Bates v. The Queen

Date: 19980217

Docket: 96-559-IT-G

BETWEEN:

JAMES A. BATES,

Appellant,

and

HER MAJESTY THE QUEEN,

Respondent.

Reasons for Judgment

Hamlyn, J.T.C.C.

[1] This appeal is in respect to the Appellant's 1990 taxation year.

[2] In computing his income for the 1990 taxation year, the Appellant did not include in his income an amount of $70,000 pursuant to subsection 146(10) of the Income Tax Act (the "Act").

[3] The Minister of National Revenue (the "Minister") reassessed the Appellant for the 1990 taxation year by Notice of Reassessment dated July 22, 1994 by including, inter alia, the $70,000 in income.

PLEADED ADMITTED FACTS

[4] On or about February 27, 1989, Hockley Associates Inc. ("Hockley") is incorporated and its 100 common shares are issued to:

Ronald G. Collins 26 shares

David W. Wilson 26 shares

Martha E. Collins 24 shares

Nora E. Wilson 24 shares

[5] On or about September 1, 1989, Nora E. Wilson transfers all her shares to Martha E. Collins; David W. Wilson transfers 25 of his shares to Ronald G. Collins ("Mr. Collins") and transfers the remaining share to Martha E. Collins.

[6] On or about February 22, 1990, Hockley issues 11 common shares to Midland Capital, in trust (a Registered Retirement Savings Plan ("RRSP") for which Mr. Collins is the annuitant) for an amount of $93,000.

[7] On or about March 20, 1990, Hockley issues eight common shares to Midland Capital, in trust (a RRSP for which the Appellant is the annuitant) for an amount of $70,000.

[8] As of November 30, 1989 and November 30, 1990, the assets held by Hockley were the following:

Nov. 30, 1989 Nov. 30, 1990

Cash ($479,129) $4,487

Receivable Limited Partnership Nil $427,164

Reserve, doubtful accounts Nil ($427,164)

Advances to Limited Partnership $1,815,690 $142,804

Advances to Sportsbeat (Guelph) $46,666 Nil

Units in Limited Partnership Nil $58,148

Other $812 $812

Total assets $1,384,039 $206,251

SIGNIFICANT EVIDENCE AT TRIAL

[9] The limited partnership was formed for the purpose of developing, owning and operating under franchise Don Cherry's Grapevine Restaurants in Ontario and beyond. Hockley was the promoter and the general partner of the limited partnership.

[10] Mr. Collins was a director and officer of the general partner.

[11] The Appellant at the time of acquisition of the shares of Hockley valued the shares of Hockley on the projected gross revenue stream of the limited partnership. Hockley owned a right to a percentage of the gross revenue stream of the limited partnership.

[12] At the time of acquisition the Appellant was not an employee of Hockley but was an employee of the limited partnership. He provided operational management services for the limited partnership in the areas of finance and administrative controls.

[13] The Revenue Canada auditor concluded, well after the time the Appellant purchased the shares, that the value/share of the assets of Hockley did not equate to the price paid by the Appellant per share. He hypothesized the money advanced by the Appellant was a loan designed to earn passive income by propping up the limited partnership. No evidence was submitted that the Appellant's funds flowed to the limited partnership. As stated, the Appellant has indicated his valuation of shares of Hockley was based on the right of Hockley to receive a percentage of the gross revenue stream of the limited partnership.

ISSUE

[14] The issue to be decided is whether the eight common shares issued to Midland Capital, in trust (of which the Appellant is the annuitant) are a qualified investment.

THE MINISTER'S POSITION

[15] The eight common shares issued to Midland Capital, in trust (of which the Appellant is the annuitant) are not a qualified investment since:

(i) the Appellant was not, at the time of their issuance, dealing at arm's length with Hockley and Mr. Collins; and

(ii) the Appellant was at that time a designated shareholder of Hockley.

[16] The Minister, at trial, also argued the monies advanced by the RRSP were at best a loan to assist the partnership in its current obligations and designed to earn passive income.

THE APPELLANT'S POSITION

[17] It is the Appellant's position that Revenue Canada erred in determining that the shares of Hockley held by the Appellant's RRSP were not a qualified investment within the meaning of paragraph 146(1)(g) of the Act and the amount of the investment should not be included in the Appellant's income under paragraph 146(10)(a) of the Act.

[18] Regulation 5100 provides that a RRSP may acquire, as a qualified investment, shares of a small Canadian corporation not listed on a prescribed stock exchange under certain conditions. The following sets out the Appellant's understanding of the conditions that apply and the Appellant's position on each condition:

- The corporation must be an active business. Hockley, at the time the shares were acquired, was in the business of developing and managing restaurants and bars. The company was the general partner of the Sportsbeat Bars and Restaurants Limited Partnership and in this capacity was responsible for operating three Don Cherry's Restaurants in Southern Ontario. It was also developing franchise locations at Guelph, Edmonton and other locations outside the limited partnership. Over 90% of the company's assets were used in the business of developing franchise locations or in meeting its responsibilities as general partner.

- The shares held by the RRSP and the plan's annuitant must not exceed 10% of the company's capital stock. The eight shares of Hockley held by the RRSP represent 7% of the company's capital stock. The Appellant does not hold additional shares outside the RRSP.

- The annuitant must deal with the company at arm's length. This must be established based on the facts as the Appellant is not related by birth or marriage to any officer or director of Hockley or any other related corporation. The Appellant at the time of the acquisition of the shares, or at any time since, was not an employee or shareholder of Hockley. The fair market value of the shares was established by negotiations between the Appellant and the company's president and were based on the future cash flows from management fees from the Sportsbeat Bars & Restaurants Limited Partnership and other locations. The cash flows from the limited partnership are documented in the Offering Memorandum as reviewed by independent auditors Peat Marwick Thorne.

LEGISLATION

[19] Section 146 of the Act, dealing with RRSPs, reads in part as follows :

(1) In this section,

...

(g) "qualified investment" for a trust governed by a registered retirement savings plan means

(i) an investment that would be described in any of subparagraphs (i) to (ix) (except subparagraphs (iii) and (vi)) of paragraph 204(e) if the references therein to a trust were read as references to the trust governed by the registered retirement savings plan,

(ii) a bond, debenture, note or similar obligation of a corporation the shares of which are listed on a prescribed stock exchange in Canada,

(iii) an annuity described in paragraph (i.1) in respect of the annuitant under the plan, if purchased from a person licensed or otherwise authorized under the laws of Canada or a province to carry on in Canada an annuities business, and

(iv) such other investments as may be prescribed by regulations of the Governor in Council made on the recommendation of the Minister of Finance;

...

(10) Where at any time in a taxation year a trust governed by a registered retirement savings plan

(a) acquires a non-qualified investment, or

(b) uses or permits to be used any property of the trust as security for a loan,

the fair market value of

(d) the property used as security at the time it commenced to be so used,

as the case may be, shall be included in computing the income for the year of the taxpayer who is the annuitant under the plan at that time.

[20] Regulation 4900 of Part XLIX, dealing with deferred income plans qualified investments reads in part:

(6) For the purposes of subparagraphs 146(1)(g)(iv) and 146.3(1)(d)(iii) of the Act, except as provided in subsections (8) and (9), a property is a qualified investment for a trust governed by a registered retirement savings plan or a registered retirement income fund at any time if at that time the property is

(a) a share of the capital stock of an eligible corporation (within the meaning assigned by subsection 5100(1)), unless the annuitant under the plan or fund is a designated shareholder of the corporation;

(b) an interest of a limited partner in a small business investment limited partnership; or

[21] Regulation 4900(12) was added by P.C. 1994-1074, SOR/94-471, dated June 23, 1994, applicable after December 2, 1992.

[22] Regulation 4901, dealing with interpretation, reads in part as follows:

(2) In this Part,

...

"designated shareholder" of a corporation at any time means a taxpayer who at that time

(a) is or is related to

(i) a specified shareholder of the corporation, or

(ii) a person who would be a specified shareholder of the corporation if, in applying the definition "specified shareholder" in subsection 248(1) of the Act, a person who has 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 of the capital stock of a corporation were deemed to own those shares, and one of the main reasons for the existence of the right may reasonably be considered to be that the person not be regarded as a specified shareholder of the corporation,

unless the aggregate of amounts, each of which is the cost amount of any share of the capital stock of the corporation or any other corporation that is related thereto that the taxpayer owns or is deemed to own for the purposes of the definition "specified shareholder" is less than $25,000,

(b) is or is related to a member of a partnership that controls the corporation,

(d) is or is related to an employee of the corporation or a corporation related thereto, where any group of employees of the corporation or of the corporation related thereto, as the case may be, controls the corporation, except where the group of employees includes a person or a related group that controls the corporation, or

(e) does not deal at arm's length with the corporation.

[23] In subsection 248(1) of the Act, a specified shareholder is defined as:

"specified shareholder" of a corporation in a taxation year means a taxpayer who owns, directly or indirectly, at any time in the year, not less than 10% of the issued shares of any class of the capital stock of the corporation or of any other corporation that is related to the corporation and for the purposes of this definition,

(a) a taxpayer shall be deemed to own each share of the capital stock of a corporation owned at that time by a person with whom he does not deal at arm's length,

...

(d) an individual who performs services on behalf of a corporation that would be carrying on a personal services business (within the meaning of paragraph 125(7)(d)) if the individual or any person related to the individual were at that time a specified shareholder of the corporation shall be deemed to be a specified shareholder of the corporation at that time if he, or any person or partnership with whom he does not deal at arm's length, is, or by virtue of any arrangement, may become, entitled, directly or indirectly, to not less than 10% of the assets or the shares of any class of the capital stock of the corporation or any corporation related thereto.

[24] Section 251 of the Act reads in part:

(1) 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.

(2) For the purpose of this Act "related persons", or persons related to each other, are

(a) individuals connected by blood relationship, marriage or adoption;

(b) a corporation and

(i) a person who controls the corporation, if it is controlled by one person,

(ii) a person who is a member of a related group that controls the corporation, or

(iii) any person related to a person described in subparagraphs (i) or (ii).

...

[25] Part LI of the Regulations deals with deferred income plans investments in small business. Regulation 5100(1) reads in part:

"eligible corporation", at any time, means

(a) a particular corporation that is a taxable Canadian corporation all or substantially all of the property of which is at that time

(i) used in a qualifying active business carried on by the particular corporation or by a corporation controlled by it,

(ii) shares of the capital stock of one or more eligible corporations that are related to the particular corporation, or debt obligations issued by those eligible corporations, or

(iii) any combination of the properties described in subparagraphs (i) and (ii),

(a.1) a specified holding corporation, or

...

but does not include

...

"qualifying active business", at any time, means any business carried on primarily in Canada by a corporation, but does not include

(a) a business (other than a business of leasing property other than real property) the principal purpose of which is to derive income from property (including interest, dividends, rent and royalties), or

(b) a business of deriving gains from the disposition of property (other than property in the inventory of the business),

and, for the purposes of this definition, a business carried on primarily in Canada by a corporation, at any time, includes a business carried on by the corporation if, at that time,

(c) at least 50 per cent of the full time employees of the corporation and all corporations related thereto employed in respect of the business are employed in Canada, or

(d) at least 50 per cent of the salaries and wages paid to employees of the corporation and all corporations related thereto employed in respect of the business are reasonably attributable to services rendered in Canada.

[26] Subsection 89(1) of the Act reads in part as follows:

(b) "taxable Canadian corporation" means a corporation that, at the time the expression is relevant,

(i) was a Canadian corporation, and

(ii) was not, by virtue of a statutory provision, exempt from tax under this Part.

and

(a) "Canadian corporation" at any time means a corporation that was resident in Canada at that time and was

(i) incorporated in Canada, or

(ii) resident in Canada throughout the period commencing June 18, 1971 and ending at that time.

ANALYSIS

[27] The Appellant's investment in Hockley does not fall under subparagraphs (i), (ii) or (iii) in the definition of "qualified investment" contained in paragraph 146(1)(g) of the Act. However, subparagraph (iv) includes "such other investments as may be prescribed by regulations...".

[28] Regulation 4900(6) states that for the purposes of the definition of "qualified investment" in subparagraph 146(1)(g)(iv) a property is a qualified investment of a trust governed by a RRSP if the property is a share of a capital stock of an "eligible corporation" unless the annuitant is a "designated shareholder" of the corporation.

[29] An "eligible corporation" is defined in regulation 5100(1) as being a "taxable Canadian corporation" of which all or substantially all of the property is used in a "qualifying active business" carried on by the particular corporation or by a corporation controlled by it.

[30] Regulation 4901(2) defines a "designated shareholder" to be a taxpayer who is or is related to a "specified shareholder" of the corporation.

[31] Subsection 248(1) defines a "specified shareholder" as a taxpayer who owns, directly or indirectly, 10% or more of the issued shares of any class of the capital stock of the corporation. Subsection 248(1), specified shareholder subparagraph (a) states that a taxpayer shall be deemed to own each share owned by a person with whom the taxpayer does not deal with at "arm's length".

[32] Subsection 251(1) states that "related persons" shall be deemed to not deal with each other at "arm's length".

[33] Subsection 251(2) defines "related persons" as being individuals connected by blood relationship, marriage or adoption. It goes on to state that "related persons" includes a corporation and: (i) a person who controls the corporation, if it is controlled by one person; (ii) a person who is a member of a related group that controls the corporation; and (iii) any person related to a person described in subparagraphs (i) and (ii).

[34] Regulation 5100(1) defines a "qualifying active business" as being any business which does not derive its income from property.

[35] Subsection 89(1) defines a "taxable Canadian corporation" as being a corporation that is a Canadian corporation.

[36] Subsection 89(1) defines a "Canadian corporation" as being a corporation that is resident in Canada and was incorporated in Canada.

[37] The question that must be determined in this appeal is whether the Appellant was dealing at arm's length with Hockley and/or Mr. Collins when he purchased shares out of the corporation's treasury stock for holding in his RRSP. It is the definition of arm's length contained in paragraph 251(1)(b) of the Act which the Court must be concerned with for the purposes of this appeal. Therefore, in order to find that the Appellant's purchase of the corporation's shares were a valid RRSP investment the Court must determine, as a finding of fact, that the Appellant and the corporation and/or Mr. Collins were dealing with each other at arm's length.

[38] In Millward v. The Queen, 86 DTC 6538 (F.C.T.D.), Jerome A.C.J. found that the taxpayer entered into a reciprocal transaction that was made feasible due to their professional relationship and that the terms of the transaction bore no relation to the market forces present at that time. Jerome A.C.J. found that the entire transaction was governed by the common interest of the taxpayer.

[39] Based upon the reasoning of Jerome A.C.J. in Millward (supra), it is my opinion that to find a non-arm's length relationship between two parties that are not related under the Act, the Court must find that the parties acted in concert for a common purpose and that this common purpose overwhelmed the separate interest of at least one of the parties. In Millward (supra), the common purpose of setting up reciprocal low interest mortgages overwhelmed the taxpayers' individual interest of obtaining the highest possible return on their money within that particular risk category of investments.

[40] In the present appeal, the Appellant invested money in the corporation with the intention that the money invested be used to further the partnership's expansion plans which would lead to stronger financial performance by the corporation in the future. Therefore, there was a common purpose underlying the Appellant's investment in the corporation. However, the Appellant testified to the fact that he based his investment on the projected future cash flow of the corporation. He stated in Court that he studied the corporation's financial projections and determined the value of the shares himself and then negotiated the price with Mr. Collins who controlled Hockley (exhibit A-1). The Minister's view of the investment was that this was at best a loan to Hockley to earn passive income. Under certain circumstances these events may give rise to suspicion. The events here were rapid and the determination of the investment followed quickly after the investment, however, until the Appellant made this investment he had no personal stake in the company aside from his former employment and he felt the venture was going to be successful.

[41] In relation to Collins, the Appellant did work for the limited partnership and Mr. Collins was in control of the general partner. However, the action of acquiring the shares of Hockley at a negotiated rate and based on the projected percentage of gross revenue of the limited partnership, in the absence of any other evidence, does not appear to be beyond the market forces at play.

[42] The fact that Mr. Collins, through his RRSP, bought 11 shares of the corporation and that was found not to be a qualified investment was a result of his total share holdings and is a determination quite independent of this adjudication.

[43] I find it difficult to believe and the evidence does not show that the Appellant invested for any other reason than the fact he believed this to be a good investment. At the time of his investment, the Appellant may have been looking at the corporation's financial prospects without full appreciation of the rapid events that were leading to the downfall of the limited partnership venture. However, I do not believe this detracts from the purpose of the investment.

[44] I conclude that the Appellant was, at the time of the issuance of the shares, dealing with Hockley and Mr. Collins at arm's length and therefore was not related to Hockley or Mr. Collins within the meaning of the Act nor was the Appellant a designated shareholder of Hockley.

DECISION

[45] The appeal is allowed for the 1990 taxation year and the assessment is referred back to the Minister for reconsideration and reassessment on the basis that the eight common shares issued to Midland Capital in trust (of which the Appellant is the annuitant) is a qualified investment.

[46] The Appellant is entitled to his taxed costs.

Signed at Ottawa, Canada, this 17th day of February 1998.

"D. Hamlyn"

J.T.C.C.