Walsh, J:—This is an appeal from a decision of the Tax Appeal Board of February 23, 1971 (reported [1971] Tax ABC 209) allowing the. appeal of the respondent from an income tax assessment dated October 26, 1967 in respect of the year 1965. No new evidence was introduced at the trial in this Court, the appeal being argued on the basis of the record before the Tax Appeal Board. The evidence disclosed that a certain Mr Werner Graupe owned at all material times substanially all the shares of a company known as Ferro Technique Ltd and that respondent never had any shareholdings or other interest in this company. This company had for some years acted as agent in North America for the distribution and sale of equipment manufactured by a German company, Fritz Werner Verwaltungs-Gesellschaft, which for the purposes of simplicity will be referred to herein as “Fritz Werner Germany”, and had also done some assembling and servicing of this equipment which required the operation of a machine shop by it. In the latter part of 1962 following lengthy discussions between Mr Graupe and representatives of Fritz Werner Germany an agreement was reached by virtue of which it was provided that a separate company would be formed to erect an assembly plant for the manufacture in Canada of some of the sizes of the Fritz Werner Germany milling machines and accessories in continuation of the existing program of Ferro Technique and would take over the plant and equipment of Ferro Technique, and that Mr Graupe would own 45% of the shares of this company, with Fritz Werner Germany owning 55%. The new company would eventually be known as Fritz Werner Canada Ltd, and Ferro Technique, which would continue to be owned entirely by Mr Graupe (save for a few qualifying shares which do not affect the issue) would become purely a sales agency.
In preparation for carrying this agreement into effect, Mr Graupe caused the company to be incorporated in Canada on January 10, 1963, under the name of “Ferro Manufacturing Ltd’. A more formal agreement between the parties was entered into in notarial form in Berlin on October 16, 1963, which set out in Clause I that Mr Graupe was the owner of all the shares of Ferro Manufacturing Ltd and that Fritz Werner Germany “will purchase 55% of the shares of Ferro Manufacturing Ltd from Mr Graupe” on the terms and conditions set out which provided that the physical assets of the company would be evaluated by a firm of evaluators in order to establish the price. To enable additional machine tools and component parts of the machines to be purchased from Fritz Werner Germany it was agreed that the parties would lend the company $300,000 of which Fritz Werner Germany would provide 55%. Clause III of the agreement provided that as soon as Fritz Werner Germany “is the owner of 55% and Mr Graupe of 45% of the shares of Ferro Manufacturing Ltd the letters patent and by-laws will be modified and completely reconstituted”. The modifications were to include a change of name and a provision that all resolutions enacted at all shareholders’ meetings should be passed with a majority of not less than two-thirds. The agreement provided further that the Board of Directors and officers would require the consent of a two-thirds majority of the shareholders for acquisitions, sale and encumbrance of real estate, making investments in excess of $5,000 in any one transaction, borrowing money when the liabilities had reached the level of the lesser of $50,000 or the average monthly turnover, entering into contracts of a business value in excess of the lesser of $10,000 or the average monthly turnover, appointment of officers, or signing of employee contracts for a term of over one year carrying a salary higher than $12,000. The parties further agreed to vote at all meetings of shareholders to elect a director nominated by each of them and to agree on the election of a third director who would not have any discretion to act independently in the case of dispute, but the majority shareholder would appoint the Chairman of the Board of Directors.
Clause V of the agreement provided:
The validity of this agreement is dependent upon the sanction of the supervisory board of (Fritz Werner Germany) and on the authorization by the competent Canadian authorities of the modification of the articles of association of Ferro Manufacturing Ltd as laid down in this agreement, ie, the granting of appropriate “supplementary letters patent”.
It went on to say that should the articles of association amendments be authorized only under certain conditions, or should the supervisory board of Fritz Werner Germany require that the agreement be amended, “the parties will convene once again in order to examine whether this agreement can be maintained under modified terms and conditions”.
In furtherance of this agreement an appraisal was made by Warnock Hersey Appraisal Company Ltd of the plant and equipment and semifinished and finished goods of Ferro Technique Ltd which fixed the depreciated value at $246,965 as of January 16, 1964. The next step was for supplementary letters patent to be obtained on March 17, 1964, which altered the capitalization of Ferro Manufacturing Ltd to some extent (which does not affect the present issue) and changed its name to “Fritz Werner Ltd”, which change is significant in that this was done presumably with the tacit consent of Fritz Werner in Germany despite the fact that Clause III of the agreement provided that the name would be altered only as soon as Fritz Werner Germany became the owner of 55% of the shares. A considerable period of time now elapsed until November 1965, during all of which period Mr Graupe remained the registered shareholder of 998 of the 1,000 shares of the new company which had been issued. On November 10, 1965 he subscribed to an additional 20,000 shares and on December 10, 1965 transferred 11,550 of these shares, representing 55% of the 21,000 shares then outstanding, to Fritz Werner Germany (of which two shares were transferred to its nominees). From the time the company was incorporated, Mr Graupe operated the business as if Fritz Werner Germany were already controlling it, consulting them in connection with major decisions. He attributes the delay in completing the agreement to red tape in Germany. On December 2, 1965 a new appraisal was made by Warnock Hersey Appraisal Company Ltd fixing the depreciated value at $333,770, this latter figure being used as the basis for the completion of the sale. On December 9, 1965 a final agreement was concluded between the parties in notarial form in Germany substantially on the same terms as the October 16, 1963 agreement, although the 1965 agreement specified in Clause XV that the notarial agreement of October 22, 1963 (sic) was superseded and cancelled by it. The 1965 agreement started out by stating that “Fritz Werner Germany and Werner Graupe are the only shareholders of Fritz Werner Ltd Canada”. By another agreement on December 17, 1965, the price paid for the shares was adjusted by starting with the depreciated value of $333,770 based on the December 2, 1965 appraisal of Warnock Hersey Appraisal Company Ltd from which a 10% deduction amounting to $33,377 was allowed by Mr Graupe. To this, however, was added the net profit of the company to November 30, 1965 amounting to $53,491.68. After these adjustments the total value was established at $353,884.68 resulting in a payment for 55% of the common shares of $194,636.20. Respondent argued that the deduction of $33,377 was made because this would be approximately 55% of the $53,491.68 profit made by the business in the interval before Fritz Werner Germany actually had the shares transferred to it and was a recognition that it was entitled to share in the profits as it had all along had an interest in the business to this extent. This appears to be pure speculation, however, as there is nothing in any of the agreements to indicate that Fritz Werner Germany would share in the net profits to the extent of 55% from the date the company was incorporated. In his evidence before the Tax Appeal Board, Mr Graupe explained it by saying: “Well, the $33,377.00 were a concession on my part acknowledging the contribution of Fritz-Werner Berlin during the time between the contract and the actual transfer of shares.” Later he says: . . this was the benefit that they got out of their supplying components, know-how and so on and so forth”.
One further point of interest is that the 1963 agreement although signed by Dr Rudolf Meyer and Herbert Fenner, who later became directors of the Canadian company, on behalf of Fritz Werner Germany it was never apparently formally sanctioned by the supervisory board of that company until November 29, 1965 when a resolution of the directors of Fritz Werner Germany was adopted, reading:
The agreement with Mr Graupe as notarized under No 434 dated October 22, 1963 for the purpose of forming the Fritz Werner Limited, Montreal should now be finalized in a new agreement but based on the original version of October 22, 1963.
lt is common ground between the parties that the formation of the new company and eventual control of same by Fritz Werner Germany Ltd resulted from a bona fide arm’s length business transaction between it and Mr Graupe and was not part of a scheme to minimize taxation.
Appellant relies on paragraph 39(4)(b) of the Income Tax Act arguing that respondent and Ferro Technique Ltd were controlled by the same person, namely Werner Graupe, during part of 1965 and were therefore associated corporations. Respondent denies this claiming that Fritz Werner Germany became owner of the majority of the shares of respondent as a result of the agreement dated October 16, 1963 prior to the commencement of the taxpayer’s 1965 fiscal period. As an alternative argument it contends that, in any event, Fritz Werner Germany is deemed to have owned for the purposes of control 55% of the shares of the taxpayer on the basis of the agreement dated October 16, 1963 from the date of that agreement by virtue of paragraph 139(5d)(b) of the Income Tax Act. Finally, as a third argument, it invokes subsection 39(6) of the Income Tax Act claiming that by virtue of it, respondent and Ferro Technique Ltd are deemed on the facts not to be associated with each other. As a consequence of these contentions, the taxpayer would, if they were upheld, have benefited from the lower rate of tax applicable on its first $35,000 of taxable income in the said taxation year 1965.
The relevant portions of the section invoked read as follows:
39. (4) For the purpose of this section, one corporation is associated with another in a taxation year if, at any time in the year,
(b) both of the corporations were controlled by the same person or group of persons, ...
(6) Where one corporation (hereinafter in this subsection referred to as the “controlled corporation’’) would, but for this subsection, be associated with another corporation in a taxation year by reason of being controlled by the other corporation or by reason of both of the corporations being controlled by the same person at a particular time in the year (which corporation or person so controlling the controlled corporation is hereinafter in this subsection referred to as the “controller”), and it is established to the satisfaction of the Minister that
(a) there was in effect at the particular time an agreement or arrangement enforceable according to the terms thereof, under which, upon the satisfaction of a condition or the happening of an event that it is reasonable to expect will be satisfied or happen, the controlled corporation will
(i) cease to be controlled by the controller, and
(ii) become controlled by a person or group of persons, with whom or with each of the members of which, as the case may be, the controller was at the particular time dealing at arm’s length; and
(b) the chief purpose for which the controlled corporation was. at the particular time so controlled was the safeguarding of rights or interests of the controller in respect of
(i) any loan made by the controller the whole or any part of the principal amount of which was outstanding at the particular time, or
(ii) any shares of the capital stock of the controlled corporation that were owned by the controller at the particular time and that were, under the agreement or arrangement, to be redeemed by the controlled corporation
or purchased by the person or group of persons referred to in subparagraph (ii) of paragraph (a);
the controlled corporation and the other corporation with which it would otherwise be so associated in the year shall be deemed, for the purpose of this section, not to be associated with each other in the year.
In defining “arm’s length”, subsection 139(5) reads as follows:
139. (5) For the purposes of this Act,
(a) related persons shall be deemed not to deal with each other at arm’s length; and
(b) it is a question of fact whether persons not related to each other were at a particular time dealing with each other at arm’s length.
Subparagraph 139(5a)(c)(i) reads as follows:
139. (5a) For the purpose of subsection (5), (5c) and this subsection, “related persons”, or persons related to each other, are
(c) any two corporations
(i) if they are controlled by the same person or group of persons,
This is modified, however, by paragraph 139(5d)(b) which reads as follows:
139. (5d) For the purpose of subsection (5a)
(b) a person who had a right under a contract, in equity or otherwise, either immediately or in the future and either absolutely or contingently, to, or to acquire, shares in a Corporation, or to control the voting rights of shares in a corporation, shall, except where the contract provided that the right is not exercisable until the death of an individual designated therein, be deemed to have had the same position in relation to the control of the corporation as if he owned the shares; and
The meaning of “controlled” in subsection 39(4) of the Act has been dealt with definitively in so many cases as to be beyond dispute. A frequently cited exposition of the meaning of it appears in the judgment of Jackett, CJ in Buckerfield’s Ltd et al v MNR, [1965] 1 Ex CR 299; [1964] CTC 504, where he states at pp 302, 303 [pp 507, 508]:
Many approaches might conceivably be adopted in applying the word “control” in a statute such as the Income Tax Act to a corporation. It might, for example, refer to control by “management”, where management and the Board of Directors are separate, or it might refer to control by the Board of Directors. The kind of control exercised by management officials or the Board of Directors is, however, clearly not intended by section 39 when it contemplates control of one corporation by another as well as control of a corporation by individuals (see subsection (6) of section 39). The word “control” might conceivably refer to de facto control by one or more shareholders whether or not they hold a majority of shares. I am of the view, however, that in section 39 of the Income Tax Act, the word “controlled” contemplates the right of control that rests in ownership of such a number of shares as carries with it the right to a majority of the votes in the election of the Board of Directors. See British American Tobacco Co v IRC, [1943] 1 All ER 13, where Viscount Simon, LC, at page 15, says:
The owners of the majority of the voting power in a company are the persons who are in effective control of its affairs and fortunes.
See also MNR v Wrights’ Canadian Ropes Ltd, [1947] AC 109, per Lord Greene, MR at page 118, where it was held that the mere fact that one corporation had less than 50 per cent of the shares of another was “conclusive” that the one corporation was not “controlled” by the other within section 6 of the Income War Tax Act.
He repeated this finding in the case of Dworkin Furs (Pembroke) Ltd v MNR, [1966] Ex CR 228; [1965] CTC 465, and this same passage was cited with approval in the judgment of the Supreme Court in that case, reported at [1967] SCR 223 at 228; [1967] CTC 50 at 52. The same passage was again approved by the Supreme Court in the case of Vina-Rug (Canada) Ltd v MNR, [1968] SCR 193 at 196; [1968] CTC 1 at 3. Again, in a very recent judgment of the Supreme Court dated May 1, 1972 in International Iron and Metal Co Limited v MNR, [1972] CTC 242, confirming the judgment of Gibson, J in the Exchequer Court, reported [1969] CTC 668, it is again stated that the meaning of “control” in paragraph 39(4)(b) “means the right of control that is vested in the owners of such a number of shares in a corporation so as to give them the majority of the voting power in a corporation”. It is de jure control therefore and not de facto control which governs, so that whatever influence Fritz Werner Germany Ltd had exercised over Werner Graupe in connection with the operation of the business of respondent from its incorporation until the time it became a 55% shareholder in December 1965, and whatever interest-free loans it may have advanced or profits it may have shared in the interval, and no matter to what extent it may have been consulted during this period in connection with any major decision, it cannot be said that it had at any time de jure control over the company prior to December 1965 as it did not have control within the meaning of paragraph 39(4)(b), so respondent’s first argument must fail.
Respondent’s second argument invokes paragraph 139(5d)(b), claiming that since Fritz Werner Germany had a right under the 1963 contract “in the future and either absolutely or contingently, to, or to acquire, shares in a corporation, or to control the voting rights of shares” in respondent company it should be deemed to have the same position in relation to the control of the company as if it had owned the shares. The meaning of subsection 139(5d) was dealt with at some length by Noël, J, as he then was, in Yardley Plastics of Canada Limited v MNR, [1966] CTC 215, but he was primarily dealing with paragraph 139(5d)(a) which reads:
(5d) For the purpose of subsection (5a)
(a) where a related group is in a position to control a corporation, it shall be deemed to be a related group that controls the corporation whether or not it is part of a larger group by whom the corporation is in fact controlled;
rather than with paragraph 139(5d)(b) (supra), and was concerned with the concept of related groups rather than with what constitutes “control” of a corporation. He does state, however, at page 221 :
. . . although Section 139(5d) and its paragraphs directly affect Section 39(4) in extending the meaning of control therein, they do not restrict its meaning.
(italics mine)
The effect of paragraph 139(5d)(b) was directly considered by Jackett, CJ in the case of Viking Food Products Ltd v MNR, [1967] CTC 101, in which he refers with approval to the above-quoted statement of Noël, J in the Yardley Plastics case. In that judgment he states at pages 103-04:
The appellant must go so far as to say that, when subsection (5d) expressly enacts that, upon certain facts being established, a person who did not own the shares is to be deemed to be in the same position as if he did own them, it impliedly enacts that, upon the same circumstances being established, the person who did own the shares is to be deemed to be in the same position as if he did not own them.
Whether or not such an inference can be read into subsection (5d) is a matter of interpretation, which must be considered in the general context in which subsection (5d) is found.
After a careful examination of the relevant sections of the Act, he concludes at page 107:
Having regard to the general scheme of the provisions in which the concept of not dealing at arm’s length was employed, as I understand it, and to the expressed legislative intent that the non-arm’s length concept extends not only to any case where parties were not, in fact, dealing at arm’s length (Subsection (5)(b)) but also to a variety of arbitrarily defined circumstances where the parties might, in fact, be dealing at arm’s length, it seems improbable that Parliament intended that paragraph (b) of subsection (5d) would have the unexpressed effect of artificially deeming a person to have ceased to control a company whose issued shares all belonged to him merely because he had granted an option to someone else to buy such shares.
Under this interpretation of the effect of paragraph 139(5d)(b) of the Act it is a section which can be applied by the Minister in order to find that two corporations are associated within the meaning of paragraph 39(4)(b) of the Act but cannot be used by the taxpayer to claim that the two corporations are not associated because his voting shares which control the second corporation have been optioned to another person, and this even if the option were not given with the intent of avoiding taxation but rather as the result of a bona fide business transaction between two parties dealing at arm’s length, as is clear in the present case. While I might, on the facts before me, have reached a different conclusion had the issue come before the Court for the first time, I believe that unless and until a different interpretation is given to the meaning of paragraph 139(5d)(b) by a judgment of a higher court, I should follow the present jurisprudence of this Court established by Jackett, CJ in the Viking Food Products case (supra).
This leaves only the third argument of respondent based on subsection 39(6) of the Act, which section was. not dealt with in either the Yardley Plastics or the Viking Food Products cases as it was not applicable in the circumstances. The only case which I have been able to find in which this section was discussed at all was in the Tax Appeal Board judgment in the case of Renown Steel & Services Limited v MNR, [1969] Tax ABC 678, which held that since subsection 39(6) is an exempting provision it must be strictly construed and as on the facts of the case the controller held the shares as a guarantor and not as a maker of a loan, he did not come within the provisions of subparagraph 39(6)(b)(i) so that the companies were held to be associated. This section was referred to in the judgment of Jackett, P, as he then was, in Buckerfield’s Ltd, et al v MNR (supra) when he said at pp 302-03 I p 507 I
The kind of control exercised by management officials or the Board of Directors is, however, clearly not intended by section 39 when it contemplates control of one corporation by another as well as control of a corporation by individuals (see subsection (6) of section 39).
This passage was again referred to by him in Dworkin Furs (Pembroke) Ltd v MNR (supra) at page 231 [p 468], and was referred to in the Supreme Court judgment in that case, reported [1967] SCR 223 at 227; [1967] CTC 50 at 52, and again by the Supreme Court in the case of Vina-Rug (Canada) Ltd v MNR (supra) but the reference is merely a parenthetical reference to subsection 39(6) as an indication that the word “controlled” as used in section 39 means control by shareholders carrying the majority of voting rights and not control by management officials or directors. None of these cases discussed the effect of the application of subsection 39(6) in a situation where the facts indicated that it might perhaps be applied. What ! now have to consider therefore is whether it could be applied in the circumstances of the present case. What must be decided is whether respondent Fritz Werner Ltd, which but for subsection 39(6) would be associated with Ferro Technique Ltd by reason of both corporations being controlled by Werner Graupe, avoids being so associated because:
(a) there was in effect at the particular time (ie 1965) an agreement or arrangement enforceable according to the terms thereof, under which, upon the satisfaction of a condition or the happening of an event that it is reasonable to expect will be satisfied or happen, . . .
the respondent Fritz Werner Ltd would become controlled by Fritz Werner Germany Ltd with whom Werner Graupe was dealing at arm’s length and:
(b) the chief purpose for which the controlled corporation was at the particular time so controlled was the safeguarding of rights or interests of the controller in respect of
(i) any loan made by the controller the whole or any part of the principal amount of which was outstanding at the particular time, or
(ii) any shares of the capital stock of the controlled corporation that were owned by the controller at the particular time and that were, under the agreement or arrangement, to be redeemed by the controlled corporation or purchased by the person or group of persons referred to in subparagraph
(ii) of paragraph (a); (ie Fritz Werner Germany Ltd)
If this is the case then by virtue of this subsection. 39(6) the two corporations would, for the purposes of that section, be. deemed not to be associated with each other. The difficulty is that this section, being a section of exception, must be interpreted strictly. There is some doubt as to whether respondent comes within the exact terms of it. While it was certainly reasonable to expect that the terms of the contract would be carried out and that in due course Fritz Werner Germany would become the owners of the controlling shares as was contemplated in it, there. appears to be some doubt as to whether the agreement was “enforceable according to the terms thereof”. The agreement of October 16, 1963 was never formally sanctioned by the Supervisory Board of Fritz Werner Germany until November 29, 1965 when a resolution was adopted providing that it should be finalized in a new agreement based on the original version.* [1] Whether Dr Rudolf Mayer and Herbert Fenner had authority to sign on behalf of Fritz Werner Germany and bind it to the purchase of the shares in question, in the absence of such resolution, is a question which was not argued before me but which seems open to some doubt. If the agreement was not enforceable by Werner Graupe due to the lack of this formality, then it would not come within the provisions of paragraph 39(6)(a) and there would be no binding agreement until that of December 19, 1965 in which event Mr Graupe would have controlled both companies until at least that date and the companies would then have been associated during the year 1965.
A second question arises as to the applicability of subsection 39(6) to the facts of this case in that in addition to an enforceable agreement dealing with the control of the shares, it is necessary to establish that the “chief purpose” why the shares of the respondent. Fritz Werner Ltd were still controlled by Werner Graupe until their transfer on December 10, 1965 was the safeguarding of his rights or interests in respect of either a loan made by him to the company, part of the principal of which was still outstanding, or in respect of those shares of the company that were owned by him and that were to be purchased by Fritz Werner Germany. While it is true that both Mr Graupe and Fritz Werner Germany lent money to the respondent company, it does not appear that the “chief purpose” for which he retained ownership, not only of the 45% of the shares of the company which it was intended at all times that he should own, but also of the 55% which were to be purchased in due course by Fritz Werner Germany, was to safeguard his rights or interests in his portion of the loan to the company, nor alternatively to safeguard his rights or interests in respect of those shares. Rather it appears on a fair appraisal of the evidence that he retained ownership of 100% of the shares until December 10, 1965 merely as a matter of convenience and because all the final details of the agreement between the parties respecting the payment to be made to him for 55% of these shares and other details had not yet been finally worked out as a result of delays in implementing the October 16, 1963 agreement by Fritz Werner Germany. It is not sufficient, in order to apply subsection 39(6), that Mr Graupe should have retained control of all the shares of the company merely as a matter of convenience though at all times admitting Fritz Werner Germany’s eventual rights to 55% of them on completion of the agreement and the making by them of the necessary payment, but the “chief purpose” for which he held the shares has to be one of the foregoing alternatives. It appears to me that this may well have not been the case. For the foregoing reasons I therefore find that subsection 39(6) cannot be applied either.
In view of these findings appellant’s appeal against the decision of the Tax Appeal Board is maintained with costs and respondent’s income tax assessment dated October 26, 1967 in respect of the year 1965 is restored.
“While the resolution refers to the agreement when notarized as of October 22, 1963, it undoubtedly has reference to the agreement dated October 16, 1963.