  further the  as  three  c r i t e r i a  to  conditions  14. Of the p r o f i t s of $400 d e s c r i b e d in the example found above at pp. 28-31, there would be $ 3 0 0 l e f t after payment of tax i n the corporate coffers of the Canadian-controlled p r i v a t e c o r p o r a t i o n as opposed to o n l y $200 r e m a i n i n g i n the hands of the s o l e p r o p r i e t o r f r o m t h e same l e v e l o f profit. 15. As i s s u g g e s t e d by t h e quotation taken from Honourable E.J. B e n s o n , M i n i s t e r of F i n a n c e , Summary o f 1971 Tax Reform Legislation, Ottawa, Queen's Printer, 1 9 7 1 , p. 37 w h i c h is found at p. 27 a b o v e a n d c o n f i r m e d i n t h e d i s c u s s i o n below on p p . 37-41.  39  mentioned as  the  these  nature two  The the  above. of  first  of  capital  markets  ensuring  small  for  earnings"^ threshold 1973,  that  17  the  $500,000  from  -  for  One  adherence  the  business active  of  to  concept  years  of  deduction"  1976  when  the  "total  "retained a  years  1974  to  from  terminated  reached  taxation  the tools  the  enacted,  was  in  important  benefitted  years  that  restriction  the  business  for  was  imperfections  business  taxation  taxation  This  originally  $400,000  enquire  "assistance"  perceived  was  "small  to  small.  above.  as  which  to  ensured.  "small"  which,  derived  for  be  deduction  figure  $750,000  of  only  the  be  therefore  through  prerequisites  basis  limit"  e l i g i b l i t y  to  mentioned  business  business  was  business  the  relevant  mechanisms  the  corporation's on  becomes  the  conditions  justified  for  It  defined 1972  and  1981  and  1975,  1 o  i n c l u s i v e ,  1  9  ?o $1,000,000  for  taxation  Legislation with  the  years  resulting  restriction  1982 to  from  embodied  in  the the  1984  inclusive.  1984  Budget  concept  of  did the  away total  16. As d e t e r m i n e d by the formula prescribed by the Income Tax A c t of Canada ( p a r a g r a p h 125(6)(b)) d e f i n i n g the content of the "cumulative deduction account". To equate the cumulative deduction account to retained earnings i s , of course, to s i m p l i f y in the extreme - e s p e c i a l l y , in view of the amendments to the Act stemming from the 1981 Budget which put an end to the possibility of "refreshing" the cumulative deduction account by paying out dividends but f o r the p r e s e n t such a d e f i n i t i o n seems a d e q u a t e . 17. P a r a . 1 2 5 ( 2 ) ( b ) of t h e Income Tax Act. 18. Para. 125(2)(b) of the Income Tax Act SC 1 9 7 4 - 7 5 - 7 6 , c . 2 6 , s u b s e c . 81(1). 19. Para. 125(2)(b) of the Income Tax Act SC 1 9 7 6 - 7 7 , c . 4 , s u b s e c . 49(1). 20. Para. 125(2)(b) of the Income Tax Act SC 1 9 8 0 - 8 1 - 8 2 - 8 3 , c . 140, subsec. 86(1).  as  amended  by  as  amended  by  as  amended  by  40 business  21  limit  and  did  away  as  well  with  i t s companion  22 piece,  the  cumulative  deduction  account.  p r o v i d i n g a s s i s t a n c e t o s m a l l b u s i n e s s had "small  business  deduction"  i s described 23  as a " s m a l l b u s i n e s s t a x i n c e n t i v e " come  to  the  fore:  The not  goal  of  changed -  the  i n the  1984  - b u t a new  "simplification."  In  the  Budget  policy  words  of  had the  H o n o u r a b l e Marc L a l o n d e , s p e a k i n g as M i n i s t e r o f F i n a n c e : ... t h e m e c h a n i c s o f c o m p u t i n g t h e c o r p o r a t i o n ' s cumulative i n c o m e , as w e l l as t h e legislation r e q u i r e d t o d e f i n e i t , have become i n c r e a s i n g l y complicated. The c u m u l a t i v e d e d u c t i o n a c c o u n t i s now one o f t h e most c o m p l e x p a r t s o f t h e s m a l l b u s i n e s s tax system . . . 2 4 the additional precision achieved by the c u m u l a t i v e income l i m i t i s not j u s t i f i e d i n l i g h t of the c o m p l e x i t y i t c r e a t e s . ^ The business resulting  other  deduction, tax  business.  as  savings  At  legislation, ineligible  criterion  the  Part  V  entitlement  originally be  tax  -  in  of  passage  a  refundable  was  to  to  enacted,  reinvested  time  investments  which ensured  for  be  the  of  the  was  small  that  the  corporation's  the  tax  the  in  control  Tax  Reform  respect  of  mechanism  that:  t h e i n c e n t i v e [was l i m i t e d ] t o s m a l l e r p r i v a t e C a n a d i a n c o n t r o l l e d c o r p o r a t i o n s t h a t r e q u i r e , and i f f a c t use, the tax s a v i n g s to i n v e s t i n t h e i r businesses.... o c  21. SC 1984, c. 45, s e c t i o n 40. 22. L o c . c i t . 23. Honourable Marc Lalonde, Minister of Finance, S i m p l i f y i n g T a x e s F o r S m a l l B u s i n e s s , C a n a d a , D e p a r t m e n t of F i n a n c e , O t t a w a , Queen's P r i n t e r , T984, p. 1. 24. op. c i t . , p. 15. 25. op. c i t . , p. 16. 26. H o n o u r a b l e E . J . B e n s o n , M i n i s t e r o f F i n a n c e , Summary o f 1971 Tax R e f o r m L e g i s l a t i o n , O t t a w a , Queen's P r i n t e r , p. 37.  41  This  tax,  force  however,  with  its  was  repealed  repeal  having  shortly  after  application  coming  into  retroactively  to  27 1972.  It  was  never  apparently,  withdrawn  change  quite  but,  complex.  In  Minister  of  replaced. on  the  simply,  the  words  The  basis  because  of  The  Part  of it  a  V  tax  was  deliberate  was  feared  Honourable  policy  to  John  not,  be  N.  too  Turner,  Finance:  I believe that the p o l i c y which gave rise to the i n e l i g i b l e i n v e s t m e n t t e s t was c o r r e c t , but I have come to the conclusion that it is too complicated.2g It small  can  invest is  the  built  in  fact  eliminated. tax  on  shape  the  w i l l  that  small this  now  its  a v a i l a b i l i t y  both  of  to  which  a  the  context,  the  by  were  potential Canada  indeed  target  "tax  devices  deduction  in  accompanied  apparent,  control  business  the  definite  Equally the  embodying  benefits  used  accumulations be  legislation  originally  businesses."  that  In  the  was  ensure  unreasonable and  that  businesses  their  into  to  their  "small" in  then  deduction  designed  restricted the  seen  business  measures  -  be  group  savings of  to  course,  originally  have  now  rationale begins  to  been for  a  take  explored.  27. S.C. 1973-1974, c. 14, s. 60. 28. C a n a d a , P a r l i a m e n t , House of Commons, O f f i c i a l R e p o r t of Debates, Ottawa, Queen's Printer, vol. 2, 1 9 7 3 , p. 1433. The v i e w e x p r e s s e d by t h e M i n i s t e r o f F i n a n c e was apparently prevalent. See for example: Goodman, p. 39 or Bernard Shinder, "The T a x a t i o n of S m a l l B u s i n e s s : An H i s t o r i c a l and Technical Overview," C a n a d i a n Tax Journal, vol. 32, no. 1 (Jan.-Feb., 1 9 8 4 ) , p p . 1 - 5 3 a t p. 1 3 .  42  It the  has  been  demonstrated  shareholder  private  or  shareholders  corporation  deduction"  when  proprietor rates  is  of  by  the  business  approximately the  sole  that,  the  deduction fifty  to  corporation greater  the for  (as  abused  as  was  represents  a  equity  fact  the  that  indirect  of  example  but  course,  that  business  fiscal  nature  is  from  the  in  that  concerns may  sole  rather  provide  available  to  was  inequity  to  28  the cent  to  31  intended  or  clearly  lies  of  in  the  to  the  business,  its  There  situation  than  given  per  available  small  a  -  principles  proprietor.  such  the be  deduction  is  the  w i l l  pages  twin  incorporated  by for  fifty  as  business  the  earned  available  be  used  deferral  equal  profits  at  The  Assuming  profits  sum  small  of  to  neutrality  it  sole  that  i t s e l f  neutrality.  the  not  the  the  eligible  than  discussed  whether  of  be  reinvested  would  and  may  reinvested  investment  to  business  of  deferral.  factor,  the  "small  situation  greater  accruing  Canadian-controlled  the  which  his  advantage  owner  shareholder, lack  cent  departure  horizontal  of  deferral  feared,  the  of  its  from  Thus,  advantage  corporation  on  per  the  i l l u s t r a t e s ) .  of  the  revenue  private  proprietor  due  to  possibility  return,  the  reason  compared  Canadian-controlled small  that  is  means,  considerations  the  sole  motivation  within  the  corporation  a of  of  a for  incorporation.  Insofar result  of  reinvested  as  the in  the  funds  operation its  active  of  left the  small  business,  business the  deduction  departure  from  as  a are the  43  principles the  of equity  proponents  justified  of  by  development deduction  the  the of  and n e u t r a l i t y  not occur,  the  corporation,  shareholders,  to  that  provide.  from  to  the When  does  through  to benefit  circumstances,  which  explanation  and,  deduction  contribution  country  i s claimed  be r a t i o n a l i s e d  business  resulting the  does  small  would  the  such  business  reinvestment  not j u s t i f y  permitting  shareholder  tax expenditure.  the corporation, i n e f f e c t ,  being  economic  small  i t , i t s  this  as  by  or  In  constitutes  such  a tax  shelter.  In the  terms  small  reinvest the  of p o l i c y ,  business  the tax savings  funds  originated above,  mechanism  f o r ensuring  the  business  small  the  the r e c i p i e n t  from  the  which  this  thesis  total  neutrality  small  business  depart  from  policy  grounds,  appears Part  V  that  funds  to  be  tax  was  would  only  suggests,  i s virtually deduction  neutrality. where  those  As  Canada Where  has such  the t o t a l  from  intended  which -  as  be  the  i n the  business  quotation  choice of  from  i n t h e hands  with  of achieving  In f a c t ,  amount  not  resulting  remain  the  to  deliberately a  do  unintentional  the problem  insoluble.  through  who  business  i f reinvested  originated.  begins  to  available  the tax savings  deduction  and  accrue  i n the active  corporation  which  the benefit  deduction  mentioned  of  that  with  the  chosen  i s made tax  to  upon  revenue  44  deferred should  is  be  important funds  as  large  taken  to  policy  for  which  the  mechanism,  but,  only  framework u t i l i t y on  as  a  it  remained  $1,000,000 $750,000  limit be  business control  in  would  value  of  device  unreasonable  existence when  the  at  best  a  would  to  seem  accumulations  its -  that a  and  preferable. seem  to  be  l i m i t ,  limit  was up  the  total  that  form an  to sole  would  business  earnings  now  A  it  its  income  that  is  a  ceiling  coffers  of  the  is  advantage.  whereas  given  tool,  tax,  business  retained  necessary faulty  at  placing  in  was  such  V  business  yet,  Thus,  by  legislative  and  amount  and  these  would  the  total  earnings  -  Part  in  to  have  -  mechanism  course,  the  total  business. be  the  the  providing  deferral  similar  that  of  of  the of  much  to  was,  of  business  control  limited  steps  principles  deduction  the  a  as  course,  inherent  retained  ensured  seem  l i m i t ,  factor  earned  of  a  repeal  was  two-thirds way  the  corporation  having  no  limit  device  after-tax  reinvested  device  the  that  then  attainment  corporation's  business  possible  of  only in  the  for  proprietor retain  small  potential  case,  indicate  29  instance,  fundamental  business  control  Notwithstanding  this the  following  the  this  successful  from  restrictive  of  the  in in  would  total  in  the  -  departure  The  is  ensure  goals  This  needed.  the  it  reinvestment  j u s t i f i e d .  was  as  a  would control  the  total  gone,  a  of  tax  new on  appropriate  29. As discussed at page 37 a b o v e , the value of the tax revenue deferred was placed at $1,305,000,000 in the Honourable Michael H. Wilson, Minister of Finance, The Corporate Income Tax S y s t e m A D i r e c t i o n f o r C h a n g e . Canada, Department of Finance, Ottawa, Queen's Printer, 1985, pp. 7-8.  45  device. the  If  appropriately  benefits  available  (now  limited  than  their  when  used  only total in  corporation's small they thus,  justification  in  chapter  In the  a  such  addition  to  deduction  in  satisfactory  method  which  qualifying  the  reasons  for  as  the  did  rather  of  goals  of  the where  business  not  w i l l  the  funds  active  which  -  where  the  exist.  The  be  discussed  for  abuse  the  the  the  It  budget  of  Tax  affected of  to by  tax  the  to  appear  a  allegedly  This  conclusion  speech  wherein  more  of  small  the  "non-  deal  that  conclude  f u l l  on  specifically  Act  the  of  could  types  provisions  would  their  a  as  category  Income  unworthy  capital.  the  the  government  was  viewed  with  the  income  deduction  from  of  above,  implemented, be  into  were  125  were  generated  example,  if  business."  provisions  business  f e l l  led  potential  described  dealing  than  professional  internally  the  take  i t s e l f ,  of  section  "non-qualifying  small  of  formerly  the  business  and  business"  into  of  same  the  accumulations,  conceivably,  forms  requirements  could  alleviating  business  unreasonable  inserted  tax  deduction  corporation  circumstances from  leave  seven.  small  business  a  the  withdrawing  in  would  increment  f u l f i l l i n g  departure  which  tax  of  corporation's  equity  for  annual  the  while  the  a  business  hands  with  -  small  the  thus,  deduction  such  their  in  -  from  the  of  accordance  diverted  form  terms  amount)  restoring  precise  through  business  business were  in  structured,  with  one  that  of the  non-qualifying benefit lesser may the  of need  be  the of  drawn,  Honourable  46  J.  Chretien  business  introduced  as  stating  originally  concept  Chretien  Insofar  as  for  follow  on  to  may  that,  in  to  generated  assert  the  the  non-qualifying  that  speech,  after  were  a  effect  of be  non-qualifying theoretical justified to  special  the  their in  were of  the  tax  to  on  business  his  measures  capital,  profits  of  the  w i l l  business"  a  on  tax  which  unreasonable  and  tax budget  targeted  in  led. at  this  their which  nor  tax  regime  distributed  would  advantage to of  of  Thus,  it  accumulations  eyes  treatment  find  them,  facto  the  to  generated  deferral  ipso  seem  unreasonable  business  reinvested  not  lesser  of  "small  corporation  the  not  those  is  a  would  (or  small  neither  have  it  they  If  which,  special  which  professionals  the  eliminate  basis the  that  instances,  part  profits  the:  of p r o f e s s i o n a l c l a s s e s the small business.  profits.  shareholders  essentially  of  many  those  that  generated  companies)  those  business  true  reinvest  accumulations  to  be  internally  management  if  In  the  justified . . . in favouring small business get the necessary c a p i t a l for growth ...  went  it  necessary  and  30  conceived.  financial situation t h e same a s t h a t o f  need  of  that: we a r e . . . to  Mr.  the  the even  class  of  for  remove  Mr.  the the  Chretien,  non-qualifying in  the  absence  "business,"  it  30. In B i l l C-37. This b i l l was not, however, the legislation which eventually gave the force of law to the concept of the n o n - q u a l i f y i n g business. Rather, B i l l C-17, a somewhat modified version of B i l l C-37, effected this r e s u l t when i t r e c e i v e d R o y a l A s s e n t on D e c e m b e r 6 , 1 9 7 9 . 3 1 . C a n a d a , P a r l i a m e n t , House of Commons, O f f i c i a l R e p o r t of Debates, Ottawa, Queen's Printer, vol. 3, 1978-1979, p. 3244.  47  would  be  possible,  accumulations, wherein  the  to  through  deal  f i s c a l  with  system  a  tax  at  least  has  been  on  one  unreasonable  source  alleged  of  to  inequity  favour  the  "professional."  In  the  absence  of  the  total  tax  on  be  preceding  the  Part  business  unreasonable  viewed  as  a  which  pertaining  to  the  tax,  limit  exemption  has  business  from  provided  for  the has  taxation  and  the  that  such  same  l i m i t .  come  a  first  tax  a  could  business as  those closely  limit  and  the  creating  $500,000  of  for  Following  1985 Budget  the  concept  time  business  the  the  the  in  justification  the  total  for  of  that  non-qualifying  at  business  of  argued  elimination  repealed  total  elimination  non-qualifying  is  accumulations  were  the  it  the  replacement  provisions  upon  V  pages,  of  an  capital 32  gains move the to  earned  by  provides  an  a  further  incorporated retain  its  possibility gains  who  able  are  have  gained  have  not  earnings  proprietor, 32. The Budget Queen's  business  to a  in  many  accomplish  very  deferred  w i l l  a  tax  for  to  this  on  lifetime.  the  cause  may  would  be  manoeuvre advantage these not  avoided  is  found  be  converted  tax  Honourable M i c h a e l H. Wilson, Papers, Canada, Department Printer, 1 9 8 5 , p. 3.  in  free.  indeed.  the to  Those  successfully  available  of  corporation  "capitalized"  it  This  shareholders their  incentive  cases  benefit have  his  earnings  significant  already they  That  retained  which  during  incentive  profits.  merely -  small  that  capital  individual  They  w i l l w i l l  retained  to  the  sole  altogether.  In  such  Minister of of Finance,  Finance, Ottawa,  48  circumstances, principles private  the  which  f a i l s  business  If  principles  the  small 42  which  is  said  flowing  tax  imminent  enactment support  becomes  avoid  desirable  they of  have are  the  corporate the  of  used  in  for  tax  to  an  in  then  a  manner  the be  is  of  such  tax  a  of  occurs. in  the  profits  very  least  If  which  ensure with  the  to his  would  those  to  it  Canadian-  it  consistent  lend  planning  over  level  the  to  tax. a  careful  exerted  which  advantage  appear  the  corporate  a_  be  funds that aims  deduction.  1985  rates  of  benefits  exemption,  would  through  at  principle  warranted  gains  favour  on  the  is  at  business) ,  income  shareholder  control  business  personal  tax  from  added  by  above  economic  the  its  violated  found  small  exemption  the  at  the of  when  corporation  some  the  by  in  exacerbated.  are  departure  capital  arguments  income  in  a  accumulations  such  remained  small  Also  case  l i a b i l i t y  makes, that  in  justified  the  to  greatly  analysis  encouragement  private  corporation  -  projected  personal  which  be  possible  controlled  be  the  are  tax  business  earnings  (as  they  the  course,  basic  small  retained  deduction  unreasonable  of  the  neutrality  escaping  absence  further  of  from  its  of  Canadian-controlled  and  this  on  the  equity  the  is  completely a  of  to  from  f o r t i o r i  If  would,  indicates  where  reinvest  business  violation  benefitting  to  active  page  occurs  corporation  deduction  the  unjustifiable  -  Budget thereby,  Canadian-controlled  private  is if  the it  proposal becomes  corporation  to  decrease  law,  allowing  to  retain  for  49  re-investment  a  it  that  is  assumed  accompanied burden  by  borne  corporation taxes  greater  of  changes  the  to  profits  by  its of  the  as  this  proposal  that  upon  the  Even  if  would  be  ultimate  distribution  dividends,  individual  33  profits.  ensure  shareholder,  its  payable  of  implementation  other by  portion  would  whose  income  tax  by  the  equal  the  came  from  34 another  source  proposal  thereby  certainly  increasing  the  resulting small  -  business  corporate  has  the  of  the  value  potential  maintaining  for  potential deferral  inequity  deduction.  rate  as  integration  In  proposed  -  this  significantly  advantage available  fact,  in  for  -  given  -  and  the  through  that  the  1985  Budget  deferral  would  exist  the  the  f u l l  would  be  35 39%,  the  the  possibility  corporation's  rate.  Thus,  shareholder  it  corporations the  rates the  of  this  weight  in  than  to  for  the  implementation  the of  a  of  some  expose  use  on  that  either  them  taxation.  if  the  accumulate  of it  arguments tax  at  By  the should  put  to  even  f u l l  controlling  private  or  prefer  within the  where  corporate  the  circumstances,  to  income  proposal, to  taxed  inconceivable  profits  personal  potential  shelter, much  might,  rather  not  was  shareholders  corporation's  coffers  a  income is  or  of  public to  the  corporate  higher  greatly  allow  marginal increasing  corporation  as  a  tax  become  would  add  forth  unreasonable  law,  above  which  favour  accumulations.  33. The H o n o u r a b l e M i c h a e l H. W i l s o n , M i n The Corporate Income Tax System A Direc Canada, Department of Finance, Ottawa, 1985, p. 3 1 . 3 4 . As s e e m s t o be t h e i n t e n t i o n . See o p . 35. op. c i t . , p. 3 1 .  ister of tion for Queen' s c i t . ,  pp.  Finance, Change. Printer, 40-41.  50  Based the  upon  several  described increase  the  legislative  above the  and  on  in  the  unreasonable  permit  Canadian  economy  attributed reducing  the  the  to  a  for  inequity small  accumulations business  with  the fiscal  possibility  for  and  and,  as  a  measure of  which  to have  while this  that  changes  tending  to  consequence,  tax  redress  deduction  benefits  abuse  each  business  could  submitted  proposed  progression,  Canadian  small  this  analysis, i t is  changes  represent  potential  non-neutrality tax  foregoing  system. the  A  balance  provide often  the been  significantly  "incentive."  51  Chapter  The  Canada  has  accumulations  Tax  enacted  previous  part  of  Tax in  such  discretion  1917.  statute considered 1972  discussed  Reform. providing  to -  and,  which to  be  below)  retroactively  to  tax  in  which  model  upon  provisions there  with  had  any  so to  date  on  seriously  flawed  necessitate upon  which  respect  of  into is  to  it  a  force  of  much  base  any  ministerial  an  basis  War in  unreasonable in  discretion, that  in  mentioned  granted been  found  Income  came  provision  ministerial  was  the  that  which  as  as  was  a  objectionable  example  tax,  was  the  neither  that  grants  V  unreasonable  f i r s t  Unfortunately,  1917  determine  second  Part  on  statute,  refundable  or  the  tax The  tax  The  the  tax:  accumulation  the  in  of  history.  income  investments  assistance future  federal  Experience  forms  f i s c a l  chapters,  ineligible as  two  its  f i r s t  Act,  had  in  Canada's  Canadian  4  a  taxing  must  alone, (as  repeal  originally  be while  w i l l  be  effective came  into  force.  Canada's expressed  in  original the  tax  following  on  unreasonable  accumulations  was  terms:  For the purpose of the supertax only, the income of a t a x p a y e r s h a l l i n c l u d e the share to which he would be entitled of the undivided or  52  undistributed gains and profits made by any corporation . . . , if such gains and profits were d i v i d e d or d i s t r i b u t e d , unless the M i n i s t e r i s of opinion that the accumulation of such undivided o r u n d i s t r i b u t e d g a i n s and p r o f i t s i s n o t made f o r the purpose of evading the tax, and is not in excess of what is reasonably require for the p u r p o s e s of the business. In  1919,  slightly  this  provision  modified  version  . . . a income, more as  was which  repealed was  said  and to  replaced  demonstrate:  changing attitude towards the c o r p o r a t i o n being thought a separate entity . . . .  Section follows:  3(4)  as  re-enacted  by  in  corporation of more and  1919  read  as  'The share of a t a x p a y e r in the undivided or undistributed gains and profits of a c o r p o r a t i o n s h a l l n o t be d e e m e d t o be taxable income of the taxpayer, unless the Minister is of opinion that the a c c u m u l a t i o n of such undivided or undistributed g a i n s and profits is made f o r the purpose of evading the tax, and is in excess of what is reasonably r e q u i r e d f o r the p u r p o s e s of the business.' While the o r i g i n a l s e c t i o n c o n s i d e r e d as income to the shareholder his proportionate share of the earnings of the company, unless distribution was withheld for some good reason, the section substituted in 1919 p r o v i d e d that the income of t h e c o r p o r a t i o n s h o u l d NOT b e c o n s i d e r e d i n c o m e of the shareholders unless distribution was withheld f o r the purpose of e v a d i n g tax.2  In  spite  of  the  corporation  commented  one  thread  common  recall  the  1. Income Report of and F a m i l y 53. 2 . loc. c i  various  to  evolving  upon both  in of  ministerial  the  attitudes above  these  towards  quotation,  provisions  pronouncements  there  the is  which  may  regarding  the  War T a x Act, subsection 3(4) as found i n Canada, t h e R o y a l C o m m i s s i o n on The T a x a t i o n of Annuities Corporations, Ottawa, Queen's P r i n t e r , 1945 at p. t .  53  small  business  value  for  deduction  future  accumulation  being  the  of  purposes  meaning  of  certainly  application: justified  the  this  and  the  where  business."  expression,  it  provides  was  concept  question  "reasonably  In  a  discussing  of  of  an  required  for  the  possible  said:  No a t t e m p t c a n be made ... to enumerate a l l the ways in which the gains and profits of a c o r p o r a t i o n may be a c c u m u l a t e d f o r the reasonable needs of the business. Undistributed income is properly accumulated if invested in increased inventories or additions to plant reasonably needed by the business. It is properly accumulated if retained for working capital required by the business, or in accordance with contract obligations placed to the credit of a sinking fund for the purpose of retiring bonds i s s u e d by t h e corporation.^ It  may  be  worthy  manifestations on the  in  unreasonable opinion,  accumulations not  as  Income  accumulations  was  Although  note  the  before  accumulation  apparently  of  for  the  the the  that  Tax  required could  purpose  of  on  enforced  War  tax  original  remained  well  after  Act  imposed,  the  tax  of  its  Canadian  Minister  evading  books  both  this  the be  Canadian the  in  to that  be  tax of the  tax.  on  unreasonable  until  1948,^  it  was  early  years  of  its  3. C h a r l e s P. P l a x t o n and F r e d e r i c k P. V a r c o e , A T r e a t i s e on t h e D o m i n i o n Income Tax Law, T o r o n t o , The C a r s w e l l Company, Limited, 1 9 2 1 , p. 2 3 3 . 4. K a t h l e e n A. Lahey, "'Active B u s i n e s s ' as a Technique of Source Discrimination in the Formulation of Corporate Tax Policy," Osgoode Hall Law Journal, vol. 16, pp. 35-79 at p. 3 7 , f o o t n o t e 4.  54  existence.  This  decisions  in  After Canada as was the  which  a a  of  an  said  to  second  have  greatest  dual  explain  is  at  The  rate  light  "extracted  structure  of  are  for  (which  V  no  reported  tax  tax, was  in  business  the  government is  criticisms small  1972  brought  reluctance  many the  a  small  from  Such the  such  Part  package"  reluctance."^ in  there  without  attempt.  been  why  issue.^  period  "incentive  understandable the  it  lengthy  made  part  may  in  which with  perhaps  levelled  business  at  deduction  g replaced)  by  the  wherein  the  Tax  Finance  after  Carter Reform  echoing  Commission. b i l l some  was of  In  presented, those  the  Budget  the  speech  Minister  criticisms  went  on  of to  say : However, with these d e f i c i e n c i e s e l i m i n a t e d , a low rate can be an effective way of encouraging i n i t i a t i v e by helping small corporations to accumulate c a p i t a l for business expansion If a corporation employs the tax savings that result from the low rate for non-business purposes, such as p o r t f o l i o investments, a special r e f u n d a b l e t a x w i l l be i m p o s e d t o r e c o v e r the lowrate benefit.g The  Part  tax  was  V  tax  included  was, in  of the  course, Tax  that  Reform  tax.  package  Thus, in  an  a  special  attempt  to  5. D. Keith McNair, "Corporate Distributions," Essays on Canadian Taxation, Toronto, Richard De B o o L i m i t e d , 1978, c h a p t e r 1 5 , p p . 5 3 9 - 6 2 3 a t p. 5 4 0 . 6. Lahey, o p . c i t . , p. 37. 7. Harold Buchwald, Small Business Incentive and Canadian T a x R e f o r m , T o r o n t o , CCH C a n a d i a n L i m i t e d , 1 9 7 2 , p. 68. 8 . See f o r example: Canada, Report of the R o y a l Commission on T a x a t i o n , Ottawa, Queen's P r i n t e r , 1 9 6 6 , v o l . 4~j p p . 2 7 0 271. 9 . C a n a d a , P a r l i a m e n t , House of Commons, O f f i c i a l R e p o r t of Debates, Ottawa, Queen's Printer, 3rd Session, 28th Parliament, v o l . VII, p. 6897.  55  ensure  that  business to  the  tax  deduction  finance  The  its  savings  would  business  Part  V  tax  in  resulting  fact  be  used  from by  the  the  small  corporation  operations.  did  not,  however,  last  long.  In February 1973, the government gave up on the proposal . . . . Concluding that the provisions required to d i s t i n g u i s h business from non-business i n v e s t m e n t s w o u l d be j u s t t o o c o m p l i c a t e d , t h e tax on i n e l i g i b l e i n v e s t m e n t s was d r o p p e d , retroactive to the b e g i n n i n g of 1972. The  description  contained great few  in  many  the  of  "the  the  Part  articles  which  which  provisions  of  In  the  Part  V  tax  is  of  its  demise,  its  potential  Canadian  tax  limited  indeed  become  the  pointless herein. quickly  very  V,  the  i t .  In  to  have  been  author  are  fact  as  accumulations  -  particularly  at  the to  in  same the  This a  detailed  time, Part  a  time  being  analysis  however, V  tax  so,  may  the  their  the  cause  a  future  extremely  simplicity  of  flaws  would  its  to that  in  for  it  provide  the  made  seems  when  of  a  complexity  as  model  in  states  the  cited a  one  numbing  that  frequently u t i l i t y  theme  to  the V  complicated"  recurring  unreasonable  engage  fatal  a  "too  on  watchword.  to At  so  is  Part  of  of  as  appears  of  view  tax  refer  Part  provisons  i m p a c t . " ^  V  quotation  attempts  convoluted  i n i t i a l  the  above  the  published  analyse  of  has seem  provisions  which  were  guidance  as  so to  10. William J. Strain, "'Capping' Provisions: The Annual and Total Business Limits and the Cumulative Deduction Account," text of a paper delivered a t a S y m p o s i u m on the Simplification of the Small Business Provisions of the Income Tax A c t h e l d i n T o r o n t o , O n t a r i o on J u l y 1 1 - 1 3 , 1983 s p o n s o r e d by t h e C a n a d i a n Tax Foundation. 11. H.O. Spindler, "The small business deduction," Canadian Chartered Accountant, D e c e m b e r , 1 9 7 2 , p p . 6 2 - 6 5 a t p. 6 4 .  56  p i t f a l l s which  avoid.  follows  intended a  to  to  w i l l  for  only  the  to  reviewing  examination manner  the  the  of  in  extent  the  which  Part the  necessary  criticisms  which  V  tax  tax  was  to  provide  were  levelled  i t .  The  focus  investment"  of  made  corporation the  the  describe  function  framework  at  Thus,  the  Part  V  by  the  Canadian-controlled  eligible  language  of  the  for  the  statute,  tax  small an  was  the  business  "ineligible  "ineligible private  deduction.  In  investment"  was:  . . . a property that was not acquired for the purpose of gaining or producing income from an active business of the particular corporation,  There not  followed be  these on  short-term private exemption money  and  lengthy  considered  essence, (whether  a  to  be  permitted  deposit debt  in  a  the  of  "ineligible  financial and  category debt  of  consisted  or  by  debt  the  would  was  or  of  In money  otherwise)  obligations  taxpayer.  ineligible  securities  which  investments."  institution  shares  controlled  short-term  "investments"  "investments"  securities  corporations from  l i s t  made  investments so  of The of  that:  ... a corporation which finds i t s e l f temporarily with idle funds i s not precluded from using them to earn a return until such time as t h e s e funds a r e r e q u i r e d by t h e b u s i n e s s . ^ The  exemption  private  12. 13.  with  respect  corporations  to  shares  controlled  The Income Tax A c t of C a n a d a , S p i n d l e r , op. c i t . , p. 64.  or by  debt the  paragraph  obligations taxpayer  189(4)(b).  of was  57  withdrawn ineligible  In an 25%  where  circumstances  the  controlled  corporation  itself  made  in  make  investments.  ineligible of  the  where  investment,  lesser  the the  corporation resulting  did  tax  was  fact "equal  to  of:  (a) 2 times the cost of ineligible investments acquired after 1971 and owned a t t h e end of year, and (b) end The  The c o r p o r a t i o n ' s of the y e a r . ^  "preferred-rate  amount"  preferred-rate  amount  at  the  was:  ... income taxed at the low r a t e [which] goes into a separate pool of funds . . . which is then d e c r e a s e d by d i v i d e n d s p a i d . The p o o l of f u n d s is increased by dividends from subsidiaries to the extent that the p a y e r ' s preferred rate amount is r e d u c e d by t h e d i v i d e n d . In o t h e r words, so long as dividends paid equal the sum of the income taxed at the low rate, plus certain dividends received, the pool w i l l be zero and no tax on ineligible investment w i l l be payable. If the annual dividend rate is lower, t h e n any purchases of ineligible investment w i l l be presumed to be o u t t h i s p o o l a n d t h e t a x w i l l b e p a y a b l e ••••15  This recovered  "recaptured" by  the  tax  corporation  saving from  the  could,  i t s e l f ,  government  be  where:  . . . a corporation sells some or a l l of the i n v e s t m e n t s on hand a t t h e end o f t h e y e r , or the corporation pays sufficient dividends to reduce its preferred-rate amount or the preferred-rate amount is reduced by a non-capital loss carryback ..  14. Canada, N a t i o n a l Revenue, Taxation, - t a x r e f o r m and y o u , p.34. 1 5 . A n a l y s i s of t h e C a n a d i a n Tax Reform CCH C a n a d i a n L i m i t e d , 1972, pp. 75-76. 16. S p i n d l e r , o p . c i t . , p. 64.  Corporate B i l l  1971,  Tax  Guide  Toronto,  58  It  was  in  this  E l i g i b i l i t y however, four  to  if  years  Aside  a  application of  the  from  of  pivotal unclear.  tax  the  of  was the  refund  "refundable." tax  was  not  was  lost,  made  within  payment.  question  about  concept It  the  refund  for  tax's  the  complaints  i t s e l f  that  receive  common the  sense  the -  was  of  Part  the  felt  complexity, V  tax  was  " i n e l i g i b l e to  one  that  of  the  the  meaning  investment"  -  was  be:  . . . b r o a d e n o u g h t o i n c l u d e many i t e m s w h i c h might not normally be considered to f a l l into this category: e.g., c a r s , y a c h t s and c l u b memberships acquired solely for a shareholder's personal benefit. I n v i e w o f t h i s , many c o r p o r a t i o n s could encounter d i f f i c u l t y in identifying a l l i n e l i g i b l e i n v e s t m e n t on hand a t any p a r t i c u l a r time.-^7  A  further  source  of  d i f f i c u l t y  was  the  requirement  that  the: . . . the company must i n v e s t a l l i t s f u n d s and not j u s t the income subject to tax at the low r a t e in its active business. A Canadian-controlled private corporation which invests a l l of i t s income i n i t s b u s i n e s s but borrows money o r s e l l s i n e l i g i b l e investments acquired prior to 1972 and uses the fund to acquire i n e l i g i b l e investments would s t i l l pay t h e t a x under Part V to recapture the low rate.jg As  unfair  as  quotation  may  described  above  the seem, could  problems there flow  described was  even  worse where  the  in -  the  the  foregoing  consequences  corporation  had  no  17. C h a r l e s B. M i t c h e l l , "Corporate-Source Income under the Tax R e f o r m B i l l , " C a n a d i a n Tax J o u r n a l , vol. 19, 1971, pp. 3 7 9 - 3 9 7 a t p. 3 8 8 . The same c o m p l a i n t i s made by L . Litman and P. W r i g h t , "Tax on i n e l i g i b l e i n v e s t m e n t s , " Canadian Chartered Accountant, November, 1972, pp. 43-47. 18. Arthur R.A. Scace, The Income Tax Law of Canada. Toronto, Law Society of Upper Canada Department of C o n t i n u i n g E d u c a t i o n , 1 9 7 2 , p. 2 1 8 .  59  preferred-rate ineligible retained  amount  at  the  investment. the  "ineligible" business),  -  l i a b i l i t y  time  as  the  This  led  one  was  not  for  Part  to  acquisition  that  investment  corporation author  of  Assuming  ineligible (i.e.  time  and  converted V  tax  acquired  suggest  future tax planning corporation to both investments.,  the  a  it  use  would  the  corporation  that  to  of  remained  in  an  commence  preferred-rate  active at  such  amount.  that: may tend to avoid carry on business  using one and make  n  In  the  preceding  ineligible  investment  Whether  was  from  it  another  issue  investment" "purpose"  of  hypothesized  remaining  possible  " e l i g i b l e "  to to  for  the  " i n e l i g i b l e " resolve.  found the  paragraph,  in  The  the  Act  acquisition.  the  matter  "ineligible" asset or  to  vice  change versa  definition seemed Thus,  in  is  to one  of  mentioned. its was  of  the  status in  fact  "ineligible  focus article  on it  the was  that:  Where control of a Canadian-controlled private corporation is acquired as a result of several transactions extending over a period of t i m e , a l l shares acquired prior to the particular transaction which gave the purchasing corporation control of the other w i l l f a l l into the category of ineligible investment. The fact that control was u l t i m a t e l y acquired w i l l not remove the taint attached to e a r l i e r share purchases. o  19. 20.  S p i n d l e r , op. c i t . , p. L i t m a n and W r i g h t , op.  64. c i t . ,  p.  44.  n  60 All  of  these  complaints  notwithstanding,  the  Part  V  tax 21  has  been  Such  a  correct  described statement one  appropriate  but  as  "fundamentally  suggests the  vehicle,  that  vehicle if  any,  was  sound  perhaps not.  w i l l  be  in the  The  conception." route question  explored  in  was  the  of  the  chapter  seven.  21. Wolfe D. Goodman, "The Small Business Credit: A Critique of the Proposed Changes," Canadian Taxation (Summer, 1 9 7 9 ) , p p . 3 8 - 3 9 a t p. 3 9 .  61  Chapter  The  In  the  recognized  United the  or  defer  early  manifestation Act  accumulations the  by  income  Concern upon  as  the  of  this  which  income to  whether  to  the  with for  on  not  it  was  was  soon  caused  An  in  of  of  the  income escaping  share  distributed.  of  the  to  shareholders  ratable  constitutionality  shareholder  found  problem  the  a  long  corporation  purpose  deeming  has  individuals.  the  the  received  or  the  recognition  by  have  of  imposed  dealt  tax  legislation  use  tax  corporations  corporations  corporate  fiscal of  income  1913  individual  such  tax  the  of  Experience  States,  possibility  avoid  Revenue  American  5  of  to  the  1  levying  focus  of  such shift  a to  2 the in to  corporation  (where  1921, l e g i s l a t i o n be  levied  circumstances. "principal  it  was  upon This  limitation"  has  remained  enacted the tax on  to  providing  corporation has the  been " f u l l  this for  day). a  Thus,  penalty  i t s e l f  in  tax such  described  as  the  u t i l i z a t i o n  of  the  1. Harry J . Rudick, "Effect of the Corporate Income Tax on Management P o l i c i e s , " 2 Howard Law J o u r n a l 2 3 2 - 2 5 3 (1956),at p. 2 3 4 . 2. Loc. c i t .  62  [corporation only  to  the  The  as  a]  device  corporate  essence  of  tax  of  rates."  the  accumulations"  United  is  Internal  Revenue  found Code  4  in of  Section 531 by t h i s chap taxable year defined in described in tax equal to  scheme  presently the  that  income  subject  3  legislative  "unreasonable States  accumulating  with  in  following  respect  force portions  to  in  the  of  the  country:  In addition to other taxes imposed ter, there i s hereby imposed for each on t h e a c c u m u l a t e d t a x a b l e i n c o m e (as section 535) of every corporation s e c t i o n 5 3 2 , an a c c u m u l a t e d earnings t h e sum o f -  (1) 27 income  1/2 not  p e r c e n t of the a c c u m u l a t e d taxable i n e x c e s s of $ 1 0 0 , 0 0 0 , plus  (2) 38 income  1/2 p e r c e n t o f t h e a c c u m u l a t e d i n e x c e s s of $100,000.  taxable  Section 532(a) GENERAL RULE the accumulated e a r n i n g s t a x i m p o s e d by s e c t i o n 5 3 1 s h a l l a p p l y to every corporation (other than those described in subsection (b)) formed or availed of for the purpose of a v o i d i n g the income tax w i t h r e s p e c t to its shareholders or the s h a r e h o l d e r s of any other corporation, by p e r m i t t i n g e a r n i n g s and p r o f i t s to accumulate instead of being divided or distributed. As  the  befits  introductory a  this  tax  over  and  tax is  which an  above  corporation's relevant  factor  words is  normal  retained in  section  intended  additional its  to  tax tax  suggest  constitute  payable  load.  earnings  determining  to  531  by  While  over  its  whether  the  3. Stanley S. Weithorn and Roger Noall, Earnings Tax, New Y o r k C i t y , P r a c t i s i n g Law p. 12. 4. In this thesis, the American Internal sometimes r e f e r r e d to as the "Code."  the the  a  and  as  "penalty," corporation  value  of  lifetime  is  corporation  the a has  The Accumulated Institute, 1968, Revenue  Code  is  63  retained  an  particular tax  is  from a on  taxable  imposed  a  tax  "excessive"  on  the  its  year  with  particular  (as  year  or  To  of  some  examined.  be  discussed  the  years.  In  earnings  from  below),  corporation's  retained  retention  the  of  Obvious  its  other  of  the  of  these  the  earnings  words,  earnings  a  it  is  not  generally  but  income  from  a  year.  appreciate  meaning  of  to  corporation's  taxable  w i l l  respect  "unnecessary"  particular  amount  f u l l  the  terminology  questions  1. What i s the corporation?  import  found  provisions, therein  the  must  be  are:  "accumulated  taxable  income"  of  a  2 . When c a n i t be s a i d t h a t a c o r p o r a t i o n h a s b e e n "formed or a v a i l e d of f o r the purpose of avoiding the income tax with r e s p e c t to i t s shareholders?" 3. W i t h r e s p e c t to w h i c h of i t s s h a r e h o l d e r s must the purpose of avoiding tax have been p r e s e n t in order for the c o r p o r a t i o n t o be s u b j e c t e d to the accumulated earnings tax? 4 . What c o r p o r a t i o n s a r e e x e m p t e d f r o m t h e t a x reason of the fact that they are "described subsection (b)" of s e c t i o n 532? Each  of  order  to  these  questions  provide  accumulated  an  earnings  a  practical  corporation  profits  which  is  tax  terms, that the  now  analysis  1. What i s the corporation?  In  w i l l  be  of  the  functions  in  "accumulated  the  portion  considered manner the  of  corporation  a  turn  in  which  the  States.  income"  taxable  particular is  in  United  taxable  "accumulated  in  by in  income"  taxable  considered  of  to  a  of  year's have  64  "unreasonably" penalty this  accumulated  tax  w i l l  be  amount  with  respect  levied.  corporation  requires  profits  that  the  for  dividends actual  a  for  after  which,  a  particular  determination year  which  into  found  in  the  the  the  its  year"  portion  of  of  shareholders needs.  535(a)  of  the  of a its  available  business  subsection  the  calculation  actually  to  account  therefore,  "taxable  of  is  distribution  taking  definition  upon  Essentially,  to  taxable  corporation  and  to as The  Code  states: the term "accumulated taxable income" means the taxable income, adjusted in the manner provided in subsection (b), minus the sum o f the dividends paid deduction (as defined in section 561) and the accumulated earnings credit as defined in subsection (c)). Briefly,  then  corporation separate  is  its  f i r s t  535(b),  such  allows  accumulated  net  exclude net  The if  taxable  income  income  subjected  income paid  This  from of  taxes  next  of  its  to  out,  pursuant  adjustment calculation on  "adjustment," the  dividends  in  deduct  whether  losses  paid  into  made  corporation  capital  translated  primarily  adjustment,  taxable  contributions.  gains  taxable  the  previously  taxes,  to  accumulated  of to  the three  "adjustments."  The  amounts  the  to  calculating from  by  subsection  way  taxable of,  or  disallowed  also  allows  of  taxable  its income  inter  a l i a ,  charitable  the  corporation  income  capital  same.  the  "dividends  Canadian actually  paid  context  paid  during  would the  deduction" consist taxation  65  year  and  within  included  within  concept  which  dividend," but  not  the  not  entirely)  the  year,  the  purpose  effect,  corporation tax  from  on  that  taxable  year  is  the  for  definition  by  in  deal  essentially  the  the  annual  a  "taxable  subject  paragraph earnings  of to  fact  the  535(c)(1)  the  profit  for  year"  for  corporation penalty of  the  w i l l  as  not  portion which  is  a  be of  result  subject its  retained  to  of  this  the  accumulated  earnings to  meet  and the  tax. Code  as:  an amount e q u a l to such p a r t of the profits for the taxable year as are the r e a s o n a b l e needs of the b u s i n e s s ^ then,  that  permit  the  credit  already  "accumulated  of  needs  535(b)  (although  has  its  in  business  accumulated  a  "consent  subsection  necessarily  year  retained  in  is  shareholder  corporation  not  amount  the the  recognition  each  the  Also  c o r p o r a t i o n . ~*  the  would  found  the  income  the  in  amounts  meeting  this  "adjustment,"  distribute  excluded  as  which  thereafter.  equivalent,  provided  practice  of  defines  by  however,  allows  . . . and for In  third  to  of  deduction  The  provision  which  out  funds  credit,"  corporation  This  paid  with  business  be  reported  dividends-paid  earnings  months  Canadian  adjustment  disbursed.  to  no  amount  the  one-half  parameters  has  an  and  and  the  actually  Both  good  two  earnings retained  subsection,  earnings  profits  from  "reasonable  5. E.M. Krader, S.R. Leimberg, A.J. Parker Satinsky, Stanley & K i l c u l l e n ' s Federal Income B o s t o n , M a s s . , W a r r e n , Gorham & L a m o n t , 1 9 8 3 a t p. 6. Internal Revenue Code of 1 9 5 4 , P u b l i c Law 591 736, s. 535(c)(1).  a  a  needs  and M.J. Tax Law, 9-22. Chapter  66  of  the  business."  of  the  corporation's  importance  of  presumption  corporation should  profits" rather, to  its  be is  used  income  in of  of  a its  discussion  mentioned  at  a  of  the  this  well  is  be  the  reasonableness existence  of  the  place  of  and  statute,  but  being  from  a l l  a  provides  of  sources.  are in  the  context  should  Code  rule the  might  "reasonable"  It  relieving  accumulations  equivalent  which  the  tax.  "earnings  as  that  an the  avoiding  the  factor.  however,  which  needs  term  below  statutory that  circumstances  take  The  71)  of  accumulations  as  the  in  sense  gains)  the  described  important.  page  defined  "purpose"  point,  reasonableness  by  at  that  capital  w i l l  very  purpose  non-technical  of  the  reasonable  the  well  which  is  below  for  as  term  needs  could  its  here  of  magnified  the  corporation's  what  during  made  analysis  that  light  in  is  exceeds  been  a  question  discussed  (including  Further indicate  be  noted not  is  factor  which has  the  "accumulations"  this  (to  accumulation  It  Thus,  be  contains  relating  to  corporation  that:  (A) IN GENERAL The credit allowable under paragraph (1) shall i n no c a s e be l e s s than the a m o u n t by w h i c h $250,000 exceeds the accumulated earnings and profits of the corporation at the c l o s e of the p r e c e d i n g t a x a b l e year. (B) CERTAIN SERVICE CORPORATIONS - In t h e c a s e a corporation the p r i n c i p a l function of which the performance of services in the field  of is of  1.Theterm"reasonable needs of the b u s i n e s s " i s a l s o used as part of the test for evaluating whether or not the corporation has been used for a tax avoidance purpose and w i l l be d i s c u s s e d b e l o w a t p p . 7 0 - 7 5 i n t h e c o n t e x t of this a s p e c t of the American l e g i s l a t i o n . 8 . See f o r e x a m p l e on t h i s p o i n t : Ted B a t e s & C o . , Inc. 24 T.C.M. 1346 ( 1 9 6 5 ) a t p. 1 3 5 7 .  67  health, law, engineering, architecture, accounting, actuarial science, performing arts, or consulting, subparagraph (A) shall be a p p l i e d by substituting "$150,000" for "$250,000". g  To  i l l u s t r a t e  this  its  f i r s t  no  accumulated  taxable  year  of  year."  service  Thus,  operation  the  $150,000,  then  accumulation  f i r s t  "formula" for  in  no  found  future  earnings  credit  ($250,000  -  corporation  the allowed  $250,000 would  in  fact  earned  year -  =)  effect  9. I n t e r n a l Revenue Code 736, para. 535(c)(2).  of  in  1954,  to  not year  be of  retained  $150,000 second  an  would  in year  of  of  the that  accumulated would  circumstances,  Law  of  $250,000  indicate  paragraph  justify  its  statutorily  application  Public  that  however,  the  such  of  Assuming,  reasonable  that  have  in  $100,000  its  The  a  =)  accumulation"  In  not  operation  $150,000  535(c)(2)  n i l .  could  and  of  terms  under  is  f i r s t  retained  "minimum"  "preceding  conclusion  that  relevance.  paragraph  years  the  $250,000  $100,000  "reasonable  has  described  during  practical  further in  to  ($250,000  and  obviously  application  =)  and  In  corporation  unreasonable.  operation  minimum  n i l  follows.  a  type  second  earned  in  the  lead  in  exceeding  then  of  If  its  considered  of  prescribed be  would  corporation  from  the  ($250,000  corporation  operation,  would  of  not  be  year  that the  unreasonable.  this  profits  of  535(c)(2)(A)  considered  that  and  example  corporation  535(c)(2)(B),  accumulation  not  brief  the  assuming  corporation  subparagraph  could  a  operation,  earnings  subparagraph  an  provision,  a l l  591  be the  further  -  Chapter  68  retentions  of  its  reasonable  in  order  respect  to  particular  By  its taxable  of  credit  a  and  profits" fiscal  into  "minimum"  the  authorities that  appropriateness  corporation's in  of  over  the  being  tax  income  for  about  the  with that  it  that  a  year.  is  in  an  the  and  American spite  of  annual  particular  on  the  earnings  the  that,  tax  in  purely  credit  "earnings  lifetime,  earnings  tax  the  indicated  levying  for  earnings  to  its  clearly  evaluated  earnings  Congress  of  as  accumulated  concept  accumulated  be  taxable  reasonable  that  have  the  cannot  the  profits  imposition  accumulated  corporation  fact  made  the  relating  of  escape  and  year.  the  year  to  earnings  accumulated  building  concept  retained  taxable  basis  Indeed,  tax,  of  one  the  comment  was:  In determining the portion, if any, of e a r n i n g s and p r o f i t s f o r a taxable year which be retained for the reasonable needs of business, the amount of the earnings and pro accumulated in prior years shall, of course, taken into account. It  seems  logical  confirms,  to  that,  if  sufficient  to  meet  be  for  no  need  the  particular  the  Code  also  the  suppose, the  and  accumulations  the  support  American from  corporation's  corporation  taxable  the  year this  in view  to  retain  question. in  TC~ S~. R E P " ! NO"! 1 6 2 2 , 83d Cong. quoted i n W e i t h o r n at page 1 3 0 .  2d  then  its The  providing  In d e t e r m i n i n g whether any and p r o f i t s of the t a x a b l e for the reasonable needs  jurisprudence  previous  needs,  the may the fits be  years  are  there  can  earnings  from  Regulations as  to  follows:  amount of the earnings year has been retained of the business, the Sess.  317  (1954)  as  69  accumulated earnings and profits of prior years will be taken into consideration. Thus, for example, if such accumulated earnings and profits of prior years are sufficient for the reasonable needs of the business, then any earnings and profits of the current taxable year which are r e t a i n e d w i l l n o t be c o n s i d e r e d t o be r e t a i n e d for the r e a s o n a b l e needs of the business.-,.  The found be  definition  in  the  Code  described  as  "unreasonable  term  and  the  provisions  the  statutory  earnings  the  "accumulated  which In  the  courts  give  amount  of  w i l l  for be  addition  money  taxable  ancillary  "formula"  tax.  however,  determining  the  accumulation"  accumulated formula,  of  thereto  can  calculating  the  subjected to  to  the  applying  considerable actually  income"  this  attention  available  to  to the  12 corporation following the  for  the  statement  purpose for  of  example  paying was  dividends.  cited  with  The  approval  by  courts: The question is primarily one of determining whether the t a x p a y e r has enough l i q u i d a s s e t s (not surplus) to meet estimated needs, including demands f o r working capital, plant expansion and a l l reasonable contingencies.^  This at  approach the  has  led  corporation's  investment  assets"  as  the  courts "cash,  being  to  look  liquid indicia  very  pragmatically  assets of  and  its  other  ability  to  finds,  for  14 distribute example, the 11.  earnings  that  in  corporation Regulation  to  shareholders.  calculating is  permitted  its to  Thus,  accumulated deduct  the  one  taxable value  income of  its  1. 535-3(b)(1)(ii).  1 2 . K o c h v . V i n a l 2 2 8 F. S u p p . 782 ( D . Neb 1964). 13. Cary, "The P e n a l t y Tax on A c c u m u l a t e d E a r n i n g s , " Encyclopedia of Tax Procedures 816 (1956) as c i t e d Bates & Co., Inc. 24 T.C.M. 1 3 4 6 ( 1 9 6 5 ) . 1 4 . W e i t h o r n , p. 5 0 .  Lasser in Ted  70  capital same  gains  in  the  relevant  taxable  year  and  yet,  at  the  time: since the general issue in accumulated earnings tax cases, whether there has, in fact, been an unreasonable accumulation of income, requires an evaluation of the corporation's accumulated earnings and p r o f i t s i n the light of its present and f u t u r e business needs, retained capital gains (because they increase earnings and p r o f i t s ) may support the Commissioner's contention that the accumulated earnings tax i s applicable.,c  2 . When c a n i t be s a i d t h a t a c o r p o r a t i o n h a s b e e n "formed or a v a i l e d of f o r the purpose of avoiding the income tax with respect to i t s shareholders?"  The  tax  corporation below), the  "formed  the  corporation to  a  is  of  themselves locating would  not does  for  the  respect  to  its  be  "formed  or  extent  those of  who the  actual  to  that  of  the  availed  with  the  "formed"  be  of  the  determine  the  that  an  of  of  avoiding  which  for  came  focus  of  to  "forbidden"  a  i t s e l f  "avail" however,  this  of  has  subjective  practice,  existence  . " ^  which  concern the  any  discussed  enquiry  would  In  the  be  on  shareholders...  later  principal  w i l l  purpose  question or  imposed  "purpose"  of"  corporation.  evidence  appear one  supposed  is  which  of  determination  significant  intent  then  might  earnings  exceptions  availed  with  it  goal  certain or  tax  facie,  i t s  accumulated  (with  income  Prima as  on  "purpose"  enquiry. purpose  How was  present ? 15.  Weithorn,  p.  138.  16. I n t e r n a l Revenue 736, s. 532(a).  Code  of  1954,  Public  Law  591  -  Chapter  71  As  might  clues,  the  be  expected,  most  important  the of  legislation  which  is  a  provides  some  presumption  that  where: "the earnings and profits of a corporation are permitted to accumulate beyond the reasonable needs of the business [this] shall be determinative of the purpose to avoid the income tax with respect to shareholders, unless the corporation by the preponderance of the evidence s h a l l prove to the contrary. The  existence  that in not  the no  of  accumulated  penalty  exceed  cause  tax  the  reasonable The  of  obvious  "reasonable  above)  it  the  payable needs  into  whether of  the  the  should  of  legislation  other  than  this  latter  for  possible  which  do  tends  to  a  earnings  of  factual exceed  the  18  how  recalled  effect  is  one In  that  earnings  group.  service  Public  determine  (as  of  this  discussed  for  a  minimum  $250,000  for  corporations  and  Recalling  corporations  1954,  to  exploring  provides  certain  of  on  fact  results  existence  focus  business?"  retained  Code  above  corporation,  the  associated  17. I n t e r n a l Revenue 736, s. 533(a). 1 8 . W e i t h o r n , p. 14.  the  to  the  accumulations  then:  be  with  described  i s ,  in  corporations  requirement  of  coupled  accumulated  f i r s t  amount  for  of  business.  question needs  on  the  "reasonable"  $150,000  credit  accumulations  needs  question,  earnings  being  inquiries  determination  presumption,  reasonable  "unreasonable"  the  this  the to  Law  Canadian  share  591  -  the  Chapter  72  "business defined  l i m i t "  for  a  "reasonable"  corporate  group  in  taxation  amount the  year,  must  case  this  be  of  a  statutorily  shared  group  amongst  of  the  corporations  20 controlled  by  enough  least  it  (at  would  the  appear  same  as  viewed  that  each  subsidiary  chain  accumulated  earnings  In  as  accumulations provide  to  the  accumulation,"  of  may  the  inter  a l i a :  1.  for  additional  2.  for  additions  3.  to  meet  well,  needs"  has  j u d i c i a l given  to  to  the  be  to  broad  perspective), in  i t s  be  a  own  deeming to  parentminimum  $250,000 a  Code  reasonable  working  maturing  the  of  be)  (or  "reasonable indicate  when  that  intended  to  capital;  plant  and  equipment;  obligations;  interpretation it  Canadian  Strangely  corporations  4. to meet the c a s h - f l o w business cycle.22 As  the  provisions  regulations found  persons.  i t s e l f  may  be  or  the  avail 21 credit.  case  the  funds,  from  can  addition  $150,000,  person  and  requirements  of  meaning  the  phrase  which  one  of  a  "reasonable might  expect  19. S u b s e c t i o n s 125(3) and 125(4) of the Act. 20. E.M. Krader, S.R. Leimberg, A.J. Parker and M.J. Satinsky, Stanley & K i l c u l l e n ' s Federal Income Tax Law, Boston, Mass., Warren, Gorham & Lamont, 1983 at p. 9-16, footnote 1. 2 1 . W e i t h o r n , p. 4 1 . 22. E.M. Krader, S.R. Leimberg, A.J. Parker and M.J. Satinsky, Stanley & K i l c u l l e n ' s Federal Income Tax Law, Boston, Mass., Warren, Gorham & Lamont, 1983 at p. 9-17. See a l s o footnote 6 f r o m page 53 of W e i t h o r n w h i c h g i v e s a reference to a specific s e c t i o n of the regulations on this p o i n t and p r o v i d e s a summary of same.  73  such  words  takes  the  to  have.  view  Thus,  the  assessing  judgment be  as  Internal  Service  that:  Where a corporation c a p i t a l and s u r p l u s the proper conduct not be incurred. consideration every prudent businessman what surplus is enterprise.2^ In  American  the  to  can show that a l l of the on hand w o u l d be r e q u i r e d for of the business the tax w i l l The Bureau w i l l take into fact and prospect that a would consider in determining reasonably needed for any  reasonableness  its  need,  the  of  following  the  corporation's  general  factors  w i l l  considered: (1) The earnings p a r t i c u l a r purpose  are being accumulated or contingency.  (2) The purpose is corporation, or the the corporation.  a legitimate activity contingency is a real  for  a  of risk  the to  (3) The c u r r e n t accumulation i s not e x c e s s i v e when considered in relation to the probable time it would take for the purpose to be e f f e c t e d or for the contingency to ripen. (4) The t o t a l amount a c c u m u l a t e d i s not excessive for the purpose or contingency for which the accumulation is made. 0 [  What  if  funds  but  1954,  this  the  has  23. op. c 24. From McLarney 25. Weith  one At  "anticipated prevailed.  plans  was  legislation.  corporation  need" In  one  for of  that and case,  has  no  expansion? the time, the for  problem there  immediate  for  Prior  to  amendment  areas  in  the  was  so-called example,  need  it  no  in  American  provision  "immediacy" was  the  stated  for test  that:  i t . , p. 9-14. a November, 1 9 4 6 s p e e c h by D e p u t y C o m m i s s i o n e r as quoted i n Weithorn at pp. 48-49. orn, p. 49.  E.J.  74  [t]he statute need a s s o c i a t e d  ... contemplates with business in  immediate hand  need,  26 Currently,  however,  "need"  includes  "reasonably  anticipated"  27 need.  "Need"  breadth  to  in  include  endeavour  not of  nature  opposed  as  a  a  planned  course,  if  the  reasonable  needs  of  the  to  into  concern  the  fact  "purpose"  i t s e l f  recognizes  preponderance i.e.  shall  the  final  of  tax  that  earnings not  notwithstanding avoidance  by  beyond  the  the the  "the  exceed  a  necessarily  a  corporation's  the  the  above,  an  expected 533(a)  corporation needs  corporation to  was  the  are  of  the  by  the  contrary,"  reasonable.  reasonable  presumption,  exceed  notwithstanding  of  preclude  -  described  be  determination  the  of  business  Subsection  prove  accumulation  then,  do  reasonable  shall  a  aptly  might  that,  profits the  of  mentioned  which  f i e l d  corporation  more  As  sufficient  new  be  intent.  that  evidence  analysis,  does  and  a  earnings  enquiry  possible the  be  providing  earnings  is  prove  accumulated business  in  accumulate it  would  of  the  endeavour  subjective  factor  "the  to  business,"  new  into by  business? an  concept  in  accumulated  is  with  this  that  permitted  the  to  then,  a  engaged  that  What,  is  expansion  one w h i c h _ 28 investment.  passive  enquiry  context  previously  provided, as  this  a  that  needs  shareholders  the  of  finding  necessary  In  the that,  purpose was  267 McCutchin D r i l l i n g Co. v. Commissioner 143 F. (5th C i r . 1944) a t p. 4 8 2 . 27. I n t e r n a l R e v e n u e Code of 1 9 5 4 , P u b l i c Law 591 736, s. 537. 28. R e g u l a t i o n No. 1.537-3(a).  of  absent. 2d  480  Chapter  75  For  example,  or  might  the  have  perhaps,  been  two  shares  in  shareholder(s) subject  shareholders, the  disposition  of  to  not  have  relatively  each  corporation the  might  holding  are  corporation's  taxable  l i t t l e  50%  unable  been  of  to  earnings  tax  the  issued  agree  (as  or,  as  to  happened  in  29 one  case  ).  The  jurisprudence  has  established,  however,  that: [t]he t a x p a y e r m u s t e s t a b l i s h by t h e preponderance of the e v i d e n c e t h a t tax a v o i d a n c e w i t h r e s p e c t to s h a r e h o l d e r s was n o t 'one of the p u r p o s e s ' f o r the accumulation of earnings beyond the reasonable needs of the business. o  Another subsection  aspect  533(b)  of  of  the  the  n  "purpose  Code  which  question"  is  found  in  states:  The f a c t t h a t any c o r p o r a t i o n i s a mere h o l d i n g or investment company shall be p r i m a f a c i e evidence of the purpose to avoid the income tax with respect to shareholders..^ A  "mere  holding  activities  company"  except  is  holding  one and  having  " . . .  collecting  practically  the  income"  no from  32 its and  holdings. additionally,  estate is  or  other  important  participates invested, holding 29.  A  Casey  or or v.  in in  "mere buys  investment and  investment this the  which  sells  a  management  investment  not  The  but  does  F.2d  26  not (2d  the  above  securities, adjective  companies  "merely"  267  does  corporation  of  company  Commissioner  stocks,  property.  context;  is  company"  which in  only f a l l Cir.  real "mere"  actively  which  it  "primarily" within  has a the  1959).  30. U n i t e d S t a t e s v. Donruss Co. 393 U.S. 297 ( U . S . C o u r t 1 9 6 9 ) , a t p. 3 0 1 , 89 S . C t . 501 a t p. 5 0 3 . 31. I n t e r n a l R e v e n u e Code of 1 9 5 4 , P u b l i c Law 591 736, s. 533(b). 32. R e g u l a t i o n No. 1.533-l(c).  Supreme Chapter  76  provisions  of  subsection  interpretation earnings and  other  of  a  tax  the  might  special  and  the  it  holding  apply  to  with  the  has and  corporations,  and  led  the  stated  the  with  "rule  investment  companies  other  passive  than  1934  respect  to  the  at  pages  earnings  change of  78 tax  to of  has  greatly  subsection  533(b).  in  the  case  probably . . .  companies in  below  This  the  accumulated  creation  accumulated  application that  the  judicial  investment  to  (discussed  company.  potential  been  tax  narrow  wherein  provision  from  holding  the  holding  company"  exemption  diminished  This  circumstances  charging  holding  personal  Thus,  the  problems  "personal 80)  of  33  533(b).  real  of  mere  affects  few  estate  holding  34 companies.  3. With r e s p e c t to which of i t s s h a r e h o l d e r s must the purpose of avoiding tax have been p r e s e n t in order for the c o r p o r a t i o n to be s u b j e c t e d to the accumulated earnings tax?  It  would  avoidance  appear  need  not  be  shareholders  in  jurisprudence  suggests  one  of  the  not  accumulation  took  place  proscribed in  for that  shareholders was  the  present  order  shareholder  33. 34. 35. Cir  that  the  W e i t h o r n , page 4 6 . W e i t h o r n , p. 4 7 . Atlantic Properties, 1975).  at  to  majority his  Inc.  of  the  tax  l i a b i l i t y  intended a  a l l  to may  avoid  apply.  tax  tax  -  The  where  only  even  if  that  -  if  the  shareholder  C.I.R.  of  corporation's  exist  instigation.  v.  purpose  35  519  F.2d  1233  (1st  77  In  the  case  corporation, apply  -  one  given  corporation control  -  that a  shareholder not  it  the  to  fact,  by  the  Regulations  be  i t s e l f the  tax  use  of  individuals  the  avoidance  is  expect  prevent  shelter  in  which  ordinarily  seeks  tax  and,  that  a  would  as  it  "require  of  of  the  who to  a to the  might  the  individual  Code income  36 tax." in  a  At  the  same  time,  parent-subsidiary  used  to  avoid  ultimately that  if  tax  the  parent.  tax  "with  respect  any  other  corporation,"  to  pay  the  subsidiary,  of  the  of  tax  subsidiary tax.  that,  mentioned  be  eligible  of  $250,000  In  to (or  Regulation  the  the  $150,000  1.532-l(a).  in  case  the  be  income  used  to  the it  and  of  of  obliged  an  parent,  accumulated  the  be  being  the  parent  provides  Vis-a-vis  would  however,  minimum  may  be who  shareholders  tax.  subjected  both  avoid  corporation  of  could  statute  the  was  that  individuals  to  or  parent  regard,  above, a  used  subsidiary  corporations).  36.  the  earnings  be  this  claim  Thus,  shareholders  could  earnings as  then  the  the  the  being  recognizes  subsidiary  to  shareholders  course, Where  the  its  accumulated  corporation." income  is  Code  the  respect  corporation to  the  relationship  with  control  the  however,  its "other  to  avoid  therefore, accumulated  should  be  subsidiary earnings certain  noted would credit service  78  4 . What c o r p o r a t i o n s are exempted from the tax reason of the fact that they are "described subsection (b)" of s e c t i o n 532?  Subsection  (b)  of  EXCEPTIONS by s e c t i o n  section  532  states:  - The a c c u m u l a t e d e a r n i n g s 531 s h a l l not a p p l y t o -  (1) a p e r s o n a l section 542),  holding  company  (2) a f o r e i g n p e r s o n a l h o l d i n g defined in section 552), or (3) a c o r p o r a t i o n exempt from s u b c h a p t e r F ( s e c t i o n 501 and  The of  corporation  l i t t l e  which  exempt  significance  is  not  to  from  this  ordinarily  by in  tax  under  tax  (as  imposed  defined  company  (as  tax under following).  subchapter  discussion  in  operated  to  in  that  it  F is  is one  profit  any  37 shareholder. The function  "personal of  its  income  statutory  definition  one  know  must  ordinary  gross  holding  sources.  of  that  the  the  income"  company"  term  becomes  Thus,  to  "personal  statutorily  such  understand  holding  defined  as  a the  company,"  term  "adjusted  means:  ... b a s i c a l l y the gross income of the corporation less capital gains and w i t h adjustments relating to income from rents, mineral, o i l and gas properties, and interest. A  personal  per  cent  of  holding the  company  value  of  i t s  is  one  which  corporate  has  more  than  stock  held  by  37. E.M. Krader, S.R. Leimberg, A.J. Parker Satinsky, Stanley & K i l c u l l e n ' s Federal Income B o s t o n , M a s s . , W a r r e n , Gorham & L a m o n t , 1 9 8 3 a t p. 3 8 . o p . c i t . , p. 9 - 2 1 .  fifty  five  and Tax 9-3.  or  M.J. Law,  79  fewer of  individuals  its  "adjusted  and  which  ordinary  receives  gross  at  least  income"  from:  (a) investments such interest, annuities royalties or  as and  sixty  rents, certain  per  cent  dividends, copyright  (b) the p e r s o n a l s e r v i c e s of i t s " s t a r " (where the person with whom t h e corporation has contracted for the services of its star has the right to designate that the "star" is the one who must perform the services contracted for and the individual who must or did perform the services owns 25 per cent or more of the stock in the corporation).^g As  a  c r i t i c a l  corporation cetera an  meeting  ownership  active  holding its  company to  by  American  citizens.  statutory  topic  at  which be  may  fewer  had  individuals"  previously  transformed that  suggest,  carried  into  business  a  a et on  personal  and  diverting  investments.  holding  company  company  controlled  There  definition  hand,  or  terminating  personal  holding  definition  "five  could  "passive"  foreign  this  criterion  personal  the  of  the  business  assets  A  reading  are,  but,  further  of  as  by  i s ,  persons  course,  they  in  who  other  are  description  essence,  not of  are  nuances  germane same  a not to  to  the  would  be  superfluous.  The holding  provisions company  owe  accumulated  earnings  intended  deal  to  39. Krader et Law, (Boston, p. 9 - 2 0 .  with  in  the  their tax two  Code  dealing  existence as  to  originally  particular  with  personal  deficiencies constituted  forms  a l , Stanley & K i l c u l l e n ' s Mass., Warren, Gorham  the  of  tax  in  the  and  are  avoidance  Federal Income Tax & Lamont, 1983),  80  which  formerly  accumulated the  could  earnings  so-called  Marshall  put  potentially tax:  the  matter  in  a  been  so-called  "incorporated  the  have  "star  wallet." 1969  subjected  As  to  the  company"  and  Mr.  Justice  case:  In 1934, Congress dealt with one of the more flagrant examples of that ineffectiveness, the p e r s o n a l h o l d i n g company The r e a s o n f o r the change was that, '[b]y making partial d i s t r i b u t i o n s o f p r o f i t s a n d by s h o w i n g some n e e d f o r the a c c u m u l a t i o n of the remaining p r o f i t s , the t a x p a y e r makes i t d i f f i c u l t to prove a purpose to avoid taxes.' As  this  quotation  would  suggest:  the 'accumulated earnings tax' and the personal h o l d i n g company t a x h a v e t h e same g e n e r a l purpose: to compel corporations to distribute their earnings as dividends taxable to their stockholders.^ The its  motivation income,  provided imposed  to  by  tax  company,  the  reasonableness is  its  taxing  upon  corporate  tax  which  "compels"  shareholders its  individuals rate.  In  purpose are  the  corporation in  income  at  rather  than  the of  immaterial  case the  these  the  top  at  the  of  the  to  distribute  instances marginal somewhat  personal  accumulation  insofar  as  l i a b i l i t y  is rate  lower holding  and for  i t s the  concerned.^  40. U n i t e d S t a t e s v. Donruss Co. 393 U.S. 297, (U.S. Supreme Court 1969) q u o t i n g from H.R. Rep. No. 7 0 4 , 73d C o n g . , 2d S e s s . , a t 11 ( 1 9 3 4 ) . 41. E.M. Krader, S.R. Leimberg, A.J. Parker and M.J. Satinsky, Stanley & K i l c u l l e n ' s Federal Income Tax Law, B o s t o n , M a s s . , W a r r e n , Gorham & L a m o n t , 1983 a t p. 9 - 1 2 . 42. Adrian A. Kragen and John K. McNulty, Federal Income Taxation, Cases and Materials, St. Paul, Minn., West Publishing Co., 1974 a t p. 9 4 3 .  81  The forth  foregoing  above  provides  jurisprudential earnings of  this  in  tax  is  deals  it  in  were  was  corporations  to  aspects  distribute  of  the  There  imposed  the  there  The  this  scope  which  remainder tax.  changes and  in  of  concern  and  were  made  impact  apparently  arbitrarily  funds  and  accumulated  were  was  set  legislative  States.  limit  tax.  questions  the  which  that  to  four  of  United  note  intended  being  the  within  other  to  earnings  of  analysis  the  with  interesting  accumulated  that  basic  functions  1954 w h i c h  the  a  framework  chapter  It  examination  forcing  fact  needed  43 in the  the  business.  creation  deduction earnings  tax.  taxable  of  year,  One earnings  amount  presents  in levy  the  then  the  a  tax  the  tax  to  that  in  was  that,  be  a  in  levied  as  a  significant the  f i s c a l  the  not  from  was  accumulated  where  could  time  credit  the  there  accumulation would  at  earnings  circumstances  d i f f i c u l t  aspects  absence  justify a  upon  of  the view  the  taxpayer's  point  of  real  potential  for,  in  cumulative  notwithstanding  respect  to  the  43.  Weithorn,  see  made  the  particular its  entire  income.  the from  change,  corporation  entire  net  changes  subject  this  its  of  tax  to  to  if  the  accumulated  inequity  sought  undistributed  tax  the  credit,  retention  of  the  Prior  for  authorities the  of  from  potential  of  One  earnings  p.  18.  of  the  fact  only  one  that  a it  taxable  accumulated is  that  sense, is  year  the being  levied  with  rather  than  82  with  respect  to  generally. was  the  This  retained  result  unreasonable  circumstances  in  in  To  a  in  certain  of  in  if  that,  year,  years,  following extent,  it  years  this  the  is  corporation  the  accumulation  then,  reasonable  subsequent  accumulations  well.  one  constituting  accumulations any  occurs  earnings  barring  grounds is  most  were a  new  for  the  likely  that  unreasonable  hidden  cost  of  as the  tax.  The "costly  accumulated and  dependence not  earnings  d i f f i c u l t on  needed  to  subjective  in  its  example,  it  was  earnings  tax  prompted  Congress  has  enforce" factors  and  the  As  constituted  to  enact  of  its  of is  for  accumulated  said  provisions  funds  above,  the  as  "partial  corporation's  which  the  described  mentioned  "ineffectiveness"  then  been  because  business.  the  as  tax  of  to  have  the  Code  45  applicable time, which cases  to  the  however, may  be  may  it  be  the  the  of  certainly  44 ^ W e i t h o r n , 4 5 . See above  the  which  of p. at  tax  surely  those  comments  in  regarding  then  problems  prosecuting  holding  disregarded  concern  compliance,  is  encountered  effectiveness taxpayer  personal  who  Rudick 13. pages  the  the  73  arguable  enforcing  At  that  the  tax  in  attempting  to  as  presently  the  tax  prompts  tax  is  effective  fiscal  choose are  company.  not  comply.  instructive:  and  74.  individual  evaluate  constituted. a  same  d i f f i c u l t i e s in  high  level  the If of  notwithstanding  authorities to  the  may In  this  have  in  regard,  83  the tax . . . was not primarily designed to r a i s e money b u t t o d e t e r t a x a v o i d a n c e and i t has to a considerable but probably not to a sufficient extent achieved this purpose. There c a n be no d o u b t t h a t t h e f e a r o f i m p o s i t i o n o f the penalty tax has spurred the payment of many dividends that would otherwise not have been declared. Looking  at  the  undoubtedly describe  matter  worthy  the  of  note  accumulated  d i f f i c u l t  to  enforce"  effective  to  a  results  from  showing  this that  the  earnings  tacitly  certain  perspective, same  tax  as  recognise  extent  in  is  authors  who  "costly  and  that  referring  it  it  must  to  be  research  that:  the constant threat of the accumulated earnings tax, and the expenditure of time and effort involved in warding off challenges with respect thereto, were important factors inducing some closely held corporations to sell stock to the public or to sell out to public corporations. Thus, the  the  American  whole  deterring relative  the  achieve use  longevity  structure enactment This  to  being  is in  accumulated  of of  a  the  certain  the  tax  the  are  case,  as  suggestive  may  offer  a  the  unchanged  also it  and  tax  would  degree  corporation  relatively 1921  earnings  of tax  fact since of  some  its  appear, success  shelter. that  its  its  on in The  basic  original  effectiveness.  guidance  as  to  the  46. Harry J . Rudick, " E f f e c t of the C o r p o r a t e Income Tax on Management P o l i c i e s , " 2 Howard Law J o u r n a l 2 3 2 - 2 5 3 ( 1 9 5 6 ) at p. 2 3 9 . 4 7 . W e i t h o r n , p . 16 a t f o o t n o t e 5 a t t r i b u t e s t h i s conclusion to the f o l l o w i n g r e s e a r c h : Hall, The T a x a t i o n of Corporate Surplus Accumulations, Study Prepared for the Joint C o m m i t t e e on t h e E c o n o m i c R e p o r t , 82nd C o n g . , 2d S e s s . 75, 187; Butters, Linner & Cary, Effects of Taxation on Corporate Mergers 101-04 (1950), see 'Economic Effects of Section 102" (1951), at xv, xvi, published by the Tax Institute, P r i n c e t o n , New J e r s e y .  84 route tax  on  which  Canada  unreasonable  could  take  i f i t were  accumulations.  to  adopt  a  form  of  85  Chapter  The alone  Canadian  in  their  avoidance  dealing that  time,  and  American  did  with  was  against  assessed  led  to  the  day  -  statute, not  a a  surtax  legal  into  have  a  legislative existence  separate  in  corporations  in  much  the  same  (or,  more was  the  accurately  Thus,  of  the  measures  in  against a  the  2  income manner  tax as  however,  measures words  of  individuals  special  At  dealing  difference,  anti-avoidance  levied  tax  statute and  of  for  1922.  now  significant  not  personality  does  One  were  potential  it  corporations. deemed  the  as  "super-tax")  was  of  authorities  first  came  not  implementation  against  provision  1  the  corporations  individuals. the  f i s c a l  separate  "shortfalls"  specifically  against  the  England,  England  Experience  realisation  in  In  with  British  early  inherent  corporation.  The  6  of the but  statutory  necessary:  1 . From 1966 t o 1 9 7 2 , t h e t e r m " s h o r t f a l l " was a c t u a l l y used in the relevant statute to describe the portion of the corporation's i n c o m e w h i c h was c o n s i d e r e d to constitute an "unreasonable accumulation." (See: Finance Act, 1965, section 77.) The term has apparently remained in common usage a l t h o u g h i t s a p p l i c a t i o n i n the context of the present legislation is described in Simon's Taxes, Income Tax, Corporation Tax, Capital Gains Tax, Revised Third Edition, London, Butterworths, 1983 (at page 584) as "conceptually inept." 2. Simon's Taxes, Revised Third Edition, p. 581, citing s e c t i o n 21 o f t h e F i n a n c e A c t o f 1 9 2 2 a s t h e o r i g i n a l source o f t h e B r i t i s h t a x on u n r e a s o n a b l e accumulations.  86  [w]ith a view to preventing the avoidance of the payment of super-tax through the w i t h h o l d i n g from distribution of income of a company which would o t h e r w i s e by d i s t r i b u t e d . ...^ The took  the  technique form  the  income  For  present  as  being  of  the  Canadian  The  English detail  of  the  company'  among  this  -  concept  of  apportionment  below  but,  in  treating, income to  would  hand  the  the  a  not  be  following  a l l  w i l l  as of  of  in  w i l l  or  a l l  of  defined  aspects  of  relevant  to  corporations.  be  discussed  apportionment  is  if  it  that  the  had,  the  in  fact,  corporation.  shades of  in the  purposes,  definition  warranted summary  of  taxation  shareholders  statutory  being  income  corporation  of  other  not  essence, for  examination  complex  company"  of  the  some  " e v i l "  adequately  the  term  this  'participators'."^  is  shareholder of  of  its  "participator" to  attack  apportionment  taxing  complete  and  to  of  of  very  England  system  distributed  A  'close  definition  undistributed been  in  "notional  equivalent  statutory  process  a  a  purposes,  the  more  of  used  the  of  meaning  term  terms  of  the  suffice  in  lieu  "close  topic  at  thereof:  Basically, the definition implies ownership or control by a s m a l l n u m b e r o f persons . . . . Major public companies whose names a r e household words can be and are close companies in circumstances where, although the shares are widely h e l d by the public, the c o n t r o l of the company has r e m a i n e d in the hands of a s m a l l f a m i l y group.^ 3. Finance Act, 1922, preamble to s e c t i o n 2 1 . 4 . R. B r a m w e l l a n d J o h n D i c k , T a x a t i o n o f C o m p a n i e s , London, Sweet & M a x w e l l , 1979 at page 1 2 7 . While the terms "close company" and " p a r t i c i p a t o r s " d i d not a c t u a l l y appear in the legislation until 1965, this description of the tax is essentially accurate. 5. S i m o n ' s T a x e s , R e v i s e d T h i r d E d i t i o n , page 5 0 3 .  87  Given  that  well  convey  body  whatever  is  the  the  its  does  mentioned  principally  above  definition  impression income  impression  definition be  the  to  this  upon  the  is  any  form  British  legislation,  meets  "trading  company."  is  with  the  "trading  topic  under  company"  i s :  as  should  this  the  any  be  company  this  consideration  if  in  chapter  this  that it  the  should  w i l l  which,  focus in  the  definition  of  focus  in  may  corporate  body),  statutory  that  company"  (which,  corporate  close  felt  to  sources it  that of  "close  applies  or  such  point  It  it  source  conveyed,  apply  at  that  of  is  consistent  this  thesis.  A  . . . any company w h i c h e x i s t s w h o l l y or m a i n l y for the purpose of c a r r y i n g on a t r a d e , and any other company whose income does not consist wholly or m a i n l y of i n v e s t m e n t income . . . . ^ This  definition  "any  . . .  mainly  with is  the  one  that  the  context  tax  on  which  provides  an  analysis  business the  Finance  most  Act,  of  might tax  the  law  active  is  sufficiently  of  the  Schedule  part  the  the  the of  its For  or  reader trading income present Thus,  application  of  in a  Canadian-controlled  from  the  English  provisions  trading  comparison. 16,  does  the  precise.  potential  "benefits"  appropriate  that  it  wholly  to  business.  to  as  consist  suggest  an  deduction,  1972,  not  greater  accumulations which  encompassing  does  income  impression  corporation  small  income  earns  on  unreasonable  private  6.  of  company,  income"  Canadian  carrying  purposes,  the  whose  investment  familiar  from  trading  company  of  company  of  paragraph  11(1).  of  company  88  In  terms  appropriate that  in  of to  1980 the  to  from  removed form  subject company.  change,  the  being  to  early  its  could  be  In  1980, of  matter  a  provide  of  presenting  Chancellor an  of  this  the  in  "active  this  income  was  had  of  to  to  1980,  source  in  source which  assessment  the  which  incentive  the  income"^  shortfall  Exchequer  their  result  income  Budget  very  potential  business  expected  seems chapter  tax  respect  prior  it  this  tax  in  Thus, of  thesis,  shortfall  companies  categories  In  this stage  English  sources.  the  of  Previously,  close  company  trading  as  the  assessment. from  the  of  an  accumulation  trading  shortfall  a l l a l l  unreasonable a  scope  matter  at  reduced.  application income  subject  mention  significantly  by  the  explained  was could  for  led  a  a  to  this  its  goal  for:  ... the generation of c a p i t a l from the i n s i d e , in the form of profits which are retained in the business. The tax system has now c o n t a i n e d for more than 50 y e a r s a series of provisions under which a close c o m p a n y may be r e q u i r e d to justify the amount of p r o f i t s w h i c h i t w i s h e d to r e t a i n in the business, undistributed. ... I now propose important changes, including the a b o l i t i o n of the apportionment of trading income ... of close trading companies . . . . These changes w i l l cut out a thicket of complex tax provisions which are time-consuming for the small t r a d i n g b u s i n e s s , and a r e a l impediment to growth. R  A the  review  Chancellor  of of  the the  legislative Exchequer  provisions should  referred  suffice  to  to  by  convince  7 . The term " a c t i v e business income" is not, in fact, used i n the E n g l i s h s t a t u t e but i s used here s i m p l y to f a c i l i t a t e the comparative analysis. 8 . S i r G. H o w e , E n g l a n d , P a r l i a m e n t , H o u s e o f Commons D e b a t e s , 26 M a r c h 1 9 8 0 , v o l . 9 8 1 , c o l . 1 4 8 6 .  89  the  skeptic  the  literature  required  by  The Budget does  that  the  speech  the  achieved  by  to  design  ambit  is  in  that  for  the  the  tax  of  Exchequer  mentions  shortfall  tax  the  that  be  it  ability  financing  business.  in  his  was  legislation "requirements"  moneys As  of its  challenged.  retention the  i t s e l f  which  is  an  the  As  speech,  from  an was  discussed  to  company  other to  hand, growth  retain  funds  the  the  of  the  the  the  more  outset the  company  fully  broad  to  justification  requirements  interpretation sufficiently  by  of  -  be  than  Chancellor  earnings for  attempt  the  of  be  an  be  then  for  retained  in  could  internally,  possible  its  in  impediment  the  as  necessarily  the  company  growth  seen  trading  on  always  w i l l  mandated  If,  the  the  rather a  is  is  impediment  of  it  then  boards"  income  that  purpose  as  that  it  which  provisions  business  the  whether  not  drawing  application.  must  being  the  tax  in  complexity,  is  its  limits  the  to  the  and  Exchequer's  ambiguous  the  of  assertion  justify  of  -  calculations  the  existence  tax  complicated  active  claimed it  the  back  from it  of  the  of  ascertain  If,  "going  the  to  "complex"  9  somewhat  growth."  removal  less  is  mere  the  removing the  to  of  Chancellor  its  validity  and  the  or  as  difficulty  reader  tax  qualify  legislation.  above  the  "impediment  question  the  from  quoted  of  conceptual  indeed  shortfall  permit  complexity  do  confirms  passage  not  the  they  of to  below, the permit  of the term the  9 . See f o r e x a m p l e : R. B r a m w e l l a n d J o h n D i c k , T a x a t i o n of Companies, London, Sweet & M a x w e l l , 1979 at page 127. See a l s o the d i s c u s s i o n below at pages 102-106.  90  retention Be  of  that  funds  as  version  it  of  the  fact  tax  as  have  of  that  i n i t i a l l y  the  tax  present  should  evolution  is  came of  the  its  of  present  the  its  inception  are,  in  fact,  of  the  the  shortfall  of  in  1966  evolution  state.  Thus,  the  apportionment" traces  tax  and  experience  the  "notional  for  fact  force  consequences  the  useful  British  examination  present  This to  into  business.  the  less  amendments  an  from  of  the  4. system its  -  -  in  their  1922  to  the  remains  it  is  basic intact  important  dates  in  the  tax:  when  apportionment  first  came  into  when t h e first separate taxing statute to corporations came into force in  when the "imputation" in England; and for  originally  formulae  so, the  1980 -  successors  statutory  four  shortfall  3. 1972 into force  that  thesis  predecessors.  merely  and  2. 1966 applying England;  being  tax  1922  involve  follows  1. 1922 being;  from  in  company's  day.  There  The  its  the this  description  than  above  development  than  the  which  mentioned  of  significant  that  of  shortfall  enacted  rather  description  growth  terms  English  other  follows  the in  purposes  dictated  which  may,  the  comparative  for  the  reason  introduced in  for  worthy  that  described  of  of  system  came  above.  in  1922  was  very  different  did  not  lay  down  extensive  measurement  framework (aside,  it  tax  of  the  independent established course,  from  " s h o r t f a l l . " examination.  in  1972 the  1980  This Given  essentially amendment  91  mentioned effect, the  above  was  into  the  system  to  it  this  differs  the in  which  is  not  an  extremely a  that  in  the  year into  it  from  system  1966  of  the  from its  its  its  change  to  which While  marked  predecessor,  reviewed both  in  examined.  in  different  be  from  be  its  description  w i l l  significantly  also  force  sufficiently  simple  shortfall  w i l l  style  significant  relatively  statute),  extensive  reason,  with  came  change  warrant  for  of  effect  significant essence  although  accomplished  language  came  which,  a  in  its  successor  provisions  only  insofar  1922  and  and, as  the  it 1972  enactments.  The  matters  to  be  examined  in  the  following  pages  include: 1. the process for d e t e r m i n i n g the p o r t i o n of the c o r p o r a t i o n ' s i n c o m e w h i c h may be s o a p p o r t i o n e d ; 2.  the  person(s)  to  whom  3. the income apportionment. Later  in  this  analysed. above  chapter,  Each  w i l l  now  be  of  tax  other  the  it  is  apportioned;  consequences  aspects  of  "preliminary"  considered  in  the  and  of  tax  matters  this  w i l l  be  enumerated  turn.  1. the process for d e t e r m i n i n g the p o r t i o n of the c o r p o r a t i o n ' s i n c o m e w h i c h may b e s o apportioned  As amount,  might if  shareholder  be  any, or  expected, which  may  the be  shareholders  process  of  determining  apportioned  to  in  of  respect  the a  the  company's particular  92  fiscal  year  i s ,  in  essence,  company's  "unreasonable  year.  is  tax  It  which  this  the  number  of  consequence, past  has  twenty  Given seeks the  to  that  two both  well,  the in  the  earnings  retained both  be  no  by  sub-paragraph the  Finance  has  that  shortfall  created  the  as  a  over  the  of  In  a  assessed  particular of  the  the  of  Act,  of  f i s c a l  year's  is  to  its  1(2)  appears  here  function  of  the  occurs.  In  concerned  corporate both  with  body  for  countries,  amounts  year  than  generally. have  been  fully there  accumulations" Schedule at  on  Thus,  shareholders,  below  as  retained  rather  of  as  anticipate  systems  this  earnings  "unreasonable  which  the  against  sub-paragraph  1972  would  corporation  corporation talk  one  legislation  shareholders.  review  same  extent,  the  is  under  the  in  to  tax  the  (a)  the  significantly  tax,  certain  available  where  further  of  the  of  presumably  speaking,  earnings  a  earnings  systems  respect  legislation  f i s c a l  its to  and,  s i m i l a r i t i e s  to  funds  l i a b i l i t y  in  complexity,  most  broadly  the  to  distributed can  and,  the  distribution  from  very  countries,  assessing  the  English  conceptual  countries  calculating  particular,  problems  accumulated  some  of  so.  the  f u l f i l ,  American  finding  or  in  greatest  changed  years  process  accumulation"  aspect,  involves  greatest  the  16  page  (as of 102  demonstrates).  Notwithstanding between  the  two  the  systems,  presence however,  the  of  some  English  s i m i l a r i t i e s scheme,  in  the  93 details  of  remains  quite  fact,  its  implementation, different  recent  developments  differences.  The  measurement  of  the  English  procedure  in  the  of  enquiry while  the  -  as  not  As  expression  the  in  prelude  a  scheme  same  common of  elements  one  of  "business of  this  many  the  factor,  factors  tax  however,  remained  formed  Whereas  focus  legislative  various  have  the  -  shortfall  elements the  of  in  to  be  things.  time,  have  permitting  "apportionment"  England  of  different  the  the  central  in  the  accentuate  distinctions.  the  merely  above,  review  these  is  for  and In  "formula"  the  was  been  counterpart.  to  question  is  once  elements  These to  the  British  At  certain  tax.  which  it  several  lifetime.  history  exemplifies  corporation  mentioned  served  available  context,  the  American  have  amount  indeed  in  its  historically  legislative  insignificant,  considered  its  the  American  needs"  from  has  w i l l  has  found  formats  during  throughout  constant now  be  and  features  examined  legislative  its  as  provisions  continue  to  of  form  a of a  part.  The since  most  the  ability  its  inception  of  distribute  the its  intended  company's  important  of  of  company profits  use  of  business."  the  if  the  the to its funds  "common  shortfall justify  tax  its  motivation for  Portions  the of  elements" has  present been  decision in  so  not  to  deciding  was  "requirements the  the  language  of of  the the  94  statute that  on  this  regard  point  be  are  unchanged  since  1922  in  specifying  had:  . . . not only to the current requirements of the company's business but also to such other r e q u i r e m e n t s a s may b e n e c e s s a r y or a d v i s a b l e for the maintenance and development of that business • • • • j Q It  clearly  would  business"  in  be  the for  circumstances  where  those  the  company  year.  A  however, view  shortfall  further  profits  in  Commerce into  to  to  the  discussions  "  w i l l  of  the  the  of  as  relevant the  be  of  taxpayer  which  taxation  House  of  Lords,  The  better  requirements  that the  to  question  businesses  legitimate  to  the  company in  business  a  "that  defence " . . .  a  whatever  taxpayer  company  to  at  to  the  generate  suffice.  measures  Association  Confederation with  or  the  the  shortfall  the  the  interpretation."'''''  appear  enable  the  led  in  contemplation  . . . .  1966 and  would  by  requirements"  on  recognise  the  ...  Reaction effect  w i l l  words  restricting  profits  decision  this  the  as  business  nature  assessment  date  its  "business  recent  the  in  of  carried  rejected  construe  passage  particular  actually  court  genuinely  relevant  the  relatively has  the  retention  the  concerning  which  is  of  to  foregoing  justification  were  possible  Inland  of  of  British  British Revenue  which  came Chambers  Industry with  into  to  respect  of  enter to  the  1 0 . Now f o u n d i n s u b - p a r a g r a p h 8 ( 2 ) ( a ) o f S c h e d u l e 1 6 o f the Finance Act, 1972, these words c a n be t r a c e d back to subs e c t i o n 21(1) of the F i n a n c e Act of 1 9 2 2 . 11. W i l s o n and Garden L t d . v. I . R . C . [1982] A l l E.R. 219, [ 1 9 8 2 ] S . T . C . 597 (H. of L.). 12. l o c . c i t .  95  application  of  the  discussions,  the  Association  and  the  Confederation  memorandum given  to  legislation.  which the  legislation.  of  dealt,  term  of  inter  that  a  British  British a l i a ,  "business  Given  As  result  Chambers Industry  with  the  requirements"  portions  of  that  of of  these  Commerce  produced meaning  under  a  to  the  be new  memorandum  are  13 said may  to be  "remain helpful  at  relevant this  to  point  the to  current quote  from  l e g i s l a t i o n , " the  it  memorandum:  6. ... It i s only companies which have accumulated cash and liquid resources in excess of their requirements . . . whose d i s t r i b u t i o n policy can be called in question. 7. While ... companies with large c a s h and liquid resources must expect their accounts to be c r i t i c a l l y examined, it does not follow that h i g h e r d i v i d e n d s c a n n e c e s s a r i l y be p a i d 8. It w i l l be n e c e s s a r y to make some comparison between the future maintenance and development expenditure on the one hand and resources available to meet it on the other The company's expenditure plans must be genuine but c a n n o t be p r e c i s e . A c o m p a n y may i n t e n d t o build new b u s i n e s s premises if it can f i n d land in an appropriate location and obtain planning permission. In such circumstances there is no absolute certainty t h a t t h e p r e m i s e s c a n be built within a specified period of time but this would not n e c e s s a r i l y invalidate the company's c l a i m to r e t a i n funds for the purpose.  10. If a c o m p a n y h a s no c a s h o r investments, and finances its trading operations by the use of borrowed money such as overdrafts, there would seem to be l i t t l e ground for any shortfall assessment i n the normal case.i/  1 3 . S i m o n ' s T a x e s , R e v i s e d T h i r d E d i t i o n , p. 6 0 1 . 1 4 . " C l o s e C o m p a n i e s and t h e S h o r t f a l l , " The Accountant (England), vol. 160 (March 1 , 1 9 6 9 ) , pp. 296-270.  96  From  the  where  foregoing,  the  company  distribution of an  those  w i l l  assets  issue.  profits  for  save  it  When  liquid  the  assets  an  a  business  of  other  -  justifying  hand,  purpose  to  to  company's  relevant  company's  the  use  business the  certain would  be  had  assets paid  to  i l l i q u i d i t y  alone  would  w i l l  be,  of  the  inter  to  adjudged  distribute  profits  As  is  purpose  of  considered  is  agreed  the  the  with  the  British  to  be  in  in  its  from  bank  case  its  found  purchased to  its  loans  circumstances  requirements  company  of  make  requirements  factors  of  failure  become  a  apportionment.  business  example  for  retention  the  company  bank  the  until the  the  to  maintaining assets and warehouses,  to on  the  Fattorini that  a l l  the  where  loan  situation, funds  company  of  a  been  the  basis  from  loan  tax,  a  income  of  had  justify  case  proceeds  American  shortfall  available  the  are  a l i a , :  . . . the need f o r and a d v i s a b i l i t y of and developing the company's fixed equipment, such as factories, plant, showrooms and o f f i c e s ; - ^ Another  only  it  requirements  from  -  its  rule  the  where  resulting  then  general  available  basis  example  from  as  of  the  for  that  question  non-business  the  considered,  has  self-induced,  a  shareholder, not  on  is  appears  the  On  i l l i q u i d i t y  it  to  bank  repaid. for  16  the  which  are  meet  its  15. John E. Talbot and G . S . A . Wheatcroft, Corporation Tax and Income Tax Upon Company D i s t r i b u t i o n s , London, Sweet & M a x w e l l , L i m i t e d , 1 9 6 8 , p. 2 4 4 . 1 6 . Thomas F a t t o r i n i (Lancashire), L t d . v. I.R.C., [1942] A . C . 6 4 3 , 6 5 6 ; 24 T . C . 3 2 8 , 351 (H. of L.).  97  requirements year  but  also  Given are,  in  more  fully  for  the  that up  its  a  the  sense,  discussed  profits  retained  from  (but  far  profits,  it  inception  corporation  or  of  is of  of  current  the  suggested  the  only)  entirely  business  provisions  company  above,  and  justification comprehensible  apportionment  its  present  as  from  the  e a r n i n g s . ^  ultimate  the  The  the  requirements  below,  of  since  consequences.  only  business  the  retention  the  not  accumulated  that  almost of  include  the  winding  had  special  their  origins  has  trace  18 back  to  a  originally amount  1927 amendment created  subject  to  to  the  Finance  apportionment)  and  Act  of  1922  provide  (which  that  apportionment:  ... for any a c c o u n t i n g period in which that occurs, or which ends in or within the months before that event comprises 100 per of i t s d i s t r i b u t a b l e income. In  assessing  distributions, were, for  from  fact,  down  distribution  company's  business  continue (a)  the  certain  1922  the  to any  sums to  and  adequacy already  1978, not  of  the  expended  by  treated having  requirements.  as been  These  be)  described  in  sum  expended  ...  the  if  company's the  s t i l l  company available  applied sums  event twelve cent,  were  legislation  to  the  (and, as  in  being:  (i) in or towards payment for the business, u n d e r t a k i n g o r p r o p e r t y w h i c h t h e company was formed to acquire or which was the first  1 7 . B r a m w e l l , p. 1 3 7 . 18. S u b - s e c t i o n 31(4) of the F i n a n c e A c t , 1927. 19. Bramwell, pp. 143-144 explaining the effect p a r a g r a p h 1 3 ( 1 ) o f S c h e d u l e 16 o f t h e F i n a n c e A c t , 1 9 7 2 .  of  98  b u s i n e s s , u n d e r t a k i n g or a c q u i r e d by t h e c o m p a n y ;  property or  . . .  in  fact  (ii) i n redemption or repayment of any share or loan capital or debt . . . issued or incurred in or towards payment for any such business, undertaking or property, or issued or i n c u r r e d for the purpose of raising money applied or to be applied in or towards payment t h e r e f o r ; or ( i i i ) in meeting any obligations of the company i n r e s p e c t of the a c q u i s i t i o n of any such b u s i n e s s , u n d e r t a k i n g or p r o p e r t y ; or (iv) i n redemption or or loan capital or incurred otherwise consideration; and  repayment of any share debt . . . issued or than for adequate  (b) a n y sum e x p e n d e d o r a p p l i e d , o r i n t e n d e d t o be expended or applied, in pursuance or in consequence of any f i c t i t i o u s or a r t i f i c i a l transaction ...•20  Sub-paragraph section  (b)  above  bears  some  Income  Tax  245(1)  of  the  necessity  for  such  a  provisions  of  treating company's  rule  sub-paragraph  "income  applied  f i r s t  for  business  seems (a), or  resemblance Act beyond  however, towards  . . .  as  of  sub-  Canada;  the  dispute.  have  the  . to  the  effect  acquisition  income  The  of  available  of a for  21 distribution "in  which  it  and has  not  have  been  been  found  described possible  as to  provisions discern  any  22 rational  philosophy.  While  sub-paragraph  (a)  remains  2 0 . C u r r e n t l y f o u n d i n p a r a g r a p h 1 2 ( 1 ) o f S c h e d u l e 16 o f Finance Act, 1972, the language of these provisions unchanged since 1922. 2 1 . B r a m w e l l , p. 138. 2 2 . B r i t i s h Tax G u i d e , L o n d o n , Sweet & M a x w e l l , Limited, 1970 and 1 9 7 3 , v o l . 2 , p. 2 8 1 6 .  in  the is  99  the  shortfall  would  appear  to  transactions the  legislation, have  rendered  between  following  new  provisions  it  nugatory  associated  comment  added  in  (except  companies  are  1978  insofar  as  concerned),  as  confirms:  ... it i s hard to see what scope there i s at a l l for the present provision having regard to the 1978 changes on the one hand and the rules relating to property investment companies on the other. , 0  Turning  now  to  those  have  not  tax,  one  finds  that,  44  years  of  f i r s t was  remained  expressed  in  aspects  constant at  its  of  the  throughout  its  the  inception  existence,  essentially  the  the  shortfall  in  history  which of  the  for  the  shortfall  tax  1922,  British  following  tax  and  terms:  ... where it appears . . . that any company . . . has n o t , w i t h i n a r e a s o n a b l e t i m e a f t e r the end of any year or other period for which accounts have been made up, distributed to its members . . . a reasonable part of its actual income . . . , the Commissioners may . . . direct that . . . the said income of the company shall ... be deemed t o be the income of the members, and the amount thereof s h a l l be a p p o r t i o n e d among t h e members.25 In  assessing  distributions, statute  to  The assessment  the  have  requirements  the  of  test made  reasonableness  Special  regard  to  Commissioners the  factor  the  company's  of  reasonableness  by  the  of  the were  mentioned  company's  instructed above:  by the  business.  directors  as  to  be  to  the  applied company's  to  the  ability  23. Finance Act, 1972, paragraph, 8(3), added to the statute by Finance Act, 1978, section 36(2) and Schedule 5, paragraph 1. 2 4 . B r a m w e l l , p. 1 4 1 . 2 5 . Income Tax A c t , 1952, section 245, re-enacting section 21 o f t h e F i n a n c e A c t o f 1 9 2 2 .  100  to  distribute  "the  actual  i t s  profits  conditions  is  based,  known  [to  as  the  might  be  expected,  directors]  at  the  on time  26 for  decision."  tax  was  that  i t  In  i t s  considered was h e l d  to  original  i n c a r n a t i o n , the s h o r t f a l l 27 "highly penal" with the result  be  that:  the onus is originally Revenue to show that unreasonably in withholding from d i s t r i b u t i o n . 2 g At  the  same,  however,  i t  was h e l d  to  and the part  remains company of i t s  on  the acted income  be:  . . . clear that for the purposes of the s e c t i o n i t i s t o be c o n s i d e r e d u n r e a s o n a b l e n o t t o distribute i n c o m e when t h e r e i s no r e a s o n , o r no sufficient reason, relevant to the needs, present or future, certain or c o n t i n g e n t , of the company's business which makes i t s retention necessary or expedient i n the i n t e r e s t s of the company's b u s i n e s s . ^ In  assessing  distributing Revenue the  of  surtax  proving  the some  the  portion  presence  would  that  company's  i t  of  of  eliminate has  been  reasonableness i t s  an  profits,  intention  any  to  possibility  reasonable  in  not  in  proof  avoid of  not  by  payment  the  the of  company's  distributing  i t s  30 profits. for  the  On  the  Revenue  to  other  hand,  prove  an  i t  has  intention  never on  been the  necessary  part  of  the  31 shareholders (quoted  above  to at  avoid page  tax 86)  and, to  in  fact,  "preventing  the  the  reference  avoidance  of  2 6 . Thomas F a t t o r i n i (Lancashire), L t d . v. I . R . C . , [1942] A . C . 6 4 3 , 6 5 6 ; 24 T . C . 3 2 8 , 3 5 1 ( H . o f L.). 27. l o c . c i t . 28. l o c . c i t . 29. A. & J . Mucklow, L t d . v. I . R . C . [1954] C h . 6 1 5 , 6 4 5 ; 35 T . C . 2 5 1 , 285 ( C . A . ) . 3 0 . Thomas F a t t o r i n i ( L a n c a s h i r e ) , L t d . v. I . R . C . , [1942] A . C . 6 4 3 , 6 5 6 ; 24 T . C . 3 2 8 , 3 5 1 ( H . o f L.). 3 1 . D. C a r l a w & S o n s , L t d . v . I . R . C . ( 1 9 2 6 ) 11 T . C . 9 6 (Court of S e s s i o n , Scotland).  101  the  payment  shortfall  of"  originally  legislation  Effective only  tax  with  in  the  no  longer  April  of  taxation  found appear  1966,  of  in  a  the  in  preamble  the  statute  bodies  the  statute.  separate  corporate  to  came  dealing  into  force  32 in  England  measures and  replacing  continued  provisions  legislation new  the  of  in  render  it  retention  one  be  subject force  by  other  a  in  by  company  the  had  been  declared  the  l e g i s l a t i o n ,  the  following:  a  to the  1922  its  amount  of  of  of  the  active  40%  of  change a  net  business  its  net In to  the  the  in  the  company's At  was  the  made  company's  1965 its  Secretary  a  Effective  "reasonable."  Chief  included  assessment. of  to  shareholders.  of  60% of  framework  intent  were  significant  shortfall  be  in  apportionment.  its  to  in  the  company  immune  legislative  similar  amongst  1966  words,  the  Anti-avoidance  apportionment  very  to  scheme.  of  enacted  calculating  into  distribution (or,  part  accumulations  would  coming  a  permit  however,  method  which  be  former  substantially  to  unreasonable time,  to  originally  statute  same  the  income  with  the  l e g i s l a t i o n , trading  would  effect,  trading  a  profits  income) In  in  the  profits  commenting  upon  Treasury  said  . . . the 60 p e r cent, is a method of eliminating from d i s c u s s i o n a whole host of c a s e s . No longer w i l l it be necessary, as it is today, for a company to s a t i s f y the Revenue t h a t i t h a s made a reasonable distribution if it has distributed 60 per cent. of its net profits . . . . it is a relaxation that is the whole purpose. A vast number of c o m p a n i e s t h a t m i g h t o t h e r w i s e have been put to the trouble of, perhaps, no more than 32.  Finance  Act,  1965.  102  writing a letter to the inspector of taxes explaining the position or having an interview w i t h h i m - w i l l no l o n g e r h a v e t h a t trouble.^3 Obviously,  even  a  a  need  for  In a  as  the  significant  1965,  corporate  revision  "imputation"  present.  as  there  was  perceived  to  be  "relaxation."  1972,  called  early  This  tax  with  the  system  "new"  system  in  England  introduction  which  remains  underwent  of in  the  so-  force  at  system:  [t]o a great extent . . . reproduced those parts of the earlier legislation dealing with the a p p o r t i o n m e n t to s h a r e h o l d e r s of a c l o s e company's income in the event of a shortfall in distributions. Thus,  while  shortfall the  tax,  exception  percentage could  of  safely  shortfall In the  the  during  the  it  did  of its  not  "new"  greatly  fear  the  affect to  business  without  50  income of  mechanics its  substance  per  cent  which  being  of  the with  in  the  the  company  subjected  to  a  35  system,  subject  changed  increase  active  retain  period  system  an  assessment.  this  amount  "new"  to  the  statutory  apportionment  1972 to  1980 was  in  was  "formula" to  essence  be as  by  which  determined follows:  (a) an a p p o r t i o n m e n t s h a l l n o t be made u n d e r paragraph unless the relevant income of company for the accounting period exceeds distributions for that period; and  this the its  33. England, Parliament, House of Commons Debates, 21 June 1965, v o l . 714, c o l . 1228 as quoted in Simon's Taxes, T h i r d E d i t i o n , p. 4 6 2 . 34. S i m o n ' s T a x e s , R e v i s e d T h i r d E d i t i o n , page 5 0 4 . 35. Finance Act, 1972, Schedule 16, paragraph 9(1).  103  (b) the amount a p p o r t i o n e d t h a t e x c e s s •• • 35 A  brief  review  of  which  the  close  this  "formula"  demonstrate shortfall  some  company to  the  the  had  its  statutory  to  own  contend  the  most  the  that  distributions,  in  (alluded  many  order  to  may  to  with apply  serve  above)  to  of  the  upon  straight-forward  which  the  of or  as  "formula"  the  this  term  consisting  "distributions"  interpretation  made  system to  or  on  38 interest  from  (a) any d i v i d e n d s w h i c h a r e d e c l a r e d i n r e s p e c t the period and are paid during the period within a reasonable period thereafter, and  defined  above  definition  is  imputation  payments  of  depends  Essentially,  the  amount  definitions  (b) a l l distributions made i n dividends which, in relation period, would f a l l under above . . . . 3 7  even  the  circumstances  complexity  amongst  but  be  l e g i s l a t i o n .  Perhaps  of  of  shall  payments  and  came  must into  behalf  of  . certain  be  of:  the to  period except any previous paragraph (a)  refers used  force  to  with  dividends  care  in  1972,  directors  (such  ., . . living  or  -  when  certain as  some  entertainment  39 expenses  )  f e l l  within  Furthermore,  the  the  payment  time  of  the  definition of  the  definition raises  of  several  dividends  which  distributions. questions may  as  to  qualify  as  distributions. 36. Finance Act, 1972, Schedule 16, paragraph 1(2). 37. Finance Act, 1972, Schedule 16, paragraph 10(1). 38. Income and C o r p o r a t i o n Taxes Act, 1970, s. 285. payments ceased to f a l l within the definition d i s t r i b u t i o n w i t h passage of the Finance A c t , 1980. 39. Income and C o r p o r a t i o n Taxes A c t , 1970, s. 284.  Such of  104  A  very  "formula"  hinges  "relevant content  important  income" by  therein.  upon  part  of  the  meaning  the statutory  and  statutory As  of  this  definition  definition  definitions  1972,  of  "relevant  of  in  of  was  above  the  turn  several  income"  the  term  i s  given  terms  used  defined  as  being: ... i n t h e c a s e o f a c o m p a n y w h i c h i s a t r a d i n g company ... s o much o f i t s d i s t r i b u t a b l e income for that period a s c a n be d i s t r i b u t e d without prejudice t o t h e r e q u i r e m e n t s o f t h e company's business;  The period  "distributable  (and today)  income"  of  a  company  during  this  was:  ... t h e a m o u n t o f i t s d i s t r i b u t a b l e p r o f i t s f o r the p e r i o d e x c l u s i v e of the part a t t r i b u t a b l e to c h a r g e a b l e g a i n s .... The  term  company's  "chargeable capital  gains"  gains  means  f o r the  that  relevant  portion period  of  the  which  i s  taxable. The  "distributable  profits"  of  a  company  were  (and  are ) : ( i ) t h e amount o f a n y p r o f i t s on w h i c h c o r p o r a t i o n t a x f a l l s f i n a l l y t o be b o r n e , l e s s t h e a m o u n t o f t h s t 1 3 x ****Z^2 One  of the i m p l i c a t i o n s  in  terms  of " p r o f i t s  to  be b o r n e "  of measuring  on w h i c h  "distributable  corporation  tax f a l l s  profits" finally  i s that:  . . . t h i s does n o t r e s t r i c t t h e c a l c u l a t i o n t o t h e r e s u l t s of the year, but a l l o w s f o r the o f f s e t of 40. 41. 42.  F i n a n c e A c t , 1972, Schedule F i n a n c e A c t , 1972, Schedule F i n a n c e A c t , 1972, Schedule  16, s u b - p a r a g r a p h 8 ( l ) ( a ) . 16, p a r a g r a p h 1 0 ( 2 ) . 16, s u b - p a r a g r a p h 1 0 ( 2 ) ( a )  105  past losses, etc. which are deducted from the profits of the year before arriving at the amount on which corporation tax f a l l s finally to be bo r n e . » Q  Having  worked  definitions close  and  company  any)  of  its  way  applied  was  not  its  same  yet  S t i l l  mentioned  permitting  calculating business small  trading  the The  company's provisions following  of  its  active process  just  described  is  to cent  of  income  exceeded  f e l l the  short  described  by  for the  the small  income less but  to than  was  no  amount  by  the  of  L15,000. of  in  active  of  portion  apportionment  rule  its  if  L5.000  one-half  to  disregard  relevant  business  (if  the  allowed  income  to  were  provision its  the  subjected  provision  calculating  subject  per  of  portion  relieving  disregard  income  be  company 50  income  business of  the  calculating  to  the  considered  This  such  L15,000,  could  be  active  sources,  calculate  further  when  where  than  a  income  to  income  company.  a l l  and,  greater  and  company  disregard L5,000  relevant  income  trading  which  its  to  multitude  its  which  apportionment.  this  to  able  income  above  through  the  44  close  pursuant  to  the  Bramwell  in  the  terms: The quantification process is made d i f f i c u l t by reason of the f a c t t h a t i t i n v o l v e s several stages and i s g i v e n e x p r e s s i o n by. t h e u s e o f a n u m b e r of  437 B.D. Easlick, "Shortfalls: How to Avoid and Why," Accountant, vol. 158 (February, 1968), pp. 138-139 at p. 1 3 8 . 44. Finance Act, 1972, paragraphs 9(2) and 9 ( 2 ) . In 1978, these amounts were increased to, in the case of the lower amount of L5,000, L25.000 and, in the case of the higher a m o u n t o f L 1 5 , 0 0 0 , L 7 5 . 0 0 0 by F i n a n c e A c t , 1978, s. 35.  106  defined meaning, The  foregoing,  complexity period to  of  in  within (and  the  are)  also tax.  corporation  omits  of  those  parts  Forms  the  The  of  a  of  during  thereof  of  liable  pertaining  considerable  hint  obvious  the  the  not  corporation  definition  rules  a  legislation  potentially  add  change was  "relevant  to  the  true  relevant pertaining  not  f a l l i n g  trading  company  to  assessed  to  be  these  volume  shortfall  implemented  income"  "other  trading  shortfall  only  have no income."^^  of  other  were to  forms  material  of  to  the  l e g i s l a t i o n .  The Budget  gives  companies. scope  relevant  fact,  it  the  shortfall  words  in  that  trading  terms of which some for example, "relevant  than  company  is  found  effected  by  amending  above  through  trading now  tax  income."  defined  as  the the  by  the  1980  definition insertion  "Relevant  of  of  income"  the of  a  being:  ... in the case of a company w h i c h is a trading company . . . so much o f its distributable income, other than trading income, for that p e r i o d as can be distributed without prejudice to the r e q u i r e m e n t s of the company's b u s i n e s s ; ^ As  mentioned  trading from other  active  potential than  retained other  (or  above,  income  it is  words  business)  l i a b i l i t y  trading  by  these  income  without needed  income  of  a  to  the  shortfall  of  the  trading  fear in  effectively  the  of  trading tax.  tax  active  can  only  the  company  The  company  shortfall  company's  remove  income also if  be that  business.  4 5 . B r a m w e l l , p. 1 2 7 . 46. Finance Act, 1972, Schedule 16, sub-paragraph 8 ( l ) ( a ) a m e n d e d by F i n a n c e A c t , 1980, Schedule 9, paragraph 1.  as  107  2.  As  a  the  person  rule,  "apportioned"  to  shareholders. however, of  the  to  income  the  In  whom  the  company,  case  and,  repeated  through  to  shareholders  human  a  subject  for  its  be  made  necessary, companies  for  calculating  insofar  as  calculated  present, result tax  the  the  this  until  tax  participators process  an  may  be  apportionment  consequences  ramifications  be  of  question  in  the  of  for In  borne  amount  inception income  mind  tax  is  l i a b i l i t y  payable, to Act,  been the  of  of  both  the  this  company  considering that  the  slightly to  apportionment  "unreasonably  "apportioned,"  Finance  "participator,"  pay  those  procedure misleading  the  tax  so  concerned.  the  distributed 47.  must  to  or  made.^y  has  the  the is  From  the  it  is  "participators"  may  of  is  apportionment  corporate  "participators."  ramifications,  to  a  3. the income apportionment  and  apportioned  of  where  chain  Apportionment  is  corporation's  sub-apportionments  that  it  has,  for  treated  1972,  Schedule  1922  accumulated,"  the as  shareholders  in  if in  16,  purpose it  had,  of in  accordance paragraph  to  and  the as  a  calculating fact, with  1(4).  been their  108  respective  interests  in  notional  distribution,  level  the  of  he  so  may  look  the  that to  ultimate  payment  this  of  the  has  the  l i a b i l i t y  for  where  never can  for  can  been  the  elect  to  f a i l s  to  of  company  the  is  pay  neglects  target. the  If  tax.  the  the  In  Revenue  same  f a l l s to  income  concerned,  so,  tax  this  calculated.  sole  At  this  upon  to  be  do  payment.  payment the  appropriate income  shareholder  company  Based  sum a p p o r t i o n e d  shareholder  the  shareholder  company.  surtax  of  shareholder  wishes,  event  the  as  the  the  the  "recipient"  Insofar however,  the  time,  back  attend  upon  to  the  matter.  Up which  until could,  paragraph, In  either  In  1966,  respect  of  the  which, 48.  new  tax  tax  upon  Finance  either  only  a  Act,  of  be  its  became  of  the  mechanism  was a  section  of  the  new  77.  or  of  corporate the  by  the  time  the  tax  company and  to  in be  shareholder  that  the  term  legislation  with  " s h o r t f a l l " the  dividends,  company.  exigible.  shareholders  this  tax  preceding  tax  upon  " s h o r t f a l l . " of  single  the  level  measuring  or  distribution 1965,  part  so-called for  in  payable at  a  shareholder  levied  to  It  accumulation" the  one  advent to  involved  described  previously  received.  introduction  "unreasonable  was  the  actually  as  from  with  the  dividends  procedure  manner  distributions  to  "shortfall"  the  there  a  its  addition  apportionment  collected  event,  came  upon  in  be  statute  in  1966,  assessment  amount 4  8  In  taxes  of a  any  system  both  the  109  corporation  and  accumulation"  obviously  loss  to  one. on  the  the  the  in  a  The effect  tax  the  at  the  in  well  the  In  made,  company  amount  which  would  have  this  is  by  the  tax  in  in  to  payable  a  company  when  if by  tax whose  to  the the  income  payment  of  in  in  amount  in was  1972  levying to  its  company may  tax  be  the  by  the  apportionment to  the  Revenue tax  apportioned The  is set  for  made  corporation  company.  credit  of  themselves  and  was  an  pay  advance  the  dealt  of  the  corporation  liable the  1966  by  tax"  distribution  becomes  for  dividends  payable  system,  is  shareholders  corporation  at  question  England  relevant "new"  and  company.  its  distributed  receives  The  and  apportioned  pays  the  -  The  against  equal  been  been  however,  taxing  "advance  company. the  as  company  which  tax,  the  it  at  at  instituted  when  merely  levels  responsibility  practice  revenue  two  amounts  of  a  tax  to  the  the  than  respect  received.  as  rather  apportionment.  company  as  cause  the  initiated  the  to  shortfall  paragraph;  "unreasonable  1966 c a l c u l a t e d  system  the  payment  of  "imputation"  known  actually  regime  that  dividends  period  levels  solely  on  by  two  potential  was  shareholders  off  the  an  through  preceding  continues  tax  upon  through  with  shortfall  at  fiscal  level,  l i a b i l i t y  with  has  accumulations  level,  shareholder  now  new  unreasonable  tax  shareholder,  government  Thus,  corporate  a  the  is an  which had  shareholder,  recognition apportioned  of to  this him.  110  The forth  examination  above  of  the  constitutes  a  three basic  description  unreasonable  accumulations"  both  England  as  in  past. the  and In  the  discussed.  The  tax  institute  such  was  a  five,  tax  mentioned  but  tax  "highly  in  is  has  of  the  in  tax  have,  exists  in  recent some  course,  to  other  the an  of  been  with  with  relevant  on  the  deals  connection  "tax  above, of  set  English  attempt  to  Canada.  accumulated  earnings  reviewed.  As  definitely  in  this  What  to  is  as  the  tax  was  penal  chapter  referred  penal."  of  country  chapter  be  matters  presently  this  this  could  very  been  that  in  was  earlier  it  created  the  States  that  shortfall  which tax  United  therein,  has  arisen  and  as  describing  remainder  chapter  the  it  have  shortfall  in  of  which  which  In  existed  course  problems  issues  it  "preliminary"  in  imposed discussed  nature.  that  the  being  not  nature  of  It  English  merely the  penal penalty  involved ?  Consideration reveals  another  followed  a  During  there  distributions "surtax be  direction."  discussed  event  would  that  below)  this  did  penal  where  path  first  that  the  area  similar  the  finding  of  to  the  that  years  44 had  aspect  been  "shortfall"  in  It  possible  not  take  the of  in  compromise  in  what  a  was to  surtax  place,  the  shortfall  tax  legislation  existence  result was  the  British  traced  of a  of  United  States.  this the  then appeal  direction ultimate  has  tax,  a  company's  known or  as  (as  but  in  a  w i l l the  consequence  Ill of  such  a  direction  shareholders  of  a l l  distributed.  In  some  the  or  might  even be  -  there  basic  in  would  the  the  retention  the  business  would  a  this  a  legal of  its  an  would  result  of  the tax for  annual  attempt of  of  this  consequences  of  the  over  the  to  during  reach  distributions practice, inadequate  the  it  business  the  would  situation  that  tax,  needed  result  on  a l l  in  for the  of  the  year.  severity  of  Inspector which  year  of  by  the Taxes  he  and  the  as  to  the  in  question.  apppear  distribution  then,  earnings  agreement for  that  regard,  taxable  whereby  company's  its  would  the  income business  American  levied  that  including  this  above  temper  the  that  the  company  profits: ... i . e . , a direction c e n t , of the p r o f i t s , p r a c t i c e grew . . . .  49.  the  and  review  —  meet In  relevant  to  fact  the  accumulated  being  developed  level  to  corporation  period,  practice  appropriate As  profits  conduct  company  of  income  with  the  in  the  previously  company's  shortfall  apportioned.  amount  not  company's  needed  years  any  the  the  company's  was  earnings  During  a  similarity  needs  corporation's  was  be  of  meet  the  early of  accumulated  penalty  of  income  amongst  notwithstanding  portion  to  which  requirements  wherein,  words,  there  a l l  apportionment  company's  greatest  thereof  a  the  the  other  if  distribut ions,  is  of  required  requirements,  portion  was  Talbot  and  Wheatcroft,  p.  and was  241.  a p p o r t i o n m e n t of 100 rarely e n f o r c e d once  per the  112  Effective statute  of  was  accumulation shortfall  tax away as  to  With for  the  ceased  some  tax,  move  in  corporations,  the  the  requests  by  the  former  To with  a  at  extent,  to  directors'  perhaps,  Taxes  report  and  allow  the  and,  the  an  deems  appropriate  that  the  Inspector  of  Simon's  Taxes,  Revised  50.  of  such in  the  other  Third  of  taxation  procedure  by  to  material this  its  is  to  the  accounts, the  company  material,  request  whether  Edition,  be  statute.  submit  as  to  above  taxing  basis  than  agreements  earnings  to  the  involves  rather  annual  the  in  described  practice  company  decide  continued.  and,  referred  submitting Taxes  system  of  move  agreements  was  company's  annual  this  annual  intervals  practice  encouraged  on  of  modified  year  the  "prepayment"  (the  shareholders  provisions  of  the  change,  the  current  three  portion  its  and,  relevant  Inspector  the  the  the  to  of  was  to  except  "imputation"  paragraph),  -  distributions  clearance  certain  recognised The  for  review.  distributed  of  tax  American  Notwithstanding  practice  a  unreasonable  this  nature as  the  an  With  in  of  respect  constitute  procedure  Revenue  to  only  regard  the  annual  respect  with  the  this  following  reviews  tax  penal.  1972 to  1966  bodies,  penal  level  in  corporate  might  penalty  force  England.  be  as  into  to  in  to  appropriate  of  the  regarded  a  the  to  adopted  what  be  absence in  tax  from  only  considered  was  that  can  coming  assessing  which  extent  the  applicable  practice amount  with  page  or  583.  not  the  113  company's Upon  distributions  receipt  months for  of  (which  a  such  can,  further  His  act  any  a  period be  bar  in  made  further  these  terms  unreasonable has  close  under  certain  of  future A  for  example,  thus  evaluating  to  use This  the  it  do  so  which within  that  an  allows  is  the  the  extended  to  make time  respect  company  an w i l l  to  the  should  to  make  a  apportionment.  effects  interesting sound  to  a  tax  note  described  has  doing  of  been  so.  on that  practice  procedure  not  be  1  three  apportionment  possible  the  of  has  this  with  recommendation  disadvantages  adequate.^  Inspector  within  considered of  been  circumstances  avoid  the  been  make  paragraph.  potential  decision  and  have  apportionment  accumulations,  company  the  to  circumstances  traditionally  previous  months)  failure  question.  in  year  request,  distribution  In  it  to  the  a  three  apportionment. as  for  for in  based  a the  upon  Wheatcroft,  writes:  L i t t l e , i f any a d v a n t a g e i s g a i n e d by n o t bringing the q u e s t i o n to a head q u i c k l y , while, if this is not done, and a company is left with a possible l i a b i l i t y for directions for six previous years, the shares in that company a r e d i f f i c u l t to sell or t o u s e t o r a i s e money and t h e u n c e r t a i n t y a s t o w h a t may be h e a v y outstanding l i a b i l i t y is bound to hamper f u t u r e development p l a n s . ^ Curiously, similar  51. 52.  American  literature  does  not  seem  to  mention  concerns.  One which  the  of  taxes  the  problems  corporate  potentially  profits  which  created have  not  Finance Act, 1972, Schedule 16, paragraph Wheatcroft, 1962, pp. 1621-1622.  by in  18.  a fact  system been  114  distributed  on  of  taxation.  double  corporation  the  w i l l  shareholders. the  of  the  contains  actual  pursuant  relevant include  a  theory,  portion  been  to  this  taxation  taxation  are  company's  shareholder's  of  the to  paid.  53  income  "solution,"  is  upon  comments  however,  course,  the  at  are  of  to  the  time  again  at  its of the  legislation  deal  with  of  provision  a a  the  subsequent  income  for  deemed  distribution  portion  The  where  relevant  subsequent the  to  consists  the  that  English  intended  solution  is  profits  once  The  circumstances  the  of  these  in  corresponds  previously regard  which  exceeds  period,  be  distribution  cases,  distribute  distribution.  which,  distribution  many  and  (attempted)  to  notional  could  distribution  The  a  In  result  provisions  problem.  of  eventually The  notional  time  basis  the  not  to  which,  in  which  tax  Bramwell  has with  instructive:  ... no r e l i e f i s d u e , f o r e x a m p l e , w h e r e interests in a close company change hands between the apportionment and the later distribution. . . . . Furthermore, the p r o v i s i o n i s d e f e c t i v e in that it gives no indication of how an amount that is subsequently distributed i s t o be i d e n t i f i e d with t h e income of an e a r l i e r a c c o u n t i n g p e r i o d . ^ As a  w i l l simple  53. 54.  be  discussed  in  the  next  chapter,  the  problem  one.  Finance Act, B r a m w e l l , p.  1972, 149.  Schedule  16,  paragraph  5(6).  is  not  115  Chapter  A  Tax  It  has  thesis of  on  that,  the  Unreasonable The Form  suggested  in  taken  together,  the  business  which  embodies  gains  exemption create  manner  in  The England suggests be  small  and  which  case  such  cumulative in  the  that  the  the  a  proposed  tax  of  simplicity in  advice  attempting of  chapter be  the  the in  new  this  concept scheme capital  corporate of  w i l l  a  tax  tax  on  consider  the  structured.  the  United  unreasonable  design  of  legislative  deduction,  Canada,  taxing of  the  of  implementation  could  of  chapters  reduction  This  history  realm  from  the  Canada:  elimination  business  for  for  earlier  limit"  accumulations.  considered  regard,  the  a  unreasonable  Accumulations It Might Take  been  "total  rates  7  and  States  accumulations  administration  to  impose  such  Professor  Surrey  may  a be  and  tax. worth  In  must this  heeding:  ... some s l i p p a g e b e t w e e n g o a l s and r e s u l t s c a n tolerated if other factors such as simplicity administration are important enough..  be of  1. Stanley S. Surrey, P a t h w a y s to Tax R e f o r m - The Concept of Tax Expenditures. Cambridge, Massachusetts, Harvard U n i v e r s i t y P r e s s , 1973, as quoted i n K a t h l e e n A. Lahey, "The Small Business Credit: A Tax E x p e n d i t u r e Analysis." Canadian T a x a t i o n (Summer, 1 9 7 9 ) , p p . 2 9 - 3 4 a t p. 3 1 .  116 An  attempt  to  to  achieve  solve  total  repetition  of  adding  unduly  The by  does  fact  not  of  the  test  have  it  alone of  time  the  the  the  situation  counterparts their  the  which to not  the  can  surface  corporation's  constituted  American  the  earnings to  tax  predict to  the  justify  to  literature  a its  on  the  court  British scope  be  a  and  viable  and  with  British  elements as  earnings The  tax  contrast  complaints  focus how  in  By  rule.  of  recent  Canadian  accumulated  an  survived  form  significant  systems,  such  has  reduced  its  clearly  manifestations  most  to  it  illustrated  this  pertained  in  attempt  of  system.  than  possible  its  severely  rather  accumulated  always  examples  tax  without  was  it  tax  American  exception  that  income  tax  the  British  a  then,  tax  which  continues  American  is  this  tax  respective  do  very  earnings  which  of  said  repealed,  been  they  of  be  and  If  purpose  issue  complexity  Canadian  been  has  Act.  the  example  truly  the  of  mere  virtually  instituted, its  how  technical  was  f u l f i l  Canadian  it  when  complexity be  its  be  of  be  advisers.  complexity  of  course,  achieved  his  to  to  the  level  -  is  American  accumulated  of  as  of  of  since  manifestation  aspect  the  it  and  complexity  the  feature  long  yet,  the  that  have  important and  to  so  of  problem  which  taxpayer  accumulations  significance  the  if  system  the  structured  insoluble  would,  error  a  to  unreasonable be  neutrality"  in  incomprehensible  must  virtually  ancient  "perfection"  on  "the  to  tax  few  of the  seem  to  complaints  with  respect  to  fact  that  is  w i l l  retention  respond of  it to  funds  a as  117  being  necessitated  business.  2  For  by  the  "reasonable  • one  example,  article  needs"  refers  to  of  the  the  "complex Q  business  reasons  Concerns to the  such  consider same  as  if  time,  accurately  problems  that this  such  be  tax  is  a  taken to  be  attributable 4  to  resentment  its the  -  present  years.  If  of  corporation to  the  problem  see  of  was  more  possible  truly the  as  has  significant,  areas  Canada.  they tax  for  more  than  to  tax  in  sixty-five  "business one  At  are  earnings  the  of  in  the  survived  way  problem  that of  interpreting  in  of  accumulated  format  accumulation."  created  is  it  an  note  it  with  expected  must  justify  however,  essentially  the  can  needs"  might  amendment  have  than  has  occurred. In issues  very to  unreasonable  general  confront  terms, in  accumulations  there  attempting for  the  are to  essentially design  Canadian  a  context.  four  tax  on  These  are:  2. See for example: David Altman and Allan B. Muchin, "Supreme Court's Donruss decision calls for a shift in t a c t i c s i n 531 a r e a , " The J o u r n a l of T a x a t i o n , A p r i l , 1969, vol. 30, no. 4, pp. 202-206 and K. Greenhut, "The Accumulated Earnings Tax A Call for Repeal," The CPA Journal, August, 1977, v o l . XLVII, no. 8, pp. 23-26. 3. David Altman and Allan B. Muchin, "Supreme Court's Donruss decision calls for a shift i n t a c t i c s i n 531 a r e a , " The Journal of Taxation, A p r i l , 1969, vol. 30, no. 4, p p . 2 0 2 - 2 0 6 a t p. 2 0 2 . 4. Bittker and E u s t i c e observe that the "corporate penalty tax on unreasonable accumulation is not popular with the business community, as i t involves a hindsight verdict on management's business judgment." B o r i s I. B i t t k e r and James 5. Eustice, Federal Income Tax of Corporations and Shareholders, B o s t o n , W a r r e n , Gorham & Lamont, I n c . , 1979 at p.8-5.  118  1. of  A t w h i c h l e v e l s h o u l d t h e t a x be i m p o s e d : that the c o r p o r a t i o n or t h a t of the shareholder?  2 . How i s i t unreasonable  Each  of  the  4.  or  Should  1. of  Which  four  would would  in  would  been  an  unreasonable  in  turn.  the  British  a  device  to  which  against  would  injustice  that  on his  determine  presumably  of  the  tax  be  i t s e l f  neither  choice  imposed he  had  this  this  situation,  by  the  individual  l i a b i l i t y  finance  paid  Would tax?  situation  directors  faced  in  apportionment  received?  he  the  be  notional  actually  in  tax or  to  would  Naturally,  potential  system How  himself  so.  the  shareholder  measuring  be  to  d i f f i c u l t y .  seem  where  shareholder.  action  -  calculation  serious  found  subjected  the  case,  most  upon  be  either  The  money  on  considered  excessive  from  not  be  has  otherwise?  was  free  funds  now  tax  accumulation  be  the  the  necessarily  shareholder  penal  w i l l  should  While  in  however,  be  accumulations  the  not  tax  issues  taxpayer  corporation?  same  the  there  A t w h i c h l e v e l s h o u l d t h e t a x be i m p o s e d : that the c o r p o r a t i o n or t h a t of the shareholder?  unreasonable  the  that  3 . Upon what amount s h o u l d a c c u m u l a t i o n s be a s s e s s e d ?  these  whether  t o be d e c i d e d accumulation?  could, of  the  the  such  as  to  tax  payment  he The  ever  that  seen  on of  that  tax  on  receive  the  shareholder  who  conceivably, corporation  bring for  an  their  119  negligence States  in  where  corporate of  a  the  advice  -  of  tax  l i t i g a t i o n  as  in  an  "deemed,"  -  seen  designed taxation  to  as  then so in  as  not to  tax  merely  tax,  it  would  as  to  such  rarely and that  the  minority accumulated To  be  suggest practical  expense  which  in  close  the  relationships  the  that  levying  of  double  retained  having  second Insofar  already  amongst  double  was  not to  intended follow  circumstances.  As  was  the  to  of  the  to  that  shareholders  the on  a  actual  corporation  of  on  conceivably  could,  portion  tax  by  taxed  when  taxation a  been  the  the  taxation  could  time as  of  earnings  distribution,  allow  the  would  at  possibility by  one.)"'  with  be  of  seem  the  to  United  indispensable.  would  a  the  levied  real  personal  constituting system  level,  accepted  problem  place.  avoid  the  very  often  actual,  is  inconvenience  the  (In  instigated  however, the  tax  subjected  a  taxpayer,  took  however,  nature,  level  the  but  used  being  distribution  distribution  If,  potential  l i a b i l i t y  being  very  shareholder  eventual  face  is  imposed.  earnings  generally  maintaining  corporation  be  is  to  be  shareholder  solution,  it  further  the  the  viewed  shareholders  A  to  corporation  addition  corporation  at  a  tax  action  a  is  entails,  the  than  derivative  earnings  the  accumulated  rather  shareholders  it  causing  penal  in  should  be  avoid  described  course, penalty.  be it  was  in  double chapter  5 . See f o r example S t a n l e y S . W e i t h o r n and Roger N o a l l , The Accumulated Earnings Tax, New York City, Practising Law Institute, 1 9 6 8 , p. 26 a n d N o t e , " D e r i v a t i v e A c t i o n s Arising f r o m Payment of P e n a l t y T a x e s Under S e c t i o n 1 0 2 , " 49 C o l u m . L. R e v . 394 ( 1 9 4 9 ) .  120  six, be  the  British  described  potential  with  as  the  to  would  and,  the  final  25%  apportioned shareholder  assume  how  for  to  him  a  is  to  in  most  attempt  to  be  accurately avoid  that  deemed  corporation  has  to  if  of  problems  shares  this  income a  of of  to  keep  earnings A's  year  1?  satisfactorily in  the  Z,  2,  3  that  year  4,  passed  If by  question,^ of  interest There  that  4?  which  which  fiscal in  seems  resolving  double  has  or  track of  A,  who  Does  resolution of  One  shareholder  In  1,  that  legislation  $10,000.  year  left  f r u i t l e s s .  $10,000.  determinative  since  of  is  upon  company  corporate  the  inherent  prove  British  one  complex  of  1  the  improve  situation  shareholder  changed  likelihood  well  the  i t s e l f  relate What  could  by  analysed, to  dividend  the  company  are  extremely  year a  moment  periods?  in  common  represent  the  potential  could  unanswered  efforts  result  receives  distributions  l i t t l e  that  example,  the  for  Z  is  its  taxation  analysis,  of  A  distribution  company  in  left  double  likely  consider,  holding  we  problems  impression  attempt  might  unsuccessful  avoid  the  in  legislation  inequity.  When attempt  shortfall  a l l  taxation  the to  of  aspect  be the of  apportionment.  Looking corporation  to  the  rather  alternate than  6. As was s u g g e s t e d by Taxation of Companies, p. 1 4 9 .  the  Richard London,  possibility shareholder,  Bramwell Sweet &  of  taxing  one  and John Maxwell,  the  finds  a  Dick 1979  in at  121  potential course)  problem cost  the  tax  rate  marginal  corporation would  a  deemed  to  raising  have  the  was  its  in  whose  would  amount  than  would  income  the  fellow  a  shared  method  of  unreasonable ultimate  if  corporation  as  the  value  regardless  of  would  into  bring  of  into  dividends.  the the  of  financial Canadian  the  was  less  same  for  whom  the  in In  fact  been  the  common  taxation  majority  would  on its  be  no  distributed  by  in  system  tax  on  corporate  then,  circumstances  would  that  the  corporate  share  of  depending  both  them  effect, at  income  amount  Canadian  consideration  50%  unfortunate  conceivable  had  than  the  it  or  the  situation  a  to  below),  relevant  As  of  that  for  him  amount  subjected  corporation,  is  than  effect  suggested  the  the  unreasonable  chosen  levied  each  of  the  that  with  the  taxes  on  the  equity.  upon  income  accumulations  on  (whose  in  be  rate  of  wished  income  scheme  of  shareholders  tax)  the  on  tax  aspect  (taking  tax had  receiving  ownership  income  than  affecting  the  of  implementation  effect  unreasonable  rate  horizontal  or  a  marginal  accumulations,  personal  different the  of  shareholder  "innocent"  and  This  lack  taxation  would  individual  directly.  constitute  the  greater  who  more  Canada  would  taxpayer/shareholder  and  If  effectively  a  low  and  (indirectly,  shareholder  profits)  corporate  50% ( a s  could  minority  distributed.  effective to  tax  relatively  implemented  result  pay  a  distribution  been  provisions  the  such  "innocent"  notional to  that  distribute  accumulations  its  in  tax  on  level,  by  the of a  same  its certain  way  owner, lack  122  of  vertical  his  low of  tax  preceding of  persons  put  the  recalled  that  potentially  for be  small  above  retaining  the  shares,  tax  appropriate agreement.  Second,  above,  necessarily  not  derivative the  unreasonable  for  into  of  minority  to  to  on  behalf acting to one  shareholders,  be  who  the Royal 1966, v o l .  them  a the  of  its  methods  to  one,  insist  as  of  the the upon  discussed  instigating  the  corporation  to  cause  contrast  of  of  shareholders'  albeit,  would  of  avoiding  a  imposed.  may  represents  purchase  in  as  be  circumstances  while  for  of  must  shareholders  two  their  exist  it  terms  the  them  attractive  consideration,  7. Canada, Report of Ottawa, Queen's P r i n t e r ,  in  possibility,  an  in  the  aspects  shareholders  minority  protection  the  so  the  Those  prior  accumulations  elements  to  advantage  would  proceedings  directors  these  is  deduction  affected  contractual  not  in  other  Specifically,  available  opportunity  rates  would  described  corporation  deferral.  First,  absolute  marginal  however,  business  deferral  risks. the  inequities  advantage  have  same  with  taxes.  private  tax  the  circumstances  explored.  adversely  described  inherent  be  shareholder  whose  perspective,  significant  might  different  into  Canadian-controlled  who  in  must the  possibilities  shareholders  potential  paragraph  "innocent"  (notionally)  different  the  situation  the  paid  fellow  appropriately  To  where  rate  as  higher,  "bear  -  marginal  amount were  equity  against  the  tax  Taking the  on these  situation  voluntarily  assume  Commision on Taxation, T~, I n t r o d u c t i o n , p~! 5 .  123  the of  risk the  just  potential  accompanied whose and  by  income  who  may  lacking  incurred  does  not  that,  by  the  Canadian-controlled the  potential  inherent imposed these  at  a the  two  might must  of  of of  level  a the  and  form.  One  risks  are  be  of  the  seriousness  vertical  accumulations  must  system  potential  shareholders The  those  tax  these  corporation.  unreasonable  of  intermediary  corporate  the  horizontal  corporate  choices  be now  which only  in  be  would  comparison  would  which  the  a  the  of  equity which  is  light  of  disadvantages  of  assessed  the  be with  levying  imposed  tax  but  system of  level would  a is be  merits  in  to of tax that the  (corporate  of  of  the  in  terms  avoid  the  be  a  tax  of  the  double  a  unreasonable entity  entity  upon  which  choices  flawed on  not  income  complexity  taxation.  apportionment, on  two  accumulations  would  imposing  or  accumulations  unreasonable  apportionment  also  level  unreasonable  on  injustice  necessary a  on  relative  of  and  appropriate  tax  A  received  corporate be  a  form  of  advantages  the  compared.  actually  the  to  targetted;  terms  favours  reviews  as  to  embodied  which  at  on  foregoing  shareholder)  not  tax  the  themselves  that  corporate  vagaries  of  in  with  definition,  private of  are  themselves  minority  lack  a  the  use  by  risks  themselves  factors.  The the  in  of  the  availing  remedies,  avail  accompany  of  whose  through  virtue  neutrality,  only  hope  legal  come  by  recall  the and  potential  which  also  in  benefits  not,  in  benefits may  described  had  factor  By which  accumulations which  the  tax  received  the  124  income be  which  in  a  gave  better  potential  for  and  undoubtedly  a  might  In  tax  imposed  of an  preferred  the  in  the  a  preliminary  above  matter  of  of  deciding  accumulation  system  the  of  to  is  a  less  business  taxation  problems the  balance,  corporate  which  relatively  associated  on  is  deferral  and  be  wherein  the  serious  t o be d e c i d e d accumulation?  comment  s u b - t i t l e ,  deciding  accumulation  abuse  level,  at  The  absent  submitted,  relatively  tax  be  small  appear  same.  with  it  level  a  would  should  be  method.  2 . How i s i t unreasonable  As  is  present  would  pay  therefore  circumstances  potential  corporate  levying  to  would  would  it  apportionment  the  which  produce  but,  the  and  equity  the  which  at  that  to  the  in  view  problems  appear the  than  tax  position  system  drawback  accompany  lesser  a  inherent  system.  the  vertical  problem  advantage  to  financial  such  horizontal  serious  rise  w i l l  be  which  regarding  it  should  that  there  dealt  with  upon  the should  that  be  has  form  the  the  has  an  of  posed the  unreasonable  the  basis  an  that  independently of  been  question  stressed  been  herein  portion  there  of  that  unreasonable  an  assessment  to  tax .  The above that,  most  would with  straightforward appear  respect  to to  approach  consist any  given  of  a  to  the  policy  taxation  year,  question which a  posed  provided  corporation  125  would  be  deemed  where  it  had  active the of  business  the  small  business  which  is  provide  the  tax  of  to  to  were  the  this  business  into  the  shelter  tax the  earnings  which  represent  parameters,  there  are,  of  a  focus  seems  credit  then  the  is  be  extremely  portion  credit.  of  Within  number  to  business  e l i g i b i l i t y  that  a  creating  this  should  course,  terms  system  continuing  from  of  tax  the  business,  small  terms  income  thesis, of  from  In  provisions  purpose  small  in  business.  Canadian  moneys  derived  needed  active  the  , If  accumulated profits  present  in  enquiry  corporation  broad  the  of  that  any  its  matter  the  its  than  of  credit  for  of  year  in  appropriate.  pertinent  of  of its  these  elements  consider.  The  question  requirements" complaints would  while  has  in  to  tax  complexity,  same  reference  to  in  some  some  same  in  Certainly,  pages  to the  of  must  have  in been,  administrative  the  be  noted the  the  chapter  in  United that  British of  its  based  upon  the  relatively  few  expression  there  as  terms  literature,  the  -  this  embodying  flawed  "business  uncertainty  it  legislation  seem  term  instances  however,  interpreting  and  the  opening  seriously  would  requirements." jurisprudential  the  time,  the  was  there  in  in  cause  occurred  general  shortfall  problems  the  interpreting  perhaps  referred  At  of  of  would  suggest  States.  lack  lacuna  funds  retained  more  that  subject  requirements  to  in  unreasonably  requirements  alleged  entirely  have  retained  business  the  to  is  experience  a  "business wealth  of  available  in  126  the  United  for  assistance  in  may  be  that  this term  States  as  well  country  in  "active  With  scrutiny that  term  the  for  in  use  d i f f i c u l t  analyses  One  might  would  such  aspect  In  three  for  the  the  months some  year  time  year.  be  of  to  fact  detract  less  the  involve  final of  a  and,  as  d i f f i c u l t of  such  from  "reasonableness" question  "retained" or  within  retained  occurrence  the  thereafter  active  to In  be  the  i t s e l f .  the  context,  that  prove  question  a  the  may  requirements  seem  is  to  it  been  case.  The  concept  assessing  this  within  corporation  accounts  the  of  subjected  of  inevitably  not  accumulations  "retained."  the  of  of  a  time.  would  simplicity  be  would  to  the  business  essentially  however,  distributed  the  be  the  accumulations.  have  could  in  f a c i l i t a t e  statute,  funds  same  otherwise  time  been  It  define  would  requirements  with  to  creation  which  by  draw  experienced  the  having  could  expression.  unreasonable  whether  questions,  from  to  defined  business  this  attempting  base  on  and  determining  corporation's  example,  tax  determining  problems, inherent  a  Canada  problems  led  business"  the  than  corporation a l l  of  into  in  legislative  connection  analysis,  1970's have  courts  examining and  with  and  which  significant  late  "active  of  business  the  upon  content  business"  implementation the  England  putting  the  jurisprudential the  and  a -  grace the  which  the  defining  would  mean  not  period  of,  for  grace to  of  of  period  prepare  its  giving final  127  It  would  seem  accumulations  by  important  reference  the  manner  adopted  in  In  other  words,  if  would  be  corporation accumulations  with  accumulation or  years  scope  under  of  the  minimise would  than  The lay  a  of  should,  as  justify  its  active  general following next  few  in  the  an  with  requirements a  retention business being  factors  too  broad be  1. of  an e x e m p t i o n i n capital gain;  2.  a  form  of  which  records  the  of  central  the  which  in  company no  the  other  is  chapter  issue:  corporation.  stand  to  tax.  section  the  the  attempt  for  unreasonable  to  be  to  the  by  year  limiting  unreasonable  discussed  also  thus  was  asset on  particular  be  require  any  carried  should  on  rule, of  (to  of  tax  the  of  the  the  unreasonable  accounts  this  Revenue,  its  would  accumulation  general  pages)  of  England.  of  in  assessment  and  in  unreasonable  financial  dealing  simplicity a  rule  its  portions  for  business  enquiry  years  on  in  purpose  of  tax  more  earned  taxation  the  a  no  on-going  permit  whether  interests  an  to  to  The  of  reasonableness  States  by  to  actually  define  foundation  the  subject  review.  preceding  determine of  to  United  challenged  was  the  individual  the  respect  number  assess  to  both  Revenue's  the  have  purpose  than  to  how in  terms In  the  accumulations  corporation  to  not  in  invested  corporation. alone, more  to  This  however, detail  in  the the  considered:  respect  accumulated  of  the  earnings  non-taxable  credit;  and  half  128  3. t h e c o m m e n t s u n d e r sub-title 3 c a l c u l a t i o n of t h e s p e c i f i c amount w h i c h t a x w o u l d be l e v i e d . Both  the  that,  in  American practice,  corporation  assets" a  viz.  this  the  corporation they  may  similar  the it  gain  could  that  earned.  of  of  the  meet  its  the  with be  role  limited  to  of  regard  to  the  "liquid  show  the  the  an  considering assets  manner  from  assets  that  In  be  the  obtain  near-cash  made.  would  of  an  the  purposes  this  of  in  the which  essentially  introduce  the  capital  in  of in  an  the  It  to  half  the  the  be that  a  year  of  a  capital  assessment  of  in  which  that  year,  complexity as  a  part  corporation  to  with  to  the  capital  capital  of  a  account  would  of  of  beyond  element  complications  which  the  dividend  available  one-half  half  exemption  to  non-taxable  year  only  accumulation  requirements.  the  that  non-taxable  for  potential  the  fact  the  earnings  such to  or  of  w i l l  to  borrowing  the  extend  appear  business  respect  of  To  retained  eliminating  of  disregarded  would  been  without  taxable,  reasonableness was  cash tend  available  -  reasonableness  application of  suggest  approach.  is  be  the  has  would  profits  w i l l  earned  recognition  however, -  been  American  capital gain  assets  generally  have  In  value  examples  the  its  presence  accumulation  matter,  into  through  the  significant  unreasonable  British  retaining  guidance  test,  the  enquiries  in  considerable  of  and  below as to the by r e f e r e n c e to  gain  a  view  exemption gain  was  would  made.  129 The  American  threshold  level  corporation earnings  of  providing  of a c c u m u l a t i o n  (a s p e c i f i c  credit  reasonable method  approach  amount  cannot  has  much  fall)  to  over  i t as  o f a l l o w i n g a modest c r e d i t  any  b u s i n e s s r e q u i r e s a minimum l e v e l  particular  the  make  respective  used  could  I t was  deferral counter  be a r g u e d  that  that  constituted t o be  created  would to  i f  was  have  of the t e m p t a t i o n this  latter  which  factor their  on  be t a x e d  therein.  a  form a  part  i t would business  tax of  when  the  business  and  i s , however,  the  that  deduction  a  T h i s argument  on  unreasonable fiscal  deduction,  ensure  been  to the extent of the There  of  by t h e s m a l l b u s i n e s s  the ' small  i t s active  had  of the s m a l l  "unreasonable"  seems more c o n v i n c i n g .  made  effective,  by  become  carry  inherent  argument which  accumulations  of a basic  amount may  accumulations  circumstances,  benefit  a  provisions.  ceased  recognises  c a p i t a l and  t h e A m e r i c a n s and t h e E n g l i s h t o e n a c t  deduction  s h o u l d , i n such  British  designating  i n a f a s h i o n c o n s i s t e n t w i t h the purposes  corporation  be  Virtually  i n terms  the t a x - c o l l e c t o r  to  i n respect of  of working  o f an a n n u a l  assessments.  "credit"  business  it  and i n t e r m s  nuisance  year  the  that year.  both  of the  deemed  Additionally,  as " r e a s o n a b l e "  of r e l i e v i n g  l e d both  It  recognised.  amount  virtue  which  be  amount  threshold  to  of t h e c o r p o r a t i o n from  certain  accumulated  does  each  earnings  should  the  i s essentially  recommend  a  the l i f e - t i m e  below which  the  this  that  then,  the tax were  used  regime assuming savings i n the  130  appropriate  fashion.  justifiably  be  effective active for  argued  upon  the  business  ceasing  deduction  the  would  contributing  to  a  winding in  carry  in  being  that  would,  to  "deferred"  This  form up  of  the be  business  functioning  -  through  tax  should  be  imposed  the  it  could  which  became of  more  penalty  than  a  portion  the  that  by  then  corporation  the  served  3 . Upon what amount s h o u l d a c c u m u l a t i o n s be a s s e s s e d ?  The  no  of  already  economy  case, recapture  by  effect,  on  have the  the  of  small its  its  tax  business  purpose  of  business.  tax  on  reference  unreasonable  to  the  lesser  of: (a) the amount by which the moneys available to the corporation in the particular taxation year exceed i t s business requirements; and (b) its profit from active particular taxation year. When  moneys  into  account,  liquid the  accumulated the  capital  reasons  imposed  by  business  in  previous  corporation is  taxation  may  have  needed  by  discussed  above,  however,  reference  only  the  than  in  particular  to  it  in  the  taxation  business  years  the  are  taken  considerably  more  its the  profits  year  in  under  business. tax  is  from review.  For to  be  active  131  4.  The the  Should  purpose  benefit  of  corporation  In  accumulated  be  the  tax  would  not  could  tax  otherwise?  essentially  business  a  be  or  be  making  regard,  earnings  penal  small  was  this  accumulations  tax  the  which  purposes.  a l i a ,  of  the  use  of  same tax  contrasted is  exigible  of  the  more  limited  unreasonable  accumulations  would  to  appear  the  no  and,  accumulations was  thus,  business  unreasonable the  only  American  where,  inter  for to  able  to  prove  paying  circumstances  8. From Code.  reason  restricted  such  to  the  do  so be  considering to  virtue  be  two  Section  a  tax  be tax  would  proposed  Canadian  context,  tax  be  the  of the  to  the tax  the  whatever  form  normal  there  benefit  which  small  business  unreasonable where  purpose.  the Thus,  opportunity it  on  except  on  avoidance  tax  penal  circumstances  given  the  or a v a i l e d of for income tax with  the  the  by  could  of  recover  be  failure  essence  for to  it no  the  to  upon  In  in  reason  to  corporation  voluntarily  function  necessary  accrued  deduction  Revenue  be  extent  originally  the  on  a  the:  view  to  from  for  with  corporation . . . [was] ... formed the purpose of avoiding the respect to i t s shareholders In  withdraw  deduction  Canadian  which  to  took  penalties  and  of only  imposed  in  appear  in  imposed.  the  tax  i t s e l f ,  there  would  choices:  532(a)  of  the  American  Internal  Revenue  132  (a) an i r r e v o c a b l e "recapture" amount of the tax s a v i n g ; or (b) Each,  of  of  seem  to  be  had  to  place, its  the  not  if  be,  in  regard  the  active  business  amount  which  relevant  the  remaining  would,  at of  undistributed  surplus  corporation  tax  The amount  payable  for  as  a  dividend as  part  the  of  and it  tax  could  the  rates,  justify business In would tax  possible profit  recapture  be  tax) be  to  this  seem  to  f i r s t  result.  corporation's of  as  recapture  would  payment  so  of  enable  in  context.  the  unable  the  there  deduction  in  basis  recaptured  which  this  designed  been  that  significant below,  appropriate  the  after  hand.  business  the  an  current  free  alternative  refundable opted  as  had  function,  the  complexity  in  be  small  on  of  for  corporation  be  portion  amount  the  "penalty"  "integration"  very  discussed  could  the  to  a  the  format  possibility  effect,  an  if  funds  the  be  hand  to  seem  have  hand,  as  the  mitigate  on  on  to  advantages.  w i l l  corporation  would  f u l f i l  twice  the  own  tax  opportunities  other  result  of  requirements,  also  the  available  which,  to  As  tax  dividend  would  significant  same  been  its  provision  on  retention  order  have  dividend  recapture,  lead  refundable  simplicity.  refundable  The  of  would  recapture  advantage  a  form  course,  The  would  a  equivalent  to to from (an  approximately  as  a  distributed  tax  paid  by  the  regard  the  dividends.  to  the  tax  on  tax  on  the  Part  recapture unreasonable hand. V  tax.  This The  is  to  accumulations was  the  problem  as  solution with  this  133  approach  is  that  questions  as  to  dividend the  t a x on  an  the  ownership  used  in  dividend  t a x on  would  be  the  basis  and  hand  the  the  which  f o c u s on  potential  in  the  are  in  this  not  we  on  would  Part  as  (and  difficult  V  tax.  latter  The  concept  a refundable be  desire  be  approach  an  annual,  in  fraught  to  avoid  addition  of having  year  advantage  in  of  mentioned  assessment  which  question.  avoiding above  unreasonable  to  the  which  or not casting  Revenue  triannual would This  would  in  exists  t h e r e may a  be  uncertainty  accrue  accumulations  thus  the  b i a n n u a l or  distributions  q u e s t i o n of whether  "shortfall"  define  f o r a tax i n these circumstances  taxation  on  the being  to  very  such  a  not, for  obvious  the the  assets  that  are  The  of  which  of  problems tax  then  from  terms  to  undesirable.  agree  significant  a  refunded i f  Surely  i t which  mechanism  the E n g l i s h  the  i t be  i n these c i r c u m s t a n c e s would  level  for  where  a  in substitution  resulting  case  of  refundable  indicate  borrow  inherent  possibility  taxpayer on  to  the  i t ) ?  purpose?  is  and,  to adopt  reasonable have  use  by  to  difficult  (as opposed  would  investments  i n the Act,  than  Can  How  this  uncertainty  Another  and  for  difficulty  rather  business.  that  on  very  which  refunded.  available  ineligible  complexity  raises  under  assets  solution  suggest  with  funds  assets  of  be  such  i t s active  significant would  may  of  unacceptable) concept  conditions  business carried  has  investment  potentially  owns i n v e s t m e n t a s s e t s  active  corporation  the hand  corporation  used  i t  shadow  the and be  a  over  134  the  corporation  the  other  Revenue  and  hand,  Canada  taxpayer  was  judgment  on  appropriate situation  would  greatly  and  could  lead  essence  its  the  make  business  requirements.  practice  may  English  provide  due tax  involved  in far  To  sum  unreasonable it  should  have to  as the less  up,  was, of  justification  it  accumulations  embody  the  the  were  following  while  less  proposed a  sit  in  seem  more  in  this  as the  to  its  English it  f i r s t of  the  consequences above  that  if  a  implemented  in  would  tax  on  Canada,  features:  1. It should be i m p o s e d a t the corporate than the shareholder l e v e l subject to: (a) an e x e m p t i o n a capital gain occurs; and  the  practice.  appear be  to  when  severe  such  to  where  consequences  taxes  would  of  decision  penal  for  workload  taxpayer  necessary  the  On  would  the  considered  very  the  value.  Canada It  with  sale  situation  Revenue  severe  then  then,  the  Furthermore,  been  case  to  rest  own  the  it  increase  decisions.  onus  its  potential  asking  business  that  developed  its  it  in  to  affecting  for in  the the  rather  non-taxable half year in which  (b) a dual accumulated consisting of both a basic annual amount.  earnings threshold  of it  credit and an  2. It should be levied only where the corporation's accumulations from the income of a particular taxation year exceed its business requirements for that year. 3. It of:  should  be  imposed  by  reference  to  the  lesser  135  ( a ) t h e a m o u n t by w h i c h t h e m o n e y s available to the c o r p o r a t i o n i n the p a r t i c u l a r taxation y e a r e x c e e d i t s b u s i n e s s r e q u i r e m e n t s ; and (b) i t s p r o f i t from active p a r t i c u l a r taxation year.  business  i n the  4. I t should be d e s i g n e d to recapture from the corporation the amount of tax which the corporation would have p a i d w i t h respect to i t s unreasonable accumulation had i t not availed itself of the small business deduction i n the f i r s t place. A  tax  lines the  on  could  small  likelihood system the  unreasonable provide  the c o n t r o l  business  tax system  that  tax  fulfil  small  accumulations  the  the function  business  device  a n d , by  deferral which  deduction.  structured  along  these  presently lacking  doing  so, i n c r e a s e the  available  justifies  in  through  this  the e x i s t e n c e  of  136 Chapter  8  Conclusions  The far  concept  from  viewed  new  from  that,  of  -  tax  whether  an  on  merit  unreasonable  i n Canada  historical  whatever  reimposed  a  a  British  warning  have,  i t would  be  that  i t i s clearly  experiences i n this that  i t must  suggestion  t a k e n w i t h o u t some t r e p i d a t i o n . and  elsewhere.  perspective,  the  i n Canada may  or  accumulations i s In be  fact,  observed  such  a  tax  not a s t e p to  Taken t o g e t h e r t h e  easy  to  be  Canadian  r e a l m must be i n t e r p r e t e d  a l l too  be  fall  into  as the  t r a p of c o m p l e x i t y . In  light  unreasonable Reform,  the  context  is  of  absence  The  horizontal  tax  system  the  upon of  elimination from  tax  has  the  of  and  created  at  between the  the  tax i n the -  the  with  of  of  but,  of  a  opposed  total  (announced  in  business the  of  by  been limit  Canadian  nonetheless, neutrality  small  business  deferral  last  medical  based  Budget)  by  d o c t o r ) of  considerable. and  on Tax  ( i . e . "delivery"  to  a b u s i n e s s has  tax  time  g o a l s of  reality  birth  the  current  allowed for s i g n i f i c a n t  manner  the  a  experience  understandable  Companies as  owner  as  such  slippage  equity  which  direct  of  perfectly  and  Registrar  Canadian  accumulations  undesirable.  merely  the  the of  The  exemption certain  137  capital  gains  greater.  The  carried  to  be  contained the  further  examples  must  be  accumulations advice of  o f one  for  active business  complaint that  i t could  advantageous corporation owner to  be  carrying  One  complainant  might  that  attempt  to d i s t i l l  of l i m i t e d  "passive"  investments  business.  might  point  out  tax  that some  in  a  tax  four  private  of  now  from  earlier  unreasonable  this  purposes sound  forceful  inconvenience  For  example,  thesis  corporations  be v e r y  only  as  on  inconvience.  probably The  on  would  and  another  advice  response  bring  an  active  also  i s a  be  more  were  to  less  (and w i t h  force)  prudent  normally still  complaint  the  reminder the  private  gives i t s  i s not a v a i l a b l e  by n o t m i x i n g  the r i s k  i t i s a  which  and w h i c h  (but with  liability with  business  that  consider  the p r i c e of a p r i v i l e g e :  of d e f e r r a l  Finally that  on  suggestions  reviewed  f o r investment  i t may  advantage  small  would  of tax f o r the Canadian-controlled  the opportunity  others.  context  tax  chapter this  regarded  rate  A  the  i n chapter  would  such  problem.  regard,  produce  return.  which  tax rates, i f  f o r f u t u r e Canadian use.  company  tax to  the  a l l the  this  Canadian-controlled  use  a  In  of  referred to  the  corporate  magnify  recognised  would  of  f o r slippage  i n the Canadian  appropriate.  some l e s s o n s  It  such  lowering  i n the preceding  chapters  owners  potential  accumulations  various  the  that  proposed  o u t , would  unreasonable seem  render  to  remind  the  take  full  t h e more  secure  associated less  made  force),  possible  with one only  138  due  to  have  the  the  in  English  statement  no  in  provision  should  presumably  of  States,  intention  to  court.  If  tax  unreasonable  on  additional  see  the  attempt  harm to  corporate plans  subsidiary  to  borrow  them  result  to  small  planning  might funds  be  from  In  both  to  be  fruition  of  the  T~. B.D. Easlick, "Shortfalls: Accountant, vol. 158 ( F e b r u a r y , 139.  the  tax of  -  it  is  practice  in  of  the  England  and  backed  w i l l  it  to  give  it  is  thereby.  bank  on  basis  that  business  a  which  with  a  satisfy  a  implementation  were  process,  made  tax  evidence  to  caused  the  should  such  seem  has  if,  business  plans.  which  and  without  A make  reasons  on  it  of  accumulations  the  which  clearly prudent  bring  motivation  consideration  justified  level  should  Canadian  re-enacted  be  as  a  the  feature.  company  certain  If  preparation  only  the  of  their  directors  that  1  that  the  frequent  the  enacted  directors  a  for  were  to -  specific  a  tax  specified.  inevitable  of  United  serious  shortfall  been  justify  that  report  accumulations  consist  existence the  annual  regarding  to  are  to  wealth.  have  the  evidence  suggestion  requirements  which  that  thereof  accumulations  business  future  their  complainant  literature  accumulations  the  be  unreasonable permitted  is  for  then  American  lack  the  accumulated  suggestions  or  example  permits  with  documentary  distributions  typical  and  countries, create  which  associated  unreasonable  those  of  a  the  on  company  fortune  problems  In taxes  good  of  provided serious  d i f f i c u l t One  a  would  presenting  How to Avoid and 1968), pp. 138-139  to not a  Why," at p.  139 business  plan  grant  from  as  one's  to  that  bank. one  intentions  that seem  available  If  have  applied  expect  perhaps been  documentary  later  the  small  to  of  for  a  provide  a  carried  when  the  to  at  evidence  unreasonable  through  one  would  and,  intentions  suggestion not  that  government,  those  does  to  direct evidence  date,  proof  fruition.  plans  be  potential  The  available  for  deferral  business  deduction  the  of  is  considered.  A  frequent  discussion  herein  distributions complaint English tax  which  tax  is  of  threatened it  is  a  to  the  Surrey's the  and  should price  be  such  made  the that  to  -  pay  price  that -  hypothetical  benefits  of  a  to  of  as  declare the  very  privilege.  deferral  of  a  to  tax  to  an  the  to  the  earnings  in  corporation  above,  of  quote method  American  then the  it  the  constitute If,  dividend,  a  Yet  countries  funds.  To find  corporate  made.  those  the  under  respect  purpose  suggested  attempt  to  corporation  requirements,  is  but,  of  the  be  tax  accumulated  both  retention  compelled  be  in  spur  with  American  of  business  a  whether or  the  as  otherwise  recalled  for  acts  form  not  requirements  j u s t i f i c a t i o n  it  would  shortfall it  with  that  hollow  business  as  is  rings  when  absence  complaint  of  feels  that  is  tax.  would  from  the  It  appear  Professor explaining  congressman:  Do y o u ask the Congressman if he w o u l d like to know a bank that would lend him money without interest charge and w i t h o u t any collateral? Do you then say to the Congressman that some  140  taxpayers the U.S. There that  would the  seem  small  are aware Treasury?  of  such  a  bank  -  they  call  it  2  to  be  business  no  j u s t i f i c a t i o n  deduction  should  for  be  an  assertion  an  unconditional  on  unreasonable  deferral.  Given  the  accumulations comment  from  current from  an  the  American  absence  of  Canadian writer  a  tax  setting,  is  the  following  interesting.  The penalty tax on corporations improperly a c c u m u l a t i n g e a r n i n g s m u s t be k e p t i n t h e statute. Its complete a b o l i t i o n , suggested by some, would provide a gateway to wholesale tax avoidance and i s simply not t h i n k a b l e . 3 It the  is  submitted  small  found  in  Canadian  that  business the  above  the  recent  corporate quotation  and  tax  anticipated  regime  increasingly  make  evolution the  of  assertion  applicable  to  the  context.  2. Stanley S. Surrey, P a t h w a y s t o Tax R e f o r m The of Tax Expenditures. Cambridge, Massachusetts, U n i v e r s i t y P r e s s , 1 9 7 3 , p. 1 0 9 . 3. Harry J . Rudick, "Effect of the Corporate Income Management P o l i c i e s , " 2 Howard Law J o u r n a l 232-253 a t p. 2 5 2 .  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