Pappas Estate v. MNR, 90 DTC 1646, [1990] 2 CTC 2132 (TCC)

Bonner, T.C.J.:—This is an appeal from an assessment of income tax for the 1985 taxation year. At issue is the question whether certain legal fees are deductible in the computation of the income of the appellant estate. In disallowing the deduction of the costs in issue, the respondent found or assumed that they were not incurred for the purpose of gaining or producing income and thus he relied on the prohibition contained in paragraph 18(1)(a) of the Income Tax Act ("Act"). He also took the position that the costs were on capital account and that the deduction thereof was prohibited by paragraph 18(1)(b) of the Act.

Steven Pappas died on August 28, 1984. He was survived by Chareklea, his widow, Maria, his daughter, and Gregory, his son by an earlier marriage. By his will, Mr. Pappas appointed his son Gregory and two lawyers, James A. Cox and Ross D. Freeman, as his executors and as trustees of trusts created by the will.

During his lifetime Mr. Pappas was active in the restaurant business in Calgary. At the time of his death he held shares in five of the eight corporations forming what was referred to in evidence as the Pappas group of companies. As well, there were bank accounts in New York and San Francisco in Mr. Pappas’ name with balances totalling approximately $2,000,000 (U.S.). Finally, Mr. Pappas owned real estate in Calgary and a house under construction in Greece. The shares of at least three of the companies yielded dividend income. The cash on deposit generated interest income. The Calgary real property was rented.

By his will Mr. Pappas bequeathed to his son Gregory all of his shares in Athens Restaurants Ltd. (later renamed Gregco Holdings Ltd.). He left all his personal and household effects to his widow. He directed that the residue of the estate be invested and held by the trustees. They were required to pay the income therefrom to the widow during her lifetime. Upon the death of the widow the residue was to be transferred to the daughter, Maria.

In the return of income for the year immediately following death the executors reported dividends of $262,000, interest from Canadian sources of $19,500 and interest from foreign sources of $130,000, They sought to deduct in computing income the sum of about $135,096.24 for legal fees. On assessment the respondent disallowed the deduction of approximately $132,000. It is therefore necessary to consider the relationship between the legal services and the income earning process.

Following the death of Mr. Pappas it was the duty of the appellants as executors to take possession of the property of the deceased, to obtain probate of the will, to pay creditors and to distribute to beneficiaries any property that was the subject of specific bequests. Subsequently, of course, the appellants as trustees were obliged to invest the trust property, pay income to the widow and otherwise proceed in accordance with the directions contained in the will. Generally speaking it was in the course of discharging duties of both types that the appellant incurred the legal fees in question.

The executors Cox and Freeman did not render separate accounts for services as executors and as lawyers. All work done by them in both capacities was charged to the estate at their respective billing rates for legal services. Their accounts are included in the amount now in dispute. The accounts are not sufficiently detailed to ascertain the amount of the fees charged for each of the various activities described in evidence.

The fees in issue were paid to seven law firms. Mr. Cox and an associate served as general counsel to the estate. Mr. Freeman served as tax counsel to the estate. Counsel were retained in both New York and California where bank accounts had been maintained by the deceased. Their services were necessary to obtain probate in the two foreign jurisdictions and gather the funds into the hands of the executors. The widow, the daughter and the son were each represented by separate law firms. In the case of each beneficiary the chosen firm provided its client with the services of two lawyers, a general counsel and tax counsel. The trustees had decided at the outset that the estate would pay the cost of legal counsel for the beneficiaries. Ross Freeman, one of the executors, testified that he felt that the administration of the estate would be considerably more difficult if competent counsel were not involved. He said that it was thought that the natural trust which ordinarily exists between mother and son might not be present between Mrs. Pappas and Gregory Pappas and that there were competing interests among the various beneficiaries. Accordingly, it was felt by the executors that the smooth administration of the estate would be facilitated if beneficiaries could make necessary decisions secure in the knowledge that they were being competently advised as to their rights.

Mr. Freeman described in a general way some of the activities undertaken by the executors. He said that they:

(a) visited restaurant properties owned by companies in which the estate held shares and reviewed leases thereof;

(b) dealt with "offsets" that is to say arrangements designed to ensure that intercompany payables and receivables were correctly dealt with;

(c) instructed the financial administrator of the estate to monitor the instruments of deposit which were available in order to secure the best possible return on invested funds;

(d) dealt with a threat of default on the Can lea mortgage, a receivable owned by one of the companies in which the estate held shares;

(e) dealt with a dispute between a company in which the estate held shares and a person who owed money to that company;

(f) monitored and engaged in tax planning including:

(i) avoiding a situation in which one company in the group suffered losses which could not be offset against gains earned by another company in the group;

(ii) avoiding by means of a corporate amalgamation the potential loss of a mortgage reserve upon the transfer to the estate by a company controlled by Gregory Pappas of the Canlea mortgage receivable;

(iii) consideration of a proposal advanced by tax counsel for one of the beneficiaries which proposal called for the winding-up of one of the companies the shares of which were held by the estate in order to trigger a loss which could then be used to offset a capital gain which had to be reported in the terminal return of income;

(iv) consideration of a proposal to form a trust in Bermuda and make ancillary arrangements intended to avoid Canadian withholding tax on payment to the widow, a non-resident of Canada;

(g) dealt with claims to certain assets made by the widow which claims were supported by threats to take proceedings under the Family Relief Act.

Mr. Freeman stated that there were problems which arose because the deceased had been secretive in relation to his assets. For example, the executors were initially unaware of the existence of the U.S. bank accounts. The activities of Mr. Freeman as tax counsel for the estate included, he said, tax planning of the estate and of the widow. Further, he dealt with problems “dove-tailing” the will and a shareholder's agreement which had been entered into by the deceased at the same time as the will was prepared. In this regard Mr. Freeman stated that an effort was made to implement what was believed to be the intention of the testator "whether the papers said it or not".

Mr. Cox was not called to testify. Mr. Freeman stated that Mr. Cox's duties included the review of documents, the investment of estate money and participation and discussions regarding tax and probate issues. His role was likened to that of a company director.

Evidence was given by Dale R. Spackman, a lawyer who worked with Mr. Cox on matters pertaining to the estate. He stated that the first thing done was the preparation of a compilation of all the documentation relating to the estate and to the estate plan. He felt it necessary to review the structure and status of the various corporations involved in the Pappas group which he said were intertwined with the estate plan. The plan, he said, called for a trust created under the will of all assets other than business assets. That trust was to be for the benefit of the widow and daughters. The business assets were to go to Gregory Pappas. A major issue which occupied the time and attention of the executors was whether certain liabilities attached to the business assets or whether the liabilities were to be borne by the estate. Another instance of executor time being spent on the question of the extent of the entitlement of each beneficiary arose in connection with the U.S. bank accounts. Although those accounts were in the name of the deceased it was established that substantial portions of each belonged to the widow and not to the estate. Mr. Spackman stated that ”. . . there was a lot of time spent coming to grips with that issue and the details of who was entitled to what and getting everybody to agree on that".

Mr. Spackman stated that Mr. Cox as senior executor acted as chairman of the meetings of the executors. Such meetings were quite frequent because the executors were trying to come to grips with the details of the estate plan. He said that Mr. Cox participated in decisions regarding such things as investment of the estate moneys, discussions regarding income tax and probate issues and discussions involving the identification and calling in of assets.

During the year following the death of Steven Pappas, Mr. Cox's firm furnished normal legal services in the corporate and commercial field to the companies forming the Pappas group. Virtually all of the fees for such services were included in the amounts charged to the estate and thus form part of the amounts now in dispute.

In my view the legal fees in dispute are costs which fall into one or more of the following categories:

(a) the cost of securing probate and locating and gathering in the assets;

(b) the cost of determining the extent of the entitlement of the various beneficiaries both under the will and estate plan and of taking the necessary steps to ensure that each beneficiary received his due;

(c) the cost of managing and supervising the activities of corporations whose shares were owned by the estate;

(d) the cost of devising and carrying out plans to minimize liability for taxation of the estate, of the beneficiaries and of companies in the Pappas group;

(e) the cost of investing liquid assets.

It is clear that the costs falling into the first two categories are not deductible. Indeed counsel for the appellant conceded that the portion of the fees of the estate solicitors related to the securing of probate are not properly deductible. Paragraph 18(1)(a) of the Income Tax Act provides:

18.(1) In computing the income of a taxpayer from a business or property no deduction shall be made in respect of

(a) an outlay or expense except to the extent that it was made or incurred by the taxpayer for the purpose of gaining or producing income from the business or property.

The taking of possession of the property of the deceased, the obtaining of probate and, where required, supplementary or foreign probate, the location and payment of creditors and the distribution of the property of a deceased to persons beneficially entitled are actions quite unrelated to the earning of income from a business or property. Such operations are not commercial in nature. They do not involve the generation of fees or other revenues payable to the estate and therefore are not carried on with a view to earning a profit. From the standpoint of the estate such activities are a cost of distributing the worldly possessions of the deceased in accordance with his wishes.

I turn next to costs of the third category. Counsel for the appellant argued that part of the work of Mr. Cox and Mr. Freeman was analogous to that performed by a corporate director and was directed toward increasing the current and future divide income earned by the estate from shares of companies in the Pappas group. Counsel relied on the decision of the Federal Court of Appeal in D. Morgan Firestone v. The Queen, [1987] 2 C.T.C. 1; 87 D.T.C. 5237. In Firestone, the Federal Court of Appeal was faced with a most unusual fact situation. There, the taxpayer, an individual, embarked on a venture involving the acquisition of financially weak corporations and rendering them profitable by proper management and supervision. It was the taxpayer's intention to hold those companies through a holding company whose shares were eventually to be publicly traded and to earn revenues from the acquired companies in the form of dividends passed up through the holding company. I assume that it was contemplated as well that revenues would be earned by the taxpayer on the sale of the shares of the holding company as well as by way of dividends. After investigating a number of prospects the taxpayer acquired all of the shares of three companies. Those shares were transferred to a holding company. In furtherance of the scheme the taxpayer obtained office space and hired employees to assist him in the supervision and direction of the operating companies. Many years later the holding company did in fact pay substantial dividends. One of the issues considered by the Court was the deductibility in the computation of the income of the appellant of the cost of supervision and management of the operating companies during periods both before and after the transfer of their shares to the holding company. It was held that the costs were deductible. That conclusion was based on a finding that the taxpayer carried on a business. At page 11 (D.T.C. 5244), MacGuigan, J. stated:

The appellant's business was in no sense solely or even principally share management. It was rather the profitable management of his operating companies, even though that was achieved at one remove from and without direct involvement in their day-to-day operations. It was in fact skillful indirect business management of a high order. It was no less so because the appellant did not keep proper accounts or issue financial statements of his own.

[Emphasis added.]

In my view Firestone is not, as counsel for the appellant seems to suggest, authority for the proposition that a shareholder who gratuitously incurs expenses in the operation of a business belonging to his corporation may always deduct such expenses. The effect of section 3 of the Income Tax Act is to require the calculation of the taxpayer's income from each source. In computing income from a source that is a business’ ordinary commercial principles require that profit be ascertained by setting against the revenues from the business the expenses incurred in earning such revenues. In order to have a source of income a taxpayer must have a profit or a reasonable expectation of profit. (See Moldowan v. The Queen, [1978] 1 S.C.R. 480; [1977] C.T.C. 310 at 313; 77 D.T.C. 5213 at 5215.) It is obvious that a taxpayer who embarks on a course involving the expenditure of money in pursuit of revenues which will belong to another person can never earn a profit and cannot be said to carry on a business.

Here, there was never any intention that the appellant would earn fees or other income for the management of the business of the corporations in which the deceased had held shares. The appellant could of course expect that proper management of companies whose shares were owned by the estate would yield income in the form of dividends. The decisions in Canada Safeway Ltd. v. M.N.R., [1957] S.C.R. 717; [1957] C.T.C. 335; 57 D.T.C. 1239 and D. W.S. Corporation v. M.N.R., [1968] 2 Ex. C.R. 44; [1968] C.T.C. 65; 68 D.T.C. 5045 make it clear that:

(a) expenditures incurred by a shareholder to make his corporation more profitable are not deductible in computing his income, and

(b) the possibility that a shareholder may receive dividends or other income arising from expenditures made by him for his company's benefit is too remote to warrant a finding that the expenditures are made to earn income.

In D. W.S. Corporation the taxpayer sought to deduct interest on money which it borrowed at six per cent interest and reloaned interest free to a subsidiary named World T and I Corporation. The claim to deduct interest was founded on paragraph 11(1)(c) of the Income Tax Act which provided:

11.(1) Notwithstanding paragraphs (a), (b) and (h) of subsection (1) of section 12, the following amounts may be deducted in computing the income of a taxpayer for a taxation year:

(c) an amount paid in the year or payable in respect of the year (depending upon the method regularly followed by the taxpayer in computing his income), pursuant to a legal obligation to pay interest on

(i) borrowed money used for the purpose of earning income from a business or property (other than borrowed money used to acquire property the income from which would be exempt),

or a reasonable amount in respect thereof whichever is the lesser.

At pages 72-73 (D.T.C. 5050), Thurlow, J. stated:

So far as the appellant's claim to deduct the interest may be based on the submission that the borrowed money was used for the purpose of earning income from the appellant's business the matter, in my view, is concluded against the appellant by the judgment of the Supreme Court in Canada Safeway Ltd. v. M.N.R.,

(1957) S.C.R. 717 (7 D.T.C. 1239). In that case the appellant sought to deduct interest on borrowed money used to purchase shares and thus to acquire control of a company which was one of its suppliers. By securing control of this company the appellant was able to obtain trading advantages over competitors which resulted in enhanced profits from the appellant's business. The Court, however, held the interest on the borrowed money not deductible not alone because the dividends from the shares would constitute exempt income but also because the borrowed money was not used in the appellant's business. With respect to the 1947 and 1948 taxation years, to which the Income War Tax Act applied, Kerwin, C.J. speaking for himself and Taschereau, J. (as he then was) said at page 723 [p. 340] [D.T.C. 1242]:

Reliance was placed upon subsection (1)(b) of section 5, but the exemption and deduction there contemplated of “such reasonable rate of interest on borrowed capital used in the business to earn the income as the Minister in his discretion may allow” do not apply, first, because the money borrowed on the debentures was not used by the appellant in its own business to earn the income and . . .

Reference was then made to sections 11, 12 and 27 and subsection 127(1) of the 1948 Income Tax Act and the learned judge observed at page 724 [p. 342] [D.T.C. 1242]:

Generally speaking, these enactments have the same effect as those applicable to the 1947-1948 taxation years and, if anything, the definitions included in the Income Tax Act clarify the situation.

Rand, J., referring to Section 11(1)(c)(i), said at page 728 [p. 345] [D.T.C. 1244]:

The language in (i) “used for the purpose of earning income from a business” corresponds with that of Section 5(1)(b) of the repealed Act and to what has been said on the latter there is nothing to be added: the business of the subsidiary is not that of the company.

Earlier Rand, J. had said at page 727 [p. 344] [D.T.C. 1244]:

It is important to remember that in the absence of an express statutory allowance, interest payable on capital indebtedness is not deductible as an income expense. If a company has not the money capital to commence business, why should it be allowed to deduct the interest on borrowed money? The company setting up with its own contributed capital would, on such a principle, be entitled to interest on its capital before taxable income was reached, but the income statutes give no countenance to such a deduction. To extend the statutory deduction in the converse case would add to the anomaly and open the way for borrowed capital to become involved in a complication of remote effects that cannot be considered as having been contemplated by Parliament. What is aimed at by the section is an employment of the borrowed funds immediately within the company's business and not one that effects its purpose in such an indirect and remote manner.

I shall therefore hold that the borrowed money here in question was not during the relevant period used for the purpose of earning income from (the appellant's) business within the meaning of Section 11 (1)(c) of the Act.

The submission was, however, made that borrowed money was used for the purpose of earning income from the appellant's property, that is to say, the demand note given by World T. and I. Corporation or the property right which it evidenced. It was not suggested that the money was used for the purpose of earning income in the form of dividends from World T. and I. Corporation but I do not think such a contention would be tenable anyway since such dividends, if received, would, I think, be income from the appellant's property in the shares of World T. and I. Corporation rather than from the property right evidenced by the demand note. On this point Rand, J. in Canada Safeway Ltd. v. M.N.R. said at page 728 [p. 345] [D.T.C. 1244-45]:

The word "property" is introduced in paragraphs (i) and (ii) but I cannot see that it can help the appellant; the language borrowed money used for the purpose of earning income from . . . property (other than property the income from which is exempt) in (i) means the income produced by the exploitation of the property itself. There is nothing in this language to extend the application to an acquisition of "power" annexed to stock, and to the indirect and remote effects upon the company of action taken in the course of business of the subsidiary.

Though in the present case there was no use of the borrowed money to purchase stock to obtain "power" or control over World T. and I. Corporation I think that the possibility of increased dividends by lending to World T. and I. Corporation must be taken to be too remote to characterize the lending of the borrowed money to it without interest as use for the purpose of earning income from the property represented by the loan. It is the loan itself rather than the shares that I think Rand, J. refers to when he says the statute means "the income produced by the exploitation of the property itself.”

On appeal to the Supreme Court of Canada (69 D.T.C. 5203) the conclusion and the reasons of Thurlow, J., were approved. Accordingly I have concluded the costs of the third class are not deductible.

I turn next to the cost of minimizing taxes. Counsel for the appellant submitted that approximately two-thirds of Mr. Freeman's time was spent in minimizing taxes arising upon the death of Steven Pappas. She pointed to work done to reduce taxes on capital gains deemed to have been realized on death and submitted that the ability of the trust to earn income ”. . . was largely dependent on Mr. Freeman's activities regarding valuation”. She further submitted that Mr. Freeman's fees for tax advice in the first year were a running expense and that the distinction between whether they are contributing to the capital cannot really be made". Such fees, she said, ”. . . did not bring anything into existence." She relied on the decision of the Supreme Court of Canada in Premium Iron Ores Ltd. v. M.N.R., [1966] S.C.R. 685; [1966] C.T.C. 391; 66 D.T.C. 5280.

This argument, in my view, rests on an unrealistic appraisal of the situation. The minimization of tax on capital gains deemed to have been realized on death can increase future income only by increasing the fund available for investment by the estate. Such a fund is a source of income and is therefore capital. Outlays on account of capital, the deduction of which is prohibited by paragraph 18(1)(b) of the Act are not, as counsel seems to suggest, confined only to outlays made to bring capital assets into existence. Furthermore, the decision in Premium Iron Ores Ltd. has no bearing in this case. There, legal costs were incurred by the taxpayer in resisting a claim of the United States Internal Revenue Service to tax on the income of the company.

At pages 404-405 (D.T.C. 5286 to 5287) Hall, J. stated:

A company such as the appellant exists to make a profit. All its operations are directed to that end. The operations must be viewed as one whole and not segregated into revenue producing as distinct from revenue retaining functions, otherwise a condition of chaos would obtain. For example, is the function of the Paymaster's Department to be considered as directly relating to the production of income, which it undoubtedly is, as distinct from the Audit Department which scrutinizes the disbursements made by the Paymaster? What of the sophisticated systems of internal and external audits adopted by commercial companies to assure that the income received by the company is properly retained? What of security arrangements to protect income already earned? What of claims against, say, a shopping centre for damages sustained by a customer or claimed to have been sustained and the legal costs of investigating and defending such claims? Counsel for the Minister freely admitted that these are routinely allowed as expenses incurred in earning "the income”.

"The income" surely means the net receipts over disbursements in the taxation year in the totality of the taxpayer's business as an on-going concern other than capital expenditures, gifts and the like. I can see no reason to regard legal expenses as differing from other expenses in that they differ solely by the fact that they are disbursements paid to lawyers as distinct from payments made to auditors or to accountants and others for work done in preparing the yearly income tax returns, or premiums paid for insurance to indemnify the taxpayer from loss by fire or from negligence or liability imposed by law. In my view, no distinction is to be drawn between proper legal expenses and other business expenses. All must be tested by the same standards.

The present case is quite different. As previously indicated the appellant did not carry on any business much less one which could be described as an ongoing concern in which running expenses might arise. The appellant did not exist to make a profit. The paragraph 18(1)(a) prohibition therefore applies. The foregoing comments apply not only to the activities of Mr. Freeman but as well to the activities of tax counsel for the beneficiaries and efforts to reduce the tax liability of the companies whose shares were owned by the estate. The business of the various companies were not the businesses of the appellant.

Finally, I turn to the deductibility of costs incurred in connection with the investment of liquid assets. It is clear that Mr. Freeman and Mr. Cox did find it necessary to consider from time to time the proper investment of funds such as those in the U.S. bank accounts. Such activities relate to the investment of capital and the costs thereof are costs on account of capital the deduction of which is prohibited by paragraph 18(1)(b) of the Act. It was argued, however, in the alternative that such costs are deductible by virtue of paragraph 20(1)(bb) of the Act. That provision reads:

20.(1) Notwithstanding paragraphs 18(1)(a), (b) and (h), in computing a taxpayer's income for a taxation year from a business or property, there may be deducted such of the following amounts as are wholly applicable to that source or such part of the following amounts as may reasonably be regarded as applicable thereto:

(bb) an amount other than a commission paid by the taxpayer in the year to a person

(i) for advice as to the advisability of purchasing or selling a specific share or security of the taxpayer, or

(ii) for services in respect of the administration or management of shares or securities of the taxpayer,

if that person's principal business

(iii) is advising others as to the advisability of purchasing or selling specific shares or securities, or

(iv) includes the provision of services in respect of the administration or management of shares or securities.

There was a total absence of evidence on which it could be concluded that the principal business of either Mr. Cox or Mr.Freeman is one falling within subparagraphs (iii) and (iv). For the foregoing reasons the appeal will be dismissed.

Appeal dismissed.