Jar Holdings LTD v. Minister of National Revenue, [1973] CTC 2214, 73 DTC 172

À J Frost:—This is an income tax appeal from assessments dated March 11, 1969, and May 6, 1969, in respect of appellant’s 1966 and 1967 taxation years, respectively. It was heard by .J O Weldon, Esq, QC at Regina, Saskatchewan on June 8, 1971 and judgment was reserved. Before Mr Weldon could reach a decision, his term of office expired. By consent of both parties, this Board was given jurisdiction to render its decision on the basis of the transcript of the evidence without further representation by counsel. The matter has now come to me for adjudication.

It was agreed at the hearing that the appeal of Jackson A Running in respect of his 1966 taxation year be heard at the same time on common evidence as the issue therein was similar.

Mr Running was president and majority shareholder of the appellant company and president and majority shareholder of Great West Motors Ltd (hereinafter referred to as “Great West”) at all material times. On December 1, 1966 the appellant company conveyed to Great West a garage building and a car-wash building being all of its Class 3 assets. The sale price of the car-wash building was at its book value. The sale price of the garage building was $5,000 and its book value $66,575.73 and, accordingly, the appellant claimed the difference of $61,575.73 as a terminal loss. On February 2, 1967, 63 days later, both buildings were reconveyed to the appellant company and capitalized at the original purchase price less depreciation.

The evidence indicated that the transfers were made to satisfy the Ford Motor Company and to improve appellant’s borrowing position. The Ford Motor Company wanted the appellant to erect a new building, and the appellant needed the Ford Company franchise to stay in business. It was on the advice of the appellant’s auditor that the transfers were made. The fair market value of the garage building at date of sale was not in excess of $5,000.

The first question in issue is: could the appellant company so arrange its affairs as to reflect in its balance sheet and profit and loss account the true and correct state of its financial affairs without offending the Income Tax Act avoidance provisions?

On the evidence I find in respect of the sale of the garage building by Great West to the appellant that:

1. The building, a one-purpose structure, had a nominal value in 1966 and the loss sustained in respect of it in that year was a real loss and not an artificial one, and the recording of the loss by the means adopted, although somewhat unorthodox, enabled the appellant company to prepare its balance sheet as at December 31, 1966 so as to reflect accurately the true and correct state of its affairs in so far as those affairs related to the fixed asset position of the company and the results of the operations with respect to the measurement of income.

2. The Ford franchise was of some importance to the appellant company and the appellant was obliged to work with the Ford Motor Company and satisfy its demands.

3. The old garage building was demolished shortly after the new garage building was ready for occupancy.

4. Capital cost allowances under the Income Tax Regulations were inadequate to establish business losses attributable to depreciation and obsolescence.

Counsel for the respondent in his argument made the following submissions:

I would like to start off by setting out the view which the Minister takes of this transaction. First of all, on December 1, 1966, the Appellant Corporation conveyed two properties to an associated corporation and these were reconveyed to the Appellant Corporation on February 2, 1967, sixty days later. In so doing the Appellant set up a terminal loss in the amount of $61,000.00. The properties transferred were the garage and car-wash businesses. Under Regulation 1100(2) the Appellant in order to claim a terminal loss has to dispose of all its assets in the class. All the assets in Class III, which was the class to which the assets involved belonged, were transferred in this particular transaction. Section 137(1) reads:

‘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.”

The important words are, expense if allowed would unduly or artificially reduce the income. One of the leading cases on Section 137(1) is Isaac Shulman v. M.N.R., [1961] Canada Tax Cases, 385. I am sure you are aware of the facts in that case where Mr. Shulman set up a management company for the purpose of looking after the managerial duties in his law firm. That being one of the first cases involving Section 137(1) Mr. Justice Ritchie set out a few tests, and I quote from page 400:

“In considering the application of Section 137(1) to any deduction from income, however, regard must be had to the nature of the transaction in respect of which the deduction has been made. Any artificiality arising in the course of a transaction may taint an expenditure relating to it and preclude the expenditure from being deductible in computing taxable income.

That case was followed by a recent case, Concorde Automobile Limitée v. M.N.R., 71 Dominion Tax Cases, 5161. Here again there is reference to the words of this section. This case was another one of those executive pension plans which involved a roundabout transaction. Mr. Justice Walsh stated at page 5174:

“This section is a general one, however, under the heading ‘Tax Evasion’ and I therefore believe it is necessary in any given case whether the company was merely incidentally gaining a tax advantage as the result of setting up a bona fide pension plan, or whether it would not have considered setting up this pension plan but for the tax advantage to be gained as a result thereof, and in the latter event Section 137(1) would be applied. Now in the present case, while there is no clear indication that the tax advantage was the sole purpose for setting up the plan as in the West Hill Redevelopment Company, Susan Hosiery and The Cottermole- Thretheway Contractors cases, I am forced to the conclusion on the evidence before me that the company would never have set up the plan had it not been assured of getting back at least the greater part of the money contributed thereto by virtue of the reinvestment of these funds in the preferred shares of the company.”

The other thing to look for is the tax advantage. There are two things, the element of artificiality and the second is the tax advantage. The tax advantage has been admitted by the Appellant and by the Appellant’s accountant on the stand. This was a consideration. The element of artificiality in the present case is simply that here you have two properties, one of which was directly connected with the business, the other being the carwash business, which were conveyed and then sixty days reconveyed. There was an expense involved in the conveying and reconveying in drawing up the deeds, registering the deeds, paying a deed tax, if there was one. This was done in order to get a tax advantage by claiming a terminal loss.

A statement was made by my friend that depreciation may not be the type of loss considered under Section 137(1). In that connection I would like to refer you to Harris v M.N.R., [1966] Canada Tax Cases, a Supreme Court of Canada decision.

I find the respondent’s position in this part of the case rather strange. In my opinion the test is: what is reasonable in the circumstances? The Board realizes that it must disallow as deductions such write-offs as offend the sense of justice of the ordinary man, but in this particular case we have a building which was almost a total loss and the respondent prays that the appeal be dismissed which, if granted, would result in the recapitalization of a non-existent asset at its former book value to be written off for tax purposes over the lifetime of the new building constructed to take its place. Reasonableness appears in my view to be more on the side of the appellant company than the respondent. The latter takes a technical position standing strictly on the Regulations and a narrow view of the language of the Act, while the appellant takes the position of a prudent businessman who wants to show the true and correct state of its financial affairs and who objects to paying taxes on non-existent profits.

As I read the evidence, it may well be that there was some surface artificiality in the method used to establish the terminal loss, but the method does not in my opinion taint the transaction or go to the root and substance of what happened. It is only when income is unduly reduced by artificial means that subsection 137(1) of the Income Tax Act applies. In my opinion, there is no question here of tax avoidance, unless it be the “avoidance” of paying tax on inflated income calculated before taking into consideration an actual loss. The write-off of the garage building was a business expense properly chargeable against profits in the year 1966. This part of the appeal is allowed in full.

The second part of the appeal deals with the validity of certain journal entries purporting to establish a fee for management services provided by Great West in the sum of $25,000 in respect of the 1966 taxation year. To repeat: during the taxation year 1966 Jackson A Running was the president and controlling shareholder of the appellant company and Running Enterprises Ltd, formerly called Great West Motors Ltd (“Great West”).

By journal entry dated December 1966, Great West set up an account of $25,000 payable to the appellant company for management services stated to have been performed by the appellant for Great West, and by journal entry Great West transferred the $7,200 salary previously paid to Jackson A Running to the account of the appellant in partial satisfaction of the account payable in the amount of $25,000.

The above transaction was also recorded on the appellant’s books of account for the taxation year 1966 as salary expense of $7,200. In December 1966 the balance in the account, namely $17,800, stated to be a management fee was transferred by Great West to the appellant company. There was no contract to support the journal entries.

It seems fairly clear to me on reading the evidence that the appellant performed no real management services. The appellant company comprised Mr Running who was an employee of Great West and his wife and two sons aged 12 and 14, who did not add to the situation from a management viewpoint. The credit therefore established by journal entry on the books of Great West in favour of the appellant company was only a bookkeeping accommodation and of no real substance.

In my opinion the transfer payment of $17,800 from Great West to the appellant company to settle the account established by journal entry is not income of Jackson A Running but income of the appellant in its 1966 taxation year. This part of the appeal is dismissed.

The appeal is allowed in part and the matter referred back to the respondent for reassessment in accordance with the foregoing.

Appeal allowed in part.