Date: 19971003
Docket: 94-1889-IT-G
BETWEEN:
KEITH E. FERREL,
Appellant,
and
HER MAJESTY THE QUEEN,
Respondent.
Reasons for Judgment
Mogan, J.T.C.C.
[1] The Appellant was the settlor of the Ferrel Family Trust ("the Trust") established in May 1983. Since December 1984, the Appellant has been the sole trustee of the Trust. Neotric Enterprises Inc. ("Neotric") is a family holding company with four subsidiary corporations. The equity shares of Neotric are held by the Trust and the non-participating voting shares are held by the Appellant. In its fiscal periods ending September 30, 1989 and 1990, Neotric accrued management fees of $152,000 and $150,000 respectively, payable to the Trust. In the 1989 calendar year, Neotric actually paid management fees of $124,000 to the Trust. In 1990, Neotric paid management fees of $128,000 to the Trust. The remaining $50,000 of the accrued management fees was paid by Neotric to the Trust in 1991. By notices of reassessment the Minister of National Revenue added to the Appellant's reported income $152,000 for 1989 and $150,000 for 1990 applying subsections 56(2) and 56(4) of the Income Tax Act. The Appellant has appealed from those reassessments. The primary issue in these appeals for the 1989 and 1990 taxation years is whether the Appellant is required to include in his income the management fees paid or payable by Neotric to the Trust.
[2] There are three subsidiary corporations which are wholly owned by either Neotric or the Trust or a combination of Neotric and the Trust: Dysan Developments Inc., Hillsboro Properties Inc. and David Leslie Holdings Ltd. There is a fourth subsidiary, Hillsboro Developments Inc. which is 50% owned by Neotric and the Trust and 50% owned by an arm's length person. Generally speaking, the subsidiary corporations were in the real property development business. The financial statements of Neotric for its fiscal periods ending September 30, 1989 and 1990 are Exhibits A-2 and A-3, respectively. In those two years, Neotric showed revenue from management fees in the amounts of $400,200 in 1989 and $346,696 in 1990. These management fees were paid by the subsidiary corporations to Neotric and are the amounts which permitted Neotric to accrue and later pay management fees to the Trust.
[3] The Appellant is a chartered accountant who identified himself in the witness stand as a businessman. He explained that the Trust was established in 1983 for a variety of purposes: to set up a fund for the education of his children; to protect family assets from creditors; to permit a transfer of family assets to the children at a low cost upon the death of the parents; and to permit preferred beneficiary elections with respect to the income of the Trust. The income beneficiaries of the Trust are the Appellant's two children, Conrad and Erin, born in 1978 and 1980, respectively.
[4] The T3 Trust income tax returns for the fiscal years of the Trust ending December 31, 1989 and 1990 are Exhibits A-6 and A-7. Those returns confirm the oral evidence of the Appellant that the income of the Trust in each year was in fact allocated between the two income beneficiaries on an equal basis and preferred beneficiary elections were filed with respect to that income. Most of the cash was left in the Trust and loaned back to Neotric for use within the family group of corporations.
[5] The two critical documents are Exhibits A-4 and A-5 which are the agreements under which the Appellant claims that the Trust provided management services to Neotric and, in turn, earned management fees. Because these documents are important, I shall set out their relevant parts. Exhibit A-4 is an agreement made January 1, 1986 between the Trust (identified as "FFT") and the Appellant in his personal capacity (identified as "KEF"). Set out below are the recitals and the first three clauses of Exhibit A-4. The corporation described in the first recital as 299377 Alberta Limited later changed its name to Neotric Enterprises Inc. and so I have changed the nomenclature in the remaining quoted parts of Exhibit A-4 from "299377" to "Neotric".
WHEREAS FFT has agreed that FFT shall provide management services to 299377 Alberta Ltd. ("299377")
WHEREAS KEF is the only trustee of FFT
WHEREAS KEF has agreed as trustee of FFT to be the manager of FFT management services offered by FFT to Neotric
NOW THEREFORE THIS AGREEMENT WITNESSETH THAT for an in consideration of the mutual covenants herein contained and other good and valuable consideration, the receipt and sufficiency whereof is hereby acknowledged, the KEF as trustee of FFT and FFT agree as follows:
1. KEF shall, subject as herein provided, be the President and Secretary/Treasurer of the Neotric and its associated companies and shall act on behalf of FFT in various other management positions. KEF may appoint and engage any other parties to represent FFT or Neotric on various boards and to perform any work necessary or needed.
2. The trustee(s) of FFT and KEF shall agree at various times as to the remuneration to be paid to KEF, if any.
3. In addition to the fee provided for in clause 2 hereof, KEF shall be entitled to be reimbursed for all expenses properly incurred by KEF in the performance of his duties hereunder.
Exhibit A-5 is an agreement made January 1, 1989 between Neotric (identified as the "Corporation"), the Trust (identified as "FFT") and the Appellant (identified as "KEF"). Set out below are the relevant provisions of Exhibit A-5:
WHEREAS the Corporation and FFT have agreed that FFT shall provide the services of KEF who shall be appointed President and Secretary of the Corporation.
NOW THEREFORE THIS AGREEMENT WITNESSETH THAT for and in consideration of the mutual covenants herein contained and other good and valuable consideration, the receipt and sufficiency whereof is hereby acknowledged, the Corporation and FFT agree as follows:
1. KEF shall, subject as herein provided, be the President and Secretary of the Corporation.
2. For services rendered by KEF the Corporation shall pay FFT management fees to be agreed upon from time to time.
3. In addition to the fee provided for in clause 2 hereof, KEF shall be entitled to be reimbursed for all expenses properly incurred by KEF in the performance of his duties hereunder.
[6] The management fees of $152,000 and $150,000 were accrued and deducted by Neotric in its fiscal periods ending September 30, 1989 and 1990 but those same management fees were reported by the Trust only on a "received" basis. In 1989, the Trust received $124,000; in 1990, it received $128,000; and it received the remaining $50,000 in 1991. In each year the income of the Trust was allocated between Conrad and Erin on a 50/50 basis and preferred beneficiary elections were filed on their behalf. According to the unchallenged evidence of the Appellant, Conrad and Erin together paid aggregate income taxes in excess of $95,000 in the years 1989, 1990 and 1991 with respect to the amounts $124,000 plus $128,000 plus $50,000 which were allocated to them in those respective years. None of the money paid by Neotric to the Trust as management fees ever came into the hands of the Appellant or his wife directly or indirectly.
[7] The Appellant argues that the Trust is a business trust in the sense that it is a trust carrying on a business (i.e. providing management services). In accordance with Exhibit A-5, the management services were provided to Neotric not by the Appellant but by the Trust through the medium of the Appellant. Counsel for the Appellant compared the three-way relationship between the Trust, Neotric and the Appellant with professional corporations which are common in the province of Alberta where a professional corporation will agree to provide professional services to a client but the professional services will in fact be performed by a particular professionally qualified individual who owns the shares of the professional corporation. In those circumstances, the services and the compensation flow between the professional corporation and the client even though the actual services are performed by the professionally qualified individual who stands behind the corporation.
[8] To support the integrity of the agreement which is Exhibit A-5, the Appellant relies on the decision of the Supreme Court of Canada in M.N.R. v. Cameron, 72 DTC 6325. In that case, Mr. Cameron and two associates had been employed by a company referred to as "Campbell Limited". Mr. Cameron and his two associates resigned from their employment with Campbell Limited and formed a new management company of which they became equal shareholders as well as employees. The new management company agreed to provide the services of Mr. Cameron and his two associates to Campbell Limited. The former employer paid amounts to the new management company which were approximately equal to the salaries which had previously been paid to Mr. Cameron and his two associates; but the new management company did not disburse to Mr. Cameron and his associates the full amounts received from Campbell Limited. The Minister of National Revenue looked at the whole transaction as a sham and assessed Mr. Cameron for what appeared to be his share of the amounts paid by Campbell Limited to the new management company. Mr. Cameron successfully appealed to the Exchequer Court from the assessment. The Minister's appeal to the Supreme Court of Canada was dismissed. The Supreme Court concluded that the agreement between Campbell Limited and the new management company was not a sham. At page 6328, Martland J. delivering judgment for the Court stated:
Those payments were made pursuant to an agreement. The receipts were reported by Independent as income, and income tax was paid by Independent and received by the Appellant. Payment of those moneys by Campbell Limited could not be legally enforced by the Respondent, Steele or Symon, or all three together, but only by Independent. The Respondent could not legally compel Independent to pay the moneys to him.
Although the Cameron decision was not based on the application of section 56 of the Income Tax Act, the Appellant argues that the same principle should apply in this appeal because the Respondent has not alleged that the arrangement between the Appellant, the Trust and Neotric was a sham. In the absence of any sham, the Appellant states that the three-party agreement in Exhibit A-5 should be given the same validity as the Supreme Court gave to the management agreement in Cameron. The Supreme Court of Canada reached a similar conclusion on different facts in The Queen v. Campbell, 80 DTC 6239.
[9] Counsel for the Appellant relied on the decision of the Supreme Court of Canada in The Queen v. McClurg, 91 DTC 5001. In dismissing an appeal by the Minister of National Revenue, Dickson C.J. delivering judgment for the majority stated at page 5012:
... The purpose of subsection 56(2) is to ensure that payments which otherwise would have been received by the taxpayer are not diverted to a third party as an anti-avoidance technique. This purpose is not frustrated because, in the corporate law context, until a dividend is declared, the profits belong to a corporation as a juridicial person: Welling, supra, at pp. 609-10. Had a dividend not been declared and paid to a third party, it would not otherwise have been received by the taxpayer. Rather, the amount simply would have been retained as earnings by the company. Consequently, as a general rule, a dividend payment cannot reasonably be considered a benefit diverted from a taxpayer to a third party within the contemplation of subsection 56(2).
In my opinion, the last sentence in the passage quoted above distinguishes the decision in McClurg from this appeal because the payments from Neotric to the Trust were not payments of dividends. Counsel for the Respondent also relied on the decision in McClurg because Laforest J. delivering judgment for the minority set out the ingredients for the application of subsection 56(2) at page 5021:
Turning to the application of subsection 56(2) to the instant case, I find it useful as a starting point to break the provision down into its constituent parts. such an analytical framework was adopted by Cattanach J. in Murphy v. The Queen (1980), 80 DTC 6314 (F.C.T.D.), where he stated at pp. 6317-18:
To fall within subsection 56(2) each essential ingredient to taxability in the hands of the taxpayer therein specified must be present.
Those four ingredients are:
(1) that there must be a payment or transfer of property to a person other than the taxpayer;
(2) that the payment or transfer is pursuant to the direction of or with the concurrence of the taxpayer;
(3) that the payment or transfer be for the taxpayer's own benefit or for the benefit of some other person on whom the taxpayer wished to have the benefit conferred, and
(4) that the payment or transfer would have been included in computing the taxpayer's income if it had been received by him instead of the other person.
It must be determined, then, whether these four elements of prerequisites to the application of subsection 56(2) are present in the transaction at hand.
Counsel for the Respondent argued that the above four ingredients are met in the circumstances of this appeal and, therefore, subsection 56(2) should be applied. With respect to the fourth ingredient, there seems to be an assumption that the payment or transfer would have been made to the person assessed by the Minister if it had not been made to the actual recipient. In this appeal, if the management fees had not been paid by Neotric to the Trust, there is no evidence that they would have been paid to the Appellant. I am satisfied that they would not have been paid at all. There would have been nothing to include in the Appellant's income.
[10] The Respondent relies on a very technical interpretation of Exhibit A-5 to argue that the Appellant was entitled to the management fees paid by Neotric. The Appellant acknowledged that he had drafted Exhibit A-5 himself without the benefit of legal assistance and so the Respondent argues that it must reflect precisely what the Appellant intended. Paragraph 2 of Exhibit A-5 states:
For services rendered by KEF the Corporation shall pay FFT management fees to be agreed upon from time to time.
The Respondent emphasized that in the above paragraph, the services are to be rendered by KEF (Keith E. Ferrel - the Appellant herein) in his personal capacity and yet Neotric is required to pay management fees to the Trust for those services. In other words, the paragraph does not state that the services will be rendered by KEF "on behalf of the Trust". In my view, this is too narrow an interpretation to be placed upon paragraph 2 in isolation from the rest of Exhibit A-5. The first recital states:
WHEREAS the Corporation and FFT have agreed that FFT shall provide the services of KEF who shall be appointed President and Secretary of the Corporation.
Exhibit A-5 is a three-party agreement among Neotric, the Trust and the Appellant. To me, it is clear from the wording of the first recital and paragraph 2 that the Appellant is agreeing that the Trust may provide his services to Neotric. The management fees in issue would not have been paid at all if they had not been paid to the Trust.
[11] Relying on the decisions of the Supreme Court in M.N.R. v. Cameron and The Queen v. Campbell, I find that there was a bona fide agreement between and among the Trust and Neotric and the Appellant in effect from January 1, 1989 as evidenced by Exhibit A-5. On the strength of that three-party agreement, the Appellant did not have a right to receive any management fees which may have been payable by Neotric to the Trust. Whether the Appellant received any personal compensation from the Trust for the management services which he was providing on behalf of the Trust to Neotric was a matter between only the Appellant and the Trust.
[12] In the absence of sham, there is nothing in law to prevent an individual from agreeing to provide his professional or management services to a client through the medium of a corporation or some other third party entity like a trust. Assuming that the Trust has agreed by lawful contract to provide the Appellant's services to Neotric, the question arises whether the Appellant may still be trapped by the provisions of section 56 of the Act. Specifically, the Minister relies on subsections 56(2) and 56(4) which are set out below with the irrelevant words omitted:
56(2) A payment or transfer of property made pursuant to the direction of, or with the concurrence of, a taxpayer to some other person for the benefit of the taxpayer or as a benefit that the taxpayer desired to have conferred on the other person ... shall be included in computing the taxpayer's income to the extent that it would be if the payment or transfer had been made.
...
56(4) Where a taxpayer has, at any time before the end of a taxation year ... transferred or assigned to a person with whom he was not dealing at arm's length the right to an amount ... that would, if the right thereto had not been so transferred or assigned, be included in computing his income for the taxation year because the amount would have been received or receivable by him in or in respect of the year, the amount shall be included in computing the taxpayer's income for the year unless the income is from property and the taxpayer has also transferred or assigned the property.
[13] The application of subsection 56(2) was considered by the Federal Court of Appeal in Winter and Winter v. The Queen, 90 DTC 6681. The facts in that case are not important but Marceau J.A. (delivering judgment for the Court) made the following statement at page 6684:
It is generally accepted that the provision of subsection 56(2) is rooted in the doctrine of "constructive receipt" and was meant to cover principally cases where a taxpayer seeks to avoid receipt of what in his hands would be income by arranging to have the amount paid to some other person either for his own benefit (for example the extinction of a liability) or for the benefit of that other person (see the reasons of Thurlow J. in Miller, supra and of Cattanach J. in Murphy, supra). ... the language of the provision does not require, for its application, that the taxpayer be initially entitled to the payment or transfer of property made to the third party, only that he would have been subject to tax had the payment or transfer been made to him. It seems to me, however, that when the doctrine of "constructive receipt" is not clearly involved, because the taxpayer had no entitlement to the payment being made or the property being transferred, it is fair to infer that subsection 56(2) may receive application only if the benefit conferred is not directly taxable in the hands of the transferee. Indeed, as I see it, a tax-avoidance provision is subsidiary in nature; it exists to prevent the avoidance of a tax payable on a particular transaction, not simply to double the tax normally due nor to give the taxing authorities an administrative discretion to choose between possible taxpayers.
So, I agree that the validity of an assessment under subsection 56(2) of the Act when the taxpayer had himself no entitlement to the payment made or the property transferred is subject to an implied condition, namely that the payee or transferee not be subject to tax on the benefit he received. ...
[14] As I understand the above passage, when the Minister relies on subsection 56(2) to assess a particular person concerning a payment to some third party, it is not necessary that the particular person be entitled to receive the payment. It is necessary, however, that the person would be subject to tax if he had in fact received the payment. Also, if the particular person was not entitled to receive the payment, then subsection 56(2) will apply only if the payment is not taxable in the hands of the third party.
[15] I accept the unchallenged evidence of the Appellant that all of the management fees were channelled through the Trust to the income beneficiaries of the Trust and that preferred beneficiary elections were filed on behalf of the income beneficiaries. The Respondent made no attempt to contradict the Appellant's statement that the two income beneficiaries of the Trust paid aggregate income taxes in excess of $95,000 on the management fees which were allocated to them by the Trustee. In other words, all of the management fees paid by Neotric to the Trust were in fact taxed in the hands of the income beneficiaries.
[16] Applying the decision in Winter to the facts of this appeal, the Appellant was not entitled to receive the management fees from Neotric but he would have been subject to tax on those fees if they had been received by him. Therefore, the first condition for the application of subsection 56(2) was satisfied. The management fees actually received by the Trust were allocated to the income beneficiaries; preferred beneficiary elections were filed with Revenue Canada; and the beneficiaries paid aggregate income taxes exceeding $95,000 on the management fees received by the Trust. Therefore, the second condition for the application of subsection 56(2) was not satisfied because the beneficiaries paid tax on the amounts in issue. I will repeat one sentence of Marceau J.A. quoted above from Winter:
Indeed, as I see it, a tax-avoidance provision is subsidiary in nature; it exists to prevent the avoidance of a tax payable on a particular transaction, not simply to double the tax normally due nor to give the taxing authorities an administrative discretion to choose between possible taxpayers.
If the assessments under appeal are upheld, the amounts of $152,000 and $150,000 will be taxed twice.
[17] Having found that the Appellant did not have any right in law to receive the management fees paid by Neotric to the Trust, I conclude that subsection 56(4) of the Income Tax Act does not assist the Respondent in supporting the assessments under appeal. Also, the Appellant was not required to include any part of the amounts of $152,000 and $150,000 in computing his income for 1989 and 1990. Therefore, the penalty assessed under subsection 163(1) for 1990 must be cancelled. The appeals are allowed, with costs.
"M.A. Mogan"
J.T.C.C.