Massey-Ferguson Ltd. v. The Queen, 77 DTC 5013, [1977] CTC 6 (FCA)

Urie, J:—This is an appeal from a judgment of the Trial Division dismissing with costs the appeal of the appellant from a decision of the Tax Review Board, wherein the learned trial judge dismissed the appellant’s appeal from a reassessment for income tax for the appellant’s 1967 taxation year. The Notice of Reassessment dated May 30, 1969 revised the appellant’s income for the relevant taxation year to include therein, inter alia, deemed interest income in the sum of $31,956.

The facts leading to the revision are relatively simple and may be summarized as follows:

The appellant is a Canadian resident corporation which is the parent company of a multi-national group engaged primarily in the manufacture and selling of agricultural machinery, construction machinery and diesel engines. During the 1967 taxation year the appellant was the beneficial owner of all of the issued shares of Verity Plow Limited (hereinafter referred to as “Verity”). Verity at all material times was one of three non-operating subsidiary Canadian corporations, its sole function being, according to the evidence, to hold investments in and assist in providing loans to other companies within the Massey- Ferguson group.

Verity throughout the same taxation year held all the outstanding shares of Perkins Engines Inc (hereinafter referred to as ‘‘Perkins’’), a company duly incorporated pursuant to the laws of the State of Maryland in the United States of America and having its head office in Farmington, Michigan. Perkins was at all material times engaged in the business of selling and servicing diesel engines, manufactured by another subsidiary of the appellant. Verity had in 1960 acquired the shares of Perkins with funds provided by the appellant. The appellant’s books of account in 1967 showed the loan to Verity for the purchase of the shares and the books of account of Verity reflected the loan from the appellant for the acquisition of the shares.

Perkins in 1967 found itself in need of additional working capital and it was ultimately determined by certain officers of the appellant that Perkins should be provided with the needed funds in the amount of $1,000,000 (US) interest-free by the appellant’s providing the funds necessary for the loan to Verity.

The sole issue in the case is to determine whether or not the appellant loaned the $1,000,000 to Verity following which Verity loaned those funds to Perkins or whether the loan was made directly by the appellant to Perkins. The importance of determining how the loan was made arises by reason of subsections 19(1) and 19(3) of the Income Tax Act which in 1967 read as follows:

19. (1) Where a corporation resident in Canada has loaned money to a non-resident person and the loan has remained outstanding for one year or longer without interest at a reasonable rate having been included in computing the lender’s income, interest thereon, computed at 5% per annum for the taxation year or part of the year during which the loan was outstanding, shall, for the purpose of computing the lender’s income, be deemed to have been received by the lender on the last day of each taxation year during all or part of which the loan has been outstanding.

(3) Subsection (1) does not apply if the loan was made to a subsidiary controlled corporation and it is established that the money that was loaned was used in the subsidiary corporation’s business for the purpose of gaining or producing income.

The appellant takes the position that all the evidence points to the fact that it was the appellant’s intention to loan the money to Verity and to cause Verity to loan the money to Perkins, and that, in fact, that intention was carried out. The loan was not a direct one from the appellant to Perkins but was, rather, a loan by it to its wholly- owned Canadian resident subsidiary, Verity, so that subsection 19(1) limited as it is to loans by a resident Canadian corporation to a nonresident person, including, of course, a corporation, had no application to the transaction. If that is the case the inclusion of the deemed interest in the Notice of Reassessment was in error and the reassessment should be set aside. On the other hand, the respondent supports the judgment of the trial judge wherein he held that the real transaction was a loan from the appellant to Perkins which while it was a nonresident corporation, was not a subsidiary controlled corporation, within the definition of that term as set out in paragraph 139(1)(aq) of the Act, of the appellant, so that subsection 19(3) could not apply to remove the transaction from the purview of subsection 19(1). In the respondent’s view, therefore, the reassessment was correct and should Stand.

Before proceeding with consideration of the relevant facts, it should, perhaps, be pointed out that the evidence is clear that Perkins received the proceeds of the loan from the New York agency of the Canadian Imperial Bank of Commerce which had been directed by the appellant to transfer the money to Perkins, debiting the appellant’s account in the City of New York. There were recorded in the appellant’s accounting records on or about the time the advance was made, entries showing a loan to Verity on March 29, 1967 in the amount of $1,000,000 (US). Verity’s accounts, which were approved by the directors and shareholders of Verity, showed receipt of the proceeds of the loan, a liability therefor to the appellant, and the making of a loan in the same amount to Perkins on the same date. Perkins’ financial reports to the appellant show its liability to Verity for the loan. Subsequently, in 1969 when the appellant purchased from Verity all of its shares of Perkins, Perkins’ indebtedness to Verity was assigned by the latter to the appellant. It was conceded by the respondent that the proceeds of the loan were used by Perkins for the purpose of gaining Or producing income.

The evidence, however, shows that Verity was not a company, actively engaged commercially or industrially, its sole function being to hold shares in and make advances to other companies in the group controlled by the appellant. Verity did not have any employees apart from those employed by the appellant. Employees of the appellant served as directors of Verity and any work necessary to carry out its functions were performed by employees of the appellant. Neither did Verity have a bank account of its own.

The learned trial judge reviewed the evidence and came to the following conclusion with respect to the first branch of the appellant’s submissions [p 676]:

It is well established that, in considering whether a particular transaction brings a party within the terms of the Income Tax Act its substance rather than its form is to be regarded, and also that the intention with which a transaction is entered into is an important matter under the Act and the whole sum of the relevant circumstances must be taken into account.

On the whole of the relevant circumstances here present, I am satisfied that it was clearly the plaintiff’s intention to lend the $1 million directly to Perkins. Verity played very little part in the transaction except in a nominal way. There was no legitimate business purpose for involving Verity. The only reason, and Mr Sherman was quite frank in admitting this, was in an attempt to keep the transaction outside subsection 19(1). I have thus concluded that the substance of subject transaction, notwithstanding the form thereof, was a loan from the plaintiff to Perkins, a non-resident corporation, so as to make applicable the provisions of subsection 19(1) of the Act.

There can be no doubt that the general principles applicable in determining liability for income tax under the Income Tax Act were correctly stated by the learned trial judge. However, in my view, in applying those principles to the facts adduced in evidence, he did not draw the proper inferences therefrom in holding, firstly, that it was the appellant’s intention to lend $1,000,000, interest-free, direct to Perkins; secondly, that there was no legitimate business purpose for involving Verity, and thirdly, that notwithstanding its form the substance of the transaction was a loan from the appellant to Perkins.

I shall deal with the first and third of these findings together for the sake of convenience. It should first be observed, I think, that what is at issue here involves the interpretation on the one hand of an agreement to lend money and, on the other hand, an agreement to borrow that money and to repay it. Speaking generally, an agreement whether formally documented or evidenced in some other fashion, is not enforceable unless the parties evince an intention to create legal relations.* [1] Where there is a formal contract, it would be unusual to find that there was no intention to create such legal relation but where, as in this case, there is no formal contract, regard must be had to all of the evidence to ascertain whether or not the parties intended such relations to be created and whether or not they were successful in doing so.

In this case there was no formal agreement setting forth the terms of an agreement to lend money either to Verity or to Perkins. However, the appellant adduced evidence of conversations, letters, memoranda, accounting records, financial statements and corporate minutes with a view to establishing the nature of the agreement between the parties involved. There can be no doubt that this evidence establishes that Originally it was contemplated that the $1,000,000 loan was to be made by the appellant to Perkins. However, it is equally without question that the transaction as originally contemplated changed at the moment that the appellant’s general tax manager at the material time, Mr Sherman, met with its treasurer, Mr Blair and the latter’s assistant, Mr Wleugel, for the purpose of advising the latter on the tax implications of the proposed loan by the appellant to Perkins. At that meeting, Mr Sherman gave the advice contained in the following excerpt from his testimony:

Q. Mr Sherman, the second paragraph of the letter contains one sentence: “As agreed with you and Mr Sherman, we will proceed as follows.’’ Was there a meeting prior to the sending of this memo? A. Yes, there was a meeting with Mr Blair and Mr Wleugel and myself and at that meeting I was asked to fulfil my responsibilities and I pointed out, as my colleagues knew, that Perkins Inc, was not a subsidiary of Limited and that, if a loan was made free of interest, as was contemplated directly by Massey-Ferguson Limited to Perkins Inc, there was some doubt about whether it would fall within the exemption provided within section 19(3) because it was a subsidiary. Consequently, I recommended to remove the doubt that loan should be made by Verity Plow and these gentlemen, who were both officers of both companies, accepted my recommendation and it was agreed and then documented by Mr Wleugel who signed this memo to the effect that the loan was to be made to Perkins by Verity or, as Massey-Ferguson shorthand has it in this memorandum, “via Verity’’.

From that moment on, it can be seen that the original proposal changed and the intention became for the appellant to loan $1,000,000 interest-free to Verity, one of its resident Canadian subsidiaries and for Verity to lend that sum to Perkins. All the documentation leads to that conclusion, commencing with the memorandum dated February 27, 1967, to which Mr Sherman referred in his testimony, the relevant part of which reads as follows:

Agrotrac via CIBC is presently lending Perkins Engines Inc, $300,000 at 6% per annum interest. It has been decided to provide Perkins US with an additional loan of $700,000 and Perkins Canada a loan of $250,000—both of medium term character.

As agreed with you and Mr Sherman, we will proceed as follows:

1.) MF Limited will lend Perkins USA, US $1,000,000 via Verity Plow at no interest charge on March 26, 1967.

3.) Perkins Inc will, upon receipt of the loan, repay CIBC’s loan of $300,000 in full (plus accrued interest).

At least to some extent, the difficulty in which the appellant finds itself, which has led to these proceedings, was caused by the imprecise language used in this underlying memorandum. In particular, the phrase “via Verity’’ seems to indicate that Verity’s role was indeed minor in the transaction and that the phrase “MF Limited will lend to Perkins . . .” shows the true nature of the transaction. But, the term “via’’ was used, as Mr Sherman testified, as “Massey-Ferguson shorthand” to show the routing of the loans. This memorandum seems to confirm that this is so since it was used not only to indicate the way the new loan to Perkins was to be made, but also to show how an existing loan by Perkins from the Canadian Imperial Bank of Commerce had originated from Agrotrac, a Panamanian subsidiary of the appellant. The evidence discloses that the $300,000 original loan had been derived from funds “loaned” to the bank by Agrotrac and the bank had in turn loaned the same amount to Perkins. That is the loan from “Agrotrac via CIBC”’ as described in the memorandum. It seems to me then, that the meaning of the term is explained in the document itself and tends to support the appellant’s contention that while it provided the original source of the money for the $1,000,000 loan it was not intended that it would be the lender thereof to Perkins.

Other letters and memoranda adduced in evidence also tend to confirm this intention. No useful purpose would be served by my detailing that evidence nor to set out in detail the accounting and other records of the appellant, of Verity and of Perkins which reflect the carrying out of this intention. Suffice it to say that a fair reading of the whole leads inevitably to the conclusion that the parties intended to create, and did, in fact, create firstly a creditor-debtor relationship between the appellant and Verity and secondly, a creditordebtor relationship between Verity and Perkins.

Thus the real question requiring determination in this appeal is whether or not those relationships and the legal rights and obligations arising therefrom were adversely affected for the purpose of deciding the applicability of subsection 19(1) of the Income Tax Act, because

(a) the admitted reason for Verity making the loan was to avoid the application of subsection 19(1) to the transaction; (b) the proceeds of the loan were paid directly to the ultimate borrower, Perkins, rather than by Verity, and (c) no formal documentation, other than the aforementioned book entries, was prepared as evidence of the loan. With the greatest respect for the contrary opinion of the learned trial judge, neither the relationships nor the rights and liabilities were thus adversely affected by any of the alleged defects.

The whole development of commercial law over the centuries is replete with examples of the courts recognizing that businessmen do not always depend on expert documentation to prove the true characterization of their transactions. Rather, they tend to achieve their desired ends, particularly when the relationships between them are close, in informal and expeditious ways which perhaps are abhorrent to lawyers. In doing so they run the risks inherent in such a practice of determining their respective rights. Frequently no difficulties ensue, but if they do, in the absence of contracts or other documents, courts must determine the intention of the parties and the nature of the obligations imposed on them by reference to credible evidence of another kind. That is what is required of the Court in this case and the inference I draw from the facts as found by the trial judge is that enforceable legal rights and obligations were created by the advance of the money by the appellant. Where those rights and Obligations lie must be ascertained from the evidence. That clearly discloses that there was imposed on Perkins the liability to repay to Verity the money it received directly from the appellant. Similarly, Verity, another separate legal entity, at some unspecified date became liable to repay the money advanced to it by the appellant, although that money never actually came into its possession. On the evidence, the appellant had no creditor-debtor relationship with Perkins and thus had no right to demand repayment of $1,000,000 from Perkins but it did have that right as against Verity. If that is the case then, it seems to me, not only is the form of the initial part of the transaction a loan by the appellant to Verity but that also is the substance of the transaction. I think, therefore, that the learned trial judge erred when he inferred from the facts as he found them that, in substance, the transaction was a loan by the appellant to Perkins.

In so far as the finding of the judge that there was no legitimate business purpose for involving Verity in the transaction is concerned, I must again respectfully disagree with him. Since this is an inference to be drawn from ascertained facts I think that this Court is, as is any court of appeal in such circumstances, entitled to substitute its view for that of the trial judge. I believe that for the reasons that follow, we are in a position to make such a substitution.

Verity had been incorporated in 1957 apparently as a successor to a long-time subsidiary of the appellant, for the purpose of holding investments in and making loans to other companies in the Massey- Ferguson group. Mr Sherman described these activities in evidence as follows:

MR MCDOUGALL: Q. Can you describe the type of business carried on by Verity Plow and its predecessor since 1957? A. Yes. I should perhaps explain that the books of the company in the early days were not easy to locate, so I was forced to have recourse to the minute book, and I had one of my colleagues prepare a brief summary for my information of the transactions referred to in the minute book and the transactions essentially involved the acquisition and disposal of investments in other Massey-Ferguson companies, the making of loans to other Massey-Ferguson companies and the repayment of loans.

Q. I show you a document entitled “Material from Minute Book’’. Is that [the] summary to which you referred? A. Yes.

Q. Mr Sherman, I interrupted you to put that Exhibit to you, so perhaps you might continue with your description of the type of transactions carried on by Verity Plow Limited in the period to which I referred, having reference to Exhibit 3? A. Yes. They involved, as I already mentioned, the type of transaction which is in the interests of the Massey-Ferguson group of companies. They involved the acquisition of shares, disposal of shares and making of loans and the repayment of loans. Perhaps I could mention, since loans are involved, that there is a reference to 25 million Argentine peso being loaned to an Argentine subsidiary wholly-owned by Massey Ferguson. . . .

Q. Where do you see that? A. Second item on page 2, June, 1961. I think that that really is a summary of what they have done. There is a reference in April of 1969 to Perkins Engines Inc.

Q. All right. What is the purpose, or what is Limited’s purpose in having nonoperating companies, as you have referred to them? A. At the time when these companies were carrying on these transactions from 1957 to approximately 1969 or ’70, they had a very necessary—they served a very necessary purpose. Massey-Ferguson Limited at that time had borrowed some money secured by an indenture and this indenture provided that, once Massey- Ferguson Limited had acquired the shares in any other company, these shares were locked in. They were owned by Limited and could not be disposed of without the prior concurrence of the bond holders. This made operating difficult, made it difficult to make business transactions without a delay while the management of the company approached the bond holders and got the necessary approvals. So, from the time that this indenture was entered into, Massey-Ferguson Limited followed the practice of having its subsidiary companies, primarily Bain Wagon and Verity Plow, acquire these subsidiary shares and hold them. This was not in any way forbidden by the terms of the trust indenture and it was in order perfectly then, if there were any need to move the ownership of these shares to another company to do so without any delay caused by having to approach the bond holders. There was a second purpose, and that is that, in many jurisdictions there has to be more than one shareholder so that when Massey-Ferguson Limited acquired effective control of the shares of a subsidiary company, this was normally handled by having all but one to five shares owned by Massey- Ferguson Limited and then the subsidiary companies would each acquire one share, so as to make them shareholders in the corporation.

This evidence is uncontradicted and certainly demonstrates that there were, in 1967, valid business reasons for Verity’s continued existence, not the least important of which, for the purpose of deciding the issue in this case, was that of loaning money to its subsidiaries. Moreover, on the basis of other evidence, there is no question of the necessity for placing in the Perkins treasury further funds to meet its working capital requirements. It was conceded by the respondent that the borrowed money was used for that purpose.

Thus, the legitimacy for the existence of Verity cannot be an issue. Its holding of all of the outstanding shares of Perkins was part of the reason for its existence and the loan of money to Perkins was a legitimate part of its business of lending money to other Massey- Ferguson subsidiaries. However, the learned trial judge, despite these facts, concluded that the only purpose for interposing Verity in the transaction was “in an attempt to keep the transaction outside of subsection 19(1)’’. He was of the opinion, further, that the intervention of Verity was a sham.

I am unable, with respect, to agree with this view of the transaction. As I have said, the evidence discloses that one of the reasons that Verity was in business was to lend money to Massey-Ferguson subsidiaries and there is some evidence derived from its financial statements to show that it did so, not only in the case at bar, but also in other cases. The money for such purpose was acquired, in other cases, as well as in this, by borrowing from Verity’s parent, the appellant. Neither the existence of the corporate entity, nor the business in which it was engaged was in any way a sham.

That being so, was something done in the case at bar which made the loan transaction a sham as the trial judge has found? In general, it may be stated that if there are two ways in which a transaction may be carried out, one of which involves a liability for the payment of tax, and the other of which results in a reduction or elimination of such a liability, then, if the transaction is otherwise a bona fide commercial one, there is no reason for not adopting the tax-saving method. That principle is stated succinctly in Inland Revenue Commissioners v Brebner, [1967] 1 All ER 779 by Lord Upjohn at page 784, as follows:

My lords, I would conclude my judgment by saying only that, when the questions of carrying out a genuine commercial transaction, as this was, is considered, the fact that there are two ways of carrying it out,—one by paying the maximum amount of tax, the other by paying no, or much less, tax— it would be quite wrong as a necessary consequence to draw the inference that in adopting the latter course one of the main objects is for the purposes of the section, avoidance of tax. No commercial man in his senses is going to carry out commercial transactions except on the footing of paying the smallest amount of tax involved.

In this case the appellant adopted a method of lending money for bona fide purposes in a manner which obviated the risk of having included in its income deemed interest on the loan, which if it had been included, would have increased its taxable income. To do so did not, in my view, make the transaction a sham. Support is found for this view, in the well-known passage from the judgment of Lord Diplock in Snook v London & West Riding Investments, Ltd, [1967] 1 All ER 518 at 528, reading as follows:

As regards the contention of the plaintiff that the transactions between himself, Auto-Finance, Ltd and the defendants were a “sham”, it is, I think, necessary to consider what, if any, legal concept is involved in the use of this popular and pejorative word. I apprehend that, if it has any meaning in law, it means acts done or documents executed by the parties to the “sham” which are intended by them to give to third parties or to the court the appearance of creating between the parties legal rights and obligations different from the actual legal rights and obligations (if any) which the parties intend to create. One thing I think, however, is clear in legal principle, morality and the authorities (see Yorkshire Railway Wagon Co v Maclure [(1882), 21 Ch D 309], Stoneleigh Finance, Ltd v Phillips [[1965] 1 Ail ER 513; [1965] 2 QB 537]), that for acts or documents to be a “sham”, with whatever legal consequences follow from this, all the parties thereto must have a common intention that the acts or documents are not to create the legal rights and obligations which they give the appearance of creating.* [2]

The legal rights and obligations to which I have earlier referred were created in this case in the manner contemplated by all three parties. The condition necessary to find a transaction to be a sham, namely, not in fact to have created the legal rights and obligations which appear to have been created, thus was not present, with the result that the learned trial judge erred, in my view, in finding that it was a sham. The legal rights and obligations having been created and the bona tides of Perkins’ need for the money advanced not having been challenged, the loan to Verity by the appellant took it outside the purview of subsection 19(1).

As I see it, reaching this conclusion is not inconsistent with the decision of this Court in MNR v Anthony Thomas Leon, [1976] CTC 532; 76 DIC 6299. In that case it was held that there was no bona fide business purpose, merely a tax purpose for the interposition of the management company whose role was at issue in that case. Moreover, it was said that in ascertaining whether or not there is a bona fide business purpose it is the particular agreement or transaction in question to which the Court must look for the answer. In the view of the Court in the Leon case, a company may be incorporated for legitimate business purposes but may engage in a transaction at some time thereafter which has no such purpose and which is a sham because of it. In the Leon case that was what the transaction there in issue was found to be.

I am not at all sure that I would have agreed with the broad principles relating to a finding of sham as enunciated in that case, and I think that the principle so stated should perhaps be confined to the facts of that case. In any event, for the reasons heretofore given, I do not think that there was the slightest bit of evidence upon which a finding of sham could have been made in this case.

Moreover, the facts in this case in other critical areas are so different from those found in Leon that it is, in my view, distinguishable. Verity had been incorporated and carried on business for sound reasons. For apparently quite proper purposes, Verity became the owner of all of the issued shares of Perkins. Both were part of the large group of Massey-Ferguson companies. Long afterwards, Perkins informed the appellant of its need of additional working capital and when it was satisfied that there was truly such a need, discussions ensued as to how this best could be legally accomplished. There were two ways at least in which it could be done, in one of which there was an inherent risk of attracting tax, ie by making the interest-free loan directly from the appellent to Perkins, where, if the latter were found not to be a “subsidiary wholly-owned corporation” of the appellant within the meaning of paragraph 139(1)(aq) of the Act, that risk could be transposed into an actual tax liability under subsection 19(1). The other method eliminated that risk by having Verity lend the money since Perkins was its “subsidiary wholly-owned corporation” and, the latter being a non-resident corporation, subsection 19(3) became applicable to the loan. That was the method chosen after the business decision to loan the money to Perkins had been made, following which, in due course, the debtor rights and obligations came into existence.

If no question of tax were involved, not the slightest criticism could have been levelled against any of the parties concerned. It was simply a question of a parent company, Verity, borrowing money for the purpose of lending it to its wholly-owned subsidiary.

Contrast this with the factual situation in the Leon case. As I understand it, the sole purpose for the interposition of the management companies, as held in the concurrent findings of the trial judge and the Court of Appeal, was to reduce the personal liability for income tax of the brothers Leon, by diverting money otherwise payable directly to them for management services, through companies individually controlled by each of them. That decision was consciously made for no other purpose than avoidance of tax and differs in that way materially from this case where the decision taken was to make a necessary loan to a member of a large group of companies, followed by the decision as to which company would lend the money. The incidental effect of the choice made was to eliminate the risk of an increase in the appellant’s taxable income—in my view, a sound business decision. But the important thing is that the underlying decision was not a decision taken solely for tax considerations. That business decision having been made, the method whereby it was made took advantage of the fact that Perkins belonged to Verity, that Verity, inter alia, loaned money to subsidiaries and that its own subsidiary was the entity which needed money. Since the result could avoid the possible application of subsection 19(1), naturally this was the method adopted.

For all of these reasons, therefore, I am of the opinion that the appeal should be allowed. It is thus unnecessary for me to deal with the appellant’s other submissions.

The judgment of the Trial Division should be set aside and the reassessment should be referred back to the respondent to exclude therefrom the deemed interest income in the taxation year 1967, in the sum of $31,956. The appellant should be entitled to its costs both in this Court and the Trial Division.

LeDain, J:—I agree.

MacKay, DJ:—I agree.