Roland St-Onge:—This appeal, heard at Montreal on February 3, 1972 by the Tax Review Board, deals with the taxation years 1964 to 1967 inclusive.
During the years 1962 to 1968 a company by the name of Rideau Terrace Apartment Limited owned as sole and “unique” asset a 70- suite apartment building located in the City of Ottawa. On May 1, 1962 the company rented the said highrise apartment building to its shareholders who in turn subleased personally to individual tenants. The appellant alleged that the lease which he and his associates entered into with the company “was an agreement which, although not at arm’s length, was a justifiable commercial transaction at fair market value and in the normal course of business”. The respondent contended that the lease was an artificial device to transfer losses from the company to its shareholders and that the said lease was terminated as soon as total losses incurred by the company were offset. The lease in question contained, among other clauses, the following:
Sec. 401. Operating Expenses. All operating expenses shall be the responsibility of the Tenant. These will be paid for by the Landlord and the Landlord will bill the Tenant yearly, and the Tenant will reimburse the Landlord within thirty (30) days of the expiry of each annual period. Operating expenses shall comprise all direct expenses incurred in the running and maintenance of the building, and will include administration charges, the whole as passed by the auditors of the Tenant, Ruby and Manolson, Chartered Accountants, whose decision and opinion will be final. There shall be no allowance whatsoever for any management fees by the Landlord to the Tenant.
Sec. 402. Rental Revenue. The Landlord shall continue to sign all leases in its name and all rental revenue shall belong to the Tenant. The Landlord Shall retain these funds as operating capital.
Sec. 403. Accounting Records. The Landlord shall maintain proper accounting records to be audited by Ruby and Manolson, Chartered Accountants, and the said records shall clearly show all income and expenses received and incurred on behalf of the Tenant. The Landlord shall not be responsible for any expenses, except capital payments on the first mortgage and capital payments on the second mortgage, and bank loans, if any, and any other debts that the Landlord owed as at April 30th, 1962, as per the list attached hereto, hereinafter referred to as Schedule “B”. All mortgage interest payments, including first and second mortgages, interest on bank loans, if any, shall be the responsibility of the Tenant.
These clauses signify that the landlord was signing all individual leases and paying all operating expenses. Apparently, this course of conduct was followed in order to ease the accounting load; to keep secret the names of the shareholders, most of whom are professional people who wished to avoid any adverse publicity attendant in the possible evictions of individual tenants; to reap the benefit of the extensive advertising done under the company name; and finally so as not to alarm the individual tenants or the creditors.
Mr Lipson, who worked full time as a distributor for Rusco Installations Reg’d, testified that according to the advice of the experts it would take one year to complete the building and have it ready for renting in May 1961, but unfortunately it was not ready until November 1961. Because the company found itself in dire financial straits, it was suggested that a lease be arranged whereby the company would rent the building to its shareholders because it was impossible for the company to claim the losses. Naturally, the shareholders who had substantial personal income would be allowed to deduct those losses from their personal income. But apparently this tax-saving implication had not entered his mind because when the project was initiated he had foreseen only profits. He also stated that he was not interested in putting more money into the company and that the company encountered substantial losses because of huge property taxes, the absence of ownership, the difficulties experienced in obtaining a good rental agent, and the existence of too many long leases at low rent. He also testified that the company, after numerous attempts to carry on by itself, granted the management of the building to Montreal Trust whose responsibility included the leasing to individual tenants and the collection of rents.
Mr Ruby, a chartered accountant and company shareholder, explained that initially the building was erected under a company because it was easier that way to obtain the necessary mortgages from finance companies and more prudent for the shareholders to utilize the company’s limited responsibility. Then when the company was in financial straits due to the huge bank loans and the aforementioned reasons given by Mr Lipson, and also because many shareholders did not want to infuse more money into the company, his firm recommended the lease. He explained that a shareholder already in the 50% income tax bracket would have to earn $100,000 a year to be able to loan $50,000 to the company. He had discussions with different trust companies in an effort to find out the fair market value of the lease and he was advised that 6% would be a fair return on the capital invested, taking into consideration the amount of the loss. He corroborated what was already stated by Mr Lipson and added that the participants had three choices: (1) loan money to the company; (2) go into business themselves and rent the building for the corporation; (3) return the building to the mortgage company. In 1963 his (Mr Ruby’s) firm was designated to hire the persons who were to look after the leases, examine the bills before paying them, and collect the rents. Finally, he stated that the lease enabled him to stay in the venture because of a loss of some $28,000, and that in the case of bankruptcy he would be in danger of losing his degree of chartered accountant.
Counsel for the appellant argued that there is a well-recognized principle in income tax law to the effect that no man must arrange his affairs so as to pay the highest rate of tax; and that once a taxpayer has embarked on a project he should stay with it, and in the instant appeal the lease was the only way to succeed. According to him, the participants were investors of considerable means who wished to build, lease and sell the building. At the time of the project nobody actually foresaw losses of that magnitude but as a result of the company’s financial difficulties they had to agree to a lease, the price of which was to be at fair market value. He stated that the losses were not artificially created and that the lease was a bona fide commercial transaction in the normal course of business. He referred the Board to numerous cases, among which were the following:
(1) David Grotell v MNR, [1970] Tax ABC 993.
(2) Crossland (HM Inspector of Taxes) v Hawkins, [1961] 2 Al! ER 812, in which artists and others in the world of entertainment adopt the device of forming a limited company and through a service agreement get from the company some modest salary. It is stated in one paragraph that “All this is perfectly legitimate and indeed in the case of persons whose high earnings may be short-lived, understandable . .
(3) Concorde Automobile Ltée v MNR, [1971] CTC 246 at 266, where it is stated that “There is nothing, therefore, to suggest that the pension plan was a sham set up with the intention of being immediately wound up.. .”.
(4) MNR v Henry J Freud, [1969] SCR 75; [1968] CTC 438.
(5) Isaac Shulman v MNR, [1961] Ex CR 410; [1961] CTC 385, in which the taxpayer had created a corporation to handle the administration of his legal office. The court held that this was. artificially reducing income.
Counsel for the appellant also stated that it is not a sin to minimize taxes and that there is a vast difference between creating an artificial situation for a tax advantage as opposed to being in a situation and choosing an alternative way of proceeding, bearing tax considerations in mind.
Counsel for the respondent argued that the lease was a sham or a mere device because:
(A) A corporation is an entity distinct from its shareholders; and a taxpayer is entitled to arrange his affairs if he can do so within the law so as to attract upon himself the least amount of tax, but, as stated in the Shulman case (supra) “Those two principles must however be considered having regard to the fact that in enacting the Income Tax Act, Parliament undoubtedly intended to impose a tax on income’’.
(B) As is stated in Dominion Taxicab Association v MNR, [1954] SCR 82 at 85; [1954] CTC 34 at 37, “‘It is well settled that in considering whether a particular transaction brings a party within the terms of the Income Tax Acts its substance rather than its form is to be regarded”.
He also argued that:
(a) The expenses claimed are not deductible and submitted to the Board the principle so often repeated in the courts to the effect that any provision which permits a deduction in computing its income must be construed strictly against the taxpayer, and that taxation is the rule and exemption the exception and therefore to be strictly construed. In support of his argument he cited W A Sheaffer Pen Company of Canada Limited v MNR, [1953] Ex CR 251; [1953] CTC 345.
(b) The expense or deduction is of the type prohibited by subsection 137(1) of the Income Tax Act as in Shulman (supra) and. Louis J Harris v MNR, [1966] SCR 489; [1966] CTC 226.
The Board agrees with submissions of counsel for the respondent. Obviously, a taxpayer is entitled to arrange his affairs so that he will pay the least amount of tax but he is not entitled to disturb his own affairs to arrange those of another taxpayer — in the present circumstances, Rideau Terrace Apartment Limited. The taxpayer cannot take all the advantages of a distinct legal entity and when its business goes wrong, assume personally all the losses and by the same token retain most of the advantages of such a separate entity. If this com- pany cannot resolve its financial difficulties on its own, I do not see why the individuals should be called upon to assume the losses personally, especially when the company was incorporated for the protection of the shareholders. It is a well-established principle in law that they cannot be sued for the debts of the company. Consequently, the lease under review should be construed as an artificial transaction for those shareholders who use their personal income to assume actual and future losses of another taxpayer. Furthermore, the lease is a sham because nothing changed. The company still managed the building, looked after the individual leases, collected the rents and paid the bills. Consequently, the expenses were not incurred to earn the income from which the appellant seeks to deduct the expenses. In other words, the expenses which the taxpayers sought to deduct individually are not related to their personal incomes, and are unreasonable within the meaning of paragraph 12(1 )(a) of the Income Tax Act which reads as follows:
12. (1) In computing income, no deduction shall be made in respect of
(a) an outlay or expense except to the extent that it was made or incurred by the taxpayer for the purpose of gaining or producing income from property or a business of the taxpayer,
Accepting the expenses in question as deductible expenses would mean going against the systematic interpretation of the Income Tax Act. It would also have the effect of using a company not for the advancement of the economy of the country but to deprive it of money needed to manage its affairs in a manner which is in the best interests of the community.
There is no provision in the Act to authorize such a deduction, whereas the combination of paragraph 12(1)(a) and subsection 137(1) prevent such a scheme.
For the above reasons the appeal is dismissed.
Appeal dismissed.