The former vice president of a health products company has won her fight to avoid paying tax on a $1.7-million settlement received following her dismissal from her job.
Shirley Patricia McKenzie, who spent 26 years with Richmond Hill, Ont.-based Swiss Herbal Remedies Ltd. before her termination in 2003, received the payment in the 2006 tax year following a bitter dispute with the founder’s family.
McKenzie was the income beneficiary of a trust set up by Swiss Herbal’s late owner, Konrad Zimmermann, that owned 20 per cent of the company. His daughter, Barbara McKerrell, was the capital beneficiary of the trust.
A dispute between the pair over how to share the costs of capital gains tax descended into contentious litigation, and both sides eventually agreed to settle the matter by having the trust pay McKenzie $1.7 million for her income interest and transferring the shares to a B.C. company owned by McKerrell.
The trust was then wound up, but the Canada Revenue Agency stepped in when McKenzie used an Income Tax Act exemption under ss. 106(2) and 106(3) to claim the money on a tax-free basis. The sections exempt income beneficiaries from paying tax on cash received when it has been “distributed by the trust in satisfaction of all or any part of the taxpayer’s income interest.”
Government lawyers attempted to argue that the $1.7 million wasn’t the property of the trust because it had never been held in trust when McKenzie received it. They also said it couldn’t have been distributed because the payment breached the rules of the trust.
In their view, McKenzie had sold her income trust to McKerrell’s company. As well, they said the only distribution of the trust’s property, the Swiss Herbal shares, was in favour of McKerrell.
But in a decision dated June 9, Tax Court of Canada Justice Patrick Boyle allowed McKenzie’s appeal of the CRA’s reassessment. He said he was “entirely satisfied” the money was the property of the trust and that the government had failed to demonstrate that the payment and termination of the trust broke the rules.
“A plain reading of subsection 106(2) and (3) of the act makes clear that the act generally does not seek to tax an income beneficiary whose rights are disposed of to the trust itself, but will tax any economic gain the income beneficiary may be able to realize on a disposition to a third party,” Boyle wrote. “I am not prepared to contort the plain meanings of the terms used in section 106.”
One of McKenzie’s lawyers calls the ruling an “excellent result” for her client. “Obviously, my client is very happy about the decision,” says Adrienne Woodyard, a tax litigator at Davis LLP in Toronto who, along with colleague David Nathanson, represented McKenzie.
Crown lawyers had relied on another case, Chan v. The Queen, that discussed the meaning of “distribute” in a similar section of the act. But Boyle said it was clear that Mai Tai Chan’s case “involved fundamentally different facts.” In that matter, the court found Chan had sold his income interest to a third party and not to the trust itself.
Woodyard says the ruling presents opportunities for tax planning when a trust needs to be collapsed or beneficiaries need to be paid out. “In order to minimize the trust tax burden when it makes distribution to an income beneficiary, it may wish to transfer cash to the extent possible,” she says.
Woodyard notes the decision is an important one because it clarifies the sections of the act and their effect. This was the first time they’ve been litigated, according to Woodyard, who says she came across virtually no commentary on their purpose during her research.
“It is very helpful from a planning perspective to have some certainty, to have a court confirm how this section operates because it is counterintuitive. It looks too good to be true at first glance.”
Woodyard says the exemption appears anomalous because if McKenzie had sold her interest to a third party other than the trust, she would have had to pay tax on the amount. Had she been paid in shares, the trust would also have realized a taxable capital gain. Making the distribution in cash was the only way for both to avoid paying tax.
But Woodyard says it makes sense to exempt tax when the sale is to the trust because the income interest will eventually be taxable when it changes hands. Cash held by a trust, she notes, is money on which tax has usually already been paid.
It therefore shouldn’t be taxed again, she argues, contrasting that scenario to property, such as shares, that could have been appreciating in value.
In any case, the McKenzie trust had paid a substantial amount of tax under the act’s 21-year deemed disposition rule that’s at the heart of much of the acrimony in the case.
McKenzie started out with Swiss Herbal in 1977 as a bookkeeper but ascended quickly through the ranks to become vice president.
In 1978, shortly before his death, Zimmermann made McKenzie an income beneficiary for life on a 20-per-cent share of the company.
The shares would revert to the capital beneficiary, McKerrell, when McKenzie died or if she decided to leave the company or was terminated for cause. The aim was to motivate McKenzie to stay at the company and keep it profitable after Zimmermann’s death.
In 1999, when the 21-year rule kicked in, the trust was exposed to $1.4 million in capital gains tax, but the amount went unpaid as McKenzie and McKerrell squabbled over who should cover it.
By 2002, the amount owed had risen to $1.7 million, and both sides agreed to pay it from undistributed dividends without agreeing on how to share the burden.
The next year, McKerrell acquired majority control of Swiss Herbal and removed McKenzie from her post, which prompted her to launch a lawsuit claiming wrongful dismissal. McKenzie said she understood her $1.7-million settlement was to be free of tax after having her life interest professionally valued at more than $4 million.
Justice Department counsel Donna Dorosh declined to comment on the case, but spokeswoman Carole Saindon noted the government has 30 days to appeal the ruling.
Shirley Patricia McKenzie, who spent 26 years with Richmond Hill, Ont.-based Swiss Herbal Remedies Ltd. before her termination in 2003, received the payment in the 2006 tax year following a bitter dispute with the founder’s family.
McKenzie was the income beneficiary of a trust set up by Swiss Herbal’s late owner, Konrad Zimmermann, that owned 20 per cent of the company. His daughter, Barbara McKerrell, was the capital beneficiary of the trust.
A dispute between the pair over how to share the costs of capital gains tax descended into contentious litigation, and both sides eventually agreed to settle the matter by having the trust pay McKenzie $1.7 million for her income interest and transferring the shares to a B.C. company owned by McKerrell.
The trust was then wound up, but the Canada Revenue Agency stepped in when McKenzie used an Income Tax Act exemption under ss. 106(2) and 106(3) to claim the money on a tax-free basis. The sections exempt income beneficiaries from paying tax on cash received when it has been “distributed by the trust in satisfaction of all or any part of the taxpayer’s income interest.”
Government lawyers attempted to argue that the $1.7 million wasn’t the property of the trust because it had never been held in trust when McKenzie received it. They also said it couldn’t have been distributed because the payment breached the rules of the trust.
In their view, McKenzie had sold her income trust to McKerrell’s company. As well, they said the only distribution of the trust’s property, the Swiss Herbal shares, was in favour of McKerrell.
But in a decision dated June 9, Tax Court of Canada Justice Patrick Boyle allowed McKenzie’s appeal of the CRA’s reassessment. He said he was “entirely satisfied” the money was the property of the trust and that the government had failed to demonstrate that the payment and termination of the trust broke the rules.
“A plain reading of subsection 106(2) and (3) of the act makes clear that the act generally does not seek to tax an income beneficiary whose rights are disposed of to the trust itself, but will tax any economic gain the income beneficiary may be able to realize on a disposition to a third party,” Boyle wrote. “I am not prepared to contort the plain meanings of the terms used in section 106.”
One of McKenzie’s lawyers calls the ruling an “excellent result” for her client. “Obviously, my client is very happy about the decision,” says Adrienne Woodyard, a tax litigator at Davis LLP in Toronto who, along with colleague David Nathanson, represented McKenzie.
Crown lawyers had relied on another case, Chan v. The Queen, that discussed the meaning of “distribute” in a similar section of the act. But Boyle said it was clear that Mai Tai Chan’s case “involved fundamentally different facts.” In that matter, the court found Chan had sold his income interest to a third party and not to the trust itself.
Woodyard says the ruling presents opportunities for tax planning when a trust needs to be collapsed or beneficiaries need to be paid out. “In order to minimize the trust tax burden when it makes distribution to an income beneficiary, it may wish to transfer cash to the extent possible,” she says.
Woodyard notes the decision is an important one because it clarifies the sections of the act and their effect. This was the first time they’ve been litigated, according to Woodyard, who says she came across virtually no commentary on their purpose during her research.
“It is very helpful from a planning perspective to have some certainty, to have a court confirm how this section operates because it is counterintuitive. It looks too good to be true at first glance.”
Woodyard says the exemption appears anomalous because if McKenzie had sold her interest to a third party other than the trust, she would have had to pay tax on the amount. Had she been paid in shares, the trust would also have realized a taxable capital gain. Making the distribution in cash was the only way for both to avoid paying tax.
But Woodyard says it makes sense to exempt tax when the sale is to the trust because the income interest will eventually be taxable when it changes hands. Cash held by a trust, she notes, is money on which tax has usually already been paid.
It therefore shouldn’t be taxed again, she argues, contrasting that scenario to property, such as shares, that could have been appreciating in value.
In any case, the McKenzie trust had paid a substantial amount of tax under the act’s 21-year deemed disposition rule that’s at the heart of much of the acrimony in the case.
McKenzie started out with Swiss Herbal in 1977 as a bookkeeper but ascended quickly through the ranks to become vice president.
In 1978, shortly before his death, Zimmermann made McKenzie an income beneficiary for life on a 20-per-cent share of the company.
The shares would revert to the capital beneficiary, McKerrell, when McKenzie died or if she decided to leave the company or was terminated for cause. The aim was to motivate McKenzie to stay at the company and keep it profitable after Zimmermann’s death.
In 1999, when the 21-year rule kicked in, the trust was exposed to $1.4 million in capital gains tax, but the amount went unpaid as McKenzie and McKerrell squabbled over who should cover it.
By 2002, the amount owed had risen to $1.7 million, and both sides agreed to pay it from undistributed dividends without agreeing on how to share the burden.
The next year, McKerrell acquired majority control of Swiss Herbal and removed McKenzie from her post, which prompted her to launch a lawsuit claiming wrongful dismissal. McKenzie said she understood her $1.7-million settlement was to be free of tax after having her life interest professionally valued at more than $4 million.
Justice Department counsel Donna Dorosh declined to comment on the case, but spokeswoman Carole Saindon noted the government has 30 days to appeal the ruling.
