John Martens Co Ltd, J M Enterprises Ltd, Falk Enterprises Ltd, Kencar Enterprises Ltd, John Martens (Sask) LTD v. Minister of National Revenue, [1981] CTC 2857, 81 DTC 665

M J Bonner:—The assessments under appeal are based on a direction made by the respondent under subsection 247(2) of the Income Tax Act that the following corporations be deemed to be associated with each other for the 1974 and 1975 years:

There are nine appeals. Each company appeals from its assessment for each year save for Engerprises which appeals from its assessment for 1974 only. The appeals were heard together on common evidence.

At the end of 1971:

(a) John Martens Jr. held 100% of the issued shares of Enterprises, which held 80% of the shares of the Manitoba company.

(b) Enterprises held an 80% interest in a partnership, John Martens (Ontario) Co (hereinafter called “the partnership”).

(c) The remaining 20% of both the shares of the Manitoba company and the partnership were held by the Falk company, the issued shares of which were held by Erdman Falk, his wife Frieda, and his son Gordon. Frieda Falk is the sister of John Martens Jr.

(d) The Manitoba company carried on the business of a wholesale distributor of sporting goods. It did so from warehouse premises in Winnipeg. Salesmen employed by it called upon customers in Manitoba, in Thunder Bay and, on an irregular basis, in Saskatchewan and Alberta. The Manitoba company distributed catalogues to customers enabling them to place mail orders with it.

(e) The partnership carried on a similar business from premises in Ken- ora. Its salesmen travelled in northwestern Ontario, save for Thunder Bay. The partnership also distributed catalogues. The catalogues were common to both the partnership and the Manitoba company but they indicated what goods were stocked in Winnipeg only and not in Kenora.

(f) The building occupied by the Manitoba company was owned by Ken- car. Each of two trusts, one for the son of John Martens Jr. and one for his daughter, held 50% of the shares of Kencar. The trustees in one case were accountants for John Martens Jr and in the other case they were his lawyers.

The sporting goods business was founded by John Martens Jr (hereinafter referred to as “JMJ”) in 1947. JMJ supplied the entrepreneurial ability and drive which resulted in the success of that business. A company of which JMJ and his father were the principal shareholders (hereinafter called “the old company”) supplied the capital necessary to start the business. Accordingly the old company carried on the business. An expansion of the business into northwestern Ontario was effected by means of a partnership between JMJ and his father to prevent the sisters of JMJ from obtaining such benefit from the expansion as they would have derived by virtue of the shares which they owned in the old company.

The father planned that his estate be divided equally among his three children. One daughter had made no contribution to the business. Frieda Falk had made no contribution. Her husband Erdman was employed in the business but he was not regarded by JMJ as having made any significant contribution to its success. In the early 1960’s the Manitoba company acquired the sporting goods business from the old company by a transaction designed by JMJ to limit participation by the Falk family interests to 20% and to eliminate participation by the other sister and her family. The Manitoba company’s parent, Enterprises, also acquired the 80% share in the partnership formerly owned by JMJ. The December 1971 structure outlined above was the result.

In the late 1960’s and early 1970’s JMJ concluded that the Manitoba company was not getting its “fair share” of the wholesale sporting goods market in Saskatchewan and Alberta. Furthermore the Winnipeg warehouse was becoming crowded. In 1969 the general manager of the Manitoba company, Mr Purves, prepared a memo outlining his “thoughts on split of company”. In it he outlined the advantages and disadvantages of several courses of action. They included splitting the company into two organizations, one for hunting equipment and the other for sporting goods, and the opening of the new branch in either Edmonton, Saskatoon or Thunder Bay. A decision was made by JMJ to incorporate a company in Saskatoon. JMJ then appointed Tom Zaluski, who at the time was a salesman employed by the Manitoba company, to the position of general manager of the Saskatchewan operation. Warehouse premises were leased in Saskatoon on January 27, 1972 by the Manitoba company. The Saskatchewan company had not at that time been incorporated. Subsequent leases were taken by the Saskatchewan company. The Saskatchewan company commenced business in the summer of 1972. It had been incorporated in March 1972. At all material times its sole beneficial shareholder was Violet Martens, wife of JMJ. JMJ however was its president for two years until, as he said, all the legal papers were signed. He explained “my wife . . . wanted to know whatever the documents were and whether she was signing her life away and it just took too long to explain it to her. ..”

JMJ gave evidence regarding his decision to make his wife Violet sole shareholder. There were he said several reasons. First he said that he wanted to “freeze” Erdman Falk out of the growth. Mr Falk’s performance was “a real irritant”. JMJ therefore instructed the accountants and lawyers that neither Mr Falk nor his family was to be permitted to hold shares in the Saskatchewan company. Secondly, Mrs Martens had no real assets of her own and it was time he said that “we moved some that way”. Further JMJ wished to freeze his estate to some extent, his objective being to save succession duties. He said that he wanted to “divest himself of growth”. It is plain that Mrs Martens, who did not testify, had virtually nothing to do with either the decision that a sporting goods business should be carried on from a location west of Winnipeg or with the decision that the business would be that of a company of which she was the sole shareholder.

JMJ’s estate planning objectives at the end of 1971 included the transfer of assets, particularly growth assets, to his children. It was intended that Kencar would hold “all real estate”. Some years later it in fact acquired a 90% interest in the warehouse property in Kenora used by the partnership and as well the building occupied by the Saskatchewan company. In 1971 however Kencar was experiencing cash flow problems. Its rental income from the Manitoba company was not enough to cover the carrying costs of the Winnipeg building which it owned and leased to the Manitoba company. Thus, according to JMJ, it was decided that Enterprises would sell its 80% interest in the partnership to Kencar in order to meet the estate planning objectives and to alleviate the cash flow problem.

While both JMJ and Mr Newman, the chartered accountant who acted for and advised JMJ in connection with the 1971-72 reorganization, testified that the named reasons were the reasons for the transactions, it seems unlikely that cash flow was a very important primary reason. Ronald Cinch, one of the assessors who was responsible for making a recommendation that the ministerial direction in question here be made, gave unchallenged testimony that at no time prior to the hearing had the cash flow been raised in representations made on behalf of the appellants as to the reasons for the sale of the partnership interest to Kencar. The sale was accomplished by agreement dated December 31, 1971. No attempt was made to suggest that the decision to effect the transaction between Enterprises and Kencar was made by anyone other than JMJ.

I do not find that the reasons advanced in evidence for the incorporation of the Saskatchewan company as a separate corporation are particularly persuasive. It was suggested by JMJ that sporting goods dealers (retailers) prefer to buy from a company identified with the province in which they do business. No serious attempt was made to create an image of the Saskatchewan company as a corporate native son of the province. The catalogues for 1973 and 1975 for example were entitled in bold print “John Martens Co Ltd, Wholesale Sporting Goods”. Below that the print indicated that the head office was in Winnipeg and that there were “offices” in Kenora and Saskatoon. The 1975 catalogue differed from the 1973 only in that it described the Kenora operation as an “agency”. Furthermore “Trade News and Monthly Specials”, being a circular distributed by the Manitoba company, the part-

March 20, 1978

Revenue Canada, Taxation,

36 Adelaide Street East,

Toronto, Ontario.

Att: Mr. Ft. Blackman

Gentlemen:

Re: Gerald A. Sian

1976 Income Tax Return

Please be advised that the partners of our firm unanimously agree that the amount of $22,526 allocated to Gerald Sian in our January 31, 1976 “Statement of Income” is properly considered a deduction from income for purposes of allocation of profits to the remaining partners. This amount represents Mr. Sian’s share of work in progress at January 31,1975 and as such represents a share of partnership profits.

If there is any further information you require in connection with the above, please do not hesitate to contact the writer.

It would appear, therefore, that Starkman et al allocated the sum of $12,695.03 on account of the balance of the appellant’s capital account in the partnership as at January 31, 1975. By unanimous agreement between themselves (exclusive of the presence and knowledge of the appellant) Starkman et al allocated as the appellant’s share of income of the partnership, the amount of $22,526 In their financial statement for the fiscal period of the partnership ending January 31, 1976. It was the appellant’s contention that the $22,526 allocated by the partnership, as work in progress, should have been on capital account as opposed to income. To this the respondent counters that the appellant received the sum of $22,526 by the agreement of the members of the partnership to allocate to the appellant the share of the income of the partnership in respect of the fiscal period of the partnership ending January 31, 1976 and, therefore, such amount was properly included in computing the appellant’s income for his 1976 taxation year, by virtue of subsection 96(1.1) of the Income Tax Act, SC 1970-71-72, c 63, as amended.

Issue

The issue is whether the payment of $22,526 designated as “work in progress” by the partnership of Starkman et al in its 1976 financial statement was a pay out of the appellant’s capital interest in the partnership as of the end of the fiscal year of the partnership January 31, 1975 or whether it was income to the appellant in 1976. In assessing the appellant, the respondent relied, inter alia, upon section 3, paragraph 34(1 )(d), sections 96, 98.1 and paragraph 111 (1 )(b) of the Income Tax Act.

Findings

The governing section is section 96, subsection (1.1) of which reads as follows:

(1.1) For the purposes of subsection (1) and sections 101 and 103

(a) where the principal activity of a partnership is carrying on a business in Canada and the members thereof have entered into an agreement to allocate a share of the income or loss of the partnership from any source or from sources in a particular place, as the case may be, to any taxpayer who at any time ceased to be a member of

(i) the partnership, or

(ii) a partnership that at any time has ceased to exist or would, but for subsection 98(1), have ceased to exist, and either

(A) the members thereof, or

(B) the members of another partnership in which, immediately after that time, any of the members referred to in clause (A) became members

have agreed to make such an allocation or

or to his spouse, estate or heirs or to any person referred to in subsection (1.3), that taxpayer, his spouse, estate or heirs, or that person, as the case may be, shall be deemed to be a member of the partnership; and

(b) all amounts each of which is an amount equal to the share of the income or loss referred to in this subsection allocated to a taxpayer from a partnership in respect of a particular fiscal period of the partnership shall, notwithstanding any other provision of this Act, be included in computing his income for the taxation year in which that fiscal period of the partnership ends.

There are other sections in the Income Tax Act, of course, dealing with the interest of a retiring partner from a partnership business or profession, but I am drawn back to the provisions of subsection 96(1.1) as being the relevant section in this appeal.

The appellant quoted extensively from Interpretation Bulletins, issued by the Department of National Revenue, but I feel that his interpretation of such Bulletins was not correct. In a nutshell he felt that he should have been involved in any allocation agreement whereby the partnership should have treated the amount of $22,526 as a capital interest as opposed to income interest to him as a retiring partner in that the allocation agreement was entered into unilaterally by the remaining partners at a “meeting” in the absence of and without the appellant taking part in their “deliberations”. The appellant felt that the remaining partners had treated him unfairly and in a cavalier fashion by making the allocation referred to above and that their unilateral allocation agreement was not binding upon him.

On the other hand, counsel for the Minister relied completely upon section 96, stating that it was a deeming provision and that the meaning of that section was that an agreement made between the existing partners of the partnership after the retirement of the appellant enabled them to determine whether the appellant’s remaining interest in the partnership was income or capital. The respondent contends that the section does not contemplate that the former member has to participate or be a party to the allocation agreement. The agreement is merely to allocate and then the former partner should be involved. In paragraph 96(1.1)(a) the relevant words are: . . that taxpayer . .. shall be deemed to be a member of the partnership;”. Then paragraph (b) comes into play whereby “. . . all amounts each of which is an amount equal to the share of the income or loss referred to in this subsection allocated to a taxpayer from a partnership in respect of a particular fiscal period of the partnership shall, notwithstanding any other provision of this Act, be included in computing his income for the taxation year in which that fiscal period of the partnership ends”. In that the allocation was made in the fiscal period of the partnership ending January 31, 1976, moneys paid to the appellant in 1976, exclusive of this capital interest, would be income to him in 1976.

It would have been so much more simple, equitable, fair and just for the remaining partners to have allocated the full amount of the adjusted cost base of $35,221 to the appellant as his total capital interest in the partnership as it existed January 31, 1975. They chose to do otherwise for their own personal tax positions. That under the law was their prerogative. A partnership break-up, like a marriage, is not a happy event and sweet reason and fairness are generally conspicuous by their absence. I am bound by the provisions of the Income Tax Act and for the reasons given above, I must dismiss the appeal.

Appeal dismissed.