McEwen Brothers Ltd. v. R., 99 DTC 5326, [1999] 3 CTC 373 (FCA)

Robertson J.A.:

This is an appeal from the Trial Division, dismissing the appellant taxpayer’s appeal from reassessments pertaining to the 1976 and 1977 taxation years. The issues raised before us involve the sham doctrine and the principles articulated by the Supreme Court in Continental Bank of Canada v. R.' [1] regarding the formation of a valid partnership. Ultimately, the outcome of this appeal depends on an appreciation of the essential facts applied against the proper legal framework.

Facts

McEwen Brothers Ltd. (“the taxpayer”) was incorporated in Manitoba in 1963 to carry on a landscape gardening business. At all material times, Melvin McEwen was the president of the taxpayer and its controlling shareholder. Over time, the taxpayer developed a fairly complex share arrangement such that, by April of 1976, most of its shares were owned by key employees who had either transferred their shares to a personal holding corporation or were in the process of doing so. The only person to place shares of the taxpayer in a holding corporation who was not an employee of the taxpayer was Melvin McEwen’s wife. Each of the holding corporations was contractually bound to provide management services to the taxpayer through an agreement between it and its individual shareholder. As a result, the shareholders were no longer directly employed by the taxpayer. As might be expected, none of the holding corporations had any employees, a line of credit with a financial institution or assets other than the management contract.

In 1976, Bruce Bros. Ltd. was invited by Manitoba Hydro to submit a tender on a “Road Project”. Bruce Bros. was in the business of heavy construction, including building roads. The taxpayer had no experience in that line of work. Adrien Bruce, a principal of Bruce Bros., contacted Melvin McEwen with respect to Manitoba Hydro’s invitation and, together with Russell Graham, prepared a bid which was submitted in March 1976.

According to the Agreed Partial Statement of Facts, it was understood that the Road Contract bid was being submitted on behalf of a partnership (hereafter, the “Road Partnership”). This understanding was not evidenced in writing, and Manitoba Hydro was not aware of the partnership agreement at the time the bid was submitted. Nor could it have been so aware, as the bid was submitted in March 1976 and the partnership was not formed until April 14, 1976. In fact, there is no evidence that Manitoba Hydro was ever apprised of the existence of the partnership.

The first draft of the Road Partnership agreement was prepared by Melvin McEwen and Adrien Bruce. The final draft was prepared by Bruce Bros.’ lawyers.

After Bruce Bros.’ tender was accepted by Manitoba Hydro, a partnership agreement was signed on April 14, 1976, in which Bruce Bros., the party of the first part, obtained a 50% interest in the Road Partnership. The party of the second part consisted of six other partners. Three of those partners were holding corporations controlled by former key employees of the taxpayer. A fourth was the holding corporation controlled by Melvin McEwen’s wife. The remaining two partners, Adrien Allard and Ronald Graham, were employees and shareholders of the taxpayer. Apparently, these two individuals had yet to transfer their shares in the taxpayer to a holding corporation. The holding corporation of Melvin McEwen’s wife held a 25% interest in the partnership. Each of the remaining five partners received a 5% interest in the Road Partnership.

I pause here to note that, for some unexplained reason, neither Melvin McEwen nor his personal holding corporation was a named partner to the venture. The Agreed Partial Statement of Facts state only that Melvin McEwen had “very little” involvement in the Road Partnership because the taxpayer’s business occupied most of his time.

Several reasons were advanced as to why the taxpayer did not wish to become a partner in the Road Partnership. First, it is said that the taxpayer would have had to have disclosed its participation to a bonding company which would have required the taxpayer to quit bidding work because it was close to its bonding limit. Second, the bonding company may have become concerned that the taxpayer was participating in work that the bonding company knew nothing about. (In the end, Manitoba Hydro did not require the successful bidder to provide a bid bond.) Third, it is alleged that the taxpayer would have lost work from companies for which it had previously done subcontracting work, because such companies were also bidding on the Road Contract. Apparently, it was for this reason that the taxpayer removed the name McEwen Bros. Ltd. from equipment that was rented to the Road Partnership.

The taxpayer’s role in the Road Partnership agreement was “Covenantor” for all of the liabilities of the parties of the second part, namely the six partners.

Profits from the Road Contract were to be divided among Bruce Bros., the holding corporations and the two individuals in accordance with their respective partnership interests. Clause 4 of the Road Partnership, which inexplicably refers to “[b]oth parties”, provides that cheques and other banking instruments “shall contain” the signature of Adrien Bruce or Marcel Bruce (president of Bruce Bros.) and Melvin McEwen or Russell Graham. As noted earlier, neither Melvin McEwen nor his holding corporation were partners in the Road Partnership. Clause 8 of the partnership agreement mandates that the parties “shall contribute capital” to the partnership, according to the percentage of their partnership interest, and “shall have sufficient funds if required to advance to the credit of the partnership”. Nevertheless, only the taxpayer and Bruce Bros. contributed capital to the Road Partnership in the amount of $195,000 and $76,000, respectively.

According to the Agreed Partial Statement of Facts, the working capital required by the Road Partnership was borrowed from the taxpayer and Bruce Bros, and interest was paid to them by the partnership. In paragraph 49 of that document, it is acknowledged that the remaining six partners did not directly contribute financing to the Road Partnership; rather, it is stated that the taxpayer loaned money to the partnership on their behalf because it was “more expedient” to do it in that manner. The loan agreements were not documented, and no interest was paid to the taxpayer by the six partners out of their respective share of the profits.

In clause 17 of the partnership agreement, the on-site management team is identified as Marcel Bruce and Russell Graham. Mr. Graham held a 5% interest in the Road Partnership. In clause 15, the parties agree that off-site management would be performed by Adrien Bruce and Melvin McEwen.

Clause 9 provides that “[t]he Parties agree that all equipment available from the respective parties will be rented from the parties”. That clause goes on to provide that equipment not available from Bruce Bros, or the taxpayer would be rented from available equipment suppliers. Clause 10 notes that the equipment listed in Exhibit “A” was rented to the Road Partnership by Bruce Bros. and the taxpayer. Bruce Bros. was reimbursed $240,000 for equipment rented from the taxpayer (of which the taxpayer received $132,000). Manitoba Hydro paid a total of $1.2 million to the Road Partnership for rental equipment.

Clause 16 of the partnership agreement provides that books of account “shall” be kept at the place of business, which is identified in clause 1 as the head office of Bruce Bros, (“the Party of the First Part”). The partners agreed to open a bank account in Churchill, Manitoba, where the work was performed. Each cheque drawn on the Road Partnership had to be signed by Marcel or Adrien Bruce and Melvin McEwen or Russell Graham. For the most part, the personnel required to complete the project were from Churchill, as required under the terms of the tendering contract. Only one person in the taxpayer’s employ was employed by the Road Partnership.

Manitoba Hydro paid for the Road Contract by cheques payable to Bruce Bros., which were then deposited into the Road Partnership’s bank account. Profits from the Road Partnership amounted to $525,000, of which Bruce Bros, reported its half as income. The remaining six partners reported the other half.

In 1976, the federal Department of Public Works advertised for tenders with respect to the construction of a dyke (hereafter, the “Dyke Contract”). This time, a bid was submitted by the taxpayer, notwithstanding that it had no previous experience in this line of work. Nevertheless, the taxpayer’s bid was accepted by the Department on August 9, 1976. According to the Agreed Partial Statement of Facts, the bid was submitted by the taxpayer on behalf of a second partnership which had been formed (the “Dyke Partnership”). The reason the taxpayer submitted the bid was because only the taxpayer was in a position to obtain a bid bond, which was required under the contract. Although the taxpayer was not in a position to obtain such a bond for the Road Contract, it was in a position to do so in respect of the Dyke Contract because the taxpayer had been able to reduce its work commitments after the Road Contract was obtained, such that the bonding requirement could be met.

On August 19, 1976, Adrien Bruce wrote to the solicitors for Bruce Bros. asking that a partnership agreement similar to the one drawn up “between Bruce Bros. Ltd. and McEwen Ltd.” be drafted, subject to a few changes. One of those changes is worthy of note. By July 30, 1976, two of the individual partners in the Road Partnership, Ronald Graham and Adrien Allard, had transferred their shares in the taxpayer to their respective holding corporations. Thus, the lawyers were instructed to substitute the names of their holding corporations for those of the individual partners in the Dyke Partnership agreement.

As noted above, Adrien Bruce waited until August 19, 1976 to instruct his lawyers to draft the second partnership agreement. For some unexplained reason, the Dyke Partnership agreement is dated July 20, 1976. I pause here to note that no one seems to have expressed concern over the unacceptable practice of “back-dating” documents. In fairness to counsel for the taxpayer, I wish to stress that their firm did not draft the partnership agreements. In the present case, the only reason I can see for back-dating the Dyke Partnership agreement is so that it would appear that the partnership was formed prior to the date the taxpayer submitted its bid to the federal Department of Public Works. In my view, however, even if the partnerships were formed after the bids were accepted, the validity of the tax planning schemes would not have been affected. In this regard it must be remembered that the Road Partnership was not executed until after the bid for the Road Contract had been accepted: see also discussion infra at paragraph 28.

The Dyke Partnership agreement is essentially the same as the Road Partnership. For example, Clause 8 mandates that the parties “shall contribute capital” to the partnership, according to their partnership interest, and “shall have sufficient funds if required to advance to the credit of the partnership”. In fact, the taxpayer and Bruce Bros. each loaned the second partnership $5,000 as working capital, while the “partners of the second part” contributed nothing. Clause 4 provides that cheques and other banking instruments “shall contain” the signature of Adrien Bruce or Patrick Bruce and Melvin McEwen or Roy Hadaller. Mr. Hadaller’s holding corporation held shares in the taxpayer, and was a partner under both partnership agreements.

Clause 17 of the Dyke Partnership identifies the on-site management team as Patrick Bruce and Roy Hadaller. In clause 15, the parties agree that off-site management will be performed by Adrien Bruce and Melvin MCEwen. The parties also agree in clause 9 to rent “all equipment available” to the partnership; however, clause 10 and Exhibit “A” reveal that the rented equipment was owned by the taxpayer and Bruce Bros. Finally, clause 16 provides that books of account “shall” be kept at the place of business, which is identified in clause 1 as the head office of the taxpayer.

The Dyke Contract resulted in a profit of $42,000, of which Bruce Bros, declared 50% in its income, with the remaining 50% being divided among the other six partners according to their partnership interest. As with the Road Partnership, 25% of the Dyke Partnership interest was owned by Melvin McEwen’s wife’s holding corporation.

I now propose to summarize the decisions below, beginning with that of the Trial Division. [2] It should be noted at the outset that the Trial Judge did not have the benefit of the Supreme Court’s decision in Continental Bank.

Decisions Below

The Trial Judge heard the taxpayer’s appeal from the Tax Court Judge’s decision pursuant to a Consent Order under Rule 473, thus, de novo. The Trial Judge considered the evidence before him in order to determine whether the two partnerships had the “required degree of substance” or if they were “mere camouflage for what was essentially a tax-driven scheme for the purpose of redirecting income which would otherwise have accrued to the [taxpayer]” [3] . Noting the six personal corporations’ lack of contribution to the two partnerships, the Trial Judge questioned how they could justify earning 50% of the profits. Based on the evidence, he found that the taxpayer was not a mere creditor, but a partner with Bruce Bros. in the two partnerships, and that the six personal corporations were merely “conduits for the income earned by their individual owners from work performed on behalf of the plaintiff’. The Trial Judge agreed with the Tax Court Judge that the arrangements had no bona fide business purpose and, therefore, the arrangements fell within the classical definition of “sham”. In addition, the Trial Judge agreed with the Tax Court Judge that the transactions were legally “ineffective”. Accordingly, he dismissed the taxpayer’s appeal.

Very briefly, the Tax Court Judge agreed with the tax principle in Inland Revenue Commissioners v. Duke of Westminster^, [4] but found that the incorporation of the six management corporations into the partnerships had no bona fide business purpose, and was “a meaningless transaction whose purpose was to artificially reduce the appellant’s income from the partnerships within the meaning of section 137 of the Act (now section 245)”. In addition to being “legally ineffective and incompletely carried out”, the Tax Court Judge found that the partnership agreements were “shams within the classical definition”; therefore, he dismissed the taxpayer’s appeal from the Minister’s reassessments.

Issues

The taxpayer submits, inter alia, that the Trial Judge erred in holding that the transactions pertaining to the two partnerships constituted a sham and, alternatively, that the transactions were ineffective in establishing valid partnerships between Bruce Bros. and the six other partners identified in the partnership agreements. The position of the Minister of National Revenue can be distilled into the simple proposition that the only partnership that existed consisted of Bruce Bros. and the taxpayer. Thus, the Minister reassessed the taxpayer, including one-half of the profits realized on both the Road and Dike Contracts in its income. In my respectful view, the Minister was correct in doing so. I reach this conclusion, not on the basis of the sham doctrine, but on the well-accepted principles of partnership law which were recently applied by the Supreme Court in Continental Bank.

Analysis

Before turning to the relevant principles of partnership law, I wish to state my respectful disagreement with the judges below with respect to the sham doctrine. Today, it is clear that a transaction which lacks any business purpose other than the attainment of a tax benefit does not, simpliciter, constitute a sham. What is required under the sham doctrine is deceit on the part of the taxpayer. In Stubart Investments Ltd. v. R. [5] , Justice Estey stated: [t]he transaction and the form in which it was cast by the parties and their legal and accounting advisers [can] be said to have been so constructed as to create a false impression in the eyes of a third party, specifically the taxing authority.

In short, to qualify as a sham, the taxpayer must say one thing to the Minister, and do another in an attempt to avoid its tax obligations.

In the present case, it appears that the taxpayer misled both Manitoba Hydro and the federal Department of Public Works by failing to disclose that the respective bids were being submitted on behalf of partnerships. But, in my view, those distortions of the facts do not support a finding of sham. The fact remains that the undisclosed partnerships may qualify as partnerships. The fact that a contract may have been obtained in circumstances where, had the true circumstances been known, it could have been set aside does not render the underlying agreement to form a partnership invalid. For tax purposes, this type of deception is irrelevant. For example, simply because a taxpayer is a successful con-artist does not mean that a sham has been perpetrated on the Minister of National Revenue. [In an earlier case, I referred to a situation in which a taxpayer was intending to mislead a third party as an “inverse sham”. [6] ] In any event, a partnership could have been formed after the bids were submitted for the purpose of raising needed capital. The only relevant evidence of a sham is that which demonstrates that the taxpayer purposefully or effectively misled the Minister. The typical situation occurs where the taxpayer’s documentary evidence says one thing, and the taxpayer does another.

The strongest evidence supporting the allegation that the partnership agreements were a sham is contained in a letter written by Adrien Bruce to the solicitors for Bruce Bros., dated August 19, 1976. In that letter, Mr. Bruce instructs the solicitors to prepare a partnership agreement for the Dyke Partnership similar to the one that had been drawn up for the Road Partnership “between Bruce Bros. Ltd. and McEwen Bros. Ltd.” The taxpayer submits that its request that a similar agreement be prepared for the Dyke Partnership is not an acknowledgement of the taxpayer’s ‘“partnership position’, but rather an acknowledgement of the Appellant’s position as covenantor”. Alternatively, the taxpayer argues that the letter pertains only to the Dyke Partnership; thus, it has no bearing on the partnership status of the taxpayer with respect to the Road Partnership. Neither argument is persuasive in my view. The letter speaks for itself, and it discusses both partnership agreements, not just the latter. Nevertheless, I am not persuaded that this evidence alone is sufficient to support a finding of “sham”.

It is obvious from their reasons that the judges below had difficulty accepting the taxpayer’s explanation for not becoming a partner in the Road Partnership. The fact that the taxpayer claims not to have been in a position to obtain a bid bond is overshadowed by the fact that no bond was ultimately required for the Road Contract. Additionally, it is somewhat suspicious that a few months later, the taxpayer was in a position to provide a bid bond with respect to the Dyke Contract, while Bruce Bros, was not. I am not aware of any explanation as to why the latter was not in a position to provide such security. The taxpayer also claimed that its relationship with its customers, who were also bidding on the Road Contract, would be jeop- ardized if it was a partner in the Road Partnership. Yet no explanation is given as to why this factor did not deter the taxpayer from bidding on the Dyke Contract.

Equally unconvincing is the taxpayer’s reliance on the fact that Melvin McEwen had very little time to devote to the business of the Road Partnership because of his commitment to manage the affairs of the taxpayer. This fact does not explain why neither Melvin McEwen nor his holding corporation was made a partner in either partnership. It is obvious that several of the named partners had no involvement whatsoever in either partnership. Nor is any explanation proffered as to why Mrs. McEwen’s holding corporation was made a partner, other than for the obvious purpose of splitting income.

Finally, the explanation as to why the taxpayer was not made a partner of the Dyke Partnership is unconvincing. The taxpayer insists that it lacked the experience necessary to build dykes. If the taxpayer lacked the requisite experience, then why did it bid on the Dyke Contract, and why would the federal Department of Public Works award the contract to an inexperienced contractor? These questions are all the more relevant since the reasons given by the taxpayer as to why it did not become a partner under the Road Partnership appear to have been resolved by the time the Dyke Partnership was formed.

The taxpayer takes the position that, in raising these kinds of concerns, this Court would err by making findings of fact that conflict with those in the Agreed Partial Statement of Facts. In response, it is fair to say that there will be circumstances in which the precise scope of what was agreed upon is itself brought into issue. For example, the Agreed Partial Statement of Facts in the present case gives three reasons for the taxpayer’s failure to bid on the Road Contract. However, the Statement fails to tell us whether those reasons are objectively true. It is one thing to agree on the fact that something did or did not take place; it is quite another to agree as to the truth or plausibility of the reasons for such conduct.

In the present circumstances, however, I must decline the invitation to decide this case on the basis of the sham doctrine. I do so for the reason that no findings of credibility were made below. The reason for this omission can be traced to the trial judge’s understanding that the sham doctrine is satisfied where no bona fide business purpose exists. However, in my view, a finding of deceit is necessary to a finding that the taxpayer (or its explanation as to why certain events took place) lacks credibility or plausibility. Accordingly, I must turn to the argument that the two partnership agreements were legally ineffective for the purpose of establishing a partnership between the “Parties of the Second Part” and Bruce Bros. My analysis begins with a recitation of the legal requirements for a valid partnership.

In order to establish the existence of a valid partnership, one must demonstrate that: (1) a business was being carried on; (2) by two or more persons in common; and (3) with a view to profit. In the present case, the first and third requirements are easily satisfied. A business or joint venture was undoubtedly being carried on with respect to the Road and Dyke Contracts. Bank accounts were opened in the name of the respective partnerships, employees were hired, and work was performed. It is equally obvious that the work was undertaken with a view to profit, and that the resultant profits were distributed to the partners in accordance with the partnership agreements. It is with respect to the second requirement that our attention must focus. In deciding this appeal, it is necessary to identify which persons were carrying on business “in common”. The Minister argues that Bruce Bros, and the taxpayer were the true partners, since only these entities were carrying on business in common. The taxpayer relies on the two partnership agreements for its claim that the parties specified therein were carrying on business in common.

The central thrust of the taxpayer’s argument is that it did not participate in the two partnerships. At most, the taxpayer claims, it was a lessor of heavy equipment for which it received substantial consideration. In addition, it claims, it acted as banker for the partners other than Bruce Bros., for which it received interest income. I do not agree with those characterizations.

In the Supreme Court’s recent decision in Continental Bank, Justice Bastarache, speaking on behalf of the entire Court with respect to the partnership issue, outlined various factors to be considered when assessing whether a valid partnership has been established. Several of those factors are relevant to the question before us. At paragraph 24, Justice Bastarache stated that “[t]he indicia of a partnership include the contribution by the parties of money, property, effort, knowledge, skill or other assets to a common undertaking, a joint property interest in the subject-matter of the adventure, the sharing of profits and losses, a mutual right of control or man- agement of the enterprise, the filing of income tax returns as a partnership and joint bank accounts”. [7]

In summary, in determining whether a business is being carried on in common, it is necessary to determine who is contributing capital, property, effort, knowledge, skill and assets to the undertaking. In this appeal, the question of who has “a mutual right of control or management of the enterprise” (for example, cheque-signing authority on the partnerships’ bank accounts), and who is to share in the profits and losses is also pertinent. In deciding this appeal, it is convenient to place these factors into one of two categories: those touching on the management and control of the two partnerships, and those involving the contribution of capital. I turn first to the control and management factors.

With respect to the Road Partnership, it is telling that joint control was held by representatives of Bruce Bros. and key employees of the taxpayer, namely, Melvin McEwen and Russell Graham. Admittedly, Mr. Graham’s holding corporation was a partner, but his services were already contracted to the taxpayer and, therefore, it is difficult to argue persuasively that he was acting on behalf of his holding corporation. With respect to the on-site management of the Road Contract, a representative of Bruce Bros. and Russell Graham retained control. As to off-site management, control was split between Adrien Bruce of Bruce Bros. and Melvin McEwen, president of the taxpayer. Cheque-signing authority rested with Melvin McEwen and Russell Graham, as well as representatives of Bruce Bros.

With respect to the Dyke Partnership, joint control was held by representatives of Bruce Bros. and key employees of the taxpayer, namely, Melvin McEwen and Roy Hadaller. Mr. Hadaller, acted through his holding corporation, which was a partner in the joint venture. On-site management was entrusted to Roy Hadaller, while off-site management was delegated to Melvin McEwen, together with representatives from Bruce Bros. In conclusion, it is clear that effective control and management of both projects was vested in Melvin McEwen and two key employees of the taxpayer, Russell Graham and Roy Hadaller. The latter two gentlemen were contractually bound to the taxpayer through their respective holding corporations.

It is accepted law that not every partner is required to contribute time, effort and skill to a partnership. The notion of a “silent partner” is well accepted in law; [8] thus, a business may be run by one or more persons on behalf of themselves and others. However, those others partners must contribute something to the partnership. If it is not time, effort and skill, then it must be in the form of capital. The facts of this case clearly reveal that only the taxpayer and Bruce Bros, provided the requisite capital for the two ventures. There is no evidence that the other partners had either the financial resources or access thereto to make the capital contributions required under both partnership agreements. It was certainly open to the taxpayer to make documented loans to the other partners, and for those partners to pay interest to the taxpayer out of the profits they received. This, however, was not done. The capital flowed directly from the taxpayer to the partnerships, and the partnerships paid interest on the use of the taxpayer’s capital. As a result, a key requirement under both partnership agreements was not met. As stated in Continental Bank, where parties have entered into a formal, written document to govern their relationship, the courts must determine whether the agreement was acted upon and whether it actually governed the affairs of the parties. In the present case, the partnership agreements’ requirements pertaining to capital contributions and the liquidity of individual partners were not respected, nor could they have been, given the financial positions of the holding corporations.

Other than the taxpayer and Bruce Bros., it is apparent that none of the partners were in a position to share any losses that might have arisen from performance of the two construction contracts. It is very unlikely that Bruce Bros, would have agreed to a profit-sharing agreement with shell corporations which were not in a position to share potential losses, unless the taxpayer had implicitly assumed their obligations. The fact that the taxpayer was the successful bidder on the Dyke Contract, and yet failed to be named a partner of the Dyke Partnership speaks for itself.

In conclusion, I am of the view that the partnership agreements were legally ineffective because the partners named therein were not carrying on business “in common”. When one examines the typical indicia of partnership, namely, contributions of capital, property, effort, knowledge, skill and assets to a joint undertaking, it becomes clear that there were only two true partners: the taxpayer and Bruce Bros. For this reason, the appeal must be dismissed with costs.

Appeal dismissed.