Basic Principles

• Author: Vern Krishna
• Profession: Professor of Common Law, University of Ottawa Barrister at Law
• Pages: 397-432

397

CH AP TER 16

BASIC PRINCIPLES

A. GENER AL COM MENT

Up to this point, we have looked at the rules in re spect of the computa-

tion of net income, taxable income and tax payable. Most of the rules

apply to all taxpayers, including individuals, corporations and t rusts.

We turn our attention now to the rules that apply specif‌ically to cor-

porations and their shareholders.

The complexity of corporate taxation derives from the division of

economic and legal ownership. In terms of economic relationships, the

shareholders of a corporation own its assets, whilst corporate prof-

its and losses accrue to their benef‌it or detriment. Thus, in economic

terms, the income and losses of the corporation ref‌lect upon the share-

holder’s f‌inancial stake in the cor poration.

In corporate law, however, a corporation and its shareholders are

separate legal entities. Thus, shareholders do not have a direct legal

interest in the asset s of the corporation, but have a legal interest in the

corporat ion’s equity.

This distinction between the economic and the legal relationships

between the shareholders of a corporation and the corporate entity

works well in corporate law. The corporation, which is a statutory en-

tity, allows shareholders to limit their personal liability for corporate

debts. Thus, for most corporate purposes, a creditor of a corporation

cannot attach personal liability to its shareholders.

INCOME TAX L AW398

Tax law generally follows the corporate model that a corporation

is a separate tax payer in its own right.1 However, the legal distinction

between a corporation and its shareholders gives rise to diff‌icult prob-

lems. Tax law cannot focus solely on the legal relationship and com-

pletely ignore the economic relationship between a corporation and its

shareholders. Thus, although the corporation and its shareholders are

separate taxpayers, we shall see many tax r ules that reach through the

corporat ion to its sha reholders.

For most purposes, we calculate the income of a corporation in a

manner simil ar to that of an individual. Of course, a corporation ca nnot

claim personal t ax credits and dependency deductions. But apart from

these disti nct circumsta nces, we determine the net income and ta xable

income of a corporation according to the general rules described in the

preceding ch apters.

There are, however, two important differences in the ta xation of in-

dividuals and corporations. First, most individuals (at least those who

are employees) f‌ile their income taxes on a cash basis. Corporations

may not use cash basi s accounting and must use the accr ual basis. This

requirement is implicit in section 9.

Second, individuals who are employees must report t heir income

on a calendar-year basis.2 In contrast, cor porations may select their f‌is-

cal year on any twelve-month basis.3

B. THE CORPOR ATE ENTITY

1) Separate Legal Entity

A corporation is a “person” and, therefore, a “taxpayer.”4 The def‌ining

attribute of a corporation is that it is a legal ent ity distinct from its

shareholders.

Thus, unlike a partnership, which is a relationship between per-

sons carr ying on business in common with a view to prof‌it,5 a corpora-

tion has a legal existence separate and apart from its shareholders.

Since a corporation is a separate entity, its property, assets and li a-

bilities belong to, or f‌low from, the corporation. This is so even if it ha s

only one shareholder who owns all of its issued and outst anding shares.

1 Income Tax Act, RSC 1985, c 1 (5th Supp) [ITA], subs 248(1) “person,” “taxpayer.”

2 Ibid, para 249(1)(b).

3 Ibid, para 249(1)(a) and subs 249.1(1).

4 Ibid, subs 248(1) “person,” “taxpayer.”

5 See, for example, Partnerships A ct, RSO 1990, c P.5, s 2.

Basic Pri nciples 399

The “one person company” is no less a separate legal identity than a

publicly-held cor poration.

2) The Salomon Doctrine

Salomon v Salomon & Co6 is the locus classicus upholding the principle

that a corporation has a legal identit y that is distinct from its sharehold-

ers. Salomon incorporated a company to which he sold his unincorpor-

ated shoe manufacturing busi ness in return for all but six of its issued

shares and £10,000 of secured debentures. When the company fell upon

hard times and wa s wound up a year later, the unsecured creditors, al-

leging that the company was a mere al ias or agent of its principal share-

holder, claimed that Salomon was personally li able to indemnify their

claims. The House of Lords held that t he parties had complied with all

of the requirements of the corporate statute authorizing the creation of

the company, that the corporation was not a sham, and that Salomon had

not acted fraudulently. As a secured creditor of the corporation, Salomon

ranked ahead of its unsecured creditors. As Lord Macnaghten said,

The company attains m aturity on its birth. There is no per iod of min-

ority — no interval of incapacit y . . . . The company is, at law, a differ-

ent person altogether from the s ubscribers to the memorandum; and,

though it may be that af ter incorporation the busines s is precisely the

same as it was before, t he same persons are man agers, and the same

hands receive the prof‌it s, the company is not in law the agent of the

subscriber s or truste e for them. Nor are the subsc ribers, as members

liable, in any shape or form, e xcept to the extent and in the man ner

provided by the Act .7

3) Parent and Subsidiary

The principle that a corporation is a legal entity separate from its share-

holders also applies to the relationship between a parent company and

its subsidiar y. Thus, in the absence of a specif‌ic statutory provision to

the contrary, a parent corporation and its subsidi ary are separate and

distinct legal entities. This is so even where the parent owns all t he

6 Salomon v Salomon & Co, [1897] AC 22 (HL).

7 Ibid at 51. Although Mr. Salomon had not comm itted any fraud on his creditors ,

it was found that he ha d sold his business to hi s company at an extravagant

price. As Lord Ma cnaghten stated, the price “re presented the sangui ne expecta-

tions of a fond owner rat her than anythin g that can be called a bus inesslike or

reasonable e stimate of value” (at 49).