F. Income of Shareholder, Director or Officer of Corporation; Adjustment of Corporation’s Pre-Tax Income

• Author: Julien D. Payne - Marilyn A. Payne
• Pages: 158-171

Page 158

Where a spouse is a shareholder, director or officer of a corporation and the court is of the opinion that the amount of the spouse’s annual income as determined under section 16 does not fairly reflect all the money available to the spouse for the payment of child support, the court may consider the situations described in section 17 of the Guidelines and determine the spouse’s annual income to include (a) all or part of the pre-tax income of the corporation, and of any corporation that is related to that corporation, for its most recent taxation year; or (b) an amount commensurate with the services that the spouse provides to the corporation, provided that the amount does not exceed the pre-tax income of the corporation.²⁵²In determining the pre-tax income of a corporation for this purpose, all amounts paid by the corporation as salaries, wages or management fees, or other payments, to or on behalf of persons with whom the corporation does not deal at arm’s length must be added, unless the shareholding spouse establishes that the payments were reasonable in the circumstances.²⁵³ The following criteria set out by the Canada Revenue Agency in IT-419R2 apply in determining whether parties are dealing at arm’s length:

(a) Is there a common mind which directs the bargaining for both parties to a transaction?

(b) Are the parties acting in concert?

(c) Is there "de facto" control?

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The IT-419R2 definition of non-arm’s length also refers to parties "acting in a highly interdependent manner," and an "element of common interest."²⁵⁴Non-arm’s length benefits and payments to a "common law spouse" may be added to a parent’s income, except insofar as such payments reflected necessary and reasonable recompense for services when measured against industry standards applicable to similar work rendered in similar circumstances.²⁵⁵In order to achieve a workable result, it has been suggested that the onus of proving that the payments were reasonable in the circumstances arises only after the applicant has made out a prima facie case of unreasonableness.²⁵⁶A

court should not interfere with the business and management practices of a corporation unless its pre-tax earnings represent money available to the obligor for the payment of child support without impairment of the ongoing operation of the corporation.²⁵⁷Section 18 of the Federal Child Support Guidelines is designed to address the unfairness which would result if a parent were to manipulate his income through a corporate structure and thereby avoid child support obligations. Corporations and businesses must operate in the real world, however, and there may be legitimate reasons for maintaining retained earnings in a corporation and not making them available to shareholder owners by way of salary or dividend. In Brophy v. Brophy,²⁵⁸Linhares de Sousa J., of the Ontario Superior Court of Justice, listed the following questions and considerations in light of relevant case law:

(i) Because of the separate legal entity of the corporation, should there be a general reluctance by the court to automatically attribute corporate income to the shareholder?

(ii) Is there a business reason for retaining earnings in the company?

(iii) Is there one principal shareholder or are there other bona fide arm’s length shareholders involved?

(iv) What is the historical practice of the corporation for retaining earnings?

(v) What degree of control is exercised by the spouse over the corporation?

In Koester v. Koester,²⁵⁹Staychyn J., of the Ontario Superior Court of Justice, observed that the principles summarized in Brophy v. Brophy, above, are consistent with the following factors outlined in periodical literature:

(i) To what extent is the availability of access to pre-tax corporate income restricted by the ownership structure?

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(ii) What restrictions on availability are imposed by nature of the corporation’s business including the amount of capital equipment required, the nature of the industry in which the company operates, the outlook in terms of expansion or contraction, the level of debt as well as any banking or financing restrictions?

(iii) Historical trends and practices of the corporation.

Applying these criteria, Staychyn J. refused to impute additional income to a father who had a fifty percent interest in a private company, where the drawing down of its retained earnings would threaten the growth and survival of the company and was strongly opposed by the co-owner of the company who was at arm’s length from the father.

It is pre-tax net corporate earnings and not retained earnings that should be used in applying section 18 of the Guidelines.²⁶⁰In Nykiforuk v. Richmond,²⁶¹Ryan-Froslie J., of the Saskatchewan Court of Queen’s Bench (Family Division), observed that, in determining whether to exercise its discretion pursuant to section 18 of the Guidelines, the court must be satisfied that additional money is actually available and that it can be paid to the shareholder without endangering the financial viability of the company. Merely looking at the retained earnings of the corporation is of limited assistance. Retained earnings are a share-holder’s equity in the corporation (its assets less its liabilities). They do not represent cash available for distribution, nor do they reflect the pre-tax income of the corporation. In making a determination pursuant to section 18 of the Guidelines, a wide range of factors must be considered, including:

(i) the pre-tax income of the corporation;

(ii) the nature of the business involved (Is it capital intensive or service-oriented? Is it subject to seasonal fluctuations or economic cycles?);

(iii) the corporate share structure, including any obligation imposed by shareholders’ agreements;

(iv) the financial position and general operations of the company (What are the company’s operating requirements, its inventory, accounts receivable and accounts payable? Are there bank covenants which may affect payment out of funds? Is there a necessity to upgrade equipment, etc.?); and

(v) is the company a well-established one or merely in its start up phase?

Simply because a company makes a profit does not mean that cash is available for child support purposes.

The onus is on the shareholder to establish that a corporation’s pre-tax income is not available for support purposes. If that onus is not met, the court can determine the obligor’s Guidelines income by either the corporate income method (section 18(1)(a)) or the personal services method (section 18(1)(b)). Fairness in the application of section 18 will depend on the nature of the relationship between the obligor and the corporation, the nature of the corporation’s business, the legitimate calls on the corporate income, and the corporation’s capitalization requirements, with the court having the ability to consider the historical income pattern of the spouse and non-recurring gains or losses.²⁶²In Beeching v. Beeching,²⁶³

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Wilkinson J., of the Saskatchewan Court of Queen’s Bench, summarized relevant judicial decisions as follows:

In the case law, legitimate business reasons for retaining earnings in a corporation have included: (1) the need to acquire or replace inventory; (2) debt-financing requirements; (3) carrying accounts receivable for a significant period of time; (4) cyclical peaks or valleys in cash flow; (5) allowances for bad debts; (6) allowances for anticipated business losses or extraordinary expenditures and (7) capital acquisitions.

An appellate court will not interfere with the refusal of a trial judge to impute income to a shareholding parent on the basis of the retained earnings of a private corporation, where there is evidence upon which the trial judge can properly conclude that the retention of earnings represents a prudent business measure.²⁶⁴Although a portion of significant retained earnings of a company in which the obligor is the sole shareholder and driving force may be judicially attributed to the obligor under the Guidelines,²⁶⁵a court may decline to make such attribution on the basis of a company’s retained earnings where they reflect the business pattern in place before the spousal separation.²⁶⁶Courts are disinclined to interfere with business decisions where such interference could undermine the viability of a business. Consequently, a court may refuse to impute income to a shareholding spouse in excess of his or her annual corporate salary where the retained earnings of the corporation are being used to build up necessary inventory at an early stage of business development; different considerations might be applicable once the business is firmly established.²⁶⁷A court may refuse to impute income to a parent on the basis of retained earnings in the parent’s private corporation where the business is highly volatile and it is prudent to set aside funds for future use as an income source. However, where the parent faces the prospect of paying child support for his second family, it may be appropriate to revisit the issue and incorporate some portion of retained earnings into the respondent’s annual income, particularly if he seeks to invoke the undue hardship provisions of section 10 of the Federal Child Support Guidelines.²⁶⁸Remuneration paid by the obligor’s company to his children or to his "common law spouse" and her child who are discharging the normal duties of employees and being paid normal rates are treated as arm’s length transactions and give rise to no attribution of income to the obligor under the Guidelines.²⁶⁹The ability of a sole shareholder of a company to control the income received is open to abuse and requires careful judicial scrutiny under the Federal Child Support Guidelines. Additional income may be imputed to the obligor under sections 19(1)(a) and (d) of the Guidelines, if the income received is unrealistic and the availability of money in the company is evidenced by circumstances, such as the...