Zeal and Gold Ltd. v. MNR, 73 DTC 5116, [1973] CTC 129 (FCTD)

Cattanach, J:—This is an appeal from a decision of the Tax Appeal Board dated August 1970 whereby the assessment of the appellant to income tax by the Minister for its taxation year ending January 31, 1963 was confirmed.

Prior to 1949 C A Zeal and S Gold, who were brothers-in-law, carried on a partnership under the firm name of Zeal and Gold, and engaged in the business of retail clothiers in Kenora, Ontario.

On February 20, 1952 C A Zeal and S Gold, the partners, caused the incorporation of Zeal and Gold Limited, the appellant herein, which acquired the business of the partnership and all property thereof. At this time the brothers-in-law C A Zeal and S Gold were the beneficial and controlling shareholders and directors of the appellant.

C A Zeal and S Gold also caused the incorporation Mercantile Investments Co, Ltd (hereinafter called Mercantile) of which they became the directors and the beneficial and controlling shareholders. Mercantile acquired all the property used to carry on the clothing business, that is the property that were tangible capital assets within Class 8 of Schedule “B” to the Income Tax Regulations.

These were admittedly non-arm’s length transactions.

The brothers-in-law, because of their many divergent interests elsewhere, thought it advisable to have a resident manager to conduct the clothing business of the appellant in Kenora, Ontario.

Accordingly in the fall of 1955 C A Zeal and S Gold sold to J J Stearns one-third of the issued and outstanding shares of the appellant and one-third of the issued and outstanding shares of Mercantile, so that Zeal, Gold and Stearns became the shareholders and the directors of the appellant and Mercantile each holding one-third of the shares in each company. The by-laws of both companies required that all corporate decisions must be unanimous. It was also provided that Zeal, Gold and Stearns would be paid equal salaries.

Apparently this arrangement proceeded harmoniously for a period then the relationship between Zeal and Gold on the one hand and Stearns on the other began to deteriorate until it became intolerable. The basis of the differences was that Zeal and Gold were dissatisfied with their returns from the business of the appellant while Stearns felt that his return should be greater than that of the other two because he did all the work.

it seems that Zeal and Gold wanted to terminate their business interests in Kenora, whereas Stearns wished to continue.

Sometime in 1958 Zeal and Gold found a prospective purchaser. However Stearns opposed and voted against the proposed sale and because the by-laws required that all decisions shall be unanimous the offer to purchase was not accepted.

The solution to the impasse was that Stearns should buy out Zeal and Gold. The obstacle to this solution was that Stearns did not have the resources to do so. This obstacle was overcome by means of a bank loan to Stearns and other financing provided to him by his solicitors.

The result was that on January 7, 1959 accord was reached by the three participants, the substance of which was that Stearns would buy the shares held by Zeal and Gold in the appellant, Zeal and Gold Limited, and Zeal and Gold would buy the shares held by Stearns in Mercantile.

This agreement was implemented by the execution of numerous documents on January 7, 1959.

The material documents for the purpose of this appeal are:

(1) an agreement between Stearns as purchaser and Zeal and Gold as vendors of two-thirds of the issued and outstanding capital stock of the appellant;

(2) the termination of the employment of Zeal and Gold by the appellant and payment of their weekly salary of $140 for 39 weeks after January 7, 1959;

(3) an offer by Stearns to purchase from Mercantile all fixtures used in the business of the appellant company for $3,300 subject to the conditions (a) that Mercantile grant a lease of the premises to the appellant, (b) that the purchase price of $3,300 was payable in cash in exchange for a bill of sale to the appellant and (c) that the offer by Stearns to Mercantile was also conditional on the acceptance of his offer to purchase the shares held by Zeal and by Gold and that Mercantile would accept through Zeal and Gold;

(4) a bill of sale as contemplated, from Mercantile to the appellant;

and

(5) an undated resignation of Stearns as a director of Mercantile.

It is admitted that it was the intention of all parties to the series of agreements that the fixtures would go from Mercantile to the appellant at a price of $3,300 and that in making the offer to purchase those fixtures Stearns was doing so as agent for the appellant. It was also agreed that the contract for the sale of the fixtures to the appellant was in substance and in fact a contract between Mercantile and the appellant.

It is not disputed that the capital cost of the property in question to Mercantile was $19,558.88.

Neither is it disputed that the undepreciated capital cost of that property was $1,850.40.

On December 26, 1962 the premises of the appellant were destroyed by fire.

The appellant was insured against loss by fire, the policy being pages 1 to 9 of Exhibit A2. This policy of insurance covered a variety of items to a liability in an amount in excess of $300,000 but the fixtures, equipment and tenants’ improvements, being the property about which this appeal revolves, were insured in the amount of $20,000.

The appellant eventually received this amount with respect to the loss of those fixtures by fire from the insurer.

In assessing the appellant as he did the Minister applied the provisions of subsection (1) and subsection (4) of section 20 of the Income Tax Act.

Subsection 20(1) reads as follows:

20. (1) Where depreciable property of a taxpayer of a prescribed class has,

(a) the amount of the excess, or

(b) the amount that the excess would be if the property had been disposed of for the capital cost thereof to the taxpayer.

shall be included in computing his income for the year.

Subsection 20(4) reads as follows:

20. (4) Where depreciable property did, at any time after the commencement of 1949, belong to a person (hereinafter referred to as the original owner) and has, by one or more transactions between persons not dealing at arm’s length, become vested in a taxpayer, the following rules are, notwithstanding section 17, applicable for the purposes of this section and regulations made under paragraph (a) of subsection (1) of section 11:

(a) the capital cost of the property to the taxpayer shall be deemed to be the amount that was the Capital cost of the property to the original owner;

(b) where the capital cost of the property to the original owner exceeds the actual capital cost of the property to the taxpayer, the excess shall be deemed to have been allowed to the taxpayer in respect of the property under regulations made under paragraph (a) of subsection (1) of section 11 in computing income for taxation years before the acquisition thereof by the taxpayer.

It is the Minister’s position that the appellant and Mercantile were related persons.

Related persons are defined in subparagraph 139(5a)(c)(i) as any two corporations that are controlled by the same person or group of persons.

For the purposes of the Income Tax Act by virtue of subsection 139(5) ‘‘related persons shall be deemed not to deal with each other at arm’s length”. As used in the context of subsection 139(5) the words “shall be deemed” have been held to mean conclusively and irrebut- tably presumed.

Reverting to subsection 20(4) it is the Minister’s position that Mercantile and the appellant, being related persons, were not dealing at arm’s length and accordingly the capital cost of the property to the taxpayer, ie the appellant, shall be deemed to be the capital cost of the property to the original owner, ie Mercantile.

That being so since the capital cost of the property to Mercantile had been $19,588.88 then by virtue of subsection 20(4) that is also the amount of the capital cost to the appellant. The undepreciated capital cost of the property was $1,850.40. Therefore the Minister applied subsection 20(1) and included the difference between the capital cost of $19,588.88 to the appellant and the undepreciated capital cost of $1,850.40 which is $17,738.48 as income to the appellant in its 1963 taxation year which amount is less than the difference between the proceeds realized by the appellant under its policy of insurance and the undepreciated capital cost.

I note that my computation of the difference between the deemed capital cost to the appellant is $17,738.48, whereas the Minister in assessing the appellant included a difference in the amount of $17,708.48 as income to the appellant as the recapture of capital cost allowances. I am unable to discern the reason for the difference of $30 between my computation and that of the Minister but it is immaterial since the Minister included a lesser amount and it is the assessment by the Minister which is the subject of the present appeal.

On the other hand the appellant contends that the assets acquired by it from Mercantile were so acquired as the result of an arm’s length transaction and therefore subsection 20(4) of the Income Tax Act is not applicable. That being so then the capital cost of the property to the appellant would be $3,300, the purchase price for that property paid by the appellant to Mercantile.

It follows from the contention of the appellant that the amount to be included in its income for its 1963 taxation year is the difference between a capital cost of $3,300 and the undepreciated capital cost of the property of $1,850.40 being an amount of $1,449.60 rather than the much greater amount of $17,708.48 which was included in the appellant’s income by the Minister.

These rival contentions by the parties are based upon the applicability of subsection 20(4) to the circumstances of the transaction outlined above and the question of the applicability of subsection 20(4) is based, in turn, upon conflicting premises, that of the Minister being that the transaction was between persons not dealing at arm’s length and that of the appellant being that the transaction was conducted by persons dealing at arm’s length.

Therefore the first issue in this appeal is to be resolved upon the determination of the question of whether the transaction was at arm’s length or not.

There is no doubt that the motives and interests of Zeal and Gold, on the one hand, were diverse from and conflicting with those of Stearns on the other hand. There was acrimony and hard bargaining.

However this was not a transaction between these persons. It was a transaction between two corporate entities, Mercantile and the appellant, in both of which the three individuals were equal shareholders. This has been accepted by the parties and the appeal argued upon that basis.

By reason of subparagraph 139(5a)(c)(ii) these two corporations were related persons because each corporation was controlled by the same group of persons.

The two corporations being related persons then by virtue of subsection 139(5) the two corporations are conclusively deemed not to deal with each other at arm’s length.

There were a series of transactions all of which were concluded and documents executed on January 7, 1959 but these transactions were all directed to the one end which was, in brief, that Stearns would become the sole shareholder in the appellant and Zeal and Gold would become the only two shareholders in Mercantile. Because the capital assets which were used in the conduct of the clothing business by the appellant were vested in Mercantile it was implicit in the deal that those assets should be transferred to the appellant. From the very nature of the ultimate end it was necessary that to achieve that end there should be an offer from Stearns to Zeal and Gold in their personal capacities to purchase their shares in the appellant and conversely with respect to the shares held by Stearns in Mercantile. It was also necessary that certain transactions must be between the individuals and the two corporations and between the two corporations. The transactions between the individuals and the companies and between the companies were not conducted at arm’s length because these transactions were conducted by related persons as defined in subsection 139(5a).

It was the contention on behalf of the appellant that at some point in time on January 7, 1959 that Stearns became divested of his shares in Mercantile and Zeal and Gold became divested of their shares in the appellant so that when the transaction was concluded for the transfer of assets from Mercantile to the appellant the two corporations were not controlled by the same group of persons. This contention is predicated upon the fact that the offer by Stearns on behalf of the appellant to purchase the assets from Mercantile was conditional upon Zeal and Gold accepting Stearns’s offer to purchase their shares in the appellant.

I do not think that this contention is tenable because the series of transactions was considered as a “package deal”. The various component transactions and documents evidencing the consummation of each transaction were all directed to an ultimate end and were so interwoven as to be inextricable. The deal being a package deal consummated on January 7, 1959, the only logical conclusion is that each of the steps must have been taken simultaneously.

This overall arrangement as conceived was required to be implemented by persons not dealing at arm’s length. The power to influence and control the decisions of both Mercantile and the appellant at the outset of negotiations was vested in Zeal, Gold and Stearns. More so the by-law of both corporations so dictated.

It seems inconceivable to me, bearing in mind that all transactions were directed to achieving one desired result, that the relationship which prevailed among all necessary parties at the initiation of the overall plan could change during the intermediary steps to bring that plan to its fruition. In the circumstance of this appeal that relationship must have continued throughout and until the completion of the whole plan.

I therefore find as a fact that at the time of the transfer of the assets here in question by Mercantile to the appellant that the two corporations were controlled by the same group of persons, to wit, Zeal, Gold and Stearns, and that being so the corporations were related persons and the transaction was between persons not dealing at arm’s length.

It follows therefore that the Minister properly included in computing the appellant’s income the difference between a capital cost to the appellant coincident with the capital cost to Mercantile and the undepreciated capital cost which the Minister determined to be in the amount of $17,708.48 which amount is not disputed.

This leads into the second issue in this appeal. It is the contention of the appellant that the amount of $17,708.48 was not properly included in the appellant’s income for its 1963 taxation year.

The appellant’s taxation year ended January 31, 1963.

The fire by which the property in question was destroyed occurred on December 26, 1962.

The policy of insurance covered several items. Proof of loss was not furnished to the insurer by the appellant, as insured, until July 1963 and payment was not made to the appellant by the insurer until June 1964.

The appellant therefore contends that the proceeds of the insurance were not payable until well after the expiry of its 1963 taxation year.

In paragraph 20(5)(b) “disposition of property” is defined as including “any event entitling a taxpayer to proceeds of disposition of property”.

“Proceeds of disposition” of property is defined in subparagraph 20(5)(c)(ii) as including “an amount payable under a policy of insurance in respect of loss or destruction of property”.

Accordingly the taxation year in which the proceeds of the disposition of the property are to be included is that taxation year in which the proceeds became payable.

On behalf of the appellant it was urged that the amount under the policy of insurance did not become payable prior to January 31, 1963 because paragraph 12 of the statutory conditions applying to the coverage and forming part of the contract of insurance provides that “the loss shall be payable within sixty days after completion of the proof of loss, unless the contract provides for a shorter period”.

On the other hand counsel for the Minister argued that the proceeds became “payable” within the meaning of that word as used in subparagraph 20(5)(c)(iii) upon the occurrence of the event insured against.

On the facts peculiar to this appeal it is not necessary for me to decide the matter on the basis of those contentions.

The risks insured against by the appellant were several and different insurers accepted different risks. The coverage of the risk on the fixtures, equipment and tenant’s improvements, which is the property here involved, was assumed by General Insurance Company of America.

Prior to January 31, 1963 the General Insurance Company of America informed the appellant that it acknowledged its liability to pay and was willing to pay the loss of $20,000 to the appellant with respect to the insurance carried on the fixtures.

The other insurance companies, which were seven in number, apparently disputed the amounts of the losses incurred by the appellant and possibly their liability therefor and it may well be that the General Insurance Company of America may have disputed the amounts and its liability for other risks it covered. However it did not dispute either the amount or its liability to pay the loss with respect to the fixtures.

On December 20, 1963 the appellant began an action in the Supreme Court of Ontario against all eight insurers. This action was settled by the payment of varying amounts by the different insurers to the appellant.

However it is significant to note that the General Insurance Company admitted its liability and offered to pay forthwith the amount of $20,000 to the appellant with respect to the loss of the fixtures suffered by the appellant and that the amount of $20,000 was the full amount of the coverage.

In his cross-examination Mr Stearns admitted that he had been informed by the insurance company prior to January 31, 1963 of its willingness to pay $20,000, the full coverage with respect to the fixtures forthwith.

In the balance sheet of the financial statements of the appellant for its financial year ending January 31, 1963 which was appended to the appellant’s income tax return for that taxation year, there is included under the heading ‘‘current assets” an item reading as follows:

Fire Insurance Claims — furniture and equipment (as per verbal offer by insurers) $20,000.00

The offer by the insurer to pay the full amount of the coverage on the property here in question forthwith constitutes a waiver by the insurer of compliance with the statutory conditions precedent to payment of the loss.

In view of the foregoing circumstances I am of the opinion that the amount of $20,000 in respect of the destruction by fire of this particular property of the appellant became payable under the policy of insurance in the appellant’s 1963 taxation year.

It follows from the two conclusions that I have reached (1) that the Minister properly included an amount of $17,708.48 in the appellant’s income and (2) that he properly included that amount in the appellant’s income in its 1963 taxation year, that the appeal herein is dismissed with costs.