David T. McDonald Co. Ltd. v. MNR, 92 DTC 1917, [1992] 2 CTC 2607 (TCC)

Mogan, T.C.C.J.:—The only issue in this appeal is whether the appellants income is derived from an active business or from a "personal services business". The two relevant definitions appear in paragraphs (a) and (d) of subsection 125(7) of the Income Tax Act, R.S.C. 1952, c. 148 (am. S.C. 1970-71-72, c. 63) (the "Act"):

125(7) In this section,

(a)"active business carried on by a corporation” means any business carried on by the corporation other than a specified investment business or a personal services business and includes an adventure or concern in the nature of trade;

(d) "personal services business” carried on by a corporation in a taxation year means a business of providing services where

(i) an individual who performs services on behalf of the corporation (in this paragraph and paragraphs 8(3)(a.1) and 18(1)(p) referred to as an "incorporated employee"), or

(ii) any person related to the incorporated employee

is a specified shareholder of the corporation and the incorporated employee would reasonably be regarded as an officer or employee of the person or partnership to whom or to which the services were provided but for the existence of the corporation, unless

(iii) the corporation employs in the business throughout the year more than five full-time employees, or

(iv) the amount paid or payable to the corporation in the year for the services is received or receivable by it from a corporation with which it was associated in the year;

It is apparent from the above definitions that they are mutually exclusive. If a corporation carries on only one business, it cannot be both an active business and a personal services business.

The appellant reported income from an active business carried on in Canada for 1985 and 1986 and claimed the small business deduction under subsection 125(1) of the Act and deducted expenses on account of office supplies and professional fees. The respondent assumed that any amount reported by the appellant as income from a business carried on in Canada was income from a "personal services business” within the meaning of paragraph 125(7)(d). Expenses on account of office supplies and professional fees may not be deducted in computing the income of a personal services business by virtue of paragraph 18(1)(p) of the Act and, accordingly, the respondent disallowed these deductions.

At all relevant times, the voting preferred shares of the appellant were held by David T. McDonald and the common shares were held by his wife and children. There is no dispute that Mr. McDonald was a" specified shareholder” of the appellant within the meaning of paragraph 125(7)(d). The appellant also conceded that the conditions in subparagraphs (iii) and (iv) of paragraph 125(7)(d) do not apply in this appeal. Therefore, the issue can be narrowed down further to the question of whether Mr. McDonald could “ reasonably be regarded as an officer or employee of the person or partnership to whom or to which the services were provided but for the existence of” the appellant.

Mr. McDonald has a long association with the importing and marketing of shoes in Canada. From 1940 to 1949, he worked for Bata Shoe Corporation of Canada Ltd. In 1947, Bata established a new plant at Belleville, Ontario and Mr. McDonald was one of the three individuals responsible for hiring the personnel, starting the plant and developing a new line of shoes to be sold in Canada. In 1949, he left Bata and became a shoe salesman for a number of companies trying to put together a general line of men's and women's footwear to sell on commission to small retail accounts (not the big department stores). In 1951, he went to work for Barum company importing footwear mainly from Czechoslovakia. This association lasted about eight years. During that time, Barum sold to the large department stores and major accounts and, with the consent of Mr. Meisel who owned Barum, Mr. McDonald started his own wholesale division to service smaller independent retailers. Mr. McDonald had no conflict of interest because Barum serviced the large accounts with shoes from Czechoslovakia, Scotland and Hong Kong but was not in the wholesale warehousing business; whereas Mr. McDonald bought his shoes from Barum but had to operate a warehouse in order to service the smaller retailers.

Around 1959, Barum offered Mr. McDonald its sources of supply to sell to all outlets in Canada. Mr. McDonald accepted the deal; dropped the Hong Kong source and worked a few years with shoes from Czechoslovakia and Scotland. He did this through a corporation named David McDonald Shoes Ltd. ("DMSL"), not the appellant herein. DMSL did well briefly until the Czechoslovakia trading company in Canada took away the supply contract for Czechoslovakian shoes for the major accounts and left DMSL to service only the small independent retailers who did not have the financial strength of the major accounts. Lastly, DMSL paid for a shipment of shoes from Scotland which were of poor quality and had to be scrapped. When the Scotland supplier refused to pay any compensation, DMSL made an assignment in bankruptcy around 1962.

From 1963 to 1969, Mr. McDonald was managing director of Concord Rubber Company which was the Canadian subsidiary of a United Kingdom manufacturing corporation, British Rubber Company. Concord was an importer bringing into Canada rubber and canvas footwear from many parts of the world but no leather footwear at all. Mr. McDonald had caused the incorporation of the appellant around 1962 with a view to starting some new kind of shoe selling endeavour. While he was working with Concord, he obtained their permission to develop his own shoe business so long as it did not conflict with Concord. At a trade show in New York City, Mr. McDonald met some people from Status Shoe (U.S.A.), a wholly owned subsidiary of Adam & Harvey (U.K.), who had an agreement for the exclusive distribution of Czechoslovakian footwear in North America and Puerto Rico. Status Shoe wanted to come into Canada and asked Mr. McDonald for advice. After lengthy negotiations, it was decided that Concord, for the first time, would import and distribute leather footwear in Canada. And so Concord became the exclusive distributor in Canada for Status Shoe (U.S.A.) which purchased its shoes from Czechoslovakia.

In 1969, when the British Rubber group of companies (including Concord) was sold to a U.S. company in Tennessee, Concord had to give up the Status Shoe line because Concord's agreement with Status was not transferable. The new parent company in Tennessee wanted Mr. McDonald to stay on with Concord but he decided to try to develop his own small business. He was approached by Status Shoe (U.S.A.) because they needed someone to pick up where Concord had left off and they were anxious to retain the sales volume they had developed through Concord. In April 1969, the chairman of Adam & Harvey (U.K.) and the president of Status Shoe (U.S.A.), its American subsidiary, met with Mr. McDonald in Montreal and asked him to put together a Canadian sales organization. In a nutshell, Mr. McDonald told them that he would, through the appellant corporation, assist them in laying the base for warehousing, office facilities and personnel in Canada but that he himself would not be tied down; he wanted to be independent and not work for anyone.

Although Adam and Harvey (U.K.) and Status Shoe (U.S.A.) at first declined such an arrangement, they returned a month later and an agreement between Status Shoe Corp, of Canada Ltd. (which I shall call ''Status Canada") and the appellant was signed on May 15, 1969. That agreement was amended from time to time but, because it goes to the heart of the issue herein, I will quote from it at length. In that agreement, the appellant corporation is referred to as “McDonald”.

WHEREAS Status is presently carrying on business in Canada as an importer and distributor of leather footwear;

WHEREAS McDonald has the necessary experience and know-how required by Status for the supervision of its Canadian operations, including without limiting the generality of the foregoing, the management of the affairs of Status, the marketing of products imported by Status, the direction and supervision of its sales and other personnel, and to assist in the styling of the products to be imported and distributed by Status in Canada; and

WHEREAS the Parties wish to enter into a contractual relationship with each other based on the foregoing premises.

NOW, THEREFORE, THIS AGREEMENT WITNESSETH:

1. Status hereby appoints and constitutes McDonald as its sole and exclusive sales and marketing manager for Canada for all leather and vinyl footwear imported into Canada by Status. The functions to be carried on by McDonald shall include:

(a) co-operation with Status in planning the latter's sales program in Canada for the aforesaid products;

(b) the implementation of such sales program through the direction and supervision of salesmen and other personnel of Status, so as to properly and to the best advantage promote, market and sell the said products in Canada;

(c) to consult with Status in matters relating to the styling of such products, having regard for the needs of the Canadian market.

2. It is expressly understood that McDonald shall, at all times during the term of this agreement, employ MR. DAVID T. MCDONALD, of Lachine, Quebec, on a full time basis as its chief executive to direct and implement the fulfilment of McDonald's obligations hereunder.

4. Throughout the term of this agreement neither McDonald nor David T. McDonald or any employee of McDonald shall either directly or indirectly, engage in the sale, promotion or marketing of any leather and vinyl footwear competitive with the products being sold by Status in Canada.

5. In consideration of the services to be rendered by McDonald, Status shall pay to McDonald the following compensation:

(a) A fixed annual fee of TWENTY-FOUR THOUSAND DOLLARS ($24,000), payable at the rate of Two Thousand Dollars ($2,000) per month, in advance, the first payment to become due on the date that this agreement comes into force, and thus to continue on the same day of each month throughout the term of this agreement;

(b) A further fee equivalent to ONE AND ONE-HALF PERCENT (1-1/2 of the gross selling price (less all discounts, returns and allowances) for all leather and vinyl footwear sold by Status directly or indirectly throughout the term of this agreement

(d) Status will reimburse McDonald for all vouchered, reasonable and normal travelling expenses incurred by McDonald or its employees in the implementation of this agreement

6.. . .this agreement is subject to prior termination by Status on thirty (30) days written notice to McDonald upon the happening of any one or more of the following events:

(c) In the event that the gross sales of Status between July 1st, 1970 and June 30th, 1971, or any subsequent one-year period commencing on July 1st, and terminating on June 30th, throughout the term of this agreement shall be less than one million dollars ($1,000,000).

(d) In the event of termination of David T. McDonald's employment by McDonald or any event which would give rise to McDonald's right to terminate the employment of David T. McDonald, including, without limitation, David T. McDonald becoming unable to regularly perform his duties as an employee of McDonald continuing for a period of fifteen (15) weeks.

The term of the original contract was from July 1, 1969 to June 30, 1974 but it was extended on five subsequent occasions to March 31, 1988 with minor modifications including changes to the compensation set out in paragraph 5 of the original agreement. For 1985 and 1986, the compensation was: (a) a fixed annual fee of $50,000 set in 1979 and adjusted each year on April 1st commencing in 1980 in accordance with the Cost of Living Index; (b) a commission of 1.5 per cent on gross sales up to $3,500,000 and 0.5 per cent on gross sales over $3,500,000 in any contract year; and (c) a profit participation of ten per cent of the audited net pre-tax profit of Status Canada. The agreement was finally terminated in March, 1988 when Status Canada paid to the appellant a lump sum of $150,000. Status Canada did not replace the appellant or Mr. McDonald after termination of the agreement.

Immediately after the agreement of May, 1969, Mr. McDonald established the Status Canada office in Montreal; hired a general manager, a sales manager, an office manager and the necessary office, warehouse and sales personnel. The appellant maintained an office in Mr. McDonald's home from 1969 until 1977 when Status Canada moved its office from Montreal to Toronto. In 1981, the appellant recruited for Status Canada a new general manager, Gerry Hornack, who spoke Czechoslovakian [sic]. Mr. Hornack testified at the hearing of this appeal after he had become president and C.E.O. of Status Canada. After 1981, Mr. Hornack made the day-to-day management decisions for Status Canada and often consulted with Mr. McDonald on various issues. Mr. Hornack stated that he travelled to Czechoslovakia two or three times a year to enter into supply agreements with the manufacturer, and he confirmed that Mr. McDonald had no management authority whatsoever in Status Canada. Mr. McDonald reported directly to the president and managing director of Adam & Harvey, the parent company of Status Canada.

By 1985, Mr. McDonald attended the Status Canada office in Toronto only two or three days a week. He never came in before 10 a.m. and he would stay only a few hours. He spent the summers at his cottage near Kingston, Ontario from which he commuted to Toronto on an irregular basis. He spent the winters in Florida and did not return to Toronto until spring. He was available, however, by telephone for consultation when required. Mr. McDonald did not directly or indirectly participate in the benefits available to the employees of Status Canada. He had a car provided by Status Canada for which he paid a monthly leasing fee of $135. Status Canada paid for business expenses of the car but Mr. McDonald paid for any personal use himself. Status Canada paid the appellant directly for services rendered by Mr. McDonald pursuant to the terms of the agreement. Mr. McDonald then received his personal remuneration from the appellant.

According to Mr. McDonald, at the time when Status Canada was required to have two resident Canadians as directors, he was appointed a director and given the title of executive vice-president. He testified that his appointment as executive vice-president enabled him to sign certain documents on behalf of Status Canada which eliminated the need to send such documents to England for signing. It appears from Mr. McDonald's own testimony that he held that office during the 1985 and 1986 taxation years but performed very few duties in that capacity and received no remuneration as executive vice-president. In argument, counsel for the respondent did not rely on Mr. McDonald's position as director or executive vice-president in applying paragraph 125(7)(d). I agree with counsel because, in the overall circumstances of the case, I think this fact is of little significance.

During the 1985 and 1986 taxation years, while the appellant was providing consulting services to Status Canada, it also purchased merchandise from Status Canada and sold it on an open line of credit to its own smaller retail customers. The appellant did not receive a commission from Status Canada for selling this merchandise nor a percentage of the profit that would have been made by Status Canada had that company sold the merchandise on its own. Instead, the appellant earned a gross profit directly from the sales.

The financial result would have been almost the same whether Status Canada sold the merchandise and paid to the appellant a commission plus a percentage of profit pursuant to the agreement or the appellant sold the merchandise and retained the gross profit from its sales. The distinguishing feature of this arrangement was that the appellant incurred the risk of loss if its clients did not pay for the merchandise sold. Mr. McDonald stated that he accepted that risk because he wanted to rekindle his relationship with clients in the market with whom he had lost contact over the years. He said he was hoping to pursue his own footwear business with retail clients upon the termination of the agreement between the appellant and Status Canada.

Paragraphs (a) and (d) of subsection 125(7) were added to the Act to remove the income tax advantages which had been available to the "incorporated employee" like the conversion of salary income into corporate business income taxed at a low rate, the deferral of tax at personal rates on that income, and the possibility of splitting that income among members of a family. The purpose of the legislation was spelled out by the federal Department of Finance in budget supplementary information and submitted in argument by counsel for the respondent. The relevant note states:

Executives and highly-paid employees of business firms can gain valuable tax advantages by incorporating themselves and continuing to provide services to their former employer through a personal corporation. A federal corporate tax rate of 23 1/3 per cent, rather than personal income tax rates, now applies to the corporation's earnings in such cases. There are other tax advantages in personal incorporations, including the possibility of income splitting among family members. This type of incorporation permits the conversion of employment income into business income of the personal corporation. The budget proposes to increase the federal corporate tax rate on such incorporated executives and employees to the general corporate tax rate of 36 per cent. As a result, the combined federal and provincial corporate tax rate on such personal service corporations will be approximately 50 per cent, equivalent to the maximum marginal tax rate that the budget proposes be applied to individuals.

I am required to determine whether the provisions of paragraph 125(7)(d) apply to the above facts. Using the words of the Act, the issue comes down to the question of whether Mr. McDonald “would reasonably be regarded as an officer or employee" of Status Canada" but for the existence” of the appellant? In other words, if the appellant corporation had never existed, would it be reasonable to regard Mr. McDonald as an officer or employee of Status Canada? I have genuine doubts about the way this question would have been answered for 1969 and the years immediately thereafter but I have no doubt that the answer should be negative for 1985 and 1986, the years under appeal.

There was, understandably, little evidence concerning the years 1969-1974. During those years Mr. McDonald must have been very busy assembling an organization to perform the services which Concord had performed prior to 1969 and maintaining annual gross sales of not less than $1,000,000 to comply with paragraph 6(c) of the agreement. It is not likely that he would have had time in those early years to make available to any other person in Canada his considerable expertise in the shoe import business. He was probably working on a full-time basis in the interests of Status Canada and may well have been an “incorporated employee” in those years. It is not the early years of the agreement that are under appeal, however, but 1985 and 1986, after Mr. Hornack had been hired as general manager. Certain evidence pertaining to Mr. McDonald's modus operand! in 1985/86 indicates that it would not be reasonable in those years to regard him as an employee of Status Canada but for the existence of the appellant. I refer to the following facts: (i) he kept his own time schedule going into the Toronto office of Status Canada for a few hours two to four days each week while in Canada and spending his winters in Florida; (ii) he was not integrated into any administrative organization answering to the president or any other senior officer of Status Canada or having other persons answer to him; (iii) he did not participate in the pension plan or medical plan of Status Canada; and (iv) he did not seem to be subject to any retirement age because he was 70 and 71 in the years 1985 and 1986.

Counsel for both parties relied on the decision of the Federal Court of Appeal in Wiebe Door Services Ltd. v. M.N.R., [1986] 2 C.T.C. 200, 87 D.T.C. 5025 which laid down certain guidelines to determine whether an individual is an employee or an independent contractor. MacGuigan, J. writing for the Court held at page 205 (D.T.C. 5029) that Lord Wright's test in the Montreal Locomotive Works case (control, ownership of tools, chance of profit, risk of loss) was not really a fourfold test but a four-in-one test requiring an overview of the combined force of the whole scheme of operations. It is useful to apply the four-in-one test to Mr. McDonald in 1985 and 1986 as if the appellant corporation did not exist. He was not under the control of any senior officer of Status Canada. His tools were his experience, knowledge and goodwill in the shoe business in Canada. He had a chance of profit in the sense that he shared the fortunes of Status Canada through his commission and profit sharing arrangement as set out in paragraph 5 of the agreement. Also, the appellant could earn a profit from the wholesale business it carried on with small retailers. Although Mr. McDonald did not have a risk of loss in a direct sense, the agreement (paragraph 6) was subject to termination on 30 days' notice if gross sales were less than $1,000,000 in any one year. It is significant to me that this condition for termination in paragraph 6 was dependent on the overall performance of Status Canada (its gross annual sales) and not dependent on the personal performance of Mr. McDonald like a commission salesman with his minimum sales quota for each year. Even if he had no risk of loss, the concept of a four-in-one test requiring an overview of the whole scheme means that any one of the four indicators may point toward employment but, considering the whole relationship between the appellant and Status Canada, the four indicators taken together may point more toward an independent contractor and less toward employment.

In Wiebe Door, supra, MacGuigan, J. cited with approval at page 206 (D.T.C. 5030) the Market Investigations case in which the question is asked: “Is the person who has engaged himself to perform these services performing them as a person in business on his own account?” To answer that question, one must consider whether the person has the capacity to engage in the particular business on his own account. If he has experience, knowledge and goodwill in the business, it is easier to conclude that he has the capacity to engage in the business on his own account and that he is not simply an incorporated employee. This is particularly true when the person has no prior employment connection with the party who benefits from his services. But if he has no experience, knowledge or goodwill in the business and offers only personal skills not related to the business, it is more difficult to conclude that he has the capacity to engage in the business on his own account; and it would probably be more reasonable to regard him as an employee of the party who benefits from his services.

In 1969, when the appellant entered into its first agreement with Status Canada, Mr. McDonald was 54 years old and had been in the shoe business in Canada for more than 20 years with an emphasis on importing and marketing shoes from Czechoslovakia. He was well known in the shoe industry in Canada and, from time to time, was consulted by the Government of Canada on problems relating to the valuation of shoes for import duties and on policies relating to import restrictions and quotas. In 1969, Mr. McDonald had enough experience, knowledge and goodwill to engage in the business of importing shoes into Canada on his own. Therefore, he could adopt the posture of a consultant and require the client (Status Canada) to obtain his services through the medium of the appellant. There was not enough evidence concerning the services actually performed by Mr. McDonald in the early years of the agreement (post 1969) to determine whether he would reasonably have been regarded as an employee of Status Canada in those years but for the existence of the appellant. Counsel for the respondent cited certain passages from the judgment of Jackett, P. in Alexander*. M.N.R., [1969] C.T.C. 715, 70 D.T.C. 6006 which probably would have persuaded me that the appellants relationship with Status Canada in the early years of the agreement was not one of independent contractor and that he was an incorporated employee in those years but, as stated above, those years are not under appeal.

In 1985/86, there was a much stronger case to be made for the appellant being an independent contractor when Status Canada had a complete management and operating team in place and Mr. McDonald had truly withdrawn to the role of consultant. The hiring of Mr. Hornack as general manager in 1981 is a significant fact in the appellant's favour. Mr. Hornack spoke Czechoslovakian [sic] and went to Czechoslovakia at least twice a year. There is the additional fact that, in 1985 and 1986, the appellant engaged in its own shoe distribution business selling to small retailers. For example, in 1986 the appellant reported sales and agency revenue of $440,000 of which $179,000 was derived from the sale of shoes on its own account. The remaining $261,000 was a combination of annual fee, commission and profit participation from the agreement with Status Canada. On the gross sales of $179,000, the appellant earned a net income of about $18,000 or ten per cent; and this is the area in which the appellant was at risk if its customers did not pay. This commercial activity in 1985 and 1986 proved not only that Mr. McDonald had the experience and knowledge to engage in the shoe business but that he did in fact engage in it. This is a further indication, if any were needed, that he was not an“ incorporated employee" in 1985 and 1986.

There are circumstances as in 533702 Ontario Ltd. v. M.N.R, [1991] 2 C.T.C. 2102,91 D.T.C. 982 in which a private corporation has no commercial independence from the person it purports to serve and paragraph 125(7)(d) would apply but, in this appeal, Mr. McDonald's experience, knowledge and goodwill in the import shoe business give to the appellant a ring of credibility with respect to its capacity to engage in the shoe business on its own account. The appeals are allowed.

Appeals allowed.