C.R. Stewart Equipment Ltd. v. MNR, 77 DTC 176, [1977] CTC 2232 (T.R.B.)

Delmer E Taylor:—This is an appeal from reassessments by the Minister of National Revenue for the taxation years 1969, 1970, 1971 and 1974. Details were provided to the appellant by the respondent in a reassessment notice dated September 4, 1975, with respect to the year 1974, and by reassessment notices dated July 7, 1975 with respect to the years 1969, 1970 and 1971. It should be added that reassessment notices dated July 7, 1975 were also issued dealing with the years 1968, 1972 and 1973. Reference to these last three years was made by the appellant in the Notice of Appeal, and at the hearing ancillary information was provided by counsel for the appellant regarding separate income tax proceedings against the appellant by the Minister of National Revenue. The Board was left with the impression that such proceedings may have dealt with other matters in the reassessment notices for all the years from 1968 through 1974. The Notice of Appeal in this hearing, however, does relate five separate points:

(1) that the reassessment notices dated July 7, 1975 disclose no income tax payable but do disclose penalties under subsection 56(2) of the Income Tax Act for the years 1970 and 1971 in the amounts of $9,885.36 and $17,715.37 respectively;

(2) that the respondent added to the taxable income of the appellant amounts of $1,509.91, $10,227.12, $18,377.12, $12,485.17 and $9,120.10, totalling $51,719.42 for the years 1968, 1969, 1970, 1971 and 1972 respectively as “unexplained income of C R Stewart deemed from Company’’;

(3) that the respondent disallowed as expenses the amounts of $18,375 and $49,014.06 with respect to the appellant’s 1971 and 1972 income tax returns, such expense items described by the appellant as “crane rental expenses’’;

(4) that the respondent disallowed as an expense legal fees paid to R B Burns, Esq, QC in the amount of $1,351.67 for the year 1972;

(5) that the respondent disallowed amounts of $10,255 and $4,074 respectively as expenses relating to the operation of an aircraft for the years 1973 and 1974.

The Board has not traced through the mathematics involved in the reassessment notices for the years 1968 to 1974 but accepted the position as stated by counsel for the appellant and agreed to by counsel for the respondent that the matters at issue before the Board, for which determinations were requested, were essentially three, and that the calculations relating to the income tax reassessments of the appellant’s affairs would flow from such determinations. These matters were:

(A) whether the contracts relating to the possession and utilization of two heavy duty cranes by the appellant were lease agreements, or agreements of purchase and sale;

(B) whether the use and operation of the aircraft in question was a legitimate business charge, or a personal expense relating to an officer or officers of the appellant company; and

(C) whether the “unexplained income of C R Stewart” is a matter for which the appellant company should be held responsible with regard to any income tax liability, it being explained that C R Stewart was Charles Roy Stewart, president and chief shareholder of the company, at least for the period 1968 through 1972.

The appellant relies, inter alia, upon the provisions of paragraph 12(1)(a) of the Income Tax Act, RSC 1952, c 148 and amendments thereto and subsection 165(7), paragraphs 18(1)(a) and 20(1)(a) of the Income Tax Act, SC 1970-71-72, c 63 and amendments thereto. The respondent relies, inter alia, upon sections 3, 4, paragraphs 11 (1)(a), 12(1 )(a) and (b) of the Income Tax Act, RSC 1952, c 148 as amended, and sections 3, S, paragraphs 18(1)(a) and (b) and subsection 20(1) of the Income Tax Act, SC 1970-71-72, c 63 and amendments thereto.

The appellant (referred to as the Company) is a limited company, carrying on the crane rental business at 281 Riverside Drive, Welland, Ontario. Counsel for the appellant introduced, in agreement with counsel for the respondent, the various income tax reassessment notices from 1968 through 1974. These were identified as Exhibit A-1. He further introduced documentary and verbal evidence through three witnesses: Mr Wayne Alfred James Millar, former secretary-treasurer of the appellant company; Mr William James Detenbeck, a chartered accountant, auditor of the Company; and Mr R Boak Burns, QC, legal counsel for the appellant.

Mr Millar dealt with his involvement regarding the heavy lift cranes, stating that the agreements which he had signed on behalf of the Company were meant to be rental agreements with an option to purchase. He identified the two crane contracts in question and these were entered as Exhibits A-2 and A-3. Mr Millar further introduced Exhibit A-4, a bill of sale for a Beechcraft aircraft, and stated that his knowledge of and association with the aircraft in question was limited as he knew only that it was a Beechcraft, that it was kept at St Catharines Airport, that there was some rental income from its use by parties other than the appellant company, and that the then president of the Company, Mr C R Stewart, did not have a pilot’s licence. He contended the aircraft was acquired for business purposes and had been SO used as far as he knew. Under questioning he agreed that he had not been on the policy or decision-making level of the Company, and that his work and involvement had been largely administrative.

Mr Detenbeck accepted the responsibility for the accounting and income tax treatment originally accorded the payments made in connection with the cranes, pointing out that the cranes were not registered in the name of the appellant, and that as an accountant he could not have shown the cranes as assets of the Company since this might have distorted the financial presentation and might have left him liable to criticism and possibly legal action. With regard to the aircraft, Mr Detenbeck’s recollection was that he had been consulted with regard to its acquisition, had regarded it as a good business investment, but that he had very little personal knowledge of its operation and function. It had, however, been acquired at a time when the Company was expanding its operations far beyond the general Welland area.

Mr Burns recalled his knowledge and association with the aircraft, pointing out that it had been limited, although he too had probably been consulted regarding the purchase. His final involvement with it, however, had been related to an effort to sell or lease it to the St Catharines Flying Club. In this connection, he introduced Exhibit A-5, copies of letters between his office and the appellant, but there was no clear evidence as to whether this effort to sell or lease had ever been consummated.

It should be observed that none of the above witnesses dealt with the third matter at issue, except in the most peripheral way. That issue is the “unexplained income of C R Stewart deemed from Company”. Counsel for the respondent proposed that due to the particular circumstances surrounding this case, he could introduce evidence relating to that matter through a Mr John McKinnon Jarrell, an auditor with the Department of National Revenue attached to the Special Investigations Division. This was agreed to by counsel for the appellant, and it became evident to the Board at this juncture that the case was unusual in that most of the records, books, documents and information rested in the possession of the respondent, and that indeed the most important documentary evidence introduced by counsel for the appellant, Exhibits A-2 and A-3, had not been available from the normal office files of the appellant, but had been made available to him by counsel for the respondent.

Counsel for the respondent, through Mr Jarrell, introduced and identified the following exhibits:

Exhibit R-1—Charles Roy Stewart

Department’s Calculation of

Assets & Liabilities as at Dates Shown (the dates are December 31 of each year, from 1967 through 1972).

Exhibit R-2—Charles Roy Stewart

Summary of Additional Income

Identified as to Source

(indicates and totals the years

1968 through 1972).

Exhibit R-3—Charles Roy Stewart

Summary Schedule of Unreported Income as Calculated through Net Worths,

Cost of Living (indicates and totals

the years 1968 through 1972).

Exhibit R-4—Charles Roy Stewart

Summary of Cost of Living by Categories and Years (indicates the years 1968 through 1972).

In essence, Mr Jarrell’s verbal supportive evidence was that he had prepared these forms from the information available to the Department, from the files of the appellant and from files and records from which cross-referencing could be done. He pointed out that on Exhibit R-2, the items indicated by an asterisk (*) denoted the various individual amounts of additional income of Charles Roy Stewart for which the source was identified, either external or internal, to the appellant company. The great majority of these identified items related to the operation of the appellant company, and the following statement concerning this apparent diversion of funds appears on Exhibit R-2: “Items marked denote Items included also in charges against C R Stewart Equipment Limited—Convictions Secured—1968-1971 inclusive. Fiscal 1972 not proceeded with in Court. Items also in Corporation charges for that year are marked *-1.” The total identified amount on Exhibit R-2 is $177,447.33 and Mr Jarrell pointed out that if reference is then made to Exhibits R-1, R-2 and R-4, it can be observed that the increase in the net worth of Charles Roy Stewart from 1968 through 1972, which cannot be explained by reported income or by the apparent diversion of funds as shown on Exhibit R-2, amounts to $51,719.42. This is shown on Exhibit R-3 as applying to the years 1968, 1969, 1970 and 1971 in the amounts of $4,529.75, $21,621.84, $11,887.68 and $13,680.15 respectively. When proper allowance is made for the difference in the fiscal years between Charles Roy Stewart, personally, and the appellant company, these amounts are attributed to the Company as $1,509.91, $10,227.12, $18,377.12, $12,485.17 and $9,120.10 for the years 1968, 1969, 1970, 1971 and 1972 respectively.

Mr Jarrell explained that the statements (Exhibits R-1, R-2, R-3 and R-4) had been prepared to the best of his ability, but in large measure without the assistance and co-operation or even the presence of Charles Roy Stewart. Under cross-examination, he also agreed that there were certain items such as living costs, etc in the summaries and calculations relating to the exhibits which might be regarded as somewhat inaccurate or even in error, but he did not believe that these were significant when looked at in perspective.

Before specifically turning to an examination of the three matters at issue, it would be of value to review the nature of the evidence presented. Exhibit A-1 is simply a statement of the basis used in the reassessments. It is informative but passive as far as support for the appellant is concerned. Exhibits A-2 and A-3 are documents relating to two different sets of contracts, one concerning a crane bearing serial number 3766, the other crane bearing serial number 17666. The first page in each of Exhibits A-2 and A-3 is entitled “Equipment Rental Agreement”. Exhibits A-4 and A-5, together with the verbal evidence of the three witnesses, Mr Millar, Mr Detenbeck and Mr Burns, would indicate that there was indeed a Beechcraft aircraft which at one time belonged to the Company, and was intended and used at least to some limited degree for business purposes. Other than that, it is difficult to attach any significance to this part of the evidence. Exhibits R-1, R-2, R-3 and R-4 are analyses and summaries of certain information to be found in major part in the records of the appellant, but in some measure based on information external to the corporation from which certain conclusions or hypotheses have been reached or extrapolated.

The positions presented to the Board in argument, with reference to the evidence on the three matters at issue, are respectively:

From the appellant:

(A) That the crane rental contracts are legitimate lease agreements and events subsequent to the signing of these undertakings by the Company should not be taken to have altered this in any way, the more so when it is recognized that neither of the option to purchase clauses involved was for the nominal sum of $1.

(B) That the aircraft was purchased for business, used for business, and not flown personally by the company president.

(C) That no evidence has been presented to the effect that the “unexplained income’’ is that of Mr Stewart, or that specific income tax assessments dealing with these amounts have been issued against him. Further, no evidence has been presented to the effect that the appellant, which is a separate corporation, should be held liable for income tax on alleged income, for which there is no evidence of any involvement by the Company.

From the respondent:

(A) That since these lease agreements each contain a clause providing an option to purchase, at a calculable amount, they are contracts of sale.

(B) That the aircraft was purchased and used personally, and not in relation to the operation of the appellant’s business.

(C) That since a great part (about $170,000) of the increase in the net worth of C R Stewart between the years 1968 to 1972 was shown, through the diligent efforts of Mr Jarrell, to be funds diverted by C R Stewart from the appellant company to his own use, then the balance of $51,719.42, calculated as the still unaccounted for apparent increase in the net worth of C R Stewart, should be deemed to be income of the Company also diverted to the use of C R Stewart personally.

In reviewing the matters at issue, the Board takes particular note of the circumstances under which counsel for the appellant has been required to present the case. A quotation from his argument is indicative of these circumstances:

Now, I apologize for not having for submission to the Board, so that those lease documents can be readily read with some degree of ease, because the copies are particularly bad. I have not had access to the originals of these documents at any time and have relied upon my friend’s good graces in Supplying me with copies that have been extracted from the files taken by National Revenue.

I also lack the sales invoice for that first piece of equipment, unfortunately, and it simply is not in the possession or the control of the appellant. Under those circumstances I have been obliged to rely upon the memory of Mr Millar principally as to what transpired subsequent to the dates of entering into those lease agreements.

I do not raise this issue, Mr Chairman, as an excuse which is abundantly to be forgotten and overlooked or forgiven, but simply by way of explaining that it was not with a view to sloppily preparing an appeal, but that is the Situation.

The files of the appellant, the files of Mr Burns and the files of Mr Detenbeck ended up in the hands of the Department of National Revenue, Mr Chairman, and if we can’t get them or if they are missing, I submit is not a matter for which we can be held 100 per cent responsible.

Dealing specifically with the nature of the contractual arrangements for the possession and use of these cranes, the Board does not accept the position that the documents involved simply speak for themselves and that they are without question lease agreements. Neither the evidence of Mr Millar that they were thus intended, nor the evidence of Mr Detenbeck that the accounting treatment accorded them was the proper one, can be regarded as more than informative—certainly such evidence cannot be regarded as decisive. The fact that the purchase options were not for a nominal sum of $1 may be indicative, but it also is not conclusive. On the other hand, the respondent’s basic position that the fact the purchase option prices could be determined in advance from the original agreements automatically makes these agreements of sale rather than leases, is not satisfactory simply on its own merits. This contention does not deal with the basic question—what value would there be in an option to purchase for either party if reference to the price were not ascertainable from the contract?

The determination of this matter—lease or sale—rests on a more careful examination of the facts and evidence and the relevant guidelines and jurisprudence. We are aided in this task by two matters: (1) Department of National Revenue Interpretation Bulletin IT-17 dated July 5, 1971, dealing with “Lease-Option and Similar Agreements”; and (2) The Queen v Lagueux & Frères Inc, [1974] CTC 687; 74 DTC 6569, decided by Décary, J. Interpretation Bulletin IT-17 was replaced on July 14, 1975 by Interpretation Bulletin IT-233 dealing somewhat more explicitly with the same subject. However, IT-17 would have contained the appropriate guidelines for the filing of at least some of the appellant’s relevant income tax returns, and in the preparation of the reassessment notices dated July 7, 1975. From IT-17, the following quotes are taken:

As there is no special provision in the Income Tax Act dealing with such agreements, this determination must be made on the basis of general law and the provisions of the agreement itself.

Some of the factors that will be considered when determining whether the substance of a transaction is a lease or sale are listed below. If the answer to one or more of the factors in items 1 to 6 is in the affirmative, a sale may be indicated:

(1) Is the option to purchase exercisable within a period which is materially less than the useful life of the property with the rental payments in that period amounting to a substantial portion of the fair market value of the property at date of inception of the lease, or, in the same circumstances, has the lessee a right to renew the lease for the remaining approximate useful life of the property at a rental substantially less than fair market rental which makes the renewal of the lease almost a certainty?

(2) Does the lessee have the right during or at the expiration of the lease to acquire the property at a price which at the inception of the lease was substantially less than the probable fair market value of the property at the time or times of permitted acquisition by the lessee?

(3) Was the property acquired by the lessor to meet the special needs of the lessee and will it probably be usable for that purpose by the lessee only?

(4) Does the term of the lease correspond substantially to the estimated useful life of the property with the lessee obligated to pay costs such as taxes, insurance, and maintenance which are usually considered incidental to ownership?

(5) Has the lessee guaranteed the obligations of the lessor with respect to the property leased?

(6) Is some portion of the periodic rental payment specifically designated as interest or readily recognizable as the equivalent of interest?

From the decision in Lagueux & Frères Inc (supra) the following is quoted from page 687 [6570]:

Accordingly, the question before the Court is as to the nature of the contracts in dispute.

In my opinion, such a question cannot be answered without analysing each of the contracts and arriving at a conclusion based on the civil law.

Recognizing that IT-17 can only be regarded as a guideline but using the six factors listed in it for that purpose, a review of the evidence and exhibits, particularly Exhibits A-2 and A-3, as required under the Lagueux & Frères judgment, shows the following:

Factor (1)

No evidence was adduced by either party regarding the useful life of the cranes.

Factor (2)

Again no evidence was brought forward regarding the probable fair market value of the cranes at the date the option to purchase could be exercised.

Factor (3)

There is no indication the cranes were specialized equipment, useful only to the appellant.

Factor (4)

As in (1) above, there was no evidence brought forward regarding the useful life of the cranes, but the original term of the lease in each case was for six months.

Factor (5)

Apparently the lessor did not guarantee any obligations.

Factor (6)

An amount in each case is readily recognizable as interest, in the event of the option being exercised.

Therefore, from this preliminary analysis, the only factor on which “a sale may be indicated” would be number 6, relating to an interest charge. The Board is not prepared, however, to accept that merely the inclusion of a clause providing a basis for such a calculation, in the event an option is exercised, should transform a document into an agreement of sale if, in all other material aspects, the document takes the form of a lease. If, however, some of the conditions indicated in the other factors listed above appear to also be fulfilled, such a basis for calculation of interest would be an important indicator. In the Board’s opinion the most important common element is that relating to useful life (factor (1)), probable fair market value (factor (2)), and again useful life (factor (4)). In essence, these deal with the same question—is the amount at which the property.is being offered for sale, “a price that reasonably approximates what is likely to be its depreciated value at the time or times, when the option is exercisable” (quoted from IT-17).

Lacking definitive information regarding useful life of the cranes, the Board has turned to the depreciation schedules and the reassessment notices of the appellant company. It appears to the Board that the acceptance by the Department of National Revenue that these assets (the cranes) belonged in Class 10 for purposes of capital cost allowance indicates rather definitely a useful life of about five years, whether the Straight line rate of 20% per year, or the diminishing balance rate of 30% per year, is used for calculation. Under the recognized rate for income tax purposes for such Class 10 assets, during the first year an amount of 30% of initial cost would be allowed as capital cost allowance. For crane 3376 this would be $11,607 for six months, and for crane 17666, $10,355 for six months. There was no evidence brought forward by either party which would raise any doubt about the original values placed on the cranes in the agreements (crane 3376—$77,385, and crane 17666—$69,033.50), being appropriate and adequate. If the Cranes were to be purchased, the net depreciated capital cost at the purchase option date in each case would be: crane 3376—$65,778 and crane 17666—$58,678. According to the terms of the agreements, the purchase prices for the two cranes respectively at the six-month option dates, would be: crane 3376—$67,028, including an interest charge; and for crane 17666—$62,330, also including an interest charge. It does not appear to the Board that any reasonable calculation of “probable fair market value”, based on such Department of National Revenue depreciation schedules would show the option purchase price for either crane to be so low that it could not possibly be turned down by the appellant, and that, therefore, at the date of signing the lease agreements, purchase of the cranes would be a foregone conclusion. The option purchase prices in both these cases would be in excess of net depreciated capital cost at the expiration of the six-month period involved. It is the opinion of the Board that the payments made by the appellant under equipment rental agreements for crane 3376 and crane 17666 were of sufficient, but not exorbitant, magnitude and that the calculable amounts related to the possible exercise of purchase options in each case bore a satisfactory reiationship to probable fair market value at the expiration of the lease periods. There is no basis from this viewpoint to consider the contracts as agreements of sale rather than lease agreements which they purport to be. Neither does the Board regard the renegotiation of the leases nor the eventual purchases by the appellant as affecting this basic situation in any way. The Board places primary importance on the original lease agreements, the conditions contained therein and the matters which can be determined therefrom.

With regard to the second matter in dispute—the cost of operation of the aircraft—the Board accepts without great difficulty the only evidence available to it. The three witnesses, Mr Millar, Mr Detenbeck and Mr Burns, indicated that the aircraft was intended to be for business purposes and to their knowledge was used for business. There was no evidence brought forward that would support any other conclusion. That the acquisition of the aircraft may have been less than wise, or that it was not used as extensively as originally intended, are possibilities, but to deduce from either of these possible situations that its acquisition by the Company was for the personal use of the president rather than for company purposes does not appear to be appropriate. The Board is unable to see any significance whatsoever in the contemplated sale or lease of the aircraft to the St Catharines Flying Club.

Regarding the question of the “unexplained income of C R Stewart deemed from Company’’, the following comments appear to be in order. The Board does not doubt the efforts expended by Department of National Revenue officials to arrive at more definitive answers regarding this matter, and indeed the Board can imagine the frustrations which may have accompanied such efforts without the co-operation or availability of the taxpayer, Charles Roy Stewart. Nevertheless, the fact remains that the $51,719.42 at issue is only alleged income, and at that only alleged income of Charles Roy Stewart personally. It is acknowledged that Charles Roy Stewart was during the period 1968 to 1972 the controlling shareholder in the Company, but if there is to be any reasonable distinction made between Charles Roy Stewart as president of C R Stewart Equipment Limited, and the corporate entity C R Stewart Equipment Limited itself, such a distinction must certainly be made at the point where the alleged shortcomings of Charles Roy Stewart personally might be visited upon the corporation, without direct connection. There is no evidence that any of the funds or assets which make up the calculations of the $51,719.42 in the alleged increase in the net worth of Charles Roy Stewart were the result of, or involved with transactions conducted by or through the accounts of the appellant company. The Board finds no basis in any income tax legislation or jurisprudence for the reassessment which has created this part of the appeal. Further, from cross-examination by counsel for the appellant, it is evident to the Board that there are at least certain parts of the summary exhibits presented by the respondent’s witness, Mr Jarrell, about which even he, Mr Jarrell, has some understandable reservations. This leads the Board to believe that these points and perhaps others could be challenged by C R Stewart personally, and that challenge must precede any attempt to involve the corporation. In reviewing this part of the appeal the Board is reminded of a portion of the judgment given by the then Assistant Chairman of the Tax Appeal Board, Mr R S W Fordham, QC, in Stanley Albert Miles v MNR, [1970] Tax ABC 151; 70 DIC 1111, where he says at page 156 [1114], and I quote:

This branch of the matter leads me to repeat an observation made in several earlier appeals. It is that—in my view, at least—it is not sufficient to send to a taxpayer a mass of figures, with little more, and invite or leave him to extricate himself, if he can, from their intended effect. The assessing party should stand prepared to substantiate his figures when, as occurred here, any doubt is cast upon them, particularly when these rest largely on assumptions made. The Board should not be expected to accept figures at their face value in such circumstances. Moreover, the appellant was not only furnished with meagre particulars of the amounts charged to him, but also had no means of ascertaining at the hearing the origin of the respondent’s figures. Hence, the appellant was placed in a well-nigh hopeless position at the outset.

With respect therefore to the three matters brought before this Board for determination by C R Stewart Equipment Limited, namely:

(1) the appeal against the treatment by the Minister of National Revenue of certain contracts entered into by the appellant as agreements of sale rather than as lease agreements;

(2) the appeal against the disallowance by the Minister of the operating cost of an aircraft; and

(3) the appeal against the inclusion by the Minister as income of the appellant of certain amounts described as “unexplained income of C R Stewart”,

the Board finds that all parts of this appeal should be allowed and the matters referred back to the Minister for reconsideration and reassessment.

Appeal allowed.