United Color and Chemicals Ltd. v. MNR, 92 DTC 1259, [1992] 1 CTC 2321 (TCC)

Kempo, T.C.C.J.:—The appeals of United Color and Chemicals Ltd. (the "company") and of Otto Vass were, on consent application, heard on common evidence. The years under appeal and the essential issues raised were common to both appellants.

Following an audit, the company was disallowed deductions from its income in respect of alleged travel, promotional and other expenses for each of its 1979, 1980, 1981 and 1982 taxation years. Penalties were levied in relation thereto pursuant to subsection 163(2) of the Income Tax Act, R.S.C. 1952, c. 148 (am. S.C. 1970-71-72, c. 63) (the "Act"). These disallowed amounts were added into the computation of Otto Vass' income for each of the said calendar years pursuant to subsections 15(1) and 56(2) of the Act and subsection 163(2) penalties were imposed on him as well.

At trial, counsel for the appellants conceded that no error had been made by the respondent with respect to the above matters with the exception of the penalties. The large matter brought forward for the Court's determination was said to have been raised many times since 1984 by the appellants at various levels with the respondent's officials. It concerned the deductibility of secret rebates or commissions purportedly paid by the company for the purpose of gaining or producing income from its business. Otto Vass allegedly had included the rebate amounts into his own income for each year in the form of dividends paid to him, and he is now seeking their exclusion.

The factual matters surrounding the main issue were expressed in the following manner by paragraphs 6, 7 and 8 of the amended notice of appeal dated September 24, 1991 and filed in the corporate appeals (such allegations being mirrored in Otto Vass's appeals):

6. The Appellant states that in the course of United Color's business of selling chemical and dye products to the paper and carpet industries United Color relied on and was dependent upon the goodwill of dyers employed by its customers who functioned as purchasing agents of the said customers. It was prevalent in the said industries that dyers required payment to them by suppliers and in particular, by United Color, of amounts, primarily in cash, in order to ensure the continuity of purchases from United Color.

7. Payments made to dyers were effected in the following manner:

(a) The principal of United Color, Otto Vass, instructed Wesley Fraser, the employee of United Color responsible for its general administration and accounting, as to the percentage arrangement which pertained to each particular dyer. The "commissions" payable to the dyers ranged between 5% and 12% of the amounts invoiced.

(b) Wesley Fraser drew cheques to Otto Vass or to "Cash". Otto Vass cashed the cheques and thereafter the dyers were paid in accordance with the agreed "commission" arrangement.

(c) United Color's practice was to defer payments as long as possible and all payments were deferred for at least several months for the following reasons:

(i) Dyers employed by any particular customer could change;

(ii) Business which dyers represented could be directed to the Appellant may not materialize or could be lost;

(iii) companies employing the dyers could close;

8. The amounts paid out in pursuance of the arrangements described in paragraphs 6 and 7 in respect of each taxation year are not less than:

1979	$24,131.84
1980	$56,964.86
1981	$46,637.20
1982	$ 5,684.00

The Evidence

Viva voce evidence for the appellants was heard from James Shepherd (one of the recipients of the secret commissions), from George Hammond (an experienced dyer and employee of the company who delivered some of the secret commissions), from Wesley Fraser (the company's full-time record and bookkeeper), from William Wyatt (a chartered accountant and the company's accounting advisor), and from Otto Vass. No testimony was called for the respondent.

All of the above testimony has been accorded, upon timely and proper request by each witness, the full protection of the Canada Evidence Act, R.S.C. 1985, c. C-5, and of the Ontario Evidence Act, R.S.O. 1990, c. E-23, and of the Charter of Rights and Freedoms.

The company was incorporated under the laws of Canada and commenced carrying on business in 1971 as a manufacturer and distributor of certain chemicals and dye-stuffs. Mr. Vass, now aged 51 years, was essentially the sole owner-manager of his company. He has a degree in chemistry. Prior to 1971 he was involved in the textile industry from which he had developed his particular knowledge of dye-stuffs and related chemical enhancers plus how the textile industry did business with some of its suppliers.

Before beginning his own business in 1971 Mr. Vass had been employed in Montreal by Francolor Corporation, one of the suppliers to Barrymore Carpets Corporation. Mr. Shepherd and a Steve Poroszlay were employees of Barrymore Carpets in its laboratory and new products division. Through the suggestions initiated by Mr. Poroszlay a 15 per cent of net sales rebate system was set up between Francolor on the one hand and Shepherd/Poroszlay on the other. The latter two individuals were to split the rebates between them and the method of payment was by delivery of untraceable cash with no record keeping. Mr. Vass made these cash deliveries on behalf of Francolor Corporation commencing mid-summer 1970 and thereafter via monthly luncheon appointments held in Toronto during which new products and other business related matters would also be discussed.

Mr. Shepherd, now retired and aged 60 years, testified with respect to the following. He had received one-half of the kickback amounts which, he readily conceded, had rightfully belonged to Barrymore Carpets and which had not been fiscally reported by him as income. In 1971, after Mr. Vass had begun his own business, the percentage rate dropped through renegotiation from 15 per cent to 12 per cent of the net invoice value but the deal had otherwise remained the same. As before, cash was delivered by Mr. Vass in conjunction with business meetings held in Toronto approximately every three weeks. The amounts averaged $1,000 weekly. At first Mr. Poroszlay received the money which was divided between them. Then he was the direct recipient and he split it with Mr. Poroszlay. This arrangement and system continued until mid-1981 when he left Barrymore Carpets' employ.

Mr. Shepherd said that kickback payments in the range of 10 per cent to 15 per cent were standard in the industry, that he had been approached by others (Sandoz, Ciba-Geigy, BASF to name a few) offering to pay to get Barrymore Carpets' business and that his biggest arrangement came from Mr. Vass' Company.

Aggressive cross-examination did not shake Mr. Shepherd's testimony respecting the frequency of payments and the amounts, that Mr. Vass had made all the calculations, and that Mr. Poroszlay had kept track of the amounts. Significant personal expenditures made during 1979 and 1980 were said to be the source of his recall with respect to the amounts he had received. He said he was not paid to testify, that he appeared voluntarily for the appellants and was not under subpoena.

Mr. George Hammond, aged 62 at trial, had some 14 years experience as a fabric dyer before being employed by Mr. Vass' Company in sales and promotions. In 1979, and while so employed, he was approached by a Raymond Allaire of Jet Tex Dyers Ltd. wanting kickbacks. He passed this request on to Mr. Vass who agreed and made the necessary arrangements. The rate was ten per cent of net invoice value. Mr. Hammond said that up until his own retirement in 1981 he had regularly and continuously delivered monthly envelopes containing cash to Mr. Allaire during business lunches. He said he had been personally offered kickback payments while in the dye production department of his previous employers but that he had refused. He added that secret kickbacks were known to him and were prevalent in the industry.

After mid-1981 (according to Mr. Vass) Mr. Allaire continued the kickback deal but via Corvelle Textiles Ltd. being the customer following his falling-out with Jet Tex Dyers. Mr. Vass said he delivered the cash after Mr. Hammond had retired.

Mr. Wesley Fraser, a current employee of Mr. Vass' Company, was 43 years of age at trial. He is a graduate of a business college and began with the Company in January of 1979. Following approximately four to six months gaining on- hands experience in the manufacturing and processing end of the business (with only part-time being spent on the general office matters), he spent full- time thereafter in the front office performing all of the office and clerical- related matters. He kept track of the customer invoices and had initially maintained a very loose and informal control on those invoices upon which the kickbacks were to have been paid. This was done via a moving divider or piece of paper. Sometimes the word "pd" was put directly on some of the invoices by Mr. Vass. After the company moved its premises to Cornwall, Ontario an improved customer record keeping system was set-up and maintained by him. He confirmed that four to six month delays for payment of the cash kickbacks were the norm to ensure customer involvement on a current basis with no product returns. He had made all the calculations "to the penny” and had advised Mr. Vass of these amounts. He said Mr. Vass usually rounded out these sums. The method employed was that either he typed out the company cheques for the rounded out amounts payable to Mr. Vass, or Mr. Vass wrote cheques to himself. These cheques would then be entered into a subsidiary ledger which at year-end was delivered to the company's accounting advisor (Mr. Wyatt) for entry into a general ledger.

The company cheques payable to Mr. Vass (typed by Mr. Fraser or written by Mr. Vass) were cashed by Mr. Vass; the cash being taken for delivery by Mr. Vass. Mr. Fraser said he was made aware of the whole scheme, the kickback percentages, its methodology and secrecy at the very outset. He also said that all of the cheques he had typed in Mr. Vass' favour were only for kickback payments. A 1980 break-and-enter office ransacking resulted in some customer invoices going missing. Exhibits A-1, A-2 and A-3 comprising of the Corvelle Textiles, Jet Tex Dyers and Barrymore Carpets invoices (each being grouped and affixed in separate file holders), respectively, were introduced. These were the invoices (except for early 1979) upon which Mr. Fraser had calculated the kickback amounts in the manner described.

Mr. Vass’ testimony correlated with the testimony of the witnesses Shepherd, Hammond and Fraser. He confirmed that all of the company cheques, whether payable to himself or to cash and cashed during the period 1979 to 1982 inclusive, represented kickbacks. He said Mr. Fraser attended to all of these record-keeping matters prior to their delivery to Mr. Wyatt's office. Exhibit A-5 comprised of twenty-two cheques for the period 25 January to 19 December 1979 totalling $26,180.65; Exhibit A-6 was of forty-nine cheques for the period 21 January to 22 December 1980 totalling $64,459.30; Exhibit A-7 was of forty-nine cheques for the period 5 January to 31 December 1981 totalling $46,320.86 and Exhibit A-8 was of nine cheques for the period 22 January to 17 September 1982 totalling $6,084.36.

Mr. Vass said all of his personal expenditures were paid out of his personal chequing account and that if it was short the bank transferred corporate funds thereto as required.

Mr. Wyatt testified that he was always aware of the kickbacks paid by Mr. Vass, that he was the one who advised they were not legally deductible by the company and that Mr. Vass had continually grumbled about it. The company cheques cashed by Mr. Vass were coded by Mr. Wyatt's office as "shareholder loan advances" and debited to his shareholder loan account. He said company dividends were declared at year-end to clear the account which included entries respecting other matters. His office issued the T-5 supplementary statements with respect to the declared dividends which amounted (non grossed-up) to $175,000 for 1979, $99,000 for 1980, $300,000 for 1981 and $210,000 for 1982. On his advice Mr. Vass had included all of these amounts into his income for each of his taxation years.

Mr. Wyatt said that in 1982, during his involvement in reviewing the financial statements of a similar business which Mr. Vass was considering purchasing, he discovered that they had been reporting, and successfully deducting, kickback (i.e., rebate) amounts paid to some of their customers. Beginning in 1984 and thereafter many meetings ensued at the behest of the appellants at the local and Ottawa offices of Revenue Canada concerning deductions for the kickbacks paid. All particulars, names and details produced at trial had been made readily available to Revenue Canada along with a statutory declaration from Mr. Shepherd, but to no avail.

Analysis—the Company

According to the testimony of Mr. Vass and from the documents filed at trial, the following information (amounts rounded-out) is illuminative of the situation:

The Barrymore Carpets business for the first ten-month period to October 1979 had been estimated on the financial basis of the ensuing years and on the testimony of Mr. Vass that this business source was so great in 1979 that it had necessitated the running of three shifts to keep up. The dearth of its actual invoices on hand for this period of time was said to be due to Mr. Fraser's part- time office involvement until mid-1979 and the 1980 break-in, both of which caused the available records to be incomplete. Mr. Vass attributed the 1982 reduced amounts earned and kickbacks paid respecting Barrymore Carpets' business entirely to the departure of Messrs. Shepherd and Poroszlay from its employ.

If the company's business from Barrymore Carpets was calculated for the entire four-year period with application thereto of the kickback rate of 12 per cent, the total amount would be $144,000. Mr. Vass said he had frequently paid cash kickbacks out of his own pocket without reimbursement from the Company and that therefore the total amount represented by the cheques ($143,043) was very conservative. The Jet Tex Dyers and Corvelle Textiles kick- backs, at ten per cent of the net invoice value, amounted to an additional $27,800. He said he had the financial ability to pay these other cash amounts and pointed to the annual dividend amounts paid to him in corroboration.

The financial statements of the company for the period 1979 to 1982 inclusive portray an average gross profit margin of 40 per cent per fiscal year. This supports a gross profit attributable to Barrymore Carpets’ business over the same period amounting to some $480,000. So even if the totality of the $144,000 kickback payments could be attributable to this one business source of $1.2 million in gross sales, it would not prima facie offend any test of reasonableness as to amount, and it is in accord mathematically with the net-invoice rate alleged to be prevalent in the industry as testified to by Messrs. Shepherd, Hammond and Vass.

Having regard to the evidence in its entirety, I am satisfied that it has been established on the balance of probabilities that the company had indeed expended the amounts shown as"pd" in the narrative reproduced above, and that its purpose was for the gaining or producing of income in respect of its own business. The evidence as a whole was credible particularly where it was supported by corroborative evidence, both in documentary format as well as by the viva voce testimony of the witnesses Wyatt, Hammond, Shepherd and Fraser. That the rebate arrangements were conducted secretly and carried an aura of impropriety are, apart from attracting a heavier burden of proof, not in themselves determinative: see, Espie Printing Company Ltd. v. M.N.R., [1960] C.T.C. 145, 60 D.T.C. 1087 (Ex. Ct.) at page 155 (D.T.C. 1093) and M.N.R. v. Olva Diana Eldridge, [1964] C.T.C. 545, 64 D.T.C. 5338 (Ex. Ct.). Appellants’ counsel pointed out in his submissions that the $143,043 shown to have been paid by way of Company cheques fell short of the true total amount. He pointed out that an analysis would show that amount covered only the Barrymore Carpets arrangement over the period of time being examined and that an additional $27,800 should be allowed having regard to the rebates paid to the individuals at Jet Tex and Corvelle. The evidence was that Mr. Vass had paid many of the cash rebates out of his own pocket.

While a hindsight-type of analysis may well justify the submission being meritorious, I would decline entitlement to the "short-fall" if it may be so described as it invites matters of estimates and speculation, particularly where persuasive corroborative documentation is lacking: see, Espie Printing Co., supra, at pages 151-52 (D.T.C. 1091).

In conclusion then, and noting that no evidence was called or led by any of the parties respecting the subsection 163(2) penalties, the appeals of the company are to succeed as hereinafter provided.

Analysis—Otto Vass

With respect to the appeals of Otto Vass, and having reviewed the written submissions of counsel for each party as requested by the Court, I am of the view that his reported income for each of the 1979, 1980, 1981 and 1982 taxation years had indeed been overstated by the amounts allowed herein as a deduction to the company respecting the proven rebate expenditures and that he should be accorded their exclusion from income.

Paragraph 12(1)(j) of the Act requires:

There shall be included in computing the income of a taxpayer for a taxation year as income from a business or property such as the following amounts as are applicable:

(j) any amount required by subdivision (h) to be included in computing the taxpayer's income for the year in respect of a dividend paid by a corporation resident in Canada on a share of its capital stock;

The related provision paragraph 82(1)(a), which is found in subdivision (h), reads:

In computing the income of a taxpayer for a taxation year, there shall be included

(a) all amounts received by him in the year from corporations resident in Canada as, on account or in lieu of payment of, or in satisfaction of, taxable dividends . . .

Neither of the above provisions are ambiguous. Dividends are taxed on a cash basis in that an amount must have actually been paid to and have been received by Mr. Vass on account or in lieu of payment of, or in satisfaction of, taxable dividends.

The true nature and substance of the amounts paid and received are what govern their taxability. That the company declared dividends each year to Mr. Vass of the amounts shown in his shareholder loan account in which the secret rebate amounts had been subsumed, and that Mr. Vass had received and had fiscally reported them employing that appellation in accord therewith, and that Mr. Wyatt had prepared the T-5 slip in the belief that this was the way it ought to have been done, all surely cannot, solely via form and erroneous belief and intention, transpose amounts which were not “income” to Mr. Vass to amounts that were.

I agree with appellant-counsel's submission that the amounts in question at no time had the quality of income in the hands of Mr. Vass, and I adopt the following abstract from page 9 of his written submissions as an accurate account of the facts and the applicable law thereto:

It was not the intention of the parties that Mr. Vass have complete and unfettered discretion to dispose of the money as he saw fit, which discretion must be present to give money the quality of income for tax purposes. The corporate intention, which one must presume was the intention of Mr. Vass, at the moment that he went to the bank counter was that these moneys were to pass through his hands to the recipients. The character or quality of income attached to the money in the hands of the recipients since it was they who had the unfettered discretion to use those moneys as they wished.

This does not, however, dispose of this appeal, for the question remains whether all of the amounts received by the appellant during any year were received as income or became such during the year. Did such amounts have, at the time of their receipt, or acquire, during the year of their receipt, the quality of income, to use the phrase of Mr. Justice Brandeis in Brown v. Helvering (supra). In my judgment, the language used by him to which I have already referred, lays down an important test as to whether an amount received by a taxpayer has the quality of income. Is his right to it absolute and under no restriction, contractual or otherwise, as to its disposition, use or enjoyment? To put it in another way, can an amount in a taxpayer's hands be regarded as an item of profit or gain from his business, as long as he holds it subject to specific and unfulfilled conditions and his right to retain it and apply it to his own use has not yet accrued, and may never accrue?" Kenneth B.S. Robertson Ltd. v. Minister of National Revenue (1944) C.T.C. 75 at p. 90-91 per Thorson, J.

I disagree with respondent-counsel's submission that Mr. Vass, Mr. Wyatt and the Company believed, and acted accordingly, that Mr. Vass would have to use his own money for the rebates. Rather, the facts of this case support the conclusion that the subject amounts had been received by Mr. Vass from the Company as its agent solely for delivery to the individuals employed by the Company's customers for the purposes of inducing and maintaining their business relationship. Further, Mr. Vass had not received the finds qua shareholder either at the bank counter while cashing the Company cheques or as subsumed in the purported dividend. The above in my view represents the essential sum and substance of the matter; the form taken by all involved was merely in response to its unpalatable nature. From the appellants’ perspective no fraud was intended or performed qua their own fiscal responsibilities.

Counsel for the respondent submitted that Mr. Vass should not be permitted to recharacterize the payment arrangements after the fact as they had resulted in the purported dividends being paid and received and being reported and represented as such to the respondent in the individual and corporate returns. The answer, as held earlier, is that the substance of the payments governs taxability in this case.

Counsel for the respondent also submitted that the case of The Queen v. Gurd's Products Co. Ltd., [1985] 2 C.T.C. 85, 85 D.T.C. 5314 (F.C.A.) would be helpful and supportive of the Court holding that"Mr. Vass had" made his bed" in the years 1979 through 1982 and now" must lie in it" ”. I disagree. The Court in Gurd's Products found that the evidence therein supported the finding that, in substance, the taxpayer by its actual activities had been carrying on a business in Canada out of which it had derived profits from doing business with the government of Iraq. That was the ratio of the decision; that the admitted purposeful deceit practised for business purposes by Gurd's Prod ucts was viewed with disfavour was obiter. In my analysis, that case has not upset the long jurisprudential line of fiscal cases wherein it has been authoritatively determined that substance is to reign over form and that substance is a question of fact and proof thereof. Matters of illegality may properly impact upon concerns involving credibility and the evidentiary onus of proof.

Having found that the income of Mr. Vass for each of his taxation years had been overstated by the proven amounts he received from the Company as its agent for transmission as aforesaid, and there being no evidence called or led by any of the parties respecting the subsection 163(2) penalties, the appeals of Mr. Vass are to succeed as hereinafter provided.

Judgment

The appeals of United Color and Chemicals Ltd. and of Otto Vass for each of their respective 1979, 1980, 1981 and 1982 taxation years are allowed and the respective reassessments are referred back to the Minister of National Revenue for reconsideration and reassessment on the basis that the following amounts and the following taxation years, respectively,

1979— $26,180 1980— 64,459 1981—46,320 1982— 6,084

represent deductions allowable to United Color and Chemicals Ltd. pursuant to paragraph 18(1)(a) of the Income Tax Act and represent overstatements of income to be omitted from the income of Otto Vass, and that the penalties assessed against both appellants pursuant to subsection 163(2) of the Act for each taxation year be deleted.

Costs

The appeals being heard on common evidence the appellants are entitled to one set of costs in respect thereof on a party-to-party basis.

Appeals allowed.