What Are Personal Distributive Taxes in Family Law BC?

Distributive taxes are tax obligations arising out of a transfer, sale, or division of property after a separation in family law proceedings in BC. The types of taxes to consider are Property Transfer Tax, taxes on RRSP withdrawals, income taxes, and other deferred taxes.

When a family property is a business, parties in family law proceedings often engage with an expert in business valuations to valuate the worth of a business. A common and frequently asked question is whether lifetime capital gains apply.

What You Need to Know About Lifetime Capital Gains in Family Law BC

If shareholders own shares in qualified small business corporations then the first $1.25 million is exempt from taxes. To qualify the company must be Canadian controlled private corporate, with 95% of the assets being used in the active business. In addition, in the 24 months before a sale more than 50% must be actively used in an active business.

Where it can becoming challenging is when companies have an operative business and the shareholders accumulate cash in the operating business or have personal use assets like boats or executive retreats, such that it renders more than 50% of the assets not being involved in the active business, this scenario could put the company at risk of being eligible for the lifetime capital gain exemption.

When parties to family law proceedings engage a business valuator, the valuator’s opinions or conclusions may not reflect distributive personal income taxes payable by the shareholder when taking cash out of the company or on the disposition of shares in the company. It is important for you and your lawyer to ask the valuator to include a calculation of distributive taxes when agreeing to a division of family property and debt in a family law proceeding. The calculation of distributive taxes can be complex and are influenced by the specific facts and circumstances of each case.

How Have the Courts Interpreted Distributed Taxes?

The leading case is Sinai v. Mahmoud, 2017 BCCA 155, where the court held that it is an error in principle for a court to fail to allow for the distributive tax burden obligations.

This was an appeal from a family law proceeding which determined the valuation and division of family property, determining the appellant’s income for support purposes, and other issues. The appeal was allowed on the financial issues.

The valuation of a family asset must be reduced by the amount a sum was both included in assets and included in post separation income for purposes of child and spousal support, as that treatment is impermissible double counting.

The valuation of corporate assets allocated to the appellant must be reduced to allow for distributive taxes in circumstances in which the respondent’s allocated assets are all net of taxes, to allow for true equality in treatment.

c)         Tax Implications of the Allocation

[25]        The appellant contends the judge erred by allocating assets to the respondent that do not attract personal income tax, while allocating assets to him that do attract personal income tax when distributed. He says the different tax status of the assets the parties received means he has been allocated assets of lesser value than the assets allocated to the respondent, resulting in a larger compensation payment than should have been required.

[26]        There are three companies implicated in this issue: GES, 144 and 151. The judge described the evidence concerning distributive personal income taxes that may be paid in these terms:

[150]   Mr. Tidball also reported that distributive personal income taxes would be payable on the removal from the companies of assets other than the funds required to repay the 151 shareholder loan and the 151 capital dividend of $81,500. In his supplemental report of July 15, 2014, Mr. Tidball opined that distributive personal income taxes of between 27% and 38% will arise on the removal of assets from the companies by way of dividends paid from income earned and taxed, respectively, at general income tax rates or small business income tax rates.

[151]   Mr. Eric Feilden, a chartered accountant retained by the claimant, has provided an expert tax opinion concerning the tax consequences arising from certain payments, reported as taxable dividends, made by GES to 144. On April 30, 2009, GES declared and purported to pay a dividend of $1,387,000 to 144. Effective April 30, 2010, GES declared and purported to pay a further dividend of $99,474 to 144. In Mr. Feilden’s opinion, in order for GES to have paid dividends to 144, the latter company would have to have been a shareholder in GES. The respondent called no expert evidence to controvert Mr. Feilden’s opinion. The corporate records of GES show that the only issued shares of GES are the 90 Class A shares issued to M.M. and the 10 Class C shares issued to M.S.

…

[153]   Mr. Feilden reported that if 144 is not a shareholder of GES, then it could not have received dividends from 144. If the amounts paid by GES to 144 were not taxable dividends, then as Mr. Feilden explained, the nature of those payments will need to be determined and the possible tax consequences identified.

[154]   The respondent confirmed that the corporate records of GES, 144 and 151 adduced in evidence at trial are accurate. They disclose no ownership by 144 of any shares in GES. Accordingly, I accept Mr. Feilden’s unchallenged opinion that GES could not have paid taxable dividends to 144. Mr. Feilden’s solution is that the monies GES paid to 144 as dividends should be recharacterized as loans from GES to 144. Mr. Feilden recommends that 144 should repay those funds to GES so that they will be available for GES to pay as taxable dividends to its shareholders.

[27]        The judge referred to Halpin; McPherson v. McPherson (1988), 1988 CanLII 4732 (ON CA), 48 D.L.R. (4th) 577 (Ont. C.A.); Laxton v. Coglon, 2008 BCCA 414; Kowalewich v. Kowalewich (1988), 1998 CanLII 4424 (BC CA), 50 B.C.L.R. (3d) 12 (C.A.); Cochrane v. Cochrane, 2013 BCSC 2114; Stein v. Stein, 2008 SCC 35; and Ouellette v. Ouellette, 2012 BCCA 145.

[28]        The judge then went on to discuss the issue of valuing distributive taxes from the perspective of a possible winding-up order for the companies, thereby to allow any tax obligation to be quantified and facilitating calculation of an accurate compensation order. This could bear on the disposition of the family home, an issue I will come to. The judge questioned his jurisdiction to order the liquidation of the companies (a move with extra provincial complexity) and in the end result, ordered the appellant to pay a sum that equalized the gross value of the assets they both received, making no general allowance for the divergent net values that result (except for an adjustment in “the event it is necessary for [the appellant] to withdraw funds from 144 in order to fund the compensation order”). That is, the respondent received apples and the appellant received oranges.

[29]        In para. 150 of his reasons for judgment replicated above, the judge adverted to the evidence of Mr. Tidball that personal income taxes, referred to by the parties as distributive taxes, will be payable by the appellant upon “cashing out” the assets of the two holding companies and GES will be between 27% and 38%, but he made no allowance for a corresponding reduction in asset value to put those assets on the same footing. This conclusion, on my reading, is based on a finding that the appellant likely will be able to satisfy the compensation order by using post-tax assets allocated to him. Indeed, he is directed to use all of his post-tax assets to satisfy the compensation order before dipping into his pre-tax assets for that purpose. On the judge’s reasoning, only the money required to be withdrawn from the companies to satisfy the compensation order shall attract shareable distributive taxes.

[30]        In my view the judge’s expressed understanding of the circumstances in which distributive taxes should be factored into division of family assets does not accord with the jurisprudence that has developed under the Family Relations Act.

[31]        The judge referred to the relevant authorities before him, and said:

[163]   … In determining the amount of the compensation order, disposition costs, including tax consequences, must be taken into account if an asset must be sold in order for the non-owing spouse to realize his or her interest in the asset. They need not be taken into account “when it is not known when, if ever, the asset would be sold”, or where those costs are “hypothetical and speculative”…

[32]        While this statement is correct, it is incomplete, and does not give effect to the first premise, which is to the extent the circumstances of the asset permits, and provided there is evidence on which to do so, the parties are entitled to equality of treatment (see Stein at para. 9). To that end, assets should be put upon the same level for fairness and proper assessment of the relative outcomes. This removes opacity and allows for a clear view of the equivalence of wealth distributed, absent which an order may effect an unintended and unrecognized redistribution, and may ricochet onto the support orders made. The principles of fairness and presumptive equal division apply, with due regard to the practical character of the assets and inherent limitations. Recently Mr. Justice Savage summarized the law under the Family Relations Act in Maguire v. Maguire, 2016 BCCA 431:

[38]      The case law that developed under the FRA provided that there is no absolute rule as to whether tax consequences should or should not be taken into account in the division of family assets. Where there is evidence that a division of family assets will attract tax consequences, an allowance should be made for tax. Where it is not clear when or in what amount taxes will be exigible, an allowance may not be made: Murchie v. Murchie (1984), 1984 CanLII 754 (BC CA), 53 B.C.L.R. 157 at para. 390 (C.A.); Halpin at para. 63; McPherson v. McPherson (1988), 1988 CanLII 4732 (ON CA), 48 D.L.R. (4th) 577 at 583 (Ont. C.A.). Likewise, where taxes are “speculative” the court may not take taxes into account: O’Bryan v. O’Bryan (1997), 1997 CanLII 4045 (BC CA), 43 B.C.L.R. (3d) 296 at para. 54 (C.A.); Ouellette v. Ouellette, 2012 BCCA 145 at paras. 31‑32.

[Emphasis added.]

[33]        I consider that the law, correctly understood, does not limit the requirement of an allowance for distributive taxes to cases in which the asset must be sold to allow the non-owning spouse to realize his or her interest in the asset. It was this feature which appears to have prompted the judge’s valuation of the corporations without allowance for personal income taxes that will become payable. In Laxton Madam Justice Smith discussed the correct treatment of tax consequences from selling the asset in issue (shares of a publicly traded company) and held the personal tax consequences to the seller “should have been deducted from the compensation award”. In doing so she affirmed the requirement for such treatment when a sale is required for the non-owning spouse to realize his or her interest, but she did not limit accounting for tax consequences to that single circumstance, citing Madam Justice Huddart’s comments in Kowalewich, in turn referring to the reminder of Madam Justice Southin in Blackett that “section 66 is not an expropriation provision”.

[34]        As Ouellette demonstrates, it will not be necessary and indeed perhaps not always even possible, to account for tax consequences inherent in liquidating an asset. In Ouellette, however, the sums discussed appear to have been speculative and unsupported by evidence as to the quantum, and the judge found “Mr. Ouellette did not intend to sell his interest in the business …”. That is not the case before us. Here the corporations are two holding companies and a personal services corporation, none of them requiring the continuity essential to an on-going concern as was the case in Ouellette. Significantly, the record here includes evidence of the scale of the tax liability inherent in bringing the wealth out from behind the corporate curtain, which the appellant was willing to do immediately, and there is no evidence to the effect the monies retained in the corporations could be sheltered so as to attract a tax burden less than posited by the expert Mr. Tidball.

[35]        In the case before us, I consider an error in principle is established in the failure to allow for the distributive tax burden the appellant will face.

Why is this Important in Family Law?

When separating from your spouse, in either a common law relationship or marriage, each party is entitled to division of family property and debt. This often includes an accounting of all the family property and debt being held in each spouse’s name, and dividing them equally (and in some cases, unequally). Often, when spouses own corporations or shares of corporations, these corporations or shares of corporations are typically valued by a business valuator. However, when the business valuator completes their report, personal distributive taxes do not usually form part of the report. It would be helpful for you and your family lawyer to ask the business valuator to assist with providing a supplementary report to calculate the spouse’s personal distributive tax obligations in order to divide family property and debt accurately and fairly.

If you have any questions about how this works, please feel free to reach out to our team.