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Citation: 2005TCC402
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Date: 20050927
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Docket: 2003-1209(IT)G
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BETWEEN:
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MANCHESTER CHIVERS & ASSOCIATES
INSURANCE BROKERS INC.,
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Appellant,
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and
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HER MAJESTY THE QUEEN,
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Respondent.
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REASONS FOR JUDGMENT
Hershfield
J.
[1] This
is an appeal with respect to the Appellant's 1997, 1998 and 1999 taxation
years. In each such year the Appellant deducted directors' fees paid for
directors who were the adult children of the shareholders of the Appellant
company (the "subject directors" or the "children"). The
directors' fees were disallowed as an expense on the basis that they were not
incurred to earn income from a business or, in the alternative, on the basis
that the expenses claimed were not reasonable. The Respondent relies on
paragraph 18(1)(a) and section 67 of the Income Tax Act (Canada) (the "Act") respectively.
[2] The
Appellant is in the insurance business. It has an October 30 year-end.
[3] One
of the principal shareholders of the Appellant, Mr. Manchester, gave evidence
at the hearing. He, his wife and the third shareholder, Mr. Chivers, were the
sole shareholders of the Appellant company. Three of the four subject directors
were children of Mr. and Mrs. Manchester and the fourth was the child of Mr.
Chivers. The three shareholders were also directors of the company throughout
the years in question as they had been prior to the appointment of the subject
directors sometime prior to the years under appeal.
[4] Mr.
Manchester admitted that the appointment of the children as directors was
largely tax driven. The Appellant's earnings were in excess of the amount
eligible for the small business deduction. Expensing corporate earnings to the
adult children would result in tax savings and help ease the financial burden
associated with the education and maintenance of the children. As things have
turned out, the denial of the deduction for fees paid to the children will
result in a double tax penalty. The denial of the expense will result in the
Appellant paying tax on the amount denied notwithstanding that the children
have included the fees in their income.
[5] Aside
from the tax savings motive for appointing the children as directors, Mr. Manchester
testified that the appointment of the subject directors to the Board of the
Appellant was also to expose them to the Appellant's business in the hope that
one or more of them would take an interest in it, become active in it and, one
day, take it over so as to ensure its continuity and value. This was forward
looking as when the children were first appointed (prior to the years under
appeal), they were all in school although only one of the children remained in
school throughout the entire period under appeal. Two of the other three children
began working in 1998 and the fourth, Jody Manchester, had left school prior to
the years under appeal and was employed during much of the period under appeal
in the insurance business but with a different firm in a different city. None of the children were employed
during the subject period with the Appellant other than in their capacity as
directors.
[6] Mr.
Manchester acknowledged that the children did little as directors of the
company other than sign necessary corporate documents as required of directors.
There were no directors' meetings and few discussions, although the children
were cautioned as to directors' liabilities, particularly statutory liabilities,
that they were exposed to as directors. Jody Manchester testified at the
hearing and confirmed that she was cautioned about liability risks. She also
made reference to occasional conversations with her father about the
corporation's business during the subject years. The other children never took
an interest in the business and did not, in any event, testify at the hearing.
Aside from Jody's evidence as to occasional conversations with her father, Mr.
Manchester's evidence was that discussions, to the extent that they occurred in
respect of the affairs of the corporation, were largely, if not solely, limited
to discussions "around the table" when the children were at home
(which would not have been often since they were for the most part not living at
home during much of the period under consideration).
[7] It
is clear that the children did not participate in the day-to-day operations of
the corporation and did not partake in the management of the affairs of the
corporation. They were not relied upon by the corporation in the performance of
any directors' duties except to sign documents required to be signed by
directors. Subject to making some allowances for Jody Manchester, I find that their
presence added little if anything to the corporation's current well being.
Little was expected of them.
[8] However,
once appointed, the corporation has no choice but to recognize the presence of
each and every member of its board. Shareholders are allowed to vote their
shares in the election of directors in their self-interests for whatever
reasons they may have. The tax saving motivation for their election cannot
impugn the appointment. That they hold office is a legal reality. They have
duties at law and to suggest that the question of the appropriate compensation
is other than one of reasonableness, determined by any number of factors
including the extent to which they attend to duties prescribed by their office,
is misguided. The corporation is imposed upon as a matter of corporate law to deal
with the issue of compensating its directors. That process is part of its
income earning process. The Respondent cannot rely on paragraph 18(1)(a)
to deny the expensing of directors' fees fixed as prescribed by corporate law.
That is, in my view, paragraph 18(1)(a)
cannot apply as the reason to deny directors' fees paid in the course of
operating as a corporate entity regardless how little a director may contribute
to the income stream or income potential of the corporation. However, that a legal requirement to pay
directors' fees arises from a required process is not sufficient in terms of
allowing the deduction under the Act given the limitation set out in
section 67 of the Act.
[9] Section
67 reads as follows:
67. In computing income, no
deduction shall be made in respect of an outlay or expense in respect of which
any amount is otherwise deductible under this Act, except to the extent that
the outlay or expense was reasonable in the circumstances.
[10] The remaining issues then are whether the directors' fees in the years
in question were reasonable in the circumstances and, if not, what amounts
would be reasonable.
[11] While reasonableness in the context of this appeal should not, as ably
argued by Appellant's counsel, be determined by the methodology employed in the
setting of directors' fees, that methodology needs to be mentioned.
Mr. Manchester's wife, a shareholder, determined each child's director's
fee on the basis of that child's requirements for the year. Indeed the fees
were fixed after the draws were made. The company was paying the personal
living expenses of the children as and when required and as approved by
Mrs. Manchester on the withdrawal from the corporation's account. Hence
you have directors' fees that are all over the map in numerical terms. There is
no relationship between the amount declared and paid as directors' fees and the
performance of duties on behalf of the company, nor does any such relationship
exist in terms of any expectations of what these members of the board might add
by their mere presence. Further, there is nothing in their remuneration
declared and paid on a current basis that can properly relate in a reasonable
way to some future goal of succession.
[12] In 1996 one child received as much as $37,589.00 and another received as
little as $9,500.00. In 1997 one child received as much as $40,000.00 and
another received as little as $1,500.00. In 1998 only two children received
fees even though all remained directors: one received fees of $16,700.00 and
the other received $35,000.00. All such amounts were determined on the basis
of, and paid to cover, personal expenses, unrelated to corporate affairs, based
on personal needs as dependants or partial dependants of the shareholders of
the company. The child in school throughout the appeal period received
$9,500.00, $40,000.00 and $35,000.00 in each of the subject years and Jody
Manchester, the child that was in the same business as the Appellant, received
$28,900.00 (due to being unemployed at the time) and $11,600.00 in respect of
the 1997 and 1998 years respectively and nil in respect of the 1998 year being
self-sufficient by that time.
[13] In these circumstances, the challenge of deciding the reasonableness
of the directors' fees for the purposes of section 67 is perplexing. On being
invited to make a suggestion on the question, counsel for the Appellant offered
for my consideration the disallowance of 30% of the expenditures as being
unreasonable based in part at least on their having a personal element. The Respondent offered no suggestions.
While I believe that the Respondent had a responsibility to assist the Court
and present views on reasonableness (and not simply fall back on the position
taken which was to let the Appellant prove its own case), I did not press the
point at the hearing given the Respondent's principal position was to deny all
the subject expenditures pursuant to paragraph 18(1)(a).
[14] It is of course impossible to delineate principles that might act as a
firm guide, in cases like this, in the identification of a reasonable expense.
What is clear is that if directors' fees are arbitrarily set, without reference
to anything meaningful in the corporate context, then they are going to
be subject to scrutiny. The more arbitrary and disproportionate to any possible
relevant factor, the more vigilant the scrutiny will be particularly in closely
held corporations where non‑arm's length, passive directors are
appointed. In such circumstances, corporations, such as the Appellant, are put
in a difficult position given that the burden of proof is on them to establish
what is reasonable.
[15] The Appellant's counsel did cite authorities, however, that should be
mentioned. In Safety Boss Limited v. The Queen the view is expressed that an expense
should not be denied unless no reasonable business person would pay such amount
having only the business consideration of the corporation in mind. What is that
amount in the case at bar?
[16] In Otto Roofing Ltd. v. M.N.R.
an earned bonus paid as an additional director's fee was disallowed based on it
being disproportionate to the corporation's earnings. It was unreasonable to
pay directors 80% of the corporation's earnings. If that were the general rule,
many high tech companies in recent years would be disallowed directors' fees
altogether. Regardless, in the case at bar, earnings were sufficient to reward
directors but that only begs the question as to determining a reasonable amount
in the circumstance of this case.
[17] The Appellant also puts reliance on the liability aspect of the office
of directors. Directors are indeed subject to risks under a number of statutory
liability provisions not the least of which we see in this Court under the Act
and the Excise Tax Act (GST) for unremitted taxes collected by the
corporation. Fiduciary duties are a breeding ground for liability as well.
While the children relied on their parents to protect them (as testified to by
Jody Manchester) and while they would not likely be called on, compared to the
other directors with resources, there is always a risk of liability that could
financially ruin any director, active or passive, at any time.
[18] On the other hand, compensating directors for the liability risks for
their own breaches is questionable where all concerned are of a common mind
that the directors will effectively ignore their fiduciary duties. Still,
persons in trust positions are exposed and insuring directors against liability
is a practical reality. Compensation in lieu of insurance at a comparable cost
to the corporation might be a reasonable approach in many instances.
[19] As to other factors that might play into determining reasonable fees,
commercial realities must be recognized. Generally it might be reasonable to pay
more where the responsibility is greater or where the very presence of the
person adds credibility and influence. A variety of intangible contributions
might be considered. Comparables for closely held corporations might have been
helpful. The Respondent might well have offered evidence on this latter aspect
of directors' compensation instead of simply leaving the burden of proof with
the Appellant. In any event, I have considered the following factors in the
limited circumstances of this case:
(1) Jody Manchester
was the child that an outsider, considering the possible best interests of the
business, might have considered as the most worthy among the children in terms
of compensating her as a director. She had experience in the Appellant's
business, some interest and, along with the others, signed documents and had liability
risks. Even though expectations and actual participation were limited she might
have been a helpful addition to the board. Until she stopped receiving compensation
in 1999, she received $28,900.00 in the Appellant's fiscal 1997 year and
$11,600.00 in its fiscal 1998 year;
(2) Each of the other
children had liability risks and performed duties only as minimally imposed on
them, namely, signing documents. They had no experience and no apparent
interest. Expectations were minimal. There is no evidence to suggest that they
could make a contribution or otherwise be a helpful addition to the board. Excluding
years in which no compensation was paid, they received differing amounts of
annual compensation for acting as directors: at the low end $1,500.00 and at
the high end $40,000.00. The mean fell between $16,700.00 and $27,600.00. At
$27,600.00, the amount is almost 250% of that paid to Jody Manchester in 1998.
This strikes me as patently unreasonable having only the business
considerations of the corporation in mind;
(3) That a director
stops receiving compensation in any given year is not a factor in considering a
reasonable compensation for that or any other director in that or in any other
year;
(4) Subject to
complying with rules governing the fixing of fees for directors, some
differential in compensation is reasonable as among directors where any
reasonable distinction can be drawn;
(5) Barring a business
explanation (such as a deficiency in a prior years' compensation, years of
service, a regulatory requirement, etc.) it is not reasonable that a
corporation expense more for fees in respect of one director than for another
where the other made, objectively and subjectively, the same or a greater
contribution.
[20] With all these factors in mind I will allow as reasonable, the amount
of $11,600.00 as a deduction in respect of Jody Manchester's services as a
director for each of the Appellant's 1997 and 1998 taxation years. That she
was, as a person in the business, capable of contributing, should be sufficient
to allow more than a small allowance in respect of her appointment. On the
other hand, if it was reasonable to pay her $11,600.00 in 1998, no more can be
justified, on the evidence, as reasonable for 1997. In respect of each of the
other directors, I will allow as reasonable, the amount of $1,500.00 in respect
of their directors' services for each year in respect of which compensation was
paid. If it was reasonable to pay Mr. Chivers' son that amount in 1997, no more
can be justified, on the evidence, as reasonable for any of the other directors
(aside from Jody Manchester) in any other of the subject years. All such
amounts allowed are, in my view, somewhat generous but, in the circumstances, I
have given the Appellant the benefit of any doubt as to the reasonableness of
the fees in question.
[21] Accordingly, the appeals are allowed, without costs, on the basis set
out above in paragraph 20 of these Reasons.
Signed at Ottawa, Canada, this 27th
day of September 2005.
Hershfield
J.
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