Norman a Cafik v. Minister of National Revenue, [1976] CTC 2183, 76 DTC 1141

Roland St-Onge:—This appeal was heard on February 11, 12, and 13, 1976 in Toronto, Ontario. At the beginning of the hearing, counsel for the appellant was allowed to file an amended Notice of Appeal which gave a fairly clear picture of the issue and which is reproduced as follows:

1. Prior to the taxation years in question the taxpayer carried on business as a designer, printer and distributor of church tithing material and tithing programs (the “Tithing Material’) produced to assist various parishes of the Roman Catholic Church in raising money from its parishioners (sic) for charitable and religious purposes.

2. The corporate entity used by the taxpayer to design and write the Tithing Material was IFC Limited (“IFC”) a private Ontario company incorporated on the 12th day of June, 1961. All of the issued and outstanding shares of IFC were owned by the taxpayer.

3. IFC at all times relevant to this notice of appeal was a persona! corporation within the meaning of that term in the Income Tax Act, RSC 1952, c 148, as amended, (“Act”).

4. IFC owned the copyright to the Tithing Material and licensed other persons to use the Tithing Material by printing and distributing it to parishes inside or outside Canada.

5. By 1966 three operating companies had been established by the taxpayer with the object of printing and distributing the Tithing Material on a worldwide basis. In Canada, the operating company was Parish Mailing Services Limited (“PMS Ltd”), a private company incorporated under the laws of the Province of Ontario, which company also operated a branch office in Australia. In the United Kingdom, the operating company was Conniff Publishing Limited, ("Conniff") another private company incorporated under the laws of the Province of Ontario. In the United States, the operating company was Cathos Incorporated (‘‘Cathos Inc”), a corporation incorporated under the laws of the State of Delaware. Each of the operating companies paid royalties for the use of the Tithing Material to IFC.

6. In 1966, the taxpayer caused Norman Holdings Netherlands Antilles Limited (“Norman Holdings”) to be incorporated under the laws of the Netherlands Antilles. By an agreement dated the 30th day of June, 1966, IFC sold to Norman Holdings all its right, title and interest in and to the copyrights to the Tithing Material.

6A The consideration for the sale was $375,000 payable $10,000 per annum, for five years, with the balance of the purchase price payable at the rate of $65,000 per annum with a right of prepayment in Norman Holdings.

7, Under license agreements dated the 30th day of June, 1966, between each of PMS Ltd, Conniff, Cathos and Norman Holdings, Norman Holdings granted a sole and exclusive license to each of the companies to produce, reproduce, print or otherwise publish the works or any adaptation of the same in the countries wherein each of the companies operated. The licensee under each agreement agreed to pay Norman Holdings a royalty of 10% of the gross revenue derived by the licensee from the sale or other disposition, of copies of the Tithing Material.

8. (a) By Notice of Reassessment dated the 26th day of July, 1971 and numbered CAFIK 370 001 7 the Minister of National Revenue (“Minister”) added to the income of the taxpayer for his 1966 taxation year the sum of $25,000 alleging that such sum was ‘additional income from your personal corporation IFC Limited”.

8. (a a) The Appellant says and the fact is that in the 1966 taxation year only the sum of $10,000 was paid or payable by Norman Holdings to {FC. The further amount of $15,000 (being the difference between the sum of $10,000 received or receivable by IFC from Norman Holdings in taxation year 1966 and the sum of $25,000 which the Minister alleges was. the additional income of IFC in taxation year 1966) such further amount was not paid or payable to IFC by Norman Holdings in 1966 and was not received by IFC in 1966 or in any year thereafter.

(b) By Notices of Reassessment dated the 27th day of April, 1972 and numbered CAFIK 370 001 7 the Minister added $42,048.55 of allegedly unreported income to the income of the taxpayer for his 1967 taxation year and $34,934.47 of allegedly unreported income to his income for his 1968 taxation year.

9. The taxpayer duly served the Minister with notices of objection in respect to each of the 1966, 1967 and 1968 taxation years. The Minister, reconsidered his reassessments of the taxpayer and by notices of reassessment dated the 19th day of December, 1974, and numbered CAFIK 370 001 7 reduced the taxable income of the taxpayer for his 1966 taxation year by $2,632.00 and by $25,379.08 for his 1968 taxation year. The Minister, however, by a notice dated the 3rd day of January, 1975 notified the taxpayer that he had reconsidered the notice of objection filed in respect to the 1967 taxation year of the taxpayer and confirmed his earlier assessment of the taxpayer in respect to that year.

10. The position of the Minister is that he ignores the sale of the copyright from IFC to Norman Holdings on June 30, 1966 and the license agreements entered into by Norman Holdings with each of PMS Ltd, Conniff, and Cathos all of which transactions are evidenced by legally enforceable contracts. The Minister alleges, therefore, that the arrangements among IFC, Norman Holdings, PMS Ltd, Conniff and Cathos were a sham and that all of the royalties paid to Norman Holdings in the years in question were the property of IFC. The Minister also chooses to ignore that at least in the 1966 and 1968 taxation years IFC had loss carry forwards sufficient to offset any royalty income deemed to be received by it.

On the other hand, the respondent considers these payments of $10,000 a year from Norman Holdings to IFC as being income of a personal corporation of the appellant and alleges, among other things:

(1) that the arrangement between IFC and Norman Holdings was a device to transfer income earned by IFC to an offshore Company, Norman Holdings;

(2) that it was an attempt to bring income into Canada in the guise of capital payments;

(3) that Norman Holdings acted as an agent on behalf of IFC so as to make it appear that income was properly earned offshore; and

(4) that Norman Holdings was a sham io facilitate the transfer of money to another jurisdiction which imposes no tax on income or profit which had been earned by IFC.

At the hearing, three witnesses were heard: the appellant, his accountant Mr Wright, and his former associate Mr Moldenhauer.

Mr Cafik left school at 14 years of age. In 1968 he became a Member of Parliament. In 1959, prior to becoming a Member of Parliament, he got involved with professional fund-raisers for institutions and churches. For two years he was the employee of a Colonel Wells who had developed a technique to increase the income of churches in the United States. This method consisted of sending an employee who would organize the fund-raising operation at the parish level. This was done for a fixed fee whether the goal was achieved or not. After two years with Colonel Wells, the appellant, with four other fund-raisers, decided to buy from him the Caiholic division known as Cathos International. Although this company was not an operating entity, it was in a good cash flow position. Mr Bridges, one of the four fund-raisers, decided to incorporate a company in England under the name of Cathos GB whereas the other fund-raisers decided to incorporate Cathos Ltd in Canada and Cathos Inc in the United States.

On June 12, 1961 they also incorporated IFC Limited (Institution Financial Consultants) which would raise funds or institutions only, such as hospitals and universities. However, this company never succeeded in achieving this aim. In 1961 Cathos GB made money, Cathos Inc made none, Cathos International had a debt of $200,000, and Cathos Lid was very successful.

During the period 1960 to 1962 the appellant proceeded to buy ail the shares of the Canadian companies and then fired the entire staff. From then on he resorted to a new method of fund-raising called “Do It Yourself”. He prepared numerous sermons to be recorded, as well as films, manuals, advertising to be circulated in churches, motivational programs, etc. This method, which was less costly than the former by one-tenth, was very successful, and bishops and priests bought the material and saw their collections increase considerably, in some cases from $200 to $1,800.

From 1961 to 1969 the appellant was the sole owner of the Cathos operation except in England. Cathos Ltd did not operate, because it was created for institutional fund raising. Cathos Inc did operate, and sent a man to the United States where Tithing Material sold for $40,000 to $50,000. Consequently, the ownership of the copyright of the new program “Do It Yourself” was invested in IFC, and PMS Ltd, which was incorporated in March 1965, and became the operating company in Canada.

In that year, the appellant went to Vatican II and met with many bishops with a view to generating business in the United States, Great Britain, South Africa, etc.

Under this new “Do It Yourself” program, the appellant was prepared to sell his Tithing Material to the parishes but was not ready to send employees to implement the said program. Because of Mr Cafik’s commitment to Mr Bridges not to operate in Great Britain, his wife incorporated a company under the name of Conniff to operate in England.

According to the financial statements filed, there was a spectacular increase in the sales volume after the appellant took over the business. Because of this success, the appellant went to see a tax adviser, who recommended the incorporation of a certain number of companies.

Norpro Holding was incorporated in Canada. The appellant received 80 common shares and his associates in the business, Messrs Fernandes and Moldenhauer, 50 preferred non-cumulative shares each. There is no document to show that the said associates were holding the shares for the appellant. Apparently, Mr Fernandes was well off and very conservative as to expenses.

Finally, the appellant swore that IFC was the owner of all the Tithing Material in connection with the “Do It Yourself” program, and the copyright thereof was sold in Curaçao on June 30, 1966.

Following Vatican Il, the appellant had to reproduce new material and new programs. He received no income and had to incur substantial expenses. He raised money by obtaining a mortgage of $35,000 on his house. Finally, the business was wound up and the records lost. During 1970 and 1971 he phoned Moldenhauer and asked him to assist the Department of Revenue to get the records, but everything was left in abeyance.

Upon cross-examination, the appellant testified, inter alia, that a sum of $16,000 was loaned by PMS Lid to his wife in order to operate Conniff.

Mr Wright, who was the chartered accountant for the Cathos group from 1963 to 1966, explained that the sale price of the copyright was fixed at $375,000 by resorting to the anticipated sales for 1967 to 1971 inclusive; that there was a dramatic increase in sales in 1965 in the United States from $32,800 to $803,000; and that, with that background and the anticipated sales, this $375,000 was a realistic sale price.

This witness also explained that, because the companies were to be involved in the international market, and because the other two individuals, Fernandes and Moldenhauer, were interested in this offshore business, Norpro and Brevirum were incorporated to allow the participation of the three persons in the large international activity. Brevirum was a subsidiary of Norpro. Mr Wright said he went to Curaçao with Mr Cafik and dictated the agreement there. According to him, all the agreements filed at the hearing were legal and binding agreements.

He also testified that the parties agreed on the figures and that a loan of $16,000 was made to Mrs Cafik in order to finance the GB organization.

Mr Moldenhauer corroborated the appellant’s testimony. He said that, in 1964, he started as sales manager for all the companies in the various countries. During his association with the appellant, he had other interests in two companies, and in a food outlet and had acquired a new Catholic encyclopedia from which he received royalties.

As to the Norpro Company, he testified that the appellant had offered him the opportunity to become a shareholder therein. With Fernandes, he became a director and took part in all the discussions with respect to its incorporation.

In Mr Moldenhauer’s opinion, he and Fernandes could participate in the profits, they had voting control, and the sale price of the copyright was reasonable. He entered into this transaction because he thought it could become a very interesting venture.

When the appellant was elected a Member of Parliament, Moldenhauer became the general manager in charge of the entire enterprise. He personally invested $15,000 in order to save the business but, because of postal strikes in the United States and Canada, the venture went sour and in 1970 he recovered only $10,000 plus the records. He then phoned the appellant to know what to do with the records and documents, and he was told to offer them to the officials of the Department of National Revenue who were investigating the appellant’s affairs.

Upon cross-examination, he admitted that he was not involved in the sale of the copyright; that he was not to participate in the profits before the sale price of $375,000 was fully paid, and that his understanding of non-cumulative preferred shares was limited.

Recalled as witness, Mr Cafik filed some samples of his Tithing Material that he had found in Toronto.

At this juncture, it has to be mentioned that the respondent had also alleged that there was no Cafik copyright, and that, if there were, IFC was not the owner and that the price of $375,000 was in excess of the market value.

After hearing the witnesses, counsel agreed that a copyright did in fact exist and that IFC, prior to the sale agreement, was the owner.

After examination of the financial statement, counsel for the appellant conceded that, for the 1967 taxation year, a sum of $32,000 should be regarded as being royalties received in that year and, consequently, as being taxable income.

Counsel for appellant argued that the sale document executed on June 30, 1966 in Curacao between IFC and Norman Holdings was a legally binding document and operated as an absolute sale of the copyright to the Tithing Material for a realistic price; that there was no way the appellant could get back the rights which had been sold; that it was the sale of a capital asset, the proceeds of which could not be regarded as income; and that it was reasonable to believe that Norman Holdings was the right company to give exclusive licences to people in various parts of the world, since that material was to be sold everywhere in the world.

He also argued that the fact that the sale price was paid at the rate of $10,000 a year for the first five years did not convert these payments into income, and referred the Board to the following extract from Murray v Imperial Chemical Industries Ltd (1964-68), 44 TC 175 at 211:

Now ICI are not dealers in patent rights or patent licences. When they granted this exclusive licence, they were to my mind disposing of a capital asset. If this had been an assignment of patent rights, there could be no doubt that ICI would be disposing of a capital asset. I see no difference in this regard between an assignment of patent rights and the grant of an exclusive licence for the period of the patent. It is the disposal of a capital asset. But this does not determine the quality of the money received. A man may dispose of a capital asset outright for a lump sum, which is then a capital receipt. Or he may dispose of it in return for an annuity, in which case the annual payments are revenue receipts. Or he may dispose of it in part for one and in part for the other. Each case must depend on its own circumstances. But it seems to me fairly clear that, if and in so far as a man disposes of patent rights outright (for example, by an assignment of his patent, or by the grant of an exclusive licence) and receives in return royalties calculated by reference to the actual user, the royalties are clearly revenue receipts. If and in so far as he disposes of them for annual payments over the period, which can fairly be regarded as compensation for the user during the period, then those also are revenue receipts (such as the payment of £2,500 a year over ten years in Commissioners of Inland Revenue v British Salmson Aero Engines Ltd [1938] 2 KB 482, and, of course, the royalties of £10,000 a year in the present case). If and in so far as he disposes of the patent rights outright for a lump sum, which is arrived at by reference to some anticipated quantum of user, it will normally be income in the hands of the recipient (see the judgment of Lord Green MR in Nether- sole v Withers (1948) 28 TC 501, at page 512, approved by Lord Simon in the House of Lords, at page 518). But if and in so far as he disposes of them outright for a lump sum which has no reference to anticipated user, it will normally be capital (such as the payment of £25,000 in the British Salmson case). It is different when a man does not dispose of his patent rights, but retains them and grants a non-exclusive licence. He does not then dispose of a capital asset. He retains the asset and he uses it to bring in money for him. A lump sum may in those cases be a revenue receipt (see Commissioners of Inland Revenue v Rustproof Metal Window Co Ltd (1947) 29 TC 243, at pages 270-1 per Lord Greene MR, who emphasised that it was a non-exclusive licence there). Similarly, a lump sum for “know-how” may be a revenue receipt. The capital asset remains with the owner. All he does is to put it to use.

Applying these criteria in the present case, it is quite clear that the royalties for the master CPA patents and the royalties for the ancillary ICI patents were revenue receipts. That is admitted. So far as the lump sum is concerned, I regard it as a capital receipt, even though it is payable by instalments. I am influenced by the facts: (1) that it is part payment for an exclusive licence, which is a capital asset; (2) that it is payable in any event irrespective of whether there is any user under the licence—even if the licensees were not to use the patents at all, this sum would still be payable;

(3) that it is agreed to be a capital sum payable by instalments, and not as an annuity or a series of annual payments.

In these circumstances I am quite satisfied that the lump sum was a capital receipt and ICI are not taxable upon it.

He also argued that Fernandes and Moldenhauer were key people whom Cafik had to keep within his organization if he were to succeed in his international venture, and that they were not lackeys or puppets but men of substance.

As to the Norpro control, he stated that, according to the ietters patent and the amendments thereto, Cafik did not have control because he did not possess a majority interest.

In his opinion, Norman Holdings could not be regarded as merely the agent for IFC or its alter ego. On the contrary, there was some suggestion, from an examination of the documentary evidence, that Norman Holdings was the agency of PMS Ltd. However, there is uncontradicted oral evidence to prove that Norman Holdings was directed by Norpro, Moldenhauer, Fernandes and Cafik. Indeed, Mr Wright testified that he was acting on behalf of Norpro; that Mr Cafik gave a Mr Root a cheque for $6,000 as a subscription to the share capital of the Netherlands Antilles Company; and that the cheque was issued by Day Wilson in trust for the Dutch company Brevirum NV which was to be incorporated. Finally, he argued that the respondent tried too hard to obtain additional taxes from the appellant by saying that the incorporation of the offshore company was a sham. He referred the Board to the case of Salomon v Salomon & Co Ltd, [1897] AC 22, to say that each company has its legal entity with power to contract.

Counsel for the respondent referred to the pleadings to say that three companies established by the appellant paid royalties to IFC; that the appellant caused Norman Holdings to be incorporated; and that the income of Norman Holdings was loaned to Mrs Cafik. He argued that the $10,000 paid by PMS Ltd and the $15,000 paid by Cathos Inc were income received by Norman Holdings, and that, if he could prove that Norman Holdings was the agent of IFC or Cafik, then the income of Norman Holdings is properly included in the income of IFC or Mr Cafik.

Then he again referred to the pleadings, in which he stated that IFC did not hold any copyright in any material. He concedes that IFC did hold such a copyright in the material and did have the capacity to dispose of it. He also stated that $375,000 was an amount far in excess of the market value but, since the funds actually received were much less than $375,000, he conceded that the copyright was properly valued at that much. The over-valuation would serve only to discover if it was a bona fide transaction.

Counsel for the respondent further argued that in fact Norman Holdings was the agent of IFC; and that the agreement between IFC and Norman Holdings and the further licensing agreements from Norman Holdings to Cathos Inc, PMS Ltd and Conniff were in fact a sham.

Referring to the facts, he said that Cafik, in the period between 1960 to 1962, acquired control of a group of companies in the fund- raising business; that he developed a promotional program to be used in churches; that he did it as an employee of IFC; and therefore IFC would hold the copyright thereon. Because of the success of the new program and the event of Vatican Il, in 1965 the appellant decided to seek the advice of tax experts Campbell and Wright. The advice seems to have been twofold: the question of capital gain for disposal of the copyright, and the incorporation of an offshore company.

Counsel for the respondent suggested that the sole reason for causing Norman Holdings to be incorporated was to save taxes; that the rights that Moidenhauer and Fernandes had to any income generated by Norman Holdings through Brevirum to Norpro was questionable; that everything was left by Cafik to Mr Wright, who became his agent; that Mr Poot and Mr Holiman, two officers of a trust company in the Dutch Antilles, would take instructions from Mr Wright for a fee of $1,000 a year; that Cafik would take all the income of Norman Holdings remaining as surplus; that there was no intention to pay dividends until the full $375,000 was paid to Norman Holdings; and that, if Cafik were allowed to use Norman Holdings as a tool to take out $375,000, it shows that Norman Holdings was his agent.

Counsel for the respondent suggested that there was no business purpose and no commercial reason for setting up Norman Holdings, the existence of which was purely fiscal. He then referred to the following list of authorities to show that the intervention of a company which has no commercial purpose is a sham:

a) United Kingdom

B. FA & AB Ltd v Lupton, [1971] 3 All ER 948 (HL) at pp 953, 954, 955, 956, 957, 958, 960, 962, 963 & 966

b) United States of America

C. Gregory v Helvering (1935), 293 US 465 (USSC), per Sutherland, J at pp 468, 469 & 470

c) Canada

D. Massey-Ferguson Ltd v The Queen 74 DTC 6529, per Heald, J at p 6533 [[1974] CTC 671]

J&J Hotels Ltd v MNR, [1973] FC 369, per Sheppard, DJ at p 374 [[1973] CTC 247; 73 DTC 5206]

The Queen v Clifford B Clark 74 DTC 6242, per Cattanach, J at p 6249 [[1974] CTC 305]

The many tentacles of the doctrine of form and substance

CIR v Duke of Westminster, [1936] AC 1 (HL), per Lord Tomlin at pp 20 & 21 and Lord Russell at p 25

In addition to the aforementioned list of cases, counsel for respondent referred the Board to other cases among which was a decision of Mr Justice Décary in Dominion Bridge Co Ltd v The Queen, [1975] CTC 263; 75 DTC 5150. In that case, Dominion Bridge Co Ltd needed steel and had normal suppliers from outside the country who were supplying steel directly to the company. Following tax advisers’ advice, an offshore company was incorporated under the name of Span to purchase the steel and to forward it to Canada at a higher price. Consequently, the income accruing offshore will be repaid to Canada by means of dividends that will be tax-free under section 28 of the Income Tax Act, RSC 1952, c 148 and amendments thereto.

As may be seen, Dominion Bridge did not sell anything to Span, and the latter was not incorporated for any business purpose or commercial reason other than purely as a scheme to aliow Dominion Bridge to earn less taxable income. On the contrary, Norman Holdings was incorporated to purchase the exclusive copyright to Tithing Material and to allow other companies in other countries to utilize the said Tithing Material in exchange for royalties.

It cannot be said that the appellant had no commercial reason to incorporate the companies, when there is ample evidence to show the contrary. In the present appeal, everything was done legally. IFC had something to sell; Norman Holdings was legally incorporated and, as a separate entity, became the owner of the copyright through legally binding documents; Norpro and Brevirum were incorporated in order to interest Fernandes and Moidenhauer in the business of selling Tithing Material in the other countries of the world and to retain their services in this regard. As a matter of fact, after the election of Mr Cafik to the House of Commons, Mr Moldenhauer was left completely alone to supervise the business in Canada as well as in the other countries.

The hearing of this appeal has established that the copyright actually existed; that IFC, prior to the sale of Norman Holdings, was in fact the owner; and that the copyright was properly valued to the extent of the money received for it.

The remaining issue to be determined is whether Norman Holdings was acting as an agent for IFC or Cafik. There is no documentary evidence to prove the respondent’s allegation. On the contrary, there is sworn testimony to the effect that there was no such agency.

The arrangement between IFC and Norman Holdings was not a sham since, at the time of the transaction, the appellant had the right to incorporate an offshore company to do business with other countries and had the right to sell his copyright through IFC to Norman Holdings. Everything was done by legally binding documents. The form and substance of the various documents concerning the transactions are the same. It shows the absolute sale of a capital asset by one company to another for a definite sum of money, payable by instalments.

The Board was very much impressed by the appellant’s own testimony, which was straightforward and credible. Actually, he had nothing to conceal, as was shown by his willingness to allow counsel for respondent to scrutinize the file he had brought with him to assist him in testifying.

The Board has to base its decision on the uncontradicted evidence adduced by the appellant and cannot rely purely on speculation. Everything appears to have been done legally and the appellant, during the years relevant to this appeal, had the right to arrange his affairs in the manner in which he did.

As it has been agreed by the appellant’s counsel that an amount of $32,000 should be included as income, being royalties received in 1967, the appeal on this particular issue is dismissed.

As to the other issue, involving the sale price of the copyright, the Board decides that the amounts received in the years under appeal as part of the sale price of the copyright are non-taxable gains. Indeed, in the light of the principles enunciated in Murray v Imperial Chemical Industries (supra), the amount of $10,000 received by the appellant was for the sale of a capital asset even if received by instalments since the appellant effectuated an absolute sale and could not get back what he had sold.

Consequently, the appeal is allowed in part and the matter is referred back to the Minister for reconsideration and reassessment accordingly.

Appeal allowed in part.