Harold Levy, Ernest Levy and Sheldon Clavir Lepovsky v. Minister of National Revenue, [1979] CTC 2254, 79 DTC 219

Delmer E Taylor:—These appeals were heard at the City of Toronto, Ontario, on November 8, 14 and 15, 1978, and deal with income tax assessments for the taxation years 1971, 1972 and 1973 in which the Minister of National Revenue increased the reported taxable income of the appellant by amounts of $2,022, $5,830 and $5,480 respectively, representing “benefits or advantages conferred on the taxpayer by a corporation of which he was a shareholder”. The respondent, in replying to these appeals, relied inter alia upon subsection 8(1) of the Income Tax Act, RSC 1952, c 148 and amendments thereto, and upon subsection 15(1) of the Income Tax Act, SC 1970-71-72, c 63 and amendments thereto. These appeals, together with those of Sheldon Clavir Lepovsky (also known as Sheldon Leonard) and Ernest Levy, for the years 1971,1972,1973 and 1974, were heard on common evidence.

Facts

On or about August 1, 1966, Ernest Levy and Howard Levy commenced carrying on the business of manufacturing, selling and installing drapes and drapery tracks, and selling household furnishings, in partnership under the firm name and style of Cousins Drapery Track (hereinafter referred to as “Drapery”). On or about April 10, 1970, Ernest Levy, Howard Levy and Sheldon Leonard commenced carrying on the business of interior decorators and the selling and installing of carpets and broadloom in partnership under the firm name and style of Cousins Interiors (hereinafter referred to as “Interiors”). Both of these businesses continued in this style through the taxation year 1971. In 1971, Cousins Interiors Limited (hereinafter referred to as the “Company”) was incorporated, and the amounts at issue in these appeals were payments made to the appellant arising from arrangements made by the Company with Drapery and Interiors.

Contentions

It was the position of the appellant that:

— both partnerships earned substantial profits in all of the taxation years up to 1971.

—on or about July 12, 1971, Drapery and Interiors were sold to the Company for a total sale price of $40,000.

—the assets of Drapery and the assets of Interiors were collectively referred to as the “goodwill” of the said partnerships. The said assets collectively referred to as “goodwill” included the following:

(a) the assignment of all rights to use the trade names of the said partnerships;

(b) the assignment and transfer of all customer lists and other essential sales information of the said partnerships;

(c) other intangible business assets;

and

(d) the accounts receivable and other current assets of the said partnerships;

(e) the inventories of the said partnerships;

(f) the fixed assets of the said partnerships, including all furniture and fixtures, automobiles and leasehold improvements;

less

(g) current liabilities of the said partnerships.

—The fair market value of the said “goodwill” of Drapery and Interiors was not less than $40,000.

—The purchase by the Company of Drapery and Interiors was a bona fide business transaction, entered into for bona fide business reasons.

—The purchase of the “goodwill” constituted a purchase of capital assets of a lasting and enduring nature, which accrued to and for the benefit of the Company.

—The amounts of $2,022, $5,830 and $5,480 were payments to the appellant for the sale of the appellant’s ownership interest in Drapery and Interiors.

—The said amounts were paid by the Company to the appellant in his capacity as one of the vendors of Drapery and Interiors, and in his capacity as an unsecured creditor of the Company and not, in any way related to his capacity as a shareholder of the Company.

—The amounts did not constitute a benefit or advantage conferred on the appellant by the Company.

— In the alternative, if any benefit or advantage was conferred on the appellant by the Company, which allegation is specifically denied, then the appellant says that pursuant to the provisions of section 15 of the Income Tax Act, the “value” of the benefit or advantage must be computed and included in computing the appellant’s income in the taxation year in which the benefit was so conferred, namely the appellant’s 1971 taxation year, and not in any subsequent taxation year.

For the respondent it was contended that:

—at the time the assets of Drapery and Interiors were allegedly sold to the Company, the appellant did not transfer any goodwill because there was no goodwill in existence capable of being transferred.

—The Company in paying $2,022, $5,830 and $5,480 to the appellant during the taxation years in question, in respect of the alleged goodwill, conferred a benefit or advantage on the appellant, a shareholder of the Company.

—The payments in respect of the alleged goodwill were not pursuant to a bona fide business transaction.

—The benefits or advantages which were taxed in the 1972 and 1973 taxation years, were conferred on the appellant in those taxation years.

Evidence

During the examination-in-chief of Mr Ernest Levy (a partner during the relevant years, and also now an appellant), the following documents were introduced as evidence:

A-1—Copy of “Declaration of Partnership” re: Interior Decorators and Cousins Drapery Track, dated February 15, 1967.

A-2—Copy of “Declaration of Dissolution of Partnership” re: Interior Decorators and Cousins Drapery Track, dated May 29, 1968.

A-3—Copy of “Declaration of Partnership” between Interior Decorators and Cousins Drapery Track, dated May 29, 1968.

A-4—Copy of “Declaration of Partnership” between Interior Decorators and Cousins Drapery Track, dated April 10, 1970.

A-5—Copy of Financial Statements of Cousins Drapery Track as at February 28, 1969, prepared by Starkman, Kraft, Rothman, Berger & Grill, Chartered Accountants, Toronto, Ontario.

A-6—Copy of Financial Statements of Cousins Drapery Track for the year ended February 28, 1970, prepared by Starkman et al, Chartered Accountants, Toronto.

A-7—Copy of Financial Statements of Cousin’s Interiors for the year ended February 28, 1971, prepared by Morris Shack, F Comm A, Toronto.

A-8—Copy of Financial Statements of Cousins Interiors Limited for the year ended February 29, 1972, prepared by Laventhol, Krekstein, Horwath & Horwath, Chartered Accountants, Toronto.

A-9—Copy of “Cousins Interiors Interim Financial Statement for Three Months ended May 31, 1971”, prepared by Morris Shack, F Comm A, Toronto.

A-10—Copy of Cousin’s Interiors Limited Interim Financial Report for Six Months ended August 31, 1971, prepared by Morris Shack, F Comm A, Toronto.

A-11—Same as above with certain notations different.

A-12—Copy of “Certificate of Incorporation” (Province of Ontario) of “Cousins Interiors Limited” on July 12, 1971 —File Number 245454.

A-13—Copy of “ORDER”—In the Supreme Court of Ontario, In Bankruptcy-signed by Registrar on April 19, 1973, with Proposal re Bankruptcy of Cousins Interiors Limited attached thereto.

A-14—Copy of letter dated March 9, 1973 from “The Higgins Company Limited” with documents attached thereto, regarding Proposal in Bankruptcy re “Cousins Interiors Limited”.

In cross-examination, counsel for the respondent introduced the following:

R-1—Copy of Cousins Interiors Limited Financial Statements (Unaudited) for Year ended February 28,1973 (prepared by Winspear, Higgins, Stevenson & Co, Chartered Accountants, Toronto.

R-2—Copy of “1971 T1 General Individual Income Tax Return” of “ERNEST LEVY”, with letter dated February 6, 1973 to District Taxation Office, advising them of a loss and requesting a reassessment accordingly (applying to all three appellants).

This witness described the history of the two partnerships, the business prospects he foresaw, the incorporation of the Company, and the ensuing financial difficulties resulting in a Proposal under the Bankruptcy Act.

Mr Frank M Dupuis, chartered accountant, who had acted for the Trustee under the bankruptcy proposal, gave evidence regarding his efforts which were finally successful in re-establishing the business of the Company after its insolvency. There were two major factors, (1) the commitment of $30,000 by Bigelow Canada Limited (a carpet manufacturer) as funding during the proposal, and (2) the withdrawal of Mr Howard Levy (this particular appellant), taking with him the drapery business. Counsel reviewed with this witness a schedule summarizing the information on Exhibits A-7, A-9 and A-10 above, entitled “Cousins Interiors Limited—Net Assets, as of February 28, 1971, May 31, 1971 and August 31, 1971”, and the document was introduced for information purposes as Exhibit A-15. Exhibit A-16, a letter to Mr Dupuis from Revenue Canada, Taxation, dated December 16,1974 was also filed and it contained this statement:

A review of the financial statements of the above partnership prior to incorporation revealed the existence of no goodwill and accordingly the value of this asset recorded at $40,000 is deemed to be Nil. When the amount of this goodwill is reversed against the regular shareholders’ advance accounts, the balances become loans to the shareholders rather than loans from them, as shown by the corporation’s records. Accordingly the assessments are proposed under Section 15 of the Income Tax Act and section 8 of the former Act.

The appellant in evidence supported the information provided to the Board by Mr Ernest Levy, and noted that although his present drapery business is quite independent of the carpet business, the two work closely together on many projects.

The respondent introduced Mr Frank Hanson, a business evaluator with Revenue Canada, who filed and explained a detailed report dealing with the goodwill valuation claimed by the appellant. This report was listed as Exhibit R-3 and the summary paragraph thereof read:

In our opinion, no commercially transferrable goodwill existed as at July 11, 1971. Given the lack of profits, a financially weak business, and ease of entry, a notional purchaser would be better off looking at alternative businesses or investments or starting his own drapery/carpet retail operation.

The procedures used by Mr Hanson, and the bases for his conclusion, were vigorously attacked by counsel for the appellant in cross-examination.

It should be noted that considerable discussion took place at the hearing between opposing counsel regarding the admissibility of certain of the documents noted above.

Argument and Findings

The argument of counsel for the appellant covered considerable ground in an effort to establish “goodwill”, and although l risk over-simplification by quoting certain portions from it, in my view they present the essential elements:

(Neither) the partners nor their advisors did—distinguish between particular assets being sold one to another, liabilities being transferred one to another. The business sold its entire undertakings. Its financial advisors called it all goodwill. In my respectful submission, that is not a proper conclusion. One cannot possibly conclude that the only thing that was being transferred was the goodwill. What about the corporate name? What about the customer lists? What about all of the financial information of the partnership which would be essential to someone carrying on that business as a going concern? What about the lease? That was duly entered into for 1309 Kennedy Road. What about the lease to the warehousing premises on Nantuckett? What about the accounts receivable? What about the fixed assets? What about the current liability? Everything was transferred. It was all transferred for $40,000.

. . . but I cannot distinguish between the value of individual particular assets.

The valuation of goodwill performed by Mr Hanson is an indication of value using a conservative approach adopted by (the) valuation section of the Department of National Revenue.

The appellant’s position is that it transferred all of its undertakings, all of its business, all of its assets both tangible and intangible, that they had a value and that value was not less than $40,000 and that that value was the value to be ascribed to all of the other assets listed in paragraph 10 of the Notices of Appeal, whether those assets are collectively called goodwill or the sale of the total undertaking of the business.

They sold capital assets and the tax department is now saying they are receiving income for the sale of those capital assets. There is taxation there. Now, when the corporation cannot deduct any payment made on account of its goodwill, it thereby reduces or increases its liability for tax purposes and when it finally does retain earnings and distributes those, the shareholders will be subject to tax again. In my respectful submission, in respect of the same amount or the same amount transferred, namely the $40,000, there would be three levels of taxation. In my submission, the Income Tax would require clear, unequivocal language to impose such a burden on the taxpayer in this type of situation.

. . . There clearly was value in July of 1971. We don’t know exactly what the nature of the value or the exact amount of the value is, but we do know that there is value. It is inconceivable that the business is not worth anything. We have a business that has now been in operation from 1969 to 1978. Every indication is that that business has a value. Surely its present existence today is determinative of the fact that it had value then, not conclusive, but it is an indication. The fact that the $30,000 was paid and funded by a company with which the appellant corporation or rather the corporation did a large volume of business, is also indicative from an arm’s length third party source apart from the taxpayers themselves and the Department of National Revenue which indicates a value. It is inconceivable that Bigelow Canada Limited is in the business of making gifts to people or corporations. They were in the business of making money. They would not put up $30,000 and invest that money in a corporation which was worthless at the time the investment was made. It wasn't only worthless, it was in a negative position. Its liabilities greatly exceeded its assets . . . (Italics mine)

Dealing with this part of counsel’s argument, the Board simply points out that goodwill as an identifiable, calculable, transferrable asset, is clearly distinguishable from “corporate name”, “customer lists”, “financial information”, “lease”, “accounts receivable”, “fixed assets” and “current liability”. It is not necessary to “distinguish between the value of individual particular assets”. It is however necessary to distinguish between these as a group, and goodwill. A review of the report prepared by Mr Hanson would render suspect any charge that he had been “using a conservative approach”, but such a charge only highlights the fact that the rationale provided by the appellant is liberal in the extreme. Also, it could well be argued that the comments of counsel for the appellant “It is inconceivable that the business is not worth anything” and “It wasn’t only worthless, it was in a negative position” are diametrically in conflict. At best they do little to establish the existence, let alone the value of goodwill. Finally, I point out that the purpose of this hearing is to examine the evidence supplied by the appellant for such existence and valuation of goodwill, and to whatever degree the appellant has relied upon the information contained in the financial statements (admissibility of which has been disputed by the respondent), he is pursuing incorrect assumptions. At best such financial information when examined objectively is confusing and conflicting, and at worst it is completely contradictory of the appellant’s contentions. There is no evidence whatsoever for the existence of goodwill for the purposes sought by this appellant at the time relevant to these appeals. The Minister’s primary position “that the appellant did not transfer any goodwill . .. because there was no goodwill in existence . . is supported.

However, the Board is now faced with a much more difficult question—that related to the Minister’s second and third charges “the (Company) . . . conferred a benefit or advantage on the appellant” and “the payment . . . was not pursuant to a bona fide business transaction”.

The Board has previously dealt with the general question of taxation under section 15 of the Act in Wolfgang Schubert v MNR, [1978] CTC 2033; 78 DTC 1039, a decision in favour of the taxpayer. Reference was made to this decision by both counsel, in full recognition that the case is presently under appeal to the Federal Court by the Minister of National Revenue. With all respect to the cogent argument put forward by counsel for the respondent in this matter, I am unable to discern anything which would lead me to a different conclusion for the present appeals than that detailed in Schubert (supra) with respect to the years in which the conferring of any benefit should be considered that is, in the event that a benefit was conferred by the corporation on this appellant, it was conferred in the year 1971 when the undertaking by the Company to pay a total of $40,000 was allegedly made. It was not conferred as a result of any payment on account of that undertaking made later in 1971, in 1972 or in 1973. Neither is the Minister’s argument supportable merely because there was insufficient goodwill or in fact no goodwill as has been already decided in the present appeals. That is however quite a different proposition than saying that a benefit was conferred (or not conferred) in circumstances where there were insufficient assets or no assets at all, which assets could include goodwill.

As indicated earlier, there is no evidence to support the existence of any goodwill, and in my opinion the immediately subsequent operating losses and the bankruptcy of the Company negate even the contention of the appellant that actual profits were made in 1971 or that any net physical assets (represented by proprietorship net worth) were transferred to the Company from the partnerships. Taken down to its essentials therefore, the appellant is requesting the Board to agree that he should receive tax free, as fulfillment of a Company obligation, the three amounts paid to him in the years 1971, 1972 and 1973. This is a visibly different situation than that which faced the Board in Schubert (supra). In that case, it was the view of the Board that indeed there were assets transferred to the corporation, including goodwill—and that while it was possible the goodwill had been overvalued, it had existed, and any “benefit” arising from such overvaluation would have occurred in the year 1971 (had the Board been called upon so to decide) but not in the years 1972 and 1973. In James F Kennedy v MNR, [1973] CTC 437; 73 DTC 5359, the learned Chief Justice of the Federal Court of Appeal made the following succinct comment at pages 440 and 5361 respectively:

In my view, when a debt is created from a company to a shareholder for no consideration or inadequate consideration, a benefit is conferred.

As I follow the argument of counsel for the appellant, under the circumstances cited above, he is asserting that there was no goodwill and no net worth of the appellant at the date of transfer to the Company—nevertheless a benefit was created at that date in 1971. I would suggest to counsel that such a conclusion presupposes that a “debt was created”, and that “consideration” can be equated with “security”. Some aspects of those propositions were examined in Her Majesty the Queen v Frank Leslie, [1975] CTC 155; 75 DTC 5086, and it would be open to question whether or not the accounting book entries, reflected to some degree in the various financial statements, are synonymous with the creation of a debt. However, the essence of Leslie (supra) is noted in Her Majesty the Queen v William G Phillips, [1975] CTC 250; 75 DTC 5188, at pages 255 and 5192 respectively:

The principles above stated established by the Kennedy case (supra), were followed by my brother Addy J in the case of The Queen v Frank Leslie, [1975] CTC 155; 75 DTC 5086. At page 159 (5089) of that judgment, Mr Justice Addy said:

Generally speaking, when a legally enforceable obligation to pay has been entered into, in one taxation year, and this obligation is met and paid in a subsequent taxation year, it is when the legally enforceable benefit is created and not when the taxpayer actually receives payment that the amount should be taken into account.

In the Leslie case (supra), Addy J, departed from the general rule above stated on the facts peculiar to that case (ie,—in the Leslie case (supra), while the legal obligation was created in 1959, it was clear that there were insufficient assets to meet the legal obligation imposed, whereas, in 1969, when the payment was made, the assets had accumulated sufficiently to allow the obligation to mature into a real benefit). In the case at bar, the Company was a solvent going concern in 1964 when the legal obligation was created, the book value of its assets being in excess of $50,000 and the market value being, in all likelihood, considerably higher. The Company was sold a few years later for $139,000.1 have no doubt, on the evidence, of the Company’s ability to comply with the obligations assumed under the contract of March 28, 1964 at that time and at all relevant times thereafter.

It is clear that even if the Board allows that there had been a legal obligation created in the present appeals, “there were insufficient assets to meet the legal obligation imposed’’. The argument of counsel for the respondent as it relates to the Leslie decision (supra) (and he relied on it heavily) was Stated this way:

... my submission on this . . . is . . . that the benefits that were conferred upon the appellants in the present case were conferred when the amounts were bestowed by the Corporation upon them. Should you make a finding that there was no goodwill, that in fact that entry on the books of account of the company was without foundation and that the money paid to the shareholders of the corporation in the taxation years to which they have been assessed, I would state, comes clearly within Leslie—there was nothing that the corporation would have to pay off this amount. (Italics mine)

I would suggest to counsel that I see no evidence in the Leslie decision (supra) that the case was decided on the basis of a benefit conferred on that taxpayer in any year—1959 or 1969! At pages 161 and 5090 respectively of the decision, one finds:

since, for the reasons above mentioned, no benefit was in fact conferred at the time of the sale in 1959, the Minister, in my view, was correct in assessing the taxpayer in 1969 under paragraph 8(1)(a) for the amount which he actually received as it was a payment made by the Company to one of its shareholders otherwise than pursuant to a bona fide business transaction, and no taxable benefit to which this amount refers had been conferred on the taxpayer in 1959.

It appears rather that the arrangement setting up the “debt’’ in 1959 was not considered “bona tide”, and neither was there a “bona fide” business transaction in the year 1969 which would have established a legitimate basis for payment of any obligation in that “taxation year”. The amount in question was held to be properly taxable under paragraph 8(1 )(a) of the Act, as nothing more or less than a payment, with no relationship whatsoever, in my opinion, to “funds or property . . . appropriated” (paragraph 8(1)(b)), or “a benefit or advantage . . . conferred” (paragraph 8(1 )(c)). I find no validity in one of the arguments proposed by counsel for the respondent that paragraphs (a), (b) and (c) of subsection 8(1) are virtually interchangeable and that the Minister should not be required to be quite specific in using them.

Neither is it in my reading of Leslie (supra) to conclude that had a benefit been conferred on the appellant in 1959 (in that case) and payment not made until 1969, it would have been taxable in 1969. Rather, I am led to believe that the promise to pay (in whatever form) given not at arm's length and/or without realizable security, could not be considered an appropriation, and did not constitute a benefit or advantage conferred.

However, as noted by the learned Justice in Leslie (supra) at pages 157 and 5088 respectively, . . I find no difficulty whatsoever in concluding that the transaction cannot be termed a ‘bona fide’ business transaction as contemplated by paragraph 8(1 )(a) of the Act”.

The Court was dealing in Leslie (supra) with a debt of $53,000, part of the price of $259,000 which constituted the net cost to the appellant for the purchase of a company building valued at $344,000. That there had indeed been a debt created from the company to the appellant, there could be no doubt—there was sufficient security in the building alone, aside from other possible assets, to support the debt. The entire case surrounded the point that excess assets had been transferred to the appellant—the precise opposite to that which faces the Board in the instant appeals.

The transaction in 1959 did not constitute a nullum pactum, it was nevertheless not bona fide. It would be my overall conclusion therefore from Leslie (supra) that where an agreement does not constitute a bona fide business transaction, payments pursuant thereto fall under paragraph 8(1 )(a) of the Act, whether or not they might also be embraced under either of the other two paragraphs (b) and (c).

The transaction in 1959 did not constitute a nu//um pactum, it was nevertheless not bona fide. It would be my overall conclusion therefore from Leslie (supra) that where an agreement does not constitute a bona fide business transaction, payments pursuant thereto fall under paragraph 8(1)(a) of the Act, whether or not they might also be embraced under either of the other two paragraphs (b) and (c).

In the instant appeals there are no assets, in addition to a non-arm’s length agreement and it is the principle laid down in Leslie (supra) that is dominant in my mind—it is not a bona fide transaction, not the principle laid down in Kennedy (supra) (and followed in Phillips (supra))—taxation occurs in the year in which the benefit was conferred. No benefit or advantage was conferred in the instant case—the Company was incapable of conferring anything on anyone. The promise to pay was not a debt enforceable against the Company at the time it was created and there was not even the intangible “goodwill” which might ultimately produce profits and assets. The determination of the central question posed in these appeals rests squarely within the framework of paragraph 8(1)(a) of the Income Tax Act.

While there is a certain validity to the assertion of counsel for the appellant that during the assessment and objection stages in Revenue Canada, and during this actual hearing itself, the respondent addressed himself more to the issue of “benefits” rather than “bona fide”, there is no basis to claim that tax may only be imposed on the amounts as “benefits”, and then only in the year 1971 if applicable. The transaction in question is not considered by the Board to be “bona fide” under paragraph 8(1)(a) of the Income Tax Act, and the assessments by the Minister are sustained.

Decision

The appeals are dismised.

Appeal dismissed.