Deductibility of amounts paid to one affiliated company on behalf of another affiliated company so as to earn dividend income from the second company
Motech Moldings Inc v The Queen, 2012 TCC 351
At issue was whether certain payments made as sponsorship fees and race car maintenance and repair expenses from the Appellant to on behalf of one affiliated company but paid to another affiliated company was deductible or not as property expense, being aimed at the dividend stream from the second company.
The TCC held that the link between the payment and the source of income (the dividends) in this case was too remote, as the payments related to the business source of income of the second affiliated company. This was a finding of fact, made on the basis that the link between the payment on behalf of the first company on behalf of the second company and the potential for dividend income from the second company was too tenuous.
FACTS
The appeal proceeded via an agreed statement of fact. The Appellant is a management and investment corporation, whose sole shareholder was Mucha. The Appellant didn’t provide services to anyone else, and its only source of income was rental income, dividends, and interest income.
Orion Racing was wholly owned by the Appellant, and Mucha was the sole director and administrator. Its main business was car racing. Mucha designs, builds and drives the race cars.
Tesla Packaging was wholly owned by the Appellant, and Mucha was the sole director and administrator. Tesla was a management corporation, and has never paid dividends.
On July 8, 2004, Tesla acquired 55% of the issued shares of Phoenix from M Frostier (who was with Mucha directors and administrators) (phoenix’s founder). Phoenix was in the business of manufacturing and marketing stretch wrap packaging equipment in the US and Canada. Phoenix has never paid dividends to Tesla.
Motech paid to Orion sponsorship fees for the racing team, and for race maintenance and expenses. These amounts were used by Orion as running and operating expenses. Phoenix’s name and logo appeared on the race cars of Orion. Phoenix was Orion’s main sponsor, and Motech’s only paid for Phoenix’s sponsorship. The fees were paid irrespective of the standing of the race team in any given race. The decision to sponsor was taken by Mucha. Other sponsors also existed, but they paid with products on based on performance while having name displayed, but the amounts were not significant.
ARGUMENTS
The Appellant argued that the amounts are deductible as they were paid for purposes of increasing the value of the two affiliated companies in order to earn dividend income or to improve the dividend income stream of the affiliated corporations.
The Crown argued that the fees were related to the business income stream of the affiliated companies, and the purpose of paying them was to improve the profitability of the company, such that the relationship between the payment to the one company in expectation of dividends for the other company was too remote.
The TCC reviewed the previous business structure of Motech (owned 100% of racing company and other firm), with the current structure and said that there is a significant differences. The first is that the corporate structure being that Motech didn’t own any shares in Phoenix, and Tesla only owned 55% of the shares of Phoenix. The other is that Motech paid the sponsorship fees to Orion for phoenix’s sponsorship (previously the sponsorships were paid by the sponsoring company). This latter pattern was taken both to protect the money from Phoenix’s creditors and to hide the payment from the other shareholder.
The companies were affiliated companies within the meaning of 251.1 of the ITA. Also, Symes v. Canada, [1993] 4 S.C.R. 695, was cited by Motech in support of the basis that an income receipt is not needed for an expense to be deductible, thus that no dividends have been paid to Motech by Phoneix via Tesla was irrelevant. Motech relied on HMQ v. Byram, 1999 D.T.C. 5117 (FCA), that with a sufficient connection between a payment and potential dividend stream, payments are deductible, citing:
22 The shareholders of a company are directly linked to that corporation’s future earnings and its payment of dividends. Where a shareholder provides a guarantee or an interest free loan to that company in order to provide capital to that company, a clear nexus exists between the taxpayer and the potential future income. Where a loan is made for the purpose of earning income through the payment of dividends, this connection is sufficient to satisfy the purpose requirement of subparagraph 40(2)(g)(ii).
Motech argued that the reasoning is the same for 18(1)(a) as for 40(2)(g)(ii), and that here Motech was affiliated with the downstream corporation, had direct control of them, and was linked to the future earnings and income of them. Motech felt that its situation was governed by Potash Corporation of Saskatchewan v. Her Majesty the Queen, 2011 TCC 213, that expenses incurred by a parent corporation to improve the return of downward corporations was a deductible business expense, quoting:
108 From a pragmatic business point of view the subject expenses did satisfy a cashflow need integral to the conduct of PCS’s business. Practically speaking tax planning costs are incurred in the ordinary course of business and expenses so incurred should not so readily be divorced from its income earning activities. Once the expenditure is divorced from the specific investment that gave rise to the income, in this case the shares in the Luxemburg entity, it must attach to the business that benefited from it. PCS’s business was enhanced by being part of a global market in fertilizers. While mining and marketing potash is its business, potash does not exist in a vacuum. It is a component of fertilizer—its value and marketability as a nutrient is interdependent with phosphate and nitrogen. Investing in other entities with a view to being a leading player in this aspect of its own business cannot be divorced from its own income earning activity. While that may not make the direct investment in shares a business expense, expenditures incurred to improve the efficiency of the investment to enable better exploitation of its own business by increasing its debt service capability and increasing its funding of Canadian operations are expenditures incurred for the purpose of earning income from its business. That the expenditure was capital in nature by virtue of paragraph 18(1)(b) does not change that finding.
The Crown argued that Motech was trying to deduct expenses that relate to the business of another corporation (ie another taxpayer) – ie applying against Motech’s source of income from dividends from Tesla, Phoenix’s sponsorship fees. They relied on Stewart v. Canada, 2002 SCC 46, that deductibility of an expense required looking at the relationship of it with the source of income to which it relates. The question here is whether the sponsorship fees were paid to earn income from property or to enhance the income stream of Phoenix. They argued that the relationship between the payment and the dividend from Phoenix through Tesla was too remote and tenuous. The agreed statement of fact and testimony was that the payments were made to attract business to Phoenix.
The Crown relied on the decision in Lyncorp Intermational Ltd. v. R., 2011 FCA 352,
73 The dilemma before me is which relationship triggers a possible deductible expense: the relationship between the expense, being the disputed flight costs, and the business income of the particular business ventures, or the relationship between the expense and the property income (dividends) of the parent company incurring the expense? I attempted to address the dilemma in argument by asking the parties about a direct or indirect relationship. They did not appear enthusiastic to take the bait. Yet, that is where, I believe, the resolution lies. To which source of income does the expense purportedly relate? The fact the Appellant incurred the expense has little impact on the answer to that question. The Appellant argues the expense relates to the property source of income. Indirectly, perhaps. But clearly, the remaining disputed flight expenses relate directly to the business income of the business ventures. The expenses were incurred to make the business ventures profitable. Yes, that might yield at some future point dividend income, but the direct cause and effect link is between the expenses and the business income of the business ventures,
75 The Appellant was, in effect, giving its business ventures several hundred thousand dollars, neither by way of debt or equity but simply by providing free services toward the operation of the business ventures’ businesses, with the hope that this generosity would help them get on their feet and maybe some day, in some manner, repay them. This generosity was neither a loan nor an equity investment by the Appellant. It might best be described as an agreement to pay someone else’s expenses. Equity investments yield dividend income. Debt investments yield interest income. Free services, with no obligation to repay, yield only hope. This is not a deductible expense.
ANALYSIS
The TCC stated that the test for deductibility on an expense was set out by the SCC in Stewart at paragraph 57:
57. It is clear from these provisions that the deductibility of expenses presupposes the existence of a source of income, and thus should not be confused with the preliminary source inquiry. If the deductibility of a particular expense is in question, then it is not the existence of a source of income which ought to be questioned, but the relationship between that expense and the source to which it is purported to relate. The fact that an expense is found to be a personal or living expense does not affect the characterization of the source of income to which the taxpayer attempts to allocate the expense, it simply means that the expense cannot be attributed to the source of income in question. As well, if, in the circumstances, the expense is unreasonable in relation to the source of income, then s. 67 of the Act provides a mechanism to reduce or eliminate the amount of the expense. Again, however, excessive or unreasonable expenses have no bearing on the characterization of a particular activity as a source of income.
[Underlining added.]
The issue then was to what source of income the payment related – the dividends potentially received through subsidiaries or the business of Phoenix? This is a purpose question, and as said in Symes:
74. As in other areas of law where purpose or intention behind actions is to be ascertained, it must not be supposed that in responding to this question, courts will be guided only by a taxpayer’s statements, ex post facto or otherwise, as to the subjective purpose of a particular expenditure. Courts will, instead, look for objective manifestations of purpose, and purpose is ultimately a question of fact to be decided with due regard for all of the circumstances.
The TCC was alive that there was no need that an expense lead to the direct production of income for it to be deductible.
The TCC found as fact that the payment of Motech for Phoenix’s sponsorship fees was to benefit the income stream of Phoenix. There was a lack of a sufficiently close connection between the sponsorship paid and the potential dividend income. The relationship between the expense and the source it is purported to relate must be examined.