Holmes v. The Queen, 74 DTC 6143, [1974] CTC 156 (FCTD)

Cattanach, J:—The plaintiffs named in the styles of cause are barristers and solicitors carrying on their profession in partnership under the firm name and style of Holmes, Crowe, Power and Johnston at the City of Red Deer, in the Province of Alberta.

The present actions, eight in all, are appeals by the plaintiffs from their respective assessments to income tax by the Minister of National Revenue, for their respective 1968 and 1969 taxation year.

On a motion to which the parties were in agreement it was ordered that the appeals of the respective parties should be heard jointly on common evidence.

In assessing the plaintiffs as he did the Minister disallowed a portion of the expenses claimed by the plaintiffs in computing their income in each taxation year in question which had been paid by the law firm to a company incorporated pursuant to the laws of the Province of Alberta, under the name of Irish Management Ltd, with which company the law firm had entered into an agreement that the company would render to the law firm management services with respect to the administrative aspects, as distinct from the professional aspects, of the legal practice conducted by the law firm. Under this agreement the company paid the expenses incurred by the law firm, which were described as an “overhead levy”, for which disbursements on its behalf the law firm reimbursed the company and in addition paid to the company 15% of the overhead levy as a management fee.

The Minister allowed the amount paid by the law firm to the company as reimbursement for direct overhead expenses but disallowed the amount paid to the company as a management fee.

This can be better expressed, narratively and visually, in tabular form:

(Parenthetically I note that there is a difference between the amount of the direct overhead expenses claimed by the plaintiffs being $68,414.15 and the total amount of $68,299.35 allowed by the Minister. That difference is $114.80. The Minister disallowed the whole of the management fee which was in the amount of $9,684.82. It is the disallowance of that amount which is the issue between the. parties. The disallowance of the additional $114.80 is not in dispute and I, therefore, assume that it was a payment by the law firm to the company which was not properly an expense and to the disallowance of which the plaintiffs agree.)

Again I note that there is a difference between the amount of the direct overhead expense claimed by the plaintiffs being in the amount of $73,576.44 and the total amount of $73,564.50 allowed by the Min- ister. That difference is $11.94. If my recollection of the evidence is correct, it was admitted that certain amounts were improperly charged to the law firm as payment by the Company on behalf of the law firm. In any event the dispute between the parties is limited to the propriety of the disallowance of the management fees in the amount of $10,439.74 in the 1969 taxation year as a deductible expense.

The disallowed expense was allocated among the partners as follows:

The sole issue is whether the management fees of $9,684.82 and $10,439.74 paid by the law firm in the 1968 and 1969 taxation years are deductible in computing the income of the partners in the law firm in those taxation years.

The basis of the Minister’s submission that the management fees are not deductible is predicated upon the fact that those fees were a percentage of the “direct overhead expenses” which were incurred by the law firm in the normal conduct of its business and which were paid by the management company but for which payment the company was reimbursed by the law firm. In essence it was the submission of the Minister that the law firm could have paid these expenses directly, without the interposition of the company, and that there was no true business motive for the intervention of the company and accordingly the payment of the management fees served no useful purpose and was wholly unnecessary.

Following on those basic premises it was the Minister’s contention that the management fees so paid by the partners in the law firm in their 1968 and 1969 taxation years were not outlays or expenses made or incurred by the taxpayers for the purpose of gaining or producing income and accordingly are precluded as deductions in computing income by paragraph 12(1 )(a) of the Income Tax Act.

Paragraph 12(1 )(a) reads:

12. (1) In computing income, no deduction shall be made in respect of

(a) an outlay or expense except to the extent that It was made or Incurred by the taxpayer for the purpose of gaining or producing income from the property or a business of the taxpayer,

If the management fees are prohibited as deductible outlays or expenses by virtue of paragraph 12(1)(a) that is an end of the matter and the appeals by the plaintiffs must be dismissed.

However should it be found that the deduction of the management fees are not so prohibited the Minister then contended that the management fees paid by the law partners were disbursements or expenses made or incurred in respect of a transaction or operation that, if allowed, would unduly or artificially reduce the plaintiffs’ incomes and are accordingly precluded as deductions in computing income by virtue of subsection 137(1) of the Income Tax Act.

Subsection 137(1) reads:

137. (1) 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.

In so contending the Minister did not allege or argue that the company was a sham. It was not disputed that the payment of the management fees to the company was not properly made to the company under a contractual obligation to do so.

Again it was the Minister’s contention, as I understood it, that there was no genuine business reason for the payment of the management fees but the payment thereof was merely a means to siphon off income with the result that the income of each plaintiff was artificially reduced by their proportionate share of those payments.

In most provinces of Canada, with the notable exception of British Columbia, the profession of barristers and solicitors is required by law, tradition or professional code to be carried on by natural persons. The reason for this is evident. To qualify as a barrister and solicitor requires a protracted period of study which can only be done by a natural person and the personal responsibility of the solicitor to his client is such that that responsibility must be assumed by a natural rather than an artificial or fictitious person. Further, membership in the provincial law societies, which are the governing bodies of the profession, is limited to natural persons and membership in those bodies is a condition precedent to practising the profession.

While barristers and solicitors are precluded from incorporating a joint stock company to carry on that profession, there is no impediment to one or more barristers and solicitors incorporating or engaging a management or facilities company to perform all non-professional services otherwise provided by the barrister and solicitor.

The non-professional services so provided are by such a corporation usually,

1. to negotiate and sign the lease for the premises from which the practice is carried on, make the rental and utility payments and enter into a sublease with the barristers and solicitors;

2. purchase, own, finance, and repair all furniture, typewriters and like assets required to carry on the practice;

3. purchase all supplies required;

4. purchase and supply a full legal library, keep it up to date by the purchase of new publications required in the practice and keeping all periodicals to date;

5. hire, train, pay and maintain employee benefits for all personnel required by the practice, other than barristers and solicitors and students-at-law;

6. provide bookkeeping and accounting services, render and collect accounts, and like services excepting the certification of trust accounts to the law society which is the responsibility of the law firm;

and

7. provide janitorial service.

It is also usual that these services are provided on a cost-plus basis, that is, the corporation makes all payments on behalf of the law firm, adds a profit factor, which in the present instance was 15% and bills the law firm accordingly.

This is precisely what the plaintiffs herein, as partners in a law firm, did.

Mr Peter C G Power, who had been the managing partner of the law firm, at the relevant times, testified at length and in detail concerning the reasons which prompted the decision of the law firm to farm out its managerial and administrative functions to a corporation to be created.

Because of his assumption of the duties of managing partner he had attended courses and read many articles on office management of legal firms. He was aware of the increasing adoption by many professional firms of the device of having non-professional functions done by a management corporation and of the advantages resulting therefrom. I shall summarize at a later stage his exposition of the advantages which were peculiarly applicable to the law firm of which he was a member.

After discussion with the law firm’s chartered accountants and following a probationary period during which more duties had been assigned to the office manager of the law firm, who had agreed to become general manager of the corporation when incorporated, a company was incorporated under the name of Irish Management Ltd on May 8, 1967 with the object of taking over the physical assets of the law firm and to carry on the business of office manager together with many other objects such as dealing in office furniture and equipment.

The shareholders, in equal holdings, were Jean Holmes, Florence Crowe, Donagh Power and Shirley Johnston who were the wives of the partners in the law firm. Each wife, prior to marriage, had business experience and training.

While the wives shared equally in the company, the members in the law firm were not equal partners. Later when a junior unmarried partner was admitted to the law firm he was offered the privilege of becoming a shareholder in the company if he so desired. Being unmarried he personally exercised that option and became an equal shareholder, but that proportion did not apply to his membership in the law firm.

Upon the incorporation of the company all office furniture and equipment owned by the law firm was sold to the company at the depreciated value so that there was no recovery of capital cost allowance.

The furniture and equipment consisting of some 215 pieces was then leased back to the law firm at 2.5% of its cost to the company, a figure suggested by the law firm’s accountants.

The financing of the purchase of this furniture and equipment was by means of bank loans to the wives without guarantee by their husbands.

The lease of the premises was entered into between the landlord and the company. The landlord was reluctant to enter a lease with the company rather than the law firm but Mr Power persuaded the agent of the landlord of the financial responsibility of the company. In effect he negotiated the lease on behalf of the company. The law firm then sublet from the company.

The law firm and the company entered into a management agreement dated May 1, 1967 whereby the company undertook to supply the following services to the law firm:

1. the employment of any and all secretarial and clerical staff;

2. the employment of all maintenance staff;

3. the leasing of all office equipment, furniture and fixtures;

4. the purchase of all stationery and legal forms;

5. the purchase of all periodicals and professional literature;

6. the purchase of all text books and reference materials;

7. the leasing of office space;

8. the management of all secretarial and clerical staff;

9, the management of all maintenance staff;

10. the appointment of any and all auditing and accounting staff and

11. such other duties as might be agreed upon by the parties.

In consideration of the performance of those services the law firm agreed to pay 15% of the amount paid by the company on behalf of the law firm.

These amounts were paid by the law firm to the company at the beginning of each month at the outset because the company had not built up the financial resources to discharge those obligations but had to rely upon the receipt of advance payment from the law firm.

The percentage of 15% as compensation for the profit to the company on the services supplied was adopted by the parties on the recommendation of the law firm’s chartered accountants.

The evidence was to the effect that this percentage rate was the prevalent rate in management contracts of this nature.

The result of this arrangement was that the law firm paid one monthly lump sum to the company for the administrative services performed by the company which would have been ordinarily performed by the law firm itself and the income of the law firm distributable among the partners was reduced by the profit margin of 15% paid to the company. In effect the income of the partners was reduced by 15% of all non-professional services. This 15% payment is income in the hands of the company.

In paragraph 2 of the declaration under the heading “Reasons in Support of Appeal” it is alleged that

2. The Minister has taxed the Company on the full amount of its income for 1968 and 1969. It is therefore inconsistent for the Minister, at the same time, to disallow the fees paid as an expense to the taxpayer and add the same amount to his taxable income. This results in double taxation.

The Minister had denied generally all allegations in that part of the declaration entitled, “Reasons in Support of Appeal”.

Because an amount may be income in the hands of a recipient it does not follow necessarily that the amount is a deductible expense to the payor and in any event the assessment of the company is not before me so that I am not obliged to decide if the 15% profit margin paid by the law firm to the company is income in its hands. The issue that is before me is whether the payment so made is an expense which may be deducted in computing the income of the partners in the law firm.

Mr Power testified that the decision to entrust the performance of the administrative function of the law office to a corporation was reached after long and careful consideration.

Mr Power, as managing partner, spent from one to two hours each day on administrative duties for which no charge could be made. He felt that his time would be better devoted to legal problems for which charges could be made.

He pointed out that the firm was engaged in a general legal practice at Red Deer, Alberta which had a population of 25,000 but served an area in central Alberta which had a population of 100,000. As a result the firm had many clients which increased the administrative work.

The expedient was first adopted of assigning more administrative responsibility to Mrs Robinson, who had been the bookkeeper for many years. She was promoted to the position of office manager.

However it was found that this expedient did not solve the problem. The staff still looked to the managing partner as the final arbitrator on all matters. Salesmen of all merchandise needed by a law office insisted upon seeing the managing partner rather than Mrs Robinson to whom they had been referred.

Also, being in a smaller community, the law firm was frequently obliged to provide gratuitous secretarial and other services to many community enterprises and political campaigns.

It was the considered opinion of the partners that there must be a clean break with the past and that in the future all such requests and consultations should be with a corporation. As Mr Power put it, there must be a new image.

The firm had occupied premises which they had outgrown and the lease for which was about to expire. The firm contemplated moving into more commodious and modern office space in a building under construction. The partners, who were about the same age, were most anxious to avoid personal liability under the new lease, to facilitate changes in the composition of the firm. If a partner wished to leave the firm difficulties were experienced in relieving that partner from his liability under the personal covenant of a lease. Further in their older premises there was a defect in the heating and air-conditioning equipment which resulted in many members of the staff suffering from carbon monoxide poisoning. This gave rise to a question of legal liability.

Upon the incorporation of the management company the lease for the new premises was between the landlord and the company. The partners in the law firm were not personally liable under a covenant.

The company assumed the responsibility for and made leasehold improvements for which it was eventually reimbursed by the law firm.

All office furniture and equipment, including the legal library, which had been owned by the law firm was sold to the company. There had been instances where a barrister and solicitor who had been employed by the firm on a salary was to be admitted to the firm as a partner. The many assets owned by the firm resulted in the prospective partner, who was usually young and on the threshold of his legal career, being faced with a substantial cash outlay for his proportionate share of those assets which was a hardship upon him. The sale of the assets to the company did away with the necessity of a prospective partner being obliged to purchase a share of the firm’s physical assets.

The office staff employed by the law firm became the employees of the company on its incorporation. The company was responsible for their salaries, and it hired and fired the staff. The company was also responsible for the library and office furniture so that all negotiations with respect to those items were conducted with the general manager of the company.

From the outset it was a key to the whole arrangement that Mrs Robinson, in whom the partners had the utmost confidence, should become the general manager of the company, which she did. Her functions underwent no change from when she was office manager of the legal firm, but she continued to perform those functions in her new capacity.

At the beginning it was anticipated that management services might be performed by the company for clients other than the law firm. It was understood however that such management service would not be contracted for with any other law firm. The directors of the company, the wives of the law partners, wrote to all persons in the City of Red Deer offering the secretarial and typing services of the company. The persons selected to be advised of those services were persons considered likely to have a need for them. Advertisements were also placed in the local newspaper.

These services for persons other than the legal firm would be done by secretarial staff who were “floaters” and not continually engaged in work for the law firm. The revenue of the company from this source was minimal. This was due to the fact that there was no demand for such services in the community.

. The objects of the company also authorized. it to deal in office furniture. The office furniture of the law firm, when replaced, was sold by the company but very minimal revenue resulted from this activity.

To all intent the services performed by the company were exclusive to the law firm.

Care was taken to ensure that all persons who had occasion to deal with the law firm in connection with its administrative activities were informed that henceforth all such activities would be performed by the company.

However Mrs Robinson continued to have her office in the premises of the law firm for which no rent was paid by the company. The name of the company appeared on the directory at the main entrance to the building but not on the door of Mrs Robinson’s office. The company was listed in the telephone directory and had its own letterhead and stationery.

The law firm did exercise control over the expenses incurred by the company on its behalf.

Mr Power, in addition to being aware of the advantages in having the administrative functions of the law firm done by the company to which he referred, in his testimony, was also aware that there might be certain tax savings. That tax advantage, as I have mentioned above, would be that the income of the law firm would be 15%, the profit margin payable to the company, less and would be taxable in the hands of the company. To determine if such a tax advantage resulted would necessitate a comparison of an application of the personal tax rates and the corporate tax rates applicable to the amounts in the hands of the law partners and the company. But over the possible tax saving, which Mr Power admitted was a factor along with the other factors he mentioned in the decision to place the administrative functions of the law firm in the company, I have no doubt that he and his partners also had in mind the benefit which would accrue to their wives as shareholders in the company. In fact dividends were paid.

Against this background of facts the first contention on behalf of the Minister was that 15% management fee based on the “direct overhead levy” was not deductible in computing the plaintiffs’ income because it was not an expense incurred for the purpose of earning income.

The well established test in this connection is: was the expenditure laid out as part of the process of profit-earning?

It is not disputed that the expenses incurred by the law firm were properly deductible as made for the purpose of earning income. Those expenses were for secretarial services, telephone rental, janitorial services, city business tax, utilities, stationery, law books and periodicals, office rent and rent for office furniture and equipment. Those accounts were paid by the company for which the law firm reimbursed the company.

The position taken by the Minister was that these expenses would have been incurred in any event and would have been paid by the law firm as had been the case prior to the interposition of the company. That being so the Minister contended that the payment to the company of a 15% management fee for doing this on behalf of the law firm was an amount which need not have been incurred by the law firm.

I am unable to accept the contention thus put forward. It seems to me that if the expenses incurred for the services in question are deductible there should be no impediment to the law firm paying the company a fee to arrange for, supply and pay for those services, and that Mr Power outlined sound business reasons for doing so and the law firm, in conducting its business as it did, conformed to accepted principles of commercial trading and did so in accordance with good business practice.

At one stage in the evidence of Mr Power it was established that his income showed a marked increase after the law firm entered into the management contract with the company. I interpreted that evidence as seeking to show that Mr Power enjoyed a greater income after the management contract than before and that such increase was attributable to that contract. In my view the evidence did not show that the increase in Mr Power’s income was attributable to the law firm entering into the management contract. It is true that Mr Power was relieved of the burden of the tedious chores of the managing partner. That took one to two hours of his time each day. He was then free to devote that time to his professional work. However the return from professional work depends on the number of clients who consult the solicitor and not the time that the solicitor has available to consult clients. It is more logical to assume that the increase in Mr Power’s income was attributable to an increase in the number of his clients rather than the time available to him. I might also mention that Mr Power had suffered a protracted illness in the previous year.

The other partners did not enjoy an increase in income similar to that of Mr Power. Their income remained constant.

However the failure to show an increase in income from an expenditure has no bearing on the matter. It is not a condition of the deductibility of an expenditure that it should result in any particular income or that any income should be traceable to the expenditure and it is not necessary to show a causal connection between an expenditure and a receipt. An expenditure may be deductible even though it is not productive of any profit.

In my view the 15% management fee was an expense incurred for the purpose of earning income and it was a reasonable amount to be paid for the benefits which enured to the law firm. The partners were relieved of personal liability under the lease with the landlord. That liability was assumed by the company. The partners were relieved of furnishing gratuitous services to suppliants therefor no matter how good the cause. Partners could withdraw or enter the law firm with greater ease and at less expense. The assumption of the responsibility for hiring staff, keeping the accounts and collecting them resulted in a more efficient operation.

I am confirmed in this conclusion by the remarks of Ritchie, DJ in Shulman v MNR, [1961] Ex CR 410; [1961] CTC 385; 61 DTC 1213, when he said at page 421 [396,1219]:

Because the management fee was paid to a corporation of which the appellant and his wife are the only shareholders and, so far as the record discloses, the management agreement was negotiated between the appellant in his personal capacity and the appellant in his capacity as the agent of Shultup does not, per se, preclude the management fee from being a legitimate operating expense of the law practice.

Later on pages 421 and 422 [397,1219] he said:

A solicitor is not precluded from entering into a contract with a corporation to perform the non-professional duties relating to the management of his law office which he, if so minded, could perform himself. Unless I find fraud or improper conduct, I cannot disregard the separate legal existence of Shultup and hold the fee payable under the management agreement is not a legitimate operating expense solely because the appellant and his wife are the only shareholders of Shultup and because the appellant, as a lawyer, negotiated with himself, as the president of the company. If the re-assessment is to stand, justification for deduction of the $9,500 fee being brought within either or both of the sections of the Act upon which the Minister relies must be found in the procedure by which the terms of the agreement were implemented and the results flowing therefrom.

Still later he said at pages 423 and 424 [398, 1220]:

In view of the uncontradicted evidence of Mr Shulman, I am not prepared to find the provisions of section 12(1)(a) demand the dismissal of the appeal. According to Mr Shulman’s testimony the duties he performed as the agent of Shultup had a direct relation to increasing the income of the office and his own professional Income. In such circumstances I am unable to find payment of the management fee, standing by itself, was not an outlay of having been made in accordance with the ordinary principles of commercial trading or accepted business practice.

I have quoted the foregoing remarks of Mr Justice Ritchie to emphasize his conclusion that the payment of a management fee was an expense incurred for the purpose of gaining or producing income from the business of a taxpayer and accordingly is not prohibited as a deduction in computing income by virtue of paragraph 12(1)(a).

Mr Justice Ritchie did hold that, in the circumstances of the Shulman case (supra) the management agreement with the corporation and the way the transactions were carried out unduly or artificially reduced the income of the appellant and the fee paid to the corporation was not deductible by virtue of subsection 137(1).

In Grotell v MNR, [1972] CTC 480; 72 DTC 1641, the taxpayer was a medical doctor who carried on his practice in partnership with three other doctors. The doctors formed a management corporation to supply non-medical services to the partnership. The shares in the management corporation were owned by the wives of the three doctors and by two of the doctors. The doctors provided most of the nonprofessional services on behalf of the management corporation to the medical partnership for which they received a salary of $40 per month from the management corporation. Nothing was changed with respect to the non-professional services rendered by the doctors, the employees were the same performing the same services, albeit more efficiently. The medical partnership paid to the management corporation a total of $13,000 which was claimed as a business expense. The Minister disallowed $4,700 of that amount which was paid as a management fee. The balance was reimbursement of expenses of the medical partnership paid on its behalf by the management corporation.

My brother Gibson held that all of the $13,000 (which included the management fee) paid to the management corporation was properly deductible by the partnership. He found that the contracts between the medical partnership and the management corporation were bona fide business transactions. He consequently held (1) the management fee (together with the other expenses) was an outlay or expense made or incurred by the appellant for the purpose of gaining or producing income from the medical practice of the appellant within the meaning of paragraph 12(1)(a) of the Act and also (2) that the payment of the management fee and other expenses was not a disbursement or expense made or incurred in respect of a transaction or operation that, if allowed, would unduly or artificially reduce the income.

The conclusion reached by Mr Justice Gibson that the management fee was not precluded by paragraph 12(1)(a) as a deduction in computing income coincides with the conclusion I have reached in the present appeal. I am unable to find any material difference in the facts in the appeal before Mr Justice Gibson and those in the appeals before me. If anything the facts before me are more favourable to the plaintiffs herein, because they did not participate in the work of the management company or as shareholders. A solicitor who later became a partner in the law firm became a shareholder in the management company but he is not a plaintiff in these appeals.

I therefore turn to the second contention by the Minister that the transaction here in question would unduly or artificially reduce the income and the deduction of the management fee in computing income is, therefore, prohibited by subsection 137(1).

Counsel for the Minister did not contend that the management company was a sham nor did he dispute that the payments made by the law firm to it were properly made pursuant to a legal contract. What he does contend is that the management fee is not deductible by reason of subsection 137(1).

As I understood the basis of that contention it was that the services performed by the management company for the law firm were services that could have been performed by the law partners themselves and had in fact been performed by them or their own employees previously at a cost to them lower than the cost for the services provided by the company by the amount of the 15% management fee and for that reason the income of the partners was unduly or artificially reduced by that amount.

There was evidence adduced that a management fee of 15% of the disbursements made on behalf of a customer is the normal and going rate for services of this kind. For that reason the payment of a management fee in that amount would not unduly reduce the income of the payor if the expense was incurred for legitimate business reasons.

In my view the propriety of the deduction of the management fee falls to be decided upon a determination of the question whether genuine business reasons existed for payment of the management fee under this contract.

In concluding that the payment of the fee was an expense incurred for the purpose of gaining or producing income from the plaintiffs’ business, I found that true business motivation existed with consequent business advantages.

That being the case it follows that payment of a management fee is a legitimate expense commensurate with the commercial and business advantages which flowed from the performance of those services and that the payment of the management fee did not result in an artificial reduction of the plaintiffs’ income.

For the reasons I have given I find that the plaintiffs, in computing their incomes for their 1968 and 1969 taxation years, are entitled to deduct their proportionate shares of the sums of $9,684.82 and $10,439.74 being the amount of the management fees paid by the partnership in the respective taxation years and the assessments must be revised accordingly.

The appeals herein are, therefore, allowed and the assessments are referred back to the Minister for the necessary revision. The plaintiffs are entitled to their taxable costs. Because the appeals were heard on common evidence there shall be but one counsel fee.