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Citation: 2007TCC96
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Date: 20070220
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Docket: 2005-68(IT)G
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BETWEEN:
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ROBERT BOUTILIER,
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Appellant,
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and
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HER MAJESTY THE QUEEN,
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Respondent.
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REASONS FOR JUDGMENT
CampbellJ.
[1] The Appellant was reassessed pursuant to subsection 56(4) of the Income Tax Act (the "Act") to include in income amounts called trailer fees which he had not previously included in his personal income for the 1998, 1999 and 2000 taxation years.
[2] When investment brokers or financial planners sell mutual fund units to clients, they are paid a commission for the sale. If they are able to retain those units after the sale and the clients do not redeem them, they will be paid amounts called trailer fees. Trailer fees are paid on a regular basis by mutual fund managers and are attributable to the services which the brokers provide on an ongoing basis to those clients that continue to maintain their mutual fund units with the broker. The fees are computed as a percentage of net asset value of a client's units that are being managed.
[3] The Appellant is a Registered/Certified Financial Planner. Since 1997, he has been associated as an independent contractor with a registered investment dealer, IPC Investment Corporation, formerly Hicks Financial Solution ("Hicks"). Both the Appellant and Hicks are properly registered and licensed under the Nova Securities Act (the "Securities Act"). When the Appellant sells mutual funds and other securities to clients, the commissions for the sales are shared between the Appellant and Hicks. If clients, who purchase mutual funds, continue to retain the units with the dealer, rather than present them for redemption, ongoing fees called trailer fees are paid to the dealer and shared with the salesperson, in this case the Appellant. Initially Hicks paid the trailer fees to the Appellant personally. However this changed in early 1997. On January 10, 1997 the Appellant incorporated 3004177 Nova Scotia Ltd. (the "Corporation") and set up a Family Trust (the "Trust"). The Appellant was a trustee for the Trust and members of his family were beneficiaries. The Appellant controlled the Corporation and was a director and officer. He then transferred into this Corporation that portion of his business activities dealing with the trailer fees in exchange for 200 preferred shares valued at $200,000.00. The Corporation filed an election with the Canada Revenue Agency ("the CRA") under subsection 85(1) of the Act. The Corporation was not registered under the Securities Act.
[4] The Appellant and Hicks had an oral agreement pursuant to which Hicks paid the trailer fees to the Corporation. This was done throughout the 1998, 1999 and 2000 taxation years and the Corporation declared these fees as income and paid tax on them. The Minister of National Revenue (the "Minister") reassessed the Appellant pursuant to subsection 56(4) and included these amounts in his income.
[5] The issue is whether the trailer fees were properly included in the Appellant's income. In resolving this issue the following questions must be addressed:
(1) What is the nature of the trailer fees?
(2) Whether the trailer fees were earned by the Corporation or whether the Appellant earned the fees and assigned them to the Corporation such that subsection 56(4) applies?
[6] The Appellant asserts that subsection 56(4) does not apply because its application requires an assignment of a right to an amount of an income nature. However in this appeal the Appellant asserts that what was assigned was the "opportunity" for the Corporation to provide services to clients to whom the Appellant had sold mutual funds. Consequently the right to income in the form of trailer fees would arise only when the Corporation provided those related services to the clients. The trailer fees were therefore earned through the provision of services by the Corporation to existing clients and they were not income that the Appellant was beneficially entitled to receive. In support of this argument, the Appellant contends that the income, earned in the form of trailer fees for services provided over time when the clients' funds are retained, is distinct from the commissions paid on the initial sale of the mutual fund units.
[7] The Respondent submits that the transfer of the trailer fees to the Corporation is a transfer of a right to income as contemplated in subsection 56(4) of the Act, which would otherwise have been included in the Appellant's income. The Appellant's entitlement to the fees crystallized when he originally sold the mutual funds to his clients. The transfer of the fees to the Corporation was simply a scheme to artificially reduce the Appellant's income. He remains beneficially entitled to those fees. The Corporation was essentially a receptacle for the flow of revenue with dividends from the Corporation flowing back into the Appellant's account.
Analysis
[8] Subsection 56(4) of the Act states:
Where a taxpayer has, at any time before the end of a taxation year, transferred or assigned to a person with whom the taxpayer was not dealing at arm's length the right to an amount (other than any portion of a retirement pension assigned by the taxpayer under section 65.1 of the Canada Pension Plan or a comparable provision of a provincial pension plan as defined in section 3 of that Act) that would, if the right had not been so transferred or assigned, be included in computing the taxpayer's income for the taxation year, the part of the amount that relates to the period in the year throughout which the taxpayer is resident in Canada shall be included in computing the taxpayer's income for the year unless the income is from property and the taxpayer has also transferred or assigned the property.
[9] The transfer of the right to trailer fees has never been considered under subsection 56(4). Cases where investment brokers have transferred the right to receive commissions on the sale of securities to a company have resulted in findings that the income was properly attributable to the broker and not the company. [Adams v. M.N.R., (1960), 24 Tax A.B.C. 154; Goldblatt v. M.N.R., 64 DTC 5118; The Queen v. Burns, 73 DTC 5219] In those cases, although an employment relationship had been created between the broker and the company, the relationship was found to be notional.
[10] Subsection 56(4) is an anti-avoidance provision that applies where a taxpayer has transferred or assigned to a person, with whom the transferor was not dealing at arm's length, a right to an amount which, had the right not been transferred or assigned, would be included in the income of the transferor taxpayer (CRA Interpretation Bulletin IT-440R2, June 20, 1995, paragraph 1). The focus of the subsection is on the potential avoidance of tax that could result when a right to income is transferred between parties not dealing at arm's length.
[11] The two tests, that must be satisfied in order for this provision to apply, are:
(1) the beneficial entitlement test; and
(2) the arm's length test.
[12] Subsection 56(4) contains an exception to its application by providing that the income shall be included in the transferor's income "unless the income is from property and the taxpayer has also transferred or assigned the property". The Appellant has not argued that the income is from property and has conceded that this exception is not applicable here (Transcript, page 109). The Appellant has also conceded the second test under subsection 56(4) as the Appellant and the Corporation were not at arm's length within the meaning of section 251 of the Act because they fall within the ambit of subparagraph 251(2)(b)(i).
The Nature of Trailer Fees
[13] The practice of paying trailer fees was described in Piche v. Lecours Lumber Co., [1993] O.J. No. 1686 as follows:
... while the company stopped sharing some of the expenses, there was instituted in 1990 the practice by many mutual funds of paying trailer fees which was a fee of one half of one percent per annum calculated on a salesman's portfolio. It was paid to encourage salesmen to service their clients, with a view to discouraging redemptions. This has added substantially to the income of those selling mutual funds as the practice has now become almost universal. [emphasis added]
[14] While the Respondent argued that the fees were attached to the sale of the mutual funds, it is clear to me that there is a distinct line between commission earned on sales of mutual fund units and fees earned for services provided which enable the retention of the clients' funds. While the right to trailer fees arises at the time of the sale of mutual fund units to a client, the broker will be eligible to receive those fees only if he provides some level of service so that the client will not redeem or transfer those units after the sale. However, if for any reason the client redeems those units the day after the sale, trailer fees cannot be earned and will not be paid. Trailer fees can be earned only over time subsequent to the initial sale. The sale merely provides the potential for earning trailer fees but whether in fact any fees will be earned is clearly dependent upon the services provided to encourage those clients, to whom the mutual fund units were sold, not to redeem or transfer the units. In addition commission is earned at the moment when the sale is successfully completed but trailer fees are earned over a period of time by the provision of some level of service. Trailer fees are tied to an ongoing service element.
[15] Although it appears that these fees have been criticized within the financial service industry because actual service may not be required for the fees to be paid, the Appellant clearly demonstrated that in this case the provision of some service is in fact required and was provided. Further, the testimony of Mr. Henry Hicks, the former President of Hicks Financial Solutions, corroborated the Appellant's evidence on this point. He indicated that if this service was not provided after a sale, a salesperson such as the Appellant would not last long in the business. He also pointed out the very important factor that trailer fees meant not only a continuing remuneration after the sale but the fees formed part of a broker's valuation of his practice, such that if the business sold, the purchaser would then have the opportunity to continue servicing those clients in order to receive trailer fee income. This also sets the trailer fees apart from a commission earned on a sale. I was provided with some evidence respecting those services but not to the degree that I would have anticipated. The Appellant simply referred to the many ongoing services he provided to clients, such as telephone calls, seminars, meetings, gifts for clients. Although it would have assisted me if I had been provided more evidence respecting specific details and the level of service provided, I am satisfied with the testimony I have from both the Appellant and Mr. Hicks that trailer fees are distinct in nature from sales commissions. However my conclusion here does not determine the issue because the Appellant must satisfy the beneficial entitlement test under subsection 56(4) in order to determine who actually earned the trailer fees. It is at this junction on the road that the Appellant's argument begins to falter.
The Beneficial Entitlement Test:
[16] This Court in MFC Bancorp Ltd. v. R., [1999] 4 C.T.C. 2468 at paragraph 23 stated that the question under the beneficial entitlement test is whether the amounts would have been included in the taxpayer's income had the right to the amount not been transferred or assigned to the Corporation. Essentially the question becomes: who beneficially earned the trailer fees? Although prior cases can be distinguished because they involved commissions and not trailer fees, they are still relevant in respect to the analysis of the beneficial entitlement test. Although counsel did not refer to these cases, both parties did refer to the Supreme Court's decision in R. v. Campbell, [1980] 2 S.C.R. The Appellant relied on this case to support the argument that it was the Corporation that earned the trailer fees. In the Campbellcase, the company was incorporated for the broad purpose of establishing, equipping, maintaining and operating a private hospital and as such the company was engaged in an active business. The medical fees in that case, which were assigned by the doctor to his company, were determined not to be his income because they were income of the hospital, making subsection 56(4) inapplicable.
[17] The Respondent argued that the Corporation did not carry on an active business. Although I believe, given the right set of circumstances, a company could be engaged in the active business of providing services to earn trailer fees, that is not the case here. The case of Campbell may be distinguished from the present appeal based on the nature of the business activities. In the Campbell case, the company was incorporated to run a hospital and not for the sole purpose of receiving the medical billings of the doctor. The Appellant's business here has more similarities to the company in the case of Adams, where it was incorporated for the sole purpose of receiving commissions. The Appellant argued that the opportunity to earn trailer fees was transferred to the Corporation and the Appellant's role was to provide the necessary services on behalf of the Corporation. The Appellant's argument therefore is that the Corporation was engaged in the business of providing services to earn the fees. The Transfer Agreement dated January 10, 1997 (Exhibit A-1, Tab 2) references in the preamble only the transfer of the "trailer fees" to the Corporation and refers within the body of that Agreement to the transfer of "Assets". However there is no list of assets referenced or included within the Transfer Agreement other than this initial reference to the transfer of trailer fees from the Appellant's investment planning business to the Corporation. It is significant that the Transfer Agreement does not reference an "opportunity" to earn trailer fees, as the Appellant suggests, or list the services to be provided but simply references a transfer of the fees themselves. Based on my earlier conclusions, that the nature of trailer fees involves the provision of ongoing services, I believe it would be possible to transfer an opportunity to service clients and earn trailer fees, but that is not what happened here. The language used in the Transfer Agreement clearly supports my finding that the Appellant transferred to the Corporation the right to receive trailer fee income from his personal investment business and not the opportunity to provide the services to earn these fees.
[18] My conclusions in this regard are not based solely on the Transfer Agreement but are also based on the existence of other factors in this appeal. One of the more important elements was the treatment of expenses. The Corporation incurred virtually no expenses to earn trailer fees, yet expenses existed which included rent, telephone, utilities and employment expenses. The Appellant incurred and claimed these expenses personally throughout the 1998, 1999 and 2000 taxation years. Although the Corporation did claim some expenses relating to interest and bank charges, licenses and legal and accounting fees, these were minor in comparison to the expenses claimed by the Appellant in his personal tax returns for the three years. For example, in the 1998 taxation year, the Corporation reported revenue of $148,146.00 and expenses of $2,226.00 while the Appellant reported $338,176.91 in commission income and $181,440.61 in expenses. During this year, he paid wages of $71,797.12 for two assistants, rent of $21,275.85 and telephone and utilities in the amount of $10,952.14. When asked on cross-examination if the Corporation ever paid for employees, the Appellant stated: "I paid them personally but expenses were allocated out to the Corporation." (Transcript, page 50). When asked how the expenses were allocated, and why the corporate financial statements contained no such reference to an allocation, he was unable to provide a satisfactory response and simply stated that it was his accountant who did it. There was no evidence provided to me that the expenses were allocated in any manner. Without this evidence it would appear that, although the Appellant separated the trailer fee income from the rest of his business activities, he continued to deduct the majority of the expenses against the other commission income.
[19] It is central to the Appellant's argument that the Corporation was set up to provide certain services to existing clients yet it is difficult to establish from the evidence that the Corporation was engaged in servicing clients to earn the fees when it incurred very few expenses. Of the expenses it did claim, there were none relating to rents, wages, employee benefits or other similar expenses which one would normally expect to see. The Appellant's testimony was that he shared his office with the Corporation but the evidence indicates that the Corporation did not pay any rent for the use of the office. In addition the Appellant stated that the Corporation shared the use of his executive assistants yet, other than in 2000, the Corporation did not incur any wage and benefit expenses. It appears that this factor has been an important consideration in other cases [Wallsten v. The Queen, 2001 DTC 215 (T.C.C.) and Shaw v. The Queen, 92 DTC 5213 (F.C.A.)].
[20] Another important factor in this appeal which points to the conclusion that the Corporation was not in fact engaged in an active business of providing ongoing services to clients is the lack of remuneration to the Appellant for the services he claims he provided on behalf of the Corporation. The only amount he received was a bonus in 2000, which appears to have been paid for the sole purpose of lowering the Corporation's income in that year to maintain the small business deduction.
[21] The manner in which the service to clients was performed does not appear to have changed after the incorporation. Although I do not believe it is essential that the Appellant in these circumstances would be required to inform clients that he is now providing the services on behalf of his Corporation, in order for me to come to the conclusion that it was the Corporation that was beneficially entitled to the income, this is one of a number of factors which again point to the status quo being retained in respect to the manner in which the Appellant conducted his affairs after incorporation. According to the evidence of Henry Hicks it was the Appellant and not the Corporation that Mr. Hicks considered would continue to be personally accountable for providing the services after the incorporation. This is another indication that only the right to trailer fee income was transferred to the Corporation and that the Appellant, at least in the eyes of the Mr. Hicks, his business associate, was still providing the services.
[22] The Appellant had no employment contract with the Corporation, unlike the case of Campbell, where there was an employment contract between the doctor and the hospital that clearly demonstrated that the doctor was required to provide services on behalf of the company for remuneration.
[23] Finally, although it is certainly not determinative, the rapid flow of trailer fees through the Corporation to the Family Trust, the beneficiaries of the Trust and eventually back to the Appellant continues to support the existence of the Corporation as a mere receptacle for the flow of income. This is clearly the type of transfer that subsection 56(4) was intended to address.
[24] All of these considerations, but especially the fact that the Appellant personally incurred virtually all of the expenses associated with earning the trailer fees, received no remuneration for performing the services on behalf of the Corporation, and continued after the incorporation to be viewed by Henry Hicks as the person that would be accountable to provide the service, support my conclusion that the Corporation was not engaged in an active business in earning the trailer fees. Therefore it was the Appellant that was beneficially entitled to this income and it was this right which was transferred to the Corporation under the Transfer Agreement. The onus is on the Appellant to provide sufficient evidence to support his appeal. If he was providing services on behalf of the Corporation, he should have been able to provide evidence of exactly what he was doing on behalf of the Corporation to earn those trailer fees. The evidence cannot support a finding that the portion of the Appellant's business relating to the ongoing servicing of clients to earn trailer fees was transferred to his Corporation. The factors which one would expect to find in a bona fide contractual relationship are simply not present here.
[25] In respect of the Appellant's submissions concerning the Nova Scotia Securities Act, because the issue has been disposed of, it is not necessary to make any conclusions in respect to a potential breach by the Corporation under that Act.
[26] The Appellant's alternative argument was that the Corporation has already paid tax on this same income that the Minister is now seeking to tax in the hands of the Appellant. Reliance was placed upon the cases of Winter v. The Queen, 90 DTC 6681 (F.C.A.) and Ferrel v. The Queen, 97 DTC 1565 (T.C.C.) for the proposition that "section 56 of the Act should not be applied in such a manner as to tax the same income in the hands of two different taxpayers" (Notice of Appeal, paragraph 27). This submission is misleading. The Federal Court of Appeal stated in the case of Winter that:
It is generally accepted that the provision of subsection 56(2) is rooted in the doctrine of "constructive receipt" and was meant to cover principally cases where a taxpayer seeks to avoid receipt of what in his hands would be income by arranging to have the amount paid to some other person either for his own benefit (for example the extinction of a liability) or for the benefit of that other person (see the reasons for Thurlow J. in Miller supra and of Cattanach J. in Murphy, supra). There is no doubt, however, that the wording of the provision does not allow to its being confined to such clear cases of tax-avoidance. The Bronfman judgment, which upheld the assessment, under the predecessor of subsection 56(2), of a shareholder of a closely held private company, for corporate gifts made over a number of years to family members, is usually cited as authority for the proposition that it is not a pre-condition to the application of the rule that the individual being taxed have some right or interest in the payment made or the property transferred. The precedent does not appear to me quite compelling, since gifts by a corporation come out of profits to which the shareholders have a prospective right. But the fact is that the language of the provision does not require, for its application, that the taxpayer be initially entitled to the payment or transfer of property made to the third party, only that he would have been subject to tax had the payment or transfer been made to him. It seems to me, however, that when the doctrine of "constructive receipt" is not clearly involved, because the taxpayer had no entitlement to the payment being made or the property being transferred, it is fair to infer that subsection 56(2) may receive application only if the benefit conferred is not directly taxable in the hands of the transferee. Indeed, as I see it, a tax-avoidance provision is subsidiary in nature; it exists to prevent the avoidance of a tax payable on a particular transaction, not simply to double the tax normally due nor to give the taxing authorities an administrative discretion to choose between possible taxpayers. [emphasis added]
[27] Clearly the above passage refers specifically to subsection 56(2) and not to subsection 56(4). Subsection 56(4) requires that a person transfer "a right to income", while subsection 56(2) does not require a taxpayer to be "initially entitled to the payment". That is, subsection 56(2) does not require the taxpayer to have a right to the payment while subsection 56(4) does require such a right to exist. Therefore the comments in Winter must be limited to subsection 56(2).
[28] In Ferrel, both subsections 56(2) and 56(4) were relied upon. The above referenced comments from the case of Winter were cited by Justice Mogan in his analysis of subsection 56(2) when he stated:
As I understand the above passage, when the Minister relies on subsection 56(2) to assess a particular person concerning a payment to some third party, it is not necessary that the particular person be entitled to receive the payment. It is necessary, however, that the person would be subject to tax if he had in fact received the payment. Also, if the particular person was not entitled to receive the payment, then subsection 56(2) will apply only if the payment is not taxable in the hands of the third party. [emphasis added]
[29] Although subsection 56(4) was also relied upon, these comments had no relevance to the finding that subsection 56(4) did not apply. Justice Mogan found "that the Appellant did not have any right in law to receive the management fees paid" and therefore concluded that subsection 56(4) did not assist in supporting the assessments in that appeal. The fact that tax had been paid by the transferee was relevant only in dismissing the subsection 56(2) argument.
[30] These cases do not assist the Appellant's argument. Whether the Corporation here has been properly assessed has little bearing on this appeal and it remains an issue which the Corporation must deal with. The CRA's administrative position in this regard is contained in Interpretation Bulletin IT-440R2, paragraph 10:
10. An amount to which subsection 56(4) applies could be included in the income of both the transferor and transferee. However, where the transfer or assignment of the right to an amount that is income does not constitute a deliberate attempt to evade or avoid tax, the amount will be included only in the income of the transferor.
[31] There is no definitive statement within subsection 56(4) respecting the probable outcome if taxes are paid by the transferee where the provision is applicable, as in this appeal. Although the Act does not appear to contain a specific provision to prevent such double taxation in these circumstances nor does there appear to be any judicial consideration of the feasibility of the CRA's administrative policy, it would appear that where the transfer of the right to income is not shrouded with a deliberate attempt to avoid tax, the CRA would and probably should be looking to tax the income of the transferor only.
[32] Despite very able representations by counsel for the Appellant, in view of my findings, I must dismiss the appeal, with costs.
Signed at Ottawa, Canada, this 20th day of February 2007.
Campbell J.
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