Mendels v. The Queen, 78 DTC 6267, [1978] CTC 404 (FCTD)

Cattanach, J:—This is an appeal from a decision of the Tax Review Board dated October 15, 1976 in which it was held that the plaintiff, Leonard Mendels was not entitled to deduct an amount of $10,000 in computing his income for his 1970 taxation year thereby confirming the assessment of the Minister of National Revenue in this respect.

This was the only issue before me although before the Tax Review Board other issues arose which have not been appealed.

The facts established before the Tax Review Board are substantially the same as established before me and the rival contentions on behalf of the parties are substantially the same before me as they were before the Board. The only possible difference would have been a reference to and a discussion of the principle in Massey-Ferguson Ltd v The Queen, [1977] CTC 6; 77 DTC 5013 decided by the Federal Court of Appeal on December 13, 1976 and accordingly was not available at the time of the decision of the Board on October 15, 1976 some two months earlier.

To pinpoint the precise issue in this appeal it is expedient to briefly summarize the facts as are pertinent thereto.

The plaintiff and another dentist, Dr Erwood, carried on the practice of their profession in partnership at two locations in the environs of the City of Toronto, Ontario. In the conduct of that practice the partners engaged the assistance of a variable number of duly qualified dentists as employees but not as partners. In conjunction with the partnership practice. there was also operated a dental laboratory, a departure from the usual practice where dentists normally send their laboratory work to a separate commercial laboratory.

On May 25, 1966 the two partners caused to be incorporated a joint stock company pursuant to the laws of the Province of Ontario under the name of Mendelwood Investments Limited.

If my recollection of the evidence is correct this Company engaged in the business of purchasing and then renting laboratory and dental equipment to the dental partnership and I believe that this was done in the taxation years of the individual partners during their respective taxation years following the incorporation of the Company up to and including the taxation year 1970 here under review.

Whether this was so or not is immaterial. Certainly in his 1970 taxation year the plaintiff as well as his partner claimed and were allowed by the Minister their equal share of an amount of $24,073.32 paid to the Company in that year under the general heading of “equipment rentals” in assessing the plaintiff as he did. The Tax Review Board confirmed the assessment in this respect holding that the amount of $24,073.32 was a proper deduction and that aspect of the assessment is not appealed.

However, Dr Mendels, the plaintiff, and Dr Erwood concluded in reviewing their activities over their prior taxation years that they had each expended a great deal of their time on purely administrative matters pertaining to their practice thereby precluding them from devoting their time so occupied to the actual practice of their profession of dentistry.

They therefore concluded after various processes of investigation that $20,000 would be a realistic sum to be attributed to their administrative functions and accordingly by appropriate journal entries paid that amount to the Company for administrative, management or supervisory functions.

The taxation year 1970 was the first year in which a payment was made by the partnership to the Company for management services of this kind and the first year in which the partners sought to deduct their share of that amount of $20,000 (each partner’s share being $10,000) from their respective incomes.

Each of the two partners owned an equal number of shares in the Company and they were the only shareholders and officers of the Company. There were no employees of the Company engaged to perform these administrative services. The plaintiff and Dr Erwood performed them just as they did before the advent of the Company. In fact the plaintiff testified that almost the entire bulk of these management services could not be delegated but must be performed by the partners themselves. For example only the partners' could resolve differences with the dentists employed by the partnership, determine what supplies should be purchased and what equipment should be replaced.

In my opinion the learned member of the Tax Review Board posed for himself the proper question which is determinative of the resolution of the issue whether 50% of the amount paid by the partnership to the Company for management services is properly deductible by the plaintiff when he said:

The simple question, therefore, is: Did the appellant, in his role as a manager of the dental partnership of Mendels and Erwood, perform this role as a partner therein, a function he might normally be expected to perform? Or did the appellant, in his role as a manager of the partnership of Mendels and Erwood, do so acting for the corporation Mendelwood Investments Limited?”

Put even more simply the question is: did the plaintiff perform the management services as a partner in the dental practice or did he perform those services as an officer of the Company?

The learned member of the Tax Review Board answered the question he posed to himself by saying:

The Board therefore finds for the year under review that the appellant has not established . . . that Mendels and Erwood received management services from or through the corporation Mendelwood Investments Limited to the value of $20,000 as claimed.

I do not think that by using the language “to the value of $20,000 as claimed’’ he was questioning the evaluation but rather he was saying that no matter what the evaluation of the services was, no management services were received by the partnership from the management Company.

Applying that language to the more succinct version of the question set out by myself the Board must have found that the appellant performed those administrative services to the dental partnership as a partner and not as an officer of Mendelwood Investments Limited just as was done before.

While I am in agreement with the conclusion reached by the learned member of the Tax Review Board I consider that it is proper that I should outline the reasons for my agreement with that conclusion based upon the principles enunciated in decided cases as I construe those principles as applied to the facts of the present appeal.

One salient fact which emerges from the evidence is that, in reality, there was no change in what was done before the payment to the Company for management services and in what was done after.

As Ritchie, DJ said in Shulman v MNR, [1961] Ex CR 410; [1961] CTC 385; 61 DTC 1213:

The dividing line between the appellant as the owner of the law practice and the appellant as the agent of Shultup was so thin as to be invisible to his own employees. By a simple exercise in mental acrobatics the appellant was to move, at will and instantaneously, over, or through, that invisible line. The transition from one capacity to the other could be effected without anyone other than the appellant himself being aware it had occurred.

By substituting the word “plaintiff” for the word “appellant”, where the latter word occurs, the words “dental practice” for the words “law practice” and the words “Mendelwood Investments Limited” for the word “Shultup” this passage describes the situation of the plaintiff in the present appeal.

Other facts emerging were that there was no increase in efficiency nor any legitimate business purpose achieved.

In Cameron v MNR, [1971] CTC 97; 71 DTC 5068 a case decided by myself, it was held the mere fact that there was no change in the duties of employees formerly performed by a company in which they had been employed and the duties performed by those same employees in a management company was not of itself sufficient reason to find that the management company was a mere sham, simulacrum or cloak but there were factors present in the Cameron case not present in the present appeal.

Neither does the fact of itself that more efficient management does not result necessarily have that effect. In the Cameron case a more efficient management did not result from the interposition of a management company. The same efficiency could have been achieved by carrying on as before. However the primary object of the management company was to facilitate the transfer of the controlling shares in the business and that was a legitimate purpose. If a saving in income tax ultimately resulted to anyone that was merely incidental to the overall plan.

This decision was confirmed on appeal to the Supreme Court of Canada in MNR v Cameron, [1972] CTC 380; 72 DTC 6325. It was held that the agreement between the contracting company and the manage- ment Company was not a sham, that the evidence supported the finding by the trial judge that the primary purpose was to carry out other objectives and that the parties conformed to the legal rights created by the agreement as were intended and if an income tax saving resulted that was incidental to the overall plan.

Some of the factors present in the Cameron case are missing in the present appeal. Other factors are common to both.

The precise arrangement or agreement between the dental partnership and Mendelwood Investments Limited is not readily apparent. In so saying I am not to be construed as saying that there cannot be an oral agreement, as in all likelihood there was, but only that it is more difficult to ascertain the terms of that agreement.

Bearing in mind that there was no agreement between the partnership and the Company that the Company would be compensated for administrative services performed for the partnership by the constituent partners as officers of the Company from the incorporation of the Company on May 25, 1966 until the plaintiff’s 1970 taxation year, leads to the assumption that it was not intended that the Company should Supply management services of this nature through the partners as officers of the Company nor that the Company would be compensated therefor. This was done sometime during the currency of the 1970 taxation year, (the evidence indicates the decision to do so was made near the end of that year when income tax returns were being prepared) and accordingly that decision was an afterthought.

There is nothing reprehensible in that but it is susceptible of the interpretation advanced by counsel for the defendant that the bulk of the administrative services for the major portion of that year were so performed by the partners in their capacity as such and not as officers of the Company. Accordingly there was no agreement covering that period, no agreement for the payment of a management fee and accordingly a charge is being made for services not performed by the Company.

It was also the contention of counsel for the defendant that there was no actual payment by cheque or cash from the partnership to the Company. That is so but the exchange was effected by journal entries. There was a credit entry in the records of the Company indicating a credit of $20,000 and I take it that there was a corresponding debit entry in the records of the partnership.

There is no need, in my opinion, to go through the formality of handing actual money or a cheque over. The transaction is necessarily bilateral and in my view those journal entries constitute actual, nor merely notional or constructive payment. The evidence or material embodiment of the transaction may consist of book entries made in pursuance of the arrangement but what has happened is, if so intended, equivalent to the receipt of money (see Lord Wright in Trinidad Lake Asphalt Operating Co Ltd v Commissioners of Income Tax for Trinidad and Tobago, [1945] AC 1 at 10 et seq.

However the plaintiff, in his personal capacity, operates on a cash receipt basis. He was not paid his half of the $20,000 received by the Company from the partnership as salary to him for the administrative services performed by him as an officer of the Company but rather that amount is retained to his credit in the records of the Company and that has also been done for the years subsequent to 1970 to date.

Therefore I cannot escape the conclusion that this was tax planning. No doubt the fund so established can be drawn upon when the plaintiff has retired from the active practice of his profession when his income has been substantially reduced with a resultant tax advantage achieved by postponement.

Reverting to the business purpose sought to be achieved by the injection of a management company into the practice of a profession I refer to Holmes et al v Queen, [1974] CTC 156; 74 DTC 6143. There the plaintiffs were partners in a law firm. Their wives incorporated a management company to take over all the administrative functions of the law firm for which the partners paid the management company. A written management agreement was entered into providing for manifold services, such as the employment of all secretarial, clerical and maintenance staff, the leasing of office space, the leasing of all office equipment, furniture and fixtures, the purchase of stationary, legal forms, periodicals and professional literature, text books and reference materials and the management of secretarial, clerical and maintenance staff and the appointment of auditing and accounting staff.

The management company had full time employees including a general manager who performed those duties to all intents and purposes exclusively to the law firm although an effort was made to solicit other clients, not including other law firms, but there was no demand for those services elsewhere.

In those circumstances it was held that the management fee was paid out for the purpose of earning income and was not a disbursement or expense made or incurred in respect of a transaction or operation that, if allowed, would unduly or artificially reduce the income and accordingly was not a deduction prohibited by subsection 137(1) of the Income Tax Act.

It was not contended that the management company was a sham and that is not contended in the present appeal.

To determine the propriety of the deduction of the management fee consideration was given to the question whether genuine business reasons existed for the payment of the management fee. On the facts of that appeal it was found that true business motivation existed with consequent business advantages. The efficiency of the law firm was substantially increased. That was the net result and this was the business advantage accomplished. The partners could devote more time to their practice with a consequent increase in earnings. There were other material business advantages as well.

There are substantial differences between the facts in the Holmes case (supra) and those in the present appeal.

The only area of similarity lies in the fact that Mendelwood Investments Limited in the present appeal purchased and leased dental and laboratory equipment. The claim for the deduction in this respect has been allowed. In this instance the management company was not operated as the management company in the Holmes case was operated. Here the partners did exactly as they did before as partners but wearing the hats of officers of the management company. No increase in their earnings as dentists were demonstrated. The facts in the present appeal are more consistent with those in the Shulman case (supra).

On October 15, 1976 when the Tax Review Board delivered its judgment, MNR v Leon, [1976] CTC 537; 76 DTC 6299 had been decided by the Federal Court of Appeal but Massey-Ferguson Ltd v The Queen (supra) had not.

In the Massey-Ferguson case Mr Justice Urie speaking for the Court of Appeal in commenting on the Leon case (supra) had this to say: at page 5020:

As I see it, reaching this conclusion is not inconsistent with the decision of this Court in MNR v Anthony Thomas Leon, [1976] CTC 532; 76 DTC 6299, Court No A-232-74. In that case it was held that there was no bona fide business purpose, merely a tax purpose for the interposition of the management company whose role was at issue in that case. Moreover, it was said that in ascertaining whether or not there is a bona fide business purpose it is the particular agreement or transaction in question to which the Court must look for the answer. In the view of the Court in the Leon case, a company may be incorporated for legitimate business purposes but may engage in a transaction at sometime thereafter which has no such purpose and which is a sham because of it. In the Leon case that was what the transaction there in issue was found to be.

I am not at all sure that I would have agreed with the broad principles relating to a finding of sham as enunciated in that case, and, I think, that the principle so stated should perhaps be confined to the facts of that case.

As I appreciate the principle with respect to a finding of sham enunciated by Mr Justice Heald speaking for the Court of Appeal in the Leon case (supra) it was that while a company may be incorporated for the purposes which it was intended to be incorporated and pursued those purposes and therefore would not be a sham within the meaning of that word as laid down by Lord Diplock in Snook v London & West Riding Investments Ltd ([1967] 1 All ER 518 at 528) nevertheless such a management company may become a sham company if the agreement or transaction with that company lacks a bona fide purpose therefor.

It was with respect to this principle that I believe Mr Justice Urie had doubt. He said in the quotation above which I repeat for emphasis:

I am not at all sure that I would have agreed with the broad principles relating to a finding of sham as enunciated in that case.

I do not think that he intended to cast any aspersion on the principle repeated in the Leon case that if there was no bona fide purpose served by the management company but only a tax advantage resulted that payments made to the management company would be disbursements or expenses made in respect of a transaction that would unduly or artificially reduce income for which no. deduction can be made even though the transaction itself may be one that can be legally entered into and is accordingly not a “sham” within Lord Diplock’s definition.

In MNR v Cameron (supra) decided by the Supreme Court of Canada, it was found that the management company was not a sham and in that instance there was a bona fide business purpose which was to transfer the controlling interest by the owner thereof to employees. If a tax saving in income tax resulted to anyone that was subservient and incidental to the overall plan.

In the present appeal it was acknowledged that Mendelwood Investments Limited was not a sham.

However, in my view, for the purposes of subsection 137(1) of the Income Tax Act which reads:

137.(1) In computing income for the purposes of this Act, no deduction may be made in respect of a disbursement or expense made or incurred in respect of a transaction or operation that, if allowed, would unduly or artificially reduce the income.

it is immaterial that a management company interposed is not a sham.

The word “unduly” relates to quantum and means “excessively” or “unreasonably” and “artificially” means “not in accordance with normality”.

The words “transaction” and “operation” appear in the section. In the context the word “operation” contemplates a continuity whereas by the juxtaposition of the word “transaction” to the word “operation” must contemplate one or more individual transactions and may lack the necessity of prolonged continuity.

The payment for the leasing of dental and laboratory equipment is a transaction which results in an allowable deduction for the reasons that this was agreement between the parties, the agreement was meticulously followed by the parties, it was entered into for a genuine business purpose and business advantages resulted.

The payment for administrative services inaugurated in the plaintiff’s 1970 taxation year is also a “transaction” and the question with re- spect to that transaction is whether that transaction is one which “artificially” reduces the plaintiff’s income.

In the consideration of this question it is of paramount importance to consider what bona fide business purpose is sought to be achieved and if any such purpose was achieved.

In my view the remarks in the Massey-Ferguson case on the Leon case do not detract from the principle that an individual transaction undertaken by a management company on behalf of its. client, while that individual transaction does not make the management company a sham, nevertheless the transaction, if it does not serve a bona fide business purpose but only results in a tax advantage, is a transaction which artificially reduces income.

In the circumstances of the present appeal there was no bona fide business purpose accomplished and the plaintiff was well aware that a substantial tax saving would result, if the deduction were allowed.

The cumulative effect of the foregoing reasons leads me to the conclusion that the plaintiff has failed to discharge the onus cast upon him of establishing that the transaction here in question was to achieve a genuine business purpose to the exclusion of reducing income or, put another way, that the plaintiff has not discharged the onus of establishing that a business advantage was the motivation for entering into the transaction and that the saving of income tax was only incidental to that business purpose from which it follows that the disbursement or expense made or incurred is one which would unduly or artificially reduce the plaintiff’s income and as such is not an allowable deduction.

Accordingly it cannot be said that the Minister of National Revenue was not warranted in assessing the plaintiff as he did.

The appeal is therefore dismissed with costs to Her Majesty.