Date: 20020321
Docket: 1999-4538-IT-G
BETWEEN:
BRUCE E. MORLEY LAW CORPORATION,
Appellant,
and
HER MAJESTY THE QUEEN,
Respondent.
Reasonsfor
Judgment
Hershfield, J.T.C.C.
[1]
This is an appeal under the Tax Court of Canada Rules (General
Procedure) from an assessment of tax with respect to the 1994
taxation year in which the Minister of National Revenue (the
"Minister") disallowed the Appellant's claim for a
small business deduction on income of $68,468.00 and, pursuant to
paragraph 18(1)(p) of the Income Tax Act (the
"Act"), a deduction of expenses in the amount of
$44,745.00. Both turn on whether the Appellant's business is
a "personal services business" within the meaning of
section 125 of the Act.
[2]
The following are set out in the Notice of Appeal as the material
facts:
1.
The Appellant ("BEM Corp.") is a law corporation
licensed under the provisions of the British Columbia Legal
Professions Act to carry on the practice of law in British
Columbia and has in fact carried on the practice of law since
June 15, 1994.
2.
The person principally providing such services during the
1994 taxation year was Bruce Morley, a member of the
Law Society of British Columbia. Bruce Morley provides such
services as an employee of BEM Corp. pursuant to terms of an
employment contract between himself and BEM Corp. dated
June 15, 1994.
3.
As part of its business activities, BEM Corp. has provided legal
services to Clearly Canadian Beverage Corporation ("Clearly
Canadian") and in computing its income for the 1994 taxation
year under Part I of the Income Tax Act (Canada) BEM Corp.
has deducted the expenses it has incurred in providing such
services. In calculating income tax payable, BEM Corp. claimed
the small business deduction under section 125(1) of the
Income Tax Act (Canada).
4.
The income tax return of BEM Corp. for its 1994 taxation year was
filed on or about June 30, 1995 and a Notice of Assessment
accepting the return as filed was issued on September 18,
1995.
5.
By Notice of Reassessment dated May 14, 1998, the Minister
reassessed BEM Corp. on the basis that the legal services
provided by BEM Corp. to Clearly Canadian constituted a
"personal services business" as defined by Section
125(7) of the Income Tax Act. On that basis the Minister
disallowed:
(a)
the expenses of BEM Corp. had deducted in computing its income
other than those permitted by Section 18(1)(p) of the
Income Tax Act; and
(b)
the small business deduction under section 125(1) of the
Income Tax Act.
6.
By Notice of Objection dated July 31, 1998 BEM Corp. appealed the
Notice of Reassessment.
7.
By Notice of Confirmation dated August 6, 1999 the Minister
confirmed the Notice of Reassessment.
[3]
The following assumptions set out in paragraph 4 of the Reply to
the Notice of Appeal are not disputed:
. . .
(b)
at all material times Bruce Morley ("Morley") was a
"specified shareholder" of the Appellant within the
meaning of that term in subsection 248(1) of the Income
Tax Act;
(c)
the Appellant did not employ more than five full-time employees
during the years under appeal;
(d)
Morley performed legal services (the "Services") on
behalf of the Appellant for Clearly Canadian Beverage Corporation
("CCBC");
(e)
the Appellant and CCBC were not associated during the years under
appeal;
(f)
during the years under appeal Morley was employed by CCBC as a
director and as its Vice-President, Legal Services;
. . .
(h)
the Appellant entered into a contract with CCBC entitled
"Legal Services Agreement" which provided for the
payment of fixed monthly amounts to the Appellant for the
Services;
(i)
the Legal Services Agreement stipulated that CCBC would reimburse
the Appellant for any expenses incurred by the Appellant in the
course of providing the Services and that CCBC would indemnify
the Appellant and its employees against any claims made against
them by third parties;
(j)
the Legal Services Agreement provided that the Appellant would be
included as a named insured in all of CCBC's insurance
policies to provide the Appellant with the benefit of that
coverage in the event of claims made against it by third parties
arising out of the performance of the Services;
[4]
The following additional assumptions in paragraph 4 of the Reply
to the Notice of Appeal are in issue:
(g)
but for the existence of the Appellant, Morley would have
reasonably been regarded as an officer or employee of CCBC in
respect of the Services;
...
(k)
the Services were services that Morley would have been reasonably
expected to provide to CCBC in his capacity as a director and
Vice-President, Legal Services and member of the management team
of CCBC;
(l)
CCBC exercised the same degree of control and supervision of
Morley in the performance of his duties under the Legal Services
Agreement as it did for the duties he performed as
Vice-President, Legal Services under his employment
contract;
(m) the
Services were in the nature of those normally provided by an
in-house lawyer;
(n)
the Appellant did not have any risk of loss or chance of profit
in providing the Services;
(o)
if the Legal Services Agreements had been concluded between
Morley and CCBC the contract would have been a contract of
service;
(p)
the Services were integral to the business operations of
CCBC;
ISSUE TO BE DECIDED
[5]
As stated, the issues to be decided turn on whether the services
provided by BEM Corp. to Clearly Canadian constitute a personal
services business within the meaning of subsection 125(7) of the
Act. That subsection provides the following
definition:
"personal services business" carried on by a
corporation in a taxation year means a business of providing
services where
(a) an individual who performs services on behalf
of the corporation (in this definition and paragraph
18(1)(p) referred to as an "incorporated
employee"), or
(b) any person related to the incorporated
employee
is a specified shareholder of the corporation and the
incorporated employee would reasonably be regarded as an officer
or employee of the person or partnership to whom or to which the
services were provided but for the existence of the corporation,
unless
(c) the corporation employs in the business
throughout the year more than five full-time employees, or
(d) the amount paid or payable to the corporation
in the year for the services is received or receivable by it from
a corporation with which it was associated in the year;
[6]
Given the facts as agreed to by the parties the sole question in
this case is whether the incorporated employee (Morley) would
reasonably be regarded as an officer and employee of the
recipient of the services (Clearly Canadian) but for the
existence of the company (BEM Corp.) that provided the services.
This question can be broken down to three preliminary
questions:
(1) Whether
the definition of "personal services business"
necessarily constitutes the business between BEM Corp. and
Clearly Canadian as a personal services business of BEM Corp.
simply by virtue of the fact that its principal Morley (the
incorporated employee) was in fact an officer and director
of BEM Corp. during the currency of the business. If such
employment is fatal to the assertion that the corporation's
business is not a personal services business, then no officer or
director of a company would be entitled, by using a corporation
to provide independent contractor services unrelated to the
employment services, to the small business deduction unless the
office was given up. Such finding in this case would result in
the failure of the appeal. If such finding is not warranted, the
analysis continues;
(2) What is
the relevance, if any, of the employment responsibilities of the
incorporated employee to Clearly Canadian that arise by virtue of
his direct employment with Clearly Canadian. To say, in response
to question (1) above, that such employment is not itself
decisive, is not to say that it is not relevant. It may have
relevance in the determination of whether Morley, the
incorporated employee, would reasonably be regarded, but for the
existence of the corporation, as an employee of the recipient of
the corporate services. That there is not a clear separation of
the role of each service provider (Morley as an officer and
Morley as an incorporated employee) under each engagement is
arguably of paramount importance in this determination. If the
roles of each service provider are distinct or any blurring does
not on the facts of this case result in a finding that BEM
Corp.'s business is a personal services business, then the
analysis continues to consider a final question;
(3) Whether
the contact between BEM Corp. and Clearly Canadian is itself
essentially an employment contract or a contract engaging
independent contractor services. The analysis here would have to
consider whether the contract between the companies is a contract
of service or a contract for services. The four-in-one test
described in the Wiebe Door Services Ltd. v. M.N.R., 87
DTC 5025 case might then be invoked to determine the true nature
of that particular relationship[1].
FACTS
[7]
Two witnesses testified at the trial of this matter; namely,
Douglas Mason the President of Clearly Canadian at all material
times and Bruce Morley. Both were called by the Appellant. Their
testimony support a finding that, amongst other things, the
services to be provided by the Appellant, and actually provided
by it, were, in large part, services that were to be performed by
Morley as an officer of Clearly Canadian. That is, the corporate
services included services that Morley personally was retained to
perform as an officer of Clearly Canadian. There was at least a
considerable overlap that neither the written legal contracts,
nor the performance of them rectified for the purposes of
determining whether the business of BEM Corp. was a personal
services business. The following recitation focuses on facts that
speak to this finding.
[8]
Douglas Mason testified first. While he did not personally
negotiate the terms of the engagement contracts produced at trial
in an agreed book of documents, I gathered that he was
responsible for hiring Morley to his executive position as a vice
president of Clearly Canadian.
[9]
Morley had been a partner at a Vancouver law firm (Boughton &
Company) used by Clearly Canadian and was the principal contact
at the firm personally doing some of the legal documentation work
required by Clearly Canadian. Prior to leaving Boughton &
Company over eighty percent of his billings were attributable to
work for Clearly Canadian much of which was not for legal
documentation work per se. In addition to such work, Morley
co-ordinated the legal work of this client amongst others in the
firm and frequently assisted it in referrals to other legal
firms, primarily in other jurisdictions where there was a
connection between the work required in such other jurisdictions
and work being done by Boughton & Company. These latter
services were sometimes referred to as quarterbacking services
but they were nonetheless legal services forming part of his
practise and billings to Clearly Canadian.
[10] Clearly
Canadian had enjoyed an expanding business in the late 1980s and
the early 1990s peaking at $187 million in worldwide sales in
1992. It had heavy demands for a variety of legal services in a
number of jurisdictions both within and without Canada. It was a
public company first listed on the Vancouver Stock Exchange, then
on NASDAQ and finally on the Toronto Stock Exchange. Selling
products in various jurisdictions, raising funds through public
financing, protecting trade rights, negotiating commercial
contracts and defending against product liability claims and
unfriendly take-overs contributed to several millions of dollars
in legal fees each year.
[11] Mason
testified that it became clear to Clearly Canadian that it was
not able to effectively administer the legal services the
corporation required. Co-ordination was lacking. Indeed he
testified that things were getting out of control and that there
was no one in the company able to effectively administer the
legal services required by the company. He testified that Clearly
Canadian felt it would be efficient for the company to seek out a
person to administer all of the legal services that the company
required to replace himself and the corporation's chief
financial officer and his assistant who were trying to administer
the legal services but who were not doing the best of jobs.
[12] Clearly
Canadian approached Morley to assist it in managing the legal
work that the company required.
[13] Morley,
personally, was attractive to Clearly Canadian because he
appeared to be a good administrator and quarterback of the legal
services performed by Boughton & Company. He was also viewed
as someone with considerable business skills whose legal
background would make him a valuable addition to the Board of
Directors of the Company as well as vice-president of legal
services.
[14] While
Mason emphasized the business skills that Morley brought to the
Board and acknowledged that Morley was expected to continue to
handle some of the legal work that he had handled at Boughton
& Company, his greatest interest in Morley was as an in-house
administrator. It was essential to Clearly Canadian that as
vice-president of legal services Morley would co-ordinate all of
the lawyers that Clearly Canadian dealt with regardless of the
nature of the matter and regardless of the jurisdiction in which
the matter arose. Morley's responsibilities to the company as
vice-president were to assist it in selecting counsel,
negotiating with them, co-ordinating their work and saving the
company money.
[15] Mason saw
such opportunity for considerable savings if he could hire Morley
to work for Clearly Canadian directly. The legal characterisation
of the engagement was of no importance to him. It mattered not
that Morley insisted that he be permitted to use a law
corporation to provide some of his services to Clearly Canadian.
He saw the engagement as taking Morley out of private practice
with his firm and having him devote his days at the offices of
Clearly Canadian administering its legal work. While Mason made
it clear that he expected Morley to be at his Clearly Canadian
desk on a full-time basis to attend to his administrative duties,
he allowed that there was no restriction on Morley carrying on a
legal business, through BEM Corp. or otherwise, outside or
coincident with his engagement. Morley was free to engage in such
other pursuits on his own time, which included time that he was
at his desk in Clearly Canadian offices when not preoccupied with
executive duties. Mason trusted that Morley would fulfil his
full-time administration duties as vice-president of legal
services and that other pursuits on behalf of BEM Corp.
would not be to the detriment of the proper fulfilment of his
executive duties.
[16] This
testimony might have been somewhat suspect to the extent it
suggested that the engagement was less than a full-time,
exclusive, engagement but for his own practise of pursing other
business interests through his own company. He came to Clearly
Canadian as a successful businessman and worked with Clearly
Canadian to promote its business while continuing to do
promotions and consulting for his own company, which also
employed other people to provide such services. Some of his
services to Clearly Canadian were provided through his company.
While being in the same situation as Morley from an income tax
point of view, in terms of wanting to ensure that his company
would be entitled to the small business deduction, might again
make his evidence suspect, there is a pattern here accepting of
senior executives being allowed to pursue their professional or
business interests (even to the point of providing them to
Clearly Canadian independently of their executive employment
services). However having recognised this pattern and recognizing
that it was open to Morley to separate his duties as an officer
from his incorporated business is neither determinative of
whether such separation in fact occurred or whether Morley was
being engaged personally as a full-time officer of the company.
Indeed in respect of the latter question, I find that Mason
intended to retain Morley as a full-time executive of Clearly
Canadian. That was the focus of the hiring. That was the essence
of the relationship. It was the raison-d'être of the
relationship. That is not inconsistent with allowing that he was
free to engage in other work through BEM Corp. even work for
Clearly Canadian for separate compensation under a separate
services agreement.
[17]
Recognizing that Morley was free through BEM Corp. to provide
services to Clearly Canadian begs a further enquiry. What
services did Clearly Canadian understand BEM Corp. would perform
for it? There is no doubt that the administration and
co-ordination of its legal work could have been included as legal
services contracted to a company to be formed by Morley but that
was not Mason's understanding. Mason never understood that
Morley intended for BEM Corp. to perform the executive duties
that were Morley's responsibilities to perform personally
as vice-president of legal services. He thought that company
would do documentation type legal work, such as employment
contracts, distribution agreements and the like, that Morley
handled when at Boughton & Company. He acknowledged that such
services could be performed by any lawyer which explains his
testimony that it was not of concern to him who BEM Corp.
retained to perform its services to Clearly Canadian.
Morley's personal services were captured in duties as an
officer of the company. However, when being cross-examined
on the actual terms of the legal services agreement entered into
between BEM Corp. and Clearly Canadian, Mason had no explanation
as to why it appeared, on the terms of that engagement agreement,
that BEM Corp. was the party responsible for the performance of
duties that Mason had testified were the responsibility of Morley
personally as vice-president of Clearly Canadian.
[18] The legal
services to be provided to Clearly Canadian by BEM Corp. are set
out in a Legal Services Agreement dated June 15, 1994. That
agreement provides for the following services to be performed by
BEM Corp. (described as "Lawcorp" in that
agreement):
3.1
Lawcorp, through the services of its officers and employees as
designated from time to time, will:
(a)
advise the Company generally on legal matters;
(b)
instruct lawyers on behalf of the Company on those matters, which
Lawcorp or the Company determines, should be referred to other
law firms for advice or other services;
(c)
maintain a liaison with law firms providing services for the
Company and report to the Company on same;
(d)
co-ordinate these matters which involve the legal services of
more than one law firm;
(e)
instruct the Company's employees, agents and other
representatives from time to tine as required on legal issues
arising from the activities such persons perform on behalf of the
Company;
(f)
cause to be kept such records for the Company as may be
appropriate or requested by the Company; and
(g)
not permit or suffer any act or thing to be done whereby the
business or any assets of the business or any other property
belonging to the Company may become liable to be seized in
execution, charged or affected unless authorized or directed to
do so by the Board of Directors of the Company.
[19] When
asked to consider these provisions of the Legal Services
Agreement, Mason acknowledged that with the exception of
paragraphs (a) and (g) he thought that the services set out were
actually services that Morley personally was to provide as
vice-president. He did acknowledge that services described in
paragraphs (e) and (f) were consistent with both services Morley
was expected to perform as an officer of the company and services
that might have been performed, in some contexts, by BEM Corp. As
to paragraph (g) he admitted he had no idea as to what that
paragraph was intended to say. Indeed Mason himself later
testified that that paragraph (g) had no place in the agreement
and was removed from later versions of it.
[20] While I
will deal with Morley's testimony separately as to why he
wanted to introduce BEM Corp. as a party to the contractual
arrangements with Clearly Canadian, I would say, at this point,
that his attempts to describe how section 3.1 of the Legal
Services Agreement described the services to be performed by BEM
Corp. verged on the ridiculous. He did not want to admit that BEM
Corp. had contracted to co-ordinate or administer Clearly
Canadian work. It had contracted, he said, to co-ordinate the
work delegated to BEM. Corp. and thereby such work did not fall
within his duties as vice-president of Clearly Canadian. He
explained that he first made a determination as to whether or not
there was a legal service to be undertaken by BEM Corp. As
vice-president of legal services he would identify a
particular matter as being a matter within the contractual scope
of BEM Corp. It was acknowledged that no one else in Clearly
Canadian could make that determination. No records were kept or
produced as to which matters were so referred. There was no
accountability even as to remuneration due to a fixed retainer
arrangement with BEM Corp. Once the referral was made, without
any accountability, in respect of a particular matter, the Legal
Services Agreement applied to that matter, which included the
services, set out in paragraphs (b) through (g). Even accepting
this approach I find it difficult to see how BEM Corp. has not
contracted to do the very things that, but for the existence of
the corporation, would reasonably be regarded as work to be
performed by Morley as an officer (see paragraph 14 above).
Consider paragraph (b) for example; it allows that BEM Corp. must
instruct lawyers on behalf of Clearly Canadian on matters that
Clearly Canadian determines should be referred to other firms for
advice and services. Even Morley's own testimony described
these services as within the scope of his duties as
vice-president of legal services. Either the agreement is
artificial/ineffective for failing to reflect the true nature of
the relationship and the intentions of the parties or it defines
the legal nature of the relationship as a legally binding
arrangement. As I will elaborate on later in these Reasons, I
find the latter alternative to be the case although the former
alternative would lead to same result in my view.
[21] The services provided by Bruce Morley personally to
Clearly Canadian as an officer and director of Clearly Canadian
are set out in a written agreement also dated June 15, 1994 (the
"Director/Officer Agreement"). That agreement provides
for the following appointments and services:
1.1
CCBC appoints Bruce to the position of Vice President, Legal
Services and Bruce accepts the position.
1.2
CCBC agrees to appoint Bruce as an additional director at the
next meeting of the Board of Directors following execution of
this Agreement which appointment will remain in effect, in
accordance with the Articles of CCBC, until such annual general
meeting of CCBC that Bruce is required to stand for re-election
at. CCBC also agrees to include Bruce as one of its company
recommended director nominees for election at such annual general
meeting and each subsequent annual general meeting at which Bruce
is required to stand for re-election at.
...
2.1
Bruce agrees to faithfully perform the duties of a director and
to act in the best interests of CCBC.
2.2
It is understood and agreed that Bruce's responsibility to
carry out duties as an officer under this Agreement shall be
limited to those duties, which are not required to be performed
under the Retainer Agreement. If a particular activity could be
performed under this Agreement or the Retainer Agreement, it
shall be considered to have been performed under the Retainer
Agreement.
[22] The
latter provision (referred to as the "default"
provision) is yet another puzzling provision. I see it as
confirming yet again that the Legal Services Agreement (defined
in the above agreement as the "Retainer Agreement")
covers the administrative services attached to the office of
vice-president not only by its own express terms but by default
as well under the Director/Officer Agreement.
[23] As to the
remuneration for services, consider the following contractual
provisions of the Legal Services Agreement and the
Officer/Directors Agreement:
Legal Services Agreement
2.1
For and in consideration of the services provided by Lawcorp to
the Company under this Agreement, the Company shall pay to
Lawcorp a fee (the "Retainer Fee") equal to $197,400
per annum, payable in equal monthly instalments of $16,450 on the
last day of each and every month. The Retainer Fee is exclusive
of any taxes to be collected by Lawcorp pursuant to the Excise
Tax Act or other legislation imposing tax on the services to
be provided. The payment for June 1994 (due June 30, 1994) shall
be prorated.
Director/Officer Agreement
3.1
Compensation payable to Bruce shall be the following:
....
(b)
CCBC agrees to enter into a retirement funding agreement with
Bruce on the terms and conditions that have previously been
agreed upon by CCBC and Bruce (which agreement as amended from
time to time is hereinafter referred to as the "Retirement
Agreement"). It is understood and agreed that the Retirement
Agreement does not impose any legal obligation on CCBC to make
any payments to Bruce.
A "Retirement Agreement" was not introduced into
evidence. Oral evidence was given as to the particulars of the
officer/director compensation.
[24]
Directors' compensation was stock options and officer
compensation consisted of a contribution, aggregating roughly
$85,000 annually, to the retirement fund with the necessary
source withholding being remitted as well. The retirement
contribution arrangement resulted in an annual T4 of some
$170,000. No part of the compensation paid for officer/director
duties were payable in a form that provided regular cash flow to
officers who had companies performing separate services for
Clearly Canadian of which there were at least three including
Morley and Mason. The retirement fund was sufficiently flexible
however to permit pre-retirement withdrawals. There was no
evidence that Morley made any such withdrawals or that he
exercised any stock options. Indeed his evidence was that with
the exception of a small window of opportunity, not availed of,
the exercise prices of his options had been higher than the
market value of the stock. It appears then that Morley's
draw requirements were satisfied by his contract with BEM Corp.
His salary from BEM Corp. was $3,000/month at least until
mid-December 1994.
[25] As to
Mason's testimony regarding remuneration, he indicated that
he did not know how specific numbers were arrived at. He
understood that there was some negotiating but it was clear to me
that the allocation as between the officer/director compensation
and the legal service retainer was of little import to Clearly
Canadian. Dividing up Morley's engagement into two
contracts with two legal entities mattered not. Once Mason had
Morley as a full-time administrator, it mattered not to Clearly
Canadian who got paid the amount Clearly Canadian was prepared to
pay Morley for those services. The amount allocated to the legal
services, which Mason believed were the services being provided
by BEM Corp. (as opposed to the administration services), was not
relevant as such services did not warrant separate attention.
They were incidental. They were part of the overall savings
opportunity but were not important enough to monitor. They
expected Morley to save them money and he did - over a
million dollars of savings in the first year was attributed by
Mason to Morley having joined the Clearly Canadian team. No one
testified as to whether any material part of those savings was
attributable to anything other than Morley's administrative
skills. No records were tendered of any work BEM Corp. actually
did. Its invoices showed no work done. The testimony of both
witnesses was that some was done but not one example file or
actual matter was brought in evidence.
[26] A
retainer arrangement might well obviate the need for
accountability and the testimony that some work was done by BEM
Corp. may be sufficient. Indeed, I have no doubt that Morley did
some pure legal work and that it was intended to be done by him
as a lawyer working for BEM Corp. with which he had an engagement
agreement.[2] I
accept that BEM Corp. had some active business and that it got
paid the retainer amount to do it, but the absence of
accountability might also evidence that the retainer was paid in
some part for the package of services that included executive
services. That is, the absence of accountability tends to add
support to the finding that BEM Corp. was carrying out some of
the duties and responsibilities attached to the office of
vice-president of legal services. As such, accounting for
legal documentation work was not relevant. This perspective is at
least consistent with Clearly Canadian not needing to monitor BEM
Corp.'s work. Indeed, this perspective might be the only
perspective that fits given that parties are at arm's
length.[3] This
perspective of why there was no need for an accounting for the
legal work done by BEM Corp. is not an "economic
reality" perspective. It simply supports a particular
construction of the Legal Services Agreement - a
construction that a reading of its express terms seems to dictate
in any event.
[27] I should
also note that the absence of accountability in the retainer
arrangement makes another aspect of Morley's testimony
suspect. He suggested that BEM Corp. could hire other people,
lawyers, to perform the contract with Clearly Canadian. Except
for the possibility to earn bonuses in the contract with Clearly
Canadian such performance option could only result in lower
profits for BEM Corp. Practically speaking at least, the idea of
the Appellant retaining third parties to do legal work for
Clearly Canadian under the Legal Services Agreement is
unrealistic in my view. The retainer is paid regardless of
whether the services are provided.
[28] As to
Morley's testimony on the use of a law corporation, he
testified that he did not want to give up his law practice per se
and that the law corporation with a guaranteed income was a
requirement he prevailed on Clearly Canadian to meet to get him
to leave Boughton & Company. He expected the law corporation
would earn its retainer and seemed to have no difficulty with the
level of trust reflected in the arrangement. The Legal Services
Agreement built in bonuses and annual increases with the
expectation that its services might be worth more[4].
[29] I took it
that Morley wanted the retainer guaranteed for a period as a
requirement to give up his law practice. In fact BEM Corp. got a
termination provision, which would pay it five times the annual
retainer amount if its contract was terminated without cause.
While such termination arrangement may not be dissimilar from
other executive employment arrangements, they are somewhat
unusual in a contract for independent legal services. This again
supports the view that the Legal Services Agreement included the
administrative services that Morley was to perform. It allowed
executive type benefits for an executive type service and thereby
ensured that there could be no termination "for
cause" even if BEM Corp. did not account for any other
legal work that it was supposed to do.
[30]
Surprisingly, both Mason and Morley testified that the five times
termination provision was there simply as a device, a poison
pill, to discourage hostile take-overs. All executives (and
their service corporations) had it and this "pill"
was shown on the audited financial statements as a liability. A
corporate raider would have to spend millions to dump
management. That not only underlines the view that BEM
Corp. was seen as management in this whole arrangement but
reveals an incredible "wink, wink, nod, nod" mind
set. Both witnesses testified that the termination clause was not
intended to be binding. The contracts supporting the audited
statements were a guise. It seems that nothing in these
arrangements are what they purport to be.
[31] Another
aspect of Mason's testimony is troubling. That pertains to
the transfer of his legal practice to BEM Corp. Morley
transferred his legal practice to BEM Corp. on June 15, 1994. The
transfer agreement is not specific as to what was transferred
other than to say it was the "practice" that he had
established and developed since 1981. Based on Morley's
evidence, I gather that the transfer was of the goodwill
associated with his legal practice which is of course his
personal goodwill as a lawyer. The value of the
"practice" was estimated at $100,000 but the
consideration paid by BEM Corp. consisting of preferred shares
and a promisary note was subject to a price adjustment
clause.
[32] There
seem to be a number of questions relating to this transfer. Is
there an implied non-compete covenant (there was no such express
covenant) and how would that relate to the administrative
services contracted for with Clearly Canadian which had been
provided (to Clearly Canadian up until June 1994) as a lawyer
with Boughton & Company and were historically part of the
"practice" established and developed by Morley since
1981? That is, was the personal goodwill relating to legal
administrative services, which Clearly Canadian was so interested
in acquiring, included in the goodwill transfer or were they
intended to be carved out of the transfer agreement? They would
have to be carved out of the transfer if they were to be provided
to by Clearly Canadian in respect of the personal
administrative services it was contracting for in hiring
Morley as vice-president of legal services. It strikes me
that these are important questions and that they have relevance
in the context of the sole issue in this case which is whether
the corporation's business is a personal services business.
It seems that the answer that the Appellant would want to assert
in respect of this appeal is that such part of his practice, that
of providing administrative services to clients such as Clearly
Canadian, was not intended to be transferred. If it had been
transferred then only the corporation could provide the
administrative services that were vice-president/director
services and as such that business would be a personal services
business. In fact, my reading of the various agreements suggests
to me that the corporation did acquire this part of the
practice of Morley. There certainly is nothing in the agreement
to suggest otherwise. That is, the transfer agreement on its face
creates a proprietary interest in favour of BEM Corp. in the
Clearly Canadian administrative services work that attached to
Morley personally while he was practising law with Boughton &
Company. This is consistent with the Legal Services Agreement
including the administrative service work, having a retainer type
compensation arrangement, having a management termination
provision and BEM Corp. being the "default" service
provider. Everything fits except that it does not reflect the
nature of the relationship that Clearly Canadian wanted to effect
with Morley. It wanted the administrative services contracted for
personally. To have allowed for this, Morley's personal
goodwill with Clearly Canadian as an administrator of legal
services should not have been transferred to BEM Corp. Once
transferred, the Appellant becomes the provider of the
administrative services, which, but for its existence, would have
been provided by Morley as an officer whether he was already an
officer or not.
[33] In
non-arm's length transfers, like the rollover of one's
legal practice, the subject matter of the transfer should be
clearly settled in the documentation. More to the point,
non-arm's length transfers that rely on deferral provisions
and capital gains exemption provisions and include transfers of
rights to income and entitlements to a preferred rate of tax on
the transferred income all in the same series of transactions
should be structured to achieve the intended results by giving
legal effect through exacting contractual terms in the governing
documents. Here, it seems the focus of the documents was to
ensure the transfer of all Morley's goodwill, perhaps for
capital gains exemption and income splitting purposes without
regard as to how that impacted the Appellant's claim for
the small business deduction.[5]
[34] While the
foregoing findings are determinative of the issue in this matter,
I will for completeness set out further findings of fact that the
parties relied on particularly in respect of the application of
the principles set down in Wiebe Door.
-
Recognizing that officers of Clearly Canadian who had personal
service companies that had contracted to provide services to
Clearly Canadian could and would use Clearly Canadian facilities
(offices, staff, equipment and supplies) in the course of
performing services on behalf of such personal service companies,
rent was charged to BEM Corp as it was to Mason's company.
This was a negotiated amount that did not vary as between service
company. There was no pretence that such rent was dependent on
actual use of Clearly Canadian facilities, which varied amongst
each user.
- BEM
Corp. had other clients and maintained an office in
Morley's home. Fees earned from clients other than Clearly
Canadian were nominal and most persons on BEM Corp.'s
client list had some connection to Clearly Canadian. Home office
equipment and resources were minimal.
- BEM
Corp. was licensed as a law corporation and was insured as
required and had done all things necessary to carry on its
business. However it did no advertising aside from relying on
word of mouth promotion of work. It had no employees other than
Morley.
- BEM
Corp. was almost entirely dependent on Clearly Canadian for work
and there was no satisfactory evidence that genuine efforts were
being made to change the status quo.
ANALYSIS
[35] I will
now consider the three questions raised at the outset of these
Reasons in the order I set them out.
Whether the definition of "personal services
business" necessarily constitutes the business between BEM
Corp. and Clearly Canadian as a personal services business of BEM
Corp. simply by virtue of the fact that its principal Morley (the
incorporated employee) was in fact an officer and director
of BEM Corp. during the currency of the business.
[36] The
answer to this question has already been answered by this Court.
The Appellant cited several cases on point. Healy Financial
Corporation v. The Queen 94 DTC 1705; David T. McDonald
Company Limited v. M.N.R. 92 DTC 1917; and Criterion
Capital Corporation v. The Queen, 2001 DTC 921. In each of
these cases the incorporated employee was an officer of the
recipient of the corporate services. In each case the business of
the incorporated employee was found not to be a personal services
business. Clearly then being an officer of the recipient of
incorporated employee services is not by itself determinative of
the issue. However where there is an overlap of duties these
cases invite further enquiry as to whether the nature of the
overlap is relevant to the application of the "but
for" test in the definition of "personal services
business".
[37] In
McDonald, Judge Mogan commented on the duties of the
office in terms of applying the "but for" test. He
noted that (unlike earlier years) in the subject years the
incorporated employee in that case had few duties as an officer
of the recipient of the incorporated services and received no
remuneration as an officer. It was not a case of overlapping
duties. Further, Judge Mogan went on to note that he had genuine
doubts about whether he could have said that the incorporated
employee would not have reasonably been regarded as an officer of
the recipient of the corporate services in earlier years when he
was likely working on a full-time basis for the same
recipient. The case postulated is not dissimilar to the one at
bar.
[38] In
Healy there was a finding that the incorporated employee
was an officer/director to protect his financial interest in the
recipient of the services but that he was not involved in the
management of the company. It would seem that his day-to-day
pursuits were largely in respect of outside interests. This is
very different from the case of the incorporated employee being a
full-time employee of the service recipient.
[39] In
Criterion, the facts were very similar to the case at bar.
In fact Criterion was the company in respect of which
Mason was the incorporated employee. That is, his personal
service company was denied the small business deduction but its
appeal was allowed. Judge O'Connor did not dwell on the
question of whether Mason's duties as President crossed
over into the services he performed on behalf of Criterion
for Clearly Canadian; his findings of fact obviated any need to
do so. Judge O'Connor found that Mason's duties as an
employee of each of Clearly Canadian and Criterion to be
as follows:
Mason's duties as President and Director of CCBC were
essentially to look after the day-to-day running of CCBC
including marketing CCBC products, dealing with suppliers,
distribution, marketing, supervising staff including the
executive staff, preparing agendas for Directors' meetings
and attending same. Mason's duties as an employee of
Criterion consisted principally in seeking out and locating
financing opportunities and new business opportunities using his
network of contacts he had made prior to joining CCBC.
[40] This
clearly shows that Judge O' Conner saw no overlap in the
duties of each position. That is a pivotal distinction between
Criterion and the case at bar. The second question
that I have seen necessary to address in my analysis of the case
at bar was not necessary to address in Criterion or in the
other cases cited.
[41] This
takes me to the second question posed above.
What is the relevance, if any, of the employment
responsibilities of the incorporated employee to Clearly Canadian
that arise by virtue of his direct employment with Clearly
Canadian.
[42] Counsel
for the Appellant addressed this question with a focus on a
reading of the Act that would require that corporate
services be considered in isolation of the services that the
incorporated employee provides directly as an employee of the
recipient of the services. The words "but for the existence
of the corporation" should be taken to mean, "if the
individual were to provide the services directly rather than
through a corporation". This suggests the duties to be
performed as an officer, where the incorporated employee is
actually an officer, should not be considered so that if the
services contracted for by the service company are capable of
being independent contractor services then they have to be
recognized as such. I agree that this is one approach suggested
by the wording of the provision but it presumes the corporate
employee has a distinct role that is not the role actually to
have been performed by an officer appointed to for that purpose.
The Appellant's suggested reading of the subject provision
cannot prevail however where this presumption does not prove to
be the case or where there is a blurring of duties. Further, it
affords no relevance to my finding that, according to the
contractual regime entered into, administration duties were
assigned to BEM Corp. and must be taken to have been performed by
Morley on BEM Corp's behalf. That is the case or else the
contracts reviewed are wholly ineffective including the Legal
Services Agreement and the blurring of roles then becomes
magnified to the point where the true legal relationship between
Clearly Canadian and Morley and BEM Corp. would have to be
re-examined. Under that approach the corporate veil seems to
collapse entirely in the "but for" test set out in
the Act. However, it is not necessary for me to pursue
this line of reasoning given my finding that the contractual
regime here is effective. Morley's personal goodwill from
his legal practice, including his goodwill relating to
coordinating legal services, was transferred to BEM Corp. and
such services were included in the Legal Services Agreement. But
for the existence of BEM Corp. they would have been performed by
Morley as an officer of Clearly Canadian. The Appellant was right
to try to lead evidence that BEM. Corp. was not to provide
administrative services however having failed in that attempt it
cannot be denied that BEM Corp. was performing duties that would
"but for" its existence have been performed by Morley
as an officer of Clearly Canadian. Those were the duties of his
office. That he held the office to do personally that very work
that was contracted to BEM to perform just underlines that it
would be wholly unreasonable to come to any other conclusion
under the "but for" test.
[43] Having
concluded that the Legal Services Agreement engaged BEM Corp. to
perform services that Mason testified were tied to Morley's
Clearly Canadian desk to do as a full-time employee of Clearly
Canadian, I should reiterate that such finding would constitute
BEM's business as a personal services business even if
Morley weren't an officer of Clearly Canadian. That he is
an officer cannot improve BEM Corp's position. I would add,
as well, that if Morley were not an officer and the
administrative services were performed solely by BEM Corp.
then, on the facts of this case BEM Corp.'s business would
still be a personal services business in my view. That
administrative services are capable of being independent
contractor services under the third question posed above is not
sufficient where the recipient of the services has a full-time
officer position in mind. To avoid classification as a personal
services business, there would have to have been some detachment
from the day-to-day operations of Clearly Canadian, some
independence in the context of the services to be performed
liberating the performer from the confines of a contractual
expectation that requires a particular person to be personally
present at, on essentially a full-time basis, the premises of the
service recipient to attend to the business of that recipient.
This suggests that there may be other cases where it will not be
appropriate to the limit the analysis of the "but
for" test to an analysis suggested by the Appellant
although considering this example under the third question may be
sufficient.
Whether the contact between BEM Corp. and Clearly Canadian
is itself essentially an employment contract or a contract
engaging independent contractor services.
[44] In
applying the principles set out in Wiebe Door and the
other authorities relied on by the AppellantI might well agree
with the Appellant that the services argued to have been
contracted for by BEM Corp. could have been independent
contractor services. BEM Corp. could have performed
non-administrative legal services while Morley, as an officer of
Clearly Canadian, could have performed administrative services.
BEM Corp. services could have been performed as any law firm
would have performed them. That overhead had been minimized by
being given space and support in a client's offices is not
fatal. That there was only one significant client is not fatal.
Even a retainer arrangement with the service recipient would not
be fatal. If BEM Corp. had been engaged to do what Mason thought
it was engaged to do, this case would likely be on all fours with
Criterion. But that is not the case before me. The
contract in the case at bar was to provide administrative
services that were to have been performed by Morley as
vice-president of legal services. That cross-over is fatal
under the foregoing analysis of the second question posed above.
If it is necessary to address the third question at all, and I do
not believe it is, I would say that the Legal Services Agreement
was a contract of service given the manner that the services
(administrative services) were performed as testified to by both
Mason and Morley. Nothing more need be said in my view.
[45]
Accordingly, I find that the business of the Appellant is a
personal services business and it is thereby denied the tax rate
reduction claimed by it pursuant to section 125 of the
Act.
[46] That
takes me to the denial of expenses under paragraph
18(1)(p) of the Act. As stated at the outset of
these Reasons, amounts denied as deductible expenses in the
subject years are denied pursuant to that paragraph which reads
as follows:
18(1) In computing the income of a taxpayer from a business or
property no deduction shall be made in respect of
. . .
(p) an outlay or expense to the extent that it was made
or incurred by a corporation in a taxation year for the purpose
of gaining or producing income from a personal services business,
other than
(i)
the salary, wages or other remuneration paid in the year to an
incorporated employee of the corporation,
(ii)
the cost to the corporation of any benefit or allowance provided
to an incorporated employee in the year;
(iii)
any amount expended by the corporation in connection with the
selling of property or the negotiating of contracts by the
corporation if the amount would have been deductible in computing
the income of an incorporated employee for a taxation year from
an office or employment if the amount had been expended by the
incorporated employee under a contract of employment that
required the employee to pay the amount, and
(iv) any
amount paid by the corporation in the year as or on account of
legal expenses incurred by it in collecting amounts owing to it
on account of services rendered
that would, if the income of the corporation were from a
business other than a personal services business, be deductible
in computing its income;
[47] The
restriction on the deduction of the subject expenses turns
firstly on whether they were incurred for the purpose of gaining
or producing income from a personal services business. Since BEM
Corp. has a personal services business, expenses attributable to
that business are not allowed except as expressly set out in this
paragraph of the Act. The reassessment has not allowed
salary paid to Morley and has disallowed $750.00 of expenses that
were never claimed. Regardless of whether BEM Corp. has a
personal services business, the salary expense claim must be
allowed and the $750.00 disallowance must be reversed.
Respondent's counsel conceded this during the course of the
trial[6].
[48] While
there seemed to be some consensus that the amount to be allowed
for salaries was to be $20,988.00 which included $487.00 in CPP
contributions, that amount included a $2,500.00 accrued salary
increase in December 1994. Strictly speaking the accrued amount
is not deductible since subparagraph (p)(i) of subsection
18(1) only allows a deduction for amounts paid. The
Appellant has a calendar year end and it was acknowledged that
the $2,500.00 accrued in December was not paid in the taxation
year in issue here. Accordingly the salary and benefit amount
deductible in the year is $18,488.00. In addition, a further
$750.00 is allowed as noted above. The appeal is allowed to this
extent without costs.
[49] Before
signing these Reasons I must add that after hearing argument I
requested and subsequently received submissions on
artificial/ineffective transactions. I was somewhat taken aback
by the testimony of the witnesses that put the parole evidence at
odds with the documentation. There was an overall sense of an
artificiality here that suggested that Clearly Canadian had
really agreed that Morley could write up what he wanted but that
was not the operative deal. The alternative to this perspective
was to accept the documents, as they were, without considering
whether or not they might be regarded as ineffective or
artificial. Support for this alternative perspective was in the
documentation itself. There is a pattern here that supports a
finding that the documents were intended to do exactly what they
do. Lawyers attended to these matters and, it seems, focused on a
particular and well co-ordinated approach to their
documentation.
The documents interrelate well and have been accepted as
giving effect to the legal relations they dictate on their terms.
They just do not give the tax consequence the Appellant was
hoping to achieve. Accordingly, while I thank counsel for their
submissions on artificial transactions, I find it unnecessary to
refer to them.
Signed at Ottawa, Canada, this 21st day of March 2002.
"J.E. Hershfield"
J.T.C.C.
COURT FILE
NO.:
1999-4538(IT)G
STYLE OF
CAUSE:
Bruce E. Morley Law Corporation
and Her Majesty the Queen
PLACE OF
HEARING:
Vancouver, British Columbia
DATE OF
HEARING:
October 16, 2001
REASONS FOR JUDGMENT BY: The
Honourable Judge J.E. Hershfield
DATE OF
JUDGMENT:
March 21, 2002
APPEARANCES:
Counsel for the Appellant: Douglas C. Morley
Counsel for the
Respondent:
Lynn Burch
COUNSEL OF RECORD:
For the
Appellant:
Name:
Douglas C. Morley
Firm:
Davis & Company
For the
Respondent:
Morris Rosenberg
Deputy Attorney General of Canada
Ottawa, Canada
1999-4538(IT)G
BETWEEN:
BRUCE E. MORLEY LAW CORPORATION,
Appellant,
and
HER MAJESTY THE QUEEN,
Respondent.
Appeal heard on October 16, 2001 at Vancouver,
British Columbia, by
the Honourable Judge J.E. Hershfield
Appearances
Counsel for the
Appellant:
Douglas C. Morley
Counsel for the Respondent: Lynn
Burch
JUDGMENT
The
appeal from the assessment made under the Income Tax Act
for the 1994 taxation year is allowed, without costs, and
the assessment is referred back to the Minister of National
Revenue for reconsideration and reassessment in accordance with
the attached Reasons for Judgment.
Signed at Ottawa, Canada, this 21st day of March 2002.
J.T.C.C.
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