RALPH E. FARAGGI,
HER MAJESTY THE QUEEN,
HER MAJESTY THE QUEEN,
2529-1915 QUÉBEC INC.,
HER MAJESTY THE QUEEN,
2530-1284 QUÉBEC INC.,
HER MAJESTY THE QUEEN,
REASONS FOR JUDGMENT
 In 1987 Mr. Robert Langlois and Mr. Ralph Faraggi,
lawyers in the Montreal law firm of Stikeman Elliott, formulated and promoted
plans to create capital dividend accounts ("CDA" or "CDAs")
in several corporations for "sale" or "transfer" to arm’s
length third party corporations for a profit. Mr. Langlois was a tax
lawyer at the firm; Mr. Faraggi was a corporate lawyer. Together they applied
their knowledge in preparing the plans and putting them into effect.
 The plan contemplated using newly formed corporations
with nominal assets to subscribe for shares in other newly formed corporations
and then create CDA through a combination of share subscriptions, redemption of
shares, capital gains by sale of shares and purported elections under
subsection 83(2) of the Income Tax Act ("Act"),
among other things. Then, through another sequence of share subscriptions and
share redemptions, third parties at arm's length to the appellants would
receive capital dividends.
 In short, after the "creation" of capital
gains several corporations would make elections under subsection 83(2) of
the Act and declare tax-free dividends on classes of preferred shares.
Near the end of the exercise the aggregate CDAs of these corporations would
find their way to an appellant corporation. A third-party corporation would
subscribe for shares in an appellant corporation. These shares would have a
nominal par value, say $0.01 per share, and a high redemption amount, say
$1,000 per share. The third-party corporation would pay $1,210 per share and an
appellant corporation would redeem the share for $1,000, electing under
subsection 83(2) of the Act that the deemed dividend of $999.99
(subsection 84(1) of the Act) be paid out of the appellant
company's capital dividend account. The third-party corporation would then have
a capital dividend account and pay its shareholders, after making its own
subsection 83(2) election, $1,000 tax-free. Before the transaction, the
third-party corporation had no amount in a capital dividend account and could
only pay its shareholders a taxable dividend of $1,210; the tax rate in Quebec
for individual shareholders was 41.87 per cent. After the transaction
the shareholders received $1,000 tax-free; the third-party corporation
effectively paid $210 for the tax-free $1,000 dividend. The effective cost to
the third-party corporation and its shareholders for the $1,000 dividend was 21
per cent, an economic saving of 20.87 per cent.
 Mr. Langlois and Mr. Faraggi are appealing their
income tax assessments for 1987 and 1988 and corporations 2530-1284 Québec Inc.
("1284 Inc.") and 2529‑1915 Québec Inc. ("1915
Inc.") are appealing assessments for 1987.
 The Minister of National Revenue
("Minister") assessed 1284 Inc. and 1915 Inc. on the basis that they
earned a profit of $4,677,717 and $8,105,344, respectively, in their
1987 taxation years from carrying on businesses or ventures in the nature
of trade, that is, selling fictitious CDA to third parties. The profits
(the $210 in the example described in paragraph 3) were included in the
corporate appellants’ respective incomes for 1987 as business income in
accordance with section 3 and subsection 9(1) of the Act. The corporate
appellants, the respondent adds, did not and could not receive capital
dividends from the corporations they allege paid them such dividends because
the corporations did not realize any capital gains nor did they receive any dividends
out of another corporation’s capital dividend account. Any capital gains, and
any elections made pursuant to subsection 83(2) of the Act, by any
of the corporations in these transactions were fictitious and shams, says the
 With respect to the appellants Mr. Langlois and Mr.
Faraggi, the Minister assessed on the basis that each received taxable
dividends of $8,114,350 in 1987 and $155,912 in 1988 notwithstanding that the
paying corporations purported to elect under subsection 83(2) of the Act
that the dividends were to be paid out of their respective CDA. The respondent
claims that the paying corporations never realized capital gains nor had they
received dividends out of the CDA of other corporations; the paying
corporations did not have CDA from which they could pay tax-free dividends to
shareholders. Any such purported capital gains or dividends from CDA received
from other corporations were fictitious and shams. The individual appellants
received taxable dividends, not tax-free dividends, according to the
 The Minister also assessed the appellants penalties by
virtue of subsection 163(2) of the Act, alleging that each
appellant was part of a vast fraud led by persons who were reckless and grossly
negligent such that each appellant knowingly or under circumstances amounting
to gross negligence made false statements in returns, forms, certificates and
statements filed or made in respect of the 1987 taxation year (and 1988 with
respect to the individual appellants) by camouflaging the origin of the CDAs.
Mr. Langlois and Mr. Faraggi omitted to declare the taxable dividends of
$8,114,350 and $155,912 received in 1987 and 1988, respectively, and are each
liable to penalties pursuant to subsection 163(2) of the Act of $304,147
for 1987 and $10,564 for 1988. Appellants 1284 Inc. and 1915 Inc. omitted
to declare business income for 1987 of $4,677,717 and $8,105,344, respectively,
and are liable to penalties pursuant to subsection 163(2) of the Act
of $421,579 and $763,316, respectively.
 The corporate appellants claim they did not carry on
any business and the capital gains reported were real, were determined in
accordance with the provisions of the Act. Valid elections were made,
also in accordance with the Act, in particular subsection 83(2). There
was no sham.
 The individual appellants say that the corporations
who paid them dividends had bona fide capital gains and made proper
elections under subsection 83(2) of the Act: the dividends they
received in 1987 and 1988 from the corporations were dividends paid out of
valid CDAs of these corporations.
 The appeals were heard on common evidence.
 The corporations participated in two series of
transactions, one on August 13, 1987 ("Series 1") and one other
("Series 2"), which was carried out in two phases in September. All
corporations in these transactions were incorporated under Part 1A of the
Quebec Companies Act. The Companies Act permitted
corporations to have par value shares; par value shares apparently were
necessary for the proposed transactions to take place in the way they did.
Also, the Quebec legislation permitted a corporation to issue shares without
immediate payment by the subscribing shareholder.
The authorized capital of the corporations in each series of transactions
consisted of an unlimited number of common shares without par value and twelve
classes of an unlimited number of non-voting preferred shares, classes
"A" to "L", inclusive, each preferred share usually having
a par value of $0.01 and redeemable, depending on the class of preferred share,
for $100.01 or $1,000.01 each, subject to adjustment. Dividends on the
preferred shares could not exceed a fixed amount. The classes of preferred
shares were identical except that they ranked in alphabetical order concerning
dividends and return of capital on liquidation or dissolution.
Class "A" shares, for example, had priority over Class
"B" shares which had priority over Class "C" shares
and so on. At the beginning of the series of transactions the companies had no
assets, except for nominal amounts paid by shareholders upon subscribing for
common shares. Only after the corporate appellants had dealt with the third
party corporations did they have any appreciable assets, the money being
assessed as profits from a business.
 The corporations were organized: common shares were issued,
directors were elected, the usual by-laws were adopted. Mr. Langlois and Mr.
Faraggi were directors of all of the companies.
 The corporations participating in
the first series and Phase 2 of the second series
2529-1915 Québec Inc.
2528-5644 Québec Inc.
2529-0099 Québec Inc.
2529-0107 Québec Inc.
2529-0115 Québec Inc.
2529-0123 Québec Inc.
2529-0131 Québec Inc.
2529-0149 Québec Inc.
2529-0156 Québec Inc.
2529-0164 Québec Inc.
2529-0172 Québec Inc.
2529-0180 Québec Inc.
2529-0198 Québec Inc.
2529-0206 Québec Inc.
 The corporations in
the first phase of Series 2
 Mr. Langlois and Mr.
Faraggi and 2411-4340 Québec Inc. ("4340
each held one-third of the common shares of 0206 Inc. and 1915 Inc.
1276 Inc. was the sole common shareholder of 1300 Inc.,
1318 Inc., 1326 Inc., 1334 Inc., 1342 Inc., 1359 Inc.,
1367 Inc., 1375 Inc., 1383 Inc., 1391 Inc., and
1409 Inc. Mr. Langlois and Mr. Faraggi were the common
shareholders of the other corporations.
 In the first series of
transactions there was a chain or group of 13 corporations, each owning a
class of preferred shares of the corporation immediately below it in a direct
vertical line. 2528 Inc. was at the head of the chain. Transactions between
these corporations were intended to create capital gains and deemed dividends.
The corporations purported to make elections under subsection 83(2) of the
Act that the deemed dividends be paid out of CDA. The appellants state
that dividends were paid or were deemed by the Act to be paid up the
chain of corporations until the aggregate of dividends, all out of CDAs,
reached 2528 Inc. In turn, 2528 Inc., paid a dividend out of its capital
dividend account, being the aggregate of all the other corporations’ CDAs, to
1915 Inc. 1915 Inc. then "sold" to third parties the bulk of
amounts of CDA it received from 2528 Inc. The following is an abridged
step-by-step description of the transactions the appellants say took place in
The initial transactions took place in a
conference room at the Place Ville-Marie branch of the Royal Bank of Canada on
August 13. Before the transactions in Series 1 started, Messrs. Langlois and
Faraggi had obtained an overdraft of $10,000,100 from the Royal Bank.
They paid for their common shares in 1915 Inc., for example, with their
own funds and loaned money to some other corporations to permit them to
subscribe for common shares.
A Inc. issued a
certified cheque in the amount of $10,000,100 drawn on its account at the Royal
Bank to subscribe for 10,000 Class "L" shares of B Inc. B Inc.
deposited the $10,000,100 in its bank account. B Inc. then declared a stock
dividend of 10,000 Class "K" shares on its Class "L" shares
to A Inc.
B Inc. issued a
certified cheque in the amount of $10,000,100 drawn on its account at the Royal
Bank to subscribe for 10,000 Class "L" shares of C Inc. C Inc.
deposited the $10,000,100 in its bank account.
Inc. issued a certified cheque in the amount of $10,000,100 drawn on its
account at the Royal Bank to subscribe for 10,000 Class "L" shares of
C Inc. declared a stock
dividend of 10,000 Class "K" shares on its Class "L" shares
to B Inc. The adjusted cost base of each Class "L" share was $0.01:
subsection 52(3) of the Act. The stock dividend was valued at
B Inc. sold the Class
"K" shares to A Inc. for a consideration of $10,000,000; the
consideration paid for the purchase was a non‑interest-bearing
$10,000,000 promissory note payable on demand. Thus, B Inc. purported to make a
capital gain of $9,999,900.
The appellants’ files at Revenue
Canada were eventually reviewed by Mr. Michel Dupuis, an auditor with Revenue
Canada and its successor, the Canada Revenue Agency. Mr. Dupuis testified
that when A Inc. issued promissory notes aggregating $110,000,000 for the Class "K"
shares, it had cash assets of $100 only.
each of C Inc., D Inc., E Inc., F Inc., G Inc., H Inc., I Inc.,
J Inc., K Inc., and L Inc. issued a certified cheque in the amount of
$10,000,100 drawn on its account at the Royal Bank to subscribe for 10,000
Class "L" shares of corporations D Inc. to M Inc. respectively,
followed by a stock dividend of 10,000 "K" shares on each
corporation’s Class "L" shares (the owners being C Inc. to L Inc.).
All the Class "K" shares were then allegedly sold to A Inc. for a
consideration of $10,000,000 in each case, payable by a promissory note, for a
total of $110,000,000. Each of B Inc. to L Inc. claimed a capital gain of
$9,999,900, or $109,998,900 for the eleven corporations. The aggregate taxable capital gains
of B Inc. to L Inc. on the alleged sales of the Class "K" shares
were $54,999,450, which is also the aggregate amount of the purported CDA of
Inc. paid a cash dividend of $10,000,000 on the Class "K" shares
to its shareholder A Inc. which used this money to reimburse the Royal Bank.
Corporations B Inc. to L Inc.
amended their articles of incorporation ("statuts de constitution")
increasing the par value of each of their Class "K" shares from $0,01
to $500. The increase in par value of the shares allegedly triggered deemed
dividends to the holder of the Class "K" shares, A Inc., of
or $4,999,900 from each corporation: subsection 84(1) of the Act.
Each of C Inc. to M Inc. purported
to elect pursuant to subsection 83(2) of the Act that the deemed
dividend of $4,999,900 on the increase in the par value of the Class
"K" shares be paid out of its CDA. A Inc. received dividends of
$54,998,900, purportedly out of the CDA.
On or about September 14, in order
to offset the taxable capital gains, the following transactions were performed
to create capital losses in the corporations B Inc. to L Inc. (i) B Inc. sold
its 10,000 Class "L" shares that it owned in C Inc. to
Mr. Faraggi for a consideration of $100. Since the cost base of these
shares was $10,000,100, there was a purported capital loss of $10,000,000,
$5,000,000 of which was an allowable capital loss. The allowable capital loss
offset the taxable capital gain of $5,000,000 that B Inc. realized when it sold
the Class "K" shares. (ii) Sales of Class "L"
shares owned by corporations C Inc. to L Inc. in corporation D Inc. to
M Inc. similarly took place one after the other to reduce their earlier
capital gains to nil.
On August 20, 1987, 1915 Inc.
borrowed $23,216.61 from its three shareholders and on or about August 21, 1915
Inc. subscribed for 495,660 Class "L" shares of A Inc. for
$55,023,216, paid as to $23,216.61 by cheque and the balance by an
interest-bearing demand note.
The directors of A Inc. declared a
dividend of $49,566,000 to be paid to the owner of the Class "L"
shares, 1915 Inc., and filed an election pursuant to subsection 83(2) of
the Act that the dividend of $49,566,000 be paid out of its CDA.
In August and September 1915 Inc.
and A Inc. paid dividends to each of Mr. Langlois and Mr. Faraggi; the dates,
amounts and shares on which the dividends were paid are as set out in Appendix
3 to these reasons. (Notwithstanding that elections were made under subsection
83(2) of the Act, the respondent says these are taxable
(i) Later, in August and
September, 1915 Inc. transacted with several arm’s length corporations which
had a substantial surplus that could only be paid out to their shareholders as
taxable dividends. To avoid the burden of distributing taxable dividends, these
corporations subscribed for different classes of preferred shares of
1915 Inc. which were redeemed in a similar manner to that described in
paragraph 3 of these reasons.
(ii) The subscription prices varied not only
for the class of shares subscribed for but even for the price of the same class
of preferred shares. For example, on September 4, 1987 Mr. Langlois
and Mr. Faraggi each purchased 64 Class "I" shares of 1915 Inc.
for $1.00 each. Their assistants at Stikeman Elliott also purchased Class
"I" shares for $1.00 each. However, on the same day a corporation at
arm’s length to the appellants subscribed for 10,400 Class "I" shares
of 1915 Inc. for $11,585,845.75.
(iii) During August,
September and November 1987 and on December 30, 1988 Mr. Langlois and
Mr. Faraggi received dividends aggregating $8,114,350 in 1987 and $155,912 in
1988 from 1915 Inc, 5644 Inc., 1292 Inc. and 1276 Inc. On September
4, 1987, the day Mr. Langlois and Mr. Faraggi each subscribed for 64 Class
"I" shares of 1915 Inc. for $64, the directors of 1915 Inc. declared
and paid a dividend of $1,000 on each Class "I" share, electing
under subsection 83(2) of the Act.
Other companies also paid dividends on common shares.
 Thus, shareholders of the arm’s length corporations
purportedly received dividends tax-free instead of receiving taxable dividends.
The difference between the cost of a share, say $1,210, and the redemption
amount, say $1,000, that is, $210, aggregated $8,105,344, with adjustments, in
respect of all of the shares so issued and redeemed. According to the
respondent, the $8,105,344 was business income to 1915 Inc. and was available
for 1915 Inc. to distribute to its shareholders or retain for other purposes.
 Mr. Faraggi described the transactions in Series 1,
once step a) at paragraph 16, took place:
. . . So the
first transaction was the subscription by 5644, 2528-5644, which subscribed for
ten thousand (10,000) Class L shares, I think, in 0099. And then, the cheque
was written and it may have been the bank that prepared the cheque or maybe I
did. In any case, I signed the cheque and they went, the runners who were in
the room, they left, they went to the counter; they had the cheque for
$10,000,000 certified. They . . . I don't recall whether they came back to
show us the cheque; actually they did come back to show us the cheque. We saw
only the certified cheque; the deposit slip was prepared for 099. Then they
left with it. So at that point we had 2528 which had subscribed for the shares
in 0099, and so there was no doubt a resolution of 2528 authorizing it to
subscribe for ten thousand (10,000) shares in 0099. That resolution was signed
and it was put aside. 2529 0099 received a subscription letter, a subscription
letter from 5644 for ten thousand (10,000) Class L preferred shares of 0099.
The resolution was signed for the subscription for the shares and 2528
presented this letter to 099. At that point, the deposit, we had the cheque
from 2528, which was now certified. The deposit was prepared and they left to
make the deposit. The resolution of 0099 authorizing the issue of ten thousand
(10,000) Class L preferred shares of 0099 was signed. Then, as far as I can
remember, 099 subscribed for ten thousand (10,000) Class L preferred shares of
0107. So a cheque of 0099 payable to the order of 2529 0107 Québec Inc.
was written. The cheque . . . the runner left, had the cheque certified and
came back. We had the certified cheque, we saw that the cheque was certified.
The deposit was prepared. Oh, in the meantime . . . it must be said that we
waited to see, we made sure the deposit had returned to 0099. We saw that the
deposit — the sum of $10,000,000 had been deposited — had been stamped by the
bank. “Fine, the money is there.” We moved on to the next subscription and so
on for about an hour and a half, the time it took to carry out all the
then, well, perhaps I should go into a bit more detail in order to . . .
because then there was the subscription in 0099, by 0099 for the shares of 107
and then 0107 declared a dividend of Class K preferred shares in favour of
0099. And then, there was a sale of these ten thousand (10,000) Class K
preferred shares, a sale by 0099 to 2528-5644, of the 10,000 Class K preferred
shares that 0099 had received, after a dividend was declared by 0107. And this
sale was for a consideration of $10,000,000. And so on from 0107 to 0115 to
0123 to 0131, 0142, 0156, etc. up to 0 . . .
to 0206, but 0206 did not sell any shares; it did not have a capital gain.
but the chain stopped . . .
. . at 0206?
 In phase 1 of Series 2, N Inc.
created CDAs with companies P Inc. to Z Inc. In Series 2, phase 2, P Inc.
was used to create capital dividend accounts with companies B Inc. to L Inc.
The following is a condensed version of the transactions in phases 1 and 2 of
Series 2 that the appellants say took place on September 9, 1987 and some days
The Series 1 transactions put the individual
appellants in a cash position. On September 9, Mr. Langlois and Mr.
Faraggi deposited sums of $3,239,500 and $2,650,500, respectively, in their
personal bank accounts at the main Montreal branch of the Canadian Imperial
Bank of Commerce and on the same day loaned these amounts to 1276 Inc.; the sum
of $5,890,200 was deposited in the bank account of 1276 Inc. at the Royal Bank
purportedly on September 9 after 3 p.m., and was used to fund the transactions
in Series 2. Bank accounts were opened by the particular companies on
September 9, also, the appellants say, after 3 p.m.
N Inc. subscribed for
5,890 Class "L" shares of Z Inc. for a consideration of $5,890,200.
This money was deposited in Z Inc.’s bank account.
Z Inc. paid a stock
dividend of $5,890,000 by issuing 5,890 Class "K" shares on the
Class "L" shares that N Inc. owned. The Class "K" shares
had a paid‑up capital of $0.01 per share, but a fair market value of
N Inc. sold the 5,890 Class
"K" shares of Z Inc. to P Inc. for $5,890,200. P Inc. paid for
Z Inc.’s Class "K" shares by issuing 5,890 Class
"L" shares, which purportedly had a value of $5,890,200. N Inc.
became the owner of 5,890 Class "L" shares of P Inc. and P Inc.
became the owner of 5,890 Class "K" shares of Z Inc.
This sale purported to create a capital gain of $5,889,941.10 for N Inc., which
gave rise to a taxable capital gain of $2,944,970.55 for N Inc.
P Inc. paid a stock dividend of
5,890 Class "K" shares having a purported value of $5,890,000 to the
owner of its 5,890 Class "L" shares, that is, to N Inc.
N Inc. sold the 5,890 Class
"K" shares of P Inc. to Q Inc. for $5,890,000. The latter paid for
these Class "K" shares by issuing 5,890 Class "L" shares
(of Q Inc.), which again gave rise to a capital gain of $5,889,941.10 for
N Inc. and each of Q Inc. to Y
Inc. entered into transactions in the same manner as above, thus giving rise to
purported aggregate capital gains to N Inc. in the amount of $58,899,411.
N Inc.’s taxable capital gain and amount available for its capital
dividend account was $29,449,705.50.
Z Inc. paid a stock dividend of
$5,890,000, issuing 5,890 Class "J" shares on its 5,890 Class
"K" shares that P Inc. owned. The Class "J" shares had a
paid‑up capital of $0.01 and a purported fair market value of $5,890,200.
P Inc. sold to L Inc. the 5,890
Class "J" shares of Z Inc. for $5,890,200 and received in return
5,890 Class "J" shares in L Inc. This sale purported to create a
capital gain of $5,890,200 for P Inc.
L Inc. paid a stock dividend of
$5,890,000 to the holder of its Class "J" shares by the issuance of
5,890 Class "I" shares to P Inc.; the paid‑up capital of
each Class "I" share was $0.01 and all of the
Class "I" shares so issued had a purported fair market value of
P Inc. then sold the 5,890 Class
"I" shares of L Inc. to K Inc. in consideration of 5,890 Class
"J" shares of K Inc. This transaction purported to create a capital
gain of $ 5,890,200.
K Inc. declared a stock dividend
of $5,890,000 on the 5,890 Class "J" shares owned by P Inc., issuing
5,890 Class "I" shares to P Inc.
Each of J Inc., I Inc., H Inc., G
Inc., F Inc., E Inc., D Inc., C Inc., and B Inc. paid in order a
stock dividend of $5,890,000 to the holder of its Class "J"
shares by issuing 5,890 Class "I" shares to P Inc., the holder
of the Class "J" shares of all these companies. P Inc. sold its Class
"I" shares to the next company in the chain in return for Class
"J" shares, as in j) above. Each of these sales purported to
create a capital gain of $5,890,200 for the vendor corporation, P Inc.; P
Inc.'s aggregate capital gain was $64,789,352.10. The alleged aggregate taxable
capital gain for P Inc. was $32,394,676.05.
following took place on September 9 and later:
O Inc. subscribed for 29,173 Class
"L" shares of N Inc. for $29,468,000, payable by a demand promissory
O Inc. subscribed for 32,070 Class
"J" shares of P Inc. for $32,295,000, payable by a demand promissory
Payment for substantially all of
the amounts represented by the promissory notes, plus interest, was demanded on
September 12 and on the same day N Inc. declared cash dividends of
$29,173,000 on its Class "L" shares and of $32,070,000 on its Class
"I" shares, which compensated for the payment of the demand notes.
N Inc. filed forms of election,
pursuant to subsection 83(2) of the Act, with respect to the dividends
of $29,173,000 and $32,070,000. O Inc. purportedly received dividends of
$61,243,000 from the CDA of N Inc.
On September 13, 1284 Inc.
subscribed for 45,125 Class "L" shares of O Inc. for
$50,820,451.25; payment was made by a demand promissory note.
September 13, 1915 Inc. subscribed for 9,806 Class "L" shares of O
Inc. for $11,043,664.16, and payment was made by a demand promissory note.
On September 14, O Inc. demanded
payment from 1284 Inc. of $1,000 per Class "L" share subscribed, that
is, $45,125,000 and demanded payment from 1915 Inc. of $9,806,000. At the same
time, N Inc. demanded payment from 1284 Inc. of the amount of $45,133,354.08,
plus interest, due to it under the demand note signed by 1284 Inc. and payment
from 1915 Inc. of the amount of $9,807,815.40, plus interest, due to it under
the demand note signed by 1915 Inc.
Also on September 14, O Inc.
purported to declare a cash dividend of $54,931,000 to holders of its Class
"L" shares, which amount was paid to 1284 Inc. as to $45,125,000 and
to 1915 Inc. as to $9,806,000.
Forms of election pursuant to subsection 83(2) of the Act were filed
with Revenue Canada.
On or about
September 24, N Inc. sold to Mr. Faraggi 5,890 Class "L" shares
in each of P Inc., Q Inc., R Inc., S Inc., T Inc., U Inc., V Inc., W Inc.,
X Inc., Y Inc. and Z Inc. it had previously acquired for $600, attempting to
trigger a capital loss for N Inc. of $58,899,400. On the same day, P Inc. sold
to Mr. Faraggi 5,890 Class "K" shares in C Inc.,
D Inc., E Inc., F Inc., G Inc., H Inc., I Inc., J Inc., K Inc., L
Inc. and M Inc. for $660, attempting to trigger a capital loss of
$64,789,340 for P Inc.
 Each of 1915 Inc.
and 1284 Inc. transacted with corporations with which it dealt at arm's length
to "sell" or "transfer" capital dividends in a manner
similar to that described in paragraph 3 of these reasons. The Minister treated the
difference between the amounts the third party corporations paid for shares and
the amounts they received on redemption of the shares as profits from a
business to 1915 Inc. and 1284 Inc. in 1987. The amounts so assessed
were $8,105,344 to 1915 Inc. and $4,677,717 to 1284 Inc. The various
transactions between 1915 Inc. and 1284 Inc. whereby they issued
shares to arm's length parties and then redeemed the shares are listed in
Appendices 1 and 2, respectively, to these reasons.
 The event giving rise to the
series of transactions under review appears to have been a transaction observed
by Mr. Langlois at the Stikeman Elliott offices in January 1987. A non‑resident-controlled
Canadian corporation which had substantial capital gains
"transferred" its capital dividend account to a Canadian-controlled
corporation. When Mr. Langlois reviewed the transaction later that evening in
January with Mr. Faraggi he was enthralled at the prospect of a similar
transaction possibly being structured for the advantage of other clients of the
 By July Mr. Langlois had prepared a "blue
print" setting out a scheme whereby capital gains could be created in
corporate entities and then capital dividends be transferred from one
corporation to another. Mr. Langlois anticipated that he and Mr. Faraggi might
each make about $200,000 from such a scheme. Mr. Langlois and Mr. Faraggi
had been approached by Messrs. Brian McDougall and Tom Sawyer, who indicated
they knew persons who would be interested in acquiring CDAs. A corporation
apparently controlled by Messrs. McDougall and Sawyer was allotted
one‑third of the common shares of 1915 Inc. to permit them to
participate in any profits resulting from the proposed transactions. Third
party corporations that "acquired" CDA would be clients or friends of
Mr. Langlois and Mr. Faraggi or persons who were referred directly or
indirectly by Messrs. McDougall and Sawyer. Messrs. McDougall and Sawyer
contacted a brokerage firm which was quite interested in the project.
 After discussions
with interested parties, Mr. Langlois and Mr. Faraggi planned to transfer
$50,000,000 of CDA to third party corporations. They anticipated that they
would require a bank loan of $10,000,000 to get things started.
 At the end of July
or in early August, Mr. Faraggi approached his account manager at the main
Montreal branch of the Canadian Imperial Bank of Commerce ("CIBC")
for a "daylight" loan
of $10,000,000. The CIBC was Stikeman Elliott's bank and the bank was a client
of the firm; most, if not all, lawyers at the firm did work for the bank,
according to Mr. Faraggi.
 As soon as the loan
request was made, the CIBC officials apparently got in touch with Stikeman
Elliott's managing partner at the time, Mr. James Grant, and informed him of
the loan request. According to Mr. Faraggi, the bank asked Mr. Grant to
support the loan. He refused to commit to the loan and the CIBC did not pursue
the matter with Mr. Faraggi; the loan request was effectively rejected.
 Mr. Langlois then
approached Richard Légaré, who was then executive director at the Place
Ville-Marie branch of the Royal Bank of Canada, for a loan of $10,000,000. Mr. Légaré referred Mr. Langlois
and Mr. Faraggi to Alain Lapointe who, in August 1987, was commercial loan
account manager at the Place Ville-Marie branch.
 Mr. Lapointe met with Mr. Langlois and Mr. Faraggi, who
explained their plans. They wanted to issue a cheque for $10,000,000 from an
account with no balance and deposit the money in another account and then
repeat the process several times until the $10,000,000 was eventually deposited
back in the original account. Mr. Lapointe described the origin of the
$10,000,000 as he understood it:
It came . . . let me explain
it to you. Let’s say we have three accounts: A, B, C, and a cheque for 10
million is drawn and deposited in account B, a cheque for 10 million is drawn
on account B and deposited in account C, and a cheque is drawn on account C
that is deposited in account A. So, to cover the original cheque that was
issued from account A, there is a deposit of 10 million that comes from account
C. So . . .
but what about the first cheque?
The very first one, because
as I understand it, it's a cascade. But the very first, does the first cheque
for 10 million exist?
Where does that 10 million
come from? I am not talking about the cheque that comes back and I am not
talking about the second one, but the very very first one.
The fact that a cheque is
issued does not necessarily mean that there is money in the account to cover
the cheque at the time it is issued.
 Mr. Lapointe believed the deposits would have been made
almost at the same time. [TRANSLATION] "There is a theoretical delay between
transactions and that's the aspect I really wanted to assess." Mr.
Lapointe discussed the proposal with his supervisor and the request was
approved. The Royal Bank advised the individual appellants that the cost for
the $10,000,000 was $10,000 plus another $500 for opening accounts for the
companies involved. The bank demanded no security and none was given.
 The cheques issued by the companies in Series 1
were certified cheques. Mr. Faraggi said the cheques were certified at his
request. Mr. Lapointe testified that in certifying a cheque the bank
guarantees that funds are in the bank account on which the cheque is drawn at
the time the cheque is certified, and the bank maintains the amount of the
cheque in the account, or that, if there are insufficient funds in the account,
the bank nevertheless will honour the cheque. A certified cheque in the amount
of $10,000,000, he agreed with the appellants' counsel, has a value of
$10,000,000. When a cheque is not certified, Mr. Lapointe stated, there may or
may not be money in the account.
 In the appeals at bar, Mr. Lapointe explained,
What is different with this case is the fact that
both the cheques and the deposits were made simultaneously at the same time and
were given to the bank at the same time. So when the cheque was issued, not
only did we know but also we were aware that there was a deposit of
10 million that had been made into that account to cover the cheque.
He was not concerned that a certified cheque could be
endorsed to a third party:
No, no, because the series of transactions, as I
explained to you, A to B, B to C and C to A, etc., took place in the presence
of the bank and the cheques and the deposits were all returned to us and we
kept them in order to process them by computer.
The only reason the bank certified the cheques, Mr.
Lapointe explained, was that all the cheques, deposits, withdrawals and
deposits back to accounts were at all times under the control of the bank.
 Asked whether the bank would have offered Mr. Langlois
and Mr. Faraggi an option to repay the $10,000,000 the day after the
transactions in Series 1, that is, September 14, Mr. Lapointe replied
negatively, explaining that in such a case there would have been a loan for
$10,000,000 for one day and the bank would not take such a risk without
 According to Mr. Lapointe, at the beginning of the
transactions in Series 1 there were zero dollars in the accounts of all
the companies and after the last transaction (before any "transfer"
of capital dividend account to third parties) there were zero dollars in the
accounts of the companies. But, he added, transactions of $10,000,000 did take
place: there was a series of cheques between accounts for $10,000,000 and a
series of similar deposits.
 The Royal Bank never intended to lend any money to Mr.
Langlois and Mr. Faraggi or their corporations, Mr. Lapointe
insisted. Without any guarantees, the bank would not advance money. Also, the
bank required an agreement of loan and there was none. There was no agreement
as to interest as is required for a loan and, according to Mr. Lapointe, no
interest was charged. The bank considered that the passing of certified cheques
and deposits was without risk to the bank since the bank was not exposed to any
loss; there was no loan, he declared.
 Mr. Lapointe denied that the bank's actions constituted
a "daylight" loan. In his view, in 1987 a "daylight" loan
was used by stock brokers when they required money to be placed in an account
at, say, 10 a.m. until a deposit to cover the amount could be made at,
say, 11:00 a.m. In such a case interest would be calculated on the number of
hours during the day the money was outstanding. Also, daylight loans required guarantees.
This was not the situation with Mr. Langlois and Mr. Faraggi, although Mr.
Lapointe admitted the transaction was structured like a "daylight"
 The appellants' counsel noted that Mr. Lapointe
indicated at the bottom of a note to file dated August 12:
$10,000 “put in place, daylight overdraft”, that is,
$10,000 at . . . one tenth of one per cent.
Q. . .
. one tenth of one per cent.
$500 opening of the current accounts.
 Mr. Lapointe explained the cost of the transaction was
0.1% of $10,000,000, that is, $10,000, plus $500 for opening the account. There
was no interest charge. The reference to "daylight overdraft", he
explained, was to serve as the basis of the rate charged; this is the basis on
which interest is calculated when brokers take out this form of loan.
 Mr. Lapointe estimated that the Series 1 transactions
at the Royal Bank took approximately one to one and a half hours. He and Mr.
Légaré were present in the conference room during the transactions. The bank
accounts had been opened for each corporation before the transactions started.
One had to be sure that the right cheque was being deposited in the right
account since there were a number of cheques and deposits that had to be made in
a certain sequence. There were eleven companies involved and some
20 transactions of cheques and deposits, and all were processed at the
same time. The processing of the cheques and deposits took seconds. The cheques
and deposits were under the bank's control, Mr. Lapointe repeated. Any
amounts of money were credited to different Royal Bank corporate accounts for
only seconds or less.
 Mr. Lapointe met with Mr. Langlois and Mr.
Faraggi, or one of them, again on September 9, when they deposited approximately
$5,800,000 in a Royal Bank account.
They opened other accounts as well on that day. These were actual funds,
Mr. Lapointe recalled, contrary to the first series of transactions. The
deposit was credited on September 10.
 The Crown queried whether the accounts in which the
amounts were deposited were even opened by the bank on September 9. In an
affidavit dated October 30, 2001, Mr. Lapointe stated that the deposit
entry of September 10 was probably due to the fact that the deposit was made
after 3 p.m. on September 9. The bank accounts could have been opened on
September 9 and, in accordance with bank practice, a cheque could be drawn on
the account on September 9 even if the deposit entry is not made until the next
day. Mr. Lapointe acknowledged that on September 9 the Royal Bank was in
control of the funds. He knew the money would be in the respective accounts the
next morning; however, deposited amounts must first be processed before they
are credited to the accounts for which they are meant.
 On September 15, Mr. Lapointe prepared a Commercial
Banking Credit Application with respect to an application for credit of
$20,000,000 by 2528 Inc. However, on Mr. Lapointe being informed of an
amendment to the Income Tax Act prohibiting transactions similar to
those already undertaken by the appellants, the credit approval was cancelled.
 Lise-Andrée Girard was a credit assistant at the main
Montreal branch of the CIBC in 1987 and dealt with many Stikeman Elliott
lawyers. During the summer of 1987 she opened several accounts for the
individual appellants, for a Mr. Faille and for another person.
 Ms. Girard recalled that about 45 to 50 accounts were
opened. All were opened in anticipation of closings of "transactions"
transferring CDA to third parties. Ms. Girard prepared bank documents in
advance of closings with third parties in order to facilitate and expedite the
 On September 22, Ms. Girard was ordered to stay late
because an account had to be opened in anticipation of a closing that day. The
transaction, according to her, took place the next day, September 23, because
the corporate charter, required for opening an account, was not available.
 However, according to the appellants' evidence, two
sets of closings took place on September 22, one by each corporate
appellant, and none on September 23. The respondent's counsel referred Ms.
Girard to deposit slips for 1276 Inc., 1300 Inc. and 1284 Inc. on which the
dates are several days earlier than the CIBC stamp thereon. For example, a slip
dated September 9, 1987 is stamped September 16, 1987. Ms. Girard
testified that it was not the policy of the CIBC to hold up the deposit of a
cheque for several days.
 Mr. Grant had other meetings
with Mr. Langlois and Mr. Faraggi. He did not testify at trial and the evidence
as to what transpired at these meetings is from the testimony of Mr. Langlois
and Mr. Faraggi.
 When he and Mr. Faraggi first approached the CIBC, Mr.
Langlois testified, they fully explained to the bank their proposal and
requested a loan of $10,000,000. He stated they told the CIBC they were acting
on their own account and invited the bank to contact Mr. Grant to satisfy
itself that the proposed transactions were ethical and would not be detrimental
to Stikeman Elliott.
 According to Mr. Langlois, Mr. Grant confirmed to the
CIBC that the proposed transactions were personal to him and Mr. Faraggi and
that Stikeman Elliott was not involved. Mr. Grant also told the bank that
he was not prepared to issue a "comfort letter" to it.
 After speaking to the CIBC, Mr. Grant directed Mr.
Langlois and Mr. Faraggi to look to another bank for financing. Mr. Grant
also told the individual appellants not to solicit Stikeman Elliott's clients
either as a source of capital dividends or as purchasers of capital dividends.
Mr. Langlois testified that some clients of the firm had earlier requested his
opinion on acquiring CDAs.
 At the same time Mr. Grant was discussing the situation
with Mr. Langlois and Mr. Faraggi, the latter — as well as Mr. Grant, it
appears — were discussing the transactions with Mr. , the head of Stikeman Elliott's
tax department in Montreal.
 I have concluded from the evidence and from observing
Mr. Régnier's demeanour during his testimony that he
accounting irregularities that cast doubt on the reality of the transactions.
For example, he noted that the
initial $10 million loan was devoid of any attribute that would qualify it as a
loan, such as interest, guarantees, and bank loan agreements. In short, he
agreed with Mr. Lapointe. The certified cheques, Mr. Dupuis declared, were an
attempt to give the appearance that the corporations had money, which they did
not have, in their bank accounts. He
There were eleven companies; there were eleven cheques, for
$110,000,100. Then there was the last company in the chain, 0206; it was $10 M
in its case. So they ended up with about $130 M; they created financial
statements in which they put $100 M in the assets of [A Inc.] and then they
issued notes for $110 M. But I can see people saying: “It’s only a cheque”.
So was there a loan of $110 M or a loan of $10 M?
 Other aspects of the transactions were also
suspect to Mr. Dupuis. He did not believe that the subsection 83(2) elections
for capital dividends were bona fide. The mechanism used to create
capital gains, namely, promissory notes and their eventual cancellation and the
declaration of stock dividends were not legitimate. Mr. Dupuis stated that:
If we look
at the entry made in issuing the K dividend in 099, 0099, they debited the
contributed surplus, and then the Class K share capital was credited in the
entries that were submitted; it is not denied that it was done against the
contributed surplus, and the value shown is zero.
. . .
contributed surplus was debited but with a value of zero. You will see that it
is the zero value that is important.
 Mr. Dupuis also alluded to the issuance and
sale of the Class “K” shares by the various companies to A Inc., also without
the requisite cash assets. He questioned whether the issue of such shares was
proper. After the initial $10,000,100 had passed through the various companies,
A Inc. continued to issue promissory notes worth $110 million to
non-arm’s-length entities. At this time A Inc. had only nominal funds in
its account. As Mr. Dupuis explained, the promissory notes delivered by A Inc.
in exchange for the $110,000,000 aggregate in Class “K” shares were all
promptly cancelled and the shares redeemed. According
to Mr. Dupuis:
So you wind
up with $110 M in promissory notes issued by 5644. How does 5644 go about
paying $110 M in promissory notes? There will be a redemption by . . .
companies 099, 0107, 0115 decide to redeem the Class K shares they sold to 5644
for $10 M, but each of them has a note in its hands that is owed by 5644; it
will take the note and cancel it. So it loses nothing in the end, $100. It’s a
scheme that had to be fully thought through from A to Z, because the $10 M, I
said to myself, is there anyone who will someday pay that $10 M for the sale of
the class K shares? No one will pay it; as we shall see later, there will be
"issued and paid for" were
paid for with a cheque dated September 9, 1987; however, the accounts of the
third party corporations were not opened until October.According to CIBC’s statement of fees,
dated October 28, 1987, the nine accounts were opened on October 28. The
cheques were essential to the transfers of shares in Series 2. Mr. Dupuis wondered:
. . . how
it is possible to prepare a deposit in advance with the account number when the
account had not been opened on the ninth of September. . . . So I have always
wondered how it was possible to be a shareholder of a company and to enter
shares as issued and paid for — because it was 1276 that acquired the whole
chain — how it was possible to record shares as issued and paid for in the
books when it wasn't even possible to write the cheque.
Petit Robert and the Oxford
English Dictionary define the words "tromper" and
1 Induire (qqn) en erreur quant aux faits ou quant à
ses intentions, en usant de mensonge, de dissimulation, de ruse;
2 (Choses) Faire tomber (qqn) dans l'erreur, l'illusion, du fait des choses ou
sans intervention d'autrui.
3 Littér. Ne pas répondre
à, être inférieur à (ce qu'on attend, ce qu'on souhaite).
4 Donner une satisfaction illusoire ou
momentanée à (un besoin, un désir).
1. To ensnare; to take unawares by
craft or guile; to overcome, overreach, or get the better of by trickery; to
beguile or betray into mischief or sin; to mislead.
2. To cause to believe what is false;
to mislead as to a matter of fact, lead into error, impose upon, delude,
‘take in’. To use deceit, act deceitfully.
3. To be or prove false to, play
false, deal treacherously with;
4. To cheat, overreach; defraud.
39 This Court has repeatedly
held that courts must be sensitive to the economic realities of a particular
transaction, rather than being bound to what first appears to be its legal
form: Bronfman Trust, supra, [ 1 S.C.R. 32] at pp. 52-53,
per Dickson C.J.; Tennant, supra, at para. 26, per Iacobucci J.
But there are at least two caveats to this rule. First, this Court has
never held that the economic realities of a situation can be used to
recharacterize a taxpayer's bona fide legal relationships. To the
contrary, we have held that, absent a specific provision of the Act to the
contrary or a finding that they are a sham, the taxpayer's legal
relationships must be respected in tax cases. Recharacterization is only
permissible if the label attached by the taxpayer to the particular
transaction does not properly reflect its actual legal effect: Continental
Bank Leasing Corp. v. Canada,  2 S.C.R. 298,
at para. 21, per Bastarache J.
Black’s Law Dictionary defines “loan” as: "1. An act of lending; a
grant of something for temporary use . . . 2. A thing lent for the borrower’s
temporary use; esp., a sum of money lent at interest".
for consumption is a contract by which the lender gives the borrower a
certain quantity of things which are consumed by the use made of them, under
the obligation by the latter to return a like quantity of things of the same
kind and quality.
loan for consumption the borrower becomes owner of the thing lent, and the
loss of it falls upon him.
1777. Le prêt de consommation est un contrat
par lequel le prêteur livre à l’emprunteur une certaine quantité de choses
qui se consomment par l’usage, à la charge par ce dernier de lui en rendre
autant de même espèce et qualité.
1778. Par le prêt de consommation l’emprunteur devient le
propriétaire de la chose prêtée, et la perte en retombe sur lui.
The Bills of
Exchange Act defines "promissory
note" as follows:
(1) A promissory note is an unconditional promise in writing made by one
person to another person, signed by the maker, engaging to pay, on demand or
at a fixed or determinable future time, a sum certain in money to, or to the
order of, a specified person or to bearer.
Le billet est une promesse écrite signée par laquelle le souscripteur
s’engage sans condition à payer, sur demande ou à une échéance déterminée ou
susceptible de l’être, une somme d’argent précise à une personne désignée ou
à son ordre, ou encore au porteur.
 I find reasonable
Mr. Dupuis’s conclusion that the purported creditors under the promissory notes
had no intention of collecting on the notes and collectively
I have little difficulty in
finding that Mr. Faraggi and Mr. Langlois intended to deceive, since they
directly controlled the various corporations as shareholders and directors and
were also responsible for how the corporations recorded the transactions.
Further, the Royal Bank and potential arm’s length subscribers for shares were
each informed as to the nature of the prospective transactions. I share Mr. Dupuis's
view that the transactions were complex and each step had to have been planned
in advance. A common intention to deceive
was present in each step; an appearance was given of legal relations and this
masked the purpose of the real intended transactions: to carry on a business
Finally, it is clear that specific provisions of the Act were abused
contrary to their object and spirit.
I do not agree with the appellants'
counsel's alternative submission referred to in paragraph 77 of these
reasons. I have determined that at no time did the corporate appellants have
any CDA. The individual appellants and the shareholders who received dividends
from the corporate appellants knew that the corporate appellants never had any
capital gains nor, consequently, any CDA. To have made an election pursuant to
subsection 83(2) in these circumstances is, to put it mildly, dishonest
and contrary to the object and spirit of the provision. Such an election is not
cured by resorting to Part III of the Act.
 Lastly, we consider the application of the penalties
against the appellants pursuant to subsection 163(2) of the Act. This
provision reads in part as follows:
Every person who, knowingly, or
under circumstances amounting to gross negligence, has made or has
participated in, assented to or acquiesced in the making of, a false
statement or omission in a return, form, certificate, statement or answer
. . . filed or made in respect of a taxation year for the purposes
of this Act, is liable to a penalty . . .
qui, sciemment ou dans des circonstances équivalant à faute lourde, fait un
faux énoncé ou une omission dans une déclaration, un formulaire, un
certificat, un état ou une réponse [...] rempli, produit ou présenté, selon
le cas, pour une année d'imposition pour l'application de la présente loi, ou
y participe, y consent ou y acquiesce est passible d'une pénalité [...]
. Yet they prepared and filed the tax returns in
issue, or caused these tax returns to be prepared, knowing full well that the
information contained in the returns for 1987 for all the appellants and the
returns for 1988 for the individual appellants contained false statements or
Signed at Ottawa, Canada, this
23rd day of May 2007.
"Gerald J. Rip"
Translation certified true
on this 31st day of July