The Queen v. Jaqer Homes Ltd., 88 DTC 6119, [1988] 1 CTC 215 (FCA)

Urie, J.:—This appeal from a judgment of the Trial Division was heard together with Appeal No. A-793-83, The Queen v. Jager Holdings (Calgary) Ltd. The actions from which the appeals arose were tried together using the transcript of evidence from the Tax Court as an agreed statement of facts, by the Associate Chief Justice who dismissed the appellant's appeal from a judgment of the Tax Review Board which had allowed the appeal of the respondents from a reassessment for income tax.

The Facts

Briefly stated, the facts are these. The respondent, Jager Homes Ltd. (Homes), which was incorporated in 1954 and which was amalgamated with four affiliated companies in 1962, carried on the business of constructing single and multi-family residential housing.

The respondent, Jager Holdings (Calgary) Ltd. (Holdings) was incorporated in 1958 and at all relevant times carried on the business of land development.

William Jager (William) and his wife Helen Jager (Helen) held 51 per cent and 49 per cent respectively of the outstanding shares of Holdings at all relevant times. Holdings was the majority shareholder of Homes at those times. Prior to September 1973 William Jager managed Holdings, the parent company, while his wife managed the subsidiary, Homes.

Marital problems between William and Helen Jager arose towards the end of 1972 and divorce proceedings were commenced on September 10, 1973 by Helen. Inter alia, she sought in the action a lump sum settlement of $1 million. At the same time she obtained a restraining order against William whereby he was no longer permitted access to his wife and the child of the marriage.

On September 26, 1973 Helen filed petitions to wind up each of the respondent corporations in the Supreme Court of Alberta. Orders issued from that Court on the same day whereby Helen was appointed special manager and John W. Halpin, C.A., Provisional Liquidator of both the respondent companies. William was restrained from the business or management of either.

Thereafter, on the application by counsel for William, orders issued by the Supreme Court of Alberta on September 28, 1973 and October 5, 1973 whereby James C. Fowler was appointed co-Provisional Liquidator of both respondents and William was appointed special manager for Holdings.

During the trial of the winding-up actions in April 1974, a settlement was negotiated whereby William purchased all of Helen's shares in the respondent companies for $1 million. On April 9,1974 the winding-up actions were dismissed by the Supreme Court of Alberta. The Court ordered that the respondent Holdings pay the costs of Helen and the solicitor and client accounts for fees and disbursements submitted by McCaffery and Company, who acted on behalf of William and Holdings in successfully defending the winding-up petitions. The petition in respect of Homes was discontinued without costs.

The legal fees incurred by the respondent companies in defending the winding-up actions totalled $36,800 and were allocated as to $17,396 for payment by Homes and $19,404 by Holdings. All incidental legal fees incurred in the day-to-day operations of the respondents, during the period of winding-up actions, were allowed as current deductions from income by the Minister of National Revenue.

The Tax Review Board set aside the assessments and the Trial Division upheld that decision. It is from the Trial Division judgment that this appeal is brought.

The Issues

The two issues requiring determination on the appeal are whether legal expenses in the aggregate sum of $36,800 incurred by the respondents to defend the winding-up actions brought against them were

(a) incurred for the purpose of gaining or producing income from the business within the meaning of paragraph 18(1)(a) of the Income Tax Act,

c. 63, S.C. 1970-71-72, as amended (the Act); and

(b) were not outlays or payments of capital and therefore not deductible in calculating the Respondent's income by virtue of paragraph 18(1)(b) of the Act.

The Opposing Views

The appellant's submissions in a nutshell were that:

(a) the primary purpose in defending the winding-up actions was to prevent the extinction of the profit-making process, i.e., to preserve the businesses as going concerns and the expenditures made for such purpose were clearly capital, and, in any event;

(b) the expenditures made for such purpose, were too remote from the ultimate result which would flow from the successful defence, viz. that the corporate entities, the respondents, would continue to generate income. Because of the remoteness from the result they were not current expenses incurred for the purpose of gaining or producing income but were for capital account;

(c) that this is so is verified by the fact that if the winding-up actions had been successful, the income-earning structures of the respondents would have disappeared and their assets would have had to be distributed ratably among their shareholders so that the legal expenses of preserving those structures were capital in nature; and

(d) as such, they were not deductible in computing the respondents' income for the year by virtue of paragraph 18(1)(b) of the Act.

The Respondents’ answer to those contentions was neatly summarized by the learned judge of the Tax Court who heard the appeals to that Court when he said: [1]

. . . the appellants incurred legal expenses, not to preserve property rights or exclusive rights, but to obtain “a judicial affirmation” of their fundamental legal rights to operate their businesses and to earn income therefrom.

The winding up action did not affect "the appellants' capital assets in its capital aspect,” it was aimed at the appellants’ freedom to operate the businesses. In my view, this is a valid instance where the principle enunciated by Sir Lyman Duff, “that in the ordinary course, legal expenses are simply current expenditures and deductible as such" must be applied.

Conclusion

The relevant paragraphs of the Act are 18(1)(a) and (b) which read as follows:

18.(1) In computing the income of a taxpayer from a business or property 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 business or property;

(b) an outlay, loss or replacement of capital, a payment on account of capital or an allowance in respect of depreciation, obsolescence or depletion except as expressly permitted by this Part;

The essential question requiring decision, then, is whether the deduction of the legal fees paid is prohibited by paragraph 18(1)(b) because the payments were on account of capital or are properly deductible in computing the respondent's taxable income by virtue of paragraph 18(1)(a). The starting point for making that determination might usefully be the following quotation from the judgment of Fauteux, J. (as he then was) in the Supreme Court of Canada in M.N.R. v. Algoma Central Railway, [1968] C.T.C. 161 at 162; 68 D.T.C. 5096 at 5097

Parliament did not define the expressions "outlay . . . of capital” or "payment on account of capital”. There being no statutory criterion, the application or nonapplication of these expressions to any particular expenditures must depend upon the facts of the particular case. We do not think that any single test applies in making that determination and agree with the view expressed, in a recent decision of the Privy Council, B.P. Australia Ltd. v. Commissioner of Taxation of the Commonwealth of Australia, [1966] A.C. 224, by Lord Pearce. In referring to the matter of determining whether an expenditure was of a capital or an income nature, he said at p. 264:

The solution to the problem is not to be found by any rigid test or description. It has to be derived from many aspects of the whole set of circumstances some of which may point in one direction, some in the other. One consideration may point so clearly that it dominates other and vaguer indications in the contrary direction. It is a commonsense appreciation of all the guiding features which must provide the ultimate answer.

As a further illustration of this view, Lord MacMillan in the widely quoted case of Van Den Berghs, Limited v. Clark, [1935] A.C. 431 at 438-39; 19 T.C. 390 at 428-29 had this to say:

Consequently it is to the decided cases that one must go in search of light. While each case is found to turn upon its own facts, and no infallible criterion emerges, nevertheless the decisions are useful as illustrations and as affording indications of the kind of considerations which may relevantly be borne in mind in approaching the problem.

He then referred to the “leading modern authority on the subject" British Insulated and Helsby Cables Ltd. v. Atherton, [1926] A.C. 205; 10 T.C. 188, and to the oft-quoted view of Viscount Cave that:

. . . when an expenditure is made, not only once and for all, but with a view to bringing into existence an asset or an advantage for the enduring benefit of a trade . . . . there is very good reason (in the absence of special circumstances leading to an opposite conclusion) for treating such an expenditure as properly attributable not to revenue but to capital.

Finally in amplification of the general principles to be employed in determining the nature of business expenditures for tax purposes, what was said by Dixon, J. in the High Court of Australia case of Sun Newspapers Limited v. Federal Commissioner of Taxation (1938), 61 C.L.R. 337, gives some helpful assistance. In that case the appellants had made an agreement whereby they paid a substantial sum of money to prevent the publication of a proposed competitive newspaper. Dixon, J., after referring to the principle enunciated by Viscount Cave in the Atherton case, supra, at page 354-55 said:

The expenditure in question is a large non-recurrent unusual expenditure made for the purpose of obtaining an advantage for the enduring benefit of the appellants' trade by conserving and increasing the value of the goodwill of the newspaper enterprise.

It is true that the payments did not result in obtaining a new capital asset of a material nature, but they did obtain a very real benefit or advantage for the companies, namely, the exclusion of what might have been serious competition.

And then at page 359 he made the following comment which was referred to with approval by Jackett, P. (as he then was) in Canada Starch Company Limited v. M.N.R., [1968] C.T.C. 466 at 471; 68 D.T.C. 5320 at 5323:

The distinction between expenditure and outgoings on revenue account and on capital account corresponds with the distinction between the business entity, structure, or organization set up or established for the earning of profit and the process by which such an organization operates to obtain regular returns by means of regular outlay, the difference between the outlay and returns representing profit or loss.

Finally, at page 363 after analyzing many cases he said that in making the determination that:

. . . I think, three matters to be considered, (a) the character of the advantage sought, and in this its lasting qualities may play a part, (b) the manner in which it is to be used, relied upon or enjoyed, and in this and under the former head recurrence may play its part, and (c) the means adopted to obtain it; that is, by providing a periodical reward or outlay to cover its use or enjoyment for periods commensurate With the payment or by making a final provision or payment so as to secure future use or enjoyment.

I now turn to some of the numerous cases to which counsel referred us which relate to claims for the deductibility of legal expenses and the disposition of such claims by various courts, in the context of the foregoing principles.

M.N.R. v. Dominion Natural Gas Co. Ltd., [1940-41] C.T.C. 155; 1 D.T.C. 499-133 is a decision of the Supreme Court of Canada decided under subsections 6(a) and (b) of the Income War Tax Act the predecessors to paragraphs 12(1)(a) and (b) of the old Income Tax Act and paragraphs 18(1)(a) and (b) of the present Act. The language employed in section 6 is substantially different than that in the later Acts which are for all practical purposes identical. In that case, the respondent sought to deduct the legal costs paid by it in the defence of a court action brought against it for allegedly supplying gas to part of the City of Hamilton contrary to the exclusive right said to belong to the plaintiff. At pages 161 (D.T.C. 499-135 and 499-136) the Chief Justice, with whom Davis, J. concurred, held that:

In the ordinary course, it is true, legal expenses are simply current expenditure and deductible as such; but that is not necessarily so. The legal expenses, incurred, for example, in procuring authority for reduction of capital were held by the Court of Sessions not to be deductible in Thomson v. Batty, [1919] S.C. 289.

Kerwin, J., with whom Hudson, J. concurred, referred to three cases which did not turn on the language of the statutes there under consideration, and said: —

However, as to the other two contentions, there are three decisions that may usefully be referred to. The first of these is Robert Addie & Sons' Colleries Ltd. v. Commissioners of Inland Revenue, [1924] S.C. 231, where the Lord President stated at p. 255 :

What is "money wholly and exclusively laid out for the purposes of the trade" is a question which must be determined upon the principle of ordinary commercial trading. It is necessary, accordingly, to attend to the true nature of the expenditure, and to ask oneself the question, Is it a part of the Company's working expenses: Is it expenditure laid out as part of the process of profit earning?

The second is the decision in the House of Lords in British Insulated and Helsby Cables Ltd. v. Atherton, [1926] A.C. 205. In that case a sum had been irrevocably set aside out of profits as a nucleus of a pension fund, but it was held that the expenditure could not be deducted from the profits. Viscount Cave pointed out that an expenditure though made once and for all may nevertheless be treated as a revenue expenditure but then he added at p. 213: —

But when an expenditure is made, not only once and for all, but with a view to bringing into existence an asset or an advantage for the enduring benefit of a trade, I think that there is very good reason (in the absence of special circumstances leading to an opposite conclusion) for treating such an expenditure as properly attributable not to revenue but to capital.

This speech of Viscount Cave has been referred to a number of times and particularly in two decisions in the English Court of Appeal, Mitchell v. Noble, [1927] 1 K.B. 719, and Anglo-Persian Oil Company v. Dale, [1932] 1 K.B. 124, but it is unnecessary to consider the applicability of either of these.

The third case is Tata Hydro-Electric Agencies v. Commissioner of Income Tax, [1937] A.C. 685, — valuable, in the present instance, not so much for the actual decision as for the fact that their Lordships quoted with approval the extract from the judgment of the Lord President in Addie's case, 1924 S.C. 231, at 235, set out above. The test established by him is applicable to the case at bar, and I have concluded that the payment of the costs was not an expenditure laid out as part of the process of profit earning. It was a ''payment on account of capital” as it was made (to use Viscount Cave's words) "with a view of preserving an asset or advantage for the enduring benefit of a trade."

[Emphasis added. I]

In M.N.R. v. Kellogg Company of Canada, Limited, [1942] Ex. C.R. 33; [1942] C.T.C. 51; [1943] S.C.R. 58; [1943] C.T.C. 1; 2 D.T.C. 601 the respondent successfully defended a trade mark infringement action brought against it thereby incurring legal expenses which it sought to deduct in calculating its taxable income. They were disallowed as not being “wholly, exclusively and necessarily laid out or expended" for the purposes of earning income, that being the language used in section 6 of the Income War Tax Act. Sir Lyman Duff, speaking on behalf of the Court at pages 60-61 (C.T.C. 3-4) of the report said:

As regards this payment, the question in issue was whether or not the registered trade marks of the plaintiffs in the action were valid trade marks, or, in other words, whether or not the present respondents, The Kellogg Company, and all other members of the public were excluded from the use of the words in respect of which the complaint was made. The right upon which the respondents relied was not a right of property, or an exclusive right of any description, but the right (in common with all other members of the public) to describe their goods in the manner in which they were describing them.

It was pointed out in The Minister of National Revenue v. The Dominion Natural Gas Company supra at p. 25, that in the ordinary course legal expenses are simply current expenditures and deductible as such. The expenditures in question here would appear to fall within this general rule.

It is very clear that the appellant does not succeed in bringing his case within the decision upon which he relies.

In M.N.R. v. The L.D. Caulk Co. of Canada Limited, [1954] S.C.R. 55 at 57; [1954] C.T.C. 28 at 30-31, legal fees in making representations to a commissioner appointed under the Combines Investigation Act were held to be deductible by virtue of paragraph 6(1)(a) of the Income War Tax Act because the "payments arose from what were considered the necessities of the practices to the earning of the income. The case is then governed by The Minister v. Kellogg, [1943] S.C.R. 58”. The Supreme Court also found that the Dominion Natural Gas case was Clearly distinguishable as having been a case of expenses “to preserve a capital asset in a capital respect."

In Evans v. M.N.R., [1960] S.C.R. 391; [1960] C.T.C. 69, the issue was as to the right to deduct under paragraph 12(1)(a) of the Income Tax Act (now paragraph 18(1)(a)) legal expenses incurred by the appellant in seeking advice and directions with respect to an estate. The Supreme Court of Canada held that the expense was made in order to protect a right to receive income in each of the years in which there was distributable income from the estate and thus fell within the purview of paragraph 12(1)(b) (now paragraph 18(1)(b)) as a non-deductible capital expense.

In Premium Iron Ores Limited v. M.N.R., [1966] S.C.R. 685; [1966] C.T.C. 391, legal expenses incurred by the appellant in successfully defending an assessment for U.S. income and capital gains tax were found by the majority of the Supreme Court of Canada to be deductible. Martland, J., at page 704 (C.T.C. 396) said:

I have great difficulty in seeing how, in principle, this expense for legal services, made as it was for the purpose of protecting the appellant's income, can be regarded as being different from that which was held to be property deductible in the Kellogg case and also in the Evans case. The disbursement made was not an outlay or replacement of capital, nor a payment on account of capital, within Section 12(1)(b).

The appellant relied heavily on William Ewart Bannerman v. M.N.R., [1957] C.T.C. 375; 57 D.T.C. 1249 (Ex. Ct.); [1959] S.C.R. 562; [1959] C.T.C. 214 (S.C.C.), as support for Her contentions. In that case the appellant sought to deduct legal expenses incurred by him in securing a winding-up order for a company in which he was the owner of half of the issued shares. The Exchequer Court held that the deduction was not proper. Kearney, J., made the following comment at page 380 (D.T.C. 1252-53) which was not disclaimed by the Supreme Court of Canada in dismissing the appeal from his decision:

In a case such as the present one, where the purpose of the expenditure is allegedly not confined to one property or to one objective but to a succession of results, each objective or result becomes increasingly remote. In the absence of any definition of the word “purpose,” as found in section 12(1)(a), I think, to conform to its meaning, there should exist at least a reasonably direct relationship between the objective sought, the means employed to obtain it and the expenditure made thereon.

The appellant, both in his pleadings and testimony, claimed that, as a result of his own action and the subsequent proceedings taken and to be taken by the liquidator, 50 per cent of the monies recovered by the company would ultimately be received by him as a taxable dividend under section 81(1) of the Income Tax Act.

I think that an immediate distinction must be drawn between the primary purpose of the expenditure and indirect and ultimate results therefrom. In my opinion there is evidence in this case of a primary purpose. The managing director, having promised to make restitution, went back on his word and defiantly declared that he had done nothing wrong and that everything that the company had made was due to him and he “was entitled to all” he “had taken," (p. 3 of transcript). In Ex. B, the appellant refers to the removal of the managing director. At p. 16 of his testimony he spoke “first of all putting the company into liquidation and having a liquidator appointed that" he “could deal with.” Batshaw, J., in his judgment removing the managing director and appointing the interim liquidator, said: ”. . . the Court is of the opinion that the elementary rules of ordinary business morality would preclude the application of that by-law” (which gave the president a casting vote) “in favour of a president who sought to use same to perpetuate his corrupt administration . . .”

On the evidence, I think the appellant's immediate and most urgent purpose in making the expenditure on winding-up proceedings was to oust a defiant managing director from the control of the company’s affairs, thus preventing him from continuing his corrupt practices and using his official position to protect his personal interest to the detriment of the shareholders in general, and the appellant in particular. The expenditure claimed as a deduction, I consider, must be attributed essentially to that purpose.

[Emphasis added.]

While other authorities were referred to by each counsel, those dealt with above are representative of all. To paraphrase Lord MacMillan in Van Den Bergh’s case, having searched for light from the decided cases, the issues herein are now capable of resolution. Fundamentally, the learned trial judge was called upon to make findings of fact as to the real character of the benefit sought and he did so in the following passage from his reasons:

I find as a fact that preservation of the corporate shell as a capital asset was incidental to the lawsuit and that the main purpose of the lawsuit was to safeguard the operations of the company. [2]

As a result, he upheld the decision of the Tax Court that the matter should be referred back to the Minister for reassessment on the basis that the legal fees were paid for the purpose of producing income and thus were deductible under paragraph 18(1)(a) of the Act.

I have some trouble with the above-quoted finding when it is read in light of the earlier finding made by the trial judge, when, after reviewing the facts, he said:

It is clear, therefore, that the sums in issue were expenses actually incurred by these two corporate taxpayers to defend an action brought for the purpose of the dissolution of the two companies [3]

[Emphasis added]

That finding is fully substantiated by the pleadings. I find real difficulty, therefore, in appreciating that the preservation of the companies “was incidental to the lawsuit and that the main purpose of the lawsuit was to safeguard the operations of the company.” I would have thought that the reverse was true. If the actions had been successful the companies would have disappeared along with their assets and, of course, neither would have had an income-earning capacity. Conversely, a successful defence of the actions would have enabled both companies to continue earning income. The defence, accordingly, must have been undertaken to preserve the corporate entities as such. From a successful result would flow the continued capacity to earn income. I am of the opinion therefore, that the Associate Chief Justice erred in fact and in principle finding that the main purpose of the lawsuit was to safeguard the operations.

I am reinforced in this view by excerpts from the evidence of William on examination for discovery which were read in at trial:

Q. In terms of the consequence of the winding up on the value of the shares of the company, what would have been the effect of that?

A. The shares would have been worthless, well, half of that value would have been what we received —

Q. Perhaps if you could clarify that, would the value of the shares have gone drastically down?

A. Yes, they did.

Q. With respect, would it be fair to say that the income earning capacity of both of these companies, essentially would have effectively disappeared?

The answer was, "Yes".

Page 29, my lord, Question 102, and it’s in reference to what the taxpayer's perception was, or Mr. Jager’s perception was at to what was going to happen if the winding up proceedings were successful.

A. Well, my idea was that if it was successful, and if it wound down, the court would sell it, and whatever proceedings, monies came out of it, of the sale of the property, would be divided between the shareholders.

From all of the evidence it is reasonable to conclude that the real objective of the plaintiff in the actions was to use the threat engendered by the petitions for winding-up to obtain a settlement of her financial claim in her divorce action or, if no settlement were achieved and the petitions were granted, as a consequence of the winding-up, to receive her ratable share in the distribution of the assets. The defence was clearly instituted to prevent the latter occurrence. That was the primary purpose of the defence in the litigation. The indirect and ultimate result of succeeding in that defence would be that the income-earning capacity for each company would continue. To use the words of Dixon, J. in the Sun Newspapers case, supra, "The expenditure in question is a large non-recurrent unusual expenditure made for the purpose of obtaining an advantage for the enduring benefit of the appellant’s trade . . .” In other words, the payments for legal fees were made to preserve the business entity, structure or organization not as the kinds of expenditures which are made to earn profits from the operation of such business entities.

As I see it, therefore, the legal expenses incurred were not on the income account and, as a consequence were not deductible in the computation of the respondent's taxable income because they did not fall within the exception contained in paragraph 18(1)(a) of the Act. They were, as I see them, made on account of capital and, thus, were not deductible unless they were incurred for the purpose of gaining or producing income. [4] For the reasons already given, I am of the opinion that they were not so incurred. Rather they were outlays on capital the deduction of which were prohibited by virtue of paragraph 18(1)(b) of the Act.

As observed earlier, the task of the trial judge in ascertaining whether expenditures for legal fees are deductible for tax purposes or not, fundamentally is a fact finding one. Is this Court entitled to interfere with his judgment in that regard? As I see it, had the error of the trial judge in making his findings of fact consisted simply of his making findings or drawing inferences which this Court in the first instance might not have made, we would not be entitled to set aside his judgment on that ground alone. In this case, however, there was "a palpable and overriding error which affected his assessment of the facts". [5] It arose from a failure to properly appreciate and weigh the evidence and was tantamount to an error in law. We are, in my opinion, therefore, entitled to set aside his decision and, on a proper appreciation of the facts, to make the decision which he ought to have made.

I would, accordingly, allow the appeal, set aside the judgment of the Trial Division and direct that the reassessments there under review be restored, with costs throughout.

Appeal allowed.