Jordans Rugs Ltd., Jordans (Victoria) Ltd., Jordans (Vancouver) Ltd., Jordans (New Westminster) Ltd., Jordans (Calgary) Ltd., Jordans (Edmonton) Ltd., Jordans (Lethbridge) Ltd. And Jordans Interiors Ltd. v. Minister of National Revenue, [1969] CTC 445, 69 DTC 5290

SHEPPARD, D.J.:—Each appellant corporation appeals from the direction of the Minister under Section 138A(2) of the Income Tax Act that the corporations be deemed to be associated”, and under Section 138A(3) (b) (ii) seeks to vacate that direction on the ground ‘‘that none of the main reasons for the separate existence of the . . . corporations is to reduce the amount of tax that would otherwise be payable under this Act’’, or to vary that direction under Section 138A(3)(c). The facts follow :

Until December 31, 1955 Jordans Limited carried on the business of selling rugs and furniture at 2645 Granville Street, Vancouver, British Columbia, and on that date the business was sold to a partnership operating under the name of “Jordans Rugs and Furniture’’, containing the following interests, namely :

all representing interests in various corporations. There was a further partnership of ‘‘Maguires Carpet Distributors’’. The Jordan business experienced problems about succession and through declining profits and in January 1960 consulted the firm of Peter A. Paauwe and Associates Ltd., Estate and Tax Consultants, and this firm was brought in to consider these matters. They later filed a plan (Exhibit A3), which advanced three proposals:

1. To provide for the position of the mother, Mrs. Gertrude

Knox ;

2. to freeze the values of Charles Jordan-Knox and Trevor Jordan-Knox in the business; and

3. the sons, Charles and Trevor Jordan-Knox during their lifetimes, to pass to their children the values arising to them out of the family business and thereby avoid estate tax.

This plan suggested the use of redeemable preference shares. The Income Tax Act was not considered.

Following introduction of these proposals, Charles Jordan- Knox and others pointed out to Peter A. Paauwe and Associates Ltd. that they had not dealt with the main problem arising out of the business, namely falling sales and profits; that competition had increased, costs also had increased, and the profits were declining rapidly and that the local managers of the retail stores in various cities in British Columbia and Alberta were paid a bonus on the gross sales, but that the bonus had no regard to net profits. Therefore, some plan had to be devised which would permit the re-establishing of the business. That led to numerous discussions with the local managers and others (Exhibit All, paragraphs 1 and 2).

On March 17, 1960, the various partners in the two partnerships held a meeting when they considered the difficulties of the existing business, the need of credit with the bank and with large suppliers of merchandise, the need to have more aggressive management in the retail stores, and to provide for investment of the senior employees; therefore, in effect, it was resolved that the assets and liabilities of the two partnerships be consolidated into one corporation having two wholesale distributing houses in Vancouver and Calgary respectively, and retail stores in Vancouver, New Westminster, Victoria, Calgary, Edmonton and Lethbridge, in which the local managers would have an equal controlling interest of the one corporation which would supply the merchandise and other requirements of the local stores, and that reorganization take effect as of June 30, 1960 (Exhibit A5).

The plan then instituted by the minute of the partners was that each local manager of the local companies which were the retail stores, would have equal control of that local store with Jordans Rugs Ltd., and the local manager would also, in addition to his salary, receive a bonus and dividends on his shares in the local company. That plan was carried out by incorporating Jordans Rugs Ltd. to operate as the wholesale company which would buy in bulk for all of the retail stores, would also supply the local stores with their capital and stock-in-trade so that the local stores would have the advantage of bulk buying. Jordans Rugs Ltd. would also provide accounting services for the local stores. The local company through its local store would in turn provide the retail sales. The local manager, having peculiar knowledge of local conditions, would have nominally equal control but could in effect have the greater control because of his knowledge of local conditions ; and because bonus and dividends were affected by the profits of the local store, he would therefore be interested not merely in gross sales but in the net profits of the local company.

On July 11, 1960 Jordans Rugs Ltd. and the other appellants were incorporated, saving Jordan Interiors Ltd. which was incorporated on July 20, 1961. The plan was carried out by allotting to each local manager in his local company 50 voting common shares at $5 each and 200 preference non-voting shares at $1 per share for which he paid a total sum of $450, to either Charles Jordan-Knox or Trevor Jordan-Knox 50 voting preference ‘‘ A ?? shares in order to have equal control of the local business, and to Jordans Rugs Ltd. 5,000 non-voting preference shares in each local company. There was one exception to the above in the Vancouver company where there were 100 voting common shares issued, fifty to each of two joint managers and 100 voting preference shares were issued to one of the Jordan-Knox brothers to equalize the control of the joint managers.

The letter of July 25, 1960 from Charles Jordan-Knox and Trevor Jordan-Knox to Gordon Campbell, the local manager of the Victoria company (Exhibit All) outlines the plan insofar as the local manager was concerned and dealt with his becoming a shareholder, and his interests in the profits of the local company which he was managing.

The agreement of July 2, 1960 between Jordans Rugs Ltd. and Gordon M. Campbell (Exhibit A12), sets out the typical contract with the local manager whereby he was employed by Jordans Rugs Ltd. which had agreed to supply the management of the local store, and the agreement of July 13, 1960 between Jordans (Victoria) Ltd. and Jordans Rugs Ltd. (Exhibit A13) sets out the duties of Jordans Rugs Ltd., namely to provide management, oversight, direction, to supply equipment and facilities, to provide for proper and efficient management and to supply the stock in trade.

The Minister of National Revenue directed under Section 138A(8) that the eight appellant corporations named in the style of cause be deemed associated with each other in the year 1964 and on appeal, the Tax Appeal Board dismissed the appeal therefrom [not reported]. The appellants have thereupon appealed to this Court under Section 138A(3). The issue on this appeal arises under Section 138A(3) (b) (ii) namely whether ‘‘none of the main reasons for the separate existence of the . . . corporations is to reduce the amount of tax that would otherwise be payable under this Act. That issue the appellants affirm and the Minister denies.

The evidence of Charles Jordan-Knox sets out the reasons for the incorporation of these respective appellants and the difficulties which led to the resolution of March 17, 1960 and the incorporation of the various appellants. Before 1955, Jordans Limited, which then owned the carpet business, would buy carpets abroad and obtain a good markup thereon, which ensured a profitable carpet business. In 1955, the carpet industry was revolutionized. There arose on this continent new mills for the manufacture of carpets and the old mills obtained new machinery. This new high-speed machinery was accompanied by the introduction and improvement of synthetic materials for the manufacture of carpets. As a result, this made the carpet mills on this continent, and in Canada particularly, more competitive than when Jordans Limited could buy in bulk from the foreign mills and import carpets for which there was no substantial competition on this continent. These changes resulted in the establishment of large distributors in Western Canada which enabled local independent stores to spring up by only obtaining samples and by relying on the stock-in-trade kept by the distributors. A small operator could establish his business with only a few samples. Again, the costs of retailing were rising and as the market was curtailed there was a smaller number of sales to produce profits to pay those extra costs. Further the retail prices came down with the result that carpets which had been obtainable from the foreign mills and had retailed at $14 or $15 per square yard were now sold for possibly $12 per square yard.

In 1959, the net profits fell to a net profit of 2.8% on the gross sales (Exhibit A7). The written plan which was submitted by Peter A. Paauwe and Associates Ltd. (Exhibit A3) did propose one operating company and did provide for the names of four companies then existing being changed, but those were none of the appellant corporations. After the plan was submitted, Charles and Trevor Jordan-Knox amongst others mentioned to Peter A. Paauwe, with some concern, the necessity of changing the method of continuing the business and the necessity of improving their marketing method as profits were rapidly decreasing, and they suggested the possibility of sharing the profits with the local managers as a means of increasing the incentive at the local level to meet the local situation and to produce greater net profits. Peter A. Paauwe orally came up with a plan for a central wholesale company and for local companies to carry on the retail business and the control would be divided. The complete proposal evolved into the plan carried out and which basically provided that:

1. the local manager was to have equal control with the Jordan family in running the business of the local store;

2. the local manager would share in the local net profits of the local company so that he would be interested in producing net profits and not only in merchandise sales.

As pointed out, the net profits for 1959 had been only 2.8% on the gross sales and in that year the local managers had been paid a bonus according to sales as an incentive but that plan had the following disadvantages :

1. the local managers were employees of a large corporation and therefore it was open to question whether or not they would regard themselves as rewarded to the extent of their actual efforts ;

2. the bonus was paid according to sales and the managers were not concerned with actual net profits but might, in order to boost sales, effect a sale at a loss.

The proposed plan was discussed with the local managers and it was eventually decided that the best way to increase the profits was to allow the local managers to have an interest in the local profits and for the reason to incorporate local companies in which the managers would have joint control and in which they would hold shares so as to share in the net profits in proportion to their interest of $450 against 5,000 in shares held by Jordans Rugs Ltd. Further by the method, the local stores had the advantage of mass-buying by Jordans Rugs Ltd. whereby a better price was obtainable as by larger stores and departmental stores. By giving the local managers control and a bonus according to net profits, the local stores were then in a position to compete with the independent retailer as the manager knew the costs which were disclosed to him and he would know whether a particular sale was to be profitable or not.

After this new plan of reorganization was brought into effect the sales and profits increased. From 1959 to 1964 the sales increased by 19%, gross profit by 32% and net profit by some 230% (See Exhibit A7). Exhibit A8 shows the comparative improvement in each of the local stores. There was also an improvement in the attitude of the local managers; there were fewer complaints; the local managers regarded the local business as their own. They had the advantage of mass-buying through Jordans Rugs Ltd. as this company supplied the stock-in-trade. Further, the local managers had permission to buy locally if they desired. That actually resulted in only about 10% of the manager’s purchases being made locally and 90% through Jordans Rugs Ltd.

Jordans Interiors Ltd. which was incorporated on July 20, 1961 was concerned entirely with interior decorating in the Lower Mainland. That was a specialized business which was found not to be readily joined with the sale of carpets — a clerk might be a good carpet salesman, but not an interior decorator. Also the goods handled by Jordans Interiors Ltd. differed in that they sold generally what was required in interior decorating including furniture. Furniture had not been sold at a profit by the retail stores and was not generally considered part of the carpet business. Further, Jordans Interiors Ltd. because of its perculiar stock in trade, eventually had its own warehouse and accounting system. Jordans Interiors Ltd. was one of the later off-shoots of the reorganization of the business.

According to Charles Jordan-Knox, the reason for incorporation of the appellant corporations was to produce profits. The problem was inadequate profits and not a problem of taxation. They had not to consider the income tax ; income tax was not a factor in setting up the plan nor was it a main reason for the separate existence of the appellant corporations.

The plan was explained from the local manager’s point of view by James Francis Scarfo, who was the manager of the local store on Kings way which was later moved to New Westminster where he was local manager until 1962. In 1962 he was one of the joint managers of the Vancouver store but he was not immediately sold shares in the Vancouver store and therefore became quite dissatisfied. Eventually the plan was modified by allowing each of the two joint managers to hold the usual amount of shares for a local manager and their control was offset by doubling the voting preference shares held by one of Jordan- Knox brothers. Before the plan Scarfo was an employee; after the plan he felt himself a shareholder and belonging to the organization. He found he had a different outlook; he was running a local company and it was his responsibility to ensure that company was profitable, whereas formerly he had no such responsibility. Also, before the plan, although he was managing a local store, he had never seen a profit and loss statement nor was he informed of the cost of the goods although he could infer that cost from the marked price. His interest was the volume of sales on which depended his bonus. He was not concerned with net profits; expenses were not his responsibility. Now as a shareholder and sharing in the net profits of the local company, he received a salary, a bonus and dividends on his shares, the bonus and dividends being determined by the net profits. Formerly he did not participate in the managing of the company ; now he had a control in the local company and with his knowledge of local conditions, his control though nominally equal, might be greater. In particular he had seen that furniture did not produce a profit when sold with carpets and recommended furniture be dropped and that was done throughout all the local stores. Further, the prices in the carpet business are two, namely: the marked or recommended prices and secondly the actual price which is arrived at through bargaining. The local manager now knew the costs, knew whether the sale would produce a profit and he could decide quickly whether or not to sell without referring to head office and awaiting instructions. He had all the advantages of the individual dealer but also the advantages of the large dealers through Jordans Rugs Ltd. buying in large quantities. In. addi tion, Mr. Scarfo testified there were as many competitors as formerly. In 1960 there were 20 to 30 competitors but now there remained only six of them in business. However, new stores opened from time to time thus keeping the same number in competition.

The evidence therefore establishes that in 1960, the plan for reorganization was not by reason of income tax but by reason of the lack of profits. Since that date and from 1964 there has been a steady rise in profits indicating the plan was a success in meeting the problems which had faced this business.

The test to be applied in considering the meaning of Section 138A(3) (b) (ii) is set out in Doris Trucking Company Limited v. M.N.R., [1968] C.T.C. 303 at 307, where Dumoulin, J. stated:

I agree with appellant’s learned counsel, as stated on page 5 of his Summary of Argument, that “proper test is . . . if one supposed that all corporations were subject to tax at a flat rate of 50%, as has been recommended by the Royal Commission on taxation, would it be expected that these particular operations would have been carried on by separate corporations”.

It was necessary to increase the net profits of the business. Therefore the business would have been carried on by these separate corporations if the income tax were a flat rate of 50% (or 51%).

In Alpine Furniture Company Limited and Monte Carlos Furniture Company Limited v. M.N.R., [1968] C.T.C. 532 at 541, Cattanach, J. stated :

It would seem to me that the findings of the Minister under paragraphs (a) and (b) of Section 138A(2) are, in reality, only one finding to the effect that the separate existence of two corporations is not solely for business purposes and is to reduce taxes for which reason reference is made to Section 138A(2)(b) in Section 138A(3) (b) (ii) and no reference is made therein to Section 138A

(2) (a).

And at page 542 :

The fact that there may be two ways to carry out a bona fide commercial transaction, one of which would result in the imposition of a maximum tax and the other would result in the imposition of much less tax, does not make it a necessary’ consequence to draw the inference that in adopting the latter course one of the main objects is the avoidance of tax. (See C.I.R. v. Brebner, [1967] 1 All E.R. 779, Lord Upjohn at page 784.) However, the foregoing proposition contemplates that the sole purpose to be accomplished is the bona fide commercial transaction.

In the course of his remarks counsel for the appellants readily admitted that a substantial tax reduction would be effected but he contended that the tax advantage was incidental to the pursuit of a genuine business advantage and therefore irrelevant.

In the light of the remarks of Lord Upjohn (supra) I would agree with his contention assuming I were convinced that the business advantage was the sole motivating reason for entering into the arrangement here adopted.

The existence of the appellant corporations was solely for business purposes and not to reduce taxes.

The evidence of Charles Jordan-Knox is supported by that of James Francis Scarfo and should be accepted to the effect that the existence of these several corporations was solely for business purposes and not to reduce taxes and that business arrangement was the sole motivating reason for evolving the plan that was herein adopted.

In conclusion :

1. None of the main reasons for the separate existence of the corporations, the appellants, is to reduce the amount. of tax that would otherwise be payable under the Income Tax Act-,

2. The direction that the appellant corporations are to be deemed associated, is hereby vacated ;

3. The assessments of the appellant corporations, are referred back to the Minister to be re-assessed in accordance with this finding ;

4. The appeals are, therefore, allowed with costs.