Basic Principles

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

397

CHAPTER 16

BASIC PRINCIPLES

A. GENERAL COMMENT

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

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

apply to all taxpayers, including individuals, corporations and trusts.

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 corporation.

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

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

interest in the assets of the corporation, but have a legal interest in the

corporation’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 taxpayer 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 rules that reach through the

corporation to its shareholders.

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 tax 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 chapters.

There are, however, two important differences in the taxation 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 their income

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

cal year on any twelve-month basis.3

B. THE CORPORATE 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 entity distinct from its

shareholders.

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

sons carrying 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 lia-

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 nciples399

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 identity that is distinct from its sharehold-

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

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

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

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

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

holder, claimed that Salomon was personally liable to indemnify their

claims. The House of Lords held that the 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, the same persons are managers, and the same

hands receive the prof‌its, 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, except to the extent and in the manner

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 subsidiary. Thus, in the absence of a specif‌ic statutory provision to

the contrary, a parent corporation and its subsidiary are separate and

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

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).