Stubart Investments Ltd. v. The Queen, 84 DTC 6305, [1984] CTC 294, [1984] 1 SCR 536

Estey, J:—The issue in this case is whether a corporate taxpayer, with the avowed purpose of reducing its taxes, can establish an arrangement whereby future profits are routed through a sister subsidiary in order to avail itself of the latter corporation’s loss carry-forward.

The facts are, for a tax proceeding, quite straightforward. The holding company, Finlayson Enterprises Limited, referred to for convenience hereafter as the “parent company’’, incorporated the appellant in 1951. In 1962, the appellant purchased the assets of Stuart Brothers Company Limited which carried on the business of manufacturing and selling food flavourings and related products (sometimes for brevity referred to as “the business’’). The appellant, at the time of this purchase, changed its original name to Stuart Brothers Limited in order to take advantage of the value of that name and the associated goodwill in the market. In 1969, the appellant again changed its name to the present name, Stubart Investments Limited.

The parent company, amongst its other subsidiaries, owned all of the shares of Grover Cast Stone Company Limited (hereinafter referred to as “Grover”) which carried on the business of manufacturing and selling precast concrete products. By 1965, Grover had incurred substantial losses which were recognized as losses under the Income Tax Act SC 1970-71-72, c 63, as amended, for the purpose of the carry-forward provisions under the Act. In 1966, the tax advisers of the parent company established a plan whereby the assets of the appellant would be sold to Grover with effect January 1, 1966. Concurrent with the agreement of purchase and sale of these assets, Grover would appoint, by a separate agreement, the appellant as its agent to carry on the business for and to the account of Grover.

The contract of purchase and sale of the assets and business of the appellant to Grover was completed by the registration, pursuant to the laws of the province of Quebec, of a transfer of the real estate in the city of Montreal; registration of trade mark assignments in the Trade Marks Office in Ottawa; registration of a registered user agreement in Ottawa whereby Grover appointed the appellant as the registered user of the trade marks purchased by Grover from the appellant; registration of a debenture given by Grover to the appellant as security for the unpaid purchase price for the assets so purchased and sold; amendment of the Letters Patent of Grover under the laws of the province of Quebec so as to authorize and qualify Grover as purchaser of these assets to perform the contract of purchase; registration under the laws of the province of Quebec of a Trust Deed of Hypothec, Mortgage and Pledge in favour of Canada Permanent Trust Company whereunder the latter company issued a debenture secured against Grover’s Quebec assets, including real estate; passage of a resolution by the Board of Directors of Grover authorizing the guaranty by Gover of the parent company’s indebtedness to the Bank of Nova Scotia in the amount of one million dollars, which indebtedness had formerly been guaranteed by the appellant under a debenture charging the assets of the appellant; the issue by Grover of a debenture in favour of the Bank of Nova Scotia in replacement of the debenture theretofore issued by the appellant and held by the said bank (all of which documents were registered in appropriate public registry offices in the province of Quebec); and by establishing in the appellant’s records a separate set of books and accounts in which were recorded the entries relating to the conduct of the business thereafter carried on by the appellant for the account of Grover.

After this agreement of purchase and sale had been so performed and closed, the appellant proceeded to carry on the business on behalf of Grover, and at the end of each of the fiscal years 1966, 1967 and 1968, the appellant paid over to Grover the net income realized from the business. Grover, in turn, reported this income under the Income Tax Act in its corporate income tax returns for these three years. The Department of National Revenue subsequently reassessed the appellant, setting aside the entry transferring the net income to Grover, and charging such net income back to the taxable income of the appellant. It is from these assessments that this appeal was taken.

The Tax Appeal Board rejected the appeal on the ground that the transaction in question was a sham. It would appear that the Tax Appeal Board (as it was then named) reached this conclusion largely because (in the words of then Chairman, His Honour Judge KA Flanigan):

. . . In the Finlayson group of companies there were sufficient common directors and officers in Stuart Brothers Limited and in Grover to reverse those overt acts at any time that it suited them.

The Trial Division of the Federal Court dismissed the appeal because testimony tendered on behalf of the appellant revealed that:

When the tax loss on Grover has been fully utilized the business carried on by Stuart Brothers will be sold by Grover to Stuart Brothers.

Grant, DJ considered this to be ‘‘an obligation on the part of Grover to reconvey the assets to Stubart [the appellant] when the Grover tax loss had been absorbed . . .”.

The Federal Court of Appeal dismissed the appeal by the appellant on the basis that the sale between the appellant and Grover was incomplete. The Court found it unnecessary to determine that the transaction was a sham. Indeed, the Court, speaking through Urie, J, stated, with reference to the avowed purpose of the transaction:

It was admitted that the transactions were entered into for the purpose of utilizing the tax losses accumulated by Grover. That in itself is not a reprehensible, let alone an illegal act, since every person is entitled to organize his affairs in such a manner as to minimize or eliminate taxes so long as he does so within the limitations imposed by the aw.

In the view of the Federal Court of Appeal, however, the transaction was incomplete because no part of the inter-company purchase price was referable to goodwill; the three licences required to carry on the business under the Excise Tax Act, RSC 1952, c 99, remained in the name of the vendor, the appellant; the information returns filed under the Corporations Information Act, RSO 1960, c 72, as amended, by Grover described its business as “the manufacture and sale of precast concrete products’’ without mention of the food flavouring business; the vendor-appellant continued to show its name on the business premises where the business was carried on; the appellant continued to pay water services and business taxes with reference to those premises; the appellant filed T-4 slips with the Department of National Revenue for the employees of the business; and no notice was sent out to trade creditors, lessors, employees, customers and suppliers of the change of ownership in this business. In relying upon one of its earlier decisions, the Court considered its obligation:

. . . to ensure that everything which appears to have been done, in fact, has been done in accordance with applicable law . . . If the transaction can withstand that scrutiny, then it will, of course, be supported. If it cannot, it will fall. That is what happened here. (Per Urie, J in Atinco Paper Products Ltd v The Queen, [1978] CTC 566 at 577-8.)

The Court then concluded that the appellant had failed to “show that the transaction was in all respects a complete, real transaction”.

No section of the Act was isolated by the Attorney General of Canada as clearly authorizing the assessments which gave rise to these proceedings. Assuming for the moment there is no sham, the respondent asks the Court to find, without express statutory basis, that no transaction is valid in the income tax computation process that has not been entered into by the taxpayer for a valid business purpose. The respondent asserts that by definition, an independent business purpose does not include tax reduction for its own sake.

The Attorney General of Canada submits that, in any case, the Federal Court of Appeal was correct in holding that the purported transfer was incomplete and can thus be disregarded for tax purposes as an ineffectual transaction. The principal authorities upon which the Department relies for this latter proposition are Atinco, supra, and Rose v MNR, [1973] FC 65; [1973] CTC 74; 73 DTC 5083.

In 1951, the Act was amended to prohibit the consolidation of separate corporate operations in reporting income under the Income Tax Act, supra. The result of this amendment was that a corporate proprietor carrying on business through more than one corporate vehicle loses the right an individual proprietor enjoys of blending profitable and unprofitable operations so as to pay income tax only on the resultant net income. After 1951 management of a corporate group could not directly merge, blend or meld the operations in two or more subsidiary corporations for the purpose of reducing the tax payable by the corporate group as a whole. In contrast, an individual proprietor with an equally diverse commercial undertaking can do so because only one taxable entity is involved.

The simple question, therefore, is whether a corporate group can avail itself of a tax loss in one of the family subsidiaries by rerouting the income from another corporate member into that subsidiary. Clearly, the corporation can do so by buying assets from any business, corporate or unincorporate, and putting these profit-generating assets into a company with an accepted loss position. The purchase of the shares of another company which has a loss carry-forward might prevent its utilization by the purchaser. With that we are not here concerned. If the taxpayer can expand an existing business to create earnings to make use of a loss carry-forward, then one must find some prohibition in the Act to say that the purchase of such additional assets may not come through a non-arm’s length transaction; apart from section 137 which has not been relied upon by the respondent here. To this consideration I will return.

The main issue is already set forth, but there are two subsidiary issues.

1. A sham transaction: This expression comes to us from decisions in the United Kingdom, and it has been generally taken to mean (but not without ambiguity) a transaction conducted with an element of deceit so as to create an illusion calculated to lead the tax collector away from the taxpayer or the true nature of the transaction; or, simple deception whereby the taxpayer creates a facade of reality quite different from the disguised reality. The Court of Appeal here found it unnecessary to determine whether or not the transaction was a sham. The Court also found that the taxpayer announced its purpose from the outset, entered into legally binding contracts of implementation, registered several closing documents in public registries in the provincial registries of Ontario and Quebec, and in federal registries in Ottawa, and entered into an enforceable security arrangement between Grover and the Bank of Nova Scotia. It was further determined by the Court of Appeal that every step required to create legally binding relationships with reference to transfer of the corporate assets of the appellant, including its trade marks, and to the retirement of its indebtedness to the Bank of Nova Scotia, was taken by the appellant. Grover, it was found, had performed all essential acts to place absolute beneficial ownership of the assets in Grover, including trade marks, and Grover did everything necessary to assume the indebtedness of the appellant to the Bank of Nova Scotia. The Court of Appeal found no element of deceit present.

2. The application of section 137 of the Income Tax Act, supra, (section 245 in the new Act): This is an anti-tax avoidance section which states that no “disbursement” which “artificially” reduces the income of a taxpayer shall be taken into account in determining tax liability. The section provides in part as follows:

Artificial transactions.

In computing income for the purposes of this Act, no deduction may be made in respect of a disbursement or expense made or incurred in respect of a transaction or operation that, if allowed, would unduly or artificially reduce the income.

While it is at least arguable that this section covers the “disbursement” by the appellant of the profits earned for the account of Grover in the operation of the business, the Attorney General of Canada expressly, in response to a question from the Court during the hearing of the appeal, said that the Crown was not relying upon section 137. Clearly the cheque transferring the profit from the appellant to Grover at the end of the year is a disbursement, and it is a disbursement the deduction of which leaves no taxable income in the appellant from the business. The Crown does not advance this argument in this appeal presumably in the hope that the tax liability of the appellant will be founded on the “genuine business purpose” principle or the “abuse of rights” principle which are said to form part of the taxation principles in the laws of the United Kingdom and the United States and elsewhere, and which the respondent submits are equally applicable in the interpretation of the Income Tax Act of Canada, supra.

Returning then to the main issues in this appeal, the respondent asserts the right to tax here on two bases:

A. The transfer is, in any event, incomplete, and therefore should be disregarded and the transferor and transferee taxed according to their respective positions as though this transaction had not taken place;

B. Canadian cases have already established the principle recently stated in the United Kingdom in Ramsay v Inland Revenue Commissioners, infra, in Commissioners of Inland Revenue v Burmah Oil Company, infra, and in Furniss (Inspector of Taxes) Appellant v Dawson, et al., infra, namely, that a transaction without a valid business purpose is not to be taken into account in the computation of liability for tax under the ITA.

A. Incomplete Transaction

It is acknowledged that the transferor, the appellant, and the transferee, Grover, completed thirty legal steps in the transfer of the business to Grover. These included the contract of purchase and sale, the implementing documentation all of which has been enumerated above. The purchase price for the business was paid by the assumption by Grover of the secured indebtedness of the appellant to the Bank and by the issuance of secured notes. The respondent did not question the appellant’s assertion that the Bank of Nova Scotia, on the default of Grover, would have had the clear right in law to recover from the transferred assets the unpaid balance of the debt assumed by Grover on the purchase of the business from the appellant.

Nevertheless, the Crown says that the following matters were not attended to in relation to the transfer of assets between the parties to the contract and that, therefore, the contract of purchase and sale was not completed:

(i) In filing its annual return for the years 1966 to 1968 under the Corporations Information Act, supra, that is, in the years after the sale, Grover answered the question: “Generally the undertaking that the corporation is actually carrying on’’, as follows: “manufacture and sales of precast concrete products”. No mention is there made of the business of the appellant which had been acquired by Grover. It is, of course, at least arguable that the question invited the answer given because, by a contract with the appellant entered into at the time of the purchase of the assets and referred to by all parties as the “nominee agreement”, Grover had appointed the appellant as its agent to carry on the business in trust for and to the account of Grover. The appellant stated in answer to the same question that its business was the “manufacture and sale of essential flavourings and oils”. In filing its income tax return for the same years, Grover completed the tax form as follows: “Nature of business — manufacture of Pre-cast Concrete Products and Food Flavours”. Both forms appear to have been correctly completed by both companies, and nothing misleading or incomplete results therefrom. In any event, this step has nothing to do with the implementation of the agreement of purchase and sale, and not by the remotest argument could it be said to have reversed the closing of the transaction of purchase and sale or in any way made it less than complete from a legal viewpoint.

(ii) The appellant, in the conduct of the business prior to the sale in 1966, held licences under the Excise Act, RSC 1952, c 99, section 10 of which provides:

No person, unless thereunto licenced, shall carry on any business or trade subject to excise or use any utensil, machinery or apparatus suitable for carrying on any such trade or business, . . .

The appellant held such a licence at the time of the transfer of its business to Grover. The appellant continued to hold such a licence for the asserted reason that the appellant, as the nominee of Grover, continued to carry on the business which entailed the use of the equipment requiring the licence. Arguably, the statute might require that a licence be held by both Grover and the appellant. The fact that the appellant held the licence or the fact that Grover didn’t take out a duplicate licence would, in my respectful view of the statute, have no impact whatever on whether or not the appellant has completed the transfer of its assets to Grover. There is no relationship in law advanced by the respondent to explain how the failure to have two licences, or the holding of one licence by the nominee appellant, would somehow invalidate, or at least render imperfect, the transfer of assets and assumption of liabilities so completely documented and properly registered as set out above.

(iii) In its factum, the Crown makes reference to the fact that T-4 slips were completed by the appellant under the Income Tax Act of Canada for the employees engaged in the conduct of the business. In this Court, no oral argument was advanced on this ground. In the Federal Court of Appeal, Urie, J remarked upon the significance of this fact as follows:

There is further disclosed in the evidence a number of instances from which it might be concluded that not only did Stuart carry on the flavourings business in fact but represented that it was so doing. Just a few examples of many support this view. . . . The appellant was shown as the employer of the employees in the flavourings business in the “Return of Remuneration Paid’’ filed with the Department of National Revenue and in the T-4 slips issued to employees.

The workers were employed by the appellant in the course of carrying on the business “for the account of Grover’’. The Income Tax Act requires the employer to deduct from wages and salaries at source the applicable taxes and to remit the moneys so withheld to the Minister of National Revenue. The Income Tax Act also requires the person making the deductions to issue evidence of such deductions to the employees so that credit may be claimed for taxes withheld. Vide Income Tax Act, RSC 1952, c 148, s 47, as amended to 1968. It is clear from an examination of the transfer documents and the documents of implementation of the transfer agreement, and particularly the nominee agreement, that the parties to these agreements intended that the appellant would carry on the business for the account of Grover, and profit derived therefrom would accrue to Grover. The parties so performed these agreements. The appellant, in doing so, also acted in compliance with the tax statute in withholding taxes from, and issuing T-4 slips to, employees. I can see no consequence at law of the type claimed in the Crown’s factum which would in any way indicate that the contract of purchase and sale of this business was somehow rendered incomplete by the performance by the appellant of its statutory obligation under the tax statute.

(iv) Perhaps related to the submission that the sale in question was incomplete and thus is to be disregarded for tax purposes, is the finding in at least two of the courts below that, by reason of the relationship between the parties, the business would be returned to the appellant when Grover’s tax loss was fully spent. The Federal Court Trial Division referred to the sale in these words:

. . . such an obligation on the part of Grover to reconvey the assets to Stuart when the Grover loss has been absorbed in reducing the Stuart income tax, when coupled with the facts set out in the Judgment appealed from, is convincing evidence that the directors of both companies never contemplated the transaction as a transfer of the Stuart assets nor a genuine sale.

This reference is apparently to the memo of the solicitor for the appellant company to which reference has already been made, and which stated in part that when the tax loss has been fully utilized, “the business carried on by Stuart Brothers will be sold by Grover to Stuart Brothers”. There is nothing in the record which amounts to an enforceable agreement or undertaking to reverse the sale, or even a commitment by an officer of either the appellant or Grover to do so. In the event, no such transfer occurred as the business was sold by Grover to an independent third party.

In 1969, Grover sold the business to a stranger. The sale included all assets and goodwill. The appellant was not a party vendor to the contract, nor did the lengthy agreement stipulate any participation by the appellant in the closing documents. The purchaser paid in excess of $2 million for the business and took conveyances and assignments only from Grover as the vendor. Both the parent, Finlayson Enterprises Limited, and the appellant joined in the agreement as third parties “‘in order to induce the purchaser to enter into the agreement” and “to be bound by all of the indemnities, warranties, representations and agreements made herein”, and to agree to change the corporate name of Stuart Brothers Limited. All the assignments and conveyances delivered on closing in 1968 were executed by Grover alone in favour of the “purchaser” whose name in the closing documents, unlike the contract, was Givaudan Limited. In fact, the appellant, as already stated, did change its name, and the purchaser, by a new incorporation or a change of name of an existing corporation, adopted the corporate name Givaudan Stuart Brothers Limited. Like the appellant in 1962 and Grover in 1966, the purchaser in 1968 adopted a name incorporating “Stuart”, obviously in order to facilitate the retention of the goodwill attaching to that name in the market. Faced with this commercial reality, it is difficult to see how the transaction between Grover and the appellant was incomplete.

At the time of the 1966 sale to Grover, Grover wished to continue the use of the name of the appellant in connection with the business for a second reason. There were serious claims outstanding in the courts against Grover in an action brought in connection with its cement business, and the testimony in the record reveals that it was desirable “to make the transfer as inconspicuous as possible” in order not to encourage Grover’s adversaries in continuing the litigation, “so long as it was legally binding”. This litigation was ultimately settled.

In my view, these facts and circumstances all lead inexorably to the conclusion that the transfer and sale of the business by the appellant to Grover in 1966 was, in law, fully complete. Grover became the owner of the business, and the appellant operated the business on behalf of and for the account of Grover.

B. Business Purpose Test

What then is the law in Canada as regards the right of a taxpayer to order his affairs so as to reduce his tax liability without breaching any express term in the statute? Historically, the judicial response is found in Bradford Corporation v Pickles, [1895] AC 587 where it was stated:

If it was a lawful act, however ill the motive might be, he had a right to do it. If it was an unlawful act, however good his motive might be, he would have no right to do it. (per Lord Halsbury LC at 594)

No use of property, which would be legal if due to a proper motive, can become illegal because it is prompted by a motive which is improper or even malicious, (per Lord Watson at 598)

In the field of taxation itself the traditional position was re-echoed in JRC v Duke of Westminster, [1936] AC 1 at 19 where it was stated:

Every man is entitled if he can to order his affairs so as that the tax attaching under the appropriate Acts is less than it otherwise would be. If he succeeds in ordering them so as to secure this result, then, however unappreciative the Commissioners of Inland Revenue or his fellow taxpayers may be of his ingenuity, he cannot be compelled to pay an increased tax.

In the courts of the United States a different philosophy was developed in the oft-cited judgment in Gregory v Helvering, Commissioner of Internal Revenue (1934), 293 US 465. The United States Supreme Court considered the Revenue Act of 1928, which, at least in 1934, contained no clause of a type generally referred to as an “anti-tax avoidance provision”. The Court, in setting aside a plan of reorganization carried out by the taxpayer, did so by asserting that the proper principles applicable in construing a taxation statute required such a result. Justice Sutherland, in giving the opinion of the Court, stated at 469-70:

When subdivision (B) speaks of a transfer of assets by one corporation to another, it means a transfer made “in pursuance of a plan of reorganization” of corporate business; and not a transfer of assets by one corporation to another in pursuance of a plan having no relation to the business of either, as plainly is the case here. Putting aside, then, the question of motive in respect of taxation altogether, and fixing the character of the proceeding by what actually occurred, what do we find? Simply an operation having no business or corporate purpose — a mere device which put on the form of a corporate reorganization as a disguise for concealing its real character, and the sole object and accomplishment of which was the consummation of a preconceived plan, not to reorganize a business or any part of a business, but to transfer a parcel of corporate shares to the petitioner.

The whole undertaking though conducted according to the terms of subdivision (B), was in fact an elaborate and devious form of conveyance masquerading as a corporate reorganization, and nothing else. The rule which excludes from consideration the motive of tax avoidance is not pertinent to the situation, because the transaction upon its face lies outside the plain intent of the statute. To hold otherwise would be to exalt artifice above reality and to deprive the statutory provision in question of all serious purpose.

The taxpayer was improperly invoking a tax allowance authorized by the legislature. By an improper application of the legislative measure, the taxpayer gains no rights to the claimed benefit which would otherwise be obtainable under the statute. The element of sham crept into the language of the court and it is not clear whether, absent this element, the result would be the same. This is not the case with which we are faced. The Act is silent on the subject; and there are general provisions in the Act dealing with artificial transactions.

The same taxation philosophy was espoused by the Supreme Court of the United States in 1960 in Knetsch v United States, 364 US 361 where the Court concluded that the transaction was a sham which created no indebtedness within the meaning of the then version of the Internal Revenue Code. Mr Justice Brennan, for the majority, concluded that the taxpayer could not rely upon formal documents “without regard to whether the transactions created a true obligation to pay interest.” (at 367). The Court was there construing an amendment which was said to have been enacted to “close a loophole” in respect of interest deductions. The word “sham” is used in a confusing sense, and at 369 in his judgment, Justice Brennan appears to extend his conclusion to cover a factual situation where “actual indebtedness” arose by reason of the transaction in question. Justice Douglas, on behalf of himself and two other justices, dissented, stating that the facts revealed that the clear and simple intention of the taxpayer was to qualify, by means of the asserted transaction, for a deduction for interest paid. He concluded: “Yet as long as the transaction itself is not hocus-pocus, the interest charges incident to completing it would seem to be deductible . . .” (at 370). Of interest in considering the issues raised in this appeal are the later observations of Justice Douglas at 371:

Tax avoidance is a dominating motive behind scores of transactions. It is plainly present here. Will the Service that calls this transaction a “sham” today not press for collection of taxes arising out of the surrender of the annuity contract? I think it should, for I do not believe any part of the transaction was a “sham”. To disallow the “interest” deduction because the annuity device was devoid of commercial substance is to draw a line which will affect a host of situations not now before us and which, with all deference, I do not think we can maintain when other cases reach here. The remedy is legislative. Evils or abuses can be particularized by Congress.

Where the taxpayer is a corporation created in the course of the execution of a tax avoidance plan, a different result may flow. There is considerable literature on this subject in the United States which is fairly represented by the following excerpt from “A US View Through the Corporate Veil”, (Jan, 1978), Tax Management International Journal 3 at 7, by the authors Baker and Killingsworth:

Where it appears that the principal purpose of forming a corporation — or multiple corporations — is to circumvent the purpose of a statute, the corporate entity will usually be ignored.

Vide Kocin v United States (1951), 187 F 2d 707; Goldstein v Commissioner of Internal Revenue (1966), 364 F 2d 734; Cardozo, J in Berkey v Third Avenue Railway Co (1926), 244 NY 84 at 95; and Singer v Magnavox Co, 380 A 2d 969 (1977). Two conditions bear upon the adoption of this approach to the interpretation of a taxing statute: first, the taxpayer is either a creature of, or comes into being because of, a tax avoidance program; and secondly, the absence from the tax statute of a general denial of recognition of artificial transactions. Thus, when examining the United States scene it is well to remember that the Internal Revenue Code and its predecessor statutes did not include an anti-tax avoidance provision in the nature of section 137 of the pre-1972 Canadian Income Tax Act.

The situation in Australia sheds further light on the problem of applying the proper interpretative approach to a taxing statute. The Australian tax statute contains a more rigorous anti-tax avoidance provision than our section 137, and which at the time of the Cridland case, infra, provided as follows:

260. Every contract, agreement, or arrangement made or entered into, orally or in writing, whether before or after the commencement of this Act, shall so far as it has or purports to have the purpose or effect of in any way, directly or indirectly —

(a) altering the incidence of any income tax;

(b) relieving any person from liability to pay any income tax or make any return;

(c) defeating, evading, or avoiding any duty or liability imposed on any person by this Act; or

(d) preventing the operation of this Act in any respect,

be absolutely void, as against the Commissioner, or in regard to any proceedings under this Act, but without prejudice to such validity as it may have in any other respect or for any other purpose.

In Cridland v Commissioner of Taxation (Cth), (1978), 52 AL JR 96, the High Court of Australia considered the application of section 260 of the Income Tax Assessment Act 1936 (Cth), as amended. The taxpayer, a university student, had participated in a tax minimization scheme which was designed to make available to the participants income averaging opportunities. In order to take advantage of the averaging provision, a taxpayer had to be registered as an income beneficiary of trusts which authorized the trustee to carry on the business of a primary producer. An elaborate scheme was devised by the trustee in this case, and a number of trusts were established in the execution of this plan. Literally thousands of participants were involved in the scheme, all of whom, including the taxpayer Cridland, paid a nominal sum as the purchase price of an “income unit”. A distribution of trust income was effected. However, the “income” paid out to the beneficiaries was negligible ($1.00). Two factors were clear. The taxpayer, as a party to the trust arrangement, had technically come within the statutory language entitling him to the income averaging provisions. Secondly, the taxpayer had entered into the transaction deliberately with a view to minimizing his tax burden. In allowing the taxpayer’s appeal against assessments made by the Commissioner of Taxation, the High Court of Australia, per Masan, J, held as follows (at 98-99):

[T]he taxpayer is entitled to create a situation by entry into a transaction which will attract tax consequences for which the Act makes specific provision and . . . the validity of the transaction is not affected by s 260 merely because the tax consequences which it attracts are advantageous to the taxpayer and he enters into the transaction deliberately with a view to gaining that advantage.

The transactions into which the appellant entered in the present case by acquiring income units in the trust funds in question were not, I should have thought, transactions ordinarily entered into by university students. Nor could they be accounted as ordinary family or business dealings. They were explicable only by reference to a desire to attract the averaging provisions of the statute and the taxation advantage which they conferred. But these considerations cannot, in light of the recent authorities, prevail over the circumstance that the appellant has entered into transactions to which the specific provisions of the Act apply, thereby producing the legal consequences which they express.

Accordingly, it is my view that s 260 has no application to this case.

The presence of a provision of general application to control avoidance schemes looms large in the judicial approach to the taxpayer’s right to adjust his sails to the winds of taxation unless he thereby navigates into legislatively forbidden waters. The legislature has provided the standards of unacceptable avoidance procedures, and there being no other limit imposed by the Act, the Court found itself under no duty, nor indeed possessed of any authority, to legislate new limits. Where, as in this appeal, the Act expressly permits the application of accumulated losses to reduce taxes on current and future earnings, the tax collector must demonstrate a statutory bar to succeed.

In the United Kingdom there is some evidence that the courts are moving from the principles enunciated in the older cases mentioned above to something approaching the United States bona fide business purpose rule.

In WT T Ramsay Ltd v IRC, [1981] 2 WLR 449, the House of Lords considered whether losses created under two separate tax avoidance schemes were artificial and should consequently be treated as fiscal nullities for tax purposes. Their Lordships were urged to accept this conclusion despite the fact that the individual transactions which gave rise to the losses were genuinely carried through and were exactly what they purported to be. Although the details of each scheme were dissimilar, the net results and overall concepts were identical. In each case, an allowable capital loss and an equivalent non-taxable gain were created. The taxpayers intended to use the synthesized capital loss to offset a previously realized taxable gain. When the individual transactions were viewed as a whole, it was clear that the gain and loss produced by this plan were meant to be self cancelling. In reviewing the facts, Lord Wilberforce concluded that the schemes were pure tax avoidance mechanisms and that the transactions had no independent commercial purpose. The House of Lords dismissed both appeals and held that the taxpayers were to be assessed without regard to the loss described above. Lord Wilberforce, at 459, offered the following reasons:

The capital gains tax was created to operate in the real world, not that of make- believe. As I said in Aberdeen Construction Group Ltd v Inland Revenue Commissioners, [1978] AC 885, it is a tax on gains (or I might have added gains less losses), it is not a tax on arithmetical differences. To say that a loss (or gain) which appears to arise at one stage in an indivisible process, and which is intended to be and is cancelled out by a later stage, so that at the end of what was bought as, and planned as, a single continuous operation, is not such a loss (or gain) as the legislation is dealing with, is in my opinion well and indeed essentially within the judicial function.

That is, the momentary, theoretical existence of an accounting quantity which does not survive the whole transaction has no existence in the taxing process. It may be that a fleeting existence is reality in the discipline of particle physics but not in the law of taxation unless it is specifically so enacted. Lord Fraser of Tullybelton, at 469, wrote to the same effect:

Each of the appellants purchased a complete prearranged scheme, designed to produce a loss which would match the gain previously made and which would be allowable as a deduction for corporation tax (capital gains tax) purposes. In these circumstances the court is entitled and bound to consider the scheme as a whole: see Inland Revenue Commissioners v Plummer, [1980] AC 896, 908 and Chinn v Hochstrasser, [1981] 2 WLR 14. The essential feature of both schemes was that, when they were completely carried out, they did not result in any actual loss to the taxpayer. The apparently magic result of creating a tax loss that would not be a real loss was to be brought about by arranging that the scheme included a loss which was allowable for tax purposes and a matching gain which was not chargeable.

The House of Lords was faced with another complex tax avoidance plan in CIR v Burmah Oil Co Ltd, [1981] 42 TR 535, where, as a result of an intricate series of intra-corporate loans and reorganizations, a substantial loss was realized by the parent company, Burmah Oil. Based on Ramsay, supra, the appellant in Burmah Oil argued for the first time in the United Kingdom that the transaction should be disregarded as artificial. The appeal was allowed on the ground that, like the transaction in Ramsay, when this scheme was carried through to completion, there was neither a real loss, nor a loss in the sense contemplated by the legislation (per Lord Fraser of Tullybelton at 541). In the reasons for judgment rendered by Lord Diplock, the significance of the Ramsay case was discussed (at 536):

It would be disingenuous to suggest, and dangerous on the part of those who advise on elaborate tax-avoidance schemes to assume, that Ramsay’s case did not mark a significant change in the approach adopted by this House in its judicial role to a preordained series of transactions (whether or not they include the achievement of a legitimate commercial end) into which there are inserted steps that have no commercial purpose apart from the avoidance of a liability to tax which in the absence of those particular steps would have been payable. The difference is in approach. It does not necessitate the over-ruling of any earlier decisions of this House; but it does involve recognising that Lord Tomlin’s oft-quoted dictum in Commissioners of Inland Revenue v Duke of Westminster, “Every man is entitled if he can to order his affairs so as that the tax attaching under the appropriate Acts is less than it otherwise would be”, tells us little or nothing as to what methods of ordering one’s affairs will be recognised by the courts as effective to lessen the tax that would attach to them if business transactions were conducted in a straight-forward way. The Duke of Westminster’s case was about a simple transaction entered into between two real persons each with a mind of his own, the Duke and his gardener — even though in the nineteen-thirties and at a time of high unemployment there might be reason to expect that the mind of the gardener would manifest some degree of subservience to that of the Duke. The kinds of tax-avoidance schemes that have occupied the attention of the courts in recent years, however, involve inter-connected transactions between artificial persons, limited companies, without minds of their own but directed by a singe master-mind. In Ramsay the master-mind was the deviser and vendor of the tax-avoidance scheme; in the instant case it was Burmah, the parent company of the wholly-owned subsidiary companies between which the pre-ordained series of transactions took place.

There are features about that case and its disposition that must be noted when considering its application in our law. The transaction created an accounting result which was then applied to reduce taxes otherwise exigible. The taxpayer did more than rearrange its affairs to avail itself of a statutory tax allowance. It was not, in my view, the non-arm’s length ideas radiating out from a central control of the corporate group that was fatal. It was the synthetic nature of the gain and the loss which rendered it unrecognizable in the eyes of the taxation program adopted by the legislature.

Secondly, and more importantly, the doctrines developing in Ramsay and Burmah, supra, reflect the role of the court in a regime where the legislature has enunciated taxing edicts in a detailed manner but has not superimposed thereon a general guideline for the elimination of mechanisms designed and established only to deflect the plain purpose of the taxing provision. The role that the judiciary must play in such a regime to control tax avoidance was recognised by Lord Reid, who, in Greenberg v IRC (1971), 47 TC 240, at 272, stated:

We seem to have travelled a long way from the general and salutary rule that the subject is not to be taxed except by plain words. But I must recognize that plain words are seldom adequate to anticipate and forestall the multiplicity of ingenious schemes which are constantly being devised to evade taxation. Parliament is very properly deter- mined to prevent this kind of tax evasion, and if the Courts find it impossible to give very wide meanings to general phrases the only alternative may be for Parliament to do as some other countries have done and introduce legislation of a more sweeping character, which will put the ordinary well-intentioned person at much greater risk than is created by a wide interpretation of such provisions as those which we are now considering.

Here the appellant has bound itself contractually to pay over the net profits of the business to Grover. Grover was already entitled to set off future earnings against a loss position recognized as valid by the administrators of the Income Tax Act. The earnings of Grover, under these valid arrangements, were gains realized in the market-place and were recognized as such by the terms of the Act. The application of the accumulated losses of Grover to reduce tax attributable to these gains is not denied by any provision in the Act. The tax administrators do not invoke section 137. Parliament has nowhere else in the Act expressed an interest in the appellant’s accounting and corporate practices in question. At issue is the role and function of a court in these circumstances.

The examination of tax avoidance schemes continued in the House of Lords in Furniss (Inspector of Taxes) Appellant v Dawson, et al (as yet unreported, delivered by the House of Lords on February 9, 1984), forwarded to the Court by the respondent after the hearing of this appeal. The appellant takes the view that this case has no relevance to this appeal. The Court found the taxpayers taxable for a gain technically realized in a company interposed between the taxpayers and a third party purchaser to whom the taxpayers had agreed, prior to the creation of the interposed entity, to sell certain shares. The object of the plan was to defer rather than to avoid the imposition of capital gains tax otherwise payable by the taxpayers on the sale of their shares had they sold these shares directly to the third party purchaser. The Court disregarded the existence of the intermediate company which had been brought into being solely for the purpose of selling the shares to the third party purchaser. The taxpayers, in the simplest analysis of this plan, had merely established the new company to perform as agent for the taxpayers the sale agreement already reached between the taxpayers and the purchaser. The explanation of the result reached in the judgment of Lord Fraser of Tullybelton was based on the decision in Ramsay, supra:

The true principle of the decision in Ramsay was that the fiscal consequences of a preordained series of transactions, intended to operate as such, are generally to be ascertained by considering the result of the series as a whole, and not by dissecting the scheme and considering each individual transaction separately.

Lord Brightman, on the other hand, interpreted Ramsay and Burmah, supra, as producing a principle of law comparable to that pronounced in Helvering, supra, in the United States Supreme Court. The transaction is to be set aside for tax purposes if the “composite transaction’’, otherwise acceptable, has inserted into it steps “which have no commercial (business) purpose apart from the avoidance of a liability of tax — not ‘no business effect’ ’’. Lord Brightman concluded that if the transaction consists of a series of transactions or a composite transaction and is accompanied by or includes steps which have no business purpose, then the result is taxation. In that circumstance, the Court looks to the end result. His Lordship acknowledged, however, that “precisely how the end result will be taxed will depend on the terms of the taxing statute sought to be applied’’. The agreement under which the tax liability would ordinarily arise had already been reached between seller and buyer before the intermediate entity was created. Its injection into the sale added nothing to the legal relationship of the parties. It simply became the agent of the vendor-taxpayer. Without any need for new principles of taxation, tax liability arose in the vendor upon completion of the sale. It is significant that no provision of the British tax statute is referred to by the House of Lords. In the view of some Canadian authorities, Ramsay, supra, does not represent a repudiation of Duke of Westminster, et al., supra. See Ward and Cullity, “Abuse of Rights and the Business Purpose Test” (1981), 29 Canadian Tax Journal 451 at 465-6. Other academic commentators, however, view the recent decisions of the House of Lords as establishing a step transaction doctrine which “places a severe limitation on the Westminster principle . . .”. See Vern Krishna: “Step Transactions: An Emerging Doctrine or an Extension of the Business Purpose Test?”, Vol 1, no 4, Canadian Current Tax, c 15 (April 1984), at 19.

This approach to the liability of a taxpayer in the circumstances of the appeal before this Court takes us back full circle to the terms of the statute itself. The policy of the Act is to allow the recipient of the payment in question, Grover, to offset income against prior losses. The taxpayer in Furniss, supra, was accorded no right by the Act which was available prior to the implementation or arrangement designed and adopted to offset or defer any taxes which might arise. It must be borne in mind that the United Kingdom tax statute, like the Internal Revenue Code of the United States under which the Helvering case, supra, was decided, contains no clause similar to our section 137. Each of the English and American statutes had specific provisions barring dividend stripping, bond washing, land transactions and the like, but no general provision barring artificial transactions appears in the statutes. Vide P Whiteman and D Milne, White- man and Wheatcroft on Income Tax, 2nd ed (1976) at 11 and 804; Ward and Cullity, “Abuse of Rights and the Business Purpose Test”, supra, 463. The United States Code contains such specific provisions as section 269 dealing with the acquisition of a deduction, allowance or credit designed to frustrate a clearly isolated particular abuse. See Merten’s Law of Federal Income Tax, Vol 7, Chap 38, at 181-84 and at 208 et seq. It may well be that each of the three House of Lords decisions, supra, can be simply distinguished on the basis that in each case, a plan was adopted whereby the taxpayer took affirmative action to create the “loss” or “gain” by a procedure not otherwise required in the ordinary course of business; or that the taxpayer designed an accounting holding tank to delay artificially the receipt by the vendor of the proceeds of sale under an agreement for sale reached directly between the true parties to the transaction before the accounting scheme was established. Here the appellant was legally bound to pay a defined amount to another company which held a valid right of allowance under the Income Tax Act against tax liability which would otherwise arise upon the receipt of bona fide future earnings. It is not the taxability of the receipt which is in issue; it is the right of the appellant payor to deduct the amount from its income account and thereby free itself from taxation on the amount so paid out to Grover. There is nothing in the Income Tax Act of Canada which expressly prevents the appellant from obligating itself to pay over the sum in question. Section 137 might arguably apply on the grounds that the transaction falls within the reach of the expression “artificial transaction” but the taxing authority has not advanced this position in support of the tax claim here made. However, there remains the larger issue as to whether Canadian law recognizes, as a principle of interpretation, that the conduct of the taxpayer, not dictated by a genuine commercial or business purpose, and being designed wholly for the avoidance of tax otherwise impacting under the statute, can be set aside on the basis of Furniss, supra, or Helvering, supra, as though the transaction were, in fact and in law, a “sham”.

The scene in Canada is less clear and has not, until this appeal, reached this Court. The first reference to ‘‘a business purpose” concept appears to be in the Exchequer Court in Lagacé v MNR, [1968] 2 Ex CR 98; [1968] CTC 98; 68 DTC 5143 where President Jackett (as he then was) referred to a series of contrived conveyances as not representing a “bona fide business transaction”. Later, at [101], he noted that the taxpayer had neglected to establish that each party was bound in “an actual bona fide contract that was in fact negotiated . . . at the time of the negotiation of the business bargain”. The court found that the profit resulted from the taxpayer’s “own business transactions” and was taxable in respect of such transactions. The court proceeded along the same lines as the House of Lords did in Furniss, supra, namely the profits arose by reason of transactions made by the taxpayer, and the interposition of legal entities after the deal had been made did not separate the profits from the taxpayer. Lagacé was cited by the same court in Richardson Terminals Ltdv MNR, [1971] CTC 42; 71 DTC 5028, where, after a series of factual findings, the trial court found that the taxpayer had simply not followed a plan prescribed by its advisers for the transfer of a business to a loss company, and had simply attempted to transfer the net income from that business. The transferee company, the court found, neither in fact nor in law carried on the business in question in its own right. The appeal court, in oral reasons, reached the same conclusion ([1972] CTC 528; 72 DTC 6431). While Lagacé was also quoted in Dominion Bridge Co Ltd v The Queen, [1975] CTC 263; 75 DTC 5150, Décary, J, in the Federal Court Trial Division, found that the transactions between the parent company and its subsidiary, designed to transfer the profits of the parent to an off-shore subsidiary, were “a sham” (p 271 [5155]) “to camouflage and hide” (p 270 [5154]) the parent company’s operations. The court then concluded that the operations in question ‘‘were those of the appellant taxpayer” (p 270 [5154]) and the profits were properly assessed to the parent company. Again, in that case, the court found that the fixing of prices by the parent for purchases by it from the subsidiary was a device to transfer income from the taxpayer to its agent, the subsidiary, in a closed, inter-company sales transaction in which the agent subsidiary in fact performed no function. The business in question was that of the parent; the subsidiary was simply its purchasing department; and by this device the parent divested itself of its income arising from the transactions in question. The court, at 275 [5158], then adopted the remarks of Lord Morris Borth y Gest in FA & AB Ltd v Lupton (Inspector of Taxes), [1971] 3 All ER 948 at 953:

These are paraded by their admirers as possessing the guise and the garb of trading transactions. Others think of the analogy of a wolf in sheep’s clothing with the Revenue as the prey.

The Federal Court of Appeal in [1977] CTC 554; 77 DTC 5367 held that there was no reason to interfere with the findings of fact made by the trial judge. The concept of “bona fide business purpose” played no part in the final outcome. Rather, this case falls into the “sham” category.

It was in MNR v Leon, [1976] CTC 532; 76 DTC 6299 that the Federal Court of Appeal may have incorporated the bona fide business purpose test into Canadian tax law. By a complex of management companies created by a group of brothers, each of whom owned all the shares of their respective management companies, the profits of a furniture business were routed through several corporate screens and eventually reached the original owners of the business after minimal taxation. In carrying out this plan, the brothers disregarded the advice of their accountants in which the true nature of the plan was discussed, and some of the documents were found to have been back-dated. The trial judge concluded that none of the companies had any employees (except the sole shareholder brother), no business facilities of any kind, and that the sole purpose of the interposition of the management companies was to reduce the brothers’ taxes in the future. Heald, J, in reviewing the evidence, stated, at 540 [6303]:

Thus, the interposition of the management companies between the employer and the employee was a sham, pure and simple, the sole purpose of which was to avoid payment of tax.

In the course of reaching this conclusion, the Court of Appeal propounded the following rule (at 539 [6302]):

It is the agreement or transaction in question to which the Court must look. If the agreement or transaction lacks a bona fide business purpose, it is a sham.

The Federal Court of Appeal in so phrasing the rule has mixed the older “sham” doctrine with the bona fide business purpose test, and has brought forth a hybrid rule. The judgment was met with immediate critical response from the taxation authors. TE McDonnell, Cdn Tax Fdn: Twenty-ninth Tax Conference, 1977, stated, at 90, that the court “. . . seemed to have made a quantum jump in statutory interpretation and added an entirely new concept to the tax jurisprudence”. For like comments, see Current Cases, 24 Can Tax J 468 (1976) and O’Keefe, “The Business Purpose Test — Who Needs It?”, 25 Can Tax J 139 (1977).

The statement of Heald, J, supra, was not essential to the conclusion reached by the court. The interposition of the management company did not, in law, establish anything but a simple agency relationship between the taxpayer and the bare incorporation so established. The company itself had no business, and indeed no business facilities. The services were entirely personal and were at all times destined for delivery to the original, ongoing furniture business, owned in the first instance by the sole shareholders of the management companies. Nothing was changed by reason of the incorporation of the nest of wholly-owned management companies. The Federal Court, in enunciating the rule, supra, cut across the United States bona fide business principle which sharply distinguishes between transactions which fail because they are shams in the sense of a deception, and those which fail because they lack an independent business purpose.

The Federal Court of Appeal shortly thereafter appears to have drawn back from the Leon proposition when Urie, J wrote:

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 [Leon], and, I think, that the principle so stated should perhaps be confined to the facts of that case.

Massey-Ferguson Ltd v The Queen, [1977] CTC 6; 'll DTC 5013 at 16 [5020].

This was another case of an interposed corporation. However, the parent company taxpayer, wishing to make an inter-company interest-free loan to an operating second-tier subsidiary, did so by loaning the money, at least in an accounting sense, through a first-tier subsidiary which was engaged in the business of financing members of the parent company’s corporate group. The issue was whether deemed interest would be attributed to the parent company because the loan, in substance, was made from the parent to the second-tier subsidiary. By the terms of the statute, the attribution of deemed interest would be required where the loan was from the parent to the second-tier subsidiary, whereas a loan by the parent to the first-tier subsidiary or by the second-tier subsidiary, whereas a loan by the parent to the first-tier subsidiary or by the second-tier to the second-tier subsidiary did not attract such a consequence. The Federal Court of Appeal found the legal form of the loan to be of controlling importance. In so doing, the Court of Appeal returned the definition of sham to its former condition but did not necessarily turn its back on the “independent business purpose” concept.

The Court of Appeal in Massey-Ferguson, supra, concluded that the underlying decision, that is to lend money to the second-tier subsidiary, was not taken solely for tax purposes, nor was the use of the first-tier company entirely divorced from the business practices of the parent company. Consequently, it could not be said that the interposition by the parent of the first subsidiary was done only to reduce taxes. Furthermore, the interposed company had an independent reason for its existence in contrast to the management companies in Leon, supra, which were created solely for the purpose of executing the plan in question. The position of the Court of Appeal is made unclear, however, by its reference, after concluding that neither the use of the intermediate company nor its business was a sham, to Inland Rev. Commissioners v Brebner, [1967] 1 All E.R. 779 where Lord Upjohn enunciated the principle, at 784:

. .. when the question 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 paying no, or as 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.

The effect of the interworking of all these considerations or rules may be that a court must apply a taxing statute so as to bar the claim of entitlement to an allowance, deduction or other advantage or benefit where the taxpayer created entities or rights and obligations in order to revise the character, under the statute, of the income or earnings already achieved by the taxpayer. The claim would not necessarily be barred, however, where the new alignment of the taxpayer’s affairs is adopted only to reduce or avoid taxation of earnings or income thereafter arising independently from the establishment of the arrangements in question.

Before returning to the immediate issue in this appeal, the state of the tax law under section 137, supra, as it has evolved in Canada should be briefly examined. Although this section is not invoked by the respondent in this appeal, it is relevant to note that to date the section has not been interpreted so as to incorporate “the bona fide business purpose test”. Cattanach, J., in the Federal Court Trial Division, after finding that the transaction in question was not a sham, determined that a tax advantage was not a benefit under subsection 137(2):

What the defendant has done has been to order its affairs as to attract a lesser tax at a subsequent time as it is entitled to do . . . The defendant has effected a tax advantage to itself as is its right and accordingly it is incongruous that that advantage should be construed as a “benefit” to the defendant within the meaning of s. 137(2).

The Queen v Esskay Farms Ltd, [1976] CTC 24; 76 DTC 6010 at 36-37 [6018].

Notwithstanding that the taxpayer there deferred and reduced taxes otherwise payable on the sale of his land by interposing an independent trust company between himself and the purchaser, and by contract with the trust company delayed his receipt of the proceeds of sale over a period of years commencing several years after the sale, the proceeds of sale were not found to be taxable income. There was no purpose in all these arrangements other than the lessening of the impact of taxation on the transaction. No “independent business purpose test” emerged, and section 137 was found to be inapplicable. Vide also Pratte, J in Produits LDG Products Inc v The Queen, [1976] CTC 591; 76 DTC 6344 at 598 [6349]:

There is nothing reprehensible in seeking to take advantage of a benefit allowed by the law. If a taxpayer has made an expenditure which, according to the Act, he may deduct when calculating his income, I do not see how the reason which prompted him to act can in itself make this expenditure non-deductible. I therefore believe that in the case at bar, there is no reason to apply s. 137(1).

To the same effect is The Queen v Alberta and Southern Gas Co Ltd, [1977] CTC 388; 77 DTC 5244 at 397 [5249] where Jackett, CJ stated:

. . . a transaction which clearly falls within the object and spirit of [a given section of the Act] cannot be said to unduly or artificially reduce income merely because the taxpayer was influenced in deciding to enter into it by tax considerations.

The courts, in applying section 137, and in applying general principles of statutory interpretation, seem, thus far at least, to have fallen short of adopting the “bona fide business purpose test”. The Richardson case, supra, like the Atinco and Rose cases, supra, falls into the category of incomplete or legally ineffective transactions. The allowance or benefits sought by the taxpayer in those cases were simply not available by the procedures adopted by the taxpayer. Leon, supra, at its highest, is a modification of the sham test, but it seems to have been isolated on its factual base by Massey-Ferguson, supra.

In light of this general background, a further subsidiary question must be considered: is the transaction affected as to tax consequences where the vendor and purchaser are not at arm’s length? There are, of course, many pragmatic and philosophical answers. In considering this issue, one must take cognizance of the many examples in the Act and its application by the Department which belie the distinction. For example, inter-spousal loans, which effectively allow income splitting with the consequential tax reduction, are approved under the present Act. See Interpretation Bulletin No IT-258R2, Department of National Revenue. There are other examples, including the transfer of invested surpluses by a corporation from bonds to stocks where the corporation moves from deficit to profit on its commercial operations. In neither of these examples is there any bona fide business purpose for the transfer or exchange of assets, both being done exclusively or avowedly to reduce or eliminate taxation.

Other sections of the Income Tax Act enable a corporation or its shareholders to reduce income upon the distribution of accumulated surplus, as for example under section 85 of the old Act. By conforming with the terms of the statute, this income, which, when otherwise withdrawn by the shareholders would be taxable at full personal rates, can be transferred to the shareholders at reduced rates, even “artificially” reduced tax rates when one considers the artifice prescribed by Parliament in these sections.

There are many other examples in the Act of tax reduction devices, most of which, by axiom, are founded upon non-arm’s length relationships. The taxpayer may acquire the marital deduction in toto for the entire calendar year by marrying on December 31st instead of January 1st in the following year. If the choice is made solely for tax reasons, surely the taxpayer’s entitlement is not thereby placed in jeopardy. The same applies to persons who deliberately avail themselves of registered home ownership savings plans whether or not the taxpayer does so because of the tax deduction or because of a long-term, bona fide intent to establish a fund to be used to purchase a home; and to businesses combining by way of joint venture rather than by minority shareholding in a project. Motive would nowhere appear to be a precondition of eligibility. The same applies to the decision of a taxpayer to incorporate or to carry on business in partnership with a corporation. Whether or not these choices are made solely on the basis of tax advantage, whenever the Income Tax Act prescribes different tax rates for different forms of business, the taxpayer must surely be free to choose whichever mode fits his plans.

As earlier indicated, two of the lower courts found the transaction to have been a sham, and therefore not determinative of the taxation consequences under the Income Tax Act, supra. The Federal Court of Appeal found it unnecessary to determine whether or not the term “sham”, in the circumstances of the case, is properly applicable to the transaction, but in reaching this conclusion it was observed that “the evidence certainly points in that direction”.

The element of sham was long ago defined by the courts and was restated in Snook v London & West Riding Investments Ltd, [1967] 1 All ER 518 at 528. Lord Diplock, at 528, found that no sham was there present because no acts had been taken:

. . . which are intended by them to give to third parties or to the courts 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.

This definition was adopted by this Court in MNR v Cameron, [1974] SCR 1062; [1972] CTC 380; 72 DTC 6325 at p 1068 [384] per Martland, J.

With respect to the courts below, it seems to me that there may have been an unwitting confusion between the incomplete transaction test and the sham test. Earlier I have enumerated the many public registrations effected by the parties in the course of this transaction. The documents establishing and executing the arrangement between the parties were all in the records of the parties available for examination by the authorities. There has been no suggestion of backdating or buttressing the documentation after the event. The transaction and the form in which it was cast by the parties and their legal and accounting advisers cannot be said to have been so constructed as to create a false impression in the eyes of a third party, specifically the taxing authority. The appearance created by the documentation is precisely the reality. Obligations created in the documents were legal obligations in the sense that they were fully enforceable at law. The courts have thus far not extended the concept of sham to a transaction otherwise valid but entered into between parties not at arm’s length. The reversibility of the transaction by reason of common ownership likewise has never been found, in any case drawn to the Court’s attention, to be an element qualifying or disqualifying the transaction as a sham. If the factual possibility of reversibility were a test as to the legal effect of a transaction under the “sham” doctrine, a retail store’s sales policy of guaranteed return of goods found to be unsatisfactory (“Goods satisfactory or money refunded”) would render a transaction incomplete, unenforceable and a sham, whether or not the goods were ever returned to the vendor. In fact, of course, we know the transaction was not reversed but was indeed relied upon by the third party purchaser of the assets and undertaking of Grover. There is, in short, a total absence of the element of deceit, which is the heart in these circumstances of the doctrine of sham as it has developed in the case law of this country.

Returning then to the issue of interpretation now before this Court, there are certain broad characteristics of tax statute construction which can be discerned in the authorities here and in similar jurisdictions abroad. The most obvious is the fact that in some jurisdictions, such as Canada and Australia, the legislature has responded to the need for overall regulation to forestall blatant practices designed to defeat the Revenue. These anti-tax avoidance provisions may reflect the rising importance and cost of government in the community, the concomitant higher rates of taxation in modern times, and hence the greater stake in the avoidance contests between the taxpayer and the state. The arrival of these provisions in the statute may also have heralded the extension of the Income Tax Act from a mere tool for the carving of the cost of government out of the community, to an instrument of economic and fiscal policy for the regulation of commerce and industry of the country through fiscal intervention by government. Whatever the source or explanation, measures such as section 137 are instructions from Parliament to the community on the individual member’s liability for taxes, expressed in general terms. This instuction is, like the balance of the Act, introduced as well for the guidance of the courts in applying the scheme of the Act throughout the country. The courts may, of course, develop, in their interpretation of section 137, doctrines such as the bona fide business purpose test; or a step-by-step transaction rule for the classification of taxpayers’ activities which fall within the ban of such a general tax avoidance provision.

In jurisdictions such as the United States and the United Kingdom, such doctrines have developed in the courts, usually in the guise of canons of construction of the tax statutes. These have included the business purpose test, step-by- step transactions analysis, substance over form, and expanded sham rules. Whether the development be by legislative measure or judicial action, the result is a process of balancing the taxpayer’s freedom to carry on his commercial and social affairs however he may choose, and the state interest in revenue, equity in the raising of the revenue, and economic planning. In Canada the sham concept is at least a judicial measure for the control of tax abuse without specific legislative direction. The judicial classification of an ineffective transaction is another. In the United States, these doctrines have expanded to include the business purpose test. The United States tax code is, as we have seen, replete with benefits in the form of special relief from general tax measures, but the problem is whether the bona fide business purpose test will, in a given circumstance, descend upon the taxpayer ex post facto. See Surrey et al, “Federal Income Taxation’’, Cases and Materials (Foundation Press 1973) at p 644. In sharp contrast is the approach of Noël, J, as he then was, in Foreign Power Securities Ltd v MNR, [1966] CTC 23; 66 DTC 5012 at 52 [5027], where he stated:

There is indeed no provision in the Income Tax Act which provides that, where it appears that the main purpose or one of the purposes for which any transaction or transactions was or were effected was the avoidance or reduction of liability to income tax, the Court may, if it thinks fit, direct that such adjustments shall be made as respects liability to income tax as it considers appropriate so as to counteract the avoidance or reduction of liability to income tax which would otherwise be effected by the transaction or transactions.

Perhaps the high water mark in the opposition to the introduction of a business purpose test is found in the reasoning of the learned authors, Ward and Cullity, supra, who stated, at 473-75, in answer to the question: can it be a legitimate business purpose of a transaction to minimize or postpone taxes?:

If taxes are minimized or postponed, more capital will be available to run the business and more profit will result. Surely, in the penultimate decade of the twentieth century it would be naive to suggest that businessmen can, or should, conduct and manage their business affairs without regard to the incidence of taxation or that they are not, or should not, be attracted to transactions or investments or forms of doing business that provide reduced burdens of taxation.

I would therefore reject the proposition that a transaction may be disregarded for tax purposes solely on the basis that it was entered into by a taxpayer without an independent or bona fide business purpose. A strict business purpose test in certain circumstances would run counter to the apparent legislative intent which, in the modern taxing statutes, we may have a dual aspect. Income tax legislation, such as the federal Act in our country, is no longer a simple device to raise revenue to meet the cost of governing the community. Income taxation is also employed by government to attain selected economic policy objectives. Thus, the statute is a mix of fiscal and economic policy. The economic policy element of the Act sometimes takes the form of an inducement to the taxpayer to undertake or redirect a specific activity. Without the inducement offered by the statute, the activity may not be undertaken by the taxpayer for whom the induced action would otherwise have no bona fide business purpose. Thus, by imposing a positive requirement that there be such a bona fide business purpose, a taxpayer might be barred from undertaking the very activity Parliament wishes to encourage. At minimum, a business purpose requirement might inhibit the taxpayer from undertaking the specified activity which Parliament has invited in order to attain economic and perhaps social policy goals. Examples of such incentives I have already enumerated.

Indeed, where Parliament is successful and a taxpayer is induced to act in a certain manner by virtue of incentives prescribed in the legislation, it is at least arguable that the taxpayer was attracted to these incentives for the valid business purpose of reducing his cash outlay for taxes to conserve his resources for other business activities. It seems more appropriate to turn to an interpretation test which would provide a means of applying the Act so as to affect only the conduct of a taxpayer which has the designed effect of defeating the expressed intention of Parliament. In short, the tax statute, by this interpretative technique, is extended to reach conduct of the taxpayer which clearly falls within “the object and spirit” of the taxing provisions. Such an approach would promote rather than interfere with the administration of the Income Tax Act, supra, in both its aspects without interference with the granting and withdrawal, according to the economic climate, of tax incentives. The desired objective is a simple rule which will provide uniformity of application of the Act across the community, and at the same time, reduce the attraction of elaborate and intricate tax avoidance plans, and reduce the rewards to those best able to afford the services of the tax technicians.

In all this, one must keep in mind the rules of statutory interpretation, for many years called a strict interpretation, whereby any ambiguities in the charging provisions of a tax statute were to be resolved in favour of the taxpayer; the taxing statute was classified as a penal statute. See Grover & lacobucci, Materials on Canadan Income Tax, 5th ed, (1981), pp 62-65.

At one time, the House of Lords, as interpreted by Professor John Willis, had ruled that it was “not only legal but moral to dodge the Inland Revenue” (51 Canadian Bar Review 1 at 26), referring to Inland Revenue Commissioners v Le- vene, [1928] A.C. 217, at 227. This was the high water mark reached in the application of Lord Cairns’ pronouncement in Partington v Attorney-General (1869) LR, 3 HL 100 at 122:

I am not at all sure that, in a case of this kind — a fiscal case — form is not amply sufficient; because, as I understand the principle of all fiscal legislation, it is this: if the person sought to be taxed comes within the letter of the law he must be taxed, however great the hardship may appear to the judicial mind to be. On the other hand, if the Crown, seeking to recover the tax, cannot bring the subject within the letter of the law, the subject is free, however apparently within the spirit of the law the case might otherwise appear to be. In other words, if there be admissible, in any statute, what is called equitable construction, certainly such a construction is not admissible in a taxing statute where you simply adhere to the words of the statute.

Cited with approval in this Court in The King v Crabbs, [1934] SCR 523 at 525.

The converse was, of course, also true. Where the taxpayer sought to rely on a specific exemption or deduction provided in the statute, the strict rule required that the taxpayer’s claim fall clearly within the exempting provision, and any doubt would there be resolved in favour of the Crown. See Lumbers v MNR, [1944] CTC 67; [1943] CTC 281; 2 DTC 631 (Ex Ct), affirmed [1944] SCR 167: and W A Sheaffer Pen Co Ltd v MNR, [1953] Ex CR 251; [1953] CTC 345; 53 DTC 1223. Indeed, the introduction of exemptions and allowances was the beginning of the end of the reign of the strict rule.

Professor Willis, in his article, supra, accurately forecast the demise of the strict interpretation rule for the construction of taxing statutes. Gradually, the role of the tax statute in the community changed, as we have seen, and the application of strict construction to it receded. Courts today apply to this statute the plain meaning rule, but in a substantive sense so that if a taxpayer is within the spirit of the charge, he may be held liable. See Whiteman and Wheatcroft, supra, at 37.

While not directing his observations exclusively to taxing statutes, the learned author of Construction of Statutes, 2nd ed, (1983), at 87, E A Dreidger, put the ‘modern rule succinctly:

Today there is only one principle or approach, namely, the words of an Act are to be read in their entire context and in their grammatical and ordinary sense harmoniously with the scheme of the Act, the object of the Act, and the intention of Parliament.

The question comes back to a determination of the proper role of the court in construing the Income Tax Act in circumstances such as these where the Crown relies on the general pattern of the Act and not upon any specific taxing provision. The Act is to be construed, of course, as a whole, including section 137 but, for reasons already noted, without applying that section specifically to these assessments. The appellant stands to save taxes if its program is successful. The Crown loses revenue it might otherwise receive. At least in theory, the burden falls on other taxpayers to make up the lost revenue. Lord Simon of Glaisdale had this to say in not dissimilar circumstances:

It may seem hard that a cunningly advised taxpayer should be able to avoid what appears to be his equitable share of the general fiscal burden and cast it on the shoulders of his fellow citizens. But for the Courts to try to stretch the law to meet hard cases (whether the hardship appears to bear on the individual taxpayer or on the general body of taxpayers as represented by the Inland Revenue) is not merely to make bad law but to run the risk of subverting the rule of law itself. Disagreeable as it may seem that some taxpayers should escape what might appear to be their fair share of the general burden of national expenditure, it would be far more disagreeable to substitute the rule of caprice for that of law.

Ransom v Higg, 50 TC 1 at 94 (1974).

All this may reflect the tradition of annual amendments to the Income Tax Act when the government budget for the ensuing year is presented to Parliament for approval. Perhaps the facility of amendment to the Income Tax Act is one of the sources of the problem since the practice does not invite the courts to intervene when the legislature can readily do so.

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.

Jerom 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.

These interpretative guidelines, modest though they may be be, and which fall well short of the bona fide business purpose test advanced by the respondent, are in my view appropriate to reduce the action and reaction endlessly produced by complex, specific tax measures aimed at sophisticated business practices, and the inevitable, professionally-guided and equally specialized taxpayer reaction. Otherwise, where the substance of the Act, when the clause in question is contextually construed, is clear and unambiguous and there is no prohibition in the Act which embraces the taxpayer, the taxpayer shall be free to avail himself of the beneficial provision in question.

In this appeal, the appellant taxpayer has done nothing to contrive the accumulated and recognized loss carry-forward of Grover. Neither has the parent nor the affiliated company Grover done so. The immediate payment in issue, the transfer of yearly profits from the business, was made by the appellant under a clear, binding legal obligation so to do. Grover’s right to apply the tax loss to the income so received from the business is technically not here in issue. If it were in issue, it is difficult to see why Grover could not have acquired production assets from any source, including non-arm’s length sources as here, so as to produce earnings in futuro in order to take advantage of its deficit accumulations before their expiry under the provisions of the Income Tax Act. Neither the loss carry-forward provisions, nor any other provision of the Act, have been shown to reveal a parliamentary intent to bar the appellant from entering into such a binding transaction and to make the payments here in question. Once the tax loss concept is included in the statute, the revenue collector is exposed to the chance, if not the inevitability, of the reduction of future tax collections to the extent that a credit is granted for past losses.

I would therefore allow the appeal, and direct that the notices of reassessment in question be vacated, with costs here and in the courts below to the appellant.

Wilson, J:—I agree with my colleague Mr Justice Estey that the transaction involved in this appeal was an effectual transaction and that it was not a sham. Indeed, I cannot see how a sham can be said to result where parties intend to create certain legal relations (in this case the purchase and sale of a business and a nominee arrangement to operate it) and are successful in creating those legal relations.

As I understand it, a sham transaction as applied in Canadian tax cases is one that does not have the legal consequences that it purports on its face to have. For example, in Susan Hosiery Ltd v MNR, [1969] 2 Ex CR 408; [1969] CTC 533; 69 DTC 5346 Mr Justice Gibson found a purported employees’ pension plan to be a mere “simulate” that was “masquerading” as a pension plan; the actions of the taxpayers in question “never established a pension plan, nor any relationship of trustee, cestui que trust, nor any other legal or equitable rights or obligations in any of the parties and none of the parties intended at any material time that there should be any” (at 420-21 [544]). In MNR v Shields, [1963] Ex CR 91; [1962] CTC 548; 62 DTC 1343 Mr Justice Cameron held that an alleged partnership agreement between the taxpayer and his son was “not a reality, but a mere simulate agreement” (at 114 [570]); the parties never intended that it should give rise to a partnership and in law it did not do so. And in MNR v Cameron, (supra), Mr Justice Martland declined to find a contract for services between an employer and a company incorporated by his former employees to be a sham because “the legal rights and obligations which it created were exactly those which the parties intended” (at 1069 [384]).

I am also of the view that the business purpose test and the sham test are two distinct tests. A transaction may be effectual and not in any sense a sham (as in this case) but may have no business purpose other than the tax purpose. The question then is whether the Minister is entitled to ignore it on that ground alone. If he is, then a massive inroad is made into Lord Tomlin’s dictum that “Every man is entitled if he can to order his affairs so that the tax attaching under the appropriate Acts is less than it would otherwise be”: IRC v Duke of Westminster, (supra), at 19. Indeed, it seems to me that the business purpose test is a complete rejection of Lord Tomlin’s principle.

The appellant would clearly be liable to pay tax on the income from the flavourings business if the business purpose test is part of our law since it is freely admitted that the saving of tax for the Finlayson conglomerate was the sole motivation for the transaction. In my opinion, the Federal Court of Appeal in Leon v MNR, (supra), characterized a transaction which had no business purpose other than the tax purpose as a sham and was in error in so doing. I do not view that case as introducing the business purpose test as a test distinct from that of sham into our law and, indeed, if it is to be so viewed, I do not think it should be followed. I think Lord Tomlin’s principle is far too deeply entrenched in our tax law for the courts to reject it in the absence of clear statutory authority. No such authority has been put to us in this case.

For these reasons I concur in my colleague’s disposition of the appeal.