Lutheran Life Insurance Society of Canada v. The Queen, 91 DTC 5553, [1991] 2 CTC 284 (FCTD)

MacKay, J.:—These are three actions, tried together on similar facts, in which Lutheran Life Insurance Society of Canada (“the Society") appeals reassessments, all dated September 9, 1982 and later modified by reassessments dated March 16, 1983, made by the Minister of National Revenue, in relation to its income tax returns for the taxation years 1978, 1979 and 1980 respectively. Each of the actions relates to a particular taxation year. [1]

Counsel were agreed on the amounts at issue in these actions. Counsel for the defendant, consistent with the statements of defence filed in these actions, also agreed that the plaintiff's action be allowed and the reassessments be referred back to the Minister of National Revenue for reconsideration and reassessment but only on account of policy reserves which should include the following additional amounts:

for 1978: $29,273

for 1979: $51,290

for 1980: $84,985

To the extent of these adjustments on account of policy reserves the Society's claims, with agreement of the defendant, are allowed.

Aside from that aspect upon which there was agreement, these actions raise two main issues, as well as two subsidiary ones. A brief overview provides the context for these issues and will assist in providing perspective for the more detailed review of facts and the law applicable to them.

Lutheran Life Insurance Society of Canada is a fraternal benefit society and has been so classed within that term, as defined in the Canadian and British Insurance Companies Act, [2] under the Income Tax Act, R.S.C. 1952, c. 148 (am. S.C. 1970-71-72, c. 63) (the 'Act") from the inception of the Society. Under the latter Act the activities of fraternal benefit societies were once exempt from income tax but for more than two decades income derived from the carrying on of a life insurance business by these societies has been taxable. In this case, as for other comparable societies, the Society's other activities not related to its life insurance business, in accident and sickness insurance business and in other fraternal activities undertaken for the benefit of its members, are not subject to income tax.

The first issue, here described as the fraternal dividend issue, arises from the following facts. In 1979, with effect for the year 1978, the Society, on the advice of its accountants and its lawyers, with approval of its actuary and approval by its Board of Directors representing its members, implemented a plan to pay members, who were holders of certain life insurance policies, an extra dividend, called a "fraternal dividend" based on the policies held. That dividend was claimed by the Society as a deduction from income for tax purposes in the operation of its life insurance business. At the same time the Board of Directors approved and assessed against the same members, i.e., holders of the same life insurance policies, a “fraternal assessment", against which the fraternal dividend was applied in payment, which members were deemed to pay for fraternal purposes of the Society. The amount was the same as the fraternal dividend paid to each member. As revenue for its fraternal purposes, the fraternal assessment was considered by the Society not to be taxable. That same procedure was followed subsequently for the taxation years 1979 and 1980. The Minister of National Revenue, in reassessments for the taxation years in question, disallowed the deduction of the fraternal dividend claimed as a deduction in the Society's income in income tax returns relating to its life insurance business. The first issue concerns the correctness of that decision, applied by the Minister's reassessments to each of the three taxation years 1978, 1979 and 1980.

Near the end of argument at the trial, counsel for the defendant raised alternative arguments, presenting subsidiary issues in relation to the fraternal dividends. He urged that if the fraternal dividend deduction were allowed, as the plaintiff sought, the fraternal assessment should be added by the Minister as taxable income from the Society's life insurance business, so that the end result would be that the reassessments are correct as to the amount of tax owed, though the basis of the calculation of tax would be altered. Counsel referred to authority for the proposition that it is the amount of the reassessment, not the reasons for its calculation, that is in issue in an appeal of the Minister's decision reassessing tax for a taxation year. In further alternative, the defendant argued that if the Society's characterization of the fraternal dividend—fraternal assessment transactions were valid, and intended for fraternal purposes, the two transactions were self cancelling, the Society's financial situation was unchanged and the dividends were not intended to be a distribution of surplus income and thus were not policy dividends within allowable deductions for a life insurance business under the Income Tax Act. Counsel for the Society objected on procedural grounds to these eleventh hour arguments, and he objected also on the merits, by way of written submissions offered after trial at my invitation.

The second issue arises from the fact that the Society manages its investments as one pool. The issue, here described as the investment income issue, is what portion of investment income is to be attributed to its life insurance business in which income is taxable. A portion of the total investment income was reported by the Society in its accounts, as it had apparently done in previous years, as attributable to its business in sickness and accident insurance, but in taxation years 1979 and 1980, it also claimed for tax purposes a portion of its investment income as attributable to fraternal assets and reduced by this amount each year the investment income attributed to its life insurance business. Those reductions for the years 1979 and 1980 were disallowed by the Minister's reassessments. There was argument about the requirements of the Canadian and British Insurance Companies Act to maintain separate accounts for its various activities. I note, however, that there are no statutory or regulatory directives that specifically require management of investments in distinct segregated funds or pools and there are no statutory or regulatory directives about how income from a single fund or pool is to be distributed between taxable and non-taxable operations of a fraternal benefit society.

With this background of the situation, I turn to more detailed examination of the facts and the law as these relate to both main issues. Then I examine first the investment income issue, simply because it can be dealt with relatively briefly, and, second, the dividend-assessment issue and related subsidiary matters raised by the defendant at the conclusion of the trial.

The Society and its operations

The Society was established in 1972 by grant of letters patent under the Canadian and British Insurance Companies Act, and it commenced operations at the end of that year, following arrangements agreed upon between its sponsors and two United States fraternal organizations which previously offered insurance and activities supportive of Lutherans in Canada. Those predecessor organizations assigned their Canadian insurance policies and substantial assets to the new Society. Thereafter, the two founding fraternal organizations ceased to carry on activities in Canada and the new Society assumed the responsibility to maintain and develop similar fraternal activities supportive of Lutherans and of the Lutheran Church in Canada, including the business of life insurance, and sickness and accident insurance, for its members.

The purposes of the Society, described as "fraternal purposes" in its letters patent, [3] are:

(a) to associate Lutherans in Canada in order to provide the benefits that accrue through membership in a fraternal benefit society;

(b) to serve Lutherans in Canada through programs of insurance, Christian Fellowship, benevolence and other fraternal activities;

(c) to aid the Lutheran Church in Canada, to aid institutions connected with the Lutheran Church and to aid such religious, educational, charitable and civic organizations as the Society may determine.

Membership in the Society was automatically extended to persons who were members in Canada of the two United States fraternal organizations and who were insured under certificates or policies assumed by the Society. In accord with the letters patent membership also includes those admitted as members who are residents of Canada, Lutherans or spouses and children of Lutherans, or persons affiliated with Lutheran Church organizations. There is a single application for membership in the Society and for insurance, and policy holders or those insured under policies are all members and they are the only regular members of the Society.

Members of the Society are assigned to local branches, which are interrelated with Lutheran Church congregations but independent of them, and membership in the Society is not synonymous with church membership. Branches have elected officers and branch meetings are conducted regularly, generally utilizing church premises, to promote local fraternal activities. Members elect the Board of Directors which is responsible for operations of the Society. There is no share capital and there are no shareholders in the Society, and it is not operated for profit. Under the Canadian and British Insurance Companies Act, R.S.C. 1970, c. 1-15, ss. 93(1) (now counterpart is found R.S.C. 1985, c. 1-12, ss. 162(1)) registration as a fraternal benefit society is precluded for an organization that "is in effect the property of its officers or collectors or belongs to any private proprietary, or if it is conducted as a trading or mercantile venture, or for purposes of commercial gain".

For fraternal purposes and for its insurance business, comprising life insurance and sickness and accident insurance, the Society's branch organizations and its sales representatives operate in Ontario, Manitoba, Saskatchewan, Alberta and British Columbia. Sales representatives, in addition to their concerns with insurance business of the Society, are expected to be actively associated with fraternal activities of the branches to which they are related, but branch and sales operations are separate. Apart from participation in local branch activities, members relate directly to the Society through its head office in Waterloo, Ontario, including the payment of premiums and dealings with policies in force.

From its inception the Society has been concerned to develop effective principles and programs for fraternal activities, other than the provision of insurance, under the leadership of a committee of its Board of Directors. Those activities include a variety of programs initiated and administered on a continuing basis at the level of the Society, such as scholarship programs to high schools, university scholarships to individual students, lecture programs for Lutheran colleges and seminaries, annual dinners for seminary graduates, support for Lutheran student organizations, a program of modest annual grants to assist in defraying postal or other administrative expenses of branches rated among the best. The Society also provides matching grants up to $1,000 to assist co-operating branches engaged in their own fund raising activities for fraternal or community purposes, and it responds to applications for special grants, relating to church or wider community assistance including disaster or hardship relief for individuals or communities. The Society also maintains a continuing support program for orphan children of deceased former members. It responds to requests for assistance from the Lutheran churches or their organizations, supports retreats for pastors, pastors’ wives, social workers, and business leaders from the church. It provides certificates and crosses for presentation upon confirmation of members of the Lutheran Church. It provides mortgage funding for Lutheran churches at less than market rates. It has produced Lutheran funeral service booklets for use in funeral chapels at the request of pastors. It annually publishes pastors' desk diaries; it has published brochures on membership and on the importance of wills and estate planning, convention materials for use at meetings of Lutheran organizations and a Branch Book or administrative brochure for guidance of branch officers. It has assisted the Lutheran braille organization with grants in support of its work.

To provide information on its activities, in fraternal matters and in its insurance business, it publishes Lutheran Life Insurance News four times each year, for distribution to its members. This publication serves as its formal channel for general communication with members. It also publishes up to four times a year, "Fraternally Yours", a publication of advice and information, largely on fraternal activities, for local branch officers, and twice a year it publishes a newsletter from the Society to Lutheran pastors to inform them of fraternal activities of the Society and other matters of interest.

I have no doubt that the Board of Directors has treated seriously its responsibilities for promoting fraternal activities and supporting the Lutheran Church and its organizations, in addition to responsibilities directly related to the Society's insurance business. In accounting for its expenditures for fraternal activities for which it reduced premium income in its life insurance business for income tax returns, the Society, in addition to the costs of grants and ongoing programs and special projects which it classified as fraternal activities, included a portion of administrative costs of the Society, for salaries and benefits of staff or portions of staff time, space, committee expenses and so on that were attributable to its fraternal activities.

The evidence provided by senior officers of the Society, which was not contradicted or shaken by cross-examination, made clear that the life insurance business of the Society was carried on as a fraternal activity, and that a portion of the assets turned over by the predecessor United States fraternal organizations in 1972 was considered to be for fraternal activities other than life or sickness and accident insurance. No practice was adopted then or later by the Society for “fraternal assets" to be separated or accounted for as distinct from the assets of the Society to support its insurance business. Further, the Society considered a portion of premium income paid by members, policy holders, to be for fraternal purposes, a concept explicitly accepted by the Department of Insurance which treated a portion of premium income, both for life insurance and for sickness and accident insurance, as income for fraternal purposes in amounts equivalent to total fraternal expenses in a given year. Implicitly this was accepted by the Department of National Revenue which did not question the reduction of premium income by that amount specified by the Society for any year, including the years here in question, in considering tax returns related to income tax on the income derived from life insurance operations.

Of interest in these actions there were two government authorities to which the Society reported annually on its activities and with financial information. The first was the Department of Insurance in accord with the Canadian and British Insurance Companies Act. If that office were satisfied with its operations the Society would annually be granted a certificate of registration, as it has been for every year since 1972. The second was the Department of National Revenue to which it annually forwarded an income tax return relating to income from its life insurance business. To this it appended the annual financial statement filed with the Department of Insurance, together with a statement reconciling that financial statement with its tax return. The Society, which commenced operations December 31, 1972, did not generate income subject to tax from its life insurance business before 1978.

The investment income issue

When assets were assigned to the new Society in 1972 by its predecessors a minor portion of these were attributed to sickness and accident insurance operations and the bulk of them were attributed to life insurance operations, on the basis of accounting principles developed by the predecessors. The basis for that division was not in issue in this case. The process was continued by the Society, not in the operation of segregated assets or other funds, but by recording separate accounts including assets, investments and investment income, premium income and expenditures for its life insurance business and for its sickness and accident insurance business.

That practice is consistent with the requirements of subsections 81(1), 99(1) and 99(3) of the Canadian and British Insurance Companies Act as that Act applied in the tax years in question. These provided [4] :

81. (1) Subject to subsection (2), where any company, in the exercise of its powers, combines the business of life insurance with other classes of insurance business, it shall maintain separate and distinct accounts, funds and securities in respect of its life insurance business, and such funds and securities shall be available only for the protection of the holders of its policies of life insurance, and shall not be liable for the payment of claims arising from the other class or classes of business that the company transacts.

99. (1) A fraternal benefit society registered under this Act, if duly authorized by by-law of the society passed on the recommendation of its actuary, has power

(a) to insure the dependent children of the members of the society;

(b) to issue to its members policies providing benefits in the event of the death of, or injury to, the member by accident or providing indemnity during the incapacity of the member arising out of accident or sickness;

(c) to issue to its members policies of life, endowment or term insurance;

(d) to grant loans to its members on the security of their policies, to grant paid- up policies or other equities in lieu thereof to members desiring to be relieved of payment of future premiums or any part thereof, or to pay cash surrender values for policies and to purchase the interest of members in the policies; and

(e) to maintain such separate funds as may from time to time be authorized by

by-law, validly enacted by the society and approved by the Superintendent.

99. (3) Any by-law authorizing a society to exercise the powers mentioned in paragraph (1)(b) shall establish a separate fund to which receipts and payments in respect of policies issued pursuant to those powers shall be credited and charged, respectively; and in like manner a separate fund shall be established by any by-law authorizing the society to exercise the powers mentioned in paragraph (1)(c).

As earlier noted, the Society considered some undesignated portion of the assets received from its predecessors to be “fraternal assets” supporting fraternal activities other than insurance and it considered a portion of premiums paid by members, in relation to both life insurance and sickness and accident insurance, to be for fraternal purposes. Officers of the Society testified that its premiums for life insurance were generally higher than those of commercial life insurance companies. No portion of the premium was designated for fraternal purposes and no membership or fraternal fee was assessed, at least until the assessment that was levied at the same time that fraternal dividends were declared for the 1978 year, the transactions which give rise to the fraternal dividend issue. Aside from those assessments the Society's practice was to account annually for its expenditures for fraternal purposes other than insurance, charging the major share of the total to its life insurance accounts and the minor share to its health and accident accounts. As revenue supporting these expenditures an equivalent amount was deducted from premium incomes in the Society's financial accounts, in its reports to the Department of Insurance and in its income tax returns. The basis on which expenditures were calculated and corresponding deductions from premium income were made differed in the reports to the Department and the tax returns but that difference was not an issue in this case. As correspondence from the Department of Insurance indicates, this practice was accepted by that Department. The practice was also implicitly accepted by the Minister of National Revenue and in the reassessments for the years 1978, 1979 and 1980. Counsel for the Crown suggested that the Minister of National Revenue may have been in error and not acting under the Income Tax Act in not questioning this practice but that was not an issue pleaded, or, in my view, of significance here. Indeed the practice was acknowledged in pleadings of the defendant.

Until 1979 the Society had no practice, or apparent concern, to identify a share of income from its investments, which were managed as one pool, as income related to fraternal purposes. Prior to 1978 it had not generated income from life insurance operations that was subject to tax, and its plans for developing fraternal activities were only recently established in accord with a policy report from the fraternal activities committee of the Board approved in 1976. In 1979, interrelated with its decisions to pay a fraternal dividend and assess a fraternal assessment, the Society's Board had approved, subject to certain conditions that were subsequently met, the purchase of some 8.8 acres of land in the city of Waterloo, to be used for building of a fraternal centre where fraternal activities in the region could be carried on and could be fostered for the Society as a whole. Those plans did not proceed after the reassessments here questioned were made. At the time of trial the Society was completing a new office building for its insurance business on part of the land but its plans for a fraternal centre were on hold pending resolution of the issues herein.

Much was made by representatives of the Society of the difficulty of allocating assets and income from them to fraternal purposes, in the absence of statutory requirement that this be done, in the absence of particular rules or procedures or advice for this purpose established by regulatory authorities and, it was said, in the absence of particular accounting rules and principles for this purpose. “Branch accounting", accepted within accounting professions as a method of allocating assets, revenues, expenses, surplus or loss to particular operations, was considered by the Society's accounting advisers and by its officers to be inappropriate and too costly for operations of the Society which were, in comparison to major multi-purpose enterprises, rather modest. With these perceived difficulties, officers of the company testifying at trial articulated no principles upon which their concept of a notional portion of assets, and income from investments, could be readily quantified for fraternal purposes other than insurance.

For the year 1979 the Society adopted the professional advice of its outside accounting and tax adviser, Ronald C. Knechtel, and followed procedures under Income Tax Regulation 2400 to determine the portion of its assets and earnings from investments to be attributed to life insurance operations. The Society apparently continued its former practice in determining the portion of investment income to be attributed to sickness and accident insurance and no question is here raised about investment income attributed to sickness and accident insurance. The balance of investment income determined by application of regulation 2400 as attributable to other than life insurance purposes was then considered bythe Society to be attributable to fraternal assets other than life insurance. It is this residue of investment income, claimed as a deduction from investment income from life insurance operations of the Society in its returns for income tax purposes, which the Minister of National Revenue in reassessments for 1979 and 1980 added back as income, $151,970 and $284,837 respectively for those years. Those amounts did not appear in the annual financial statements filed with the Department of Insurance as separate from the life insurance funds of the Society, although the portion of investment income attributed to sickness and accident insurance was reported in a separate sickness and accident account. In effect the reassessments of the Minister did not acknowledge the existence of a portion of assets, or income from investments, for fraternal purposes, or for any purpose other than life insurance and, implicitly, sickness and accident insurance.

The Society's accounting and tax adviser, Mr. Knechtel, was a senior. chartered accountant, with some years service in auditing with the Department of National Revenue prior to his entering private practice, where his specialized practice interest was in taxation applicable in the life insurance industry. He had served as an adviser to the association of life insurers in relation to the tax changes implemented in the late 1960's. On the recommendation of that association ne had served as special adviser to the Minister of Finance from 1976 to 1979, concerning measurement of income and its taxation in the life insurance industry. He had also served as special adviser to the Minister of National Revenue from 1975-1979. In advising Ministers, his involvement on a continuing part-time basis had been concerned with issues of taxation of life insurance companies and policy holders. As part of his general accounting practice he had also been a long time consultant and adviser for the Society, advising its predecessors on their Canadian activities, and, from its inception in 1972, Lutheran Life itself.

Knechtel's advice to the Society was based on his acceptance of the views of the Society that its fraternal activities warranted a share, undetermined in amount until 1979, in the investment assets of the Society. That acceptance also recognized a notional share of premium income as related to fraternal activities. His advice was also based on the fact that the Society's operations were not for profit and that any surplus revenues were for the benefit of members, and he drew an analogy between the Society's operations and co-operative societies generally. From his involvement as a ministerial adviser he had substantial knowledge of the background of regulation 2400 and discussions about it.

Regulation 2400 applies to multi-national life insurance companies doing business in Canada and provides a formula whereby a portion of their total assets and income therefrom are attributed to Canadian operations for tax purposes. Knechtel testified that this regulation had been adopted after regular branch accounting principles had been considered and rejected for purposes of assessing tax applicable to multi-national life insurers, and though preliminary consideration had been given to extending the proposed regulation to the activities of fraternal societies in Canada, that had not been done when the regulation was adopted.

He acknowledged that the regulation was not specifically applicable to the Society, but in his view it was appropriate to follow the formula of regulation 2400 to assess the portion of gross investment income of the Society attributable to life insurance operations and to thus separate out any balance that could then be considered attributable to other activities. After assigning a portion of that balance, in accord with the Society's past practice, to sickness and accident insurance operations, the residue was then deemed attributable to fraternal activities other than insurance. In Knechtel's view, regulation 2400 provided an acceptable formula for this, particularly in the absence of any other statutory formula or any other method proposed by regulatory or tax authorities. In his view, the Society's responsibility to restrict its investment income to that attributable to its life insurance operations in reporting income for tax purposes was analogous to that of the multi-national life insurer in reporting income for tax purposes attributable to its life insurance operations in Canada.

Underlying the plaintiff's submissions were the following factors. The Society had not earned income subject to tax before 1978 and so had no concern until then to separate out from gross investment income any portion attributable to fraternal assets. As this situation changed, it had a responsibility to report income from life insurance operations and under section 149 of the Income Tax Act [5] it was bound to report income only from its life insurance operations, a responsibility with which counsel for the defendant agreed. In the view of the Society and its advisers the process provided by regulation 2400 was a sensible and reasonable means to account for its investment income from life insurance operations and to separate out all other investment income. It was urged that the report to the Department of Insurance was required and prepared to establish solvency of the Society's insurance operations. The completed income tax return, required and prepared for an entirely different purpose, was the stage at which investment income attributable only to life insurance operations was required to be calculated.

The defendant's views were otherwise. It was submitted that regulation 2400 did not apply, a matter readily conceded by witnesses for the Society. Further, the Crown argued that the failure of the Society to establish accounts for its fraternal activities separate from its insurance activities resulted in its income from premiums and from investments, its two sources of income, being attributable only to its insurance activities. In short, there was no recognized income from premiums or from investments that was attributable to fraternal activities. It was urged, in light of the relatively small portion of total expenditures on fraternal activities, that the Society in fact was defraying these expenditures from its life insurance revenues, there was no separate income to support these, and none was quantified except by reference to its expenditures and later by its inappropriate reliance upon regulation 2400 in relation to investment income. Even the tacit acceptance by the Department of National Revenue of the Society's practice of reducing premium income by an amount equal to fraternal expenses, following acceptance of that practice by the Department of Insurance, was not adequate evidence of recognition of income for fraternal purposes for that acceptance may not have been warranted under the Income Tax Act. In the alternative, those expenses would only be allowable if they were incidental to, and part of the life insurance operations. The Society, which reported to the Department of Insurance one amount as investment income in its life insurance account, could not later represent in its income tax return that that income was less by an amount considered to be attributable to fraternal assets. Having reported to the Department of Insurance a certain sum as investment income in its life insurance accounts, that amount was said to be required to be available only for the purpose of satisfying claims of life policy holders and insureds, in accord with subsection 81(1) of the Canadian and British Insurance Companies Act. The Crown's arguments, in my view, were largely posited on the Society's practice of reporting on its finances to the Department of Insurance entirely on the basis of two types of insurance operations and not establishing in its accounts a separate fund for fraternal activities.

The Society had not established separate accounts for fraternal activities other than life insurance, and sickness and accident insurance, and it did not propose to do so. There had been correspondence and discussion with Department of Insurance officers about the appropriateness of separate accounts for its fraternal activities. The reporting forms of the Department for fraternal benefit societies included a separate column for accounting for revenues and expenses for fraternal activities, in addition to columns for the two insurance activities carried on by the Society. In February 1976 a senior officer of the Life Insurance Division of the Department of Insurance wrote to the Society about its practice in respect to financing its fraternal activities and advised in part ". . . it would be appropriate for the society to establish a separate and distinct fraternal fund", a practice said by the writer to be contemplated by the Canadian and British Insurance Companies Act, since it appeared from the Society's report that it had the “intent . . . to accumulate a substantial fund for fraternal purposes”. The letter also noted:

It is this Department's policy that in cases where a society chooses not to establish a separate fraternal fund it may finance its fraternal operations directly with allocations from the premium account. These allocations in any year must be equal to the expenditures dispersed on fraternal activities during that year. It does not seem appropriate, however, to contemplate allocating a portion of the investment income of assets, ostensibly held for the life insurance fund, to the support of fraternal activities. . . .

The letter went on to suggest inclusion of certain funds in financial reports either in the "fraternal funds column” or to remove funds from the revenue account to an "increase in special reserve" item on the form for reporting to the Department. The response to this from the Society was to write that it was not its intent to accumulate a substantial fund for fraternal purposes and it had chosen not to establish a separate fraternal fund.

The Society apparently assumed this concluded the matter. However, following its decision to implement a program for fraternal dividends and fraternal assessments, the same senior officer of the Department of Insurance wrote again to the Society on June 24, 1980. He indicated that after their review of the Society's operations for 1979, the question of the "special dividend assessment" was considered a serious matter. While it discusses the practices adopted by the Society at length, no specific reference was made to the investment income issue. The letter does urge establishment of a separate fund but only in relation to the fraternal assessments. Thus it states, in part,

In 1978 and again in 1979, special dividends of substantial magnitude were awarded to the policyholders with a simultaneous assessment being levied in the appropriate manner against these same policyholders. The assessment was for an amount exactly equal to the special dividends. On the surface this transaction appears quite artificial and when it is investigated in detail it causes us great concern. . . . In fact, reading the by-law established by the Society to authorize this assessment, we note that the funds are to be accumulated and set aside for future benevolent purposes. What is happening in practice is that the funds are not being set aside and they disappear in the life insurance fund immediately after the assessment is made. We were led to the conclusion that the purpose of this artificial transaction is to reduce the income tax liability of the Society.

We strongly suggest that transactions in connection with these assessments be reversed for 1978 and 1979 and that the funds assessed be placed into a special fraternal fund to be maintained and accumulated for future fraternal purposes. In our opinion there are no grounds at.present for arguing that the assessment is being employed for any fraternal or benevolent purposes.

We recommend that a separate fund be created, therefore, and we will advise Revenue Canada that this is our position in the matter. . . .

Subsequently, a senior officer of the Society, serving as vice-president and actuary, together with Mr. Knechtel met with officers of the Department of Insurance in Ottawa. This was followed by a letter of November 10, 1980 from Knechtel's firm, Clarkson, Gordon, on behalf of the Society setting out the basis on which the Society's operations were carried on and the reasons why it seemed more appropriate not to establish separate funds for fraternal activities. In the meantime the Department of Insurance had written to the Department of National Revenue on August 5, 1980 recommending that the amount claimed as a deduction for fraternal dividends for 1978 be added back as taxable income of the Society, though apparently the Society was not then advised of this. That correspondence set out the view that the assessments for fraternal purposes and simultaneous fraternal dividends by the Society in its 1978 and 1979 years caused concern in relation to the Society's treatment of these in its tax returns, but no reference was made to separate fraternal fund accounting. Officers of the Society testified that they had not heard further after the November meeting from the Department of Insurance about the establishment of separate accounts for fraternal purposes and that they assumed the Department was satisfied with the Society's decision not to create separate funds for these purposes, particularly since following the November meeting the Society had written in December to the Department expressing its understanding that the latter's concerns and questions about the fraternal assessments had now been thoroughly discussed. The president and chief executive officer of the Society met annually with auditors from the Department of Insurance following their examination of the Society's records and the matter of establishing separate fraternal fund accounting had never been raised with him on any of these occasions.

There was difference between the parties concerning the application and the meaning of subsections 81(1) and 99(1) and (3) of the Canadian and British Insurance Companies Act. In my view all three subsections apply to the operations of the plaintiff. None of them are expressly excluded from application to fraternal societies as certain other sections of the Act are by subsection 92(2) [6] . Subsection 99(1) provides the statutory authority for a fraternal benefit society to provide by by-law for providing certain types of insurance for its members, to issue policies, to issue loans on the basis of policies or otherwise deal with members about their policies and to maintain separate funds, subject to approval. Subsection 99(3) provides that a by-law authorizing certain types of insurance for members is to include provision for a separate fund for receipts and payments in respect of policies issued. Subsection 81(1) directs that a society combining operations of a life insurance business and another insurance business shall maintain separate accounts for its life insurance business, and funds and securities held in those accounts are to be available only for the protection of life insurance policy holders and are not liable for claims arising from other insurance operations carried on by the Society.

It is my conclusion that there was no requirement for the Society to establish a separate fund accounting for fraternal activities. The provisions of the Canadian and British Insurance Companies Act do require separate fund accounting for different classes of insurance carried on by one insurer, and that life insurance funds be available to satisfy claims from those operations only, and not from other insurance operations. These do not require nor necessarily imply any requirement for separate fund accounting for fraternal purposes other than insurance activities. For example, as I read subsections 99(1) and (3), and 81(1), a fraternal society which carries on a life insurance business but no other insurance business would be required to maintain accounts only relating to its life insurance operations. It would not be required to maintain separate accounts for fraternal activities other than life insurance, though it might choose to do so, by by-law approved in accord with paragraph 91(1)(e). Had there been a statutory or regulatory requirement for it to do so undoubtedly the Society would have complied, and I have little doubt that if the Department of Insurance were really concerned about separate accounts for fraternal activities, it would have insisted that a separate fund be established if it had the regulatory authority to do so. On the evidence it is clear that the Department had not made further suggestions about separate accounts for fraternal purposes after receiving representations from the Society, including the meeting and the letter from the Society's accounting advisers in November 1980.

While there was no requirement for the Society to establish a separate fund for fraternal activities other than insurance the fact that it did not do so has implications, in my view, for its claim to deduct a portion of investment income, said to be attributed to fraternal assets and purposes, in relation to income tax on its life insurance operations. It was the conviction of officers of the Society that a notional portion of assets, and income from them, as from premium income, was for fraternal purposes other than insurance. Yet in the case of income from investments attributed to those purposes the sums claimed to be deducted from life insurance investment income, $151,960 for 1979 and $248,837 for 1980, are not identified and do not appear in financial statements submitted to the Department of Insurance, or the summary statements published in annual reports. In fact those amounts are determined only by subtracting investment income attributed to the sickness and accident insurance accounts in the report to the Department of Insurance from the total, stated for the first time in the 1979 tax return statement reconciling that return and the annual statement, and followed in 1980, for "other-than-life investment income".

Acceptance by the Minister of National Revenue of the reduction in premium income or an amount equivalent to annual expenditures for fraternal purposes other than insurance, a practice followed by the Society with explicit acceptance by the Department of Insurance, does not lead necessarily to accepting the claimed deduction from investment income. The bases for the two were different. The first recognizes the special functions of a fraternal society and accepts that fraternal activities carried on are financed from income assessed to members within their policy premiums. The latter deduction, of a portion of investment income, is not related to fraternal activities carried on, but to a notional portion of assets, not quantified, and identified only by applying a formula under regulations admittedly not applicable to the Society. That process the Minister of National Revenue, by reassessments, was not prepared to accept.

In my view, the Society failed to establish that the deduction from investment income for fraternal purposes other than insurance was not income from its life insurance business as reported in its financial statements to the Department of Insurance. It proposed no basis other than its own recognition that a notional portion of its assets related to fraternal purposes other than insurance and the application of regulation 2400, which admittedly did not apply in its case, to identify investment income to be attributed to those notional assets. This does not persuade me that the Society brings itself within the exemption from income tax provided for fraternal benefit societies except for its business in life insurance which is taxable, including in income from that business all income from investments identified by the Society itself in its financial statements as income from its life insurance business. All such income must, in my view, be deemed taxable income "on the assumption that it had no income or loss from any other source" (Income Tax Act, subsection 149(4), supra, note 8).

Let me make clear that I recognize a fraternal benefit society as provided for by the Canadian and British Insurance Companies Act is a special type of organization, with special capacities and a recognized role in fraternal activities for its members. I do not deny the possibility that the Society's assets and income earned from them include some portion properly attributable to fraternal activities other than insurance. Yet they were not identified by the Society in its financial returns or described or quantified by representatives of the Society at trial. In these circumstances, I have concluded that investment income attributable to fraternal activities other than insurance has not been proven for the purpose of exempting it from life insurance income subject to taxation.

On this issue I conclude that the reassessments by the Minister are affirmed, including in 1979 and 1980 income the amounts claimed to be exempt as other than life investment income, except for that portion attributed by the Society to its sickness and accident insurance.

The fraternal dividend issue

Acting on advice from the Society's accountants, including Mr. Knechtel, and with approval of its actuary, the Board of Directors of the Society approved for each of the three years (1978, 1979 and 1980) the payment of a fraternal dividend to a substantial number of its members, essentially to those who held participating life insurance policies. At the same time Lutheran Life assessed each of the same members with a fraternal assessment, that is, a fee payable by those members, for fraternal purposes, in the same amounts as paid to them by way of the fraternal dividend. As authorized by amended by-laws the Society applied the fraternal dividend payable on account of the assessment levied on each member.

In the view of the Society the fraternal dividend, as in the case of its regular or normal dividend to policy holders, was paid out of income arising from its life insurance operations. The fraternal dividend was in addition to the regular dividend and paid from the same life insurance funds. Regular dividends were paid and provided for, and if sufficient surplus remained at the end of the year, fraternal dividends could be declared and paid out. Thus, in the Society's view the fraternal dividend was a deduction from income for tax purposes in accord with subparagraphs 138(3)(a)(iii) and (iv) of the Income Tax Act, which provided:

138.(3) Deductions allowed in computing income. In computing a life insurer's income for a taxation year from carrying on its life insurance business in Canada, there may be deducted

(a) such of the following amounts as are applicable:

(iii) an amount equal to the lesser of

(A) the amount, if any, by which the aggregate of policy dividends (except the portion thereof paid out of segregated funds) that became payable by the insurer after its 1968 taxation year and before the end of the year under its participating life insurance policies exceeds the aggregate of amounts deductible under this subparagraph in computing its incomes for taxation years before the year, and

(B) the amount, computed in accordance with prescribed rules, of the insurer's income for the year from its participating life insurance business carried on in Canada,

(iv) an amount as a reserve for policy dividends equal to the least of

(A) the amount of policy dividends that will, according to the financial statements of the insurer as of the end of the year, become payable by the insurer in the immediately following year under its participating life insurance policies,

(B) 110% of the aggregate of policy dividends that become payable by the insurer in the immediately following year under its participating life insurance policies, and

(C) the amount, if any, by which the amount for the year described in clause (iii)(B) exceeds the amount for the year described in clause (iii)(A).

The fraternal assessment, it was urged on behalf of the Society, then constituted income arising from other than the life insurance operations and as an assessment for fraternal purposes was not income taxable in the life insurance operations of Lutheran Life.

In the case of its regular dividends, Lutheran Life's Board declares a dividend, usually in July of each year, which, if its payment appears actuarially sound at year's end in light of the Society's operations, is then paid to the policy holder on the anniversary date of the policy in the following year. There is no question that these dividends qualify within subparagraphs 138(3)(a)(iii) and (iv) as deductions from income for tax purposes.

For 1978, the first year in which the Society generated significant income from its life insurance business that would otherwise be subject to tax, the Society's Board declared the first fraternal dividend. The manner and timing of so doing was different from that followed in the case of regular dividends. Thus, at the end of the 1978 year the Society's operations were reviewed and by resolution adopted in March 1979, after amending by-laws to authorize payment of a fraternal dividend and the levying of a fraternal assessment, the Board approved resolutions declaring a fraternal dividend and a fraternal assessment, actually paid and assessed in July 1979 but considered as payable and recoverable in December 1978 and so recorded in the Society's financial accounts for that year. Similarly, the 1979 fraternal dividend declared in March 1980 and paid out in July 1980, is recorded in the 1979 accounts; and the 1980 fraternal dividend declared in March 1981 and paid out in July 1981 is recorded in the 1980 accounts. The amount recorded as payable by way of fraternal dividends at the end of each year was an authorized amount which in practice exceeded the dividends credited to members in July because of changes, reductions, in the numbers of eligible policy holders from December to July. Appropriate adjustments were made in the Society's accounts for fraternal dividends, and for fraternal assessments in each succeeding year.

I have noted that the by-laws of Lutheran Life were amended to implement plans for fraternal dividends and fraternal assessments. Prepared for the Board of Directors' meeting on March 8, 1979, the President's Report includes the following passage:

TAXATION

Directors have noted that they did not receive an Annual Report with the materials provided in advance of this meeting. The reason for this was that the closing of our 1978 books was delayed when our tax advisors, Clarkson, Gordon & Co., surprised us with the news that Income Tax would not be payable from 1978 onward.

Briefly, this can be accomplished by declaring a dividend in the amount of the taxable income. Then, by declaring a special levy on members (for fraternal purposes) for the same amount, no tax—or very little tax—would be payable. Such an action would require some change in our Bylaws. The procedure has been checked out with the Tax Department, the Insurance Department and independent legal advice obtained on various aspects of this situation.

I have requested that a tax specialist from Clarkson, Gordon & Co. be present at our meeting to explain this rather complicated procedure to the Board this morning. If approved, it can widen the horizons of our thinking at Lutheran Life with respect to our future activities.

On the basis of advice received at that meeting the Board of Directors approved amendments to the Society's By-law No. 1 to authorize the Board to:

1) determine annually the divisible surplus and the apportionment thereof as between surplus refunds or dividends and fraternal or special dividends and determine the further apportionment of each among the members or among members holding particular types of policies, all such determinations being based on the recommendation and approval of the Actuary of the Society (Lutheran Life Insurance Society of Canada, By-Law No. 1, clause 4(g) as amended March 8,1979);

and

2) determine from time to time any assessment for fraternal purposes and the amounts thereof to be levied on the members or on members holding particular types of policies (Idem, clause 4(j)).

The amendments to By-law No. 1 also provided:

Notice of any assessment for fraternal purposes shall be given in the official publication of the Society at least one month before the due date for payment thereof. The Society may apply on account of any such assessment levied on a member the whole or any part of any fraternal or special dividend payable to such member and such application shall constitute payment to such member of the amount so applied and payment, pro tanto, to the Society of the assessment levied on such member (/dem, section 13).

At the same meeting, on March 8, 1979, the Board of Directors approved resolutions relating to fraternal dividends to be payable on July 1, 1979 out of divisible surplus to members holding policies in force on that date (excluding designated types of policies so that those to whom these dividends were payable were essentially holders of participating life insurance policies). The formula for distribution of the fraternal dividend was set out, provision for these dividends was to be made in the accounts as of December 31, 1978 and reflected in the financial statements at that date.

constitutes a debt owed to the policy holder on the date specified for payment in the resolution declaring the dividend (Re Gamble and Robinson and City of Sault Ste. Marie (1923), 54 O.L.R. 93, per Logie, J. at 97). Payment of the dividend affected the adjusted cost base of a policy so that a policy holder with a taxable gain on the policy when a disposition is made may be subject to tax, and a significant number of policy holders have been so affected. Thus the fraternal dividend like the regular dividend, passed income from the Society to its members and it was subject to tax in the hands of the member, not the Society. In these circumstances it was not the intent of the Income Tax Act to tax the same income twice, which would be the result if the Minister's reassessments in relation to fraternal dividends were allowed. Both the fraternal dividends and the fraternal assessments were approved by the Board acting within its powers; members were notified of both by publication each year in the official publication of the Society and that the assessment was to be set off against fraternal dividends paid, in accord with the amended by-law, and the Society had received no complaint from any policy holder with respect to the fraternal dividend, the fraternal assessment, or the set-off process. The assessment was not income related to life insurance but was intended entirely for fraternal purposes other than insurance. In any event, the reassessments by the Minister had not claimed the assessments as income in the life insurance activities of the Society. There was nothing artificial, or incomplete, or in the nature of a sham, about the Society's dividend and assessment transactions, they had been completed in accord with the law and for purposes integral to the Society's existence. While they had the effect of reducing the Society's income subject to tax, the Society was free to arrange its affairs in a tax efficient manner.

The defendant raised a number of issues in relation to the reassessment of fraternal dividends, all relating to guidelines set out in Stubart, and for most of them an underlying thesis was that the fraternal dividend and fraternal assessment were so interconnected that they should be considered as interdependent transactions, or virtually a single transaction. I propose to summarize the issues raised by the defendant and to deal with each, in turn. Before doing so it is helpful to set out the guidelines useful in dealing with an issue such as that raised in this case as set out by Mr. Justice Estey in Stubart (at pages 316-17 (D.T.C. 6322-23; S.C.R. 579-80)). While section 245 of the Income Tax Act (or its predecessor then applicable, section 137) was not in issue in Stubart, as it is in this case, these guidelines do make reference to that section. Referring to a situation where the Crown relies on the general pattern of the Income Tax Act and not upon any specific taxing provision, Mr. Justice Estey said:

Nonetheless, some guidelines can be discerned for the guidance of a court faced with this interpretative issue.

1. Where the facts reveal no bona fide business purpose for the transaction, section 137 may be found to be applicable depending upon all the circumstances of the case. It has no application here.

2. In those circumstances where section 137 does not apply, the older rule of strict construction of a taxation statute, as modified by the courts in recent years, (supra), prevails but will not assist the taxpayer where:

(a) the transaction is legally ineffective or incomplete; or

(b) the transaction is a sham within the classical definition.

3. Moreover, the formal validity of the transaction may also be insufficient where:

(a) the setting in the Act of the allowance, deduction or benefit sought to be gained clearly indicates a legislative intent to restrict such benefits to rights accrued prior to the establishment of the arrangement adopted by a taxpayer purely for tax purposes;

constitutes a debt owed to the policy holder on the date specified for payment in the resolution declaring the dividend (Re Gamble and Robinson and City of Sault Ste. Marie (1923), 54 O.L.R. 93, per Logie, J. at 97). Payment of the dividend affected the adjusted cost base of a policy so that a policy holder with a taxable gain on the policy when a disposition is made may be subject to tax, and a significant number of policy holders have been so affected. Thus the fraternal dividend like the regular dividend, passed income from the Society to its members and it was subject to tax in the hands of the member, not the Society. In these circumstances it was not the intent of the Income Tax Act to tax the same income twice, which would be the result if the Minister's reassessments in relation to fraternal dividends were allowed. Both the fraternal dividends and the fraternal assessments were approved by the Board acting within its powers; members were notified of both by publication each year in the official publication of the Society and that the assessment was to be set off against fraternal dividends paid, in accord with the amended by-law, and the Society had received no complaint from any policy holder with respect to the fraternal dividend, the fraternal assessment, or the set-off process. The assessment was not income related to life insurance but was intended entirely for fraternal purposes other than insurance. In any event, the reassessments by the Minister had not claimed the assessments as income in the life insurance activities of the Society. There was nothing artificial, or incomplete, or in the nature of a sham, about the Society's dividend and assessment transactions, they had been completed in accord with the law and for purposes integral to the Society's existence. While they had the effect of reducing the Society's income subject to tax, the Society was free to arrange its affairs in a tax efficient manner.

The defendant raised a number of issues in relation to the reassessment of fraternal dividends, all relating to guidelines set out in Stubart, and for most of them an underlying thesis was that the fraternal dividend and fraternal assessment were so interconnected that they should be considered as interdependent transactions, or virtually a single transaction. I propose to summarize the issues raised by the defendant and to deal with each, in turn. Before doing so it is helpful to set out the guidelines useful in dealing with an issue such as that raised in this case as set out by Mr. Justice Estey in Stubart (at pages 316-17 (D.T.C. 6322-23; S.C.R. 579-80)). While section 245 of the Income Tax Act (or its predecessor then applicable, section 137) was not in issue in Stubart, as it is in this case, these guidelines do make reference to that section. Referring to a situation where the Crown relies on the general pattern of the Income Tax Act and not upon any specific taxing provision, Mr. Justice Estey said:

Nonetheless, some guidelines can be discerned for the guidance of a court faced with this interpretative issue.

1. Where the facts reveal no bona fide business purpose for the transaction, section 137 may be found to be applicable depending upon all the circumstances of the case. It has no application here.

2. In those circumstances where section 137 does not apply, the older rule of strict construction of a taxation statute, as modified by the courts in recent years, (supra), prevails but will not assist the taxpayer where:

(a) the transaction is legally ineffective or incomplete; or

(b) the transaction is a sham within the classical definition.

3. Moreover, the formal validity of the transaction may also be insufficient where:

(a) the setting in the Act of the allowance, deduction or benefit sought to be gained clearly indicates a legislative intent to restrict such benefits to rights accrued prior to the establishment of the arrangement adopted by a taxpayer purely for tax purposes;

(b) the provisions of the Act necessarily relate to an identified business function. This idea has been expressed in articles on the subject in the United States:

The business purpose doctrine is an appropriate tool for testing the tax effectiveness of a transaction, where the language, nature and purposes of the provision of the tax law under construction indicate a function, pattern and design characteristic solely of business transactions.

Jerome R. Hellerstein, “Judicial Approaches to Tax Avoidance”, 1964 Conference Report, p. 66.

(c) "the object and spirit" of the allowance or benefit provision is defeated by the procedures blatantly adopted by the taxpayer to synthesize a loss, delay or other tax saving device, although these actions may not attain the heights of "artificiality" in section 137. This may be illustrated where the taxpayer, in order to qualify for an “allowance” or a “benefit”, takes steps which the terms of the allowance provisions of the Act may, when taken in isolation and read narrowly, be stretched to support. However, when the allowance provision is read in the context of the whole statute, and with the “object and spirit” and purpose of the allowance provision in mind, the accounting result produced by the taxpayer's actions would not, by itself, avail him of the benefit of the allowance.

The defendant's submissions in relation to the fraternal dividends declared by the Society were numerous and detailed, relating to each of the guidelines set out in Stubart. It was argued that subsection 245(1) of the Income Tax Act applied because the deduction here claimed, in relation to those dividends, was in respect of a transaction or transactions that unduly or artificially reduced the Society's income. Counsel referred to jurisprudence defining “unduly” as excessively or unreasonably and defining "artificially" as meaning unnatural, not in accord with normality [7] . Counsel referred to information about tax savings which the transactions were said to permit in a memorandum from the president to the Board and to information to members included in the Society's official publication for members in 1979, to reference in the latter to the transactions having permitted the Society "to retain more than $225,000 which otherwise would have been paid out in additional 1978 taxes”, and to testimony of Lutheran Life's senior vice-president and actuary that calculation of the total provision for fraternal dividends for each year end was made in light of the Society’s anticipated tax liability on income from its life insurance activities. Counsel submitted the amount of tax said to be saved was an indication that the deduction was excessive and unduly reduced the Society's income. Moreover, the transactions for payment of the dividend and recovery of the fraternal assessment were artificial and not in accord with normality in that the plaintiff's surplus from which the dividends were said to be paid was unaffected, that levying the fraternal assessments did not result in a separate account for this purported fraternal income, and the purpose for which it was said to be levied, to construct a fraternal centre, was never initiated. Even if the fraternal dividend were considered by itself, apart from the assessment, the transaction was not in accord with normality and lacked a business purpose, for unlike the Society's normal process of declaring regular dividends, the fraternal dividends were not declared until after the Society's year end at December 31, were declared with the aim of eliminating the plaintiff's tax liability for the past fiscal period, did not result in advice to individual policy holders as was done in the case of regular dividends, and did not result in reducing the plaintiff's surplus profits because of the link between the fraternal assessments and the fraternal dividends.

It seems to me two principles have to be borne in mind in considering these arguments. There is the long standing principle that a taxpayer is free to organize affairs so as to be tax-efficient, i.e., so that the tax is less than it otherwise would be [8] . Here that principle must be considered in relation to a particular taxpayer, a fraternal benefit society which is not taxable in relation to its activities except the carrying on of a life insurance business. The second principle, enunciated by Chief Justice Jackett as he then was, in The Queen v. Alberta Southern Gas Co., [1978] 1 F.C. 454 at 462-63; [1977] C.T.C. 388 at 397; 77 D.T.C. 5244 at 5249 (F.C.A.) in relation to subsection 245(1) is that a transaction within the spirit and purpose of a provision permitting a deduction is not one that can be said to artificially reduce income merely because the taxpayer was influenced to enter into it by tax considerations.

In all the circumstances of this case I find that the declaration of the fraternal dividends, as in the case of regular dividends, was consistent with the business purposes of the Society in returning surplus earnings to its members holding participating life policies, notwithstanding that the timing of the declaration and pay-out of dividends was made differently. It was also, it seems to me, within the spirit and purpose of subparagraphs 138(3)(a)(iii) and (iv) of the Income Tax Act, just as was the annual declaration of regular dividends. Both resulted in annual provisions for payment of dividends in the succeeding year. Nor does the fact that the resolutions concerning fraternal dividends were linked to resolutions levying fraternal assessments result in the dividend transaction being artificial. While the surplus situation of the Society may ultimately have been unchanged, this resulted from replenishment of surplus as a result of the assessment. The timing of the decisions concerning the fraternal dividends, after year end but before the accounts were closed seems to me indicative of no more than prudence, as was the decision not to proceed with construction of the fraternal centre as planned pending the resolution of this matter.

One key circumstance in this case, in my view, was the status of the plaintiff Society. It was not a commercial enterprise in the normal sense; there were no shareholders and it did not operate for commercial gain. It was a fraternal benefit society subject to regulation because it engaged in the insurance business as one of its fraternal purposes; those purposes were to benefit its members and not to derive profit from its fraternal functions, including the writing of insurance policies. That status, coupled with its earnest effort to serve fraternal purposes identified by its Board for the benefit of its members, underlay its decisions to implement fraternal dividends and to levy fraternal assessments. In so doing it acted within the spirit and purpose of subparagraphs 138(3)(a)(iii) and (iv), consistent with its own letters patent, and in so doing it was not acting in a manner that unduly or artificially reduced its income. The amount claimed as a deduction from life insurance income for the fraternal dividend was an amount determined by the Board to be provided for payment from surplus in the following year and in practice was subject to appropriate adjustment in the following year in light of the amount actually paid and credited to the accounts of policyholders. The Society treated these dividends for accounting purposes in the same way as regular dividends. There was nothing, in my view, to make the fraternal dividend transaction artificial.

A second main argument of the defendant was that the transaction here was legally ineffective or incomplete for a variety of reasons, virtually all based on the conception that the resolutions concerning fraternal dividends and fraternal assessments were interdependent and indeed constituted a single transaction. The defendant contended one would not have proceeded without the other, yet the Board failed to establish a separate fund for the assessments and the income from those was simply attributed to the life insurance account of the Society. The process was said to be ineffective because the assessment could not oe set off against the fraternal dividend without the consent of the policyholders, relying upon Thompson v. Big Cities Realty and Agency Co. (1910), 21 O.R. 394 per Riddell, J. at 402 for the proposition that to constitute a payment of a debt a transaction must have the assent of both parties. In my view, the circumstances of Thompson limit the application of the principle here relied upon to circumstances where money alleged to be wrongfully taken is pleaded as payment on promissory notes that give rise to suit. More applicable, in my view, is the decision cited by the plaintiff, Royal Trust Co. v. Molsons Bank (1912), 27 O.L.R. 441 per Falconbridge, C.J.K.B., at 443, which upheld the right of a bank to set off indebtedness due under promissory notes against a depositor's account. Moreover, here there was no objection by any policyholder to the assessments or to their being satisfied from fraternal dividends.

A further argument about the incompleteness of the transaction was related to the nature of the debt, if any were created, owed to policyholders by way of fraternal dividend distribution which was not a specialty debt but an ordinary debt subject to being statute barred after six years. This, it was said, indicated that there had not been any intention to create the possibility of suit by a policyholder to recover the fraternal dividend. In my view, this did not affect the completeness of the dividend transaction either in the case of regular or fraternal dividends, both of which constituted the same form of debt. A somewhat more telling argument presented was that the action of the Board was ultra vires because for existing policyholders their rights arising by contract could not be adversely affected by action of the Board. Under the insurance contract it is provided:

This policy, the application (a copy of which is attached), the instrument of incorporation and bylaws, and all amendments to each thereof, constitute the entire contract. Any changes, additions or amendments to the instrument of incorporation and bylaws made subsequent to the issue date of this policy shall be binding, and shall thereafter govern and control this policy in all respects, except that no such change, addition or amendment shall diminish benefits which the Society contracted to give as of the issue date.

Sample policies also included provision that the policy would share in divisible surplus as determined and apportioned by the Society, with options for the policyholder on how surplus refunds should be received or applied and provision that unless a different option were elected, surplus refunds would be applied, in one sample contract to purchase paid up additional insurance, and in another sample contract to meet premiums payable. In my view this argument fails. The Board was authorized by statute and its own by-laws to declare dividends from surplus, and it clearly had authority to amend its by-laws under its charter and its by-laws. The amendments were incorporated by reference in the contract with the policyholder, and the latter's right to share in surplus refunds expressly provides that right shall be "as determined and apportioned annually by the Society". In the circumstances I am not persuaded that the Board's decisions diminished benefits which the Society contracted to give as of the date of issue of a policy. Rather the fraternal dividend was, in my view, an additional benefit for there was no suggestion that it had reduced or replaced regular dividends or surplus refunds provided annually. Thus, in my view, the Board was not acting beyond its authority, indeed it acted within the authority recognized by statute and provided for in its own Letters Patent and the by-laws of the Society.

A final argument that the transaction was incomplete was that the dividend, meaning a distribution of profits or surplus among policyholders, could not have been distributed because the Society's surplus was left intact. Moreover, the fraternal assessment, with which the fraternal dividend was said to be interdependent, was not levied until the July following the year for which the dividend was provided. Since one stage was not effective in the year in question, the other must also be ineffective. This argument depends upon a determination that the provision for distribution of the fraternal dividend was only part of one transaction, the other part being the levy of the assessment. It ignores evidence that the provision for this dividend was a separate transaction with distribution in the accounts of policyholders and the implications that distribution had for tax liability of those individual holders who on disposition of their policies had an adjusted cost basis subject to tax as a result in part at least of the distribution of fraternal dividends. It also ignores the application of subparagraph 138(3)(a)(iv) which authorizes deduction of dividends to be distributed in the year following the tax year.

My conclusion is that the deduction claimed for fraternal dividends was not legally ineffective or incomplete.

The defendant also argued that the transaction by the Society was a sham in the classical sense. It was urged that no distribution of surplus resulted from the fraternal dividend for the surplus remained the same and the interdependent assessment led to no separate fraternal fund. The defendant urged that there was no intent to affect surplus or to create fraternal funds, and even if there were such intent that was nullified by the decision that the assessments would be paid from the fraternal dividends. Individual policyholders generally received no individual advice about the effect upon their policies of the fraternal dividends except through T-5 slips issued on disposition of a policy, unlike the practice of the Society in relation to regular dividends. This, it was urged demonstrated an intent to conceal the essence of the transaction which was said to be simply to create a bookkeeping entry to reduce taxes. In my view, the latter factors concerning advice to policyholders either in relation to regular dividends or fraternal dividends was not clear from the evidence presented. For example, it is doubtful policyholders would have been aware of the effect of either dividend upon the adjusted cost base of their policies, at least without special calculation, until they made a disposition of their policies which resulted in the issue of T-5 slips. Moreover, the Society was open about the transactions, members were advised through the official publication, Lutheran Life News, of the change in by-laws authorizing them and annually of the resolutions of the Board concerning fraternal assessments and their being levied against fraternal dividends paid.

In all the circumstances 1 do not find any deceit on the part of the Society. As I understand it, without the element of deceit the classical concept of a sham is not properly ascribed to the taxpayer's actions (see Stubart, supra at 313 (D.T.C. 6321; S.C.R. 573)). The transaction here in question, the provision for fraternal dividends, even when considered as related to the fraternal assessment process, was not merely an arrangement to create a bookkeeping entry to reduce the Society's tax otherwise payable. Rather, it was an arrangement undertaken by the Board, representing members of the Society, to further the fraternal purposes other than insurance which were integral aspects of the Society's reason for being.

There is further the necessity for the transaction or transactions to be viewed as a whole, for as the defendant contends it is the substance not the mere form, of the step transaction which must be considered by the Court [9] . As Mr. Justice Estey's last guideline notes, supra, the object and spirit of the allowance or benefit provision in the Act is defeated if procedures blatantly adopted by the taxpayer are determined by the Court to be simply to synthesize a loss or other tax saving device. It is the defendant's contention that the steps here taken by the Society, described as occurring in the order of declaring the fraternal assessment, declaring the fraternal dividend and then offsetting the assessment against the dividend were, viewed as a whole, simply one transaction or a series of transactions to create a bookkeeping entry to reduce income subject to tax and to create income not subject to tax. As for the latter no separate fraternal fund was established, the funds were simply attributed to surplus in the life insurance accounts. Since surplus in those accounts was not diminished there was no fraternal dividend within the meaning of policy dividends under paragraph 138(3)(a) of the Income Tax Act.

I am not persuaded that when considered together the steps adopted by the Society were in substance to synthesize a deduction, to create bookkeeping entries to reduce income for tax purposes. In my view the order in which those steps were taken was dividend, assessment and application or set-off of dividend to satisfy the assessment. Fraternal dividends were credited to the accounts of policyholders. T-5 slips were issued to those with an adjusted cost base gain subject to tax as a result of the dividends and some of those persons were taxable as individuals on the income from that gain. Those dividends were paid from the same surplus funds as the regular dividends. It was not as though the surplus was fictitious or as though the dividend declared reduced it below appropriate levels for solvency in its life insurance operations. As the testimony of an expert, unquestioned in qualification or opinion by the defendant, made clear, the fraternal dividends declared and the formula for their distribution were both based on acceptable actuarial principles and left the insurance funds at levels well above the minimum required for solvency requirements. The fraternal assessment was intended to increase funds for fraternal purposes other than insurance and assessed for those purposes would not ordinarily be considered income from life insurance operations. The application of fraternal dividends paid to the fraternal assessment levied, provided for by decision of the Board, was not unlawful, nor in the absence of any objection from a policyholder can it be said to be contrary to the interests of the policyholder. Each of the steps was acceptable. Together, if the plaintiff's view be upheld, they resulted in a deduction from income otherwise subject to tax, by dividends paid to policyholders, a purpose within the participating life insurance program of the Society, and also they result in income not subject to tax, by assessments paid by policyholders to foster fraternal purposes, a matter clearly within the general purposes of the Society and its members. The latter income if attributed to a separate fund might have raised less concern, now and on a continuing basis, but as indicated earlier in dealing with investment income, there was no legal requirement for the Society to establish separate fund accounting for fraternal activities other than insurance. It chose not to do so, a choice which may have some implications, as we have seen. But that choice does not result in a determination that the assessment did not replenish total surplus of the Society by an amount equivalent to fraternal dividends paid, nor does it result in the determination that the Society's overall surplus position, ultimately unaffected by the series of transactions, negates the payment of the fraternal dividends as policy dividends within subparagraph 138(3)(a)(iv).

I conclude that the step transaction was effected for other legitimate purposes in addition to reducing income otherwise subject to tax. The latter was a legitimate end for the Society to pursue, as it is for any taxpayer, and particularly in view of its exempt status for all but its life insurance business.

The defendant's final argument concerning the validity of the provision for fraternal dividends as a deduction from income earned in the Society's life insurance operations was directed to guideline 3(a) as outlined in Stubart. The argument, to paraphrase that guideline, is that the setting of subparagraphs 138(3)(a)(iii) and (iv) under which the deduction is sought clearly indicates a legislative intent to restrict the deduction to rights accrued prior to the establishment of the arrangement adopted by the taxpayer for tax purposes. Here, it is said, the arrangements adopted by the Society were to revise the rights or obligations from income or earnings already achieved by the taxpayer. They were not adopted with reference to future earnings, but rather at the end of each year, based on income and the tax that would otherwise be payable, dividends were declared merely to revise the income, already earned, that was subject to tax. This was said not to be within the intent of the subsection of the Income Tax Act relied on by the Society.

I am not satisfied that the argument fits neatly within the guideline but in any event, I am not persuaded that declaring provision for fraternal dividends at the end of the year, in light of the Society's operations for the year and including such a provision within the accounts for the year then ended, as is generally permissible in accounting practice, results in the exclusion of that dividend provision from subparagraphs 138(3)(a)(iii) and (iv). The statute does not stipulate when in the course of the year dividends are to be declared if they are to be deductions from income. If regular dividends were to be declared, not in mid-year, but at year-end, I do not think they would be barred from deduction from income under the subsection. Neither, in my view, are the fraternal dividends, additional dividends, declared for the year to be excluded simply because they were declared at a different time than regular dividends were, and after the end of the year but within the year under accepted accounting practice.

I should make explicit what is clearly implicit in my assessment of the defendant's arguments. It seems clear to me that the transaction here in issue is the declaration, provision and ultimate payment of the fraternal dividends viewed as a distinct transaction, apart from the levying of the fraternal assessments. At the risk of repeating, that transaction, the provision for fraternal dividends and their ultimate payment, is what has been disallowed by the Minister's reassessments. This provided for payment of a portion of the surplus in the life insurance accounts. As with regular dividends the fraternal dividends were credited to policy holders' accounts. That is a common act of a life insurance company carrying on a business with participating life policies and as such it has a bona fide business purpose. It was not legally ineffective or incomplete. The powers of Lutheran Life were in place under the law and such action is permitted. In my view, nothing was left undone, the by-laws authorizing the fraternal dividends were in place, the declarations of the dividends were made, notice was given, and the amount was paid out when credited to the accounts of policyholders. There was no deceit in the dividend transaction, it was done openly and with notice to policyholders; it was not a sham.

In the event I am wrong in considering the transaction in issue to be that for the fraternal dividends on its own, I have already considered the possibility that the transaction here in issue is really the three-step process of dividend, assessment and set-off or application of fraternal dividends to meet the fraternal assessment levied. In my view, there are bona fide business purposes served by the whole transaction, i.e., payment of dividends within the purposes of Lutheran Life and receipt of income for fraternal purposes other than life insurance. The set-off of the debts created by the resolutions of the Board were permissible and an efficient way of dealing with the situation. From the absence of objection from any member the process was apparently acceptable to all concerned. The arrangements did reduce tax payable by the Society, but the Income Tax Act itself provides a deduction from income paid out of the life insurance surplus of an insurer to policyholders and it also provides tax exemption for a fraternal benefit society except for its life insurance operations so that income received for purposes other than life insurance is not taxable. In my view, all the Society did was to organize its affairs, fostering its fraternal purposes generally, by taking advantage of arrangements provided for in the Act.

Thus, I conclude on the main argument relating to the fraternal dividend issue that the deductions claimed for provisions made for fraternal dividends in each of the years 1978, 1979 and 1980, subject to appropriate adjustment in each succeeding year in light of the amounts actually paid, were proper deductions from income for tax purposes in accord with subparagraphs 138(3)(a)(iii) and (iv).

As noted early in these Reasons, the defendant advanced alternative arguments at the end of trial, predicated on the assumption that my conclusion might be as just set out—that the fraternal dividend and fraternal assessment and set-off transactions were separate and the dividend transaction was a proper deduction. I propose to deal with those alternate arguments briefly.

Two arguments were raised as alternatives late in the trial by counsel for the defendant. The first was that, assuming the fraternal dividends were found to be an allowable deduction, the fraternal assessments, for a variety of reasons, were properly considered as income from life insurance premiums, classed as income from insurance under paragraph 138(1)(c) of the Income Tax Act™ [10] and should be added back to that income of the Society. Since these were the same in amounts as the deductions claimed the tax was the same and thus the Society's appeal should be disallowed since it is the amount of the tax assessed and not the reasons for it which is subject to appeal [11] .

This alternative argument I am not prepared to accept. There are procedural grounds for rejecting it in my view, related to the lack of reference to it in the pleadings or in the reassessments by the Minister [12] . Moreover, it changes the very basis of the reassessments which make no reference to the fraternal assessments as income from insurance and it negates the basis on which the reassessments were made (see Harris, supra), i.e., that the fraternal dividends were not policy dividends allowable under subparagraph 138(3)(a)(iv). Further, subsection 152(5) of the Act, as it applied to the years in question, precludes the Minister from including amounts in the income of a taxpayer by issuing a reassessment, which would here be required to give effect to this alternative argument, more than four years from the date of the original assessment, which was September 9, 1982 for all three years in this case. Finally, paragraph 138(1)(c), if applicable to fraternal benefit societies, which the plaintiff here disputes, provides for the inclusion in income of an insurance corporation of "every amount received by the corporation under, in consideration of, in respect of or on account of . . . a contract" [of insurance]. Here the fraternal assessments arising by virtue of the by-laws and the resolutions of the Board, were authorized for members by reference in the contract which was both a contract for insurance and for membership in the Society. The assessments were for purposes other than life insurance. I am not persuaded they were received under the contract of insurance, in consideration of, in respect of, or on account of the insurance contract.

The second alternative argument of the defendant was that the fraternal dividends were not policy dividends within the meaning of subparagraphs 138(3)(a)(iii) and (iv). This argument, like the last, is subject to objection on procedural grounds, in light of the pleadings, but I prefer to dispose of it on its merits. If they were dividends paid from fraternal funds, not otherwise identified, the fraternal dividends would not have been taxable in any event since only life insurance income of the Society is taxable. The evidence presented, not countered by any evidence for none was presented by the defendant except through documents admitted, clearly showed that the by-laws and resolutions of the Society specifically provided for the fraternal dividends to be paid out of divisible surplus in the life insurance funds. As I understand the defendant's argument it is that the fraternal dividends and fraternal assessments, interdependent transactions, cancelled one another and the dividends were intended to foster fraternal purposes and not as a distribution of surplus income. Moreover, no separate fraternal fund was established and the surplus in the Society's life insurance account remained undiminished. In these circumstances it was said the fraternal dividend could not be a policy dividend within the meaning of subparagraphs 138(3)(a)(iii) and (iv). In my view this argument is based upon factors similar to those I have not found persuasive in considering whether the fraternal dividend transaction was valid for tax purposes. The argument takes no account of the special nature of the Society or of its tax exempt status for all but its life insurance operations; rather it is based on the perception of the Society as concerned with life insurance, and sickness and accident insurance, in the same manner as a regular commercial insurer operating for profit. And it takes no account of the fact that members to whom the dividends were credited, holders of participating life policies, were affected by the distribution of fraternal dividends in the sense that those who made a policy disposition were subject to tax on any gain in the adjusted cost base of their policies. I am not persuaded that the fraternal dividends do not qualify as po icy dividends within the Income Tax Act as deductible from income in life insurance operations.

Conclusion

I found no reason to disbelieve or to doubt the witnesses for the plaintiff in any material matter to which they testified. They were not contradicted by any witness for the defendant who, as noted, called no witnesses. In cross- examination, the witnesses responded in an open, straight-forward manner, and were not shaken in their views or their recollection of events or the purposes of the Society's actions. The figures involved in the issues between the parties are agreed upon and there are no real differences about facts relevant to the issues, though there are differences about the conclusions to be drawn from them and the legal issues arising from those conclusions. My conclusions have been set out in dealing with each issue. I summarize them here for convenience.

I find no basis to support the Society's claim for the years 1979 and 1980 to deduct investment income from the amount of investment income reported in its financial statements to the Department of Insurance as attributable to its life insurance business. On this matter the plaintiff's appeal from the reassessments by the Minister is dismissed.

On the fraternal dividend issue the appeal of the Society is allowed and the reassessment is referred back to the Minister on my finding that the fraternal dividends declared for the years 1978, 1979 and 1980 are permissible deductions from surplus income of the Society's life insurance business under subparagraphs 138(3)(a)(iii) and (iv), subject to adjustment in each succeeding year in light of the amounts actually credited to policyholders. While the question of the nature of income from fraternal assessments levied in those years was not directly in issue, except as raised by the defendant's arguments which I have not accepted, it is implicit in these reasons that income was not for purposes of life insurance but rather for fraternal purposes other than insurance, and in view of the tax exempt status of the Society on all its activities except life insurance the fraternal assessments are not income subject to tax.

Finally, as noted at the beginning the defendant agreed that the Society's claim to policy reserves greater than those permitted by the Minister's reassessments should be allowed, in amounts stipulated by the defendant for the years 1978,1979 and 1980. These amounts were not further contested in this action.

Thus, the plaintiff's action is allowed and the reassessments are referred back to the Minister to be reconsidered and reassessed in relation to the fraternal dividends claimed and the increased policy reserves conceded, but not in relation to the investment income claimed as a deduction from income in 1979 and 1980. An order goes in relation to each of the actions, one for each of the taxation years in question and a copy of these reasons is filed on each of the three Court files.

On behalf of the plaintiff Society, counsel requested, in written outline of argument, “interest on all amounts paid to Revenue Canada with respect to the reassessments". Interest was not stipulated as a claim in the prayer for relief in the statements of claim and the question of entitlement to interest was not discussed in oral argument. In these circumstances, and since the Income Tax Act includes general provisions for interest to be paid in relation to refunds (subsection 164(3)), a provision that I assume is applicable here if in the result there has been overpayment of tax giving rise to entitlement to refunds, no provision for interest is included in the orders implementing these reasons.

Since on the two main issues argued at trial success is divided between the parties, it seems fitting that no costs should be awarded, rather each party should bear its own costs.

Appeal allowed in part.