Kenneth James v. Her Majesty the Queen, [1996] 3 CTC 234

Rothstein J.: — This is an appeal de novo from a decision of the Tax Court of Canada. The issues are whether amounts received by others were in reality the income of the plaintiff. The plaintiff is a lawyer practising in Toronto. At the relevant time, the plaintiff was practising in partnership with another lawyer.

In the years 1974, 1975, 1976 and 1977, he was performing legal services for one Ken Robinson and later Robinson’s company, K.C.R. Investments Limited. K.C.R. was a mortgage broker and the legal work involved the assignment of vendor takeback mortgages to financial institutions and, less frequently, new or replacement mortgages. Over this period of time and until about 1984, the plaintiff was living in a common-law relationship with Elsa Kirsten. The plaintiff says that in the relevant years Kirsten did photocopying and deliveries for K.C.R. and, for that, she received from K.C.R. $35 per mortgage transaction in the case of vendor takeback mortgages and $50 per mortgage transaction in the case of other mortgages. The plaintiff also says Ms. Kirsten received finder’s fees from K.C.R. for introducing investors to K.C.R. for the purpose of providing a source of funding for the acquisition of some mortgages.

In some cases the amounts paid by K.C.R. were paid to others such as a company in which the plaintiff and Kirsten had an interest, Pedigree Holdings Inc., Kirsten’s sister and her father. The plaintiff says all these amounts were the income of Elsa Kirsten. In addition, there were amounts that were received by the plaintiff that he says were the income of Elsa Kirsten.

The defendant says the monies the plaintiff says were received by Elsa Kirsten or her nominees, in truth, constituted legal fees that should have been reported by the plaintiff as his income.

In addition, Pedigree Holdings Inc. declared a dividend to one Chris Teremy, a nephew of Elsa Kirsten, in 1976. The plaintiff says he held one of the two shares of Pedigree in trust for Teremy from the time the company commenced in 1972. The dividend was reported by Teremy on his income tax return for 1976, but, by virtue of the gross up and dividend tax credit and other deductions available to Teremy, no tax was payable on the dividend.

The defendant says the trust arrangement was a sham and that the beneficial owner of the share in Pedigree was the plaintiff and that the dividend should have been reported by him in his income tax return for 1976.

Bonner, J.T.C.C. found that the amounts received by Elsa Kirsten from Robinson and K.C.R. were properly assessed to the plaintiff. However, he found that the Pedigree dividend need not have been included in the income of the plaintiff and that penalties assessed by the Minister were not exigible.

At the trial before Bonner, J.T.C.C., Elsa Kirsten and Ken Robinson were not called as witnesses. Bonner, J.T.C.C. found this left the factual picture incomplete. Before me, Ms. Kirsten, Mr. Robinson, the plaintiff and others testified. I now have a more complete factual picture than that available to Bonner, J.T.C.C.

I have concluded that the plaintiff’s conduct during the relevant period with respect to K.C.R. was deceitful and fraudulent all for the purpose of improperly avoiding liability for income tax and that his actions were taken knowingly. I briefly summarize what I consider to be the plaintiff’s course of conduct.

The plaintiff filled out Ms. Kirsten’s income tax return for 1974 and failed to disclose in the return income from K.C.R. The plaintiff says that no T4A slips were issued to K.C.R. for that year. However, he was the one who kept the records and he knew the amounts in question. Especially as a lawyer, he cannot claim to be naive and rely on not having T4A slips.

For the year 1976, the first in which Ms. Kirsten reported K.C.R. income, the plaintiff paid her income tax balance, relative thereto, implying that the income in question was his.

The plaintiff admitted that he prepared fraudulent invoices from Pedigree to K.C.R. allegedly for consulting services. K.C.R. paid Pedigree amounts which the plaintiff later said were owing to Ms. Kirsten for her services to K.C.R. The apparent reason for the Pedigree invoices and payments was that Pedigree might have deductions to offset against the K.C.R. revenue which would not be available to Ms. Kirsten.

An amount of $6,083 was paid to the plaintiff by K.C.R. which he later said was income of Ms. Kirsten. His explanation was that the payment to him was a repayment of a loan of $5,500 from Ms. Kirsten or for an investment the plaintiff was making for Ms. Kirsten. The evidence was extremely vague, no documents supported this explanation, and there was no explanation for the balance of $553.

The plaintiff negotiated the terms of compensation between K.C.R. and Kirsten. He kept the records of amounts owed to her and she did not know how much she was entitled to at any time. Her work, photocopying and deliveries, was, by her own admission, minimal. She took instructions from the plaintiff and not Robinson. Ms. Kirsten could offer no names of investors who she allegedly introduced to K.C.R., other than her brother-in-law who said he relied on the plaintiffs involvement and in respect of which no finder’s fees were paid.

Ms. Kirsten admitted she knew very little about the mortgage business. She was a school teacher who worked until between 3:00 and 3:30 each day. She would have had little time to perform deliveries and was unable to indicate the location of offices to and from which she is supposed to have made deliveries.

The amounts received by Ms. Kirsten for photocopying and deliveries in some years far exceeded her income as a school teacher. For this minimal work, these amounts were grossly disproportionate to the legal fees which were received by the plaintiffs law firm e.g. $100 per file. There is no rational explanation as to why Ms. Kirsten was paid $35 per transaction for vendor takeback mortgages and $50 per transaction for other mortgages. I do not accept the explanation that the difference is because there was more photocopying in the case of the latter.

In K.C.R.’s books, the amounts paid to Ms. Kirsten were designated “additional legal fees”. Mr. Robinson testified that he would make payments in whatever manner the plaintiff directed. For some period of time, the plaintiff actually wrote out K.C.R. cheques. He was clearly in control of the payments from K.C.R. to his firm and to Ms. Kirsten and Robinson would agree to whatever split he wished.

It is unnecessary to cite further examples. It is obvious that the plaintiff, in an attempt to avoid income tax, devised a scheme whereby a portion of amounts that would otherwise be legal fees were directed to Ms. Kirsten and others. These amounts were the income of the plaintiff and should have been reported by him. They were improperly diverted to Ms. Kirsten, contrary to sections 3, 9 and subsection 56(2) of the Income Tax Act.

In a deceitful scheme such as this there is no question that the con- dirions precedent for the application of subsection 56(2) have been met. The amounts were legal fees and nothing else. Ms. Kirsten did not provide adequate consideration for the amounts paid to her. And, in any event, the arrangement between her and K.C.R. was not a legitimate business relationship. As the monies were not her income, she was not required to include them in her income for income tax purposes.

I accepted Ms. Kirsten accompanied the plaintiff to K.C.R. and photocopied some documents. After that, she may have done a few deliveries. To the extent she did any of this work, it was not for Robinson or K.C.R., it was for the plaintiff.

The plaintiff says that if the Court finds that Ms. Kirsten was working for the plaintiff, the plaintiff would be entitled to deduct, as an expense, amounts equivalent to the payments to Ms. Kirsten by K.C.R. in any event, such that the plaintiff’s income would not be increased. However, there is nothing before me in the pleadings whereby the plaintiff claims that he should be entitled to deduct the expense of paying Ms. Kirsten and treat the amounts from K.C.R. as his income. Further, such expenses must be reasonable, pursuant to section 67 of the Income Tax Act.

The evidence is that other employees of the plaintiff in his law practice earned a fraction of what Ms. Kirsten was receiving for a little photocopying and a few deliveries after she finished her regular teaching job. The amounts that she was receiving, as I have said, were disproportionate to the amounts received by the law firm for doing the actual legal work. I would not, even if the pleadings had so provided, accept that the plaintiff was entitled to deduct the additional legal fees paid by K.C.R. In so finding, I do not say that income splitting in appropriate circumstances and in accordance with the Income Tax Act is not allowed, but that is not what occurred here.

As to the Pedigree dividend, I have a serious concern about the alleged trust arrangement. The plaintiff bought out Teremy’s entitlement to his dividend by signing a promissory note in Teremy’s favour and ultimately took the dividend. The note did not bear interest. There were some vague references in the evidence to payments having been made on the note in the early 1980’s, but no witness produced any document or cheque evidencing such payment and no witness could specify any particular amount paid.

Teremy was an infant. The fact that the promissory note did not bear interest, that no other investment was made for him and in all likelihood nothing was paid to him suggests that there was never an intention that Teremy was entitled to anything from Pedigree. The evidence given by both the plaintiff and Ms. Kirsten in their family law dispute in 1986, was that it was never anticipated there would ever be a claim by Teremy and, to this day, I do not believe there has been a claim.

On the other hand, there is an undated confirmation by the plaintiff that he held his share in Pedigree in trust for Teremy and a copy of a share certificate to the same effect. Witnesses with no apparent reason to protect the plaintiff also said the trust arrangement existed.

The plaintiffs action in respect of other matters pertaining to Pedigree, namely the Pedigree invoices to K.C.R., were dishonest and were part of a pattern of attempting to avoid income tax by improper means. Also it is extremely doubtful that the plaintiff carried out his fiduciary obligations as trustee for Teremy. But these factors do not prove that the trust arrangement was a sham. I cannot say, on a balance of probabilities, that the trust arrangement, with all the imperfections noted, was not bona fide.

Finally, I have concluded that the plaintiff’s actions in respect of K.C.R. were done intentionally and therefore knowingly. The plaintiff says that not following correct procedures for income splitting is not a grounds for the imposition of a penalty. With respect, that argument misses the point.

Here the plaintiff participated in filing a false income tax return, prepared invoices and obtained cheques which he admitted were done for dishonest purposes, and otherwise improperly diverted moneys that were legal fees to his common-law spouse. I am satisfied that the burden on the Minister under subsection 163(2) has been met and that the penalties initially assessed against the plaintiff with respect to the K.C.R. payments should stand.

The plaintiffs appeal is dismissed. The defendant’s cross appeal is allowed with respect to penalties pertaining to the K.C.R. transactions. Otherwise the cross appeal is dismissed. The defendant is entitled to costs.

Appeal dismissed; Minister’s cross-appeal allowed.