McAllister Drilling Ltd. v. The Queen, 95 DTC 5001, [1994] 2 CTC 211 (FCTD)

Simpson J.:—The plaintiffs McAllister Drilling Ltd. ("Drilling"), McAllister Holdings Ltd. ("Holdings") and McAllister Waterwells Ltd. ("Waterwells") appeal, pursuant to subsection 172(1) of the Income Tax Act, R.S.C. 1952, c. 148 (am. S.C. 1970-71-72, c. 63) (the "Act"), the decision of the Tax Court of Canada, dated November 8, 1990, upholding the reassessment of income by the Minister of National Revenue (the "Minister") dated September 15, 1987 in respect of the plaintiffs’ 1981 and 1984 taxation years. The plaintiffs appeal on the basis that they were not associated corporations during the 1981 and 1984 taxation years.

By notice of reassessment dated September 15, 1987 the Minister reassessed the plaintiffs for their 1981 and 1984 taxation years after issuing a direction on August 14, 1987 (the "direction") that each of the plaintiffs were deemed to be associated with each other, pursuant to subsection 247(2) of the Act.

The effect of the direction was to eliminate the small business deduction (the "deduction") which was available to Drillings, Holdings and Waterwells as separate corporations. In 1981 and 1984 the three corporations saved tax in the amounts of $47,399 and $57,518 by reason of the deduction. If the three corporations are associated, the deduction and related tax savings are lost. Accordingly, the separate existence of the corporations in 1981 and 1984 did have the effect of reducing taxes.

The relevant sections of the Act provide:

247(2) Where, in the case of two or more corporations, the Minister is satisfied

(a) that the separate existence of those corporations in a taxation year is not solely for the purpose of carrying out the business of those corporations in the most effective manner, and

(b) that one of the main reasons for such separate existence in the year is to reduce the amount of taxes that would otherwise be payable under this Act the two or more corporations shall, if the Minister so directs, be deemed to be associated with each other in the year.

247(3) On an appeal, from an assessment made pursuant to a direction under this section, the Tax Court of Canada or the Federal Court may

(a) confirm the direction;

(b) vacate the direction if

(i) n/a

(ii) in the case of a direction under subsection (2), it determines that none of the main reasons for the separate existence of the two or more corporations is to reduce the amount of tax that would otherwise be payable under this Act; or

(c) vary the direction and refer the matter back to the Minister for reassessment.

A direction under 247(2) can be issued only if both prerequisites in the section are met. However, it is only the prerequisite in section 247(2)(b) that is of concern in this appeal. It provides that the Minister must be satisfied that one of the main reasons for the separate existence of Drilling, Holdings and Waterwells in 1981 and 1984 was to reduce the amount of taxes which would otherwise have been payable if their businesses had been carried on by only one corporation.

Issue & onus

The question for determination is one of fact arising pursuant to subparagraph 247(3)(b)(ii) of the Act. It is whether, on a balance of probabilities, the direction should be vacated. This will occur only if the plaintiff satisfies the onus of demonstrating that none of the main reasons for the separate existence of Drilling, Holdings and Waterwells was the reduction of taxes. The test to be applied is one of purpose and not of result. The result was a tax saving, however the issue is whether that saving was one of the main purposes for the creation of three separate corporations.

Much has been submitted about the onus borne by the plaintiffs. Counsel for Her Majesty the Queen ("crown counsel”) relies on the decision of Mr. Justice Marceau in the case of R. v. Covertite Ltd., [1981] C.T.C., 464, 81 D.T.C. 5353 (F.C.T.D.). In that case, His Lordship found that the plaintiff’s denial of any tax motivation for their creation of separate corporations and their explanations for the existence of the separate companies were not credible. He therefore determined that no weight could be given to a taxpayer's mere denial of tax motivation as a main purpose. He felt that a taxpayer's intention could not be devined from his or her direct evidence alone. Corroboration was required in the form of inferences reasonably drawn from objective readily ascertainable facts. It is clear to me that Marceau J. adopted this approach because the credibility of the taxpayers in Covertite, supra, was in doubt and because he recognized the likelihood that, generally, taxpayers' evidence in cases of this kind could not be considered trustworthy. Accordingly he held that, to succeed, plaintiffs must either:

(i) disprove the facts assumed by the Minister or;

(ii) convince the Court that the inferences drawn by the Minister from the facts assumed were unreasonable and unwarranted, or;

(iii) add further facts capable of changing the whole picture and leading to different inferences pointing to the conclusion that the other reasons alleged have actually been prevalent.

I am satisfied that this approach is the correct one in the majority of cases because, normally, the taxpayers’ credibility will be in issue. However, crown counsel conceded in his opening statement and repeated in his final argument that the credibility of the plaintiffs and their witnesses was not in issue. In the somewhat unusual circumstances of this case where credibility is conceded, if I agree that the taxpayers’ evidence is credible, it will not require the bolstering or corroboration afforded by external facts.

The appropriate approach to an appeal of this kind was also considered in M.N.R. v. Furnasman Ltd., [1973] C.T.C. 830, 73 D.T.C. 5599 (F.C.T.D.). In that case the Court said that the test to be applied in reviewing a plan to set up separate corporations is whether “If there had been no tax advantage, would the plan have been adopted in any event?”

I was also directed to cases which considered the concept of “main” as used in the phrase “main reason” in section 247 of the Act. In Honeywood Ltd. v. The Queen, [1981] C.T.C. 38, 81 D.T.C. 5066 (F.C.T.D.), the definition at page 43 (D.T.C. 5070) reads:

"Main" is the key word in this subsection of the Act. The Shorter Oxford Dictionary records as some of its meanings as follows: "of pre-eminent importance; principal, chief, leading”.

Accordingly ! should only vacate the direction if I am satisfied by the taxpayers' evidence that none of the principal or paramount reasons for the separate existence of the corporations was the achievement of a tax reduction.

Finally, because it was the subject of a variety of submissions by counsel, I should note that this matter proceeds before me as a trial de novo. The findings made by the Tax Court of Canada are not binding and the decision I reach will be based solely on the evidence adduced before me in this Court.

Facts

The McAllister business saga began with Frank W. McAllister. In 1940, he started a business which involved drilling waterwells (the "business"). The Business was based at his home located on a farm six miles from Lloydminster, Alberta. Lloydminster is located on the border between Saskatchewan and Alberta approximately 100 miles east of Edmonton. Frank W. McAllister did not give evidence. He is 84 years old and has retired.

Frank W. McAllister had a number of sons. One was William Roy McAllister ("Roy"). Roy is now 57 years old and has also retired. However, he gave evidence in this case. As a young man he worked for his father’s business on a part time basis while he attended school and on a full time basis thereafter. In 1953, Frank

W. McAllister set up a partnership to run the business and to formally involve two of his sons in its operation (the "partnership"). Frank W. McAllister together with Roy and Roy’s brother Glenn were the partnership's three partners.

In 1953, the partnership provided two distinct services. It drilled domestic waterwells and it also performed roadwork on oil fields. The oil field work was known as the construction or "dirt" business. Roy worked on domestic waterwells while his brother Glenn focused his energy on the construction business. Their father, Frank W. McAllister scouted for work, prepared the contracts for the construction business and helped his sons in the field when needed. In 1956 the partnership opened two separate bank accounts to segregate the finances of the waterwells and construction businesses as the latter experienced slower collections.

In 1967 the partnership incorporated its two businesses in order to limit the liability of the participants. Roy's domestic waterwell business became McAllister Drilling Limited (already described as Drilling) and Glenn’s construction business became McAllister Construction Ltd. ("Construction"). Drilling was incorporated with five shareholders who each held a 20 per cent interest. They were Roy, another of his brothers called Bert, his stepmother Pauline (the second wife of Frank W. McAllister) and his sister-in-law Dorothy (his brother Glenn's wife). Roy operated Drilling on a daily basis and, into the 1970s he worked with two drilling rigs.

Construction was also a McAllister family company. However, it is not involved in this proceeding. Frank W. McAllister ran Construction.

During the later years of the partnership and following the incorporation of Drilling and Construction, the waterwells and construction businesses were each operated as separate businesses from a small office building on the family farm. Each company paid 50 per cent of the operating costs. The farm was served by a party line telephone service. This did not suit the McAllister’s operations, so, they brought one private phone line to the farm's office building at a considerable cost of $1,500. Because it was too expensive to install two private lines, the phone was simply answered "McAllister". In the 1970s a large shop was built on the family farm and it was also shared by Drilling and Construction.

In the late 1960s Roy's sons (Dean, Bryon and Frank E. McAllister) began to work with him on the waterwell drilling rigs. They were all certified as journeymen drillers by 1975. This certification gave them the ability to operate a waterwellrig without supervision and hence the potential to go into business for themselves. Roy testified that his sons approached him on the basis that they no longer wished to work for wages and, with minimal capital, wanted to establish themselves so that their earnings would be a reflection of their efforts and not of a fixed wage.

The evidence disclosed that thought was given to allowing Roy's sons to buy into Drilling. However Roy, who was the operating force at Drilling and who led its shareholder discussions, testified that Drilling’s shareholders did not want Roy's sons to join its shareholder group. It was in a state of disharmony and flux due to marriage breakdowns and related divorce proceedings.

In addition, Roy gave evidence that his sons had insufficient funds to purchase Drilling’s shares which, according to its January 1978 financial statements, had a book value of $569,876. However, it was conceded by crown counsel, that the actual value of the shares was greater than their book value.

Roy's eldest son, Frank E. McAllister ("Frank") testified that, from the younger generation's perspective, their participation in Drilling was not a very attractive alternative even if the share price had been within their reach. Frank and his brothers wanted to be involved in a corporate situation where all the investors were active in the business. This was not and was unlikely ever to be the case in Drilling. Frank also testified that, with his brothers, he explored the possibility of borrowing sufficient money to purchase a drilling rig for a new business. Unfortunately, the banks restricted them to a loan which did not permit the purchase of a satisfactory rig. There remained, however, the option to lease a rig.

Roy testified that McAllister Holdings (earlier defined as Holdings) was incorporated by his three sons Dean, Bryon and Frank E. McAllister and two of their cousins (Glen and Allen McAllister) on the basis of an arrangement made with Drilling whereby:

Holdings would pay to Drilling 60 per cent of the gross invoiced value of Holdings work (the 60 per cent payment). The 60 per cent payment would be made whether or not the amounts were actually collected and whether or not Drilling experienced a profit or a loss.

The 60 per cent payment was to compensate Drilling for the services and equipment it provided to Holdings including:

- office space in the building on the family farm which was also occupied by Drilling and Construction;

— Roy's services as the purchaser of supplies;

— two drilling rigs and two trucks;

— one service rig used to repair waterwells;

— insurance and gas for the rigs;

— bookkeeping and tax services;

— equipment maintenance services.

It was understood in turn that Holdings would be responsible for:

— invoicing its own customers and overseeing its own collections;

— all personnel matters including hiring and firing of employees;

— compensation for its owners and its employees.

Prior to Holdings’ creation, Drilling and Construction had used the services of a bookkeeper called Jack McLean ("McLean"). He worked for the McAllisters on a contract basis and also had other clients. Bob Alexander ("Alexander") was the accountant for Drilling and Construction. He reviewed the books prepared by McLean and prepared income tax filings at year end. After its creation, Holdings also used the services of McLean and Alexander.

Roy and Frank both testified that, when Holdings was created in 1977, the 60 per cent Payment was recommended to both Drilling and Holdings by Alexander and that the percentage was not the subject of much negotiation. There were discussions, however, about what the 60 per cent Payment covered and Frank recalled discussing a list of items with Jack Alexander. However, there was no written agreement recording the 60 per cent Payment, what it covered or how it was to be paid.

During its investigation Revenue Canada was troubled by the absence of a written agreement which described the obligations of Drilling, Holdings and later Waterwells in respect of the 60 per cent Payment. Roy McAllister testified that the 60 per cent Payment was arranged on a handshake which was all that "kin" required. Frank E. McAllister recalled that Alexander did have a note of the agreement on a piece of paper at the time but stated that it was lost long ago. It is undisputed, however, that the 60 per cent Payment was paid. Payments were not scheduled and appear to have been made when McLean thought to organize them. They were made two or three times each year. The evidence disclosed that it was one of Alexander's year end tasks to reconcile the 60 per cent Payment and ensure that a sufficient sum was paid to Drilling and that any overpayments were refunded to Holdings. As credibility is not in issue and because the financial records show that the 60 per cent Payment was made, I accept that it was the basis (subject to amendments) on which Holdings, and later Waterwells, operated.

McAllister Waterwells Ltd. (earlier defined as Waterwells) was incorporated in 1980 following two serious disagreements between Holdings’ shareholders. Glenn and Allen (Frank E.’s cousins) had never been active in Holdings. This was a source ofdiscontent on the part of the active shareholders who had understood that Holdings would not have inactive participants. As well, Frank E. was unhappy because his brothers Dean and Bryon were not prepared to work away from home. In his view, successful business development required this commitment and Frank E. decided that he wanted to work with his uncle whose approach mirrored his. Accordingly, Glenn and Allen left Holdings in 1980 and incorporated McAllister Oilfield Construction (Oilfield). Oilfield is not involved in this case although it also operated from the office on the family farm. At the same time, Frank E. left Holdings and, with his uncle George F. McAllister (Roy's half brother), incorporated Waterwells. Waterwells operated using the same 60 per cent Payment plan that had been set up for the establishment of Holdings. It rented equipment from Drilling. It hired its own employees and kept separate books.

Accordingly, in 1980, five companies were owned and operated by members of the McAllister family: the two construction companies (which are not involved in this case) and the three drilling companies, Drilling, Holdings and Waterwells (the “Drilling Companies"). They carried on business from the sixteen foot square office on the family farm. It is conceded that none of the Drilling Companies are a sham. All proper steps were taken to establish them as bona fide corporations.

However, crown counsel argued that, because the operation of the drilling business was substantially unchanged after the incorporation of Holdings and Waterwells (the "Incorporations") the Minister correctly concluded that tax savings must have been a main purpose because there was no other apparent business justification for the Incorporations.

This submission raises two issues:

The first is factual and the question is whether the drilling business did change after the Incorporations. The second issue is what is a “main purpose” within the meaning of section 247(2) of the Act. Is it only a business purpose in the sense that the objective must be greater efficiency, output or profitability for a business or can a main purpose relate to broader issues such as succession within a family business?

The evidence was that in 1980 the Drilling Companies carried on business using one phone with two extensions in the office on the family farm. Work that came through the office phone was assigned by Roy depending on the geographic location of a customer. A significant amount of work was obtained by each company at its drill site. Drilling, under Roy's direction, was the only company licensed to operate in Saskatchewan and its one rig was occupied there for the most part. All Saskatchewan work was given to Drilling. In Alberta, Holdings operated to the South of Edmonton. It dug deep domestic waterwells and also serviced wells of that kind. Waterwells drilled industrial waterwells in Edmonton and Western Alberta. It extended its area of operationsand, in 1980, began to provide cathodic protection. This was a new service designed to prevent the deterioration of metal materials installed underground. Each company invoiced its own customers on its own stationery, paid its own employees from its own bank account and handled its own hiring, firing and accounts receivable. Roy pur chased supplies for all the Drilling Companies and their books of account and taxes were prepared separately by McLean and Alexander. Although Waterwells and Holdings engaged in local advertising near their rigs, Drilling had the only yellow pages listing until 1984. The single phone was answered "McAllister". A customer would not know which company performed its work until it was invoiced unless it saw a local ad or was present at the work site and saw a sign on the rig.

On this evidence, I have concluded that the businesses did begin to change after the Incorporations. The new directing minds had the freedom to begin to make management decisions which took their companies in new directions such as cathodic protection.

I have relied on the decision of Mr. Justice Mahoney in R. v. Arthill Enterprises Ltd., [1975] C.T.C. 594, 75 D.T.C. 5419 (F.C.T.D.), as authority for the proposition that a main purpose under subsection 247(2) need not be a strictly business purpose. In that case, the creation of an estate plan was accepted as a “main purpose". In this case I accept that a main purpose for the Incorporations was to provide for the succession and independence of the next generation of McAllisters.

The incorporations served this objective. The shareholders were given the opportunity to own and develop their businesses according to their respective interests and priorities. They were also independent as there were neither crossshareholdings nor inter-corporate loans. Those who worked hardest benefited most.

Tax Considerations — holdings

When Holdings was incorporated in 1977 Roy's sons asked McLean and Alexander for suggestions about incorporating a company and about an appropriate percentage payment for Drilling. Roy was not involved in the structure of the Holdings business. His role was to arrange the approval of the 60 per cent Payment by the five Drillings shareholders. Roy testified that his sons and their cousins never mentioned tax. Although Roy testified that, in the past, it was Alexander who provided Drilling with tax advice, Roy’s evidence was that Alexander provided no tax advice to Drilling’s shareholders before the 60 per cent Payment was approved. Roy stated that the percentage was the focus of all the discussions together with a common wish to set up the next generation in business. He frankly admitted that tax is normally a consideration but that, in this situation, tax issues were not a focus and were not discussed. Frank E. McAllister described the organization of Holdings in 1980 and said that McLean helped them reach the 60 per cent Payment and Alexander advised them on corporate structure. No lawyers were involved. He said that therewere no discussions about taxes although he acknowledged that Alexander must have taken taxes into consideration. However, his evidence was clear that the mood of the younger generation was such that they would have started Holdings "whether taxes helped or not”.

Finally, Dean McAllister, another of Roy's sons, confirmed that he was unaware of any discussions about taxes when Holdings was incorporated.

Waterwells

Roy had no evidence to offer about tax discussions in relation to the establishment of Waterwells. He was again involved in the approval of the 60 per cent payment by Drilling and could not recall tax issues being raised. Frank E. McAllister testified that Waterwells was incorporated in 1980 by McLean's wife who was a legal secretary. No other professional advice was obtained. The 60 per cent payment arrangements with Drilling were easily made as Drilling was accustomed to them. They had been in place for Holdings for three years.

There was no evidence of a tax planning scheme or even a recognition of potential tax advantages in connection with the establishment and operation of Holdings and Waterwells. The evidence was clear that tax was not discussed even by Alexander, who, though not an expert tax planner, could have been expected to raise tax issues, had they been considered a main purpose for the incorporations.

Roy testified that he was not involved in the discussions about the incorporation of Waterwells. He knew that his sons and his nephews had had a falling out and he left them to sort through their difficulties. He recalled no discussions about the tax implications associated with the creation of Waterwells. His only focus was to ensure that Drilling approved the 60 per cent payment as the basis for Waterwells’ operation. Frank E. McAllister testified that Waterwells was incorporated by McLean's wife who was a legal secretary. He said that Waterwells was set up because he wasn't happy with Holdings’ operations. He also stated that he had no professional advice and simply arranged with his father to have Drillings extend the 60 per cent payment arrangement to Waterwells.

Alexander wrote a letter to Revenue Canada dated October 10, 1986 which set out the facts relating to the incorporation of Holdings and Waterwells. In it, he said:

We point out to you that the companies were not expressly set up to reduce taxes. McAllister Drilling Ltd. was an old established company and the younger generation did not want to pay large sums to purchase the company as they were not sure how business would turn out for themselves, Also the case of Frank McAllister leaving in a dispute with Dean & Bryan McAllister certainly cannot be said to be a main reason to reduce tax.Clearly the specialization areas and the facts enumerated above substantiate business reasons and NO application by the Minister of subsection 247(2).

Although the word “expressly” is somewhat ambiguous, in context it does not contradict the evidence that taxes were not discussed and that another motive, not tax, was the sole main purpose for the separate existence of the drilling companies.

Conclusion

There is no doubt that the drilling companies were established primarily to afford the younger members of the McAllister family the independence they needed to operate as successful entrepreneurs. As wage earners in the family business they had no prospect of seeing their energy and ideas reflected in their incomes ana in management decisions.

That this motivation was real is borne out by objective facts. The companies developed in different geographic areas and with different expertise according to the preferences of their new owners. Indeed, Waterwells was established on the sudden following a disagreement because Roy's nephews were not active in Holdings as had been planned and because one of Roy's sons had different ambitions for the business. This was not a situation where one business was carried on with three sets of books.

The evidence also discloses that the establishment separate corporations linked to Drilling by the 60 per cent payment plan was the only practical way to achieve the younger generations’ objectives. Its members did not have the capital to begin their business careers in any other way. Alternatives were considered but proved impractical.

Finally, the evidence is clear that Alexander, a long time family friend and advisor on tax matters, did not discuss the tax advantages associated with organizing three drilling companies with Roy, with the Drilling’s shareholders or with the shareholders of Holdings and later Waterwells. Given his role as sole advisor on tax issues, it is impossible to conclude that tax considerations were a second main purpose when the only outside advisor who could be expected to raise the issue did not do so and when no family members discussed the matter. I have found the evidence given by Roy, Frank E. and Dean McAllister to be credible. There is also objective evidence which, although not necessary in this case, supports the McAllisters’ testimony. The taxpayers have therefore established that tax savings were not a main purpose for the incorporation of Holdings and Waterwells.

The appeal is allowed with costs.

Appeal allowed.