Classic's Little Books Inc v. Her Majesty the Queen, [1973] CTC 94, 73 DTC 5096

The Associate Chief Justice:—This is an appeal from a decision of the Tax Review Board dismissing an appeal by the plaintiff from its assessments for the taxation years 1966 and 1967. The sole question involved in this appeal is whether the plaintiff is entitled to a direction under subparagraph 138(A)(3)(b)(ii) of the Income Tax Act vacating a direction under subsection 138A(2) that the plaintiff and Classic’s Little Books (Airport) (hereinafter referred to as “Airport”) be deemed to be associated for the purposes of section 39 of the Act for the 1966 and 1967 taxation years. There was a further argument advanced by the plaintiff in that the assessment against the plaintiff was issued on June 20, 1969 and that it was only on or about August 20, 1969 and in any event at a date subsequent to the issuance of the assessment that a notice was issued to the plaintiff directing that it and Airport are deemed to be associated for purposes of section 138A of that Act rather than as a prerequisite to the assessment as required by law as the notice sent to the plaintiff in August 1969 was dated April 25, 1969, contrary to the clear intent and requirement of subsection 138A(2) that such an assessment should only issue “if the Minister so directs”. This. argument was however abandoned at the trial by counsel for the plaintiff.

The controlling shares of the plaintiff company are held by Mr Louis Melzack and those of Classic’s Little Books (Airport) Limited are all held by his wife, Mrs Louis Melzack, and both companies were engaged in the operation of bookstores.

The Minister invoked subsection 138A(2) and directed that the plaintiff and Airport were deemed to be associated with each other, being satisfied that one of the main reasons for the separate existence of the companies was to reduce the amount of taxes otherwise payable. The Minister, therefore, reassessed the plaintiff for its 1966 and 1967 taxation years. The plaintiff contends that the separate existence of the two corporations involved was solely for the purpose of carrying out the business of those corporations in the most effective manner without contemplating a reduction of taxes.

The principal shareholder of the plaintiff is and was at all relevant times Louis Melzack. He had commenced his business operations in the retail sale of old and new books at a book shop on Bleury Street, in Montreal, which was known as the Classic Bookshop. Originally, the Classic Bookshop was owned by Louis Melzack’s father and subsequently Louis Melzack became a partner of his father in the operation of the Classic Bookshop. In 1938 the Classic Bookshop was moved to a new location at 1380 Ste Catherine Street West, in Montreal. A new company (the plaintiff) was incorporated in February 1955 in order to operate an additional retail bookstore located at 1373 Ste Catherine Street West, Montreal. Eventually, Louis Melzack transferred to the plaintiff company the retail bookstore business which had been conducted by him as a partner and later as the sole proprietor so that the plaintiff thereupon commenced to operate more than one bookstore. Gradually, additional stores for the sale of books were opened by the plaintiff in different areas both in Montreal and elsewhere, so that by 1961 the plaintiff had seventeen bookshops in Canada.

The plaintiff submitted that Rose Melzack, Louis Me!zack’s wife, has as much experience as himself, or more, in the retailing business and from the very advent of their marriage onwards played an active full- time role in the operation of the bookshop owned by the plaintiff and in the introduction of new books.

She had been largely instrumental in the opening of the first bookshop owned by the plaintiff at 1373 Ste Catherine West which, accord- ing to the plaintiff, represented a pioneer effort in the establishment of a retail bookshop specializing in what is referred to as “paperbacks”. In 1960 Rose Melzack caused to be incorporated a new company under the name of “Classic’s Little Books (Airport) Limited” in order to operate a new airport book store at the newly established Dorval Airport. This new company did not, however, take over any business or any part of the business operated by the plaintiff. The plaintiff submitted, and this seems to have been the case, that the establishment of a bookstore at the Dorval Airport, represented a new and rather hazardous undertaking in view of the fact that there had never been established at an airport a bookshop whose sole function would be limited to the sale of books (as distinct from a retail operation in which the sale of books was coincidental with the sale of any other products such as tobacco, novelties, tourist items, newspapers, magazines, etc), that the rental to be charged for the Dorval Airport location was very high by comparison with the standard of rentals to which the plaintiff was accustomed, and that the venture appeared to be much more difficult because the location offered was not situated in the main stream of passenger traffic for domestic travel which formed the principal type of passenger business at the Dorval Airport.

The plaintiff says that Louis Melzack as the principal operator of the plaintiff company was preoccupied with the affairs of the plaintiff and did not have the time to devote to the establishment of the business of the new company. Counsel for the plaintiff further points out that the plaintiff company increased its profits and continued to prosper after the incorporation of the Airport company and that there was no diversion of profits from the plaintiff company to the Airport company. The plaintiff also ‘submitted that Rose Melzack is an independent entrepreneur with vast knowledge of, and experience in, the book retailing business who has worked on a full time basis, often to the extent of 50, 60 or 70 hours a week throughout the entire year in the operation of the business and that she had all the technical knowledge, experience, expertise, energy and ability to justify the establishment of the Airport company. Counsel for the plaintiff, therefore, concludes that there were sound and compelling business reasons for the incorporation of the Airport company and its separate existence was, he says, solely for the purpose of carrying out the business of Airport in the most effective manner.

He further submits that in pleadings before the Tax Review Board, and specifically in his reply to the notice of appeal, this point was acknowledged in the statement by the solicitor for the defendant that:

It is agreeable to the Minister that the lawyers may have had a compelling reason to incorporate Classic’s Little Books (Airport) Limited to limit the liability which might arise from the opening of the international airport store . . .

He also says that the Minister’s direction was not based on any tests relevant to the separate existence of the two corporations as contemplated in subsection 138A(2) but is rather based upon the existence of separate shareholders in the two companies.

He pointed out that at the time of incorporation of the Airport company, there were serious prospects that a loss would be sustained in the operation of the Airport bookstore and if tax considerations had been the guiding ones, it would have been more prudent not to incorporate the Airport company. There was, he says, no compulsion on the part of the plaintiff to incur the risks involved in the opening of the Airport bookstore and the decision to open such a bookstore represented a business judgment made by Rose Melzack. Rose Melzack, he adds, was under no compulsion to work for the rest of her life for her husband’s company and was fully entitled, both legally and morally, and as a matter of exercise of business judgment, to open a new company in which she had a proprietory interest and to which she could, and did, devote her time, efforts and talents.

Counsel for the plaintiff submits that the Minister’s “direction” was made on the basis of errors of fact in the submissions that were reported to him and also errors of law in the interpretation of section 138A of the Income Tax Act. He says that notwithstanding the provisions of subsection 138A(2), the “direction” was made not because the Minister was “satisfied” as is required by law, but only by reason of what he calls a standard practice to ignore, as though it did not exist, the independent efforts of a wife to operate a business apart from that of her husband.

The plaintiff says that in respect of the taxation years at issue, the separate existence of each of the corporations was an absolute legal necessity, in view of their previous existence as separate corporations, as well as being the sole and most effective manner of carrying out their respective operations.

The Queen, on the other hand, in assessing the plaintiff relies on the following assumptions of facts:

(1) The plaintiff has been properly directed as deemed associated with Classic’s Little Books (Airport) Limited under the provisions of subsection (2) of section 138A of the Income Tax Act and that the plaintiff has been assessed in accordance with the provisions of subsection (3) of section 39 of the Act.

(2) On September 5, 1960 Mrs Rose Melzack (wife of Louis Melzack) so!d the common shares she owned in the plaintiff’s company.

(3) On or about October 21, 1960 a new company was formed under the name of Classic’s Books (Airport) Limited having as shareholders the following persons:

(4) The first store leased by the new company is located at International Airport of Montreal and the details of the lease have been negotiated in the first instance by Mr Louis Melzack on behalf of plaintiff and the said lease was subsequently assigned to Classic’s Little Books (Airport) Limited.

(5) On November 1, 1961, plaintiff has sold its inventory of books then located in the store at 1373 Ste Catherine Street West, Montreal, to the new store located at 1327 Ste Catherine Street West, leased by Classic’s Little Books (Airport) Limited. The value of the inventory has been transferred at cost from one company to the other.

(6) The two companies above referred to are being managed by Mr and Mrs Louis Melzack and they are using the same administrative personnel.

(7) The two companies identify themselves as retail book shops, are selling the same product, namely paperback books, have the same administration and, in fact, Mr Melzack is doing the purchasing and looking after the expansion of the two companies and Mrs Melzack takes care of accounting and the execution of orders for the two companies. Also the two companies are using the same advertising.

(7) [sic] The new company has realized profits right from the commencement of its operations:

the profits varied between $34,000 and $35,000 and the operations of the new company have been set in such a way as to make sure that the losses from the store at Dorval, if such losses could occur, could be used.

(6) As a matter of fact, from November 1, 1966 the new company had been operating the business of the former company in the same district, namely, at 1327 Ste Catherine Street West instead of 1373 Ste Catherine Street West.

(9) In regard to the onerous, hazardous speculative lease, we will leave the lease speak for itself and it is the assumption of the defendant that it is a no more worrisome lease than those ordinarily encountered in the business.

(10) From all of the above facts and other facts deriving therefrom, it cannot be denied that one of the main purposes, if not in fact the only one, for the incorporation of Classic’s Little Books (Airpod) Limited was to reduce income tax in an artificial manner.

(11) Thai the defendant has assumed that the carrying out of business did not contemplate that the sole purpose to be accomplished is the bona fide commercial transaction and that the substantial tax reduction has ensued.

The sole issue in this appeal is whether or rot on the evidence the appellant, by virtue of subparagraph 138A(3)(b)(ii) of the Income Tax Act, has satisfied the onus of establishing that none of the main reasons for the separate existence in the relevant taxation years of the two corporations was to reduce the amount of tax that otherwise would have been payable under the Act.

The reasons advanced by the taxpayer for the incorporation of the airport company were threefold:

(1) to obviate the risk of a bad investment and its possible effect on the other company;

(2) to conduct under different companies businesses substantially different, ie, paperback and hard-back books, and

(3) to provide a separate investment and interest for the wife.

The evidence discloses that in 1961, when the airport company was incorporated, some risk was involved in the setting up of a store in the Dorval airport. The Melzacks had never opened a book-store in an airport before and having had some difficulties in installing a book store in the Rockland shopping centre, near Montreal, they considered that some risk was involved not only because it was in an airport, but also because it was located in what they called the international end which was some considerable distance from the main flow of passengers. The amount of the lease was also greater than what they were paying for other stores.

I am quite prepared to accept the evidence of the Melzacks that the desire to protect their main stores from the effects of losing the airport venture was an important consideration in incorporating the airport business. Both Mr and Mrs Melzack so stated and the fact that the incorporation of this business would prevent the deduction of any losses sustained therein from the profits of the old company would seem to indicate that their hopes of a profitable venture at the airport were not too good. On the other hand, Mrs Melzack, before incorporating the airport company, sold whatever shares she had in the old company and thereby made it impossible for both companies to be associated under section 39 of the Act. This, of course, cannot be considered otherwise than as a deliberate gesture to prevent both companies from being held to be associated and whether this was done by a sophisticate or one with little knowledge of fiscal matters, it surely must have been the result of some fiscal advice or knowledge at a time when the provisions of subsection 138A(2) had not yet been adopted. Indeed, subsection 138A(2), which placed the question of associated corporations under ministerial discretion, was introduced in 1963 and was made applicable to the 1964 and subsequent taxation years. The selling of the shares at the time, of course, meant that both companies would be able to benefit from the reduced rate of 18% up to $25,000.

The second reason adduced by the taxpayer to incorporate the airport business was to conduct, under different companies, the sale of paperback books and hardback books which are, it says, businesses substantially different.

I must say that I cannot find any evidence to support such a submission. The facts are that both businesses deal with books and although the paperbacks would probably appeal more to a certain class of people because of their price, their appeal would not necessarily be restricted to persons with modest means. In so far as the pur chasing and selling of both are concerned, Mr Melzack, the husband, purchases the hardbacks and one of his sons purchases the paperbacks. Furthermore, all the stores of both companies sell one or the other, even if they do so in different proportions and even if the airport company store sells a good deal more of the paperbacks than the hardbacks. This, however, does not mean that because of these differences a separate corporation was or is required. Mrs Melzack, it is true, took a special interest in the Ste Catherine Street paperback store when it was part of the old company but the new company then took over the lease on Ste Catherine Street and then the inventory Of paperbacks was transferred at cost to that store from the old company. Up to then, however, the old company was selling paperbacks and it does not appear that the transfer of the books was due to any difficulty the old company had in selling them.

I now come to the third reason submitted by both Mr and Mrs Melzack to justify the incorporation of the airport company. It was, they say, to provide a separate investment and a special interest for the wife.

There is no question that Mrs Melzack worked personally at the airport store and for the first year, at least, without a salary, although she was drawing a small one of $60 a week from the old company where she was looking after bookkeeping. She stated that she would get up at 6 o’clock in the morning and spend most of the day in the airport store. Before entering into the airport venture, she had, she said, discussed the matter with her husband and as a result had decided to enter into this venture. Counsel for the appellant says that there is no reason why Mrs Melzack as a person should not have her stake in the economic world and that a wife is not a chattel or a slave and is not owned by her husband. I have, of course, no hesitation in agreeing with this submission nor would I dispute counsel’s statement that the greatest mainstay of human activity is incentive. However, these are not the only matters to be considered under subparagraph 138A(3)(b)(ii). This section is, of course, directed at preventing a proliferation of companies, yet the creation, or continued existence of one corporation, may, in some cases, be sufficient to bring it into play. The matter, here, involves some complexities in that we are not dealing with the case of a wife entering into a new business, but doing so when the corporation of her husband in which she works is already not only in the same business but is expanding all over the country. The airport store, as a matter of fac , could very well have been a store of the old company and nearly became so. as the first lease was oriainally granted to the old company and then was assigned to the airport company.

It is also possible that Mrs Melzack was the deciding factor in entering so extensively in the paperback business. She may also have been instrumental in increasing the income and adding to it and in the process may well have taken nothing away from the old corporation. The latter may indeed have continued to grow notwithstanding the airport operations. It is also possible that there was no division of business yet the two corporations may yet be deemed to be associated by the Minister on the basis that one of the main reasons for the continued existence of the two companies during the taxation years under review was to reduce taxes. A corporation may, indeed, be brought into existence for one reason and be continued in existence after that reason has ceased to operate.

Counsel for the defendant submitted that in applying subparagraph 138A(3)(b)(ii) we must forget about the reason for the creation of “the separate existence of the two corporations” and address our mind to the question as to why both corporations have continued to exist separately during the year in respect of which the Minister has made his declaration. I agree that that is the manner in which the separate existence of both corporations must be considered under the section.

It appears here that although there was some risk in embarking on this new store at the airport in 1961 when the new company was incorporated and that the Melzacks may well have had at the time good reasons to believe that the bankruptcy of the airport business might have an effect on their main business, this possibility had diminished as early as the end of 1961 when a small profit of $5,000 was realized at the airport store and it had disappeared entirely in the 1966 and 1967 taxation years under review when the airport business was operating at an interesting net profit of $45,795 and $40,183 respectively.

I must conclude from the fact of the incorporation of the airport store and the circumstances preceding and following its implementation that the eventual probability of a reduction in the amount of tax payable was one of the main reasons for the incorporation of the airport business and it was continued and maintained in the years 1966 and 1967 for the same reason.

I cannot indeed ignore that Mrs Melzack sold her shares in the old company prior to the incorporation of the new company for the purpose of avoiding that the old company and the new one would be associated under section 39 of the Act even if the Melzacks incorporated the new company in order not to endanger the old company. I cannot indeed disregard the fact that in 1966 and 1967 there no longer was any reason to maintain both companies as at that time the new company was as prosperous as the old one.

I appreciate counsel for the appellant’s able submission that the dominant consideration was to provide a challenge and interest for the wife who was actively engaged in the business and who wanted to have and to realize a business success of her own in a speciality which she knew well as she had dealt with such wares over a number of years.

I cannot, however, in view of the intimate connections not only between both corporations but also between both Mr and Mrs Melzack, not because one happens to be the spouse of the other but merely because they are both intimately involved in the operations of both companies, come to any other conclusion but that one of the main reasons for the existence of both corporations in 1966 and 1967 was to reduce the amount of taxes that would otherwise be payable.

Even to this day the buying of both types of books for both companies is effected in part at least by the husband, whereas the wife still supervises the bookkeeping not only of the airport business but of that of her husband’s company as well. When the lease or the renewal of the lease or the changing of the location of the airport store took place, Gérard Gougeon, Director of Marketing, who looks after leases for the Department of Transport, stated that in all his discussions with the airport store he dealt only with Mr Melzack, the husband, and that he always thought he was the owner. Furthermore, both corporations use the word “Classic” in their corporate names as well as in their advertising and although the use of the same name by two entirely independent corporations for the purpose of benefiting from the goodwill of such name may be a common occurrence in the business world and would not necessarily involve an association, I find it difficult in a case such as here not to consider it as an additional element which indicates the closeness not only of the operations of both corporations, but also of their respective businesses.

The onus of establishing that the sole main reason was that of a business consideration falls upon the appellant. In my view, it has failed to discharge that onus. The appeal is dismissed with costs.