MSS Inc v. Minister of National Revenue, [1984] CTC 2183, 84 DTC 1123

Roland St-Onge [TRANSLATION]:—The appeal of MSS Inc came before me on May 25, 1983 in Quebec City, with respect to expenses claimed by the appellant as management fees for the 1976 and 1977 taxation years.

The facts of this appeal are clearly stated in the reply to a letter from Samson, Bélair, Côté, Lacroix et Associés, requesting an advance ruling. This letter, filed as Exhibit A-3, and paragraph 2 of the reply to the notice of appeal, read as follows:

We acknowledge receipt of your letter of October 30, 1974, regarding a request for an advance ruling on behalf of the aforementioned taxpayers.

We take the facts to be as follows:

1. MSS Inc (“MSS”) was incorporated under the legislation of Quebec. Its share capital consisted of 4,000 ordinary shares having a par value of $10 each, 400 of which are issued and paid-up. MSS is a wholly-owned subsidiary of A G Joyce Limited, and operates a business distributing industrial equipment.

2. A G Joyce Limited, a management company, was incorporated under the legislation of Quebec. Its authorized and issued share capital consists exclusively of:

A. ten ordinary shares having a par value of $100 each, of which Mr Donald Joyce is the real owner;

B. 1,000 preferred Class A voting shares, having a par value of $10 each, of which Mr A G Joyce is the real owner; from its incorporation until December 31, 1971, A G Joyce Limited was a private corporation;

C. 1,890 preferred Class B voting shares, having a par vlaue of $100 each, only

1,140 of which are issued and the real owner of which is Mr A G Joyce.

Proposed transactions

Four key employees of MSS wish to acquire control of the company. They have no connection with each other or with Mr A G Joyce. They propose to form a management company (GMDB Limitée) and the latter will purchase the 400 ordinary shares of MSS from A G Joyce Limited.

2. Before GMDB Ltée makes the proposed purchase, MSS will pay tax on its 1971 undistributed income on hand (estimated at $200,000), pursuant to s 196 of the Income Tax Act, and will transfer the undistributed tax-free surplus to A G Joyce Limited. The fair market value of the ordinary shares of MSS following this allocation is estimated at $600,000.

3. In order to purchase the ordinary shares of MSS for the fair market value ($600,000), GMDB Limitée will pay:

$100,000 on signature of the contract (taken from an investment by the four shareholders in GMDB Limitée); $500,000 in combined payments of $7,761 a month for seven years (8 per cent rate).

4. Mr A G Joyce would contine to be employed by MSS for seven years and would receive $50,000 a year.

5. MSS would pay GMDB $40,000 a year for management fees.

6. GMDB Ltée would take steps to ensure that MSS continues doing business as before, and would not cause a substantial reduction or disappearance of the assets of MSS, as provided by s 247(1) of the Act.

Purpose of transactions

The proposed transactions are designed to transfer the ownership of MSS to four key employees, by the formation of a management company by those employees.

Rulings requested

Assuming we correctly understand the facts as set forth above, and that the operai- tons are completed in the manner proposed in your submission, our rulings are as follows:

A. You ask us to state that s 18(a) of the Income Tax Act will not result in disalow- ing the deduction for management costs of $40,000 a year, paid to GMDB by MSS, and s 245 of the Act will not apply to make the expenses of MSS non-deductible.

Under paragraph 9(j) of Information Circular 70-6, published by the Department of National Revenue in September 1970, we are unable to grant your request, since the nature of the services rendered by GMDB Limitée annually in return for management fees constitutes essentially a question of fact. If, however, the management fees are reasonable in the circumstances and paid annually for the purpose of gaining or producing income from a business, and if s 18(1)(a) or s 67 does not preclude the deduction of these expenses, you may be sure that the Department will not attempt to disallow the expense as an artificial or improper reduction of income under s 245(1).

B. You ask us to state that s 247 of the Income Tax Act will not be applied to tax A G Joyce Limited for the sale of the MSS shares.

We will not recommend that the Minister rule against A G Joyce Limited because of the sale of MSS shares to GMDB Limitée in itself. These rulings are made in accordance with the general reservations stated in Information Circular 70-6, issued in September 1970 by the Department of National Revenue, Taxation, and are binding on the latter provided that A G Joyce Limited completes the sale of MSS shares to GMDB by March 31, 1975.

Yours truly,

(signed)

for the Director

Rulings Division

Legislation Branch

Department of National Revenue, Taxa tion

(Appendix)

We, the four shareholders of GMDB Ltée, a company which will be formed to purchase the shares of MSS Inc, will take steps to ensure that MSS Inc continues its operations as at present, and we will not cause a substantial reduction or disappearance of the assets of MSS Inc, as described in s 247(1) of the Income Tax Act.

Mr Claude Gagnon

Mr Allyre Martin

Mr Gilbert Dumoulin

Mr André Bélanger

Reply to notice of appeal:

2. In assessing the appellant for its 1976 and 1977 taxation years, the respondent relied inter alia on the following presumptions of fact:

(a) the appellant is a wholly-owned subsidiary of GMBD Ltée;

(b) in calculating its income for each of the 1976 and 1977 taxation years, the appellant claimed a deduction for the amounts of $33,300 and $40,000 respectively, which it alleged that it paid its parent company GMBD Ltée as management fees;

(c) during the years at issue, GMBD Ltée employed no one;

(d) GMBD Ltée had no organization, and no administrative or management system, that would have enabled it to provide management services to the appellant;

(e) GMBD Ltée in fact provided the appellant with no management services during the years at issue;

(f) the only activities of GMBD Ltée consisted of collecting dividends and management fees from the appellant MSS Inc and repaying A G Joyce Ltd for the debt of GMBD Ltée in connection with the purchase of the appellant’s shares;

(g) the only managemnt services which were rendered to the appellant were by the directors and/or employees of the appellant, and in that capacity only: their salaries and other expenses were paid by the appellant;

(h) the amounts paid to GMBD Ltée by the appellant were not paid for the purpose of producing an income for the appellant;

(i) the amounts in question are unreasonable in the circumstances.

At the hearing, the following witnesses were heard:

(1) Mr André Bergeron, a chartered accountant for thirty-one years, who as such was familiar with the transactions of the companies involved in the case at bar;

(2) Mr Claude Gagnon, managing director of MSS Inc before the sale of the company to GMBD Ltée, and currently president of MSS Inc;

(3) Mr Martin, the accountant and controller of the appellant since 1963 and a shareholder in the new company, GMBD Ltee;

(4) Mr Bertrand Gilbert, an auditor since 1972, who for one week conducted a field audit of the appellant company’s books.

Mr Bergeron explained that Mr Joyce, at age sixty-four, wanted to retire and sell his company to a single individual. This is why a management company named GMBD Ltée (“G” for Mr Gagnon, “M” for Mr Martin, “B” for Mr Bélanger and “D” for Mr Dumoulin — the four key men in MSS Inc) was incorporated to hold a majority of the MSS Inc shares. This company had the same purposes as MSS Inc and was supposed to provide it with management services.

Following this sale, the responsibilities of the four key men increased and they had to become more involved in the operations of the business. Mr Joyce gradually withdrew from the business and spent longer and longer periods in Florida, in the United States, where his wife had spent the winter for many years.

From this date onward, dividends and management fees were paid by the appellant to GMBD Ltée as follows:

The appellant’s turnover was as follows:

$4,531,350 in 1976

$3,961,061 In 1977

This reduction of $900,000 in 1977 is explained by an eight-month strike at Alcan: this company represented 50 per cent of the appellant company’s sales.

After the transaction, the salaries of the new shareholders remained the same, but they were compensated for their increased responsibilities by management fees paid by the appellant to the management company GMBD Ltée. Mr Joyce received $50,000 a year as an adviser, a salary which was less than in previous years.

In cross-examination, Mr Bergeron admitted the following:

the list of shareholders filed as Exbibit I-2 indicates that Mr Gagnon held 51 per cent of the shares of GMBD Ltée, Mr Martin 18 per cent, Mr Belanger 16 per cent and Mr Dumoulin 15 per cent;

and the opening balance, dated March 1975, indicates an issued and paid-up capital of four shares worth $10,000.

In the first year, the management fees of $33,600 paid to GMBD Ltée correspond to the interest paid by GMBD Ltée to A G Joyce Limited, which totalled the sum of $32,967.

In summary, the shareholders purchased the appellant company with a loan of $100,000 from Mr Joyce and a debt of $500,000 payable at the rate of $7,000 a month.

In February 1975, MSS Inc had a book value of $599,750, since an accumulated profit of $211,000 and bonuses of some $275,000 had been paid to A G Joyce Ltd and Mr Joyce respectively.

In 1976 and 1977, GMBD Ltée had neither employees nor customers, and the only asset consisted of an investment of $9,500 with the Banque Provinciale.

In 1975, Mr Joyce decided to freeze the shareholders’ salaries, and for seven years he controlled all the important decisions of the appellant company. There was no written management contract between MSS Inc and GMBD Ltée, and the amount of $33,000 paid by GMBD Ltée in 1976 corresponds to the amount of interest which the appellant company had to pay on the debt of $398,000.

Mr Gagnon, the majority shareholder in GMBD Ltée, explained that after the acquisition of the appellant company by GMBD Ltée the shareholders in the management company participated in administration of the appellant company, but as before, Mr Martin acted as accountant and controller, Mr Bélanger handled purchasing and Mr Dumoulin was the sales representative. They had meetings to decide important matters, as for example the purchase of a $40,000 computer, but Mr Joyce always had the last word. Before the acquisition, he accompanied Mr Joyce to puchase industrial equipment and afterwards he went by himself. During the strikes at Alcan and the paper mills in 1977, they had very frequent meetings.

Mr Martin testified that both before and after the acquisition, he handled accounting, made up the financial statements each month and reported to Mr Joyce, who took the decisions and did not cease to be active. In the purchase of the shares, he did not spend more than $1,800, and dividends and management fees were sufficient to meet their obligations to Mr Joyce. The latter froze the salaries because he feared that the key employees were being extravagant. He had forbidden them to increase expenses.

Mr Joyce always retained his office and the GMBD Ltée shareholders had to report to him on their management. GMBD Ltée had no employees, office or telephone; and its only activity was to receive and cash the cheques made out to it by MSS Inc to discharge its obligations to Mr Joyce. To use his own words, he said that the activity of GMBD Ltée was “not time-consuming, only cashing cheques”.

Mr Martin concluded his testimony by saying that Mr Joyce authorized the financial statements; he was always present when important decisions were taken; during the strikes it was he who directed that inventories be reduced; and he always closely followed the activities of the appellant company.

Mr Bertrand Gilbert, an auditor for the Minister of National Revenue since 1972, testified that he spent one week auditing the appellant company’s books, and found that the representation fees paid by the appellant to Mr Joyce had not decreased greatly: from $30,000 to $50,000, which they were before, they had decreased after the acquisition. They had decreased to $25,000 and $30,000 a year. These fees represented several trips to Florida in the winter.

Counsel for the appellant maintained that he had nothing to hide, that all the facts had been submitted to the Minister before the transaction in order to obtain an advance ruling, and that the only thing missing from the picture was a written management contract. Mr Joyce handed over the management of the company and protected himself 100 per cent by legally selling it to his four key employees.

The facts demonstrated a transfer of power and there is nothing in the Income Tax Act, SC 1970-71-72, c 63, as amended, to prohibit a deduction for management fees. MSS Inc paid for services received for the purpose of producing an income, services which it did not have before the transaction and which were provided to it by the four key employees; the management fees of $40,000 a year determined at the outset were reasonable, since they represented only 1 per cent of the turnover of the company, which was $4,000,000.

For his part, counsel for the respondent argued that no management contract, not even a verbal one, existed between the parties; that GMBD Ltée had no employees, office, telephone, address or customers, and that its only activity consisted of making a payment of $7,000 a month for seven years to discharge a debt of $398,000 to Mr Joyce.

MSS Inc was under no legal obligation to pay management fees to GMBD Ltée. He referred the Board, among other cases, to that of Léonard Mendels v Her Majesty the Queen, [1978] CTC 404; 78 DTC 6267, to say that a taxpayer who wants to take advantage of a deduction must follow all the legal requirements and execute the necessary contracts. In his submission, the facts showed that no management contract existed between the parties, and MSS Inc was therefore under no legal obligation to pay management fees to GMBD Ltée.

In the opinion of the Board the appellant comapny was under no legal obligation to pay management fees to GMBD Ltée. Accordingly, the question is not whether the manaagement fees were unreasonable, or whether they enabled the appellant to produce an income, for they did not exist.

The four key employees who became owners of the appellant company through GMBD Ltée, which they called a managemnt company, had their salar- ies frozen by Mr Joyce for performing exactly the same work as they did before they purchased the company.

Accordingly, what GMBD Ltée received in 1976 and 1977 constituted the dividends usually received by shareholders, except that in the case at bar instead of these dividends being paid directly to the key employees, they were paid to a company in which they were the majority shareholders because Mr Joyce had decided this would be done.

Accordingly, the amounts paid by the appellant company in 1976 and 1977 are not management fees, but dividends which were used to pay Mr Joyce, and thereby served to make the four key employees owners of the appellant company through GMBD Ltée.

The evidence showed that GMBD Ltée was not in any way a management company. It was only a tool used by Mr Joyce to carry out the sale of his company to his four key employees.

For these reasons, the appeal is dismissed.

Appeal dismissed.