Rosner Management Inc. v. Minister of National Revenue, [1993] 1 CTC 2153, 93 DTC 127

Mogan, T.C.C.J.:—In March 1989, the Minister of National Revenue issued a direction under subsection 247(2) of the Income Tax Act, R.S.C. 1952, c. 148 (am. S.C. 1970-71-72, c. 63) (the "Act") to the appellant with respect to its 1986 and 1987 taxation years. As a result of that direction, the appellant and Bryan's Fashions Ltd. were deemed to be associated with each other in those years. The appellant and Bryan’s Fashions Ltd. ("BFL") were not otherwise associated under section 256 of the Act. On October 23, 1989, notices of reassessment were sent to the appellant with respect to its 1986 and 1987 taxation years on the basis that it was associated with BFL. The appellant has objected to and appealed from those reassessments. Section 247 has been repealed but, for the appellant's 1986 and 1987 taxation years, the relevant subsections read as follows:

247(2) Where, in the case of two or more corporations, the Minister is satisfied

(a) that the separate existence of those corporations in a taxation year is not solely for the purpose of carrying out the business of those corporations in the most effective manner, and

(b) that one of the main reasons for such separate existence in the year is to reduce the amount of taxes that would otherwise be payable under this Act or to increase the refundable investment tax credit under section 127.1

the two or more corporations shall, if the Minister so directs, be deemed to be associated with each other in the year.

247(3) On an appeal from an assessment made pursuant to a direction under subsection (2), the Tax Court of Canada or the Federal Court may

(a) confirm the direction;

(b) vacate the direction if it determines that none of the main reasons for the separate existence of the two or more corporations is to reduce the amount of tax that would otherwise be payable under this Act; or

(c) vary the direction and refer the matter back to the Minister for reassessment.

Brian Rosner is the effective voice in the appellant and BFL. He grew up in Winnipeg where he operated a ladies clothing store from 1964 to 1974. Mr. Rosner moved to Vancouver in 1974 where he opened a retail store selling ladies fashions. By 1980, Mr. Rosner had three stores in the Vancouver area all owned and operated by BFL and carrying on business under the name "Bryan's". Mr. Rosner felt that his small chain of three stores was inadequate because his competitors were getting bigger with many stores and he did not have the knowledge or experience to run a bigger chain. He knew one of the partners who operated a successful chain of ladies clothing stores under the name “ Suzy Creamcheese". In 1980, the Suzy Creamcheese Group purchased from Mr. Rosner a two-thirds interest in the three" Bryan's" stores. It is not clear from the evidence whether Suzy Creamcheese purchased two-thirds of the shares of BFL or whether the three" Bryan's" stores were operated by a partnership in which BFL and Suzy Creamcheese participated on the basis of one-third and two-thirds respectively. The Suzy Creamcheese Group took over the management of the stores and Mr. Rosner became primarily a buyer. Between 1980 and 1984, the small chain of "Bryan's" stores expanded from three to eleven.

In 1984, the two partners who owned Suzy Creamcheese were having a dispute and Mr. Rosner was given the opportunity to buy back the two-thirds interest owned by Suzy Creamcheese. He reacquired 100 per cent of the "Bryan's" stores and the transaction closed on August 1, 1984. At that time, BFL operated eleven stores. Mr. Rosner decided that he would implement in BFL some of the management and operating procedures he had learned through his association with the Suzy Creamcheese Group from 1980 to 1984. In particular, he decided that he would maintain the administrative offices, the accounting services and the warehouse at a location separate from any of the retail stores. When the group of retail stores started to expand after 1984 from 11 to more than 20, Mr. Rosner formed the Bryan's Fashions Ltd. Partnership (the "Partnership") to own and operate the newer stores. This was done as part of an estate plan because he wanted some of the increase in value to accrue for the benefit of his two sons and he wanted to isolate his business interests from his wife. Mr. Rosner and his wife had a brief separation around 1982; they formally separated in 1984; divorce proceedings were commenced; but they were reunited in 1988 and the divorce proceedings were discontinued. In 1986/87, the Partnership operated only three or four stores but all stores (those operated by BFL and the Partnership) carried on business under the name "Bryan's".

I turn now to the shareholders to determine who owned what in the relevant years. Yale Rosner and Richard Rosner are the teenage sons of Brian Rosner. Bruce Gelhorn is a chartered accountant, a full-time employee and controller of the appellant and BFL, and not related to Brian Rosner. Set out below is the substance of Exhibit R-3 which illustrates the respective shareholdings [not reproduced].

Yale Rosner and Richard Rosner are the only beneficiaries of the Brian Rosner Family Trust and the beneficial shareholders of their respective management companies which each own a 47 per cent participating interest in the Partnership. BFL is the general partner of the limited partnership. Bruce Gelhorn owns a five per cent interest in all of the retail stores because they are operated by BFL or the Partnership. The trustees of the Trust are the brother of Brian Rosner and his long-time friend L. Steingarten.

RYB Management Ltd. ("RYB") was incorporated under the laws of British Columbia in 1974 and its original function was to hold the lease for the first "Bryan's" store in the Pacific Centre. In January, 1981, RYB entered into a management agreement with BFL (Exhibit R-1) to provide "basic comprehensive management services” for BFL. At that time, Suzy Creamcheese owned a two-thirds interest in the "Bryan's" stores. After Mr. Rosner had reacquired 100 per cent of the Bryan's stores, the appellant company was incorporated (May 16, 1985) and a new management agreement was entered into between the appellant and BFL (Exhibit A-2) under which the appellant was to provide “management and administrative services in connection with the business of BFL”. The new agreement was made as of October 1, 1985.

When deciding an appeal under subsections 247(2) and (3), it is important to remember that the issue is one of fact. In M.N.R. v. Furnasman Ltd. et al., [1973] C.T.C. 830, 73 D.T.C. 5599 (F.C.T.D.), Addy, J. stated the concept well at page 836 (D.T.C. 5604):

The question as to whether or not one of the main reasons why two or more companies either came into being or continue to exist, is for the purpose of reducing the amount of tax that would otherwise be payable under the Act, is a pure and simple question of fact. A question of intention or motive is necessarily subjective; it cannot be otherwise, for nothing can be more subjective or dependent upon credibility than intention or motive, since it is essentially a condition of the mind. It is, indeed, the type of issue that would be eminently suitable for determination by a jury.

In The Queen v. Covertite Ltd., [1981] C.T.C. 464, 81 D.T.C. 5353, Marceau, J. took the question of fact one step further and described at page 467 (D.T.C. 5355) what the corporate taxpayer must do to succeed:

The difficulty stems from the very nature of the conclusion of the Minister that is put into question and must be verified. It is indeed a conclusion of fact as opposed to a conclusion of law, but one of a purely psychological content, since it refers to the state of mind and the intention of those responsible for the creation and the continued separate existence of the two entities. . . . The Minister has inferred from a certain number of facts that the saving of taxes, which was actually realized, was not a mere side effect but rather one of the main goals contemplated by the individuals acting behind the corporations. In verifying the conclusion, the Court cannot but adopt an approach similar to that followed by the Minister. The mere denial of the taxpayer, whether or not accompanied by a simple indication of the other causes that could have prevailed, can be given no weight. Being a mere assertion of a negative fact, and a fact which has to do with the state of mind of the witness, it can have no convincing probative force; it cannot constitute the proof required to annihilate the conclusion of the Minister. To succeed, the taxpayer must: (a) disprove the facts assumed by the Minister in reaching his conclusion; or

(b) convince the Court that the inferences drawn by the Minster from the facts assumed were unreasonable and unwarranted; or (c) add further facts capable of changing the whole picture and leading to different inferences pointing to the conclusion that the other reasons alleged have actually been prevalent.

And finally, in the more recent case of Krag-Hansen et al. v. The Queen, [1986] 2 C.T.C. 69, 86 D.T.C. 6122, the Federal Court of Appeal accepted the findings which the Minister must make under subsection 247(2) and, in the following words (Pratte, J. for the Court) at page 71 (D.T.C. 6123), reduced those findings to a single determination:

In our opinion, the two paragraphs of subsection 247(2) require the Minister to make what is in substance only one determination, namely that the existence of the various corporations is not solely for the purpose of carrying out business in the most effective manner because one of the main reasons for the existence of separate corporations is to reduce the amount of tax payable under the Act.

The incorporation of the appellant in May 1985 and its new management agreement with BFL in October 1985 are important facts in the determination of this appeal. During his examination-in-chief, Mr. Rosner stated his three major reasons for establishing the appellant company:

1. Freezing his estate and putting his matrimonial affairs in order was“ "at the top of his list”. He and his wife were separated in 1985. He wanted to isolate her from any future growth in the company and to have his children participate in that future growth.

2. He wanted to create a vehicle that could provide management services to other retailers. The appellant employed the buyer who is an important person in the women's fashion business; it also provided the accounting services and good inventory control in the warehouse.

3. He wanted to avoid unions and picketing at his retail outlets. He thought that if a union were to be organized in his business, it would probably start in his warehouse or head office; and having the retail outlets in a different business unit could protect them from picketing or being unionized.

In cross-examination, counsel for the respondent suggested to Mr. Rosner that, in 1985, he already had a corporation (i.e., RYB) which had a 1981 agreement to provide comprehensive management services to BFL. His response was that after 1984 RYB was replaced by the appellant. It is necessary to look at Mr. Rosner's three major reasons for establishing the appellant corporation and to compare the appellant with RYB. In my view, Mr. Rosner's second and third reasons could be satisfied just as easily in RYB as in the appellant. If there was in 1985 a realistic opportunity to provide the "Bryan's" type of management services to other retailers, there was no evidence to indicate why those services could not have been developed in and sold through RYB. I have some doubts as to whether such a realistic opportunity existed in 1985. The retail business is very competitive in any particular product line whether it be women's fashions or hardware. I question whether a competitor selling women's fashions in the Vancouver area would want to disclose her trade secrets to Mr. Rosner; and a retailer selling other products would have different suppliers not known to Mr. Rosner's buyer. Mr. Rosner acknowledged in evidence that he made no attempt to advertise his management services and relied on word of mouth in his own area of business. The fact is that in the five years following 1985, the appellant did not acquire any client for its Bryan's type of management services (except for a brief relationship with a store in Alberta), and those services could have been provided by RYB.

The third reason for establishing the appellant corporation was the potential union problem. There is an obvious advantage in avoiding a strike and a picket line at a retail outlet. Mr. Rosner's concern was that a union could be more easily organized in his warehouse. Therefore, he located the administrative office and warehouse away from any retail outlet and caused the buyer, the administrative staff and the warehouse personnel to be employed by the appellant. The persons working in the retail outlets were employed by BFL. All of this made good business sense but there was no evidence to indicate why the buyer, administrative staff and warehouse personnel could not have been employed by RYB.

The first reason for establishing the appellant corporation was the estate freeze and separation of business assets from domestic property. This subject raises more complex questions and requires a more detailed analysis of the way that the appellant corporation really worked. The appellant and BFL shared the same premises, the same equipment and the same telephone which was answered "Bryan's". There was always a "Bryan's Fashions Ltd.” sign at the premises but there is considerable doubt as to when there was a sign with the appellant’s name. Those premises were at 878 Cambie Street where Mr. Rosner went to work each day. He had separated the warehousing, inventory control and accounting from the retail outlets by having the appellant perform those functions but the appellant performed those functions under the name "Bryan's Fashions”. BFL owned the office furniture, equipment and warehouse racking system. Those assets could have been sold by BFL to the appellant at fair market value but Mr. Gelhorn described the actual arrangement in the following words (transcript page 132):

So anyhow, a verbal agreement was made that Bryan’s Fashions Ltd. would provide the equipment or the use of equipment to Rosner Management in exchange for not being charged a fee for its use. It was a very reasonable arrangement, and definitely a very simple arrangement.

The upshot of this very simple arrangement was that the appellant could operate with no tangible assets—not even a pencil. The appellant's balance sheets at July 31, 1986 and 1987 disclosed the following assets:

The balance sheets indicate that the appellant had no bank account and no cash on hand. This is explained by the unusual financing arrangement which the appellant and BFL had with the Royal Bank of Canada. The appellant was to pay all of BFL’s expenses and did in fact issue all of the cheques required to meet the expenses of the retail outlets. At the end of each day, the Royal Bank would determine the dollar volume of the appellant's cheques which had cleared the Bank that day and then would transfer from the BFL account just enough funds to honour those cheques. As a result of this arrangement, the balance in the appellant's account at the Royal Bank at the end of each day was nil. Although the appellant had the designated responsibility to pay all of the BFL expenses, the responsibility was performed in name only because all of the funds required to pay those expenses came directly from BFL. The arrangement was really a facade. The appellant had a second less active account at the Bank of Montreal from which it paid its own expenses but I infer that they were few in number because the only ones mentioned were the fees for annual financial statements; and this less active account also had a nil balance at year end.

BFL reported taxable income in its four taxation years 1985 through 1988 in the following amounts:

BFL as a Canadian-controlled private corporation was entitled to the "small business deduction” under section 125 of the Income Tax Act. That section permitted BFL's Canadian active business income (up to an annual limit of $200,000) to be taxed at a lower rate; the higher standard corporate tax rate would have applied to any income in excess of $200,000. The annual income of BFL was reduced to a level just below $200,000 by the payment of a management fee to RYB; and the annual income of RYB was reduced to nil by the payment of a management salary to Brian Rosner. In effect, Mr. Rosner's personal compensation came from the active business operations in BFL (i.e. the retail outlets) through RYB directly into his hands. BFL and RYB were "associated" within the meaning of section 256 but the income of RYB was always nil as a result of the management salary to Mr. Rosner. Therefore, the $200,000 business limit in subsection 125(2) was relevant only to BFL unless, as in this case, the Minister directed that BFL be deemed to be associated with another Canadian-controlled private corporation like the appellant.

The revenue of the appellant was derived only from BFL and the Partnership by way of reimbursement for expenses and a management fee. For the taxation years ending July 31, 1986 and 1987 the appellant's financial statements showed gross revenue as follows:

Summarizing the above evidence, BFL paid two management fees in each year: one to the appellant for various services; and one to RYB as an indirect salary to Mr. Rosner. According to the above table, the management fee from the Partnership was only nominal ($6,000) in 1986 and nil in 1987. Also, reimbursed expenses of $743,461 in 1987 were 65 per cent greater than in 1986 but the management fee from BFL decreased from $104,000 to $75,000. It seems strange that the management fee to the appellant from BFL would decrease in 1987 by 28 per cent when the services with respect to payment of expenses increased by 65 per cent.

According to Mr. Gelhorn, the management fee to the appellant was negotiated between BFL and the appellant and “would depend on the volume of business done and the success of the operation” (transcript page 158). That explanation does not make any sense to me. Why should the fee for services to the appellant depend upon the success of the retail outlets in BFL and the Partnership when the appellant could have so little effect on such success? The real decision maker in the organization is Brian Rosner (transcript page 95) and he is compensated through RYB. I have inferred that there was much latitude in determining the amounts of any management fees from BFL or the Partnership and whether they would be processed through RYB or the appellant. The only true arm's length negotiation which I can perceive, and it was not referred to in the evidence of Brian Rosner or Bruce Gelhorn, is the protection of Mr. Gelhorn's five per cent equity in the retail outlets (BFL and the Partnership). Subject to that minority interest, it seems that Brian Rosner could be arbitrary in determining and allocating the management fees.

This brings me back to Mr. Rosner's first major reason for establishing the appellant corporation. There was very little evidence of how the incorporation of the appellant helped to freeze Mr. Rosner's estate or protect his business assets in the event of a divorce. How many new retail outlets were opened and operated by the Partnership after 1985? Were any new retail outlets opened and operated by BFL after 1985? What was the relative volume of gross sales and profits (before management fees) in BFL and the Partnership after 1985? Why did the Partnership contribute only $6,000 in management fees to the appellant in its 1986 and 1987 taxation years when BFL contributed $179,000? Do those amounts indicate that there was little business actually carried on by the Partnership? Was there anything to prevent the transfer of a particular store from BFL to the Partnership as the lease on that store expired? If all new business after 1985 was developed in the Partnership, did this not achieve the protection of business assets from marital problems without involving the appellant corporation because the two sons held a 94 per cent interest in the partnership? Did the Partnership in fact earn a profit or was it reduced to nil by management fees? If the Partnership profit was reduced to nil by management fees, now could it be said that any growth was accruing to the sons? If the Partnership did earn a profit, was any part of it actually distributed to the four partners? Why were the financial statements of the Partnership not presented in evidence? What was the aggregate of all management fees paid in each year by BFL and the Partnership to RYB, the appellant or other persons? These questions were not adequately explored in evidence and some of them would prove whether the Partnership (94 per cent held indirectly by the sons) was in fact used to freeze Mr. Rosner's estate. Without answers to most of these questions, I cannot conclude that the existence of the appellant was necessary or even useful in any attempt to freeze Mr. Rosner's estate or to protect his business assets from marital problems. Bland statements from Mr. Rosner and Mr. Gelhorn are not adequate in this matter.

Counsel for the appellant argued that the shares in RYB would be family assets under the Family Relations Act of British Columbia, R.S.B.C. 1979, c. 121, and that Brian Rosner's wife could be entitled to 50 per cent of those shares following a marriage break-up. That may be a valid argument but it does not rebut the Minister's conclusion that one (and I emphasize "one") of the main reasons for the separate existence of the appellant and BFL was to reduce the amount of taxes that would otherwise be payable under the Act. Mr. Rosner acknowledged that he knew about the small business deduction (i.e., section 125 of the Act) but he was vague in cross-examination and deferred to his controller (Mr. Gelhorn) on almost all questions of a financial nature.

Counsel for the appellant refers to the decision in M.N.R. v. Furnasman Ltd. et a!., supra, in which Addy, J. at page 837 (D.T.C. 5604) refers to a number of cases which establish a test for the application of subsection 247(3) as it was in the pre-1972 legislation. In particular, the words of Sheppard, D.J. are quoted from Jordan Rugs Ltd. et al. v. M.N.R., [1969] C.T.C. 445, 69 D.T.C. 5290:

In short the test amounts to this — if there had been no tax advantage would the plan have been adopted in any event?

Applying that test to the facts in this appeal, I have concluded that the appellant would not have been incorporated if there had been no tax advantage to the appellant and BFL because (i) RYB could have satisfied the second and third alleged reasons for establishing the appellant corporation; and (ii) the Partnership with the two management companies owned by the two sons could have satisfied the first alleged reason.

I have already stated that the reimbursement arrangement with the Royal Bank was a facade. Apart from being the nominal employer of a few individuals who in fact performed the administrative and warehousing functions for the retail outlets, there was no substance to the appellant corporation. It did not perform any commercial function which was truly independent of the retail outlets operated by BFL and the Partnership. And according to its balance sheet, it had no tangible assets at all. I find as a fact that one of the main reasons for the separate existence of the appellant and BFL in 1986 and 1987 was to reduce the amount of taxes that would otherwise be payable under the Income Tax Act. If the appellant had never existed, the very limited commercial functions which it did perform in 1986 and 1987 would have been per- formed by RYB (already "associated" with BFL) under its 1981 management agreement or, alternatively, the individuals nominally employed by the appellant would have stayed with or been hired by BFL, their natural centre of gravity in a commercial sense. The appeal is dismissed.

Appeal dismissed.