Valeriote Electronics Limited v. Minister of National Revenue, [1988] 1 CTC 2091, 88 DTC 1034

Rip, T.C.J.:—The appellant corporation, Valeriote Electronics Limited ("Electronics"), appeals reassessments of income tax for its 1980, 1981, 1982 and 1983 taxation years in which the respondent, the Minister of National Revenue, Taxation, disallowed expenditures for management fees and director's fees since they were not made or incurred for the purpose of gaining or producing income from a business or property within the meaning of paragraph 18(1)(a) of the Income Tax Act ("Act").

Mr. Denis J. Weiler, CA, was the only witness testifying on behalf of Electronics. Mr. Weiler has practised his profession as a chartered accountant since 1975; he worked on the appellant’s accounts while a student with the appellant's auditors in 1972 and since 1975 as partner in charge of the accounts. He worked closely with Mr. Michael Valeriote, the sole shareholder of Electronics, and the appellant's other key personnel; he estimated he spent 250 hours per year on the appellant's accounts, although the evidence indicates more hours were spent on the accounts of its subsidiaries than that of the appellant.

Immediately prior to October 1, 1977, Mr. Michael Valeriote owned all of the issued and outstanding shares of Electronics. Electronics did not carry on any business but in turn owned all the shares in two operating corporations, Valeriote Electronics (Guelph) Limited ("Valcom") [1] , an Ontario corporation, and Valcom Inc., a New Mexico corporation. Mr. Valeriote was president and chief executive officer of all three companies. He made all major business decisions and was responsible for marketing the subsidiaries' products.

In all relevant years the fiscal year of Electronics and Valcom terminated on September 30.

Mr. Valeriote had acquired 25 per cent of the shares of Electronics from his father sometime in the 1960s; he acquired the balance of the shares from his father and uncle in 1975 when the company was, to use Mr. Weiler's words, “in bad shape". Valcom had a loss from operations in 1974 of $94,316. In 1975 Valcom's operating profit was $71,792; it also had a gain of $112,576 from sale of land and building.

Valcom carried on the business of selling specialty products to the Department of National Defence and to the Coast Guard of the United States of America; it also repaired and overhauled the equipment it sold.

Mr. Valeriote had invented a 35-foot fibreglass antenna for use by ships; the antenna operated notwithstanding great winds. Mr. Valeriote was owner of the patent. The antenna was manufactured by Valcom for sale without public tender to the U.S. Coast Guard. By 1977 the antenna represented 20 per cent of Valcom's sales but because Valcom had a monopoly on its manufacture and sale it was a high profit item and generated much more than 20 per cent of Valcom's profits, Mr. Weiler indicated.

The New Mexico company manufactured and sold a citizen's band antenna developed by Mr. Valeriote; this company, still in operation, has not been successful.

Mr. Weiler testified Mr. Valeriote was responsible for the development of Valcom's and the New Mexico company's products; he also said Mr. Valeriote was consulted by the engineering staff "for everything". Mr. Weiler described Mr. Valeriote as “beating the bush” for sales, constantly visiting Ottawa, Washington and a Coast Guard station in Minnesota to promote Valcom's products.

Once Mr. Valeriote became the sole shareholder of Electronics Valcom became profitable. In 1976 Valcom showed an operating profit of $13,971; in 1977, Valcom had a profit of $149,552 after making provision for payment of bonuses aggregating $190,000 to Mr. Valeriote and two other employees, including a Mr. P. McPherson, who subsequently caused a corporation, all the shares of which he appears to have owned, to acquire the shares of Valcom.

Electronics sold its shares in Valcom on October 1, 1977, to the corporation owned by Mr. McPherson for $825,000, payable $150,000 on closing, $175,000 ten weeks after closing and the balance of $500,000 was to be paid over ten years with interest of eight per cent per annum on the outstanding balance; the outstanding balance was to be reduced by $40,000 per year during the first five years and $60,000 per year for the last five years [2] . The balance of purchase price was secured by a note by the purchaser to the vendor; the shares subject to the sale were pledged as security for payment. In Mr. Weiler's view the sale price was an offer Mr. Valeriote could not refuse notwithstanding the risk on the balance of $500,000.

Mr. Valeriote remained as a director of Valcom, according to Mr. Weiler, to protect his interest in the $500,000 note and at the request of the purchaser so that his expertise would be available. Mr. Weiler stated Mr. Valeriote has been consulted by Valcom since the sale.

The appellant has received interest monthly on the balance of purchase price and the scheduled payments of principal.

It was not always clear during the trial what corporate entity Mr. Weiler and the appellant's counsel were referring to in examination-in-chief. Mr. Weiler testified that it was corporate policy to distribute as bonus to "shareholders" all profits not available for the small business deduction, as defined by section 125 of the Act. This was the reason, Mr. Weiler stated, for the payment of bonuses aggregating $190,000 in 1977. According to Mr. Weiler the first time any money was available for distribution in this manner was in the year ending September 30, 1977. Later on in the trial it became clear that the $190,000 of bonuses was paid by Valcom, not the appellant. The evidence also disclosed that prior to its 1978 taxation year Electronics did not pay any salaries; salaries had been paid by the operating companies. In 1976 Valcom paid Mr. Valeriote a salary of $28,500; in 1977 he was paid a salary of $25,335, plus "probably" one-third of the bonus of $190,000. In prior years Mr. Valeriote was not “specifically” remunerated by Valcom.

Mr. Weiler also testified that Electronics commenced paying management fees to Mr. Valeriote during its 1978 fiscal year, after the sale of the Valcom shares. Mr. Weiler indicated Mr. Valeriote moved to Puerto Rico sometime between 1978 and 1980, probably in 1979. It appears that earlier he had moved to the continental United States of America. The respondent did not disallow the deduction of management fees paid to Mr. Valeriote by the appellant in 1978 and 1979.

During the years under appeal Mr. Valeriote resided in Puerto Rico. The affairs of Electronics were looked after by Mr. Weiler who participated in a "few" telephone calls with Mr. Valeriote. Mr. Weiler testified Mr. Valeriote was occupied with the New Mexico company and there was not much for him to do as an officer or director of Electronics as long as the purchaser of the Valcom shares was making payments of interest and capital on the outstanding balance of the purchase price. The only asset of Electronics generating any income was the note receivable from the purchaser. Other assets included accrued interest receivable, amount due from an associated company, an amount due from Mr. Valeriote in respect of a housing loan and shares in Valcom. The balance of purchase price receivable from the purchaser of the Valcom shares, interest income reported by Electronics on the balance of the purchase price and the management fees or director's fees claimed in the years under appeal are as follows:

In each of the years Electronics reported an income loss.

Counsel for Electronics submitted that the management fees and director's fees paid to Mr. Valeriote were reasonable since firstly, the success of Valcom was due to Mr. Valeriote and he was not fully compensated during the years prior to the sale of the shares, and secondly, the sale of Valcom was heavily leveraged and Mr. Valeriote was representing Electronics' interests on the board of directors of Valcom to ensure payment of interest and principal on the outstanding balance of purchase price. He also said Mr. Valeriote continued to operate the New Mexico company. Counsel added that if the appeal is dismissed the aggregate tax to be paid by Mr. Valeriote and Electronics as a result of the interest received, the disallowance of the fees as an expense and the withholdings tax of 25 per cent, would equal 75 per cent of the management and director's fees as opposed to approximately 62 per cent if Electronics had paid tax on the interest received and then withheld 25 per cent of taxable dividends paid to Mr. Valeriote.

Mr. Weiler explained that he had two options how to deal with the interest received from the purchaser of the Valcom shares: the funds could remain in Electronics and the corporation would be taxed at the 50 per cent rate; the balance of the income, after payment of tax, and any surplus funds could be paid as a dividend, with tax of 15 per cent withheld in the years Mr. Valeriote resided in the United States of America and 25 per cent withheld in the years under appeal, when he was a resident of Puerto Rico; secondly, "the company policy not to pay a high rate of tax would continue" and Electronics would pay a management remuneration to Mr. Valeriote, its sole shareholder, in an amount of the interest received, less a withholding tax of 15 per cent in the years he resided in the United States, and of 25 per cent when he resided in Puerto Rico, and any surplus. Electronics opted for the second alternative.

Mr. Weiler said he found support in paying management fees from, and listening to, a discussion on tax matters by officials of the respondent at the annual meeting of the Canadian Tax Foundation in Vancouver in November 1981. At that discussion the following questions were asked to the respondent's officials:

1. Can Revenue Canada provide guidelines with respect to the ''reasonableness" of salaries paid to employees-shareholders where a private company earns substantially all its income from property?

2. We have seen a situation where an inactive or partially inactive shareholder has had his remuneration questioned as to its reasonableness. In this case, it was “suggested” that salary/bonus in excess of $25,000 in a year may be unreasonable. Could you please comment?

3. Large bonuses are often paid in order to reduce the taxable income of a CCPC to $150,000. These bonuses are then reviewed in the light of section 67. Could you please comment?

Their answers were as follows:

1. No specific guidelines have been established to determine the reasonableness of salaries paid to employees-shareholders where a private company earns substantially all its income from property. The amount, if any, that is considered to be reasonable must be based on the facts of each particular case.

In general, when determining whether salaries paid to employees-shareholders are reasonable, comparisons with like services performed in the same or similar businesses are required. In making this evaluation the following information is usually obtained:

(a) the duties performed by the employee and the time expended in carrying out these duties,

(b) the remuneration of other employees of the same business who have similar types of responsibilities, experience, and skills,

(c) the remuneration paid by other businesses of a similar size to employees

who render services corresponding to those of the employee concerned.

2. The determination of a reasonable amount for salaries paid to employees- shareholders must be based on the facts of each particular case. Generally, the services performed by an inactive or partially inactive shareholder are substantially less than the services performed by a shareholder involved in the day-to-day operations of an active business and, therefore, the value of the services would be substantially less. It would not be considered reasonable for a shareholder who provides no services to the corporation in which he holds shares to receive a Salary.

3. Subject to the bounds of reasonableness with respect to both the level of salary and bonuses for services performed and the rate of return on investment in shares, the Department generally accepts that a principal shareholder-manager is entitled to determine a mix of salary and dividend that he considers appropriate. Where there is more than one principal shareholder-manager, the creation of separate classes of shares solely to achieve dividend flexibility would usually lead to a presumption of artificiality.

In general, the Department will not challenge the reasonableness of salaries and bonuses paid to the principal shareholders-managers of a corporation when

(a) the general practice of the corporation is to distribute the profits of the company to its shareholders-managers in the form of bonuses or additional Salaries; or

(b) the company has adopted a policy of declaring bonuses to the shareholders to remunerate them for the profits the company has earned that are, in fact, attributable to the special know-how, connections, or entrepreneurial skills of the shareholders.

Bonuses paid to shareholders other than the principal shareholders-managers will be subject to the normal test of reasonableness that is set out in (a) above.

Mr. Weiler, in reviewing Revenue Canada's answer to the third question considered that Electronics met the tests imposed by the respondent: (a) it was company practice to pay out all profits taxed at the high rate as bonus, and (b) the success of the company was attributable to the special knowhow and skills of Mr. Valeriote; the shares of Valcom were sold at a high price because the patents and know-how of Mr. Valeriote were also being sold.

Counsel for Electronics submits his client's appeal be allowed for the following reasons:

(a) the sale of Valcom was heavily leveraged and Mr. Valeriote remained as a director of Valcom to protect the appellant's interests;

(b) Mr. Valeriote continued to operate the New Mexico company;

(c) the success of all these companies was due to Mr. Valeriote; and

(d) the tax to be paid by the appellant, if the appeal is dismissed, is greater than the aggregate tax that would have been payable by both the appellant and Mr. Valeriote if the appellant and Mr. Valeriote had acted on Mr. Weiler’s first alternative.

The respondent's counsel argued the management and director's fees paid to Mr. Valeriote were not reasonable since he made no contribution to the income of Electronics which would merit management fees in the amounts paid to him. The purpose of the fees paid to Mr. Valeriote was twofold: to reduce taxes and to compensate Mr. Valeriote for his past services to Valcom. Management fees approximated interest income in 1980, were one-third greater than the interest earned in 1981; in 1982 and 1983 the fees were almost three times the gross income of Electronics. The fees, she submitted, were not made or incurred by Electronics for the purpose of gaining or producing income from a business or property pursuant to paragraph 18(1)(a) of the Act; in any event, she added, the fees were not reasonable in the circumstances and therefore their deduction is prohibited by section 67 of the Act.

An outlay or expense of a taxpayer may be deducted in computing the taxpayer's income only to the extent it was made or incurred for the purpose of earning income from a business or property. Paragraph 18(1)(a) reads:

18(1) In computing the income of a taxpayer from a business or property no deduction shall be made in respect of

(a) an outlay or expense except to the extent that it was made or incurred by the taxpayer for the purpose of gaining or producing income from the business or property;

Section 67 provides that:

67 In computing income, no deduction shall be made in respect of an outlay or expense in respect of which any amount is otherwise deductible under this Act, except to the extent that the outlay or expense was reasonable in the circumstances.

The appellant corporation carried on no business. Any business carried on by a subsidiary is not that of the appellant: Canada Safeway Limited v. M.N.R., [1957] S.C.R. 717 at 728; [1957] C.T.C. 335 at 345 per Rand, J. Valcom and Valcom Inc. each carried on business prior to and subsequent to October 1, 1977. The success of Valcom may have been in no small part due to the efforts of Mr. Valeriote. That Valcom may not have remunerated him to the extent it might have does not give licence under the Act to Valcom's parent, the appellant, to make up for the reduced salary and bonus paid in the earlier years. [3] Paragraph 18(1)(a) leaves no doubt that in computing a taxpayer's income from a business the only expenses that may be deducted are those made or incurred for the purpose of gaining or producing income from that business.

The appellant cannot take any solace from the fact Mr. Valeriote continued to operate Valcom Inc. in the United States or that Valcom’s success was due to his efforts. A payment to him by Electronics for services performed for a subsidiary is not an outlay or expense incurred by Electronics for the purpose of gaining or producing income from a business or property. In D.W.S. Corp. v. M.N.R., [1968] C.T.C. 65, 68 D.T.C. 5045, Thurlow, J. stated

The submission was, however, made that the borrowed money was used for the purpose of earning income from the appellant's property, that is to say, the demand note given by World T. and I. Corporation or the property right which it evidenced. It was not suggested that the money was used for the purpose of earning income in the form of dividends from World T. and I. Corporation but I do not think such a contention would be tenable anyway since such dividends, if received, would, I think, be income from the appellant's property in the shares of World T. and I. Corporation rather than from the property right evidenced by the demand note. On this point Rand, J. in Canada Safeway Limited v. M.N.R., said at page 728 [p. 345]:

The word "property" is introduced in paragraphs (i) and (ii) but I cannot see that it can help the appellant; the language

borrowed money used for the purpose of earning income from . . . property (other than property the income from which is exempt)

in (i) means the income produced by the exploitation of the property itself. There is nothing in this language to extend the application to an acquisition of "power" annexed to stock, and to the indirect and remote effects upon the company of action taken in the course of business of the subsidiary.

Though in the present case there was no use of the borrowed money to purchase stock to obtain "power" or control over World T. and I. Corporation I think that the possibility of increased dividends by lending to World T. and I. Corporation must be taken to be too remote to characterize the lending of the borrowed money to it without interest as use for the purpose of earning income from the property represented by the loan. It is the loan itself rather than the shares that I think Rand, J. refers to when he says the statute means "the income produced by the exploitation of the property itself”.

Income the appellant was susceptible of gaining or producing during the years in issue was from property, that is, shares owned in Valcom Inc. and the promissory note for the balance of the purchase price of the Valcom shares. If I were to accept the argument that Electronics paid Mr. Valeriote to somehow ensure the interest payments, then surely Electronics would not have paid him more than what it was entitled to receive by way of interest since no income or profit would be gained. In order for an expense to be admissible as a deduction from a taxpayer's income, it must have been incurred in order to make a profit and not just to obtain gross income: The Deputy Minister of Revenue of Quebec v. Julius Lipson, [1979] C.T.C. 247 at 250 (S.C.C.) per Pigeon, J. [4] Vide section 9.

If I were to accept the argument that Mr. Valeriote was paid by Electronics to remain a director of Valcom to protect Electronics’ interests, namely, the principal amount owing on the purchase price, then in my view the payments were on account of capital, to protect a capital asset, and therefore not deductible (paragraph 18(1)(b)).

Appellant counsel’s submission that if the appeal is dismissed the tax payable by Electronics will be greater than the aggregate tax it and Mr. Valeriote would have paid had they acted on Mr. Weiler's first alternative cannot be considered, seriously or otherwise. As stated by Mr. Justice Dickson in The Queen v. Bronfman, [1987] 1 C.T.C. 117 at 129; 87 D.T.C. 5059 at 5067:

. . . the courts must deal with what the taxpayer actually did, and not what he might have done: Matheson v. The Queen, [1974] C.T.C. 186 at 189; 74 D.T.C. 6176 at 6179 (F.C.T.D.) per Mahoney, J.

In certain cases when a taxpayer is presented with several options on how to structure a transaction for a minimum tax result and he chooses a particular course of action he accepts some risk that the scheme he has elected to follow may not be in accordance with the law and his tax return will be assessed, perhaps with adverse consequences.

The appeals are dismissed.

Appeals dismissed.