Leonard’s Holdings Limited v. Minister of National Revenue, [1983] CTC 2576, 83 DTC 515

Taylor TCJ:—This appeal was heard by me in St John’s Newfoundland, on July 6, 1983 in my capacity as a member of the Tax Review Board but this judgment is rendered in my capacity as a judge of the Tax Court of Canada. In his appeal, the taxpayer contested income tax assessments for the years 1977, 1979 and 1980 on the following grounds:

1. The detemination of the amount of loss deductible in respect of a property disposition in 1977.

2. The determination of the amount deductible in respect of a bad debt written off in 1979.

3. The determination of the amount deductible in respect of a management fee paid in 1980.

At the commencement of the hearing, the appellant withdrew the number 2 issue above, and it will be dismissed.

Counsel for the respondent noted for the Board that since the testimony and evidence adduced by the appellant with regard to the number 1 issue above did not provide a valuation report, it did not support in any material way the valuation placed on the property sold. Counsel, nevertheless, introduced into evidence the Minister’s valuation report and provided his witness in support of it. It is the view of the Board that the appellant did not discharge the onus of proof, and the number 1 point above will also be dismissed.

With regard to the number 3 issue, the appellant stated in its notice of appeal:

Issue# 3: Management Fees Disallowed

— Leonard’s Holdings Limited is a Canadian-controlled private corporation incorporated under the Companies’ Act of Newfoundland on August 30, 1972.

— The issued common shares of the company are, and have always been, beneficially owned 100% by Mr Patrick Leonard, businessman and director of the Company.

— During the fiscal year ended August 31, 1978, the Appellant constructed the Chateau Park Hotel. The hotel commenced operations in August, 1978.* [1]

— Mr Patrick Leonard provided management services to the company, for which no expense was accrued in the accounts for the fiscal year ended August 31, 1978.

— For the fiscal year ended August 31, 1979, management services were provided to the company by Mr Patrick Leonard. A salary of $17,000 was recorded in the accounts at August 31, 1979 by a debit to wages expense and a credit of Mr Leonard’s loan account. This entry was recorded by the firm of Chartered Accountants who prepared the 1979 financial statements for the Appellants.

— This salary expense has been allowed by the Respondent.

— On about October 29, 1979, the firm of Harris and Murphy, Chartered Accountants (as they then were), completed the preparation of financial statements and income tax returns for M Connors Limited, an associated company with the Appellant, and also owned 100% by Mr Patrick Leonard. This return was for the year ended January 31,1979. This return indicated losses carry forward in the amount of $44,389 in M Connors Limited. M Connors Limited was not actively engaged in business at that time.

— In meetings with Mr Leonard to discuss this situation it was suggested to him that M Connors should try to carry on a profitable business. A suggestion that the business of providing management services to the Appellant could be carried on in the company. The Appellant and Mr Leonard readily agreed to this arrangement. Mr Leonard, being the sole shareholder of both companies and the manager involved could not, however, be persuaded to, in his words “sit down and write himself a letter, send it to himself, sign it and send it back to himself, then sit down and negotiate a contract with himself, and execute it as both contractor and contractée.” Consequently, Mr Leonard simply removed himself from his employee status. No amount was recorded in the accounts as salary for him for the year ended August 31, 1980. No other perks or benefits of an “employee” type were left to him. M Connors Limited proceeded to provide the management services.

— When the August 31, 1980 financial statements were prepared, an entry was made as follows:

Dr. Management fee $15,000

Cr. Management fee payable $15,000

To record management fee to

M Connors Limited for the year

ended August 31, 1980.

— A corresponding entry was made in the accounts of M Connors Limited for the year ended January 31, 1981 recording the revenue.

— Mr Patrick Leonard, sole shareholder, and president of the Appellant states that he authorized the Appellant to enter a verbal contract with M Connors Limited to provide management services to the Appellant.

— Mr Patrick Leonard, sole shareholder and president of M Connors Limited states that he authorized M Connors Limited to enter a verbal contract with the Appellant to provide management services to Leonard’s Holdings Limited.

— Mr Patrick Leonard states that he removed himself as an employee of the Appelant at the meeting referred to . .. above and made himself an employee of M Connors Limited.

— The course of conduct of the parties since this time is consistent with the facts outlined.

The appellant relied on subsection 9(2) and paragraph 18(1 )(a) of the Income Tax Act, and contended that:

— it incurred the management fee expense to obtain management services. . .

— an outlay or expense was in fact made or incurred . . .

— a valid liability exists to M Connors Limited.

— . . it paid the $15,000 to obtain management services. The services were obtained.

In response, the Minister stated:

— Mr Leonard, at all material times, was an employee of the Appellant and in such capacity provided management services to the Appellant;

— Mr Leonard, at no material time, was an employee of M Connors Ltd,;

— M Connors Ltd, at no material time, provided management services to the Appellant;

— at all material times, a contract of service existed between the Appellant and Mr Leonard.

— Mr Leonard was at all material times an employee of the Appellant with the result that management services were never rendered by M Connors Ltd. . .

— if Mr Leonard did cease employment with the Appellant and became an employee of M Connors Ltd, the rendering of management services, which could only be performed by Mr Leonard, through inter-position of M Connors Ltd was not a bona fide business transaction but a sham as it served only to accomplish objects directed solely to the avoidance of tax desired by M Connors Ltd.

In all material aspects, the factual situation including Mr Leonard’s relaxed attitude toward corporate or business formalities and record-keeping, were not in dispute. Mr Douglas G Harris, CA, presently the accountant for the appellant, gave testimony that it was perfectly evident to him that some income tax value would accrue to the appellant by virtue of using M Connors Limited (“Connors”) as the vehicle through which to charge the management fee, and that the fee would also be of tax advantage to Connors under the circumstances of that company at the time. The corporate tax returns of Connors for the fiscal years (February 1 to January 31) were filed with the Board for the taxation years 1979 and 1980. The management fee of $15,000 shows up as income for Connors, and as an expense in Leonard’s in each case for the 1980 fiscal year. The fiscal year in the case of the appellant is from September 1 to August 31, each year. Counsel for the respondent brought out in cross-examination of the appellant’s witneses that some dispute might also exist regarding the appropriate (reasonable) charge because of this difference in year ends, but the Board did not regard that point as a serious contention.

Counsel for the appellant relied upon the jurisprudence in Laidlaw Transport Limited v MNR, [1974] CTC 2246; 74 DTC 1179, upheld on appeal in The Queen v Laidlaw Transport Limited, [1977] CTC 151; 77 DTC 5091, John J Daly v The Queen, [1981] CTC 132; 81 DTC 5025, and Frederick G Vivian v The Queen, [1983] CTC 107; 83 DTC 5144. Counsel recognized that Day (supra) had been appealed and reversed, but regarded some of the reasoning and comments as particularly significant to this case.

Counsel for the respondent relied upn Stubart Investments Limited v The Queen, [1981] CTC 168; 81 DTC 5120, The Queen v John J Daly, [1981] CTC 270; 81 DTC 5197, and referenced Vivian (supra). In essence, the position of the respondent was that since Mr Patrick Leonard had not formally and officially left his position of employee of Leonard’s, the reasoning in the Daly Federal Court of Appeal case (supra) prevailed, and the appeal must be dismissed.

It was the essence of the contention of counsel for the appellant (although not specifically stated) that the service provided by Connors was, in effect, under a contract between Connors and Leonard’s, by which Connors agreed to and did provide the services of Mr Patrick Leonard to Leonard’s as a manager. Therefore, Connors, in the view of counsel, was capable of making such a contract and providing such services. It was basic to the position of the respondent that Leonard’s paid $15,000 to Connors but received nothing from Connors, only from Mr Patrick Leonard personally. That leaves the question — what bona fide business purpose was served by Connors?

Counsel for the applellant also proposed (based on Vivian (supra) that even if the Board held that there ws no bona fide business purpose served by Connors, the Minister could not attach to the transaction the term “sham” in order to effect the assessment at issue. To this counsel for the respondent replied that under that set of circumstances, the specifics of the alleged transaction between Leonard’s and Connors would not withstand the scrutiny referenced in Vivian (supra), in that “what was purported to be done was, in fact, done”. In the view of counsel for the respondent, all the “i”s had not been dotted, not the “t”s crossed, in particular there was no Official written record of the arrangements.

In my view, the contention of the respondent that Mr Patrick Leonard remained an employee of Leonard’s during the years in question cannot be supported. It was precisely Mr Leonard’s total control of Leonard’s and Connors that permitted him (however nonchalantly) to use the companies as he saw fit. Without examining at all at this point whether the transaction involved “could withstand scrutiny” in itself (see Vivian (supra)), I am unable to perceive of any legal impediment to Mr Leonard either being, or not being, an employee of Leonard’s without the necessity of formal documentation. In the extreme I suppose I could conceive of Mr Leonard as an employee of Leonard’s one day, not an employee the next day, but the following day reverting to his employee status. Accordingly for the Minister’s assessments to be valid, they must be able to resist the thrust of the evidence presented against the alternative contention of the respondent — “not a bona fide business transcation, but a sham as it served only to accomplish objects directed solely to the avoidance of tax desired by M Connors Ltd”.

The learned justice in Vivian (supra) determined that the facts in that case were similar to those of MNR v Leon, [1976] CTC 541; 76 DTC 6303, but he did not adopt the definition of “sham” contained therein. While not agreeing that the transaction at issue ws a “sham”, the judge did determine that in Vivian (supra) the transaction had no bona fide business purpose. The tax benefit sought by the appellant in Vivian (supra) was to channel the income to the corporation, not to Mr Vivian personally. The learned judge ws not required to determine specifically if the amounts received by the corporation from the transaction, without a bona fide business purpose, were taxable income to the corporation. He decided only that the amounts were not income to the appellant personally. In a similar way, in the instant case I am not called upon to decide whether the amount is taxable income to Mr Patrick Leonard personally, or to Connors (although I understand it so remains). I am not called on to decide if it was income at all, and in that way I believe there may be a distinction made with Vivian (supra). On the facts of Vivian (supra) therefore, the judge was not deciding whether an amount paid by a corporation could be a deductible business expense, even though it arose out of a transaction that did not have a bona fide business purpose. I am restricting my remarks and comparison with case law to a determination of the simple question — was the amount of $15,000 at issue a deductible business expense for income tax purposes for this appellant corporation

— Leonard’s?

In any jurisprudence to which I have referred, I have been unable to find a rationale by which a transaction without a bona fide business purpose could serve to provide a taxpayer with a deductible business expense from income for purposes of arriving at taxable income. Therefore, if the amount in question in this appeal, claimed as an expense, resulted from a transaction without a bona fide business purpose, it could be argued that the appeal should be dismissed. However, to be without any bona fide business purpose (as I understand that term), it would be necessry that the amount in question were expended solely for the purpose of the reduction of income taxes payable by Leonard’s. Again I note, I am not concerned with the alleged effect on the income or even taxable income of Connors in this appeal. The obvious question then arises — can it be said that the $15,000 was paid to Connors by Leonard’s for nothing? I do not believe so. In my view, Leonard’s as a corporation was quite entitled to obtain from any available source, services of any description that it felt it required — and I am satisfied that management services were provided to the company in the person of Mr Patrick Leonard. In effect, leaving aside the common control of both companies by Mr Patrick Leonard, the directing mind and will of Leonard’s was Mr Patrick and the appellant corporation, following his direction, paid the amount in question to Connors for management services it did receive. While the net result may be abhorrent to Revenue Canada, the transaction looked at in isolation cannot be classified either as a sham, nor as a transaction without a bona fide business purpose, and since the assessment at issue is based on that premise, the appellant must succeed.

The appeal is allowed in part and the matter referred back to the respondent for reconsideration and reassessment in order to permit the deduction of the amount of $15,000 paid as a management fee in the year 1980. In all other respects the appeal is dismissed.

Appeal allowed in part.