Franklin Montgomery v. Minister of National Revenue, [1987] 2 CTC 2023, 87 DTC 355

Goetz, T.C.J.:—This is an appeal with respect to the appellant's 1977 taxation year. The issue to be determined is whether the appellant, who received funds from Charted Plans Inc. (the Company), his Company's Employees Profit Sharing Plan (EPSP), representing profits of the Company, could be used to purchase an income averaging annuity contract.

Facts

Charted Plans Inc. was incorporated by the appellant in 1976. That Company marketed tax shelters to suit the requirements of individual taxpayers. On July 11, 1977 a trust agreement was entered into between the Company and the appellant and two of his employees, as trustees. On July 13,1977 the appellant and one of the Company's employees, Joan Jayson, had served notice to the Company that they wished to participate in EPSP. On the same day, the Company executed minutes of the meeting of the board of directors of the Company. The Company declared the appellant and Joan Jayson as eligible to participate in the Plan. At the same meeting the Company agreed to contribute “$40,000.00 on the 19th of July 1977 to CHARTED PLANS INC., EMPLOYEES PROFIT SHARING PLAN for its 1977 fiscal year". The appellant was allocated $39,700 and Joan Jayson $300.

The appellant, on July 11, 1977, wrote the Department of National Revenue, Taxation, Pension & Profit Sharing Plan Section, as follows:

July 11,1977

Department of National Revenue, Taxation

Pension & Profit Sharing Plan Section,

400 Cumberland Street,

Ottawa, Ontario

KIA 0X5

Att: Mr Roberts,

Dear Mr Roberts,

We are filing our election under Section 144

of the Income Tax Act with respect to

Employees Profit Sharing Plan and Agreement

which has been created and established as of

July 11, 1977 as well as a Resolution of the

Board of Directors adopting the aforementioned

Agreement as of the effective date

hereby stated.

We now ask that you review the documents and

advise us as quickly as possible as to their

acceptance and to our election under Section

144 of the Income Tax Act.

Sincerely yours,

CHARTED PLANS INC.

Franklin W. Montgomery, LL.B President

FWM:em

enclosures

The evidence showed that the Company deposited $40,000 into the EPSP, and the Company's Trustees (the appellant and two of his employees) loaned this amount back to the Company.

On August 17, 1977 Revenue Canada, Taxation Division, advised Charted Plans Inc. that it approved the Employees Profit Sharing Plan on the basis of documents forwarded to it by the appellant.

On July 27,1977 the appellant advised the Trustees of EPSP that he wished to withdraw all his moneys credited to his account in satisfaction of all his rights in or under the Plan. On the same day, at a meeting of the Board of Directors the Company approved payment to the appellant of the sum of $39,700.

On March 1, 1978, the appellant purchased from Victoria and Grey Trust Company an income averaging certificate in the amount of $35,537.05. The appellant deducted from his income for his 1977 taxation year, the amount of $35,537.05 with respect to his contribution to the income averaging annuity contract. By notice of reassessment dated April 2, 1982, the Minister refused to allow the deduction on the grounds that such amount was not qualifying income pursuant to subparagraph 61 (2)(a)(iii) of the Income Tax Act.

The appellant frankly admits that the EPSP thus created by him, and the purchase of the income averaging annuity contract, had all been planned from the outset when the EPSP was set up. He admits and says that all steps taken by him through his Company and on his own behalf were taken with a full view of avoiding full tax liability and setting up all the documentation to come within the provisions of the Income Tax Act.

Appellant's Position

The appellant contends that all actions taken by him personally and through his Company were in compliance with the provisions of section 144, and subparagraph 61 (2)(a)(iii) of the Income Tax Act and that all his actions were within the framework of the Act and that the end result was of reducing his full tax liability in the 1977 taxation year and the purchase of the income annuity contract was all within the law.

Respondent's Position

The respondent, on the other hand, contends as follows in the amended reply to notice of appeal:

7. The payment received by the Appellant between August 1, 1977 and December 31, 1977 was not required to be included in computing the appellant's income within the meaning of subparagraph 61(2)(a)(iii) of the Income Tax Act. The amount allocated to the Appellant uner the EPSP either contingently or absolutely, was required to be included in computing the Appellant's income for the 1977 taxation year pursuant to subsection 144(3) and paragraph 6(1)(d) of the Income Tax Act, but the amount of the payment received by the Appellant as referred to subparagraph 4(e) herein, (hereinafter reproduced) being attributable to the amount required by subsection 144(3) and paragraph 6(1)(d) to be included in computing the Appellant's income for that year within the meaning of paragraph 144(7)(b) was not required to be included in income pursuant to subsection 144(6). Accordingly no amount of the payment received by the Appellant from the Appellant from the trustees of the EPSP was an amount within the meaning of subsection 61 (2)(a)(iii).

Subparagraph 4(e) referred to in paragraph 7 of the amended reply to notice of appeal reads as follows:

4. In so reassessing the Appellant, the Respondent relied, inter alia, upon the following findings or assumptions of fact:

(e) some time between August 1, 1977 and December 31, 1977, inclusive, the Appellant requested and was paid $39,700.00 from the EPSP;

The respondent further contends that the scheme with respect to the setting-up of the EPSP and the payments therefrom to the appellant unduly or artificially reduced his income and that no deduction may be made in respect of such operation by virtue of subsection 245(1) of the Act. The respondent agreed that the steps taken by the appellant could seemingly come within the scheme of the Act but takes a different interpretation of subparagraph 61(2)(a)(iii). Subparagraph 61(2)(a)(iii) provides as follows:

61. (2) For the purposes of subsection (1), an amount described in this subsection in respect of an individual for a taxation year is any following amount:

(a) any single payment received by him in the year

(iii) pursuant to an employees profit sharing plan in full satisfaction of all his rights in or under the plan, to the extent that the amount thereof is required to be included in computing his income for the year in which the payment was received, . . .

The respondent says that this amount was not required to be included in computing the appellant's income because the allocation was included. He further says that the EPSP was not set up to share the profits of the Company among the employees which is the intent of that provision but rather it was a way of the appellant taking the profits of the Company into his hands and that was not the intention of the section nor what Parliament wished to encourage. He says that the allocation, in fact, was the determining factor.

Findings

It is clear that, ab initio, steps taken by the appellant to set up the EPSP and the acquisition of the income averaging annuity contract were with a view to reduce the appellant's personal tax liability. There is nothing wrong with a taxpayer arranging his affairs in such a manner that would reduce or avoid his tax liability to Her Majesty the Queen. Nevertheless, all such transactions are subject to the scrutiny of the taxing authorities and of the courts. In the case of Stubart Investments Limited v. The Queen, [1984] C.T.C. 294; 84 D.T.C. 6305, Mr. Justice Estey set up certain interpretation guidelines. He said at 316-17 (D.T.C. 6323-24):

Nonetheless, some guidelines can be discerned for the guidance of a court faced with this interpretative issue.

1. Where the facts reveal no bona fide business purpose for the transaction, section 137 may be found to be applicable depending upon all the circumstances of the case. It has no application here.

2. In those circumstances where section 137 does not apply, the older rule of strict construction of a taxation statute, as modified by the courts in recent years (supra), prevails but will not assist the taxpayer where:

(a) the transaction is legally ineffective or incomplete; or,

(b) the transaction is a sham within classical definition.

3. Moreover, the formal validity of the transaction may also be insufficient where;

(a) the setting in the Act of the allowance, deduction or benefit sought to be gained clearly indicates a legislative intent to restrict such benefits to rights accrued prior to the establishment of the arrangement adopted by a taxpayer purely for tax purposes;

(b) the provisions of the Act necessarily relate to an identified business function. This idea has been expressed in articles on the subject in the United States:

The business purpose doctrine is an appropriate tool for testing the tax effectiveness of a transaction, where the language, nature and purposes of the provision of the tax law under construction indicate a function, pattern and design characteristic solely of business transactions.

Jerome R. Hellerstein, “Judicial Approaches to Tax Avoidance”, 1964 Conference Report, p. 66.

(c) "the object and spirit” of the allowance or benefit provision is defeated by the procedures blatantly adopted by the taxpayer to synthesize a loss, delay or other tax saving device, although these actions may not attain the heights of “artificiality” in section 137. This may be illustrated where the taxpayer, in order to qualify for an “allowance” or a “benefit”, takes steps which the terms of the allowance provisions of the Act may, when taken in isolation and read narrowly, be stretched to support. However, when the allowance provision is read in the context of the whole stature, and with the “object and spirit” and purpose of the allowance provision in mind, the accounting result produced by the taxpayer's action would not, by itself, avail him of the benefit of the allowance.

There were only three employees in the Company and the appellant was one of them. The year that the payment of $40,000 was made by the Company into the EPSP, the appellant took no executive salary. No explanation was given why Miss Jayson, an employee, was allocated $300 out of the EPSP in July 1977 when the evidence is clear that she had not applied to take part in the EPSP until September 1977. She withdrew the $300 in February 1978. The minutes of the Company show that Miss Jayson was purportedly involved in the EPSP as of July 1977. While the respondent had given approval of the EPSP, that approval was withdrawn when he was apprised of all the series of transactions taken by the appellant to funnel profits of his Company to himself in 1977 through the EPSP.

The series of transactions taken by the appellant must be examined in light of substance rather than form. While the tranasactions appear to be bona fide, it must be determined whether in fact a true EPSP had been properly set up. The appellant's appeal stands or falls on whether the EPSP was, indeed, a bona fide EPSP. All the circumstances surrounding the various steps taken by the appellant to get profits from the Company into his hands personally were done solely with that purpose in mind. There is no evidence that payments by the Company into the EPSP was for the benefit of the EPSP, rather, it points to being a benefit to the appellant. There is no doubt that all necessary documentation was carefully drawn by the appellant to give the appearance of a bona fide EPSP and that in fact it was not bona fide, it was a sham or a plan designed to artificially reduce tax liability. In examining the facts, it is quite clear that the sole purpose of setting up the EPSP was to flow profits from the Company to the appellant personally through the conduit of the EPSP.

On payment to the appellant of the $39,700, all that was left in the EPSP was the sum of $300, (which had already been allocated to Miss Jayson in July 1977) which was eventually turned over to Miss Jayson in February 1978. The turning over of the $40,000 from the Company to the EPSP was not made for the benefit of the Plan rather, it was for the benefit of the appellant. The whole arrangement, on the face of it, was seemingly proper and legal. When the veil of legitimacy is pierced, the true nature of the EPSP and the trust agreement becomes clear. The whole series of transactions was designed to artificially reduce the appellant's income.

Subsection 245(1) of the Act reads as follows:

245. Artificial Transactions.

(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.

In the case of West Hill Redevelopment Company Limited v. M.N.R., [1969] C.T.C. 581; 69 D.T.C. 5385, Kerr, J. says at 595 (D.T.C. 5393):

By-laws No. 5 and No. 6, the Pension Plan, the Deferred Profit Sharing Plan and the Trust Agreements, taken at their face value, purport to create legal rights and obligations and to establish a pension plan and a deferred profit sharing plan. But, considering them in all the circumstances and in the course that was followed, it is my conviction that the appellant did not intend to establish and did not establish real and true plans of that character. There was no intention that the Pension Plan would operate long enough to make annuity or periodical payments. It was in fact terminated and its funds were disbursed within a short time after it was estab- lished, and when eventually the money was put back into the revived Plan it was immediately taken from it and returned to the company rather than left in the Plan or invested by the Plan for the purpose of paying pensions. It is my conviction that the plans were, as submitted by the respondent, simulates used as a cloak to disguise the payments in question and make them appear to be what they really were not, namely, payments into a pension plan which would qualify for deduction in computing the appellant's income for income tax purposes. In my view, also, the payments, if allowed to be deducted, would artificially reduce the appellant's income; and section 137 prohibits their deduction.

In Produits LDG Products Inc. v. The Queen, [1976] C.T.C. 591; 76 D.T.C. 6344, Justice Pratte at 596 (D.T.C. 6348) says:

Counsel for the respondent several times used the English expression "sham" to describe the pension plan. We must rememeber that this English word does not have any magical qualities. A sham is a pretence, that is, in law, a fictitious or bogus act. In the case at bar it must be ascertained whether appellant, when it set up its pension plan, intended to set up a genuine retirement plan, with all the legal consequences that would involve, or whether it merely wished to appear to do so, with the aim of cheating the tax authorities.

It is not necessary to make a specific finding as to sham, in that having crossed through the façade of the series of transactions which were neatly formalized to appear legal, it was clear that these transactions were taken solely for the purpose of artificially reducing the appellant's income for the taxation year 1977, contrary to section 245 of the Act.

For the above reasons, the appeal is dismissed. The appellant will not be entitled to costs.

Appeal dismissed.