El Pine Construction Company LTD v. Minister of National Revenue, [1976] CTC 2091, 76 DTC 1074

The Chairman:—This is the appeal of El Pine Construction Company Ltd from income tax assessments in respect of the 1970 and 1971 taxation years.

Although the facts in this appeal are somewhat complicated the principal issue, as I see it, is simply whether or not the appellant realized a profit as the result of the sale of a motel and, if so, what portion of that profit is taxable.

Prior to December 1969, Belvedere Motel Inc was owned jointly by René Lépine and Edmund Asselin on a 50-50 basis. Over the years Edmund Asselin had borrowed moneys from the Royal Bank of Canada and, as collateral for the loan, had pledged his shares in Belvedere Motel. Mr Lépine was somewhat unhappy with his relationship with Mr Asselin on two counts. First, Mr Asselin, occupied with his law practice, did not spend as much time in administering the motel as Mr Lépine thought necessary .Secondly, Mr Lépine was not only aware of Mr Asselin’s indebtedness to the bank but knew that the bank was pressing Mr Asselin for repayment of his loan.

On October 21, 1969 an offer to purchase all of the assets of Belvedere Motel, which comprised a restaurant and some 65 units, was received by Mr Lépine and was accepted by him on October 23, 1969. The price stipulated in the offer to purchase was made up as follows:

(a) $105,000 cash at endorsing of the deed of sale, which, when added to the $10,000 deposited with the offer to purchase, made a total cash payment of $115,000.

(b) The assumption by the purchaser of a $217,500 mortgage due to the Royal Trust Company.

(c) The balance of the purchase price of $157,500 was to be paid at the rate of $1,500 a month for a period of 29 months, ie until September 1972, without interest. If at September 1972 the purchaser was unable to pay the balance of $114,000 which would still be owing at that time, he was to continue paying $1,500 a month, but would then commence paying interest, at a rate 1% higher than the going interest rate, until October 1974, at which time the balance of $78,000 would become due. (Exhibit A-1.)

On November 11, 1969 a Deed of Sale for the moveables of Motel Belvedere, comprising two sightseeing buses and all other moveable assets, was executed. The selling price was $42,100, payable no later than September 1, 1974. (Exhibit A-2.)

On November 11, 1969 on the closing of the Deed of Sale, which was in substantially the same terms as the Offer of Purchase (Exhibit A-1), an agreement was reached whereby the Royal Bank which held Belvedere shares as security for loans made to Edmund Asselin, would accept $95,000 in full payment of the said loans. Both Mr Asselin and the bank endorsed the shares to El Pine Construction Company Ltd, the appellant in this appeal, which company was beneficially owned by Mr René Lépine who was and is its president. At a shareholders’ meeting, the business of Belvedere Motel was wound up and the remaining operating assets and the building were considered to be the property of Mr René Lépine and El Pine Construction Ltd.

As I understand it, all the above transactions took place simultaneously with the sale of the Belvedere assets by René Lépine and EI Pine Construction Ltd to the Voutsinas Brothers on November 11, 1969. As a result of the sale (Exhibit A-3), an amount of $115,573 was paid in cash by the purchasers. After minor adjustments, including $10,000 in cash which was to remain in trust pending the transfer of the liquor permit, the balance of the cash payment, in the amount of $101,000 went to El Pine Construction Ltd. In return for the Asselin shares, El Pine Construction Ltd paid to Asselin and the Royal Bank the $101,000 in cash which it had received from the purchasers.

The balance of the purchase price to be paid amounted to $332,326.27. Of that amount, the purchasers assumed the payment of a first mortgage in favour of the Royal Trust which at the time amounted to $216,926.27. The remaining balance of payment for the effective purchase of the Motel Belvedere assets was therefore $115,400. This amount, plus the purchase price of the moveables sold to the Voutsinas Brothers (Exhibit A-2) in the amount of $42,100, made a total amount of $157,500 to be paid to Mr. Lépine in accordance with the terms above described and as finally set out in the Deed of Sale (see Exhibits A-3 and A-4).

This balance, however, was to remain in trust until all the motel’s creditors had been paid, which occurred in March 1971, and the balance of payment was then transferred to Mr Lépine (Exhibit A-6). This balance was secured by a second hypothec in favour of the vendors following the first hypothec of $216,926.27 in favour of the Royal Trust.

Although in the Deed of Sale there was no allocation of the selling price of Motel Belvedere between the vendors, the Memorandum of Agreement, also dated November 11, 1969 (Exhibit A-4) which was admitted by the appellant not to be at arm’s length, did make such an allocation. By this Memorandum of Agreement, El Pine Construction Ltd and René Lépine, who. allegedly were equal partners in Motel Belvedere, agreed that $101,000 in cash would be paid to El Pine Construction Ltd to meet, as previously mentioned, its obligations in acquiring the Belvedere shares owned by Asselin and the Royal Bank, and that Mr René Lépine would be entitled to the entire balance of $157,500, less $2,500 which was to be refunded to El Pine Construction Lid.

It was stated in the said Memorandum of Agreement that the present value of the $157,500 balance of price discounted at 10% was approximately $106,000. After the $2,500 had been refunded to El Pine, both René Lépine and El Pine would, on the discounted basis, each receive a payment with an estimated value of $103,500.

Mr Michael Klein, who had acted as attorney and chartered accountant for the appellant and was a principal witness at the hearing of the appeal, produced as Exhibit A-5 the mathematical formula by which an amount of $106,000 was arrived at as the discounted value of the $157,500 balance of price which was to be paid in monthly instalments on capital account without interest until September 1, 1972, with the balance to be paid at the same rate but with interest of one percentage point in excess. of the current bank interest rate, up to October 1, 1974.

Mr Klein, who has been an accountant as well as a lawyer for 14 years, had worked out the figure of $105,909 as the discounted value of the unpaid balance of price with his partner Dan Miller. Mr Klein, in his testimony, stated that the discount rate of 10% used in his calculations was, in the circumstances, a low figure when one takes into account the fact that a second hypothec, such as the one which secured the balance of payment in favour of Mr Lépine, usually carries interest of some 4% to 6% higher than the prime interest rate, whereas in this instance no interest was payable on the balance of price until September 1, 1972, and then interest of only 1% more than the bank’s prime interest rate was to be paid from 1972 to 1974.

Considerable evidence was given and argument made as to the validity of a non-arm's-length agreement which would divide the proceeds of the sale so that El Pine would receive that part of the selling price which was paid in cash and Lépine would receive a discounted balance of price which was to be paid according to the terms of the contract.

The dispute between counsel centered around the question of whether an allocation of the selling price in a non-arm’s-length agreement was binding on third parties, viz, the Department of National Revenue, and whether discounting the balance of price which Mr Lépine was to receive as his share of the proceeds of the sale of Motel Belvedere was justified.

In my opinion, discounting a balance of price which was to be paid on monthly instalments over a period of two years without interest, after which time interest of one per cent above the current bank interest rate was to be paid for another two years, is justified. I am also of the opinion that a discount rate of 10% on a balance of price to be paid under the above-mentioned terms, as opposed to an immediate cash payment, is reasonable. In my view, such a discount is legal, realistic, and in conformity with accepted accounting practices.

However, as I see it, the issue that was debated is not the real issue in this appeal. The main issue, in my opinion, stems from the moment the amount of $101,000 paid in cash by the purchasers of the motel was turned over to El Pine Construction Ltd for the purchase of Mr Asselin’s shares in Belvedere Motel.

Although Mr Lépine was the sole owner of El Pine Construction Ltd, both are nevertheless two distinct legal entities which cannot be interchanged at will. Yet this is, from the evidence, what appears to have happened in this instance.

I have checked and rechecked the evidence produced and the verbal evidence given at the hearing, and I can find no evidence whatever to explain how El Pine Construction Ltd was legally entitled to receive, from the proceeds of the sale of the motel, the amount of $101,000 with which it purchased Mr Asselin’s shares for its own account. It is clear that proof of ownership of any part of the Motel Belvedere assets by El Pine Construction Ltd is basic and essential in determining its right to a share of the proceeds of disposition on the sale of the said motel and to the profits realized thereon. Yet there is no evidence before the Board that a contract, an agreement, or even an understanding existed between Lépine and El Pine Construction Ltd in this respect; and, more importantly, there is no evidence that any consideration was paid by El Pine Construction Ltd to Lépine for half ownership of the Belvedere Motel which might justify its receiving $101,000 from the proceeds of its sale.

Counsel for the respondent’s principal contention was that since Lépine and Asselin were on a 50-50 ownership basis of the motel, and since El Pine Construction was in possession of Asselin’s shares in Belvedere, the profit of $93,000 on the sale of the motel should not be divided on the basis of $20,000 to El Pine Construction Ltd, as reported in its income tax returns, leaving $73,000 of profit to Lépine, but that the profit should be divided evenly between the equal owners.

The question that arises in my mind is much more basic than that, and that is whether El Pine Construction Ltd at any time legally owned any part of Motel Belvedere and whether it has a legal right to any of the profits realized on its sale.

It is now generally accepted that a taxpayer may arrange his affairs to attract the least possible tax, but it is trite indeed to say that whatever arrangements are made must be legal, that they must conform to accepted business and accounting practices, and must come within the principles and intent of the Income Tax Act.

On the basis of the evidence before me, the introduction of El Pine Construction Ltd in the overall transaction relative to the sale of Belvedere Mote! meets none of these criteria. In my opinion, the participation of El Pine Construction Ltd in the transaction is not only a sham, it is simply non-existent, and the only legal vendor entitled to the remaining proceeds of Belvedere Motel, once Mr Asselin had sold his shares therein, is Mr René Lépine himself.

One might well ask why Mr Asselin’s shares could not have been paid for directly from the cash proceeds of the sale of the motel, since Mr Asselin and the bank were anxious to sell? Why was it felt necessary to introduce El Pine Construction Ltd as an intermediary into an already complex transaction?

Since El Pine Construction Ltd had, according to the evidence, sustained a business loss of $89,903.59 in 1969, and since the recapture of capital cost allowance on Motel Belvedere was in the amount of $107,000, it was obviously advantageous for Mr Lépine to be able to share that cost with El Pine Construction Ltd, which he in fact did on a 50-50% basis.

Had El Pine Construction Ltd been proven to be the legal owner of 50% of Motel Belvedere, the question as to whether such an arrangement could be considered as an artificial transaction within the meaning of section 137 of the old Act might well have been considered. In the circumstances of this appeal, however, there is no evidence of a legal acquisition and ownership of half of the Belvedere assets by El Pine Construction Ltd and no legal justification as to how it could legally use any part of the proceeds of sale of Belvedere on its own account for any purpose. From the evidence, we are faced with an unwarranted substitution and the unexplained interchange of two distinct legal entities, whereby half of the rights in the motel are automatically and without cause transferred to El Pine Construction Ltd. In my opinion, such a procedure is legally untenable and not binding; it is contrary to business and accounting practices, and unacceptable for income tax purposes.

If there is a valid reason why this fundamental aspect of the appeal was glossed over and not debated, it was not brought to the attention of the Board. In the circumstances, the Board simply cannot ignore the absence of proof in respect of a fact which is basic to the issue and essential in reaching a judicious decision in this appeal.

I feel it unnecessary to deal with the other arguments made in debate, which are founded on what I consider to be an erroneous assumption that El Pine Construction Ltd was at any time the legal owner of 50% of the Belvedere Motel shares.

I conclude therefore that the appellant did not establish to the satisfaction of the Board that El Pine Construction Ltd at the time pertinent to this appeal, was the legal owner of any part of the Motel Belvedere, that it had any legal right to any of the proceeds of the sale of the said motel, or that there existed any legal justification for its participation in the profits realized from the said sale.

For these reasons, the appeal is allowed in part and the matter referred back to the Minister for reconsideration and reassessment so that he may take into account that the appellant was not legally entitled to one half of the profits realized from the sale of the Motel Belvedere and, furthermore, had no legal right to any portion of the profits realized from the sale.

Appeal allowed in part.