Thiele Drywall Inc. v. Her Majesty the Queen, [1996] 3 CTC 2208 (Informal Procedure)

Rip J.T.C.C.: — Thiele Drywall Inc., the appellant, has appealed (Informal Procedure) assessments of income tax for its 1990 and 1991 taxation years in which the Minister of National Revenue (“Minister”) disallowed its claim for the deduction of legal expenses of $1,265 in 1990 and $32,563 in 1991 in computing its income for each of those years. The Minister assessed on the assumptions that the disallowed legal expenses were not incurred for the purpose of gaining or producing income from a business or property in accordance with paragraph 18(l)(a) of the Income Tax Act (“Act”) and were not incurred in connection with the appellant’s dry wall business in the normal course of its income earning activities. The respondent also relies on section 9 and paragraph 60(o) of the Act. The appellant states the legal expenses were deductible under section 9 of the Act and the deductions thereof are not prohibited under any other provision of the Act.

The legal expenses were incurred by the appellant to defend itself against charges brought under paragraph 239(1 )(d) of the Act that it evaded or attempted to evade payment of tax in 1987 and 1988. The appellant pleaded guilty to participating in a scheme to falsely record payments it made to certain individuals as reimbursements for expenses rather than income and also failed to withhold and remit tax in respect of the payments. The Agreed Statement of Facts produced during the trial of the tax evasion charges was produced at the tax appeal and served the same purpose in this hearing. The following are excerpts from the Agreed Statement of Facts which may assist the reader in understanding what lead to the criminal charges:

1. Thiele Dry wall (1981) Ltd. was a Canadian- controlled private corporation, incorporated under the laws of Alberta. As a result of amalgamation, the corporation became Thiele Dry wall Inc. (the “corporation”) on December 1, 1988. The corporation maintained offices in Edmonton and Calgary, its head office being in Calgary. During the period in question (January 1, 1987 to November 30, 1988), the corporation was in the business of residential and commercial dry wall construction.

2. During the period in question, the corporation had two Directors, Arnold F. Thiele and Delva J. Thiele. Arnold F. Thiele was the majority shareholder of the corporation, holding approximately 80% of the shares. Arnold Thiele had been involved in the drywall industry for over 30 years and was a knowledgeable businessman as a result of his experiences in the industry.

MOTIVATION BEHIND THE SCHEME:

3. In 1985 Alberta’s economy, including the construction industry, was experiencing a very slow period. At the same time, the construction industry in southern Ontario was booming. Under these circumstances, the corporation opened its Mississauga operation in 1985.

4. As a result of the boom, the Mississauga operation experienced a constant manpower shortage from its outset. This manpower shortage situation put employees in a position of being able to insist on overtime work.

5. While employees wanted the financial benefits of overtime work, the Corporation was not prepared to pay employees more than straight time, for such work. During this same period, the Corporation began experiencing heavy financial losses, particularly in its Mississauga operations.

6. As an alternative to paying time and one half, as the union contract called for, the Corporation devised a scheme which would accommodate the interests of both the employees and the Corporation, thereby addressing the labour problem without increasing its labour costs.

OVERVIEW OF SCHEME:

7. This scheme was devised in the corporation’s head office in Calgary. While the scheme was a management decision, it relied on an extensive network of individuals throughout the Corporation for its successful implementation. The scheme required the involvement of both management and personnel, in both the Calgary and Mississauga offices.

8. While the Mississauga employees were not coerced or required to participate in this scheme, it was understood by all Mississauga employees that this was the only way in which overtime would be paid. They did not have the option of working overtime and being paid the union rate of one and a half times the standard hourly pay.

9. While the workers did not receive time and one half or double time for overtime worked, their net after tax position remained approximately the same under this scheme as it would have been had they been paid time and a half for overtime, and the entire amount subject to tax deductions. This outcome was only possible because straight time pay for overtime work was characterized and paid out as expenses. There was awareness on the part of management and employees alike that this would be the effect of the scheme.

DETAILS OF THE SCHEME:

12. The characterization of overtime payments as expenses was a false and deceptive method employed to circumvent the income tax system, in contravention of subsection 239(1 )(d) of the Income Tax Act.

13. As a result of this mischaracterization of the payments, these payments were not subject to source deductions for tax, CPP or UI, as standard overtime payments would have been. Nor were these amounts included in earnings on employee T4 slips. It was understood by the employees that this would be the case.

14. While information uncovered in the course of the investigation indicated that files containing records of individual employee overtime hours were kept by the Corporation, a search conducted on the corporation’s Head Office on July 10, 1990, pursuant to search warrant, failed to uncover any records relating to overtime hours. Nor were the original timecards or copies found.

15. This scheme of paying overtime in the form of expenses is noticeably distinct from the corporation’s strictly enforced method for handling legitimate expenses. All legitimate expenses incurred by employees (e.g., for out of town travel or supplies), had to be supported by receipts and vouchers. These vouchers were generally attached to the back of the time card.

BENEFITS TO THE CORPORATION:

16. Substantial financial gain accrued to the corporation, which benefitted the corporation directly, in terms of a more favourable cash flow during a financially difficult period.

17. The overall benefit to the Company was by paying lower wages than those stipulated by the Union as overtime rates, and concomitant savings with respect to vacation pay, and the corresponding CPP, WCB, Union dues and UI payable on overtime in those instances where the employee would not have otherwise reached the statutory maximums for CPP, WCG, UD and UI, amounting to a total benefit to the Company of approximately $400,000.00.

FINDINGS OF THE INVESTIGATION:

20. The investigation resulted in the finding of the following facts: for 1987 and 1988 combined

a) Total Employees Involved - 70 in 1987; 84 in 1988;

b) Total Unreported Wages Subject to Prosecution - $537,198.98;

c) Total Federal Tax Evaded - $119,065.25.

IMPACT OF THE INVESTIGATION ON EMPLOYEES:

21. The investigative and audit work lead to the issuing of civil reassessments on the former employees involved. The amount of these reassessments totalled $215,590.20 in taxes and interest for 1987 and $279,890.15 for 1988, for a combined total of $495,480.35 for the period in question. The employees were only reassessed for Federal and Provincial taxes and accrued interest. No civil or criminal penalties were levied.

IMPACT OF INVESTIGATION ON CORPORATION:

22. The Corporation’s tax position was not altered by this scheme, since the amounts paid to the employees were a deductible expense for the corporation, whether paid as overtime wages or as expenses. As a result, the corporation had not been reassessed for any additional tax in this matter. Nor have any civil penalties been levied.

Issue

The issue before me is whether the appellant is entitled to deduct the legal expenses disallowed by the Minister in computing income from a business under Part I of the Act for its 1990 and 1991 taxation years, that is, whether the legal expenses paid by the appellant to defend itself against fines imposed by subsection 239(1) of the Act were incurred for the purpose of gaining or producing income from its business.

Statutory Provisions

Subsection 9(1) of the Act states that:

(1) Subject to this Part, a taxpayer’s income for a taxation year from a business or property is his profit therefrom for the year.

Paragraph 18(1 )(a) provides that:

(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;

Appellant’s Submissions

The appellant submitted that the determination of profit for purposes of subsection 9(1) of the Act is a question of law and is based on “well accepted principles of business (or accounting) practice” or “well accepted principles of commercial trading”. Paragraph 18(l)(a), appellant’s counsel declared, confirms the “business test” for taxable profit and reinforces the point that subsection 9(1) is a legal test rather than an accounting test. He referred to Iacobucci J.’s comments in Symes v. R. (sub nom. Symes v. Canada), [1993] 4 S.C.R. 695, [1994] 1 C.T.C. 40, 94 D.T.C. 6001, at pages 723-24 (C.T.C. 51-2, D.T.C. 6009-10).

Appellant’s counsel stated that in “modern cases”, paragraph 18(1 )(a) has been interpreted narrowly and the threshold for deductibility has thereby been lowered. He cited Symes, supra, for the authority that the purpose of the expense rather than the result of the expense is determinative and that the purpose test is subjective. At page 86 (D.T.C. 6013) lacobucci J. explained:

...All of these tests include some reference to the purpose of an expense. In considering the extent to which a purpose test is appropriate, I wish to make note of the decision of Wilson, J. in Mattabi Mines Ltd. v. Ontario (Minister of Revenue), [1988] 2 S.C.R. 175. Therein, Wilson, J. considered a taxation provision substantially similar to section 18(l)(a), she examined jurisprudence on section 18(l)(a), and she came to the following conclusion (at page 189):

The only thing that matters is that the expenditures were a legitimate expense made in the ordinary course of business with the intention that the company could generate a taxable income some time in the future.

In making this statement, and in proceeding to discuss an interpretation bulletin reference to the “income-earning process” (at pages 189-90), Wilson, J. was not considering the personal versus business expense dichotomy. Instead, she was rejecting both the need for a causal connection between a particular expenditure and a particular receipt, and the suggestion that a receipt must arise in the same year as an expenditure is incurred. Her reference to the “ordinary course of business” is merely a reflection of these other conclusions. It is not a rejection of the idea that section 18(l)(a) focuses upon purpose, nor does it signal her acceptance of an “income-earning process” test intended to distinguish analytically between personal and business expenses. Indeed, in this regard, it is instructive to note Wilson, J.’s reference to the “intention” of the taxpayer.

Appellant’s counsel concluded from the Symes, supra and Tonn, infra, decisions that expenses incurred in a commercial setting that have an income earning purpose, in a general sense, are deductible under subsection 9(1) so long as the deduction is not prohibited under paragraph 18(1 )(a) of the Act. Counsel maintained that although the activities of the appellant were found to be illegal, they were an integral part of its day-to-day operations and income earning process. This, he opined, is confirmed from the following agreed facts:

(a) amounts paid to the employees were deductible expenses for the appellant notwithstanding the illegality of the scheme;

(b) the scheme was motivated by commercial difficulties encountered by the appellant in the course of carrying on its business;

(c) the scheme relied, for its successful implementation, on an extensive network of individuals throughout the corporation in both provinces in which the appellant carried on business;

(d) the scheme impacted upon how the appellant related to its employees, how the appellant recorded employee time sheets and how the appellant remunerated its employees;

(e) substantial financial gain accrued to the appellant as a result of the scheme;

and

(f) as a result of the scheme, the appellant was able to reduce its labour costs by paying lower wages to its employees.

A reported case with facts similar to those in the appeal at bar, counsel stated, is Ben Matthews & Associates Ltd. v. Minister of National Revenue, [1988] 1 C.T.C. 2372, 88 D.T.C. 1262. In Matthews, the taxpayer incurred legal expenses in defending itself and a director on charges under subsection 239(1) of the Act of making false and deceptive statements and wilfully evading the payment of taxes. The main difference in the appeal at bar and Matthews is that in Matthews the taxpayer was found not guilty. However, whether the taxpayer is guilty or not should not impact on the deductibility of the legal expenses. In Matthews, I held, at page 2379 (D.T.C. 1267), that the legal expenses incurred to defend the charge under the Act were deductible since the charge arose out of the taxpayer’s business operations. Among the authorities I relied on were Minister of National Revenue v. L.D. Caulk Co., [1952] C.T.C. 1, 52 D.T.C. 1034 (Ex. Ct.); affirmed [1954] S.C.R. 55, [1954] C.T.C. 28, 54 D.T.C. 1011 and Rolland Paper Co. v. Minister of National Revenue, [1960] C.T.C. 158, 60 D.T.C. 1095 (Ex. Ct.).

Counsel for the appellant distinguished the facts in the appeal at bar from those in Cormier v. Minister of National Revenue, [1989] 1 C.T.C. 2092, 89 D.T.C. 44. In Cormier, Kempo T.C.C.J. found that the failure to declare income was not a normal business activity carried out in the course of the taxpayer’s business operations or which had been carried out for the purpose of gaining or producing income from a business. The legal expenses to defend the charges of tax evasion were held not to be deductible. Counsel declared that appellant’s illegal activities were carried out in the appellant’s income producing process and were part of its normal business operations. Counsel also distinguished Sommers v. R. (sub nom. Sommers v. Canada), [1993] 2 C.T.C. 3122, 93 D.T.C. 1489 (T.C.C.).

With respect to what constitutes normal business operations, appellant’s counsel referred to Commissioner of Internal Revenue v. S.B. Heininger, 44-1 USTC 14, a decision of the United States Supreme Court. In that case, the taxpayer was a dentist that made false teeth and sold them through a mail order business. The taxpayer incurred legal expenses in an unsuccessful attempt to overturn a fraud order instituted against him by the Post Office Department in respect of fraudulent misrepresentations made by the taxpayer in his advertising. In order that the expenses be deductible, the taxpayer had to establish that the expenses were “ordinary and necessary expenses” of his business. In finding for the taxpayer and holding that the legal expenses were deductible, Mr. Justice Black, at page 15, said:

The government does not deny that the litigation expenses would have been ordinary and necessary had the proceeding failed to convince the Postmaster General that respondent’s representations were fraudulent. Its argument is that dentists in the mail order business do not ordinarily and necessarily attempt to sell false teeth by fraudulent representations as to their quality; that respondent was found by the Postmaster General to have attempted to sell his products in this manner; and that therefore the litigation expenses, which he would not have incurred but for this attempt, cannot themselves be deemed ordinary and necessary. We think that this reasoning, though plausible, is unsound in that it fails to take into account the circumstances under which respondent incurred the litigation expenses. Cf. Welch v. Helvering, supra, 113, 114. Upon being served with notice of the proposed fraud order respondent was confronted with a new business problem which involved far more than the right to continue using his old advertisements.

Counsel also added where deductions have been disallowed for reasons of public policy, the cases distinguish between deductions of fines and penalties and the deduction of associated legal expenses. His authority was King Grain and Seed Co. v. Minister of National Revenue, 61 D.T.C. 322 and Commissioner of Internal Revenue v. W.F. Tellier, 66-1 USTC 85, 672, a decision of the United States Supreme Court.

Counsel concluded that the activities of the appellant which lead to its conviction were undertaken to increase the appellant’s profits from a business. The activities leading to the conviction involved the payment of wages through a guise without withholding statutory deductions. The costs incurred to defend those activities is a direct result of the activities and are deductible in computing the appellant’s income.

Respondent's Submissions

The respondent’s submission in brief, is that the criminal activities of the appellant were not undertaken in the normal course of its income earning operation. Therefore, the legal expenses are not deductible.

In the Reply to the Notice of Appeal the respondent acknowledged the appellant gained financially from the scheme. However, said her counsel, “just because” a corporation benefits “does not mean it earns income”. One of the ways the appellant gained financially was that it failed to remit statutory source deductions. Hence, by not remitting money, the appellant retained the money for its own benefit. As far as computing income from its business is concerned, the money paid purportedly for overtime was allowed as a deduction since it was paid for labour.

Analysis

In 1947 Thorson P. held that payments of damages and costs were deductible by a taxpayer when the negligence resulting in the damages was a normal and ordinary risk and incidental to the taxpayer’s business: Imperial Oil Ltd. v. Minister of National Revenue, [1947] 3 D.T.C. 1090 (Ex. Ct.). Imperial Oil Limited (“Imperial”) was engaged in the manufacture, transportation and marketing of petroleum products and operated a fleet of 20 oil tankers. One of the tankers collided with and sank another vessel. The owners of the other vessel sued for damages, and the claim was settled. Imperial deducted the settled amount as an expense in the year the case was settled and the Minister denied the deduction. At page 1096, Thorson P. noted that the issue of fact was “whether the payment made was in respect of a liability for a happening that was really incidental to the business” and in his view, it was. The president stated:

… that the risk of collision between vessels is a normal and ordinary hazard of marine operations generally, and that, while the amount of the appellant’s liability in the present case was unusually large, there was nothing abnormal or unusual about the nature of the collision itself. Negligence on the part of the appellant’s servants in the operation of its vessels, with its consequential liability to pay damages for a collision resulting therefrom, was a normal and ordinary risk of the marine operations part of the appellant’s business and really incidental to it.

The Federal Court of Appeal adopted the test of avoidability of offenses leading to fines and penalties, and thus the avoidability of taxes and penalties, in the reasons for judgment in Amway of Canada Ltd. v. R. (sub nom. Amway of Canada Ltd. v. Minister of National Revenue), 193 N.R. 381, 96 D.T.C. 6135 (F.C.A.), per Strayer A.J., at page 6141. However, Strayer A.J. was reluctant to pronounce a more general rule concerning the deductibility of other types of expense. The question, according to Strayer A.J.:

is not: could the taxpayer have run his business more cheaply? It is: could the taxpayer have reasonably been expected to run his business in consistent conformity to this kind of law?

In the Amway case, the appellant adopted a deliberate and elaborate scheme for defrauding Revenue Canada of large sums by falsifying the value of goods it imported into Canada. The Crown took several actions against Amway, and eventually a final settlement was reached. Amway paid Revenue Canada $45,000,000, of which $7,900,000 was in respect of payments of duties and taxes and therefore deductible. The remaining sum, according to the Minister, represented non-deductible penalties. The Federal Court of Appeal agreed with the Minister. Strayer A.J. stated, at page 6141:

On the facts of the present case it would have been impossible for the trial judge to have concluded that this deliberate and fraudulent scheme to avoid payment of higher duties and taxes to the revenue of Canada was an unavoidable incident in the operation of Amway’s business of importing goods and selling them in Canada. There was nothing to suggest that this was other than an intentional and cynical scheme to mislead Canadian customs officials as to the value of the goods ... Nor was any evidence brought to our attention that the nature of the taxpayer’s business was such that chronic undervaluation of its goods for importation purposes was unavoidable.

And later, on the same page,

... a fine or penalty cannot be considered to have been incurred for the purpose of producing income unless in all the circumstances the incurring of the fine or penalty must be seen as an unavoidable incident of carrying on the business.

The question for me to decide, then, is whether the appellant’s evasion to comply with the Act was a normal or ordinary incident of carrying on its business. If so, the legal costs of defending the action, whether the appellant was guilty or not, is deductible; if not, then the costs are not deductible. In my view they are not.

Where the courts have allowed appeals to permit the taxpayers to deduct legal expenses, the expenses were incurred in accordance with sound accounting and commercial practices and were incurred to defend the taxpayers’ trade practices in the conduct of their businesses and to preserve the systems that helped produce their incomes: Caulk, supra, and Rolland Paper, supra. The legal expenses in Heininger, supra, also related to a taxpayer’s way of doing business. The decision in Tellier, supra, is not relevant to the appeal at bar since the United States Tax Code at the time “allowed as a deduction all the ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business ...” [26 U.S.C. paragraph 162(a)], a much wider scope than “expenses made or incurred for the purpose of gaining or producing income from the business ...” [paragraph 18(l)(a) of the Act].

In Tonn v. R., [1996] 1 C.T.C. 205, 96 D.T.C. 6001 (F.C.A.), Linden J.A. described how paragraph 18(l)(a) is to be interpreted. At page 212 (D.T.C. 6005), he said:

... paragraph 18(l)(a) is to be read in light of subsection 9(1). The paragraph 18(l)(a) reference to income must therefore be read as a reference to net income, or profit. Taken as such, paragraph 18( l)(a) sets out a deductibility test quite similar to that implicit in subsection 9(1). Wilson, J., in Mattabi Mines Ltd. v. Ont. (M.N.R.), has called the former a “general purpose or intention test” for deductibility. ([1988] 2 S.C.R. 175, [1988] 2 C.T.C. 294 at 189 (C.T.C. 301)). To be deductible according to paragraph 18(l)(a), an expense must have been incurred with the intention of producing profit. In other words, the expense must have been incurred within a business framework, bearing some relation to the income earning process. I might mention in this context that such intention, strictly speaking, is subjective; no requirement of objective reasonability is expressly imposed by the section.

The scheme devised by the appellant was executed in the course of carrying on its business and, in a general sense, was for the purpose of gaining or producing income from the business. The business required labour to work overtime but the appellant was not prepared to pay labour more than normal hourly rates. By pretending to reimburse expenses, the appellant managed to have its employees work the additional hours and, as a result, gain income from the business. But is this sufficient for the appellant to succeed in its appeal?

For expenses to be deductible, the Caulk and Rolland Paper cases, supra, require the activities in which expenses were incurred be carried on in the normal course of the taxpayer’s income earning operations.

As I wrote in Matthews, supra, at page 1268:

Where a business carries out activities in the normal course of its operations, and the cost of those activities is deductible in computing the income of the business, any expense incurred to defend those activities is a direct result of the activities themselves and is permitted by paragraph 18(1 )(a) to be deducted: vide The Queen v. Phyllis B. Bronfman Trust, (supra). The legal expenses in the case at bar were incurred to defend a prosecution against the appellant which arose directly from the practice of preparing financial statements in the normal course of business.

Expenses of activity taking place after profits have been earned are usually not deductible: see, for example, Parkland Operations Ltd. v. R., (sub nom. Parkland Operations Ltd. v. Canada), [1991] 1 C.T.C. 23, 90 D.T.C. 6676 (F.C.T.D.), Cormier, supra, and Sommers, supra. On the facts of this appeal, the activities generated by the scheme were undertaken during the appellant’s income earning stage.

In Matthews the financial transactions in issue were fully recorded in the taxpayer’s books of account. In the case at bar, the activities leading to the fines were not in accord with the appellant’s established practice; for example, the purported reimbursement of expenses was not done according to established and normal practice: see paragraphs 14 and 15 of the Agreed Statement of Facts. The payment to employees of money characterized as expenses, when in fact the payment was for services, is not, in my view, a normal business activity undertaken by the appellant. The parties agree that “the characterization of overtime payments as expenses was a false and deceptive method to circumvent the tax system”. The scheme, coupled with the deceit and illegality required for its existence, was not part of the normal income earning process of the appellant’s business. The fine imposed by subsection 239(1) cannot be considered to have been incurred for the purpose of producing income unless it can be proven -and it was not - that in all the circumstances the incurring of the fine was an unavoidable incident of carrying on the business. Appellant’s counsel argued the Minister allowed the appellant to deduct, in computing its income, the amounts of purported expenses that were reimbursed. This is so, but in allowing the expenses the Minister, I assume, considered the amounts to be employees’ wages.

The deductions of the legal costs are not sanctioned by subsection 9(1) since these costs were not incurred in the ordinary course of the appellant’s business. The purpose of the expense was not to defend the appellant against a charge bearing a relation to the appellant’s income earning process. The legal expenses to defend the fines were not incurred for the purpose of gaining or producing income from a business within the meaning of paragraph 18(1 )(a).

The appeals are dismissed.

Appeals were dismissed.