Special Risks Holdings Inc. v. The Queen, 86 DTC 6035, [1986] 1 CTC 201 (FCA)

Pratte, J.:—This is an appeal from a judgment of the Trial Division dismissing an appeal from income tax reassessments under Part III of the Income Tax Act.

The only question raised before the Trial Division and on this appeal relates to the computation of the appellant’s "1971 capital surplus on hand”’ (1971 C.S.O.H.). In making that computation, the appellant included, pursuant to subparagraph 89(1)(l)(ii) of the Act,* [1] a sum of $1,350,555 in respect of the disposition that it had made, on December 23, 1976, of certain shares of Richards, Melling & Co. Ltd. (RMC), when, following a modification in the capital structure of that company it had exchanged its voting shares of that company for non-voting preferred shares. This, the appellant was authorized to do unless, as was decided by the Trial judge, that amount of $1,350,555 was deemed to be nil by virtue of subparagraph 89(5)(a)(ii)*. [2] The sole question, therefore, is whether that subparagraph applied in the computation of the appellant’s 1971 C.S.O.H. so as to reduce to nil the amount of $1,350,555. If it did, the appeal must be dismissed; otherwise, the appeal must succeed.

Under subparagraph 89(5)(a)(ii), the amount of $1,350,555 here in question was deemed to be nil if the property disposed of by the appellant, i.e., its shares of RMC,

(a) were shares of a corporation that was controlled, within the meaning of subsection 186(2),t [3] by the appellant immediately before the disposition, and

(b) were disposed of by the appellant to a person with whom the corporation was not dealing at arm’s length immediately after the disposition.

It is convenient to pause here and consider immediately one of the arguments put forward on behalf of the appellant. According to that argument, subparagraph 89(5)(a)(ii) could not apply in this case since the disposition by the appellant of its shares of RMC was not a disposition “to a person" as required by the subparagraph because RMC could not own its own shares. That argument was rightly rejected by the trial judge. In reality, the surrender by the appellant of its old RMC shares was neither a disposition by the appellant nor a disposition to RMC. However, it is common ground that the substitution of the new RMC shares for the old ones was deemed by section 86 to be a disposition of the old shares in consideration for the new ones. I have no difficulty in deciding that it logically follows that the substitution of the new shares for the old ones must also be deemed to be a disposition to RMC. The appellant, as the trial judge said, cannot have it both ways and claim that there was a disposition for the purpose of subparagraph 89(1)(l)(ii) and no disposition for the purposes of subparagraph 89(5)(a)(ii).

It remains, however, that two conditions had to be met in order for subparagraph 89(5)(a)(ii) to apply in this case:

1. RMC had to be controlled, within the meaning of subsection 186(2), by the appellant immediately before the disposition, and

2. RMC had to be a person with whom the appellant was not dealing at arm’s length immediately after the disposition.

Whether those two conditions were met at the relevant times cannot be determined without knowing the circumstances in which the appellant disposed of its shares in RMC.

In the spring of 1976, the appellant began discussions with the Hogg Robinson Group Ltd. (HR), a United Kingdom company, concerning the acquisition by HR of an interest in RMC At the time, RMC’s issued capital stock was allocated as follows: 2500 class "A" shares all owned by the appellant; 2500 class "B" shares, 200 of which were owned by D. H. Butler, the rest by the appellant.

On August 12, 1976, A. F. Melling (the president, principal shareholder and directing mind of SR) and A. V. Hopkinson (the overseas director of HR) arrived at what Mr. Hopkinson called, in a letter of August 16 to Mr. Melling, “the deal that we agreed together,’ but which the appellant argues was only a stage in negotiations. At this meeting of August 12, the parties "agreed" inter alia: that the existing common stock in RMC (owned only by Messrs. Melling and Butler) would be exchanged for redeemable preference shares, that a new holding company to be called Melling Hogg Robinson Limited (MHR) would be formed with a capital of $100,000 of which 51 per cent would be subscribed by the appellant and 49 per cent by HR, and that MHR would subscribe $100,000 new common stock in RMC Discussions continued through the fall of 1976 and MHR was incorporated on December 17 with 100,000 shares in authorized capital. On December 20, MHR subscribed 100,000 shares of RMC and the appellant and HR each subscribed 50,000 common shares of MHR, a modification of the original 51-49 split which was apparently first suggested in mid-September. However, on December 31, the original plan was reverted to and HR sold 1000 of its shares in MHR to the appellant at the original subscription price of $1 a share. In the meantime, on December 23, RMC's authorized capital had been modified and new classes of preferred and common shares issued and the appellant had exchanged its old class "A" and “B” voting shares in RMC for new class “‘A”, “B” and "C" non-voting preference shares.

In its statement of claim, the appellant alleged summarily the various transactions to which I just made reference. In Her statement of defence, the respondent admitted most of those allegations but denied the allegation that "On 20 December 1976, MHR subscribed and purchased 100,000 RMC common shares at a par value of $1 thereby acquiring control of RMC"; the statement of defence added, in paragraph 4, that “in assessing the Plaintiff, the Minister of National Revenue assumed that the Plaintiff, in effect, controlled at all relevant times Richards, Melling and Co. Ltd." and, in paragraph 5, that the “Plaintiff was not dealing at arm's length with Richards, Melling and Co. Ltd. immediately after it disposed of its shares."

At the beginning of the trial, counsel for the respondent made clear that his contention was that, immediately before the disposition, RMC was controlled (within the meaning of subsection 186(2)) by the appellant because, at that time, more than 50 per cent of the issued share capital of RMC belonged to MHR which was a person with whom the appellant was not dealing at arm’s length. The respondent also contended that, immediately after the disposition, RMC was not a person with whom the appellant was dealing at arm's length.

Paragraph 251(1)(b) of the Act provides that "it is a question of fact whether persons not related to each other were at a particular time dealing with each other at arm's length." Two persons are not dealing at arm’s length when there exists between them a relationship that enables one of them to dictate the terms of a bargain to the other.

The position of the respondent, therefore, was and still is, first, that there existed between the appellant and MHR, immediately before the disposition, a relationship such as to prevent them from dealing at arm's length and, second, that a similar relationship existed, immediately after the disposition, between the appellant and RMC.

The appellant argued unsuccessfully in the Trial Division that the allegations of the statement of defence were not sufficient to enable the respondent to contend and prove that, at the relevant time, the appellant was not dealing at arm's length with MHR and RMC That argument was, in my view, rightly rejected by the trial judge. True, the allegations of the statement of defence were vague and should have been more precise. However, the appellant chose not to apply for particulars or for an order striking out the defective allegations. In those circumstances, the appellant could not, at the trial, when he fully knew what the real issue between the parties was, take advantage of the fact that the statement of defence did not comply in all respects with the rules of pleading.

The evidence before the trial judge showed clearly that at all relevant times RMC had remained under the “de facto” control of the appellant. It was clear, therefore, that, immediately after the disposition here in question, the appellant and RMC were not persons who could deal at arm's length. The only real factual issue between the parties, therefore, related to the relationship existing between the appellant and MHR immediately before the disposition: was it such as to prevent them from dealing at arm's length?

On this question, the trial judge found, as I read her reasons, that HR never intended to acquire more than 49 per cent of the issued common shares of MHR; that, however, as the appellant did not wish, for income tax purposes, to appear to control MHR at the time of the disposition here in question, an informal understanding was reached pursuant to which HR, for the sole purpose of accommodating the appellant, did acquire its 49 per cent interest in MHR in two steps: HR first subscribed 50,000 of MHR thereby acquiring a 50 per cent interest in the new company and, a few days later, reduced its interest to 49 per cent by selling, to the appellant, at cost price, 1000 of the shares it had just subscribed and not yet paid. From those findings, the judge concluded that HR's temporary ownership of a 50 per cent interest in MHR was "one of form only, to accommodate the [appellant's] purposes” and that, as a consequence, the appellant immediately before the disposition, had the “de facto” control of MHR with which it could not, for that very reason, deal at arm's length.

The findings of the trial judge that I just summarized are fully supported by the evidence and counsel for the appellant did not try to impeach them. His attacks were directed against the inference that the judge drew from those findings that the appellant and MHR were not dealing at arm's length.

The appellant’s first point was that the judge could not find that the appellant was not dealing at arm's length with MHR and RMC at the relevant times since there was no evidence that the appellant had then dealt with those companies. He said that the phrase found in subsection 186(2), “persons with whom the other corporation does not deal at arm's length,” means, in fact, persons with whom the other corporation deals not at arm's length because, otherwise, any person with whom the corporation does not deal would be a person with whom the corporation does not deal at arm's length. It follows, according to counsel, that in order to prove that two unrelated persons are not dealing at arm’s length, it is necessary to establish, first, that those two persons are dealing with each other and, second, that their relationship is such as to prevent them from dealing at arm's length.

That argument is based on the English version of subsections 186(2) and 251(1); however, it cannot be reconciled with the French version of those provisions where the expression “[not] to deal at arm's length" is translated by the phrase “avoir un lien de dépendance." The French version makes clear, in my view, that what parliament had in mind in referring to persons dealing or not dealing at arm's length was not persons who were actually dealing with each other but, rather, persons between whom existed a relationship of subordination.

The appellant's second argument, as I understand it, was that, as the appellant was clearly dealing at arm’s length with HR and its representatives, it is logically impossible for an agreement between those two parties to give rise to a non-arm's-length relationship between the appellant and MHR.I must say that I do not understand that argument. It seems to me that if the agreement between HR or its representatives and the appellant were such as to give to the latter the “de facto” control of MHR, it would necessarily follow that, by reason of that agreement, the appellant would not be dealing at arm’s length with MHR. And, as I understand the judgment under appeal, it is because the judge considered that such was the effect of the informal arrangement that had intervened between the appellant and HR that she concluded that the relationship between the appellant and MHR was not an arm’s length relationship. I cannot find fault with that reasoning nor with the premise on which it was based. If, as the trial judge correctly found, HR's temporary ownership of 50 per cent rather than 49 per cent of the capital stock of MHR was “one of form only,” it necessarily follows that while that temporary ownership lasted the appellant had the “de facto” control of MHR and could not deal at arm's length with it.

I would dismiss the appeal with costs.

Appeal dismissed.