FCA decision in Kern bolsters Sommerer decision

The Federal Court of Appeal has recently made it clear that the decision in Canada v. Sommerer
[2012] FCA 207 is correct and subsection 75(2) of the Income Tax Act does not apply to property sold for fair market value.

In March 2014, The Lawyers Weekly published
our article commenting on the Tax Court of Canada’s decision in Brent Kern Family Trust v. Canada [2013] T.C.J. No. 286. The BKT appealed the Tax Court’s decision to the Federal Court of Appeal. In October 2014, the FCA heard Brent Kern Family Trust v. Canada [2014] F.C.A. 230 and delivered judgment from the bench.

In the case, Kern wanted to withdraw the retained earnings of Wilf ’s Oilfield Services Ltd. (Opco) on a tax-free basis. In an attempt to achieve this laudable goal, Kern undertook a reorganization designed to distribute income from Opco’s retained earnings tax-free. He caused the incorporation of a holding company (Holdco) and two trusts. BKT was one of these trusts, and Opco was one of the BKT’s beneficiaries. Opco sold shares in Holdco to BKT for fair market value. Holdco issued dividends totalling $395,000 to BKT. BKT did not report the dividends based on BKT’s position that subsection 75(2) attributed the dividends to Opco and, therefore, BKT was not required to report the dividends. BKT distributed the dividends to its capital beneficiary, Kern, on a tax-free basis. Opco did not pay tax on the dividends that it was deemed to receive from Holdco pursuant to the tax-free intercorporate dividend rule in section 112 of the ITA. The Canada Revenue Agency reassessed BKT to include the $395,000 of dividends in BKT’s income.

The Tax Court dismissed BKT’s appeal, relying on the FCA’s Sommerer decision. In Sommerer, the FCA clarified the correct subsection 75(2) interpretation, holding that subsection 75(2) does not apply to property sold for fair market value. In this regard, the facts in BKT were on all fours with Sommerer, i.e. BKT paid Opco fair market value to acquire the Holdco shares and, therefore, subsection 75(2) did not attribute the dividends to Opco. The Tax Court applied Sommerer to BKT and dismissed BKT’s appeal.

BKT appealed to the FCA on the basis Sommerer did not apply or, in the alternative, the FCA’s decision in Sommerer was manifestly wrong and the FCA should not follow the FCA’s previous decision. At the hearing of the appeal, BKT focussed on its alternative argument. In particular, BKT submitted that, in Sommerer, the FCA did not undertake a sufficient subsection 75(2) analysis. BKT submitted that the history of subsection 75(2) showed that the purpose is to prevent a taxpayer from reducing tax exposure when the taxpayer transfers property to a trust but retains the right to acquire the property again. BKT submitted that the consideration related to the property transferred to the trust is not relevant. BKT argued that, instead, the taxpayer’s right to claw back property ownership and the taxpayer’s ability to control the property are the only relevant considerations.