Canadian Tax Cases – Mamdani Family Trust and Subsection 160(1).
The recent case of Mamdani Family Trust v. HMQ[1] illustrates the absolute nature of subsection 160(1)of the Income Tax Act (the “Act”). The Mamdami Family Trust (the “Trust”) is an inter vivos trust resident in Alberta, Canada. The only trustee of the Trust is Mr. Riaz Mamdani, and the beneficiaries are Mr. Mamdani, his spouse, his children and various other relatives, all of whom are resident in Alberta. During the tax years in dispute, (2000-2002) the Trust owned all the shares of Global Equity Fund Ltd. (“Global”), a Canadian private corporation. During those same years, Global was liable to pay one or more amounts under the Act. In each of the three years at issue Global paid taxable dividends to the Trust in the respective amounts of $2.7m , $743k and $25k, even though it owed more in tax in each year than it paid in dividends to the Trust.
Under s.160(1) of the Act if a taxpayer transfers an amount to a non-arm’s length taxpayer for no consideration while it owes tax, then the recipient becomes liable for the tax payable by the transferor to the extent of the fair market value of the transfer. This provision is in the Act to prevent people from simply giving their assets away to friends and family when they owe taxes.
In its Notice of Appeal, the Trust admitted that it did not deal at arm’s length with Global, and that Global had tax owing at the relevant times and that there was no consideration paid for the divided. The sole issue in the dispute was what was the fair market value (FMV) of the dividend. The Trust’s case came down to the fact that under Canadian tax law, if a trust receives an amount of income, such as a taxable dividend, it has to pay tax on that amount. A trust does not have to pay tax on the amount if the trust distributes the income to a beneficiary, but then the beneficiary has to pay the income tax on the amount. As a result, the Trust’s case was the FMV of any dividend received has to be modified by the tax cost that goes with it, particularly as tax had been paid by the beneficiaries who had received amounts as income distributions from the trust.
This position was diametrically opposite to the position set out in Gilbert[2]case decided by the Federal Court of Appeal (“FCA”). In that case, the court had determined that the issue of the FMV of the transfer for purposes of s.160(1) was to be determined at the value to the transferor, not the value to the transferee. The Trust’s argument was that Gilbert should not apply because in that case there had been no expert testimony with regard to the FMV of the dividend at issue, and that as a consequence, the FCA had not really opined on the issue of the meaning of FMV. This position was not entirely unfounded as it relied on both the Nash and Henderson Estate and Bank of New York[3]which defined FMV as the value at which arm’s length parties would pay in the entirety of the circumstances.
These arguments did not sway Justice Sommerfeldt in any way. First of all, the argument relied on the concept that a company like Global could “sell” a dividend, and obviously no arm’s length party would pay more than the amount it would benefit after it had paid the tax on the amount of the dividend. While this may seem logical, neither the judge nor the Trust’s valuation expert had come across such a transaction.
Indeed there are such things as “dividend rental arrangements” whereby a non-taxable entity (pension fund, charity) will purchase shares of companies from the taxable owner just before a dividend, and pay an amount that effectively “splits” the tax between the non-taxable and the current owner, and that results in the current owner’s additional income to be “capital gain” rather than dividend income. Of course these transactions are controversial and often banned in tax systems, but the fact that the closest analog to the taxpayer’s argument works exactly the opposite to the position taken by the taxpayer is not helpful to say the least. Justice Sommerfeldt dismissed the concept of a dividend having an FMV of less than its face value. Regardless, the court found that Gilbert did apply, and that the FMV of the amount transferred was the amount transferred by the transferor, as any other position would defeat the purpose of the provision.
In this case, the result was in some ways harsh. As noted above, Trusts can either pay the tax on the income they receive, or distribute the income to beneficiaries who then become taxable in their own right on the income. In this case, Mr. Mamdani and his wife had received some distributions from the trust in the form of these dividends (the “form” of the payment also passes through a trust) and paid tax on them. As a result, there is the potential for a form of double tax, because the trust becomes fully liable for the amount transferred even though it, or one of its beneficiaries have paid tax on the amount. This issue can of course be remedied if the transferor were to pay its taxes.
This case further illustrates the harsh and absolute consequences under s.160(1) of a Canadian taxpayer making transfers or paying dividends at a time when it owes tax. There are far too many of these cases in Canadian law, and they almost always arise when taxpayers are misinformed or uninformed about how the Act works, and what can happen to them if they transfer assets between family members or related without proper tax advice. If you are involved in transactions with related parties and are concerned about the potential risks under s.160(1) or otherwise, please contact us to discuss.
[1] 2020 TCC 93
[2] The Queen v. Gilbert, 2007 FCA 136; reversing 2005 TCC 672.
[3] Henderson Estate and Bank of New York v. MNR (1973), 73 D.T.C. 5471, as affirmed by the FCA in [1975] F.C.J. No. 613)
