Lixo Investments Ltd. v. R., 97 DTC 1030, [1997] 2 CTC 2772 (TCC)

Archambault T.CJ .:

Lixo Investments Limited (Lixo) appeals income tax assessments issued by the Minister of National Revenue (Minister) with respect to the 1987, 1989 and 1990 taxation years (relevant taxation years). The Minister assessed Lixo for its failure to deduct, withhold and remit taxes owing to the Receiver General in respect of interest paid by Lixo to Slupy AG (Slupy), a corporation resident in Holland. Lixo claims that no tax had to be withheld on the interest because of the exemption provided for in subparagraph 212(1 )(/?)(vii) of the Income Tax Act [1] (Act). The Minister contends, and this is the only issue raised by these appeals, that this exemption does not apply because Lixo and Slupy were not dealing with each other at arm’s length during the relevant taxation years.

Facts

Lixo is a corporation resident in Canada. During the relevant taxation years, it was primarily engaged in the real estate business. It held rental properties and purchased vacant land for development. One of its major projects is a building situated at 70 Yorkville Avenue in Toronto (Yorkville Property).

As of March 1987, Lixo’s common shareholders were members of Mrs. Girotti’s family and Slupy:

Mrs. Girotti’s husband, Mr. Raffaele Girotti was born in Italy in 1918. He started out as an aeronautical engineer after World War II. He worked for one of Italy’s largest oil and gas companies (EN/). Towards the end of the 1970s, he became its president. When he retired from this company, he sat in the Italian Senate.

During the mid 70s, many Italians became concerned about the political situation in their country. The Communist Party was becoming more powerful, so that many Italians with money started to look for investment opportunities outside of Italy and Europe. At that time, Mr. Girotti decided to move his family to Canada and make investments in this country, although he himself would remain in Italy. Mrs. Girotti first moved to Calgary where Mr. Girotti wanted his family to invest in the Canadian oil and gas industry. Then, she moved to Toronto where the family decided to redirect its energy to real estate.

Mr. Girotti knew a lawyer, Doctor Arnaldo Bolla, in Lugano, Switzerland. Dr. Bolla had in the past rendered professional services to ENI. Dr. Bolla’s father had also been a friend of Mr. Girotti’s father and a trustee of a family trust (Girotti Family Trust) settled by Mr. Girotti’s father at a time when he was concerned about an invasion of Italy by the Germans. Towards the end of 1976 or at the beginning of 1977, Dr. Bolla introduced Mr. Girotti to a Mr. Genattini, one of his clients.

Mr. Genattini had, around that time, started up his own consulting firm (FGK) in Lugano in a partnership with Mr. Aldo Kern. Mr. Kern was a specialist in organizing companies and advising clients on tax law. Mr. Genattini’s speciality was more in the areas of investment and management of assets. Both Messrs. Genattini and Kern had previously worked together for a Lugano bank which eventually became insolvent and closed in February 1977. Being located close to the Italian border, Lugano was well situated to attract Italian investors. FGK helped the nervous Italians to make investments outside of Italy. Some of its clients were former clients of the Lugano bank.

Messrs. Genattini and Kern established in 1976 or 1977 an investment company in Panama (Trisoldi). Most of its shareholders were Italian clients of FGK. Mr. Kern confirmed that Mr. Girotti was not a client of FGK and that to his knowledge, neither Mr. Girotti nor his family were among Trisoldi’s shareholders. Mr. Kern helped structure this company: he chose the country of incorporation and the company’s capital structure but it was Mr. Genattini who dealt with the Italian investors.

When he met Mr. Genattini, Mr. Girotti informed him of his family’s plans to invest in Canadian real estate. Mr. Genattini offered financing of up to $12 million for such real estate activities in Canada. He then came to Toronto to get acquainted with the Canadian real estate market and he negotiated the terms of the financial arrangements with a Mr. Ugo Ratti, an architect, who handled the day-to-day management of Lixo from 1977 to 1979. Unfortunately, Mr. Ratti passed away in 1980.

Mr. Girotti did not get closely involved in these negotiations: he was only informed of the general terms of the arrangements. Apparently, Mr. Genattini was prepared to provide up to $10 million in shares and $2 million by way of advances. The funds were to come from Trisoldi. Mr. Genattini asked Mr. Kern to assist him in structuring Trisoldi’s investment in Lixo. Mr. Kern suggested that the entity lending money to Lixo should be situated in a country with which Canada had a tax treaty. This is the reason why Slupy became a subsidiary of Trisoldi and was interposed between Trisoldi and Lixo. Mr. Genattini and Dr. Bolla were among Slupy’s directors.

Mr. Genattini negotiated the financial arrangements on behalf of Slupy. Trisoldi funded Slupy by lending money to it. Slupy in turn funded Lixo by lending money to it and by subscribing preferred shares (Preferred Shares). In addition, Slupy acquired 4% of the common shares issued by Lixo. It wanted to be granted more voting shares but, apparently, this was not done because of concerns about the Foreign Investment Review Act.

Based on Lixo’s financial statements as at the December 31, 1978 year- end, Slupy invested $1,500,000 in Lixo Preferred Shares and advanced to that company an aggregate sum of $2,049,899. These statements describe the Preferred Shares as 8% non-cumulative, non-voting, non-participating, redeemable preferred shares with a par value of $1 each. At that time, Lixo owned three buildings whose total cost was $6,968,453. The mortgages on these properties amounted to $3,944,349. The common shares had a paid-up capital of $4,000 and were issued mostly to the Girotti family. For the 1978 fiscal period, Lixo had a loss of $18,253 on rental revenues of $324,871.

On November 21, 1979, Mrs. Girotti and Slupy entered into an agreement (1979 Agreement), negotiated by Mr. Girotti and Mr. Genattini, whereby Slupy stated that it was prepared to advance more funds to Lixo. Mrs. Girotti was to oversee the day-to-day management of Lixo and, as security for Slupy’s investments, she was to pledge her Lixo shares as collateral for the repayment of any current or future debts to Slupy. As an additional guarantee, Mrs. Girotti issued a blank promissory note, called a cambiale in Italy, signed by her and undated so that it could be filled in and used if Lixo defaulted on any of its debts to Slupy. It was Doctor Bolla who recommended that these guarantees be used to protect Slupy’s interest. He wanted to have this cambiale in preference to a mortgage on the assets of Lixo situated in Canada because Mrs. Girotti had assets worth about 4.5 million dollars in Italy and he thought that it would be easier to enforce payment of Lixo’s loans by means of the cambiale. At the end of 1979, Slupy had invested $3 million in Lixo’s Preferred Shares and had advanced to it $3,149,899.

In his dealings with Slupy, Doctor Bolla stated, he never acted in any capacity on behalf of Mr. Girotti nor any member of his family; he did not receive any instructions from them either. He generally dealt with Mr. Girotti, who negotiated on behalf of Lixo the financial terms of the investments of Slupy in Lixo. Mrs. Girotti was described by Dr. Bolla and Mr. Kern as a homemaker. According to Dr. Bolla, when Slupy and Lixo were negotiating, they were each trying “to have the better out of the bargain.” Doctor Bolla and some members of his family had an interest in Trisoldi. He confirmed that as far as he knew, none of the funds of the Girotti Family Trust were invested in Slupy or in Trisoldi. Mr. Girotti stated that neither he nor his family ever invested any money in Trisoldi or Slupy.

Slupy’s residence was moved to the Netherlands in 1981 or 1982. Doctor Bolla then became the sole director and shareholder of Slupy at the request of Mr. Kern who, later, also became a director of Slupy. This was not done at the request of Mr. Girotti nor of anyone related to him. At the end of the 1981 fiscal period, Slupy held $6 million in Preferred Shares and $4,969,347 in outstanding advances which, it appears, included capitalized interest.

Up to 1982, Mr. Genattini was responsible for overseeing the investment of Slupy in Lixo. Sometime around 1980, Mr. Genattini lost his daughter in difficult circumstances and this seems to have caused him severe stress. Mr. Kern stated that he gradually became concerned about the mental capacity of his partner. In 1982, one of FGK’s clients was very unhappy with the return on his investment in Trisoldi. Mr. Kern had to buy that client’s shares and he then started to pay closer attention to the affairs of Slupy and Lixo.

Other Trisoldi investors were also becoming increasingly disenchanted with their investments. Mr. Kern explained that they were not all that concerned when they first invested in Trisoldi and during the following few years. During this period, the value of the Italian lira was falling in relation to other currencies. Investments in Swiss francs were not attractive: the rate of return was either very low or negative. Investing in North America seemed to be a more attractive choice. However, when the lira stabilized in relation to the other currencies, the investors in Trisoldi paid more attention to the low return on their investments.

In 1982, Mr. Kern went to Toronto to obtain more information about Lixo and to inquire as to why no dividends were being paid on the Preferred Shares. He was told that Lixo was still in its development stage and that its funds were being reinvested. During his visit, Mr. Kern asked for the corporate documents relating to the Preferred Shares issued to Slupy. Mr. Girotti undertook to provide them to him. Before receiving these documents, Slupy agreed to convert $4 million of advances into more Preferred Shares.

When Mr. Kern finally received the documentation, he realized that his shares were not participating in the earnings of Lixo. Further, the dividends on the shares were non-cumulative. Mr. Kern stated that this was contrary to his understanding. He thought that the Preferred Shares were a financial instrument, something between a share and a loan, and that at least a minimum return would have been guaranteed from year to year. Mr. Girotti said that Mr. Kern, upon being informed that the Preferred Shares were nonparticipating, became very upset. He advised Mr. Girotti that he would not have agreed to convert the $4 million advanced by Slupy into Preferred Shares had he known about their attributes. Mr. Girotti said that he was not aware of the Preferred Shares’ attributes and he undertook to look into the matter. The problem was solved, in part, two years later, when Mr. Girotti advised Mr. Kern that the $4 million in Preferred Shares had not in fact been issued and therefore adjustments were made to the balance sheets for the 1984 fiscal period to reflect this. However no interest was paid on the $4 million which had never been converted into Preferred Shares. Mr. Girotti was advised that it was not possible in Canada to pay retroactive interest.

When asked why it took so long to correct the attributes of the Preferred Shares, Mr. Kern explained that he did not believe that he had any legal grounds to sue Lixo and that his shares were neither retractable nor voting. One of his client’s had learned from experience that it was not good to put undue pressure on Mr. Girotti. In Mr. Kern’s assessment, Slupy was in a vulnerable situation. At that time, Slupy had close to $12 million invested in Lixo while Mr. Girotti’s family had only invested approximately $300,000. Mr. Kern therefore decided not to take any legal action or exercise the arbitration clause found in the 1979 Agreement. He also stated that he believed in Mr. Girotti’s word to look into the matter and that he trusted him.

By 1984, FGK was threatened with several suits from its discontented clients who had invested in Trisoldi. In the end, Mr. Kern, Mr. Genattini and another partner of FGK, Mr. Giovanni Bordoni, agreed to buy their interests in Trisoldi for approximately 40% of their original investment. According to Mr. Kern, one of the reasons why they sold for such a low price was apparently the fact that the value of real estate in Canada had diminished. The last investor was bought out in 1985. However, because of his concerns about being sued by some of the investors, Mr. Kern formed another corporation called Kern and Bordoni S.A. Around the same time, Mr. Kern and Mr. Bordoni purchased Mr. Genattini’s interest. Mr. Genattini eventually passed away around 1985. Mr. Kern testified that none of the funds used to purchase the shares from Trisoldi’s shareholders were provided by Mr. Girotti or his family. Mr. Bordini is now the biggest shareholder of Trisoldi and he was financed by his wife, who came from a wealthy family.

In an agreement dated December 3, 1984 (1984 Agreement) and written in Italian, Lixo and Slupy acknowledged that Mrs. Girotti had become a Canadian citizen and that she was holding some of her Lixo shares on behalf of her children who were about to reach the age of majority. In this agreement, Lixo states that the Yorkville Property was to serve as collateral to guarantee Slupy’s advances to Lixo. However, no mortgage would be registered against that property. Lixo only undertook not to reduce Lixo’s equity in it to less than $6 million which represented approximately the amount of Slupy’s advances to Lixo. At the time, the property was valued at about $9 million.

Mr. Kern confirmed that it was his idea to ask for a mortgage on the Yorkville Property and he requested Dr. Bolla to prepare the agreement of December 3, 1984. However, Mr. Girotti was not prepared to register a mortgage on the Yorkville Property unless the cambiale was returned to his wife. Mr. Kern followed Dr. Bolla’s recommendation not to insist on a registered mortgage and to rely instead on the cambiale. In arriving at this decision, Mr. Kern stated that he was not under the influence of Mr. Girotti. He was trying to protect his interests as best he could. Mr. Kern confirmed that the appraisal that was obtained at the time of the 1979 Agreement was destroyed and no update was obtained on the value of Mr. Girotti’s European assets in 1984.

On December 14, 1984, Lixo signed a more formal agreement in English pursuant to which the balance of its outstanding debts to Slupy was to bear interest at market rates to be decided upon by mutual agreement before the beginning of each calendar year. The Yorkville Property was to stand as security for Slupy’s advances. But no mortgage was to be registered until such time as Lixo should be in default. However, contrary to the informal agreement of December 3, 1984, Lixo undertook to maintain its equity at $3 million instead of $6 million. Doctor Bolla believes that this was an error and that the December 3, 1984 Agreement reflects the true intent of the parties namely that the equity be maintained at $6 million. In fact, the equity was maintained at that level in the following years.

Mr. Kern stated that the rate of interest payable by Lixo to Slupy was determined by negotiations between himself and Mr. Girotti. The rate was, generally speaking, determined by reference to the interbank rate of interest for a 12-month period plus 1% Mr. Girotti did not have control over Mr. Kern’s decision to agree to the rate of interest. The interest paid by Lixo to Slupy from 1987 to 1990 is as follows:

Mr. Kern stated that, after he and Mr. Bordini acquired the ownership of Trisoldi, he became more interested in having Slupy convert its Preferred Shares into loans. Mr. Kern did not have much knowledge of the real estate market and he did not believe very much in it. Lengthy negotiations were begun between Mr. Kern and Mr. Girotti. Mr. Girotti was not prepared to meet Mr. Kern’s request; he wanted Slupy to retain some capital exposure in Lixo. However, he recognized that Slupy’s return on investment had been inadequate. On November 29, 1985, a hand-written Memorandum of Agreement was concluded between Mr. Kern and Mr. Girotti in Lugano. Mr. Girotti agreed, in principle, that the Preferred Shares should be converted into non-voting participating shares. The conversion price was set at $3,500 per share. This agreement stated that the conversion price took into account profits in which Slupy had not participated in the past and was subject to terms and conditions to be negotiated, for which Lixo’s acceptance was required.

Mr. Kern’s initial reaction was not too favourable. He did not think that the price was so attractive. Before accepting such an offer to become a bigger Shareholder, he wanted Mr. Girotti’s family to invest more of its funds to insure that the company would have sufficient financing in the future.

Mr. Girotti proposed, on December 1, 1988, to redeem $3,040,000 of the $6 million in Preferred Shares. One million dollars of that amount would be paid to Slupy and $2,040,000 would be reinvested in 600 nonvoting participating shares. On December 21, 1988, Mr. Kern informed Lixo that the offer was not acceptable. Instead, he suggested a redemption of all the Preferred Shares and a conversion of 50% of the proceeds into non-voting participating shares. The balance would be reinvested as a loan with interest at 12.5% for 1989.

On January 17, 1989, Lixo made a counterproposal: $4.5 million in Preferred Shares would be redeemed, of which $3,060,000 would be reinvested in 900 non-voting participating shares and the balance of $1,440,000 would be reinvested by way of a five-year loan bearing interest on the same conditions as those applying to the outstanding advances. On January 31, 1989, Slupy agreed to this proposal. Mr. Kern did so because he thought that was the best he could get under the circumstances. He could not enforce the Memorandum signed in November of 1985 because the terms and conditions and the timing had to be agreed to by Lixo. Mr. Kern stated that when he signed the agreement to accept the conversion into non-voting participating shares, he was not aware that Revenue Canada was contesting the existence of an arm’s length relationship between Slupy and Lixo. Revenue Canada had commenced its audit during the 1988 calendar year and the auditor raised the issue of the arm’s length relationship on June 7, 1989. The situation at the end of the 1989 fiscal period was the following: Slupy had $1.5 million in Preferred Shares, 900 Class “A” non-voting participating shares and $9,243,939 in outstanding loans.

Mr. Girotti explained that one of the reasons why it took so long to convert the Preferred Shares into Class “A” participating shares was the fact that his family did not have access to substantial funds until 1986. These funds were to come from the Girotti Family Trust. Under its terms, certain conditions had to be met before the distribution took place, including the requirement that Mrs. Girotti have attained the age of 60 (and not be divorced), and the children, the age of majority. In 1986, Mrs. Girotti advanced $3,123,119 to Lixo. Mr. Girotti’s children advanced $785,916. In the years that followed, these advances to Lixo increased to an amount in excess of $10 million. Mr. Girotti stated that these funds came from the Girotti Family Trust.

When cross-examined about the fact that no interest was paid to Slupy in respect of the period during which the $4 million in Preferred Shares were thought to have been issued, Mr. Kern said that he was not concerned about this. He was just happy to have been successful in getting the $4 million back as advances. Furthermore, it took him six years to convince Mr. Girotti to convert more of Slupy’s Preferred Shares into promissory notes and the 900 Class “A” participating shares. He thought that this was his greatest achievement together with the fact that he had convinced the Girotti family to put several million dollars of advances into Lixo which Lixo invested in term deposits. The income generated from these substantial term deposits helped Lixo pay the interest owing to Slupy.

The interest paid from 1987 to 1990 inclusive totals $4,154,844. Except for payments made in 1978 and in 1986, all interest had basically been capitalized up to 1987. Interest owing to Slupy has essentially been paid only after substantial advances were made by the Girotti family. At the end of the 1987 fiscal period, the total amount invested by Slupy both in Preferred Shares and in advances came to $12,021,416, of which $2 million basically represented the capitalized interest. Since Mr. Kern and Mr. Bordoni purchased the $10 million investment made by the Italian investors through Trisoldi for $4 million, the total amount of interest paid during the four relevant taxation years represents a pretty good return for them: about 69% over that four-year period for an average annual rate of 17%.

During the course of the 1990 fiscal period, $258,400 worth of Preferred Shares were converted into 76 common shares which represents a conversion rate of $3,400 per share. The purpose of this conversion was to increase to 5% the interest of Slupy in the common shares of Lixo for certain Dutch tax purposes.

In his testimony, Mr. Kern confirmed that the interest received by Slupy was used to pay interest that the latter owed to Trisoldi, except to the extent of 1/8 of 1% which was left in Slupy, ultimately for the benefit of Dr. Bolla, who at that time was Slupy’s sole shareholder. The interest paid to Trisoldi from 1987 to 1990 were ultimately for the benefit of Mr. Kern and Mr. Bordoni and their families and none of these funds were returned to Mr. Girotti or his family. Mr. Girotti corroborated Mr. Kern’s testimony on this point.

Only copies of the common and Class “A” share certificates were filed in court. The original share certificates of Mrs. Girotti and her children are still being held by Mr. Kern’s office as collateral for the loans. Mr. Kern stated that all the shares of Lixo that belong to Slupy were beneficially owned by Slupy and were not being held for the benefit of Mr. Girotti or his family.

In Slupy’s financial statements, the shares and the advances to Lixo are shown as shares in and advances to a “related company”. Mr. Kern explained that this was in accordance with generally accepted account principles because Slupy’s Preferred Shares and advances represent a substantial investment in Lixo. They are not mere portfolio investments.

In his testimony, Mr. Girotti confirmed that he had never been a shareholder nor a director of Slupy. Neither he nor his family ever advanced, directly or indirectly, any money to Slupy. He basically confirmed the same with respect to Messrs. Kern, Genattini and Bordoni. He was not related to them and neither he nor his family gave them any money to invest on their behalf.

Position of the Minister

The Minister assessed Lixo on the basis that Slupy was not dealing at arm’s length with Lixo during the relevant taxation years. The position of the Minister is that Mr. Girotti was the directing mind behind both Lixo and Slupy. The financing arrangements offered by Slupy to Lixo were, in counsel’s own words, “just simply too sweet a deal for Lixo”. The Minister draws this inference from the description of the transaction presented by the four witnesses called by Lixo. Counsel for the Minister did not introduce any evidence, he simply cross-examined Lixo’s witnesses. During her argument, the Minister’s counsel introduced a summary of the circumstances suggesting that Slupy and Lixo were not dealing at arm’s length. They are:

1. Disproportionate equity in Lixo.

2. Substantial investment by Slupy in Lixo.

3. Quality of Slupy’s equity-terms of preferred shares.

4. Absence of documentation defining terms of Slupy advances.

5. No fixed rate of interest on amounts loaned by Slupy to Lixo.

6. Accounting behaviour of Lixo.

7. Interest of $1,080,000.00 foregone from 1982-1985.

8. Lack of participation by Slupy and unwarranted delay in resolution.

9. Resolution achieved.

10. Kern’s willingness to act on pro forma evaluation.

11. Lack of adequate security; failure to secure by mortgage.

12. Change in financial statements.

13. Lack of documentary evidence.

I believe the circumstances most favourable to the Minister’s position are the following:

First, it seems that Trisoldi, through Slupy invested most if not all of its funds in one venture, Lixo. This investment by Trisoldi represents a disproportionate investment in relation to its own equity in Lixo, which was only 4 to 5% of the common shares of Lixo. One more aspect of this investment which makes it incredible is the fact that out of the first $3.5 million that Slupy held in Lixo in 1978, $1.5 million was invested in non-voting preferred shares, non-cumulative and non-retractable. We usually see this kind of share in a corpora- tion subscribed for by related shareholders and not by strangers who do not control the corporation. And the story worsens when we look at the balance sheet at the end of 1983 when Slupy is shown as holding $10 million in Preferred Shares and close to $1.9 million in advances. The story becomes a nightmare when we realize that no dividend was paid on Preferred Shares until 1988, when the Preferred Shares were down to $6 million and the advances close to $7.8 million. Furthermore, with the exception of a small dividend of $12,765 in 1988 and $90,861 in 1990, no dividends were declared on Preferred Shares from 1978 to 1993. The Preferred Shares being non- cumulative, any dividend not declared in a particular year represents a lost return for their holders. Counsel for the Minister estimated the amount of foregone dividends represented $960,000 from 1978 to 1981; from 1981 to 1988, it represented $3.3 million. These amounts are astounding.

One more set of circumstances supporting the view of the Minister is the fact that the Girotti family at the outset had only invested $3,840 in the common shares representing 96 per cent of the common stock of the company. As a result, it was almost the sole beneficiary of any growth resulting from the investment activities of Lixo.

Also troubling is the fact that Slupy did not press Lixo hard to pay interest on the $4 million in advances which were misstated in the financial statements of Lixo as being Preferred Shares.

Finally, in 1984, Slupy agreed to lend money to Lixo for a five-year term with an understanding that the interest should be fixed by agreement of both parties on a yearly basis. The agreement is silent as to what would have happened had the parties not agreed on the interest rate.

Position of the Appellant

Notwithstanding these facts, counsel for Lixo argues that Slupy and Lixo were dealing at arm’s length during the relevant years, that is from 1987 to 1990. Three witnesses swore under oath that the money that was invested in Lixo came from Trisoldi through Slupy. Trisoldi was a Panamanian corporation incorporated to make investments for the benefit of a group of Italian investors. It is quite possible that a lot of these investors had invested in Trisoldi in breach of Italian currency regulations. However, all three witnesses testified that Mr. Girotti was not one of these investors, among whom were Dr. Bolla and clients of Messrs. Kern and Genattini.

Analysis

The key relevant provision for the purposes of this appeal is, in addition to subparagraph 212(l)(b)(vii), subsection 251(1) of the Act which reads as follows:

— Arm’s length.

(1) For the purposes of this Act,

(a) related persons shall be deemed not to deal with each other at arm’s length; and

(b) 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.

In his pleadings and in his argumentation before the Court, the Minister did not argue that Slupy or Trisoldi were related to Lixo. Lixo was legally controlled by Mr. Girotti’s family and during the relevant taxation years, Slupy was controlled by Dr. Bolla, and Trisoldi, by Mr. Kern and Mr. Bordoni. The only real issue before this Court is whether or not, from a factual point of view, Slupy was dealing at arm’s length with Lixo. The concept of non-arm’s length has been addressed by several cases in the jurisprudence. One of these cases which sets out the test is Minister of National Revenue v. Merritt, (1969), 69 D.T.C. 5159 (Can. Ex. Ct.), at 516 where it was held:

In my view, the basic premise on which this analysis is based is that, where the “mind” by which the bargaining is directed on behalf of one party to a contract is the same “mind” that directs the bargaining on behalf of the other party, it cannot be said that the parties are dealing at arm’s length. In other words where the evidence reveals that the same person was “dictating” the “terms of the bargain” on behalf of both parties, it cannot be said that the parties were dealing at arm’s length.

[my emphasis]

This concept of the “directing mind” has been extended to cases where the parties are acting in concert, such as when two or more persons are acting together as a directing mind to dictate the terms of a transaction to which a third person is a party. One of the leading cases dealing with this issue is Swiss Bank Corp. v. Minister of National Revenue, (1971), 71 D.T.C. 5235 (Can. Ex. Ct.), affirmed 72 D.T.C. 6470 (S.C.C.). The Exchequer Court expanded the directing mind test prescribed in Minister of National Revenue, as follows, at p. 5241:

To this I would add that where several parties — whether natural persons or corporations or a combination of the two — act in concert, and in the same interest, to direct or dictate the conduct of another, in my opinion the “mind” that directs may be that of the combination as a whole acting in concert or that of any one of them in carrying out particular parts or functions of what the com- mon object involves. Moreover as I see it no distinction is to be made for this purpose between persons who act for themselves in exercising control over another and those who, however numerous, act through a representative. On the other hand if one of several parties involved in a transaction acts in or represents a different interest from the others the fact that the common purpose may be to so direct the acts of another as to achieve a particular result will not by itself serve to disqualify the transaction as one between parties dealing at arm’s length.

The “acting in concert test” has also been used when the two parties, although unrelated, had “a mutual and common interest which directed them as one mind”. (See Giusti v. Minister of National Revenue, (1982), 82 D.T.C. 1781, 1786 and Sayers v. Minister of National Revenue, (1981), 81 D.T.C. 790 (T.R.B.)(T.R.B.)).

As counsel for Lixo stated, I do not believe that there is any middle ground in this case. Furthermore, it boils down to an issue of credibility. Unfortunately, the main actors in negotiating the arrangement that led to the investment of Slupy in Lixo around 1977 did not testify. Mr. Genattini passed away in the mid-80s and therefore we are missing his explanations as to why he agreed to invest in the Preferred Shares. The other person who might have shed some light on these negotiations was Dr. Ratti who had also passed away. One possible explanation for this very unusual investment is that Mr. Genattini may have been ill advised in agreeing to take up to $10 million in Preferred Shares.

If one were to accept the testimony of the three key witnesses, Dr. Bolla, Mr. Kern and Mr. Girotti, then one would have to conclude that Mr. Girotti, his family and the Girotti Family Trust did not have any interest in Trisoldi nor in Slupy. Slupy’s funds came from Trisoldi whose funds came from a group of Italian investors not connected with the Girotti family. So we have two groups, each with its own particular financial interest.

Furthermore, Mr. Girotti and Mr. Kern confirmed that the interest paid on the advances made by Slupy was not returned directly or indirectly to Mr. Girotti or to members of his family. These three witnesses were cross- examined by an able Crown attorney and I do not believe that he was able to impeach their credibility. If we assume that Mr. Genattini made a bad investment in agreeing to subscribe for non-voting, non-participating, non- cumulative and non-retractable Preferred Shares, then it is possible to accept that the testimony of the three witnesses was coherent and plausible.

Although the evidence disclosed that Mr. Kern was involved in structuring Trisoldi and Slupy, it did not disclose that he was involved in the decision to acquire the Preferred Shares. On the contrary, it shows that it was Mr. Genattini who negotiated the investment by Slupy in Lixo and agreed to subscribe for the Preferred Shares. Mr. Kern stated that he only became aware of the terms and the attributes of the Preferred Shares when he asked for the corporate documents describing the capital stock of Lixo. When Mr. Kern learned that the Preferred Shares were non-participating, he became very upset. Given that it was Mr. Genattini who was responsible for negotiating and overseeing the investment in Lixo, it is possible that Mr. Kern did not pay that much attention to the financial statements which provided the description of the attributes of the Preferred Shares.

One fact which supports the theory that Mr. Genattini made a very poor business decision in agreeing to subscribe for the Preferred Shares is that the Italian investors became very unhappy with the return on their investment and agreed to sell their original investment at a 40% discount. Mr. Kern stated that his cost was approximately $4 million. This corroborates the fact that the Italian investors had put about $10 million into Trisoldi and that $10 million was used to invest in Lixo. That would be consistent with the testimony of Mr. Girotti who said that he did not invest any money in Slupy nor in Trisoldi.

Furthermore, if we accept, and I do, the testimony of Mr. Kern who stated that he became involved in the management of Slupy on a gradual basis from 1982 to 1984, then his behaviour is consistent with that of an investor who is stuck with a very bad investment. As he stated, Slupy had $12 million invested in Lixo (including roughly $2 million in capitalized interest). While Mr. Girotti’s family had only about $350,000 invested in Lixo during this period, Slupy held only 4 per cent of the common shares of Lixo and non-voting, non-retractable Preferred Shares. Slupy was truly stuck in Lixo. Presumably, it had no legal ground to force Lixo and Mr. Girotti to convert those non-participating, non-cumulative, non-voting Preferred Shares into a class of participating shares, and even less right to force a retraction of the Preferred Shares. The information on Mr. Girotti was that it was not a good thing to push him around and therefore Mr. Kern had to protect Slupy’s investment by convincing Mr. Girotti to improve Slupy’s return.

It is true that once the original $10 million of investment had been turned into a $4 million investment by Mr. Kern and his business associate, Mr. Bordoni, then the return became a lot more attractive. On a $4 million investment, the return becomes outstanding: an average of 17% for each of the 1987 to 1990 taxation years.

Furthermore, the results are that Mr. Kern was in the end successful in having the Preferred Shares redeemed by having them converted either into a class of participating shares or into advances. In 1994, Slupy held Class “A” shares at a cost of about $3 million and advances of $10,485,539. The Girotti family had also increased its investment in Lixo since its loans exceeded $10 million.

In the relevant taxation years, Slupy and Mr. Kern tried to get the best deal they could in the circumstances. It was Mr. Kern who asked for a mortgage to secure the outstanding amount of Slupy’s advances in 1984, which represented close to $6 million. He relied on his counsel, Dr. Bolla, to determine the best course of action. In the end, he decided to stick with the cambiale. Dr. Bolla testified that, in his opinion, that was a better approach in the circumstances. Furthermore, there is no evidence that Mr. Girotti was acting in concert with Slupy, Trisoldi or Mr. Kern in dictating and directing the conduct of the negotiation of the loan agreements applicable during the relevant taxation years. I find that Slupy acted independently of Mr. Girotti and that it defended its interest as best as it could under the circumstances.

Finally, I think it is useful to take into account the context in which the notion of dealing at arm’s length is to be applied. Here, it is in the context of subparagraph 212(l)(b)(vii) of the Act. The exemption from the withholding of taxes at source on the payment of interest is only given to help Canadians obtain financing from arm’s length parties to fund Canadian business activities. Presumably the intent behind the arm’s length requirement is that the rate of interest be a reasonable one and that this rule not be used by a non arm’s length party to withdraw from Canada its surpluses without being subjected to any withholding taxes in Canada.

In this particular instance, these goals seem to have been achieved. The rate of interest paid by Lixo to Slupy represented 1 per cent above the interbank rate, which rate does not appear to be unreasonable. The interest paid to Slupy was ultimately paid for the benefit of Dr. Bolla, Mr. Kern and Mr. Bordoni. Mr. Girotti testified that the interest paid to Slupy was not returned directly or indirectly to him or his family.

In summary, when Mr. Kern became more personally involved in the management of Slupy in 1982, that company held $10 million in Preferred Shares. By 1994, Slupy was successful in having all those Preferred Shares redeemed. In addition, the Girotti family started to invest its own money starting in 1986. As counsel for Lixo stated, this case boils down to a question of credibility. The Minister contends that Mr. Girotti was the directing mind behind Slupy and Trisoldi. If I am to believe the evidence of the three key witnesses, Mr. Girotti controlled neither Slupy nor Trisoldi. After having purchased Trisoldi with their own money, Mr. Kern and Mr. Bordoni were the owners of Trisoldi and, through Slupy, of the Preferred Shares and the advances. Because of the bad investments made by Mr. Genattini origi- nally, Trisoldi and Slupy were not in a position to dictate the conduct of Lixo. Slupy held no voting shares; the Preferred Shares were non-retracta- ble and non-voting and represented a substantial investment when Mr. Kern became involved with Slupy in 1982. Therefore, I believe that, taking into account all the particular circumstances of this very unusual case, I must conclude that Mr. Girotti was not the directing mind behind Slupy during the relevant taxation years. I believe that during those years Mr. Kern and Mr. Bordoni were controlling Trisoldi and Slupy [2] and that their economic interest was different from Lixo’s interest. During the relevant taxation years, we saw two parties trying to bargain for the best deal that they could obtain under the circumstances.

It should be stressed that most of the circumstances supporting the position of the Minister all occurred as a result of actions taken prior to Mr. Kern’s becoming involved with Slupy and acquiring with Mr. Bordoni the control of Trisoldi and Slupy.

Therefore, I conclude from the evidence before me that Slupy and Lixo were dealing at arm’s length with each other and that the conditions of subparagraph 212(l)(7?)(vii) were satisfied.

For all these reasons, the appeals are allowed with costs.

Appeal allowed.