Leonard Mendels v. Minister of National Revenue, [1976] CTC 2346, 76 DTC 1256

Delmer E Taylor:—This is an appeal from an income tax assessment for the year 1970. The appeal was heard in Toronto, Ontario on September 20, 1976 and there are two matters at issue, both disallowances by Revenue Canada (Taxation) of amounts used by the appellant, in filing his 1970 tax return, to reduce his taxable income from other sources. The first of these matters is the amount of $4,981.51 referred to as a farming loss, and the second matter is the amount of $11,187.20 described as the appellant’s share of a charge for management services, paid by a partnership to which he belonged, to a corporation in which he was a 50% shareholder. The appellant’s position is

(a) that the farm loss was incurred from operations which had an expectation of profit; and

(b) that the management charge from the corporation was the result of a bona fide arrangement for the provision of such services to the partnership.

The respondent’s position is

(a) that the expense, and therefore the loss, in the farming operation was personal and not business; and

(b) that the corporation did not perform management services for the appellant’s partnership on a bona fide, arm’s length basis.

As a matter of clarification, it should be pointed out that the management charge disallowed by Revenue Canada (Taxation) was not described as a “management charge” in the financial statements attached to the appelant’s income tax return for 1970, but was included in a larger amount described as “equipment rentals”. The appellant, however, has stated that the original description was a misnomer and that the item should have been more accurately described. The respondent has not disputed this lack of clarity in the original tax return but, by simply reducing the original expense amount shown as “equipment rentals”, has left to the appellant the task of substantiating the disallowed portion of the original amount. It is essentially this difference which the appellant claims was incurred for management services and which he contends should have been allowed as a deduct- ible expense rather than disallowed as an excessive equipment rental charge.

The appellant is a licensed dentist and was at all material times carrying on the practice of dentistry in the City of Toronto in partnership with a Dr A Erwood. In recent years there were two operating clinics, one in Don Mills and the other in Don Valley Village. In the year 1970 the two partners in the dental practice worked in association with about six other associate dentists in these locations. The business arrangements with the six associate dentists were verbal, but generally each dentist received, by way of salary from the Mendels and Erwood partnership, 50% of the income earned by him, leaving the remaining 50% as his contribution to the operating costs of the two clinics.

Separately, in 1964, as a result of a serious illness and on the advice of his doctor, the appellant had purchased a farm on which he kept several horses up to and including the year 1970.

With respect to the portion of the appeal dealing with the farm loss, the Board is of the opinion that the verbal evidence given by the appellant supports the position that, when the farm was purchased, he expected it to be economically viable. It is difficult for the Board to accept that a man convalescing in 1964, with his income from his profession seriously disrupted and with no certainty of ever returning to full-time practice, would consciously assume the potentially large financial burden of such a venture merely as a hobby. On the other hand, the size of the farm (some 11 usable acres) and the appellant’s acknowledged lack of experience with farming, and particularly with the breeding, raising and selling of horses which he undertook, does not support the proposition that he would maintain his original objective for very long. This is particularly evident in view of the fact that he did return very actively, and fairly soon, to the practice of his profession as a dentist. The appellant and his family lived on the farm, and he made no serious attempt to operate it himself with hired help or to contract it out. The appellant left no doubt about the busy and businesslike manner in which he used his available time in the dental practice. The Board is of the opinion that, by the year 1970, the appellant had concluded that his efforts could most profitably be devoted to his dental practice and, having organized that practice in such a way that he had substantial assistance from a partner, six or more professional associates, and a very large office-and-clinical- support staff, the farm became merely a place of personal rest and relaxation, albeit also the site of hard physical work on occasions.

Turning to the matter of the charge for management services, this came from Mendelwood Investments Limited (hereinafter referred to as the corporation), a company incorporated in 1966, with the appellant and his dental partner, Dr A Erwood, each owning 50% of the capital stock. According to the appellant’s testimony, the corporation was formed for the purpose of purchasing the equipment needed in the partnership’s dentistry practice, which was beginning to expand in 1966. The position of the appellant, as indicated in his Notice of Appeal, is that “the business of this company [Mendelwood] is to rent laboratory and other dental equipment and to render management services to the dental practice . . .”’; and this is further indicated in paragraph 7 of the Notice of Appeal, which reads as follows:

7. The dental practice carried on by the Appellant and Dr Erwood is a very substantial operation and requires a large amount of time and expertise in its management and supervision. For the fiscal period of the Appellant’s dental partnership ended July 31, 1970, Mendelwood rendered the necessary management and supervisory services to this partnership. The fees paid by the partnership to Mendelwood were calculated on the basis of the time expended by employees of Mendelwood in rendering these services.

It would be in order to review the precise nature of this aspect of the appeal and, to do so, the Board will quote several further paragraphs or excerpts thereof, from the Notice of Appeal:

8. Mendelwood owns laboratory and other dental equipment which it has available for rent. In the fiscal period of the Appellant’s dental partnership ended July 31, 1970 Mendelwood rented laboratory and other dental equipment to this partnership. The rent charged by Mendelwood to the partnership was comparable to what the partnership would have been required to pay to other persons to secure equipment of similar quality and quantity.

9. In his income tax return for 1970, the Appellant included a statement showing the expenses of the dental partnership. One such expense was the sum of $46,448.32 described as “equipment rentals”. This figure included $26,448.32 as actual equipment rental paid to Mendelwood for laboratory and other dental equipment and the $20,000 management fee paid to Mendelwood as described in paragraph 7 hereof. The description of these combined items as “equipment rentals” was an error and the two components were intended to be segregated. Of the total expense of $46,448.32, the Appellant sought to deduct $23,224.16 or the one-half relating to his share in the partnership’s business.

11. By Notice of Reassessment dated March 26, 1973, the Minister of National Revenue disallowed as a deduction in computing the Appellant’s income for 1970 the amount of $11,187.20 and added this amount to net income previously reported, as described in paragraph 1 hereof. The Appellant understands that the Minister regarded $46,448.32 as an excessive amount for renting equipment from Mendelwood and calculated that $24,173.92 was a proper rental. Because of the error in describing the amounts paid to Mendelwood, the Minister was apparently unaware that $20,000 of this $46,448.32 was expended as a management fee. The amount of $11,187.20 is one-half (or the Appellant’s share) of the excess of $46,448.32 over $24,173.92.

Taken then in the most literal sense, the appellant is requesting the Board to increase the amount allowed by the respondent to the partnership for equipment rentals from $24,173.92 to $26,448.32 and also to allow an amount of $20,000 for management services, thereby restoring the total amount of the original deduction claimed. The respondent, on the other hand, is simply requesting the Board to uphold the reduced amount for equipment rental, and to deny in its entirety the appellant’s claim for relief in the form of a charge for management services.

In support of his claim, the appellant provided the Board with copies of the financial statements of the corporation, and although the affairs of that corporation are not the subject of this appeal, to the extent that it may shed some light on the matter, a short review of the history of the corporation and of its financial record would be in order. The appellant stated in evidence that, due to legal requirements, the corporation was precluded from providing its services (presumably those relating to laboratory work) to outside dentists, and therefore, to this extent, it was restricted to dealing with the dental practice of its two shareholders. There was no indication given that any such restriction applied to the rental of equipment to other dentists, or in fact to anyone, nor to the provision of management services to other firms. The evidence, however, is that no equipment rentals or management services were ever provided to other firms, and that the only client of the corporation for any purpose whatsoever was the dental partnership. Its shares were owned and its operations controlled by the two dentists, and it was restricted, either by law or by the business decisions of the two shareholders, to dealing only with the partnership dental practice carried on by those same shareholders.

The financial statements of the corporation show that its only apparent asset, up to and including April 30, 1969, was dental and laboratory equipment worth $44,000 at net depreciated cost. This is completely consistent with the evidence given by the appellant. In the fiscal year 1970 two other assets appear—a minor capital expenditure of $578 for leasehold improvements and a current asset of $8,132.64 described as “Accounts Receivable—Shareholders”. Continuing this on for the fiscal year ended April 30, 1971, one finds that this latter amount has now increased to $37,071.56. This is significant because, as described earlier, the only source of income of the corporation was the partnership, and there is no indication from the financial statements that the corporation had borrowed any new funds in large amounts. Therefore, one must conclude that the moneys received went in large measure to the shareholders of the corporation.

A summary of the revenue, expense and “net profit before tax” figures of the corporation for the four-year period, rounded off for simplicity, shows the following:

The major item of expense incurred each year is quite logically that for depreciation of the equipment, which accounts for 85% or 90% of the total expense amount. The other expense items making up the balance consist of small items of interest, supplies, maintenance, etc. There is significantly no expenditure on account of salaries or wages, the reason being that there are no employees.

The Board gives no opinion on whether indeed the professional fee income of the appellant would have been greater if his time had all been available as “chair time”, to use his expression, nor does the Board express any opinion regarding the correctness of the amount of $26,448.32 suggested by the appellant, or the amount of $24,173.92 determined by the respondent, for equipment rental, other than to say that neither of these amounts seems to bear any dollar relationship to the actual costs (largely depreciation) of the provision of the equipment to the partnership, and that no other substantive evidence was given on which such an opinion as to appropriate cost could be based. The amount determined by the respondent’s officials, namely, $24,173.92, is the lower of the two amounts suggested, and therefore closer to the actual known amount involved in the provision of the equipment for use by the partnership, and the Board accepts this as the amount which should be allowed for equipment rental. This decision will therefore deal only with whether or not the partnership should be allowed to deduct $20,000 for management services, 50% of which would be to the benefit of the appellant. The simple question, therefore, is: Did the appellant, in his role as a manager of the dental partnership of Mendels and Erwod, perform this role as a partner therein, a function he might normally be expected to perform? Or did the appellant, in his role as a manager of the partnership of Mendels and Erwood, do so acting for the corporation Mendelwood Investments Limited?

The evidence of the appellant indicated that the management services for which a charge was made by the corporation consisted of supervising and organizing the work relating to the laboratory, keeping. records, and bookkeeping, billing and collecting, among other things. All of these functions were performed by employees of the dental partnership and the cost of all laboratory supplies was charged against the partnership. That management, supervision, administration and organization were required within the operation of the partnership is self-evident, and that these function were carried out in large measure by the appellant and his partner, the Board does not doubt. The partnership, in the year under review, grossed over $285,000 in fees and showed a net income of $59,337.94 after the deduction, inter alia, of the already mentioned ‘equipment rental’ of $46,448.32. It is a matter of simple mathematics, therefore, to discern that, before making an allowance for any payment to the corporation, the net income of the partnership for the fiscal year 1970 would have been in excess of $100,000, to be divided equally between the two partners. /t is of interest also to note that, in that year, according to the appellant's evidence, the six associate dentists brought in about $156,000 of the $285,000 gross revenue which, on a per capita basis, is much less than the balance of about $130,000 in fees apparently earned from the professional efforts of the two partners. The contention of the appellant is that it is this result—his professional fee income—which was adversely affected by his necessary involvement in the management of the dental practice, and that, since he was performing his service on behalf of the corporation, this corporation should be recompensed for it.

Generally, the rules which have considerable merit in the view of the Board are those to be found in Interpretation Bulletin No 189 (and any amendments thereto) dealing with professional corporations. These are provided for guidance by the Minister of National Revenue. This quotation is taken from paragraph 5 of that bulletin of November 25, 1974:

5. There is no one method to determine the incomes of the individuals and of the corporation in these cases. Generally the Department accepts any reasonable method. A method is not acceptable if it—

(a) permits a practitioner to defer or avoid tax on significant amounts of income, or

(b) allocates unreasonably high charges te the practitioner for premises and services.

In argument, counsel for the appellant contended that the corporation was a legitimate means for the provision of the management services, and the decision, whether verbal or written, to use the corporation for this purpose was at the judgment of the partners of the dental practice. Furthermore, since the Minister had recognized the partnership’s dealings with the corporation as legitimate for the purpose of allowing the charge for equipment rental, the management service charge ought to be treated in the same way. This latter point implied that the Minister had set aside any possible argument that the corporation and the dental partners were not dealing at arm’s length. Also in argument, counsel for the respondent made the point that there was no written agreement between the parties (that is, between the corporation and the partnership, or indeed the partners and the associates in the partnership), and therefore there was simply no basis for the management service charge and that the corporation was not at arm’s length from the appellant, that it existed only as a vehicle for the reduction of income tax liability, and served no legitimate purpose which could not have been performed as well or better by the individuals concerned.

Dealing with the arguments advanced by the appellant, the Board reserves comment on the legitimacy and factual nature of the corporate role in the provision of management services, but rejects the argument that it is incumbent upon the Board to accept the charge for management services as legitimate merely because the Minister has recognized the right of the corporation to make a charge for equipment rental. The provision of equipment is a tangible, physical matter; it can be calculated and should bear some relationship to the capital cost of the equipment, and to operation and maintenance expenses. The provision of management services in circumstances such as those before the Board is not based on the same criteria.

Turning to the points made by the respondent, the Board does not accept the argument that the lack of written contracts nullifies the matters at issue or that the arrangements could not be regarded as ‘‘bona fide” merely because of this circumstance. The Board is prepared to accept that the persons involved, whether acting as individuals, as partners in a dental practice, or as directors of a corporation, were competent to make oral as well as written agreements. With regard to the corporation being only a ‘‘sham” vehicle, or virtually so, the Board does not believe that this argument is supported. The purpose for establishing the corporation (that is, to buy, own and rent the dental equipment), its operation, financial statements and liabilities, including accounts payable and bank loans, all point to a viable entity for a legitimate business purpose.

There can be no comparable competitive relationship established solely on the basis that the services of a full-time qualified manager (if one could be found), or two managers of lesser calibre (if they could be found), would have cost a certain ascertainable amount of money. The services provided by third parties under such actual circumstances would probably be very different from those provided directly by one or both of the two partners. Such services might be better, or they might be worse. It could be argued that if a full-time qualified manager would cost $25,000, then a part-time, unqualified (because he is a professional practising dentist) manager would only be worth $500. The reverse could also be argued, that the supposedly unqualified part-time dentist manager would be worth $50,000 simply because he would be dealing with his own business affairs, with which he was thoroughly familiar and because the incentive to work hard and produce would be greater for him than for anyone else. The Board can visualize the sole shareholders of this corporation, in their capacity as directors thereof, assessing in a very objective way the appropriate charge for equipment owned by the corporation and rented to their own professional partnership, but the Board has great difficulty in visualizing the same corporate, impersonal assessment being undertaken when the subject matter would be the value to the partnership of management services contributed by the partners to themselves allegedly through the corporation. To expect the Board to hold that the corporation and the partnership were in those circumstances dealing at arm’s length would indeed be a great deal to ask, since Dr Mendel and Dr Erwood were equal participants in the arrangements of the partnership as well as equal shareholders in the corporation. The partnership provided the dental service: the corporation provided the equipment used by the partnership.

It would be well at this point to make reference to one Specific sentence in paragraph 7 of the Notice of Appeal: “The fees paid by the partnership to Mendelwood were calculated on the basis of the time expended by employees of Mendelwood in rendering these Services.” There is no indication at all that Mendelwood, in its own right, had any employees or any other capacity for providing management services, even to the extent of having as employees of the corporation one or more of the two shareholders. The connecting links between the partnership and the corporation were the two dentists, Dr Mendel and Dr Erwood: in one situation, as partners and in the other, as shareholders. They totally controlled the functioning and operation of both organizations; the associate dentists had no recognized or legitimate interest in, or impact upon, those operations. In this matter, therefore, the provision of the equipment by the corporation and a rental charge to the partnership for its use as a a physical asset can be viewed quite differently from the charge for the services of a corporate shareholder and director, who was not an employee of the corporation, to his own partnership.

The Board therefore finds for the year under review that the appellant has not established that he should be entitled to claim a farming loss; nor that Mendels and Erwood received management services from or through the corporation Mendelwood Investments Limited to the value of $20,000 as claimed. The Board finds no reason to vary the amounts of $4,981.20 and $11,187.20 disallowed by the Minister respectively as a farming loss and as equipment rental.

The appeal is dismissed.

Appeal dismissed.