Date: 20000630
Docket: 98-1411-IT-G
BETWEEN:
IAN STRACHAN,
Appellant,
and
HER MAJESTY THE QUEEN,
Respondent.
Reasons for Judgment
Lamarre, J.T.C.C.
[1] This is an appeal from an assessment made by the Minister of National Revenue ("Minister") under subsection 15(1) of the Income Tax Act ("Act") with respect to the appellant's 1992 taxation year. In assessing the appellant, the Minister added $114,640 to the appellant's income as a shareholder benefit conferred upon him in that year. This amount represents legal expenses paid to an American law firm by the Northside Development Corporation ("Northside"), of which the appellant was the sole shareholder in the year at issue.
Facts
[2] The facts admitted by the parties are summarized in paragraphs 2 through 12 of the written submissions of the respondent as follows:
2. At all relevant times, the Appellant was the sole shareholder and an employee of Northside Development Corporation ("Northside").
3. On or about April 25, 1990, the Appellant, Norman Mutrey, and Clifford Jones caused the company, C.N.I. Forest Products Limited ("CNI") to be incorporated.
4. On or about April 27, 1990, the Appellant, Norman Mutrey, Clifford Jones and CNI entered into an agreement with Omex International Incorporated ("Omex").
5. Disputes subsequently arose under the said agreement and Omex commenced arbitration proceedings in Virginia, U.S.A. against the Appellant and CNI. The matter went to an arbitration hearing, which resulted in an award against the Appellant and CNI.
6. The aforementioned award, on application made by Omex, was given recognition in the Newfoundland Courts and an Order was issued on July 7, 1993 by the Supreme Court of Newfoundland granting Judgment against the Appellant and CNI for the sum of $516,600.88, together with interest and costs.
7. At no time was Northside a party to the aforementioned proceedings, nor did it have any direct involvement in the action.
8. The legal firm of Birch, Stewart, Kolasch and Birch ("BSKB") represented the Appellant in the above noted proceedings in Virginia, U.S.A. In relation thereto the Appellant personally incurred legal fees with BSKB in an amount of at least $114,640.00.
9. In the 1992 taxation year Northside paid to BSKB $114,640.00 for the personal legal fees of the Appellant.
10. During the relevant period, Northside carried on its business in the hangar property at Northside, Goose Bay (the "Facility").
11. The Appellant held the leasehold interest in the Facility from November 1, 1990 to March 30, 1993 and during the relevant period, the Appellant leased the Facility to Northside.
12. The leasehold interest in the Facility was transferred to Northside on March 30, 1993.
[3] According to the respondent, Northside operated from the hangar facility unimpeded by the aforementioned proceedings and orders against the appellant in favour of Omex International Incorporated ("Omex"), which assertion the appellant disagrees with. The respondent's position is that the fact that Northside paid the legal expenses to the American law firm created a benefit to the appellant. Accordingly, the appellant had to include the amount of the legal fees paid by Northside in his income as a taxable benefit.
[4] The appellant's position is that he incurred those legal expenses for the benefit of Northside and had Northside not been jeopardized by those proceedings with Omex, he personally would not have defended himself in the United States.
[5] The sole issue is whether Northside, in paying the legal expenses of the appellant, conferred a benefit of $114,640 on the appellant in his capacity as shareholder, or alternatively in his capacity as employee.
[6] The appellant testified that Northside was incorporated in 1989 to bid on a Department of National Defence military contract for the construction of a plant in Goose Bay, Labrador, at which liquid and gaseous oxygen and nitrogen would be manufactured for use by Canada's foreign allies operating out of the Goose Bay air base.
[7] The Government's request for proposals with respect to that project asked questions about financial viability. It was imperative for a small company like Northside to show that it had available all the funds required for the contract. To that end, Northside dealt with the Federal Business Development Bank, ("FBDB") which agreed to lend to Northside and the appellant concurrently on the security provided by the hangar facility. That facility was originally leased by the Newfoundland and Labrador Housing Corporation ("NLHC") to North Limited (a corporation owned by the appellant's wife) under a lease dated November 4, 1985, for a term of 50 years from that date. At the FBDB's request, North Limited assigned this lease to the appellant by means of an assignment dated November 1, 1990, so that he personally held the leasehold interest in the hangar property. The funds were made available to Northside and the appellant in November and December 1990.
[8] Northside was awarded a first five-year contract on January 15, 1991 by the Government of Canada through the Minister of Supply and Services. Very soon thereafter, the appellant realized that Northside would have to build a second plant to meet production requirements. A first request for proposal to revise the contract was made by Supply and Services Canada on February 5, 1991. In the fall of 1991, the appellant approached the FBDB for additional financing and on March 30, 1992, Northside completed an application form requesting a further loan of $1,601,862 from the FBDB (Exhibit R-1, Tab 17).
[9] Another request for proposal to revise the contract was made by Supply and Services Canada on June 19, 1992, and on October 29, 1992, the FBDB authorized an additional loan of $1,000,000 to Northside and the appellant on the joint and several guarantee of Northside and the appellant. At that time, the balance owing on the previous outstanding loan from the FBDB to Northside amounted to $688,317 and the balance owing on the outstanding loan to the appellant for the military contract amounted to $188,747.
[10] Among other things, a mortgage on the aforementioned 50-year lease between the NLHC and the appellant on the hangar facility was given as security to the FBDB, which required that the said facility not be subject to any other prior charges, except in favour of the FBDB. All the issued Northside shares owned by the appellant were also hypothecated in favour of the FBDB.
[11] On November 24, 1992, an amended contract was executed between the Government of Canada, through the Minister of Supply and Services, and Northside for the supply of liquid and gaseous oxygen and nitrogen, and, as per a letter dated May 17, 1993 from the FBDB (Exhibit R-1, Tab 21) the $1,000,000 loan proceeds were disbursed by the bank at that time.
[12] In 1991, Northside paid $25,000 to the appellant for the use of the leasehold interest in the hangar facility. No payments were made under that lease afterwards because Northside was facing financial problems with respect to production in the first plant. The lease was finally assigned to Northside on March 31, 1993.
[13] During all that period, the appellant was a party in an arbitration proceeding which took place in the State of Virginia in the United States. The agreement which ultimately became the subject of the arbitration process was an agreement dated April 27, 1990 made between Omex (a Virginia corporation), the appellant and two other individuals and C.N.I. Forest Products Ltd. ("CNI"), a Newfoundland corporation. It related to a timber harvesting and exporting arrangement applying to the forests in the region of Goose Bay, Labrador. The agreement provided that any and all disputes, claims or controversies of any nature arising out of or in connection therewith, should be dealt with in accordance with the laws of the State of Virginia, and settled by arbitration under the auspices of the American Arbitration Association. The agreement also provided that judgment on the award of the arbitral tribunal could be entered in any court having jurisdiction over one or more of the parties or their assets.
[14] Disputes occurred under that agreement and as a result, Omex filed with the American Arbitration Association a Demand for Arbitration dated March 25, 1991. The matter proceeded to a hearing before the arbitrators in Virginia and the original arbitration award was issued on September 8, 1992 in favour of Omex and against the appellant and CNI. The award was in the amounts of $224,966 US and $62,094 Canadian with interest.
[15] The appellant appealed that award and it was followed by several amended interpretation awards which did not change the decision set forth in the original award. Ultimately, Omex made an application to the Supreme Court of Newfoundland, Trial Division, on June 9, 1993, to have the arbitration award recognized and enforced against the appellant. This resulted in an order of the Newfoundland court giving recognition to that arbitration award. Omex then issued an Execution Order for the seizure and sale of the property of the appellant. On October 14, 1993, copies of the Execution Order were served on Northside and the appellant's wife.
[16] All the above is confirmed in the appellant's former counsel's letter dated September 20, 1996 and addressed to the appellant's accountant (Exhibit R-1, Tab 7). In that letter, the appellant's former counsel goes on to say:
Both Strachan and Northside were always aware of the fact that if the arbitration proceeding in Virginia was decided against Strachan, this would result in a judgment against Strachan enforceable against him in this Province which could place in jeopardy the hanger property which in turn would cause Northside considerable problems. When the dispute originally arose with Omex under the Agreement, consideration was given to whether or not Strachan should participate in the arbitration at all, whether or not he had already submitted to the jurisdiction of the State of Virginia by executing the agreement in the first place, the extent to which an arbitration award in Virginia could become a judgment by our court and therefore enforceable against Strachan here and whether or not Strachan could argue the merits of the dispute in the Newfoundland court not having done so at the arbitration hearing in Virginia. It was quickly realized that it was in the best interest of Strachan and Northside (Northside because of the hanger property) for Strachan to participate in the arbitration proceeding in Virginia and defend himself there. Accordingly, legal counsel in Virginia were retained to represent Strachan at the arbitration hearing.
It was also realized that any attempt by Strachan to convey his leasehold interest in the hanger property to Northside at any time after the arbitration proceeding commenced or after the dispute arose would be open to attack by Omex as a fraudulent conveyance designed to protect the hanger property from Omex's Execution Order. It was therefore decided that every effort should be made by both Strachan and Northside to contest the claim of Omex at the arbitration proceeding in Virginia.
[17] According to the appellant, had the leasehold interest in the hangar facility not been in his name and had the facility not been essential to the Northside military contract, it would not have been deemed necessary to contest the Omex action. He said that the action by Omex was contested vigorously in order to protect an asset necessary for Northside's very existence.
[18] The appellant finally assigned the lease on the hangar facility on March 31, 1993 and the FBDB did not object at that time. During discovery proceedings in the fall of 1993, Omex officials were informed that the appellant held no assets and that attempts in the Newfoundland courts to prove otherwise would be protracted and costly. In exchange for lifting the judgment against the appellant, various barter-type financial offers were made by Omex. None were accepted and no agreement was entered into. According to the appellant, he never had any intention of paying anything to Omex. If he had had the money, he would have used it to invest in the second plant instead of spending it on legal costs to protect Northside's military contract.
Submissions of the Parties
[19] Counsel for the respondent submits that Northside, in paying the legal expenses of the appellant in the amount of $114,640, conferred on him a benefit in his capacity as shareholder (or alternatively in his capacity as employee) and that consequently that amount should be included in computing his income for the 1992 taxation year, pursuant to subsection 15(1) (or paragraph 6(1)(a)) of the Act.
[20] The relevant portions of subsection 15(1) and paragraph 6(1)(a) read as follows:
SECTION 15: Benefit conferred on shareholder.
(1) Where, in a taxation year, a benefit has been conferred on a shareholder, or on a person in contemplation of his becoming a shareholder, by a corporation . . .
the amount or value thereof shall, except to the extent that it is deemed by section 84 to be a dividend, be included in computing the income of the shareholder for the year.
SECTION 6: Amounts to be included as income from office or employment.
(1) There shall be included in computing the income of a taxpayer for a taxation year as income from an office or employment such of the following amounts as are applicable:
(a) Value of benefits. – the value of board, lodging and other benefits of any kind whatever received or enjoyed by him in the year in respect of, in the course of, or by virtue of an office or employment . . . .
There are various exceptions outlined in subsection 15(1) and paragraph 6(1)(a), none of which are applicable in the present case.
[21] According to counsel for the respondent, the word "benefit", which is not defined in the Act, must be given a broad meaning when referring to subsection 15(1) and paragraph 6(1)(a) (counsel cited A. Clemiss v. M.N.R., [1992] 2 C.T.C. 232 (F.C.T.D.) quoting the cases of The Queen v. Savage, [1983] 2 S.C.R. 428 and The Queen v. Poynton, [1972] C.T.C. 411 (Ont. S.C.); Doyle v. R., [1997] 1 C.T.C. 2659 (T.C.C.); T. Pellizzari v. M.N.R., [1987] 1 C.T.C. 2106 (T.C.C.)).
[22] Counsel for the respondent submits that payment of legal fees of an employee or shareholder is a benefit contemplated by these provisions. According to counsel, it is indisputable that the legal fees incurred were those of the appellant alone in his defence against the action commenced by Omex in the United States. Furthermore, Northside was never a party to the subject proceedings and was never legally bound to pay the appellant's legal fees.
[23] Counsel for the respondent further contends that the fact that Northside may have benefited from the defence is irrelevant for purposes of determining whether a benefit was conferred upon the appellant himself. Whether Northside benefited is not the issue in this appeal, and even if it did so benefit, that does not preclude a finding that the appellant also received a benefit under the Act (see Doyle, supra).
[24] According to counsel for the respondent, there is no connection between the legal fees incurred and the appellant's position with Northside. Northside had no interest nor any say in the appellant's dealings with Omex or CNI. Although counsel admits that the dealings with Omex could have an adverse effect on Northside (speaking specifically of the appellant's leasehold interest in the hangar facility), she submits that this potential adverse effect does not change the nature of the benefit conferred upon the appellant through the payment of his legal fees. She argues that this was a risk the appellant freely chose to take of his own accord.
[25] Counsel also points out that throughout the relevant period, Northside continued its operations in the facility unimpeded by the subject proceedings and resulting judgment against the appellant. She submits that the claim that the action had to be defended because of the potential adverse effects on Northside is pure speculation on the part of the appellant and is not evidenced by anything solid.
[26] On the other hand, the appellant contends that if he had not defended himself in the United States, Northside would not have been able to fulfill its contractual obligations toward the Department of National Defence. It was imperative for Northside to borrow funds and this would have been jeopardized by the threat of seizure of the leasehold interest in the hangar facility by Omex. The appellant claims that through his actions the impediment to Northside's operations did not materialize. Indeed, a failure on his part to deal with the matter of such an impediment for a two-year duration would have seen the demise of Northside, which would have been unable to borrow and to carry out its contractual obligations.
Analysis
[27] Under subsection 15(1), the courts must determine whether a benefit was conferred on a shareholder in that capacity. In the Federal Court of Appeal's judgment in Canada v. Fingold, [1998] 1 F.C. 406, Strayer J. referred on this point to the comments of Cattanach J. in M.N.R. v. Pillsbury Holdings Ltd., [1965] 1 Ex. C.R. 676, at p. 684, on the real meaning to be given to the equivalent provision in the Act as applicable prior to 1972, namely paragraph 8(1)(c). Strayer J. stated at p. 413:
For example in Minister of National Revenue v. Pillsbury Holdings Ltd., [1965] 1 Ex. C.R. 676, at p. 684, a case frequently relied on for the dichotomy reflected in the Tax Court Judge's decision in the present case, Cattanach J. stated:
. . . in my view, there can be no conferring of a benefit or advantage within the meaning of paragraph (c) where a corporation enters into a bona fide transaction with a shareholder. For example, Parliament could never have intended to tax the benefit or advantage that accrues to a customer of a corporation, merely because the particular customer happens to be a shareholder of the corporation, if that benefit or advantage is the benefit or advantage accruing to the shareholder in his capacity as a customer of the corporation. It could not be intended that the Court go behind a bona fide business transaction between a corporation and a customer who happens to be a shareholder and try to evaluate the benefit or advantage accruing from the transaction to the customer.
On the other hand, there are transactions between closely held corporations and their shareholders that are devices or arrangements for conferring benefits or advantages on shareholders quashareholders and paragraph (c) clearly applies to such transactions . . . . It is a question of fact whether a transaction that purports, on its face, to be an ordinary business transaction is such a device or arrangement.
What Cattanach J. was addressing there was the question of whether there had been a benefit conferred. The concept of "business purpose" is relevant to determining whether the shareholder was getting something like any other customer of the company could get or whether he was receiving some special advantage as a shareholder. In seeking to answer this question it is relevant to see whether the advantage is conferred in a normal business transaction or otherwise. But this does not suggest that the existence of some original business purpose necessarily determines the nature of the specific benefit actually conferred on the shareholder in question.
[28] In L. Youngman v. Canada, [1990] 2 C.T.C. 10 (F.C.A.), the court had to value a benefit allegedly received by a shareholder. The court stated at p. 14 that "a shareholder receives no benefit for the purposes of paragraph 15(1)(c) if, in the same circumstances, he would have received the same benefit from a company of which he is not a shareholder". At first instance (L. Youngman v. The Queen, [1986] 2 C.T.C. 475 (F.C.T.D.)), McNair J. determined on the following basis whether a benefit was conferred on a shareholder, at p. 480:
Clearly, the countervailing factors of business purpose or personal use must play a significant role in determining as a question of fact whether the particular corporate transaction is a bona fide business transaction in the sense of something that might normally accrue to an outsider in the ordinary course of business of the corporation or whether it was an inside arrangement designed primarily to benefit a shareholder.
[29] In C. A. Crosbie Estate v. M.N.R., [1966] C.T.C. 648 (Ex. Ct.), the court had to decide whether a benefit was to be treated as part of a deceased's estate for estate tax purposes. Shortly before the deceased's death, a corporation controlled by him had granted stock options to two employees, one of whom was a blood relation of the deceased, in recognition of their services to the company, past and future. Jackett P. pointed out one aspect of the case that called for special attention, namely whether the benefit was conferred on the beneficiary as an employee of the company or as a blood relation of the deceased. In Jackett's view, the provisions of the Estate Tax Act as it then read, did not apply to a payment made by a company to an employee for services merely because that employee happened to be connected with the deceased, as long as the employer-employee relationship between the controlled company and the blood relation was not being used as a means of making to the blood relation a gift consisting in whole or in part of the amount of the payment or benefit (Crosbie Estate, supra, at p. 656-7).
[30] In the present case, it is obvious to me (and the respondent admits that the dealings with Omex could have had an adverse effect on Northside), that Northside paid the legal expenses for legitimate business reasons. Had it not done so, according to the testimony of the appellant, which is confirmed indirectly by the letter written by his former counsel, the military contract with the Department of Defence could have been jeopardized. The only asset owned by the appellant that was threatened by the law suit instituted by Omex was the leasehold interest the appellant held in the hangar facility.
[31] The evidence disclosed that the appellant entered into the agreement with Omex before there was any serious hope for Northside of obtaining a military contract. When the call for proposals for the military contract came out, the appellant was already engaged with Omex and the disputes with Omex occurred at a time when the appellant and Northside were pushing hard to obtain the funds necessary to bid on the military contract. Clearly, the FBDB would not have advanced the funds if the hangar facility had been seized by Omex. This is evidenced by the loan agreements whereby the leasehold interest in the hangar facility was given as security on the express condition that no other prior charge would affect that property.
[32] I believe the appellant when he says that he incurred all these legal expenses in the U.S.A. to buy time in order for Northside to get all the financing required for the construction of a new plant to meet production requirements. In my view, the primary purpose of, and the real business motivation for Northside's paying those legal expenses was to protect a very important asset, without which Northside could not have operated. Although it was the appellant personally who was sued by Omex, I find that the purpose behind the payment of legal expenses by Northside was a plain business purpose rather than a personal one. The weight of the evidence supports in my view the conclusion that a bona fide transaction existed from the very outset. The fact that the appellant had not intended to defend himself against Omex, but did so to protect the hangar facility in the interest of Northside, is also confirmed in my view by the fact that he never paid the award made against him. As soon as the leasehold interest in the hangar facility was assigned to Northside and all the funds necessary for the construction of the second plant were received, the appellant did not incur any more legal expenses for his own defence.
[33] In view of the comments made by Cattanach J. in Pillsbury Holdings Ltd., I do not find that it is unreasonable to consider the arrangement between Northside and the appellant as a bona fide transaction entered into with the appellant qua holder of the leasehold interest and not qua shareholder or qua employee of Northside. It is highly conceivable that Northside paid the legal expenses for the appellant not because he was a shareholder but rather because he was the holder of that leasehold interest in the facility that was crucial to the continuation of Northside's operations. In that regard, I disagree with counsel for the respondent that there was no connection between the legal expenses incurred and the business operations of Northside.
[34] The cases referred to by counsel for the respondent are not relevant. This is not a case where the legal expenses were paid by the employer by reason of the appellant's employment or shareholding. The legal expenses were paid by Northside to protect an asset that was given as security to the FBDB to guarantee a loan with respect to which Northside and the appellant were jointly and severally liable. In that sense, I do not agree with counsel for the respondent that Northside had no interest in the appellant's dealings with Omex. That is in my view clearly not the case.
[35] The fact that Northside was not a party to the Omex legal proceedings does not alter my conclusion. As Jackett P. said in C. A. Crosbie Estate, supra, at p. 655:
. . . Nevertheless, good business can dictate, depending on the circumstances, disbursements over and above the amounts legally owing for what the business man has received or is to receive.
[36] In conclusion, even though the appellant was closely intertwined with Northside, I find that the legal expenses were paid by Northside in the ordinary course of business and that they were not paid pursuant to an inside arrangement designed primarily to benefit a shareholder or employee.
[37] The appeal is allowed with costs.
Signed at Montreal, Quebec, this 30th day of June 2000.
"Lucie Lamarre"
J.T.C.C.