Phyllis K. Egerton v. Her Majesty the Queen, [1994] 1 CTC 2895, 94 DTC 1500

McArthur, J.T.C.C.:—This is an appeal by Phyllis K. Egerton (the appellant) with respect to her 1987 and 1989 taxation years.

On June 16, 1987, the appellant transferred 5,850 shares of Egerton Associates Limited (the "corporation") to her son Drew Egerton ("Drew") for $234,000 calculated at $40 per share. With her 1987 return she requested a $200,000 capital gains deferral pursuant to subsection 73(5) of the Income Tax Act, R.S.C. 1952, c. 148 (am. S.C. 1970-71-72, c. 63) (the "Act")).

The Minister of National Revenue (the "Minister") in reassessing the appellant, determined $51 per share was fair market value as opposed to $40 and disallowed the request for a T2211 $200,000 deferral.

For the 1989 taxation year, the appellant reported a capital gain of $36,400 on the transfer of 650 shares of the corporation to her son having placed a value of $56 per share. The Minister determined $71.50 to be the fair market value in the reassessment.

The Minister determined further that the corporation was not a small business corporation in that an approximate average of 55 per cent of the corporation’s assets were permanently set aside from 1986 to 1989 for investment purposes and these investments were not required for working capital of the corporation. The appellant questions the methodology used by the Minister in valuating the shares and submits that the corporation was a small business corporation and that all or substantially all of its assets were employed in an active business.

Issues

There are two issues: firstly, whether $56 per share and $71 per share, respectively, was the fair market value of the corporation shares in 1987 and 1989, and secondly, whether the corporation qualified as a small business corporation.

Facts

Egerton Associates Ltd. was incorporated in 1971 by Drew's father, to conduct the business of appraising real estate and to act as real estate counsellors.

Drew Egerton's testimony included the following:

Drew went to work for the corporation in 1975. The senior Egerton was president and very much in control of the corporation until his death in June 1985. He had built a solid business and was known in the London areas as the "Dean of Appraisers". He was well known in the community and belonged to social clubs to assist in cultivating business. Drew's duties during his first ten years were limited exclusively to appraising. Generally the firm did well.

Mr. Egerton, senior died suddenly in June of 1985 and Drew, at age 33, was obligated to fill his role in the corporation. Drew had considerable difficulty adjusting in the early months. The corporation's statement of earnings for the year ended February 28, 1986, reflects a loss (before the $60,000 life insurance proceeds received upon the death of Mr. Egerton, senior) of $19,331 and the comparative figures for the year ended February 28, 1985 reflects a loss of $14,011.

While apprehensive of his new duties, Drew proved quite capable of guiding the corporation and it enjoyed increased revenues in 1987, 1988 and 1989 under its new leadership. Financial facts of the corporation extracted from exhibits A-5 and A-6 include the following:

$60,000 of the cash and term deposits reflected from 1986 forward were derived from the proceeds of a life insurance policy paid upon the death of Mr. Egerton senior in 1985. The insurance was designed to carry the corporation through the transitional period of when Drew Egerton took over his father's role of managing director.

In the fiscal year ending February 28, 1985, the corporation lost $14,011 and Mr. Egerton senior had reduced his salary by 50 per cent. Drew Egerton testified that he was apprehensive in his new role in 1985 and that he was conservative and cautious by nature. He depended on the security and liquidity of the reserves, as set out under the heading cash and term deposits, to withstand the fluctuations of an unpredictable income in such a volatile business and to fund possible losses, particularly in light of the 1985 losses.

Drew further testified that funds were required as a cash reserve to fund legal liability and costs in a lawsuit; the corporation's total exposure being a maximum of $50,000. He stated that he used part of the reserve funds to purchase short-term deposits with institutions as a goodwill gesture to generate appraisal business in return.

In cross examination, Drew acknowledged that the lawsuit was discontinued in 1991 without payment by the corporation.

The witness did not offer evidence, other than his own word, to support the submission that the purchase of term deposits with various institutions generated return appraisal business for the corporation.

First issue — share valuation

Having been unable to present his own witness after consideration was given to provisions contained in rule 145, counsel for the appellant called an expert witness William A. Ovens, an employee of Revenue Canada, who had prepared a valuation of the common shares, at issue. Counsel for the respondent had previously indicated he was not going to produce in evidence the share valuation report prepared by Mr. Ovens.

Mr. Ovens graduated from the Laurentian University, Sudbury, Ontario, with an honours bachelor of commerce degree. Subsequently, he completed postgraduate courses including the Canadian Institute of Chartered Business valuations course. Since 1983, he has been employed with Revenue Canada taxation as an equity valuator and has qualified as an expert before this Court on at least two previous occasions. He was open and forthright in explaining and defending his report. This was the first real estate appraisal business he had appraised. He did not use comparisons nor did he take the lawsuit into consideration or speak to anyone in the business.

He made many assumptions, used “ball park" numbers and relied on material that may have or may not have been accurate. He obtained some information from what he described as “files kicking around". The appellant presented no other evidence with respect to the value of the shares. The respondent called no witnesses. I do not feel it serves a useful purpose to review the evidence of Mr. Ovens in detail. The valuation procedure was far from an exact science.

Analysis for share valuation

The onus is on the appellant to demolish the Minister’s assessment. After the detailed examination and brief cross examination of the appraiser, I have no difficulty in concluding from the evidence that the Minister’s share value assessment is flawed.

The appraiser used a text book (Horvath) for guidance in certain instances and a by guess and by God" approach in others. He disregarded the effects of a pending lawsuit, although with hindsight he was correct. He used “ball park figures” and arrived at a cap rate by referring to unidentified files "kicking around". He presumed the economy was inflating because he observed rising prices upon returning to homes he had seen sometime earlier while shopping for a house personally in 1988. He included redundant assets, having accepted a figure from “Jack Philips” in blind faith, and a figure of $15,000 from a third party as "excess salaries” in the same manner. He used “rules of thumb” without any apparent evidence of their accuracy.

He apparently did not take the losses in 1985 and 1986 (minus the $60,000 insurance proceeds) into consideration.

The evidence to support the appellant's share value was incomplete and unconvincing. The words of Walsh, J. in Bibby Estate v. The Queen, [1983] C.T.C. 121, 83 D.T.C. 5148 at page 131 (D.T.C. 5157), seem appropriate in the present circumstances:

While it has frequently been held that a Court should not, after considering all the expert and other evidence merely adopt a figure somewhere between the figure sought by the contending parties, it has also been held that the Court may, when it does not find the evidence of any expert completely satisfying or conclusive, nor any comparable especially apt, form its own opinion of valuation, provided this is always based on the careful consideration of all the conflicting evidence. The figure so arrived at need not be that suggested by any expert or contended for by the parties.

Taking all the evidence available into consideration I have reached the conclusion that a fair and equitable market value per share in 1987 is $44 and $62 for 1989.

Second issue — small business corporation

Taxpayer's position

The appellant’s position is that during the relevant taxation year it carried on the active business of real estate appraising and counselling and that the reserves in 1987, approximately $197,000, were pertaining to or incident to the business. Counsel submitted that the Minister’s reassessment was wrong because paragraph 129(4.1 )(b) of the Act does not include income from any property that is incident to or pertains to an active business carried on by it, and that as a result, the corporation is a “small business corporation" and can avail itself of the provisions in subsection 73(5) of the Act. In support of this position counsel submitted:

(i) the interest income earned by Egerton Associates during 1987, 1988 and 1989 was derived from current account interest and short-term investments and that the funds were required by the corporation to capitalize and sustain the business;

(ii) the funds were set aside in a reserve for a pending lawsuit;

(iii) the corporation had incurred operating losses and required a strong cash position to fund future losses;

(v) the deposit business with financial institutions was a means of getting appraisal business; and

(vi) the death of a principal shareholder had resulted in payment of insurance proceeds to the corporation.

Respondent’s position

The respondent's position is that the cash and term deposits, the corporation reserves, were not required for the business to operate successfully and their removal would not have put the corporation at risk:

(i) the corporation was in the business of real estate appraisal;

(ii) from 1986 to 1989 an average of 55.35 per cent of the corporation's total assets were permanently set aside for investment purposes;

(iii) the investments were not required for working capital of the corporation;

and

(iv) the investment income arising from the corporation's investments is Canadian investment income and not active business income.

The respondent brought attention to an analysis by the Minister of the corporation's investments noting that an average of 53.35 per cent of its assets had been set aside for investment purposes. The Minister’s detailed analysis is as follows:

In order to succeed, the taxpayer would have to show that its investment income was “incident to” or that it "pertained to" its active business within the meaning of paragraph 129(4.1)(b) of the Act.

The issue of focus gives rise to the difficult and often litigated question of whether the corporation was a "small business corporation" and that all or substantially all of its assets were employed in an active business.

The relevant provisions of the Act include subsections 248(1) (definitions of small business corporation and active business); 73(5) (rollover); 125(1) (small business deduction); paragraphs 129(4.1)(b) (income or loss from a source that is property), 125(7)(a) (active business carried on by a corporation), and 125(7)(c) (income from active business). The relevant parts read as follows:

248(1) In this Act,

“small business corporation" at any particular time means a particular corporation that is a Canadian-controlled private corporation all or substantially all of the assets of which were at that time

(a) used in an active business carried on primarily in Canada by the particular corporation or by a corporation related to it,

“active business", in relation to any business carried on by a taxpayer resident in Canada, means any business carried on by the taxpayer other than a specified investment business or a personal services business;

73(5) For the purposes of this Part, where at any particular time a taxpayer has transferred property to his child who was resident in Canada immediately before the transfer and the property was, immediately before the transfer, a share of the capital stock of a small business corporation, except where the rules in subsection 74(2) require any taxable capital gain from the disposition by the taxpayer of that property to be included in the income of a person other than the taxpayer, the following rules apply:

(a) the taxpayer shall be deemed to have disposed of the share at the time of the transfer and to have received proceeds of disposition therefor equal to the amount, if any, by which

(i) the fair market value of the share at that time

exceeds the lesser of

(ii) the taxpayer's capital gain otherwise determined from the disposition of the share, and

(iii) the amount of the taxpayer's cumulative small business gains account immediately before the transfer or such lesser amount as the taxpayer specifies in respect of the transfer of the share;

(b) the child shall be deemed to have acquired the share at a cost equal to the proceeds of disposition deemed to have been received by the taxpayer under paragraph (a); and

(c) where two or more shares have been disposed of at the same time, this subsection applies as if each share had been separately disposed of in the order designated by the taxpayer or if the taxpayer does not so designate, in the order designated by the Minister.

125(1) There may be deducted from the tax otherwise payable under this Part for a taxation year by a corporation that was, throughout the year, a Canadian-controlled private corporation, an amount equal to 20 per cent of the least of

(a) the amount, if any, by which the aggregate of

(i) the aggregate of all amounts each of which is the income of the corporation for the year from an active business carried on in Canada (other than the income of the corporation for the year from a business carried on by it as a member of a partnership), and

(ii) the specified partnership income of the corporation for the year

exceeds the aggregate of

(iii) the aggregate of all amounts each of which is a loss of the corporation for the year from an active business carried on in Canada (other than a loss of the corporation for the year from a business carried on by it as a member of a partnership), and

(iv) the specified partnership loss of the corporation for the year,

(b) the amount, if any, by which the corporation's taxable income for the year exceeds the aggregate of

(i) /4 of the aggregate of amounts that would be deductible under subsection 126(1) from the tax for the year otherwise payable by it under this Part if the amount determined under subparagraph 126(7)(d)(i) were determined without reference to paragraph 123(1)(c), ana

(ii) two times the aggregate of amounts deducted under subsection 126(2) from the tax for the year otherwise payable by it under this Part, and

(c) the corporation’s business limit for the year.

129(4.1) For the purposes of paragraph (4)(a) and subsection (6), "income" or "loss" of a corporation for a year from a source in Canada that is a property includes the income or loss from a specified investment business carried on by it in Canada other than income or loss from a source outside Canada but does not include income or loss

(b) from any property that is incident to or pertains to an active business carried on by it. . . .

125(7) In this section,

(a) “active business carried on by a corporation" means any business carried on by the corporation other than a specified investment business or a personal services business and includes an adventure or concern in the nature of trade;

(c) “income of the corporation for the year from an active business" means the income of the corporation for the year from an active business carried on by it including any income for the year pertaining to or incident to that business, but does not include income for the year from a source in Canada that is a property (within the meaning assigned by subsection 129(4.1)). . . .

For the corporation to qualify for the $200,000 capital gains deferral under subsection 73(5) of the Act, it must have active business income and not be a "specified" business. There was no disputing the fact that it was not a “specified business”. Paraphrasing the relevant parts of subsection 129 (4.1) income from an active business includes all income from carrying on, pertaining to or incidental to an active business. The appellant had the burden of establishing that the corporation's income and the reserve fund were pertaining to and incidental to its real estate appraisal income to qualify as a small business corporation.

In Atlas Industries Ltd. v. M.N.R., [1986] 2 C.T.C. 2392, 86 D.T.C. 1756, Christie, J. of this Court concluded that there must be a financial relationship of dependence of some substance between the property (described as reserves in present case) and the acting business income before the exclusion in paragraph 129(4.1 )(b) comes into effect.

In The Queen v. Marsh & McLennan Ltd., [1983] C.T.C. 231, 83 D.T.C. 5180 (F.C.A.), the issue was whether interest income derived by an insurance brokerage corporation from temporary investment in short-term obligations (funds from premiums received for remittance to the appropriate insurance corporations) should be characterized as investment income within the meaning of paragraph 129(4)(a) of the Act. The Federal Court of Appeal determined that the test is not whether or not the investment was subsidiary or ancillary to the taxpayer's main business, but whether the investment of funds for revenue had "some" connection with the taxpayer's business.

LeDain, J. proposed a test at page 243 (D.T.C. 5190):

. . .was the fund employed and risked in the business? In my opinion it was, because an amount equivalent to this notional fund was committed to the carrying on of the business in order to meet the company's obligations to insurers.

[Emphasis added.]

In Ensite Ltd. v. The Queen, [1986] 2 S.C.R. 509, [1986] 2 C.T.C. 459, 86 D.T.C. 6521, Wilson, J., speaking for the Court, using the test of Le Dain, J. in Marsh & McLennan, supra, reached the conclusion that the holding or using of the property must be linked to some definite obligation or liability of the business and the corporate obligation means more than a remote risk.

In McCutcheon Farms Ltd. v. M.N.R., [1988] 1 C.T.C. 2349, 88 D.T.C. 1208, aff'd [1991] 1 C.T.C. 50, 91 D.T.C. 5047 (F.C.T.D.), the fact situation was similar to the present case. The taxpayer's surplus earnings were invested in short-term bank deposits. The principal was never encroached upon. The taxpayer claimed it necessary to have substantial cash available, up to $200,000, to pay suppliers to maintain inventory levels among other reasons. He operated a farming operation, processing and selling seed and chemicals.

The Court found that the cash and term deposits were not an integral part of the business and not necessary to the overall operation, but were surplus and collateral to the active business.

Sarchuk, J.T.C.C. relied, together with other cases, on Atlas Industries, supra, and quoted the Court statement at page 2404 (D.T.C. 1764-65):

Giving the words “incident to or pertains to an active business” their grammatical and ordinary sense, and bearing in mind their context, there must I think be a financial relationship of dependence of some substance between the property and the active business before the exclusion in paragraph 129(4.1)(b) cornes into play. The operations of the business ought to have some reliance on the property in the sense that recourse is had to it regularly or from time to time or that it exists as a back-up asset to be called on in support of those operations when the need arises. This I regard to be the basic approach to paragraph 129(4.1 )(b).

Analysis

Turning to the facts before me, with these tests in mind, I have decided that the appeal fails. After reviewing all the evidence, it cannot be concluded that the reserves were an integral part of the appraisal business and necessary for the operation of the business. There was no evidence other than the statement of Drew Egerton to support the submission that the deposits generated appraisal business. While the lawsuit was a potential liability, the corporation regarded it as frivolous and did not deem it serious enough to report to its liability insurer. It is reasonable to rely on a source of available cash to weather the fluctuations of the business income and expenses but the quantum of the reserves far exceeded the corporation's needs.

From the evidence, the funds were not used regularly, if at all, during the relevant years. They were not used as collateral security for bank loans or other such requirements. The reserves may have given Drew Egerton peace of mind, but that is not a relevant criteria. There was no evidence that the liquidity was used during the relevant years for the operation of the corporation.

The corporation had a profitable history with a well established infra structure and clientele. The deposits were never called upon to cover operating needs or to provide security. From the evidence, there was little expectation of risk of losing the funds.

Conclusions

The appeal with respect to the value of shares is granted on the basis that for the 1987 taxation year the valuation of each share is $44 and for 1989 $62 per share and it is ordered that the matter be referred back to the respondent for reassessment on that basis.

The appeal by the appellant claiming eligibility of the T2211 election, in connection with the transfer of the subject shares by the appellant to her son in 1987, is dismissed.

There shall be no order as to costs.

Appeal allowed in part.