M.S.S. Inc. v. The Queen, 87 DTC 5088, [1987] 1 CTC 130, [1986] 2 CTC 99 (FCTD), aff'd 89 DTC 5502 (FCA)

Pinard, J. [Translation]:—This is an appeal in the form of an action pursuant to subsections 172(1) and 175(3) of the Income Tax Act, SC 1970-71-72, c. 63, as amended, brought by the taxpayer M.S.S. Inc. against a decision of the Tax Review Board on May 26, 1983, dismissing the appeal of the plaintiff against notices of reassessment by the Minister of National Revenue for the taxation years 1976 and 1977.

In his notification confirming the said notices of assessment the Minister of National Revenue gave the following reasons, inter alia:

. . . the management costs of $33,600 in 1976 and $40,000 in 1977 were not made or incurred by the taxpayer for the purpose of gaining or producing an income from the business within the meaning of s. 18(1)(a) of the Act.

It may be noted at once that, by consent of the parties, the plaintiffs statement of claim was amended at the hearing to substitute the sum of $40,800 for that of $40,000 with respect to the deduction claimed by it for management fees during 1977; the plaintiff was also allowed to amend the conclusions of its statement of claim to claim the costs of its expert witness.

During the taxation years 1976 and 1977 the plaintiff M.S.S. Inc., a corporation legally formed under the Quebec Companies Act, was engaged in the business of distributing industrial equipment. As admitted by the parties in the pleadings, all the shares in its capital stock were owned by Les Entreprises G.M.B.D. Ltée (G.M.B.D. Ltée), which had purchased them from A.

G. Joyce Ltd. by an agreement signed on May 29, 1975.

G.M.B.D. Ltée was a company in which the shares were held exclusively by four key employees of the plaintiff, namely Messrs. Claude Gagnon, Al- lyre Martin, André Bélanger and Gilbert Dumoulin, who wished to purchase the shares of their employer M.S.S. Inc.

The plaintiff alleged that Messrs. Gagnon, Martin, Bélanger and Dumoulin, while retaining their respective jobs of manager, salesmen and accounting clerk during the taxation years in question, provided management and administrative services through the intermediary of G.M.B.D. Ltée; the plaintiff further stated that in return for these services it paid G.M.B.D. Ltée the sums of $33,600 in 1976 and $40,800 in 1977 as management fees.

The plaintiff accordingly argued that as these amounts paid its parent company G.M.B.D. Ltée as management fees were expenses incurred in gaining income from a business they were admissible as deductions from its income. The plaintiff argued in particular that the management and administrative services were actually provided by G.M.B.D. Ltée through its directors, Messrs. Gagnon, Martin, Bélanger and Dumoulin, that the expenses were fair and reasonable in terms of the services rendered and the work done, and finally that the expenses were actually incurred and were not artificial.

The defendant, for her part, alleged that M.S.S. Inc. is a wholly-owned subsidiary of G.M.B.D. Ltée; she added that G.M.B.D. Ltée employed no one, had no organization and no administrative or management system that would have enabled it to provide management services to M.S.S. Inc., and that it in fact provided no such services to M.S.S. Inc. during the years at issue. The defendant further stated that G.M.B.D. Ltée's only activities consisted of collecting dividends and the so-called management fees of M.S.S. Inc. and repaying A.G. Joyce Ltd. for the purchase of the M.S.S. Inc. shares. The defendant submitted that the only management services which were rendered to M.S.S. Inc. were by its own directors and/or employees, and in that capacity only, and this was why, inter alia, M.S.S. Inc. paid their salaries, bonuses and other expenses.

The defendant accordingly submitted that the expenses claimed by M.S.S. Inc. as management fees were not true management fees, and were not incurred for the purpose of gaining an income within the meaning of paragraph 18(1)(a) of the Act; the defendant further stated that, even assuming these expenses were management fees, in the circumstances they were in any case unreasonable within the meaning of section 67 of the Act. Additionally, the defendant argued that the deduction claimed by M.S.S. Inc. for these expenses, if allowed, would have unduly or artificially reduced the income of M.S.S. Inc. as stated in subsection 245(1) of the Act.

Sections 18(1)(a), 67 and 245(1) of the Income Tax Act, which are relevant, must be reproduced here; they provide:

18. General limitations.

(1) In computing the income of a taxpayer from a business or property no deduction shall be made in respect of

(a) General limitation.—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 business or property;

67. General limitation re expenses.

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.

245. Artificial transactions.

(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 the case at bar the plaintiff had a duty to establish that it had actually spent the sums of $33,600 and $40,800 in the taxation years 1976 and 1977 for management and administrative services actually provided to it by G.M.B.D. Ltée; in addition to showing that these expenses were capable of enabling it to produce an income, the plaintiff had to establish that they were reasonable in the circumstances.

The evidence further disclosed the following relevant facts.

(1) Negotiations to purchase the shares of M.S.S. Inc. held by A. G. Joyce Ltd., through a company which was to be formed, began in 1972, and in early 1973 the four eventual shareholders of G.M.B.D. Ltée assumed they would thus become owners of the shares of their employer M.S.S. Inc.

(2) On account of his relatively advanced age Mr. Joyce, the president of A. G. Joyce Ltée, wished to sell his company to the four key men in its subsidiary M.S.S. Inc., but through a single individual: hence the subse- quent incorporation of the company G.M.B.D. Ltée (“G” for Gagnon, “M” for Martin, “B” for Bélanger and “D” for Dumoulin).

(3) At the request of Mr. Joyce in late 1972 the accountant Bergeron, auditor for the companies M.S.S. Inc., G.M.B.D. Ltée, A. G. Joyce Ltd. and Mr. Joyce personally, prepared a draft sale of the shares in M.S.S. Inc. to its four key employees; this draft sale was given to Mr. Joyce in January 1973 and included a clause providing for the payment of management fees by M.S.S. Inc. to the future company G.M.B.D. Ltée in the annual amount of $36,000; the draft was subsequently submitted to other consultants and discussed by all concerned, finally resulting in the agreement signed on May 29, 1975, which says nothing about management fees.

(4) A request for an advance ruling on behalf of the taxpayers in question, dated October 30, 1974, to the Legislation Branch of the Department of National Revenue, Taxation, referred inter alia to a deduction for management fees of $40,000 a year on the assumption that such fees would be paid by M.S.S. Inc. to G.M.B.D. Ltée.

(5) In 1973 Messrs. Gagnon, Martin, Bélanger and Dumoulin accordingly became more involved in the activities and management of M.S.S. Inc.; their responsibilities were increased while Mr. Joyce gradually withdrew from the business, to such an extent that very little was changed by the agreement signed on May 29, 1975 between G.M.B.D. Ltée and A. G. Joyce as far as they were concerned, except “mentally”.

(6) On the one hand, as of May 25, 1975 the salaries and bonuses of shareholders in G.M.B.D. Ltée, except for the commission salesman Dumoulin, were essentially frozen on the instructions of Mr. Joyce himself; on the other hand, the salaries and bonuses of the same individuals, for the year immediately preceding signature of the agreement between A. G. Joyce Ltd. and G.M.B.D. Ltée, were substantially increased over other earlier years.

(7) G.M.B.D. Ltée ultimately purchased the company M.S.S. Inc. with a loan of $100,000 from Mr. Joyce personally and by means of a debt of $500,000 payable to A. G. Joyce Ltd. in monthly instalments of $7,761, including interest at eight per cent per annum, for seven years.

(8) In 1976, M.S.S. Inc. paid G.M.B.D. Ltée the total sum of $70,614; pursuant to a “regularization” by the auditor for these companies at the close of the fiscal year this amount was divided in two, $37,014 as dividends and $33,600 as management fees; the latter corresponded essentially to interest then due by G.M.B.D. Ltée to A. G. Joyce Ltd., totalling $32,967.

(9) Similarly, in 1977 the total sum of $99,704 paid by M.S.S. Inc. to G.M.B.D. Ltée was divided into two parts, $58,904 as dividends and $40,800 as management fees.

(10) The M.S.S. Inc. turnover of $4,531,350 in 1976 fell to $3,961,061 in 1977 because of an eight-month strike at Alcan, a company to which M.S.S. Inc. made more than 50 per cent of its sales.

(11) To purchase the shares in M.S.S. Inc. the four shareholders in G.M.B.D. Ltée only had to spend $10,000 of their own money, each in a proportion corresponding to his interest in G.M.B.D. Ltée, 51 per cent in the case of Mr. Gagnon, 18 per cent in the case of Mr. Martin, 16 per cent in the case of Mr. Bélanger and 15 per cent in the case of Mr. Dumoulin.

(12) From the date of the transaction, May 29, 1975, and in particular in the years 1976 and 1977 at issue, Mr. Joyce, despite his many absences, re- mained chairman of the board of directors of M.S.S. Inc. and effectively exercised full control over this business, which he had expressly reserved in the same contract; as confirmed by the witness Allyre Martin, every major decision was submitted to Mr. Joyce for approval, he was regularly given the financial information on the business and generally signed the tax returns.

(13) Commencing with the date of the transaction on May 29, 1975, Mr. Joyce in fact received from M.S.S. Inc. an annual salary of $50,000 plus certain expenses; he always retained his office in the M.S.S. Inc. premises; finally, it was he who selected the third director, Mr. Gagnon, to sit with him and his wife on the board of directors of M.S.S. Inc., until the debt owed by G.M.B.D. Ltée to A. G. Joyce Ltd. had been paid in full.

(14) During the taxation years 1976 and 1977 G.M.B.D. Ltée had no employees or customers; it had no telephone or special office, as its address was that of M.S.S. Inc.

(15) There is no written contract confirming an agreement for the supplying of management and administrative services by anyone to M.S.S. Inc.

(16) The said Messrs. Gagnon, Martin, Bélanger and Dumoulin did in fact meet outside the usual working hours of M.S.S. Inc. to discuss its management and administration specifically.

In my opinion M.S.S. Inc. has not only been unable to establish the existence of even a verbal agreement about the management services the cost of which it is claiming as a tax deduction, but has been unable to establish that the management services were provided to it by or through G.M.B.D. Ltée; the facts and circumstances which follow together help to confirm these conclusions.

— Despite the reference to management fees contained in both the draft agreement prepared in January 1973 by the auditor Bergeron and in the request for an advance ruling made to the Department of National Revenue, Taxation, in October 1974, the elaborate agreement ultimately signed on May 29, 1975 was nevertheless silent on the matter; the shareholders of G.M.B.D. Ltée in December 1975 did find it possible to put into writing other agreements between them, but said nothing regarding the management fees that could entitle them to a tax benefit.

— No minutes of meetings of the directors and/or shareholders of G.M.B.D. Ltée or M.S.S. Inc. referring to any agreement about the management costs in question were produced.

— The purpose of creating G.M.B.D. Ltée was to enable the four key employees of M.S.S. Inc. to purchase the shares in their employer held by A. G. Joyce Ltd., and allow the latter to have a single debtor to pay for those shares and so enjoy more protection for its debt; in this regard one has only to look at the many guarantees and restrictions stipulated in the contract of May 29, 1975 to benefit Mr. Joyce and A. G. Joyce Ltd.

— In actual fact, the only activity of G.M.B.D. Ltée was to collect from M.S.S. Inc. the amounts needed to pay the price for the sale of the latter's shares to A. G. Joyce Ltd.; in addition, G.M.B.D. Ltée had no employees, customers, office, telephone or specific address.

— According to the spontaneous admission by the witness Martin, accountant and controller for M.S.S. Inc., the amounts of money paid by M.S.S. Inc. to G.M.B.D. Ltée monthly were paid to allow the latter to repay A. G. Joyce Ltd.; indeed, the amount of management fees was not determined in advance, but was the result of a “regularization” by the auditor Bergeron, at the end of the M.S.S. Inc. and G.M.B.D. Ltée fiscal years; further, this accounting operation meant that, despite the increase in turnover at M.S.S. Inc., which was now up to about $7 million the amount of the management fees continued to decrease, going from $39,600 in 1978 to $37,200 in 1979 and $34,920 in 1980.

— Despite his gradual withdrawal, Mr. Joyce retained full control over the administrative decisions of M.S.S. Inc. until the debt owed by G.M.B.D. Ltée had been paid in full; he continued to be chairman of the board of directors of M.S.S. Inc., he personally appointed a third person to sit with himself and his wife on the board of directors; moreover, important matters were submitted to him for approval and M.S.S. Inc. paid him an annual salary of $50,000 in addition to other expenses; and for all practical purposes it was he who decided to freeze the salaries and bonuses of the key employees of M.S.S. Inc. after the agreement of May 29, 1975 had been signed, all in order to provide a better protection for his debt and that of A. G. Joyce Ltd.

— The four shareholders and directors of G.M.B.D. Ltée continued to be employees of M.S.S. Inc., with the same responsibilities, after the agreement of May 29, 1975 was signed; from 1973 on, they had become increasingly involved in the activities and management of M.S.S. Inc. to the point that the written agreement, in their words, had no practical effect on their work, the change being only “mentally” significant; though their salaries and bonuses were for all practical purposes frozen when this formal agreement was signed, they had nevertheless been considerably increased the previous year; all this tends to show that M.S.S. Inc. obtained all the management and administrative services it needed from its own key employees, to whom it paid salaries and bonuses, and these management services were complemented by those actually and legally provided by Mr. Joyce.

— It is true that Messrs. Gagnon, Martin, Bélanger and Dumoulin met outside the usual working hours of M.S.S. Inc. to discuss its management and administration specifically; however, there are only seven handwritten minutes of these meetings, and they do not indicate that they were meetings of G.M.B.D. Ltée; moreover, in view of the nature of their duties and interests in the circumstances it would be normal practice for these employees of M.S.S. Inc. to meet in order to perform their duties with respect to their own business M.S.S. Inc.

— No specific verbal agreement about the management fees in question was established by the witnesses for the plaintiff, whether between G.M.B.D. Ltée and M.S.S. Inc., between the shareholders of G.M.B.D. Ltée and M.S.S. Inc. or between the shareholders of G.M.B.D. Ltée and G.M.B.D. Ltée itself; the employees of M.S.S. Inc. simply said that they had themselves provided management services to their employer, which paid G.M.B.D. Ltée for them, they confirmed that an amount was ultimately fixed by the auditor Bergeron as the value of these services at the end of the fiscal year of these two companies. Additionally, if the management fees had been the subject of a specific agreement, even a verbal one, Mr. Joyce would not have had, through the auditor Bergeron, to draw the attention of Messrs. Gagnon, Martin, Bélanger and Dumoulin after fiscal year 1976 to the fact that by an accounting operation the management services provided by them personally to M.S.S. Inc. had been credited to their company G.M.B.D. Ltée, and obtain their consent to this; if the latter consent was in some way the verbal agreement referred to by the plaintiff, which in my view it was not, the agreement would be to say the least very incomplete.

— Finally, the expert witness Jacques Vallerand did show that the amount of the expenses M.S.S. Inc. maintained it had incurred for management services in 1976 and 1977 is proportionately lower than that generally applied to management fees by businesses of the same type for the same period of time; additionally, the expert witness was not really able to come to other conclusions on the said management fees, as he was clearly not made aware of all the circumstances of the case at bar.

It accordingly appears from the weight of the evidence that the amounts paid by M.S.S. Inc. to G.M.B.D. Ltée in 1976 and 1977 were not management fees but actually all dividends used to repay A.G. Joyce Ltd., and thereby to make Messrs. Gagnon, Martin, Bélanger and Dumoulin owners of the shares of M.S.S. Inc. through G.M.B.D. Ltée.

In any case, M.S.S. Inc. cannot succeed if only because it was not legally required to pay management fees to G.M.B.D. Ltée, in view of the absence of any written or even verbal agreement to this effect. The relevant provisions of the Income Tax Act have to be interpreted in light of the principles stated in the judgment of the Supreme Court of Canada in Stubart Investments Limited v. The Queen, [1984] C.T.C. 294; 84 D.T.C. 6305, where in a similar matter Estey, J. gave the following guidelines for interpretation, at 316-17 (D.T.C. 6323-24):

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, s. 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 s. 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

(My emphasis. It should be noted that the section 137 referred to by the Supreme Court of Canada corresponds to section 245 of the Income Tax Act now in effect.)

On the matter of the importance of a legally binding transaction or complete transaction in this area, it is also worth noting the following observations of Mahoney, J. of the Federal Court of Canada in Frederick G. Vivian v. The Queen, [1983] C.T.C. 107 at 108; 83 D.T.C. 5144 at 5145:

There is no point in a detailed review of the extensive documentary evidence, all admitted by agreement. Suffice it to say, the Plaintiffs and the companies took and meticulously followed the competent professional advice. Every move is properly documented and, in the documentation, every “i” is dotted and “t” crossed.

The plaintiff accordingly has not succeeded in establishing that it incurred an expense for the purpose of producing income within the mean- ing of paragraph 18(1)(a) of the Act, and I have no alternative but to dismiss the action with costs.

Appeal dismissed.