Halifax Green Elevator Ltd. v. The Queen, 96 D.T.C 1178, [1996] 1 CTC 2955 (TCC)

O’Connor J.T.C.C.: — These appeals were heard at Halifax, Nova Scotia on August 21 and 22, 1995 pursuant to the General Procedure of this Court. Written submissions of counsel were subsequently received by this Court, the last dated October 6, 1995.

Testimony was given by John Edward Oakley, the Chief Operating Officer of the Appellant from January of 1986; by Allen Stevens, a shareholder and director of the Appellant and provider of services to the Appellant and from January, 1992, the president of the Appellant; and by Tony Howatt, a chartered accountant. Also approximately 58 exhibits were filed by the Appellant.

Issues

The only issues in these appeals, which relate to taxation years 1986 through 1991, are whether certain lease guarantee fees and certain management fees and interest expenses on some of those fees are deductible expenses in computing the Appellant’s income, and, if not, whether the Notice of Reassessment for 1986 was statute barred.

Facts

1. By Notices of Reassessment dated December 17, 1991 (for the 1986, 1987, 1988, 1989 and 1990 taxation years) and October 19, 1992 (for the 1991 taxation year) the Minister of National Revenue (“Minister”) reassessed the Appellant’s income tax liability for its 1986 through 1991 taxation years inclusive) by disallowing the deduction of certain expenses as follows:

The contents of this table are not yet imported to Tax Interpretations.

2. 'l'he Appellant is a Canadian corporation, incorporated in 1985, with a fiscal year end of September 30 and was formerly known as Nosco Marine Industries Limited (for the 1986 and 1987 years the Appellant had a fiscal year end of December 31);

3. Prior to 1985 the Halifax Port Corporation, a Crown corporation (“Port”) operated a grain elevator in Halifax. By 1985 the Port wished to privatize the grain elevator operation and, in this regard, it was approached by a Mr. Walter van den Broek, a former general manager of the Port’s operations;

4. Mr. van den Broek represented himself as agent for the Appellant, which was interested in leasing the Port’s facilities and running same as a private operation.

5. The Appellant was related to Curaçao Marine Management, N.V. (“CMM”), a foreign corporation resident in the Dutch Virgin Islands which had been formed in 1985 to manage ship breaking, steel brokerage and marine interests;

6. Late in 1985 the Port and the Appellant entered into an interim lease arrangement whereby the Port agreed to lease to the Appellant the Port facilities and the Appellant agreed to take over port operations commencing in October 1985. A final lease agreement was entered into late in 1986 with effective date as of October 1, 1985. The lease was for a period of six years commencing October 1, 1985 and terminating September 30, 1991 with a right to renew for a further six year term. The rental was $50,000 per annum for the first three years and $75,000 per annum for the last three years. In addition to rental the Appellant had various other monetary obligations related to wharfage, throughput charges, insurance, real estate taxes and maintenance;

7. The Port insisted that since the Appellant had little or no assets all of the obligations of the Appellant under said lease had to be guaranteed. The Appellant at first attempted to obtain guarantees from bonding companies and banks but such guarantees were not forthcoming because of the Appellant’s lack of assets. Because of this CMM considered furnishing the guarantee. Three of the shareholders of CMM, namely, John Oakley, Allen Stevens and Gabriel Sherover, were convinced that the Appellant could operate the Port at a profit which would accrue eventually to the benefit of the shareholders. Three other shareholders disagreed and a fourth remained neutral. Consequently, the following resolution at Tab 18 of Exhibit A-1 was enacted:

Curaçao Marine Management

Directors Meeting

In accordance with the Company byelaws, the following Resolution was passed at a meeting of the Board of Directors properly called and constituted at the offices of Gabriel Sherover, 1806-680 Fifth Avenue, New. York on October 16th, 1986 under the chairmanship of Allen L. Stevens, President.

WHEREAS Nosco Marine Industries Inc. have been unable to obtain a guarantee from a Canadian Bonding Company or Commercial Bank acceptable to the Halifax Port Corporation, they have required this company to provide a performance guarantee for their obligations under the lease.

BE IT RESOLVED that in view of the split in the Board over the viability of this enterprize and the high level of risk which would be placed on our shareholders given this Company’s performance to date [i.e., the Appellant’s], this Board has recommended issuance of said guarantee under the following conditions:

1. Personal guarantees be provided to CMM in the total amount of Canadian dollars THREE MILLION by Allen L. Stevens, Gabriel Sherover, John

E. Oakley.

2. All assets and earnings of Nosco Marine Industries, including payables to CMM, be pledged against the guarantee.

3. Nosco Marine Industries will suspend dividends until such time as their assets exceed ONE MILLION DOLLARS, unless first approved by the Board.

4. That CMM charge a fee for this guarantee based on the most probable financial exposure if NMI defaults. The rate to be established by NMI auditors equivalent to that available in Canada related to the asset base of NMI and the degree of risk.

Dated at New York this 15th day of November 1986.

8. At first the optimism of Oakley, Stevens and Sherover was based upon projections proposed by Mr. Van den Broek, the original president of the Appellant. These projections later proved false in the extreme with the result that Mr. Van den Broek was removed/resigned in 1986 and was replaced by Mr. Oakley.

9. The shareholders of CMM and the Appellant were essentially the same. They determined that a profit would only be attainable by the Appellant if considerable improvements were made in the Appellant’s operations. Recognizing that Mr. Oakley did not have all of the expertise required to improve the operations it was agreed that CMM would provide various services to this end. Consequently a Management Agreement with effect as of October, 1985 was entered into by the Appellant and CMM. The most relevant provisions are as follows:

The following Management Agreement between Nosco Marine Industries Inc. and Curaçao Marine Management N.V. to organize and operate a grain elevator facility leased from the Port of Halifax Corporation is agreed subject to the following terms and conditions:

1. That Curaçao Marine Management N.V. will provide full management and sales services towards increasing throughput at the grain elevator facility, advising and supervising elevator improvements, controlling costs of operations, advising on legal and contract matters, administrating the lease agreement with Port of Halifax Corporation, promoting the use of the grain elevator both within Canada and abroad, advising on investment of retained capital, advising on labour relations, advising on taxation, and any other duty normally associated with day to day operations of a grain elevator....

5. That the management fee be payable annually for as long as any of the management obligations remain outstanding.

6. That said management fee be based on the following scale of net before tax profits, as follows:

Net profits B.T.:	0-	$1.5 million	fee $300,000.
	Over -	$1.5 million	30%

7. Curaçao Marine Management N.V. will provide a resident manager and such advisors as are, from time to time, considered essential to the operations. The salary and bonus of said manager and advisors will be fixed annually by the Directors of Nosco Marine Industries Inc. and paid from Corporate earnings before calculation of the management fee. All reasonable expenses incurred by the resident manager and advisors shall similarly be paid from Corporate earnings of Nosco Marine Industries Inc. before calculation of the management fee.

8. Curaçao Marine Management N.V. will be responsible for the performance of the resident manager and may apply discipline up to and including dismissal as they see fit.

9. Curaçao Marine Management N.V. may choose to waive payment of all or any part of the said management fee in any one year, or may choose to loan this to Nosco Marine Industries Inc. for an indefinite period. Should a management fee be waived or loaned to the Company, it shall bear interest at the rate of Canadian prime plus 1 per cent for the full period of such waiver or loan.

10. Should Curaçao Marine Management N.V. loan or waive payment of any fees payable, they shall have the sole option to fix the repayment period and/or have the option to demand payment at any time.

The management fees for the three months of 1985 and for the year 1986 were waived by CMM because the Appellant was not in a position to pay.

10. CMM, pursuant to the said resolution, guaranteed the lease and the fee was fixed at 7 per cent per annum of the total monetary exposure under the lease from year to year. As can be seen from the figures in paragraph 1, these fees diminished over the years as the exposure under the lease diminished. Also, Messrs. Stevens, Sherover and Oakley each executed guarantees limited to $1,000,000 whereby each unconditionally underwrote the lease guarantee provided to the Port by CMM. In other words, if CMM could not fulfil its obligations under the guarantee to the Port, CMM could look to these three shareholders for payment under their backup guarantees.

There are numerous other facts evidenced by the many exhibits filed by the Appellant and the testimony. Not all of these facts need be reviewed here in detail. Some of them are referred to below in the submissions. All facts have been reviewed and considered in formulating the decision in these appeals.

Submissions of Appellant

The Appellant’s initial submission made in writing and dated September 14, 1995 is essentially to the effect that based upon all of the evidence it is clear that CMM gave the lease guarantee in question, that without that guarantee there would never have been a lease with the Appellant, nor a profit, that the guarantee fee charged was reasonable in the circumstances and consequently the Appellant is entitled to deduct the guarantee fees indicated above.

With respect to the services provided, advisory and otherwise, by the shareholders of CMM to the Appellant, Appellant’s counsel submits that the evidence is extensive to the effect that the services of the three shareholders mentioned above, and other persons, retained by CMM were absolutely essential to change the fortunes of the Appellant and to turn what promised to be a losing proposition into a profitable one. The expert business skills, connections and profile of the persons involved at CMM were evident. These services, summarized by Mr. Stevens in Tab 55 of Exhibit A-l, involved, according to Mr. Stevens, a total of 6,352 manhours from 1985 through 1990 and covered items such as lease negotiations, management organization, dealing with government boards, commissions and councils, finances, efficiency studies, competition analysis, proposals to introduce feed grain shipments, large tonnage vessels and self-unloading vessels, evaluation of costs of moving U.S. grain to European and Middle East markets and studying other potential cargoes, reorganizing following removal of the At and East grain export subsidy, a subsidy which had enabled the railways to charge lower than market rates for shipments to Halifax and other easterly ports.

With respect to interest charged on the fees, Appellant’s counsel submits that if the two sets of fees are found to be acceptable, the interest charged on the unpaid fees was reasonable and similarly should be allowed.

Submissions of Respondent

These are best set forth in the following excerpts from the Respondent’s counsel’s written submission dated September 28, 1995:

11. The Respondent says that CMM was a shell corporation in that if it existed as a legal entity, which is by no means certain throughout the period under appeal but will be assumed for purposes of argument, it had no assets and did not carry on business. Consequently, CMM could not have honored its guarantee.

12. The Respondent submits that the payment of the lease guarantee fee to CMM was an artificial arrangement whereby the Appellant and CMM arranged their affairs to make it appear that the Appellant was incurring an expense to CMM. In fact, the fee charged for the guarantee was part of the artificial arrangement whereby the Appellant transferred funds offshore under the guise of being a valid expense. There is not a shred of evidence that CMM had any assets at risk to justify the payment of a lease guarantee fee. The only assets at risk were those of the individual shareholders who provided guarantees and who chose to charge no fee.

13. The Respondent does not dispute that the specific circumstances probably did not exist throughout the period under appeal for the Appellant and CMM to be deemed to be associated corporations pursuant to paragraph 256(1 )(b) of the Income Tax Act (the “Act”) and therefore dealing at non-arm’s length. However, the Respondent submits that pursuant to paragraph 251(l)(b) of the Act it is a question of fact whether the parties were dealing at arm’s length. The Respondent further submits that the evidence is overwhelming that the Appellant was not dealing at arm’s length with CMM.

14. The shareholders of CMM were primarily shareholders of the Appellant and vice versa. ... One has only to review any of the exhibits submitted by the Appellant to determine that the existence of the Appellant and CMM was so intertwined as to make them almost one entity. At Tab 14, which is notes of a meeting of the Board of Directors of CMM held in New York on January 21, 1986, the Board waived a management fee from the Appellant and appointed John Oakley the general manager of the Appellant. As exhibited at Tabs 36 and 37, CMM appointed John Oakley as President of the Appellant. The testimony of Mr. Oakley was clear that he did not distinguish between a corporation and its shareholders. (reference transcript, August 22, pages 27-28)

15. …

16. In the present case it is submitted that the guiding mind of both the Appellant and CMM were one and the same, being the same group of shareholders who caused each to be incorporated and who directed the affairs of each throughout the period in question. Consequently, it is clear on the facts that the Appellant and CMM were always dealing on a non-arm’s length basis.

17. There is no objective evidence that CMM existed or carried on business in 1986 or any subsequent year. At paragraph 3(j) of the Reply to Notice of Appeal the Respondent assumed this very point. The Appellant produced evidence in the form of testimony and documents that actions were carried out in the name of CMM. There were various directors’ resolutions produced and documents such as the interim lease and final lease with the Halifax Port Corporation were signed on behalf of CMM. However there is no evidence that CMM was anything but a shell at best, unable to honor any form of guarantee.

18. Tab 13 of Exhibit A-l contains a financial statement of CMM as at August 1, 1985. It shows all assets of the company already allocated. John Oakley stated in cross examination that, because of commitments with the company’s bank, CMM was required to get approval for any large expenditures. (reference transcript, August 22, pages 18-20).

19. Subsequent to August 1, 1985 there are no indications that CMM had any assets or was in business. Both Messrs. Oakley and Stevens indicated that throughout the taxation years relevant to the appeal they never saw a financial statement of CMM. Mr. Oakley testified that as late as 1987 he saw a combined financial statement of CMM and its subsidiary but after that he relied on information given by third parties and that he had no direct knowledge of the assets of CMM, if any. (reference transcript, August 22, pages 45-52). Mr. Stevens gave similar testimony despite the fact that he claimed to be the President of CMM in this period, (reference transcript, August 22, pages 152-53).

20. It is common ground that guarantees were given to CMM totalling $3,000,000 should CMM become liable pursuant to its guarantee to the Halifax Port Corporation (reference Exhibit A-1, Tabs 19, 20 & 21).

21. The memorandum from Mr. Stevens to Mr. Oakley located at Tab 53 of Exhibit A-l shows clearly that following 1985, these shareholder guarantees were more than sufficient to cover any potential liability to the Port Corporation. Both Mr. Oakley and Mr. Stevens testified that the guarantors were each capable of meeting their obligation under the guarantees.

22. The Appellant led evidence in the form of expert testimony by Tony Howatt to the effect that the rate of 7 per cent charged by CMM for the lease guarantee was reasonable. In reaching his opinion that the rate was reasonable, Mr. Howatt assumed that CMM was at all times able to meet it obligations and honour the lease guarantee, (reference transcript, August 22, page 181) He further testified that a reasonable lease guarantee was calculated as a percentage of the assets of the guarantor at risk. Consequently, if CMM had $1.00 of assets, a reasonable fee would be 7 cents, (reference transcript, August 22, pages 181-83).

23. The Respondent says that the Appellant’s deduction of the lease guarantee was properly disallowed pursuant to paragraph 18(1 )(a) of the Act as it was not incurred to earn income. This is evident because there is no indication that CMM had any assets at risk even though this point was clearly put in issue in the Respondent’s pleadings. In effect, the Appellant was paying a fee for nothing. The only logical conclusion is that the “owners” of CMM and the Appellant were using this as a means of funneling wealth from Canada to the offshore under the guise of a legitimate business activity.

24. In the alternative, it is submitted that the payment of the fee was unreasonable in the circumstances. The shareholder guarantees were given to CMM free of charge. It is unreasonable for CMM to then demand and for the Appellant to pay a fee. Keeping in mind the close relationship among all of the parties involved, the only reasonable course of action would have been for the shareholders to give guarantees directly to the Appellant, free of charge.

ISSUE B. - WHETHER THE MINISTER WAS CORRECT IN DISALLOWING THE DEDUCTION OF MANAGEMENT FEES FOR THE YEARS 1987 TO 1991, INCLUSIVE;

25. By agreement dated September 15, 1985, CMM and the Appellant agreed, inter alia, that CMM would provide management services to the Appellant for remuneration.

26. The Appellant has introduced memoranda detailing work that was done by persons on its behalf in an effort to justify the management fees. These persons were shareholders of both CMM and the Appellant or were employees of shareholders. (reference Exhibit A-l, Tabs 15, 30, 43 & 54). The Respondent does not dispute that work was done by the shareholders and that this work was directly connected to and responsible for the Appellant’s financial success. However, the Respondent says that CMM could not have and did not perform the services.

27. John Oakley testified that he was president of CMM until January, 1986 and that he drew a salary from it. He then moved to Nova Scotia, began to work for the Appellant, became an employee of the Appellant and ceased to be paid by CMM. He further testified that in 1986, after he left, CMM had at best two employees, a secretary and Gabriel Sherover, a shareholder. He did not know if Mr. Sherover was paid by CMM (reference transcript, August 22, pages 9-12)

28. Mr. Allen Stevens testified that neither he nor any of the other CMM principals were paid by CMM. Mr. Stevens was not certain whether he was reimbursed for his expenses incurred in working on behalf of the Appellant or who would have paid if he was reimbursed. To Mr. Stevens knowledge none of the shareholders of CMM were under contract to work for it exclusively.

29. The Courts have held that corporations dealing at non-arm’s length may charge one another reasonable management fees when the employees of one corporation perform services on behalf of and that directly benefit the other. In all of the decisions cited by the Appellant, this was the case.

30. In R. v. Laidlaw Transport Ltd., [1977] C.T.C. 151, 77 D.T.C. 5091 (F.C.T.D.), the parent charged a management fee to the Defendant. The Court found that “DeGroote was an employee of both the defendant and the parent in the period in question. His services as an employee were primarily to the parent. The defendant reaped the benefit (at pages 154-55 (D.T.C. 5093)).

31. The Respondent says that CMM did not provide management services to the Appellant. There is no evidence in the present case that any work was done by employees of CMM that benefited the Appellant. In fact, the only evidence on this point is that CMM did not have employees. Certainly, none of the persons described in the evidence as having performed services to benefit the Appellant were employees of CMM. What is clear is that services were performed by shareholders of the Appellant for its benefit and, quite reasonable, they asked for no compensation in return except for Mr. Oakley who was paid by the Appellant for his position as its General Manager.

32. The Respondent says that the management agreement between the Appellant and CMM was an artificial arrangement designed to make it appear that CMM was providing management services to the Appellant when, in fact, CMM was never capable of providing any kind of management service as it had no employees or persons under contract to provide those services.

33. The Respondent says that the Appellant’s deduction of the management fees was properly disallowed pursuant to paragraph 18(1 )(a) of the Act as they were not incurred to earn income. The evidence indicates conclusively that CMM provided no services to the Appellant. Like the lease guarantee fees, in effect, the Appellant was paying a fee for nothing. The only logical conclusion is that the “owners” of CMM and the Appellant were also using this as a means of funneling wealth from Canada to the offshore under the guise of a legitimate business activity.

34. In the alternative, it is submitted that the payment of the fee was unreasonable in the circumstances. The shareholders performed services free of charge. it is unreasonable for CMM to then demand and for the Appellant to pay a fee.

ISSUE C. - WHETHER THE MINISTER WAS CORRECT IN DISALLOWING THE DEDUCTION OF INTEREST EXPENSES FOR THE YEARS 1989 TO 1991, INCLUSIVE

35. The interest expenses arose as a result of the accrual of fees owed to CMM. The Respondent says that if the lease guarantee fees and management fees were properly disallowed, then the interest cannot be said to have been incurred for the purpose of gaining or producing income pursuant to paragraph 20(1 )(c) of the Act.

Response of Appellant to Respondent's Submissions

These are best summed up by quoting certain extracts from the written response of Appellant’s counsel dated October 6, 1995.

Lease Guarantee Fees

With respect to paragraph 11 of the Respondent’s Submission, it appears that the reference to “shell corporation” means a corporation that had no or insignificant assets. The testimony established (Exhibit A-1, tab 13); transcript of August 21, 1995, pages 24, 80; transcript of August 22, 1995, pages 86, 149) that CMM was incorporated with substantial assets, which were augmented by payments received from the Appellant and others (transcript of August 22, pages 99, 137-38, 150-51); its assets were retained by it in the form of portfolio investments and not distributed to its shareholders but transferred intact to the successor company incorporated in 1990 in the Isle of Man (transcript of August 21, pages 187-88; transcript of August 22, pages 47, 99, 104, 139., 153).

Even if that were not the case, CMM had an enforceable legal right, reflected in tabs 19, 20, and 21 of Exhibit A-l, to call upon its major shareholders for up to $3,000,000 in connection with its guaranteed commitment to the Halifax Port Corporation. Tab 18 in Exhibit A-1 makes it clear that the guarantees were provided to CMM for purposes of enabling it to assure the Port Corporation that CMM could fulfil its obligations under its guarantee to the Port Corporation, regardless of what other assets CMM might have had. These backup guarantees were substantially sufficient to ensure that CMM could meet its maximum guarantee exposure, as reflected in tab 17 of Exhibit A-1.

The evidence indicated (Exhibit A-1, tab 18, third paragraph; transcript of August 21, pages 94- 95; transcript of August 22, pages 110-11) that there was a lack of unanimity within the board of CMM whether the guarantees should be given to the Port Corporation, and the consent of the board was only obtained on condition that the three shareholders in question supported their confidence in the grain elevator operation by providing personal backup guarantees to CMM. Consequently full value was provided by CMM to the Appellant in exchange for the guarantee fee. The fact that the Port Corporation considered the guarantee to be of continuing importance is evidenced by its insistence that the guarantee be renewed with the renewal of the lease (Exhibit A-l, tab 57; transcript of August 22, pages 102-03).

It is hard to see on what basis it is claimed in paragraph 12 of Respondent’s Submission that the arrangement to pay a guarantee fee, at a rate that expert testimony has established to be reasonable (Exhibit A-2; transcript of August 22, pages 165-84), for a guarantee that the Appellant needed in order to carry on its business and could not obtain elsewhere (transcript of August 22, p. 171), was artificial. The Appellant did incur an expense to CMM and, with or without some delay, paid that expense (see Submission of Appellant to this Honourable Court dated September 14, 1995 - “Appellant’s Submission” pages 14-16; also transcript of August 21, pages 176, 179; transcript of August 22, page 99).

It is not clear under what section of the Income Tax Act or what case law paragraph 12 of the Respondent’s Submission is claiming that alleged artificiality justifies a disallowance of the deduction of the lease guarantee fees. Former subsection 245(1) of the Income Tax Act was not pleaded in the Reply, but in any event it is submitted that it is not applicable where a reasonable commercial arrangement is in place. That provision was in issue in Mark Resources Inc. v. R. (sub nom. Mark Resources Inc. v. Canada), [1993] 2 C.T.C. 2259, 93 D.T.C. 1004 (T.C.C.; under appeal), where Bowman J.T.C.C., said, at page 2266 (D.T.C. 1009):

It is fair to say that artificiality is in the eye of the beholder, and where one draws the line between “acceptable” and “unacceptable” tax avoidance schemes is a matter of perception. In that determination the fact that the scheme may have been predominantly or exclusively fiscally motivated plays a minor or even a non-existent role.

Here there is no evidence before the Court, and no questions were raised on cross-examination, concerning the possibility that the arrangements in question were tax-motivated. Even if they were, that would not make them artificial. This subject will be discussed further at a later point, in relation to “income splitting”.

It is submitted that it is incorrect, in the last sentence of paragraph 12 of the Respondent’s Submission, to allege that “the only assets at risk were those of the individual shareholders”: by reason of the backup guarantees, those assets were available at any time to CMM, if required, to discharge CMM’s corporate obligation; the assurance that CMM had access to the required funds, wholly apart from any other assets of CMM, provided substance to the CMM guarantee (see transcript of August 22, page 175). As will be established later, it was irrelevant to the value of the guarantee to the Appellant, or to the reasonableness of the fee that it paid for the guarantee, whether the shareholders of CMM who provided the backup guarantees were directly compensated by CMM for so doing.

The Respondent’s Submission, in paragraphs 13 to 16 inclusive, argues that CMM and the Appellant, at all relevant times, were not dealing at arm’s length. While there was not an identity of shareholders, there clearly was a close relationship between the two corporations, particularly in the early stages. Tab 12 of Exhibit A-l, among other things, in paragraph 7 empowered CMM to provide a resident manager and other advisers to the Appellant. Hence CMM’s appointment of Mr. Oakley to take charge of the Appellant in early 1986. As Mr. Oakley testified, however, (transcript of August 21, pages 191-92; Exhibit A-l, tabs 2, 56) it was in his personal interest to minimize the intercompany charges, and he agreed to them because he felt that they were reasonable in the circumstances.

In any event, as counsel for the Appellant indicated to His Honour in response to a question (transcript of August 21, pages 35-37), it is not critical to the Appellant’s case whether or not the two companies were dealing at arm’s length at the relevant times. Whether the applicable provision of the Income Tax Act is section 67 (which can apply whether or not the parties to a transaction are at arm’s length) or subsection 69(2) (which only applies if the parties are not at arm’s length), the deductibility of the expenses in question depends upon the reasonableness of their amount having regard to all surrounding circumstances. Consequently the main thrust of the testimony presented on behalf of the Appellant related to the reasonableness of the intercompany charges, which it is submitted has been amply established by the evidence. Reference is made to pages 22 and 23 of Appellant’s Submission.

In paragraph 17 of the Respondent’s Submission it is alleged that there is no “objective evidence” that CMM continued to exist in 1986 or subsequent years or, failing that, that it was anything other than a shell. The latter point has already been answered. Since it is admitted by the Respondent that CMM came into existence, the suggestion must be taken as being that the Appellant has not proved that CMM’s corporate existence did not terminate at or before the beginning of 1986 or, if not, some time during the years in question. It is submitted that, unless some reason caused the shareholders (of whom Mr. Oakley and Mr. Stevens had significant holdings) to take steps to terminate a corporation’s existence, it is a reasonable inference that the corporation, once established, would continue as such. In addition, it is clear that all parties concerned regarded CMM as continuing to exist (see, for example, Mr. Stevens’ views in transcript of August 22, page 99) and acted on that basis:

1. The CMM guarantee to the Port Corporation continued (transcript of August 22, pages 102-03;

2. CMM continued to invoice the Appellant (see, for example, tab 36 of Exhibit A-l), and, as previously noted, the Appellant made significant payments to CMM;

3. As noted earlier, CMM continued to retain, augment, and invest its assets and delivered those assets intact to the successor corporation in 1990;

4. Mr. Sherover and then Mr. Stevens acted as president of CMM in the late 1980s (transcript of August 22, pages 152-53);

5. Further capital was put into CMM (transcript of August 22, pages 137-38);

6. Mr. Stevens purchased shares from Mr. Sherover upon the latter’s death in 1989 (transcript of August 22, page 138; see also transcript of August 21, page 163; transcript of August 22, pages 99, 129);

7. The shareholders did not withdraw funds from CMM by way of dividends or liquidating payments (transcript of August 22, pages 100, 104-105), which would naturally happen if the corporation had been terminated unless a fraud had been perpetrated - and there is no basis for suggesting fraud (transcript of August 22, page 53);

8. The Isle of Man company commenced operation with significant assets, without any infusion of additional capital from the shareholders (transcript of August 22, page 138).

9, Annual audited financial statements were prepared for the Appellant showing the ongoing financial relationship between it and CMM (Exhibit A-1, tabs 31, 37, 38, 44, 45, 46);

10. In early 1988, the Appellant issued to CMM 250,000 Class C shares from the Appellant’s treasury in payment of the 1986 guarantee fee (Exhibit A-l, tabs 2, 27; tab 37, note 6; transcript of August 21, pages 121-26);

11. Meetings of directors and shareholders of CMM continued to be held, mostly in New York (Exhibit A-l, tabs 18, 36, 42; transcript of August 21, pages 80, 86, 94, 167-68; transcript of August 22, pages 44-45, 161).

It is clear that the shareholders had no reason to terminate the corporation and, indeed, that their only concern was the geographic location of their investments: having terminated their business operations in Curaçao, they investigated the possibility of transferring the company to Bermuda (transcript of August 21, pages 187-88; transcript of August 22, page 48) and, when that was found not to be possible or appropriate, to the Isle of Man (transcript of August 21, page 188; transcript of August 22, page 47,49).

Consequently it is submitted that there is every reason to conclude that CMM continued in existence, in its original corporate form until late 1990 and thereafter as the reincorporated company in the Isle of Man, and that it provided the various services in consideration for which the fees in question were paid by the Appellant.

In any event, regardless of the corporate status of CMM, the valuable services in question were performed, and the fees in question were accrued and paid.

It is submitted that the argument in paragraph 22 of the Respondent’s Submission, suggesting that Mr. Howatt agreed that a nominal lease guarantee fee would be appropriate if CMM had insignificant assets, misses the point of Mr. Howatt’s testimony. It is clear that, when his testimony is read in context, he was saying that, providing CMM had the resources, or had access to the resources, to honour its guarantee in full, a reasonable guarantee fee would be based on its full exposure to potential liability (transcript of August 22, pages 175, 179, 183). No other interpretation of Mr. Howatt’s testimony makes sense.

With respect, it is submitted that paragraph 23 of the Respondent’s Submission is wrong in suggesting that “the Appellant was paying a fee for nothing”. The Port Corporation did not think so, nor did Mr. Oakley in agreeing that the payments were proper (transcript of August 21, pages 191-92). Again there is a hint here of illegitimate tax avoidance, which was not raised in cross- examination and, it is submitted, is irrelevant anyway. In effect, the claim being made here is that there was a species of “income splitting” because some of what otherwise would be the income of the Appellant became the income of CMM or of its shareholders. On the question of income splitting, Rothstein J., in Neuman v. Minister of National Revenue (sub nom. R. v. Neuman), [1994] 1 C.T.C. 354, 94 D.T.C. 6094 (F.C.T.D.; under appeal), at page 364 (D.T.C. 6102), noted:

It may also be appropriate for me to observe that nothing in the scheme of the Income Tax Act as a whole suggests an overall intention to prevent income splitting.

Again, no section of the Income Tax Act is cited as authority for disallowing the guarantee fees on the basis that they accomplished a splitting of income.

If a motive on the part of the Appellant’s shareholders to split income with an offshore entity were relevant to this appeal, it is hard to infer such a motive when CMM agreed to forego management fees for 1985 and 1986 (Exhibit A-l, tabs 14, 36). Further income splitting would have been possible by not waiving these fees, allowing them instead to create or increase non-capital losses for the Appellant for the years in question, and carrying those losses forward, under section 111 of the Income Tax Act, to reduce the Appellant’s taxable incomes for its profitable years commencing in 1987.

The argument in paragraph 24 of the Respondent’s submission that the guarantee fees were unreasonable has already been addressed. It is hard to see on what basis, in the last sentence of paragraph 24 of the Respondent’s Submission, it is suggested that no fee should have been charged for the valuable guarantee nor why the backup guarantees had to be given directly to the Appellant rather than to CMM. It was CMM to which the Port Corporation was looking for guarantee support, and the backup guarantees were given to CMM, for legitimate business reasons, to alleviate the concerns of several of the shareholders. Those concerns, expressed in late 1986, reflected an assumption that CMM had, or was expected to have, assets of its own that otherwise would be at risk.

Management Fees

In paragraph 26 of the Respondent’s Submission, it is indicated that “the Respondent does not dispute that work was done by the shareholders and that this work was directly connected to and responsible for the Appellant’s financial success.” The only issues remaining, therefore, are whether these services could be regarded as having been provided by CMM and whether the amount of the fees was reasonable. For reasons already given, it must be concluded that CMM continued in existence and continued to provide services pursuant to the management agreement. There was no suggestion that the management agreement is a sham or should be ignored. In effect, services were provided as admitted by the Respondent, were invoiced to the Appellant as having been provided pursuant to the management agreement, and were duly paid for by the Appellant. It is not clear on what basis these clearly established relationships between the parties can be ignored because Revenue Canada was unhappy with the tax result.

With respect to paragraphs 27 to 31 of the Respondent’s Submission, it is respectfully submitted that the only issue under the Income tax Act with respect to the management fees (once it is admitted that valuable services were provided) is whether the fees were reasonable in the circumstances. How CMM chose to provide those services - whether through paid or unpaid employees, through paid or unpaid shareholders of CMM acting on a contract basis, or through independent third parties contracted for by CMM (see transcript of August 22, pages 34, 42), was of no relevance to the Appellant and of no relevance to the reasonableness of the fees.

It is submitted that the Respondent’s arguments concerning who may or may not have been an employee, and which employees may or may not have been compensated by CMM in the form of salary, are beside the point. All of the documentation and testimony establishes that the services were provided pursuant to the management agreement, and therefore CMM was entitled to be paid the agreed fees regardless of what arrangements it made for the provision of those services. Those who provided the services would expect to benefit in some way or other — if not by salary or consulting fees then ultimately by dividends or capital gains from the growth in value of their shares. That was a matter of no concern to the Appellant. Similarly it was of no concern to the Appellant whether any of the shareholders of CMM who provided management services to the Appellant were under contract to work for CMM exclusively - a point raised in paragraph 28 of Respondent’s Submission.

The Respondent cites Laidlaw, a case also referred to in the Appellant’s Submission. It is submitted that there is no suggestion in the judgment that the reasonableness of the intercompany fee depended upon the status of Mr. DeGroote as an employee of the parent. The significant point here is provided at page 5093 of the judgment, in the second full paragraph in the right-hand column, where it is noted that the fact that DeGroote received no compensation from the parent company was irrelevant.

Again, at paragraph 32 of the Respondent’s Submission, a reference is made to “an artificial arrangement”. It is submitted that there is nothing artificial about adhering to a legally enforceable contract entered into by the two parties. The Court’s task, it is submitted, is to address the legal relationships that were created, not alternative legal relationships that might have been created. There is no suggestion anywhere that the transactions in question amounted to a “sham”.

It is submitted that all the points raised in paragraphs 33 and 34 of the Respondent’s Submission have already been answered.

Interest Expense

The Appellant agrees with paragraph 35 in the Respondent’s Submission but takes the position that the converse is also true: if the lease guarantee fees and management fees should not have been disallowed, then the interest should be deductible pursuant to paragraph 20(1 )(c) of the Income Tax Act.

Preliminary Issue

There was a preliminary issue raised by a motion of counsel for the Respondent under rule 146 of the Tax Court of Canada Rules. The Respondent had served counsel for the Appellant with a subpoena duces tecum ordering Mr. Oakley to produce financial records of CMM for the years 1988 to 1990 and Mr. Oakley being unable to obtain these records did not furnish them.

Rule 146 provides as follows:

146(1) A party may secure the attendance of a person who is,

(a) an adverse party, or

(b) an officer, director or employee of an adverse party, as a witness at a hearing by,

(c) serving the person with a subpoena, or

(d) serving on the adverse party or the counsel of record for the adverse party at least ten days before the commencement of the hearing, a notice of intention to call the person as a witness....

(2) Where a person referred to in subsection (1) is in attendance at the hearing a party may call the person as a witness without previous notice or the payment of witness fees and expenses.

(3) A party calling a witness referred to in subsection (1) may cross-examine the witness.

(4) Where a person required to testify under this section,

(a) refuses or neglects to attend at the hearing or to remain in attendance at the hearing,

(b) refuses to be sworn, or

(c) refuses to answer any proper questions put to that person or to produce

any document or other thing which that person is required to produce,

the Court may grant judgment in favour of the party calling the witness, adjourn the hearing or give such other direction as is just.

On this point counsel for the Respondent submitted as follows:

RULE 146, GENERAL PROCEDURE RULES

39. Rule 146 allows the Crown, by means of a subpoena, to secure the attendance of an adverse party, or an officer, director or employee of an adverse party. It is common ground that Mr. Oakley is a director of the Appellant. It is also common ground that Mr. Oakley was served with a subpoena by the Crown to attend the appeal with financial records of CMM.

40. The purpose of the subpoena is self evident. This case involves financial dealings between CMM, a foreign offshore corporation, and Halifax Grain Elevator Limited, a Canadian resident corporation. The issues raise questions of whether CMM had any assets; whether CMM was in business; whether CMM had employees. Was CMM merely a corporate name for use in funnelling funds offshore? If CMM is merely an assetless shell, a conduit for transferring funds to the account of the Appellant’s shareholders, how can it legitimately charge a guarantee fee for anything? If CMM isn’t employing anybody, how can CMM charge a management fee; what services are they offering?

41. It is the Respondent’s position that it is severely prejudiced by the lack of the financial statements and financial records of CMM because the Crown and The Court is left guessing as to the existence of and true financial position of CMM. As stated by Judge Bowman in the Farm Business Consultants Inc. [ ] case: “the essential nature of a transaction cannot be altered for income tax purposes by calling it a different name. It is the true legal relationship, not the nomenclature, that governs.” [at page 203] Enquiries for records were made of an Isle of Man corporation that was incorporated in 1990 and that appears to be the successor of CMM. CMM doesn’t exist anymore. Mr. Oakley was told that CMM’s records were destroyed.

42. In the case of Crestbrook Forest Industries Ltd. v. R. (sub nom. Crestbrook Forest Industries v. Canada), [1992] 2 C.T.C. 81, 93 D.T.C. 5186 (F.C.A.), a Canadian company had dealings with offshore corporations to which it was very closely related. Questions were asked on Discovery, and the answers to those questions had to be provided by the offshore corporations as the Canadian company didn’t have the answers. The offshore corporations refused to answer the questions when the request was made by the Canadian company. The Federal Court approved of a passage from Monarch Marketing Systems Inc. v. Esselte Metro Ltd. which they quoted:

Today’s commercial reality, with international corporations, large and small, doing business through affiliates across much of the world and treating national boundaries as minor inconveniences to be coped with by international organisations, dictates that the corporate veil ought not to be permitted to inhibit the administration of justice in Canada. Examination for discovery is an important tool in the administration of justice on its civil side. I have no doubt that under proper sanctions by the court, Canadian companies can readily and economically obtain from their foreign affiliates answers to proper questions on discovery. I am convinced that they should be required to try and pay the consequences of their failure or their affiliates’ recalcitrance. International businesses ought not be permitted, either as an incident or object of their organisational set-ups, to avoid full compliance with the law of Canada in respect of the business they do here.

43. Under the laws of Canada, the Appellant is required to keep all books and records. As an extension of the principle cited in Crestbrook it is the Respondent’s position that if the Appellant is going to engage in international activity, it is the Appellant’s obligation to ensure that proper books and records are maintained. If those books and records have been destroyed then the Appellant must pay the price for the failure or the recalcitrance of their foreign affiliate’s failure to keep books and records.

44. The Crown is looking for very specific and elementary information. Things as basic as, and this is made apparent in the Reply to Notice of Appeal, did CMM exist, or was it just something someone assumed continued to exist. Was it a legal entity? Did it have any assets? Did it have any employees? Did it pay any salaries or wages? Without answers to these questions the Respondent is in an impossible position in this case. The Crown is clearly prejudiced without CMM’s financial records.

45. Consequently, the Respondent is asking that pursuant to Rule 146, this appeal be dismissed on the basis that these financial records have not been supplied. If the Court is not prepared to grant this remedy then the Respondent requests that any evidence that could be supplied or verified by these financial records not be admitted by an indirect means.

Counsel for the Appellant filed a letter as Tab 50 of Exhibit A-l which read as follows:

August 1, 1995

Ms Elke Juckes

General Manager

Halifax Grain Elevator Limited

937 Mitchell Street Halifax,

Nova Scotia 83H 3R5

Dear Mrs. Juckes

Re: Financial Statements - 1985/1990

We refer to a request we have received from Mr. John Oakley, asking for copies of our financial reports for the years 1985 to 1990 inclusive in support of the Halifax Grain Elevator Court Case.

Whilst we would like to provide every assistance, the business of CMM was moved in November 1990 and incorporated in the Isle of Man. As there was no legal requirement to retain the business records of its former jurisdiction, a formal decision was made to destroy those records not required under Isle of Man Company Law.

We are therefore very sorry to report that we are unable to comply with your request.

Yours sincerely

for and on behalf of

Curaçao Marine Management Limited

Martin J S Katz

Director

Mr. Oakley and Mr. Stevens further explained the rather casual approach to documentation by CMM, which in essence was a holding or investment company, the shares of which were closely held. I am satisfied that Mr. Oakley made an effort to get the documents but could not get them because they had been destroyed. I believe further that there was sufficient evidence given in the testimony and the exhibits to enable the Respondent and the Court to understand how CMM was established and functioned in relation to the matters under appeal. Consequently the motion is dismissed.

Analysis — Main Issues

With respect to the guarantee fees charged, I am satisfied on the basis of all of the evidence that the liability was a real one for CMM. The agreement signed in my opinion was not altered by the fact that three shareholders in essence guaranteed the guarantee of CMM. The exposure of CMM’s general assets was no doubt reduced by the existence of the back-up guarantees but I do not believe this alters the legal situation. The back up guarantors could, during the six year term of the Port lease, have fallen on hard times. This would not have altered the direct liability of CMM to the Port. Further, based on the expert evidence of Mr. Howatt, I am satisfied that the 7 per cent rate charged by CMM to the Appellant was reasonable. Counsel for Respondent argues that since CMM had little or no assets, it really was not at risk and the 7 per cent rate is unreasonable. In fact the back-up guarantees constituted a valuable asset of CMM, even if contingent. Moreover there is other evidence indicating CMM existed and had assets other than the back-up guarantees.

With respect to the management fees, I am satisfied that CMM through the services of its shareholders, apparent experts in their respective fields, saved the Halifax Port facility and made it profitable. It may be that some of the services might be considered as not for the Appellant’s benefit but rather as time put in by the persons rendering services in seeking out other investment opportunities for themselves or for other corporations or legal entities to be put in place if the investment materialized. Nonetheless considerable services were for the Appellant’s benefit and in my opinion, given the results, the fees charged were reasonable and deductible in all years except 1990 and 1991.

It is clear that after Mr. Sherover’s death in 1989 the services rendered reduced considerably and eventually disappeared. Based upon the testimony and the summaries of CMM’s services prepared by Allen Stevens and filed at Tabs 54 and 55 of Exhibit A-l, I find that since no services were rendered in 1991 the management fee for that year is not deductible and based upon the same sources showing reduced services in 1990, the management fee for 1990 is only deductible to the extent of $150,000. Resolutions of CMM adopted February 12, 1988 and February 20, 1989 refer to the waiver of the fee in 1985 and 1986 and contain a provision that CMM retains the option of applying a higher compensatory fee in future years where operations are secure. I do not believe this unilateral act is sufficient to oblige the Appellant to pay fees in years where no or only reduced services were provided.

With respect to the interest charges, they are deductible save for any that may relate to the disallowed management fees for 1990 and 1991.

Considering the decision I have arrived at there is no need to discuss whether the 1986 year was statute barred.

For all of the above reasons, the appeals, to the above extent, are allowed with costs and the matter is referred back to the Minister of National Revenue for reconsideration and reassessment.

Appeals allowed.