Case Comment Volume 55:1

From Sham to Reality: Should a Wrong Be Taxed as a Right?

Table of Contents

McGill Law Journal ~ Revue de droit de McGill

FROM SHAM TO REALITY:

SHOULD A WRONG BE TAXED AS A RIGHT?

CASE COMMENT

Chris Sprysak*

How should a sham be treated for tax
purposes? In 1524994 Ontario Ltd. v. M.N.R.,
the Federal Court of Appeal treated a sham as
if it reflected the true agreement between the
parties in order to uphold a GST assessment.
The result was inconsistent with existing juris-
prudence and undesirable. Courts should apply
the law to the true facts only, and should not
overlook or give effect to a sham in order to
achieve the desired juridical consequences.

The author reviews the origins and devel-
opment of the sham doctrine and introduces a
three-part typology of sham cases. In situations
like 1524994 Ontario Ltd. v. M.N.R., the sham
is intended to obtain non-tax benefits from a
third-party victim, but in the process triggers
unintended tax consequences, which are the
subject of litigation. Although the traditional
approach in Continental Bank Leasing Corp. v.
M.N.R. (under which recharacterization is per-
missible only if the label attached to a transac-
tion does not reflect its actual legal effect) could
result in non-payment of taxes and retention of
improperly obtained benefits, the author con-
cludes that this result would be preferable to
that of the Federal Court of Appeal judgment.
Treating a sham as real, and taxing a wrong as
a right (1) will not deter parties from creating
shams to obtain non-tax benefits, (2) will violate
longstanding principles that tax law be applied
with neutrality and equity and without consid-
ering its effects, and (3) will increase uncer-
tainty and inconsistency in the case law.

Comment une opration fictive devrait-elle
tre traite aux fins de limpt ? Dans 1524994
Ontario Ltd. c. M.R.N., la Cour dappel fdrale
a trait une opration fictive comme refltant le
vrai accord entre les parties de manire leur
imposer une cotisation la TPS. Le rsultat
ntait pas conforme la jurisprudence actuelle
et tait
indsirable. Les cours devraient
appliquer le droit aux faits rels et ne devraient
pas ignorer ou prendre en considration une
opration fictive afin dimposer les consquences
juridiques dsires.

Lauteur passe en revue les origines et le
dveloppement de la doctrine sur les oprations
fictives et introduit une typologie en trois parties
des affaires traitant de lopration fictive. Dans
des cas comme 1524994 Ontario Ltd. c. M.R.N.,
lopration fictive visait obtenir un avantage
non fiscal dune tierce partie victime, mais
lopration fictive attira des litiges fiscaux non
dsirs.
dans
Continental Bank Leasing Corp. c. M.R.N., selon
laquelle la redfinition est permise uniquement
lorsque le nom attach la transaction ne reflte
pas ses effets juridiques rels, pourrait rsulter
en le non-paiement dimpts et en la rtention de
profits obtenus
indment. Lauteur conclut
nanmoins que ce rsultat serait prfrable
celui du jugement de la Cour dappel fdrale. Le
fait de traiter lopration fictive comme tant relle
et de percevoir des impts comme si la transaction
tait lgitime (1) ne dissuadera pas les parties
sengager dans des oprations
fictives afin
dobtenir des avantages non fiscaux, (2) violera les
principes bien tablis voulant que le droit fiscal
sapplique de faon neutre, quitable et sans gard
ses effets, et (3) crera plus dincertitude et
dincohrence dans la jurisprudence.

traditionnelle

Lapproche

* C.A., LL.M. Assistant Professor, Faculty of Law, University of Alberta.

Citation: (2010) 55 McGill L.J. 123 ~ Rfrence : (2010) 55 R.D. McGill 123

Chris Sprysak 2010

125

126
126

128
131

136
136
138
140

142

144

144

146

146
147
148

124 (2010) 55 MCGILL LAW JOURNAL ~ REVUE DE DROIT DE MCGILL

Introduction

I.

II.

III.

The Sham Doctrine in Canada
A. The Origins and Use of the Sham Doctrine
B. The Proper Application of the Sham Doctrine: The

Continental Bank Approach

C. The Classification of Sham Cases

1524994 Ontario Ltd. v. M.N.R.
A. The Facts
B. The Tax Court of Canadas Findings and Decision
C. The Federal Court of Appeals Approach and Decision

The Problems with Taxing a Sham
A. The Federal Court of Appeals Approach Will Not
Discourage Parties from Creating Shams to Obtain
Non-Tax Benefits

B. The Federal Court of Appeals Approach Constitutes

a Biased, Results-Driven Application of Tax Law

C. The Federal Court of Appeals Approach Will Create
Additional Uncertainty and Inconsistency in the Law
1. Inconsistency in What Behaviour Merits the Application

of the Federal Court of Appeals Alternate Approach

2. Inconsistency in the Legal Effect of a Sham

Conclusion: A Wrong Should Not Be Taxed as a Right

COMMENT: 1524994 ONTARIO LTD. V. M.N.R. 125

Introduction
How should the Canada Revenue Agency (CRA) and the courts prop-
erly treat a sham1 for tax purposes? Should they treat it as though it re-
flects the actual transaction or relationship between the parties, or should
they first acknowledge it as a sham and then ignore it in favour of the
true facts, once ascertained? Should the proper approach be influenced by
whether the sham was intended to obtain a tax or a non-tax benefit?2 Fi-
nally, how does the proper approach in tax cases correspond to the courts
general treatment of shams where there are no tax implications or at
least none being litigated?

In the recent case of 1524994 Ontario Ltd. v. M.N.R.,3 the Federal
Court of Appeal had the opportunity to address these questions in decid-
ing the appropriate goods and services tax4 (GST) result in respect of a
fraudulent agreement designed to obtain funds from the Ontario Health
Insurance Plan5 (OHIP). In my respectful opinion, the Federal Court of
Appeals decision to tax the sham as opposed to the real underlying situa-
tion, while understandable in the circumstances, was both undesirable
and inconsistent with existing jurisprudence. Simply put, given the Tax
Court of Canadas factual findings, the wrong should not have been taxed
as a right.

This paper has two purposes. The primary purpose is to argue that re-
gardless of the outcome, courts should apply the law only to the true facts
in a case. That is, a court should not overlook the possibility of a sham or,
even worse, give it legal effect in order to achieve a result that it feels is
appropriate in the circumstances, as the Federal Court of Appeal did in
1524994 Ontario Ltd. The second purpose is to use this decision as a
warning to parties and their professional advisors of the dangers of inac-
curately documenting their transactions and relationships. Specifically, a

1 The definition of a sham in Canadian law is provided in Part I, below.
2 For the purposes of this paper, I am using the definition of a tax benefit contained in
the Income Tax Act (R.S.C. 1985 (5th Supp.), c. 1): a reduction, avoidance, or deferral of
tax or other amount payable under this Act or an increase in a refund of tax or other
amount under this Act (s. 245(1)).

3 2007 FCA 74, 278 D.L.R. (4th) 690, [2007] G.S.T.C. 19 [1524994 Ontario Ltd.], revg

2006 TCC 87, [2006] G.S.T.C. 20, [2006] G.T.C. 200 [1524994 Ontario Ltd. (T.C.C.)].

4 Excise Tax Act, R.S.C. 1985, c. E-15, Pt. IX.
5 OHIP is administered by the Ontario Ministry of Health and Long-Term Care and pro-
vides health insurance for medically necessary services to Ontario residents. For fur-
ther information, see Ministry of Health and Long-Term Care, Public Information:
OHIP, online: Ontario Ministry of Health and Long-Term Care .

126 (2010) 55 MCGILL LAW JOURNAL ~ REVUE DE DROIT DE MCGILL

court may hold parties and apply the relevant law to what they have
documented the facts to be, rather than to what the facts actually are.

I. The Sham Doctrine in Canada

A. The Origins and Use of the Sham Doctrine

At least since the Supreme Court of Canadas decision in M.N.R. v.
Cameron,6 Canadian courts have relied on Lord Diplocks definition of a
sham in his decision in Snook v. London and West Riding Investments Ltd.:

[I]t means acts done or documents executed by the parties to the
sham which are intended by them to give to third parties or to the
court the appearance of creating between the parties legal rights and
obligations different from the actual legal rights and obligations (if
any) which the parties intend to create. … [F]or acts or documents to
be a sham, with whatever legal consequences follow from this, all
the parties thereto must have a common intention that the acts or
documents are not to create the legal rights and obligations which
they give the appearance of creating.7

Three important points can be derived from this definition. First, a sham
is intentional. The parties to the sham must jointly intend to create the
appearance of legal rights or a relationship that differs from the actual
rights or relationship.8 Second, the essence of a sham is the attempted de-
ception of a third party.9 While this deception is typically designed to ob-
tain a benefit that would not otherwise be available to the parties, shams

6 (1972), [1974] S.C.R. 1062, 28 D.L.R. (3d) 477 [Cameron]. Even before the Supreme
Court of Canada in Cameron (ibid. at 1068) adopted Lord Diplocks definition of a sham,
Canadian courts were already using it in cases. See e.g. Susan Hosiery Ltd. v. M.N.R.,
[1969] 2 Ex. C.R. 408, [1969] C.T.C. 533 [Susan Hosiery].

7 Snook v. London and West Riding Investments Ltd., [1967] 2 W.L.R. 1020 at 1030,

[1967] 1 All E.R. 518 (C.A.) [emphasis added, Snook].

8 In cases where one party alone is involved in the faade, courts have typically labelled
this as a misrepresentation as opposed to a sham. See e.g. Canada (A.G.) v. N & H Log-
ging Ltd. (1993), 43 M.V.R. (2d) 208 at para. 71, 38 A.C.W.S. (3d) 508 (B.C.S.C.), affd
[1994] B.C.W.L.D. 2948, (sub nom. Needham v. Hadikin) 52 B.C.A.C. 73.

9 In the United States, a sham has been held to exist where there has been no intention
to deceive but only an intention to obtain a tax benefit and otherwise no commercial or
economic purpose. See e.g. Brian A. Felesky & Sandra E. Jack, Is There Substance to
Substance Over Form in Canada? in Report of Proceedings of Forty-Fourth Tax Con-
ference, 1992 Tax Conference (Toronto: Canadian Tax Foundation, 1993) 50:1 at 50:17.
See also Pierre Barasalou, Review of Judicial Anti-Avoidance Doctrines in Selected
Foreign Jurisdictions and Supreme Court of Canada Decisions on Tax Avoidance and
Statutory Interpretation in Report of Proceedings of Forty-Seventh Tax Conference,
1995 Tax Conference (Toronto: Canadian Tax Foundation, 1996) 11:1 at 11:16-18.

COMMENT: 1524994 ONTARIO LTD. V. M.N.R. 127

have also been used to avoid a detriment that would otherwise result.10
Third, while many cases that have applied the sham doctrine have been
tax cases, the sham doctrine is not tax-specific.11 Indeed, Snook was a non-
tax case that concerned whether the seizure of a financed vehicle was ap-
propriate in the circumstances. In Canada, the sham doctrine has been
applied in practically all areas of the law including: corporate law,12 pen-
sion plans,13 receivership and bankruptcy law,14 health law,15 constitu-

10 The most common example of this latter scenario is where a person creates the appear-
ance of having no assets in order to prevent these assets from being seized by a creditor
in satisfaction of an outstanding debt. This avoidance of a detriment could also be
framed as a benefitnamely, the preservation of assets.

11 The general application of the sham doctrine was acknowledged by Roger Taylor in his
summary of the Supreme Court of Canadas decisions in several cases in the 1990s. As
shams, these agreements or instruments are ineffective for all legal purposes including
tax purposes: Roger Taylor, The Supreme Court of Canada: Principles of Adjudication
of Tax-Avoidance Appeals from Stubart to Shell Canada in Report of Proceedings of
Fifty-First Tax Conference, 1999 Tax Conference (Toronto: Canadian Tax Foundation,
2000) 17:1 at 17:6.

12 See e.g. Trident Foreshore Lands Ltd. v. Brown, 2004 BCSC 1365, 50 B.L.R. (3d) 141,
134 A.C.W.S. (3d) 371 (whether a transfer of voting shares of a non-profit corporation
that affected the election of the Board of Directors constituted a sham); Alberta Gas
Ethylene v. Canada (1988), 89 D.T.C. 5058, 24 F.T.R. 309 (F.C.T.D.), affd (1990), 112
N.R. 399, 90 D.T.C. 6419 (F.C.A.) (whether a Canadian parent corporation had to with-
hold Canadian taxes on interest paid to a U.S. subsidiary, which was incorporated only
for the purpose of obtaining U.S. financing, or whether the U.S. subsidiary was a sham,
in which case no withholdings would be required).

13 See e.g. New Brunswick (Human Rights Commission) v. Potash Corp. of Saskatchewan,
2008 SCC 45, [2008] 2 S.C.R. 604, 295 D.L.R. (4th) 1 (whether a pension plan and its
mandatory retirement terms were bona fide or a sham designed to circumvent the Hu-
man Rights Act prohibition against age discrimination); Loeb v. Canada, [1978] 2 F.C.
737, [1978] C.T.C. (N.S.) 56 (F.C.T.D.) (whether an agreement signed between a teacher
and her federation constituted a sham that allowed her to continue participating in her
pension plan while on strike).

14 See e.g. F.W.C. The Land Co. (Receiver of) v. Bohun (1997), 87 B.C.A.C. 107, 29 B.C.L.R.
(3d) 179 (whether an illegal agreement between a real estate salesperson and a licensed
real estate agent also constituted a sham and hence precluded the salesperson from
making a claim for commissions that were held by the agent, now bankrupt, based on a
trust relationship); Re G.M.D. Vending Co. Ltd. (Trustee of) (1994), 45 B.C.A.C. 231, 94
B.C.L.R. (2d) 130 (whether a dividend that was paid from an operating subsidiary cor-
poration to its holding parent company and subsequently loaned back to the subsidiary
constituted a sham, or whether such a loan was legitimate and could form the basis of a
claim on the now bankrupt subsidiarys assets).

15 See e.g. College of Optometrists of Ontario v. SHS Optical Ltd. (2006), 153 A.C.W.S. (3d)
227, 2006 CanLII 39463 (Ont. Sup. Ct.) [SHS Optical No. 2 cited to CanLII], affd 2008
ONCA 685, 93 O.R. (3d) 139, 300 D.L.R. (4th) 548 (whether agreements that were set
up to satisfy provincial health legislation requiring the involvement of a physician or
optometrist in the dispensing of eyewear constituted shams).

128 (2010) 55 MCGILL LAW JOURNAL ~ REVUE DE DROIT DE MCGILL

tional law,16 employment insurance,17 contract law,18 and employment
law.19

B. The Proper Application of the Sham Doctrine: The Continental Bank

Approach

In Continental Bank Leasing Corp. v. M.N.R.,20 Justice Bastarache
quoted the following passage from the English Court of Appeal judgment
in Orion Finance Ltd. v. Crown Financial Management Ltd. as being the
proper approach for identifying and handling a possible sham:

The first task is to determine whether the documents are a sham in-
tended to mask the true agreement between the parties. If so, the
court must disregard the deceptive language by which the parties
have attempted to conceal the true nature of the transaction into
which they have entered and must attempt by extrinsic evidence to
discover what the real transaction was. …
Once the documents are accepted as genuinely representing the
transaction into which the parties have entered, its proper legal
categorisation is a matter of construction of the documents. This
does not mean that the terms which the parties have adopted are
necessarily determinative. The substance of the parties agreement
must be found in the language they have used but the categorisation
of a document is determined by the legal effect which it is intended
to have, and if when properly construed the effect of the document as
a whole is inconsistent with the terminology which the parties have
used, then their ill-chosen language must yield to the substance.21

16 See e.g. British Columbia (Milk Marketing Board) v. Bari Cheese Ltd. (1993), 42
A.C.W.S. (3d) 202 (B.C.S.C.), affd (1996), 79 B.C.A.C. 34, 26 B.C.L.R. (3d) 279 (whether
defendants efforts to sell milk products outside the scope of the provinces milk quota
system constituted a sham).

17 See e.g. Martin v. M.N.R., 2000 TCC 98787 (whether four skilled craftsmen who de-
cided to form a corporation were employed by that corporation for employment insur-
ance purposes or whether the arrangement was a sham and they were working to-
gether as joint venturers).

18 See e.g. M.N.R. v. Esskay Farms Ltd. (1975), 76 D.T.C. 6010 (F.C.T.D.) (whether the
creation of a corporation and the interim sale of land to that corporation, which was
then resold to a municipalityall done for the purpose of allowing the original owner of
the land to claim the gain on the sale over a two-year periodwas a sham).

19 See e.g. Semenoff v. Saskatoon Drug & Stationery (1988), 49 D.L.R. (4th) 102, 64 Sask.
R. 75 (Q.B.) (whether a joint venture agreement between a former employee and his
former employer constituted a sham in a wrongful dismissal case).

20 [1998] 2 S.C.R. 298, 163 D.L.R. (4th) 385 [Continental Bank cited to S.C.R.].
21 Orion Finance Ltd. v. Crown Financial Management Ltd., [1996] 2 B.C.L.C. 78 at 84
(C.A.) [Orion], cited in Continental Bank, supra note 20 at para. 21. While Bastarache
J. was in the minority, his discussion of the proper approach to dealing with sham cases
was affirmed by the majority in that case as well as in subsequent Supreme Court of

COMMENT: 1524994 ONTARIO LTD. V. M.N.R. 129

This approach was subsequently summarized by Justice McLachlin (as
she then was), writing for the Supreme Court of Canada in Shell Canada
Ltd. v. Canada:

This Court has repeatedly held that courts must be sensitive to
the economic realities of a particular transaction, rather than being
bound to what first appears to be its legal form. But there are at
least two caveats to this rule. First, this Court has never held that
the economic realities of a situation can be used to recharacterize a
taxpayers bona fide legal relationships. To the contrary, we have
held that, absent a specific provision of the Act to the contrary or a
finding that they are a sham, the taxpayers legal relationships must
be respected in tax cases. Recharacterization is only permissible if the
label attached by the taxpayer to the particular transaction does not
properly reflect its actual legal effect.22

In short, the proper approach for identifying and, if necessary, dealing

with a sham consists of two steps generally and three steps in tax cases.
First, a court must consider whether the presented documentary evidence
accurately reflects the true agreement or relationship between the par-
ties. If it does, then the court can proceed to the second step of determin-
ing the legal effect of such evidence. This legal effect may or may not cor-
respond to the description contained in the documents themselves.23 How-
ever, if it is discovered that the documentary evidence does not reflect the

Canada decisions, including McLachlin J.s decision for the Court in Shell Canada (in-
fra note 22).

22 Shell Canada Ltd. v. Canada, [1999] 3 S.C.R. 622 at para. 39, 178 D.L.R. (4th) 26 [em-
phasis added, references omitted, Shell Canada]. Most recently, this approach was ap-
proved by the Federal Court of Appeal: Faraggi v. M.N.R., 2008 FCA 398, [2009] 3
C.T.C. (N.S.) 77, (sub nom. 2529-1915 Qubec Inc. v. M.N.R.) 387 N.R. 1 [Faraggi]. After
restating the Snook definition of a sham, Noel J.A. stated on behalf of the court, It fol-
lows from the above definitions that the existence of a sham under Canadian law re-
quires an element of deceit which generally manifests itself by a misrepresentation by
the parties of the actual transaction taking place between them. When confronted with
this situation, courts will consider the real transaction and disregard the one that was
represented as being the real one (ibid. at para. 59 [emphasis added]).

23 It is important to appreciate the fundamental difference between these two steps. In the
first step, the issue is whether the documents are real in the sense that they accu-
rately describe the transaction(s) or relationship between the parties. This is not so
much a legal issue as an inquiry into whether the court has accurate information with
which it can carry out its legal analysis. In contrast, in the second step, the issue is the
legal effect of such documents. At this stage of the analysis, while a court may disagree
with the parties as to the legal effect of the documents, it does not mean that the docu-
ments themselves constitute a fraud or sham. For example, in Wiebe Door Services Ltd.
v. M.N.R. ([1986] 3 F.C. 553, 70 N.R. 214 (C.A.)), the issue was not the facts surround-
ing their relationship, but rather the legal effect of said factsnamely, whether the
parties, at law, had an employment or business relationship.

130 (2010) 55 MCGILL LAW JOURNAL ~ REVUE DE DROIT DE MCGILL

real facts, then the court must ignore such evidence and attempt to ascer-
tain the true facts in issue.24 It is only after a court has the requisite
knowledge of the facts (or has made its best efforts to discover them) that
it should proceed to the second step of determining their legal effect. In
tax cases, the third step is to apply the relevant tax law to the legal sub-
stance previously determined.25
While the approach set out in Orion (and the Supreme Court of Can-
adas adoption of it) is relatively recent,26 it has long been a part of Cana-

24 Admittedly, it will not always be an easy and straightforward endeavour. In many
cases, it will be the most difficult task for the courts: to find out what really happened or
what the true relationship was.

25 It is only in the third step that the relevant tax law is considered and applied. Prior to
this point, all of the analysis generally occurs outside of the taxation realm. Put another
way, absent a tax provision to the contrary, tax law will be applied to the legal sub-
stance of the transaction or relationship previously determined; tax law will generally
not determine the legal effect of the transaction or relationship.

26 In addition to the Supreme Court of Canadas approval in Continental Bank (supra note
20), Orion (supra note 21) has also been specifically cited and followed in Canada in the
following cases: Pro-Ex Trading v. M.N.R., [2001] G.T.C. 584, [2001] G.S.T.C. 111
(T.C.C.); OSFC Holdings Ltd. v. M.N.R., [1999] 3 C.T.C. (N.S.) 2649, 46 B.L.R. (2d) 195
(T.C.C.).

COMMENT: 1524994 ONTARIO LTD. V. M.N.R. 131

dian tax jurisprudence and its associated literature.27 For example, in the
Courts 1933 decision in Palmolive Manufacturing Co. (Ontario) v. Can-
ada, Justice Cannon ruled on behalf of the Court that the character and
substance of the real transaction must, for taxation purposes, be ascer-
tained and the tax levied on that basis.28 Similarly, in M.N.R. v. Shields,
Justice Cameron held, I think it is settled law … that for income tax pur-
poses it is insufficient to establish a partnership in fact merely by the pro-
duction of a partnership deed. It must also be shown that the parties
thereto acted on it and that it governed their transactions in the business
being carried on.29

C. The Classification of Sham Cases

While every sham, by definition, is a joint and intentional deception
designed to obtain a benefit (or avoid a detriment) from a third party, it is
a mistake to think that all sham cases are essentially the same. By paying
particular attention to the intended victim of the sham, the benefit sought
by the sham, and whether the case is a tax or non-tax case, I believe that
it is possible to distinguish between three different types of sham cases.
This typology will reveal a shortcoming of the Continental Bank approach
and will help explain the Federal Court of Appeals deviation from this
approach in 1524994 Ontario Ltd.

The first type of sham case (Type I) is one in which the third-party vic-
tim is the Minister of National Revenue (Minister), the benefit sought is a
tax benefit, and the case is a tax case. Perhaps the most famous example
of a Type I sham case is Stubart Investments Ltd. v. M.N.R.30 In Stubart,
two sister corporations, one profitable and the other with significant

27 See e.g. Taylor, supra note 11 at 6-8.
28 Palmolive Manufacturing (Ontario) v. Canada, [1933] S.C.R. 131 at 139, [1933] 2 D.L.R.

81.

29 M.N.R. v. Shields, (1962) Ex. C.R. 91, [1962] C.T.C. 548 at 553 (Ex. Ct. Can.). Cameron

J. went on to state,

These facts lead me to the conclusion that while there was a partnership
agreement, it was never considered by the respondent as binding on him. It
was put aside and did not in fact govern the actions of the parties thereto, ex-
cept to the extent that it was helpful in carrying out his scheme to reduce his
own taxable income, namely, by making payments of income tax on account
of Victors alleged profits (ibid. at 568).

In other words, in this case the court found it appropriate to disregard the partnership
agreement on the basis that it did not reflect the true relationship and actions between
the parties. This approach was approved and adopted by Gibson J. in Susan Hosiery
(supra note 6).

30 [1984] 1 S.C.R. 536, 10 D.L.R. (4th) 1 [Stubart cited to S.C.R.] (typically cited as the

leading case concerning the sham doctrine in Canada).

132 (2010) 55 MCGILL LAW JOURNAL ~ REVUE DE DROIT DE MCGILL

losses, attempted to restructure business operations between them to
transfer the profitable business to the loss corporation in order to reduce
the corporations overall tax liability.31 The problem that the Minister had
with this restructuring was that, while certain documents were indeed
executed to reflect the transfer of assets from the profitable corporation to
the loss corporation, there was little else that reflected the change in who
was carrying on the profitable business.32 For example, the employees of
the profitable corporation continued to carry on the profitable business,
though now as agents for the loss corporation, pursuant to the transfer
documents. Accordingly, the Minister reassessed both corporations and
taxed the profits as being earned by the profitable rather than the loss
corporation. In the Ministers opinion, the documentary evidence was a
shaman attempt by both corporations (as well as the parent corporation)
to deceive the Minister into believing that the loss corporation was now car-
rying on the profitable corporations business when in reality it was not.
At trial, in addition to examining the transfer documents, Justice
Flanigan considered other evidence that was brought to his attention by
the Minister and the corporations lawyer.33 Based on the totality of this
evidence, he concluded that the agreement was a sham: the documenta-
tion was designed to utilize the losses in the loss corporation for tax pur-
poses without ever truly transferring the profitable business to the loss
corporation.34 As a result, he ignored the transfer documentation, treated
the profits as belonging to the profitable corporation, and upheld the Min-
isters reassessment. While this result was confirmed by the Federal
Court, Trial Division35 and the Federal Court of Appeal,36 it was ulti-
mately overturned by the Supreme Court of Canada.37

31 More specifically, the loss corporation attempted to use its accumulated tax losses to re-

duce (or eliminate) the taxable income generated by the profitable business.

32 Stubart, supra note 30 at 541-42.
33 Stubart Investments Ltd. v. M.N.R., [1974] C.T.C. (N.S.) 2284 at 2287, 74 D.T.C. 1209
(T.R.B.). At this time, tax cases were first heard by the Tax Review Board, with the op-
portunity for a trial de novo at the Federal Court, Trial Division. Appeals from this
court were made to the Federal Court of Appeal and, if leave granted, to the Supreme
Court of Canada.
34 Ibid. at 2287-88.
35 Stubart Investments Ltd. v. M.N.R., [1978] C.T.C. (N.S.) 612, 78 D.T.C. 6414 (F.C.T.D.).
36 Stubart Investments Ltd. v. M.N.R., [1981] C.T.C. (N.S.) 168, 81 D.T.C. 5120 (F.C.A.).
The Federal Court of Appeal dismissed the appeal on the basis that the transfer be-
tween the two corporations was incomplete and hence legally ineffective. Given this
conclusion, the court did not need to rule on whether the transfer documents consti-
tuted a sham.

37 Stubart, supra note 30. Going through the same process as the lower courts of
considering all of the evidence to determine the true facts in issue, the Supreme Court

COMMENT: 1524994 ONTARIO LTD. V. M.N.R. 133

The second type of sham case (Type II) is one in which the third-party
victim is someone other than the Minister, the benefit sought is a non-tax
benefit, and the case does not involve a question of taxation. One example
of a Type II sham case that is somewhat similar to 1524994 Ontario Ltd.
is SHS Optical No. 2.38 This case arose as a result of an earlier case in
which the College of Optometrists of Ontario (College) had taken SHS Op-
tical Ltd., Bruce Bergez,39 and several others to court to obtain an order
that they comply with the applicable health care legislation in Ontario.40
This legislation required that the diagnosis, prescription and dispensing
of glasses be executed with the involvement of a physician or an optome-
trist.41 In SHS Optical No. 1, the College successfully convinced the court
that SHS Optical Ltd.s employees (who were neither physicians nor op-
tometrists) were writing their own prescriptions and dispensing glasses,
both in contravention of the legislation. As a result, the court ordered
Bergez, SHS Optical Ltd., and its employees to discontinue these activi-
ties immediately and comply with the legislative requirements.42

INTENDED VICTIM
OF SHAM
INTENDED
BENEFIT SOUGHT
FROM SHAM
RESULTING
BENEFIT AT ISSUE
IN COURT
EXAMPLE

TYPE I
M.N.R.

TYPE II
Not M.N.R.

TYPE III
Not M.N.R.

Tax benefit

Non-tax benefit Non-tax benefit

Tax

Non-tax

Tax

Stubart

SHS Optical

No. 2

1524994

Ontario Ltd.

of Canada found that the transfer of the profitable business to the loss corporation was
legally effective and complete (ibid. at 552) and accurately represented the transactions
between the corporations (ibid. at 580-81). Given these findings, the Court held that the
documents did not constitute a sham.

38 SHS Optical No. 2, supra note 15.
39 Bergez was the optician who managed three optical stores (operating under the Great
Glasses name) that were owned and operated by SHS Optical Ltd. He was also the
husband of the sole shareholder of SHS Optical Ltd.

40 College of Optometrists of Ontario v. SHS Optical Ltd. (2003), 124 A.C.W.S. (3d) 1169,

2003 CanLII 39086 (Ont. Sup. Ct.) [SHS Optical No. 1 cited to CanLII].

41 Regulated Health Profession Act, S.O. 1991, c. 18, ss. 27, 30; Opticianry Act 1991, S.O.

1991, c. 34, ss. 3, 4, 5(1).

42 SHS Optical No. 1, supra note 40 at para. 95.

134 (2010) 55 MCGILL LAW JOURNAL ~ REVUE DE DROIT DE MCGILL

In response to this court order, Bergez created an elaborate corporate
structure and executed various agreements that, in his opinion, brought
SHS Optical Ltd., its employees, and its franchisees in compliance with
the legislation and the court order. After three years of investigations, the
College took SHS Optical Ltd. and Bergez back to court to apply for an or-
der of contempt in respect of the court order given in SHS Optical No. 1.43
To support this application, the College argued and led evidence that the
elaborate structure and agreements were shams and that, in reality, SHS
Optical Ltd. and its employees continued to operate in contravention of
health care legislation by prescribing and dispensing corrective eyewear
without the involvement of a physician or optometrist. After considering
all of the evidence, Justice Crane of the Ontario Superior Court of Justice
held in favour of the College.44 He ignored the shams, found the defen-
dants to be in contravention of the applicable legislation and the previ-
ously issued court order, and fined them one million dollars to disgorge
the profits that they obtained from their illegal activities.45

In both of these cases, and indeed in all of the Type I and Type II
sham cases that I have reviewed, the courts applied the Continental Bank
approach without issue. That is, the courts were open to the possibility
that the documents did not accurately represent the true facts in issue
and allowed further evidence to confirm or deny their validity. Then,
based on the totality of the evidence, they determined whether the docu-
ments accurately represented the transactions or relationship. When they
did not, the courts ignored the documents creating the sham and applied
the relevant law to the true facts in issue.

This finding is not surprising. In Type I and Type II sham cases, fol-
lowing the Continental Bank approach allows a court that discovers a
sham to strip away any benefits that the parties received as a result of the
sham or to impose the detriment that would have otherwise occurred but
for the sham. Put simply, for Type I and Type II sham cases, the result of
applying the Continental Bank approach is intuitively satisfying; it takes
away from the parties to the sham what they should have never had.46

43 See SHS Optical No. 2, supra note 15.
44 Ibid. at para. 8.
45 Ibid. at para. 93.
46 See also Faraggi, supra note 22. The Federal Court of Appeal, affirming the Tax Court
of Canadas decision, held that the transactions entered into by the parties to create
capital gains were shams (ibid. at paras. 67-73). By ignoring these transactions, the
court eliminated the benefits sought from themnamely, capital dividends that the
third parties could sell for profit to third parties.

COMMENT: 1524994 ONTARIO LTD. V. M.N.R. 135

This brings us to the third type of sham case (Type III). Like a Type II
sham case, a Type III sham case is one in which the third-party victim is
someone other than the Minister and the benefit sought is a non-tax bene-
fit. However, unlike a Type II sham, which does not trigger any tax con-
sequences (or at least none that are litigated), a Type III sham triggers
unintended tax consequences that are the subject of the litigation. It is in
this type of case that the shortcomings of the Continental Bank approach
are revealed. Simply ignoring the sham in favour of the true facts in a
Type III sham case could actually help (or at least not hurt) the parties to
the sham. Since the case would concern only the tax implications trig-
gered by the sham, disregarding the sham could actually eliminate these
unintended tax consequences while having no effect on the non-tax bene-
fits improperly obtained from the sham. In other words, if courts apply
the Continental Bank approach to a Type III sham case, the parties to the
sham could potentially have their cake (retention of the non-tax benefits
improperly obtained from the sham), and eat it too (not pay the associated
taxes).47
Given this awkward and intuitively unsatisfying result, it becomes
readily apparent why a court might want to apply a strategy different
from the Continental Bank approach to deal with a Type III sham case.
Faced with the real possibility that the victimized third party may never
bring the matter to court as a Type II sham case and give it the opportu-
nity to strip the parties to the sham of their undeserved non-tax benefits
using the Continental Bank approach, a court might resort to more des-
perate measures, namely, treating the sham as if it were real. While ad-
mittedly not the best solution, a court could at least impose a tax penalty
on the parties to a Type III sham.

This alternative approach is what the Federal Court of Appeal ap-
pears to have opted for in its recent decision in 1524994 Ontario Ltd.
Faced with a Type III sham, the court decided to tax the sham rather
than apply the Continental Bank approach, which would have allowed the
parties to escape paying GST on their ill-gotten gains.48 While intuitively

47 Dcary J.A. described this situation as allowing a misrepresenting party to profit twice

from its misdeed: 1524994 Ontario Ltd., supra note 3 at para. 15.

48 In my opinion, this represents the second time that the Federal Court of Appeal has
taken this alternate approach in a Type III sham case, the first time being M.N.R. v.
Gurds Products Co. Ltd. ([1985] 2 C.T.C. (N.S.) 85, 60 N.R. 184, (F.C.A.) [Gurds Prod-
ucts (F.C.A.) cited to C.T.C. (N.S.)]). In this case, the international soft drink conglomer-
ate known as the Crush Group wished to establish a franchise in Iraq. The problem
was that Iraq would not allow any business activity in its country by U.S. corporations
and all of the Crush Groups international operations were carried out in the United
States. To solve this problem, the Crush Group reactivated a Canadian subsidiary cor-
poration, transferred one of its U.S. employees to be the face of the Canadian subsidi-

136 (2010) 55 MCGILL LAW JOURNAL ~ REVUE DE DROIT DE MCGILL

this may appear to have been the better approach in the circumstances,
for reasons that I will discuss below, I believe that it was not.

II. 1524994 Ontario Ltd. v. M.N.R.

A. The Facts49

The taxpayer corporation, 1524994 Ontario Ltd., was incorporated by
Brian Field (who also owned all of the outstanding shares) to carry on the
business of The Audiology Clinic of Southwestern Ontario (Clinic). The
Clinic employed Field as its licensed audiologist and also employed an
administrative staff. It leased space and possessed all of the equipment
necessary to carry on its business of providing audiology services to indi-
viduals living in Ontario. In short, it was a self-sufficient business.

The Clinic and Field faced a major difficulty: in order for the Clinics
audiology services to be covered by OHIP,50 the services had to be, among
other things, both prescribed and performed by or under the supervision

ary, and flowed all of the correspondence and money associated with the Iraqi franchise
operation through the Canadian subsidiary. While this created the appearance that the
Iraqi operations were being carried on by a Canadian corporation, in reality it was a
sham. All of the decisions and activities were made and carried out by or under the di-
rection of the U.S. corporation. What made this case a Type III sham was that the issue
in the case was one of taxationspecifically, were the dividends paid by the Canadian
subsidiary to the U.S. corporation subject to Canadian withholding taxes? The Crush
Group argued that they were not, since the Canadian subsidiary did nothing in respect
of the Iraqi franchise other than create the faade that a non-U.S. corporation was car-
rying on the business operations. In reality, the payments received by the U.S. corpora-
tion were coming from Iraq and not the Canadian corporation. After reviewing all of the
evidence, Addy J. of the Federal Court, Trial Division agreed that the involvement of
the Canadian subsidiary in the Iraqi operations was a sham and that it did not carry on
any business in Canada (which was required to trigger the Canadian withholding
taxes): Gurds Products Co. Ltd. v. M.N.R., [1981] C.T.C. (N.S.) 195, 81 D.T.C. 5153
(F.C.T.D.). The Federal Court of Appeal disagreed with this decision and reinstated the
Canadian withholding taxes as assessed by the Minister. While the basis on which it
overturned the decision of the Federal Court, Trial Division is not entirely clear, on be-
half of the Federal Court of Appeal, Urie J.A. expressed his serious concerns about al-
lowing the parties who had created the sham to ask the court to disregard it in order to
avoid an undesirable tax consequence of the sham (Gurds Products (F.C.A.) at 94). In
my opinion, while Urie J.A. in Gurds Products was not as blatant as Dcary J.A. in
1524994 Ontario Ltd. (supra note 3), he did the same thing: he treated the sham as if it
were real in order to impose a tax penalty on the parties.

49 Unless stated otherwise, the facts are taken from the judgment of the Tax Court of

Canada. See 1524994 Ontario Ltd. (T.C.C.), supra note 3.

50 The creation and operation of OHIP is set out primarily in the Health Insurance Act

(R.S.O. 1990, c. H.6, ss. 10-29).

COMMENT: 1524994 ONTARIO LTD. V. M.N.R. 137

of a medical doctor.51 While most of the Clinics clients appeared to have
been referred by doctors, the services were provided by Field (who was not
a medical doctor) through the Clinic. As a result, the Clinics business
presumably suffered because its clients would have to pay for the audi-
ological services out of their own pockets.
In an effort to get its services covered by OHIP, Field, the Clinic, and

two family doctors who carried on their separate medical practices across
the hall from the Clinic, entered into an agreement in 1989. This agree-
ment was executed approximately two years before the GST came into
force.52 The important terms of the agreement were as follows: the doctors
would lease the premises and equipment from the Clinic and also employ
Field and the Clinics administrative staff to provide audiological services
to the Clinics clients. The Clinic would otherwise continue to operate the
business, and as part of its operation, would prepare the claims for sub-
mission to OHIP. The doctors would submit these claims to OHIP (which
were over ten thousand dollars per month) using their billing numbers. In
return for this service, the doctors would retain ten per cent of the
amounts received from OHIP, up to a maximum of one thousand dollars
per month each, which was reached each month of the period under ap-
peal. The remaining ninety per cent would be paid by the doctors to the
Clinic in respect of: lease costs, employment costs, and management fees.
In their respective accounting records, the parties reported these pay-
ments in accordance with the agreement; for tax purposes, the doctors is-
sued a T4 employment slip to Mr. Field.53 However, at no time was GST
ever charged or collected by either party in respect of the transferred
amounts.
While excluding details, Justice McArthur noted in his judgment that
the parties had discussed this agreement with officers from OHIP prior to
executing it.54 Presumably, the OHIP officers were satisfied that if the

51 Ibid., s. 11.2. Presumably, these requirements were enacted to ensure that (1) the audi-
ology services were in fact medically necessary procedures for the recipient (hence justi-
fying reimbursement by the state), and (2) the services were performed (or supervised)
by a competent individual.

52 Excise Tax Act, supra note 4. This fact makes this a Type III sham case; the parties in-
tention was to obtain non-tax benefits from OHIP, but in the process, triggered an unin-
tended GST issue, which was the subject of the litigation.

53 1524994 Ontario Ltd., supra note 3 at para. 17.
54 1524994 Ontario Ltd. (T.C.C.), supra note 3 at para. 23.

138 (2010) 55 MCGILL LAW JOURNAL ~ REVUE DE DROIT DE MCGILL

terms of the agreement were followed by the parties, then the Clinics ser-
vices would be eligible for OHIP coverage.55
More than ten years after the agreement was implemented, the CRA
provided an assessment of the Clinic for outstanding GST (GST Assess-
ment) in respect of the lease and management fees paid from the doctors
to the Clinic for the period from 1 August 1997 to 30 April 2000.56 The
GST Assessment appears to have been based solely on the agreement and
supporting records (i.e., the accounting and tax entries) that were exam-
ined by the GST auditor.

The Clinic and the doctors objected to the GST Assessment on the ba-
sis that nothing they did attracted GST. More specifically, they argued
that the true transactions in issue were payments from OHIP (via the
doctors) to the Clinic for GST-exempt audiological services,57 and pay-
ments from OHIP to the doctors for participation in the Clinics activi-
ties.58 In their notice of objection and in court, both Field and the doctors
led evidence that their agreement had been prepared only for the purpose
of obtaining OHIP coverage, and that it should otherwise be ignored. Ac-
cording to the parties, the agreement did not reflect (nor was it intended
to reflect) the true nature of the relationship between the Clinic, the doc-
tors, and Field, or any of the transactions between them. While they did
not call their agreement a sham, the parties asked the court to treat it as
one by requesting that they be taxed (or, more accurately, not taxed) on
what they testified they did, as opposed to what the agreement and ac-
counting records showed they did.

B. The Tax Court of Canadas Findings and Decision

Based on a review of the relevant jurisprudence, including the Su-
preme Court of Canadas dicta in Shell Canada set out in Part I.B above,
Justice McArthur stated that his role was to ascertain the true legal rela-

55 Nothing in either the Tax Court of Canada decision or the Federal Court of Appeal de-
cision suggests that OHIP ever questioned the agreement or its implementation, or de-
nied coverage for claims made by the doctors.

56 Excise Tax Act, supra note 4, s. 165(1) (taxable supply).
57 Ibid., Sch. V, Pt. II, s. 7(g) (audiological services).
58 In his Editorial Comment to 1524994 Ontario Ltd. (T.C.C.) (supra note 3), David
Sherman raised the question of why the doctors were not assessed GST in respect of the
$1,000 payments that they effectively received from the Clinic. He also provided a pos-
sible answer, namely, that the CRA might have taken the position that these payments
were exempt under health care service (Excise Tax Act, supra note 4, Sch. V, Pt. II, s.
5). In any event, the doctors share of OHIP payments and the appropriate tax treat-
ment thereof were not at issue in this case.

COMMENT: 1524994 ONTARIO LTD. V. M.N.R. 139

tionship of the parties and give it effect.59 In this regard, he allowed the
oral testimony of Field, whom he described as an impressive witness,
and considered the correspondence between the CRA and one of the doc-
tors who was party to the agreement.60 Justice McArthur found this tes-
timony and correspondence (as opposed to other prior documentation in-
cluding the agreement) to be accurate, reliable, and representative of the
true facts. He went on to state that while the parties arrangement was
not praiseworthy,61 the appellant company was rendering valuable ser-
vices to patients and Dr. Rooneys intentions were laudable in that he be-
lieved there was a need in the community for the Appellants services.62
Based on this evidence and his generally positive view of the parties in-
tentions, Justice McArthur found that the agreement did not reflect the
dominant or overall relationship of the parties and that the parties did
not create legally binding lease and employment contracts.63 Instead, he
held that the true relationship between the doctors and the Clinic was one
of agency, with the doctors being agents of the Clinic; as such, GST was
not applicable to the payments received by the Clinic as they were for
non-taxable audiological services.64
Despite the facts of the case and the parties testimony, Justice
McArthur concluded that the agreement was not a sham for two reasons.
First, he seemed uncomfortable raising the doctrine of shams when nei-
ther the parties nor the Minister presented arguments on the point. Sec-
ond, the documents had been disclosed to OHIP officials prior to the
agreements execution.65
In summary, Justice McArthur, as trier of fact, found the parties to be

credible and, based on their testimony, held that their agreement did not
reflect their actions and had to be ignored. He characterized their rela-
tionship at law as that of principal and agent to support his decision that
GST was not applicable to the payments made between the parties.

59 1524994 Ontario Ltd. (T.C.C.), supra note 3 at paras. 17, 21. In other words, McArthur
T.C.J. set out to apply the Continental Bank approach even though he did not cite the
case in his judgment.

60 Ibid. at paras. 6, 19. In response to the GST Assessment, Dr. Rooneys letter to the CRA
dated 8 March 2002, stated that he felt that he did not possess the technical skills nec-
essary to provide the required audiological services.

61 Ibid. at para. 6.
62 Ibid. at para. 23.
63 Ibid. at para. 18.
64 Ibid. at paras. 23-24.
65 Ibid. at para. 23.

140 (2010) 55 MCGILL LAW JOURNAL ~ REVUE DE DROIT DE MCGILL

C. The Federal Court of Appeals Approach and Decision

At the Federal Court of Appeal, Justice Dcary, for a unanimous court,
made it clear from the outset that the Clinic would not be permitted both
to reap the non-tax benefits from deceiving OHIP, and to escape GST (as
was the result of Justice McArthurs decision).66 Thus, the court over-
turned both the approach employed by the Tax Court of Canada as well as
the ultimate decision that GST was not applicable.
With respect to the Tax Court of Canadas approach, Justice Dcary
held that

the Tax Court Judge erred in law in basing his decision on after-the-
fact evidence of the parties intention to re-characterize an agree-
ment, which was clear, complete, and so effective as between the
parties that they had acted upon it to obtain substantial monetary
benefits from OHIP.67

In his opinion, and without citing any cases or legal principles in support,
once the Clinic started receiving payments via the doctors from OHIP, the
illusion became real and acquired legal effect. As such, it was no longer
open for Justice McArthur to consider the parties subsequent, self-
serving, oral testimony and written evidence that the agreement did not
reflect the true facts in issue. In the Federal Court of Appeals opinion, the
tax courts approach caused two significant problems. First, it violated the
principle set out by the Supreme Court of Canada in Shell Canada that
the taxpayers legal relationships must be respected in tax cases, and
that [r]echaracterization is only permissible if the label attached by the
taxpayer to the particular transaction does not properly reflect its actual
legal effect.68 Where the agreement had acquired legal effect by the par-
ties receiving payments from OHIP, it was not open for the Tax Court of
Canada to recharacterize the agreement for tax purposes. Second, the tax
courts approach would open the floodgates in the future for both taxpay-
ers and the CRA to argue that the documents did not reflect the parties
true intentions. Quoting from Justice Lindens judgment in Friedberg v.
M.N.R.,69 Justice Dcary reiterated the concern that if such evidence were
allowed,

Revenue Canada and the courts would be engaged in endless exer-
cises to determine the true intentions behind certain transactions.
Taxpayers and the Crown would seek to restructure dealings after

66 1524994 Ontario Ltd., supra note 3 at para. 15.
67 Ibid. at para. 11.
68 Shell Canada, supra note 22 at para. 39 [reference omitted].
69 (1991), [1992] 1 C.T.C. (N.S.) 1, 135 N.R. 61 (F.C.A.) [Friedberg cited to C.T.C. (N.S.)],

affd [1993] 4 S.C.R. 285, 160 N.R. 312.

COMMENT: 1524994 ONTARIO LTD. V. M.N.R. 141

the fact so as to take advantage of the tax law or to make taxpayers
pay tax that they might otherwise not have to pay. While evidence of
intention may be used by the courts on occasion to clarify dealings, it
is rarely determinative. In sum, evidence of subjective intention
cannot be used to correct documents which clearly point in a par-
ticular direction.70

In this case, not only did the parties agreement reflect the fact that pay-
ments were being made by the doctors to the Clinic in respect of rent,
salaries and management fees, but so too did the parties accounting and
tax records. In this situation, where all of the existing documentary evi-
dence was consistent and indicated a particular state of affairs, the Fed-
eral Court of Appeal decided that subsequent contradictory testimony
should not be considered.71 Doing otherwise would presumably cause too
much uncertainty in the law.
With respect to the Tax Court of Canadas finding of an agency rela-
tionship, the Federal Court of Appeal overturned this conclusion on two
grounds. First, the court held that there was no evidence to support an
agency relationship.72 Second, the court held that the doctors could not
have been the Clinics agents because they possessed a power that the
Clinic itself did not havespecifically, the power to submit billings to
OHIP. Citing the case of Haggstrom v. Dey,73 the court restated the rule:
An agent cannot have a legal capacity that exceeds that of the principal.
A principal can only appoint an agent to make a contract which the prin-

70 1524994 Ontario Ltd., supra note 3 at para. 14, citing Friedberg, supra note 69 at 3.
71 See e.g. Robert M. Beith et al., Revenue Canada Round Table, Report of Proceedings of
Fortieth Tax Conference, 1988 Tax Conference (Toronto: Canadian Tax Foundation,
1989) 53:1 at 53:12-13. Revenue Canada (as it then was) stated that its general ap-
proach to the characterization of leasing transactions for tax purposes would be simply
to follow the form of the parties agreement. In other words, if the parties drafted their
agreement in the form of a lease, then Revenue Canada would normally assume that
the agreement reflected the true (and legal) relationship between the parties and would
treat the agreement as a lease for tax purposes. Revenue Canada further stated that
while it would always be open to investigate and recharacterize the legal (and tax) ef-
fect of the agreement if it felt that the agreement did not represent the true relationship
between the parties, it would not be open for taxpayers to do so (i.e., to contradict their
own agreement and take the position that the form did not accurately represent the
true reality). While certain courts agreed with Revenue Canadas official position, Tho-
mas Gillespie concluded at the 1992 Corporate Management Tax Conference, based on
a review of all of the case law, that the better view was that Revenue Canadas position
was wrong at law and that taxpayers could legitimately take the position in court that
their agreement did not reflect the true substance of their relationship or transactions.
See Thomas Gillespie, Lease Financing in Income Tax and Goods and Services Tax
Considerations in Corporate Financing, 1992 Corporate Management Tax Conference
(Toronto: Canadian Tax Foundation, 1993) 7:1 at 7:17-20.

72 1524994 Ontario Ltd., supra note 3 at para. 18.
73 Haggstrom v. Dey (1965), 54 D.L.R. (2d) 29 (B.C.C.A.).

142 (2010) 55 MCGILL LAW JOURNAL ~ REVUE DE DROIT DE MCGILL

cipal himself has the capacity to make.74 As the Clinic could not get reim-
bursed for its services without the assistance and participation of the doc-
tors, the Clinic could not, at law, be the principal, and hence there could
not be an agency relationship.

Two final points from the decision are important to note. First, like
Justice McArthur, Justice Dcary was reluctant to characterize the par-
ties agreement as a sham.75 He too was concerned that the allegation of a
sham had not been explicitly raised by either party to the case, and felt it
inappropriate to raise on his own. He stated, without providing details
how, that labelling the agreement a sham would, at best, only support his
ultimate finding that GST should be applied. Second, Justice Dcary was
concerned that if he allowed the parties to repudiate the contract for tax
purposes while still taking its benefit in OHIP fees, this could be inter-
preted as the courts endorsement of this type of scheme.76

In overturning the Tax Court of Canadas decision and reinstating
GST Assessment against the Clinic, Justice Dcary left the parties (and
anyone else considering such a scheme) with this final warning:

In the end, I have reached the view that a person who creates a
contractual fiction designed intentionally to misrepresent a legal re-
lationship, and who takes advantage of it, cannot later invoke the
true economic reality to avoid the tax disadvantages flowing from it.
When a fairytale becomes the real world with respect to third parties
for one purpose (OHIP), it remains the real world with respect to
third parties for other purposes (the Minister). The Supreme Court
of Canada has invited us to look at the real economic world when
examining a transaction in the context of a tax assessment. Where a
taxpayer has created a fiction and has lived by it, his fiction has be-
come its real economic world, for better and for worse, plus GST.77

III. The Problems with Taxing a Sham
Was it proper for the Federal Court of Appeal to use an alternative to
the Continental Bank approach to deal with the facts in 1524994 Ontario
Ltd., a Type III sham case? Strictly speaking, the answer is no: the Su-
preme Court of Canada did not provide for any exceptions to the applica-
tion of its approach in either Continental Bank or Shell Canada. That
said, both these Supreme Court of Canada decisions were Type I sham
cases where applying the Continental Bank approach would have resulted

74 1524994 Ontario Ltd., supra note 3 at para. 18 [references omitted].
75 Ibid. at para. 19.
76 Ibid. at paras. 15-16.
77 Ibid. at para. 20 [emphasis in original].

COMMENT: 1524994 ONTARIO LTD. V. M.N.R. 143

in the parties losing their benefits (assuming the Court had found that
the documents indeed constituted a sham).78 Given this fact, should the
Continental Bank approach be limited to Type I and II sham cases, leav-
ing the Federal Court of Appeals alternate approach in 1524994 Ontario
Ltd. to be used for Type III sham cases?
In my opinion, there are too many problems created and no real bene-

fits realized by this alternate approach to justify its use in dealing with
Type III shams. More specifically, the Federal Court of Appeals approach
(1) will not deter parties from creating shams in order to obtain non-tax
benefits, (2) will violate longstanding principles that tax law be applied
with neutrality and equity and without considering its effects, and (3) will
result in additional uncertainty and inconsistency in the case law. For
these reasons, I believe that the Continental Bank approach should con-
tinue to be applied to Type III sham cases.79

78 Indeed, had Englands Court of Appeal in Orion (supra note 21) found that the docu-
ments had constituted a sham (more specifically, a Type II sham), then its approach
also would have had the effect of taking away the benefits derived from the sham. Put
simply, in all three of these cases, the approach would have worked.

79 See e.g. United Color and Chemicals Ltd. v. M.N.R., [1992] 1 C.T.C. (N.S.) 2321, 92
D.T.C. 1259 (T.C.C.). In this case, the issue was how to tax properly cash bribes that the
corporation made through its owner Mr. Vass, to certain key employees of potential cus-
tomers in order to ensure the viability of their business (which the litigants stated was
the typical practice for that industry). The corporation would make cash payments to
Mr. Vass, who would then use the cash to pay off the purchasing agents. As the corpo-
rations bookkeeper did not believe such amounts could be deducted by the corporation
for tax purposes as a business expense, he reported the payments in the corporations
accounting and tax records as non-deductible dividends to Mr. Vass, who also reported
the receipt of cash in his personal tax returns as dividend income. When the Minister
denied certain other deductions claimed by the corporation, the corporation, in addition
to challenging the Ministers assessment, also raised the issue of the deductibility of
these secret commissions against the corporations income and the propriety of the in-
come inclusion to Mr. Vass as dividends. After hearing the oral testimony of various in-
dividuals who were involved with the bribes, both internal and external to the corpora-
tion, Kempo T.C.J. concluded that such testimony was credible and, as opposed to the
existing documentary evidence, reflected what actually occurred, namely, that the cor-
poration had been making cash payments under the table through Mr. Vass to various
purchasing agents in order to get their companies business. Having knowledge of the
true facts in issue, she held that the bribes were misreported as dividends at both the
corporate level and in Mr. Vasss personal income tax return, and that they were prop-
erly deductible for tax purposes to the corporation as a business expense with no income
inclusion for Mr. Vass. In other words, she disregarded the sham and applied the rele-
vant tax law to the true facts in issue.

144 (2010) 55 MCGILL LAW JOURNAL ~ REVUE DE DROIT DE MCGILL

A. The Federal Court of Appeals Approach Will Not Discourage Parties

from Creating Shams in Order to Obtain Non-Tax Benefits

As previously defined, a Type III sham case involves a sham that is
designed to obtain a non-tax benefit but, in the process, triggers unin-
tended tax consequences that are then the subject of litigation. In
1524994 Ontario Ltd., the non-tax benefit was OHIP coverage of audi-
ological services performed without the required direct involvement of a
medical practitioner. Given that the primary purpose of a Type III sham
is to obtain non-tax benefits, it is highly unlikely that the imposition of
taxes on the sham would deter parties from creating such a sham unless
such taxes took away all or substantially all of the benefits derived from
the sham. In 1524994 Ontario Ltd., the imposition of GST by the Federal
Court of Appeal resulted in a seven per cent charge on the funds received
from OHIP and paid from the doctors to the Clinic. Viewed the other way,
even after the imposition of GST, the parties still retained over ninety per
cent of the payments from OHIP (excluding any interest assessed on the
outstanding GST balance and any applicable income taxes).80 Given this
fact, it is likely that taxing a Type III sham as if it were real would not de-
ter parties from creating these shams as Justice Dcary had hoped. All it
would do is reduce the quantum of benefits enjoyed by the parties by allo-
cating a share to the Minister.81

B. The Federal Court of Appeals Approach Constitutes a Biased, Results-

Driven Application of Tax Law

In the interpretation and application of tax law, courts have generally
adhered to two basic principles in the absence of a statutory provision to
the contrary. First, tax laws are to be interpreted and applied in a neutral
and equitable manner without consideration of the possible underlying
impropriety of the parties behaviour.82 Second, the interpretation and ap-

80 As there was nothing in this case concerning compliance with the Income Tax Act (su-
pra note 2), the Clinic was presumably properly reporting and paying income tax in re-
spect of these payments.

81 Given this fact, it is curious that the Clinic challenged the Ministers assessment for
taxes on its sham benefits. The only possible reason that comes to mind for doing so is
that it truly believed that it could have its cake and eat it too. That said, by challenging
the Ministers assessment, in my opinion, the Clinic risked the discovery of its deception
by OHIP. If this had occurred and OHIP had brought a case against it, then it appears
at least possible that this could have ultimately resulted, as it did in SHS Optical No. 2
(supra note 15), in the Clinic losing all of its benefits from the sham rather than just a
small component for GST.

82 See e.g. 65302 British Columbia Ltd. v. Canada, [1999] 3 S.C.R. 804 at para. 66, 179
D.L.R. (4th) 577. In this case, the issue before the Supreme Court of Canada was
whether a corporation that had intentionally violated its quota for egg production could

COMMENT: 1524994 ONTARIO LTD. V. M.N.R. 145

plication of tax law should not be influenced by its results.83 Both of these
principles reflect the courts overall view that because tax law is exceed-
ingly complex and full of a variety of legislative objectives, courts should
be reluctant to find and apply an unexpressed legislative intention as
this could inadvertently frustrate any of these objectives.84
In taxing a Type III sham as if it reflected the true facts in issue, in

the absence of a statutory provision authorizing such an approach, the
Federal Court of Appeal in 1524994 Ontario Ltd. violated these general
principles of interpretation and application of tax law, and exceeded its
judicial authority. If Parliament wishes to tax shams or, phrased in a less
controversial manner, to tax the described form of a transaction or rela-
tionship as opposed to its actual substance, then it is up to Parliament to
enact the appropriate provisions in tax law. Absent such provisions, the
courts role is simply to apply tax law to the true facts underlying the
sham, without consideration of the parties arrangement and without re-
gard to its effect. The courts role should not extend to manipulating the
application of tax law in order to impose a penalty for what is considered
inappropriate behaviour. This is neither the purpose of tax law nor the
proper role of the courts.

deduct the fine it received from its violation as a business expense for tax purposes. In
holding that it could, Iacobucci J. for the majority stated that tax authorities are not
concerned with the legal nature of an activity (ibid. at para. 56). See also M.N.R. v. El-
dridge (1964), [1965] 1 Ex. C.R. 758, [1964] C.T.C. 545 (Ex. Ct. Can.) (the court allowed
a taxpayer who had been assessed taxes on the gross revenues of her call-girl operation
to deduct the associated expenses she incurred in carrying on that illegal activity). One
example of a statutory provision that overrides this general principle is s. 67.6 in the
Income Tax Act (supra note 2), which disallows, effective 22 March 2004, the deduction
of any fine or penalty imposed under a law of a country by any person or public body
that has authority to impose the fine or penalty.

83 See e.g. M.N.R. v. Antosko, [1994] 2 S.C.R. 312, [1994] 2 C.T.C. (N.S.) 25 [cited to
S.C.R.]. Iacobucci J. stated on behalf of the majority that a normative assessment of
the consequences of the application of a given provision is within the ambit of the legis-
lature, not the courts (ibid. at 330). One example of a statutory provision that overrides
this general principle is the general anti-avoidance rule in s. 245 of the Income Tax Act
(supra note 2). Pursuant to s. 245(4), a court is required to consider whether a transac-
tion could reasonably be considered to result in a misuse of a particular provision or
abuse of the Income Tax Act as a whole. Where this requirement as well as the other
requirements in s. 245 are satisfied, then a court can tax the transaction under s. 245(2)
in a manner that is reasonable in the circumstances.

84 Shell Canada, supra note 22 at para. 43. See also Canderel Ltd. v. Canada, [1998] 1
S.C.R. 147 at para. 41, 155 D.L.R. (4th) 257; Royal Bank of Canada v. Sparrow Electric,
[1997] 1 S.C.R. 411 at para. 112, 143 D.L.R. (4th) 385.

146 (2010) 55 MCGILL LAW JOURNAL ~ REVUE DE DROIT DE MCGILL

C. The Federal Court of Appeals Approach Will Create Additional

Uncertainty and Inconsistency in the Law

While there will always be uncertainty in the legal outcome of a par-
ticular case,85 courts will try to minimize this uncertainty by applying the
law in a consistent, predictable, and fair manner.86 Another reason for re-
jecting the Federal Court of Appeals alternate approach is that it will
likely increase uncertainty in the law concerning the proper treatment of
shams, due to inconsistent application of the alternate approach and in-
consistent treatment of the legal effect of shams.

1. Inconsistency in What Behaviour Merits the Application of the

Federal Court of Appeals Alternate Approach

Why was there such an extreme difference in the two decisions in
1524994 Ontario Ltd.? Based on the same underlying behaviour of the
parties, the Tax Court of Canada and the Federal Court of Appeal used
two different approaches to facilitate two completely different tax results.
In my opinion, the answer is that each court viewed the impropriety of the
parties behaviour differently.87 This illustrates one of the problems that
will likely result if courts are able to use the Federal Court of Appeals al-
ternate approach to dealing with third category shams: the tax conse-
quences to the parties will be based on how the court views the parties
conduct. Not only will this result in inconsistent decisions as different
courts view parties behaviour differently, as did the Tax Court of Canada
and Federal Court of Appeal in 1524994 Ontario Ltd., but it will also in-
troduce an irrelevant consideration into what should be a neutral applica-
tion of tax law to the facts in issue.

85 See e.g. Lipson v. Canada, 2009 SCC 1, [2009] 1 S.C.R. 3 at para. 52, 301 D.L.R. (4th)

34.

86 Canada Trustco Mortgage v. Canada, 2005 SCC 54, [2005] 2 S.C.R. 601 at para. 12, 259
D.L.R. (4th) 193. See also Still v. M.N.R. (1997), [1998] 1 F.C. 549 at para. 45, 154
D.L.R. (4th) 229 (C.A.) [Still].

87 While McArthur T.C.J. did not find the parties conduct to be praiseworthy, he did be-
lieve that the Clinic was providing valuable services to its clients and that Dr. Rooneys
intentions in participating in the scheme were laudable. Given this generally positive
view, he was not concerned that the Clinic would escape paying GST as a result of ap-
plying the Continental Bank approach. Indeed, I believe that he was so determined to
find in favour of the parties that instead of fully applying the Continental Bank ap-
proach, once he determined that GST should not be applicable, he tried to justify it by
(incorrectly) finding an agency relationship. In contrast, from the tone in the very first
paragraph of his decision, it was clear that Dcary J.A., on behalf of the Federal Court
of Appeal, had a totally different opinion of the parties behaviour. Rather than being
neutral or even positive towards the parties like McArthur T.C.J., he was offended by
their actions. Not surprisingly, he chose to deviate from the Continental Bank approach
in order to penalize them for their inappropriate behaviour.

COMMENT: 1524994 ONTARIO LTD. V. M.N.R. 147

2. Inconsistency in the Legal Effect of a Sham

Under the Continental Bank approach, a sham, once established, will
be disregarded by the court regardless of who alleges it, and the true facts
in issue (to the extent they can be ascertained) will be used to decide the
case. In this respect, the Continental Bank approach provides for consis-
tency in the law. In all sham cases, once the deception has been estab-
lished, a court will deny it any legal effect.

In contrast, under the Federal Court of Appeals alternate approach to
dealing with Type III shams, the treatment of an alleged sham will be in-
consistent in its legal effect. Specifically, whether a sham will be given or
denied legal effect will depend on who has brought the matter to court
and the specific issue being litigated. If the victim of the sham brings the
case, then in either a Type I or II sham, the sham will be ignored and all
of the benefits obtained taken away. However, if the Minister brings the
case, and the Minister is not the intended victim (as in 1524994 Ontario
Ltd.), then the sham in a Type III sham case will be given legal effect in
order to impose a tax penalty.

Strictly speaking, it might be possible for one court to give a sham le-
gal effect in a tax case and for another court to deny the same sham legal
effect in a second case concerning non-tax implications.88 However, this
would create an inconsistency in the law of the kind criticized by Justice
McLachlin (as she then was) in her majority decision in Hall v. Hebert,89
as a threat to the integrity of the legal system. While Hall was a tort case
that concerned whether the ex turpi causa doctrine90 should be applied to
deny a plaintiff damages in a personal injury action, the comments by
Justice McLachlin summarize another key problem with adopting the
Federal Court of Appeals alternate approach of taxing Type III shams:

It would put the courts in the position of saying that the same con-
duct is both legal, in the sense of being capable of rectification by the
court, and illegal. It would, in short, introduce an inconsistency in
the law. It is particularly important in this context that we bear in
mind that the law must aspire to be a unified institution, the parts
of whichcontract, tort, the criminal lawmust be in essential

88 It is unlikely that the Federal Court of Appeals finding that the sham had legal effect
for tax purposes would ultimately prejudice OHIP on the basis of issue estoppel or
abuse of process if it decided to take action against the parties for allegedly violating the
provisions of the Ontario Health Insurance Act (supra note 50). However, a discussion of
this issue is beyond the scope of this paper. See generally C.R.B. Dunlop, Creditor-
Debtor Law in Canada, 2d ed. (Toronto: Carswell, 1995) c. 19 (chapter written by P.J.M.
Lown).

89 [1993] 2 S.C.R. 159, 101 D.L.R. (4th) 129 [Hall cited to S.C.R.].
90 Ibid. at 209. The full expression is ex turpi causa non oritur actio, which, in translation,

means no right of action arises from a base cause.

148 (2010) 55 MCGILL LAW JOURNAL ~ REVUE DE DROIT DE MCGILL

harmony. For the courts to punish conduct with the one hand while
rewarding it with the other, would be to create an intolerable fis-
sure in the laws conceptually seamless web. We thus see that the
concern, put at its most fundamental, is with the integrity of the le-
gal system.91

As further noted by Justice McLachlin92 and other justices in other
cases,93 though courts have established the principle that they will gener-
ally not assist parties whose actions involve illegal behaviour,94 this prin-
ciple is not to be applied mindlessly, but only where it protects the integ-
rity of the judicial process.95 In taxing a Type III sham as if it reflected the
true facts in issue, the integrity of the judicial system is harmed more
than it is protected.

Conclusion: A Wrong Should Not Be Taxed as a Right
Under the Continental Bank approach, absent a statutory provision to
the contrary, a court must consider whether the documents before it rep-
resent the true facts in issue. In those few cases where the documents do
not, a court must then attempt to determine the true facts before deter-
mining their legal and, as appropriate, tax effects. This approach is neces-
sary to preserve consistency and integrity in our legal system. While this
may have the unfortunate result of allowing parties to a Type III sham to
escape certain tax consequences, this is preferable to taxing the sham, as
the Federal Court of Appeal did in 1524994 Ontario Ltd. For the reasons
above, a wrong should not be taxed as a right.
That said, this paper should not be interpreted as encouraging parties

and their professional advisors to be careless or even fraudulent in re-
cording their transactions and relationships. As aptly stated by Justice
Bowman in Molinaro v. M.N.R., if one makes ones bed in a particular
way one shouldparticularly if one has had help from professional ac-

91 Ibid. at 176 [reference omitted].
92 Ibid. at 169.
93 See e.g. Norberg v. Wynrib, [1992] 2 S.C.R. 226 at 316, 92 D.L.R. (4th) 449; Still, supra

note 86 at paras. 12-37.

94 See especially Holman v. Johnson (1775), 98 E.R. 1120. Lord Mansfield held:

The principle of public policy is this; ex dolo malo non oritur actio. No
Court will lend its aid to a man who founds his cause of action upon an im-
moral or an illegal act. If, from the plaintiffs own stating or otherwise, the
cause of action appears to arise ex turpi caus, or the transgression of a posi-
tive law of this country, there the Court says he has no right to be assisted. It
is upon that ground the Court goes; not for the sake of the defendant, but be-
cause they will not lend their aid to such a plaintiff (ibid. at 1121).

95 Hall, supra note 89 at 170.

COMMENT: 1524994 ONTARIO LTD. V. M.N.R. 149

countants and lawyers in making the bedbe prepared to lie in it.96 It is
always open for parties to try to convince the courts (and the CRA) that
their documentation does not reflect reality in order to avoid an undesir-
able legal outcome. However, parties seeking to do so will have to over-
come the civil burden of proof by providing sufficiently clear, convincing
and cogent evidence that satisfies the trier of fact, on a balance of prob-
abilities, that their documentation does not reflect the true facts in is-
sue.97 In many cases, the parties will be unable to overcome this burden
and will have to accept the legal and tax consequences flowing from their
documentation.98 It is important to note, however, that in these cases, a
court is not taking the position that it will treat the sham as real despite

96 Molinaro v. M.N.R., [1998] 2 C.T.C. (N.S.) 2871 at para. 27, 52 D.T.C. 1636 (T.C.C.)

[Molinaro], affd (2000), 252 N.R. 178, [2000] 2 C.T.C. (N.S.) 12 (F.C.A.).

97 F.H. v. McDougall, 2008 SCC 53, [2008] 3 S.C.R. 41 at para. 46, 297 D.L.R. (4th) 193
[F.H.]. Prior to this decision, some courts hearing sham cases took the position that
while the standard balance of probabilities test governed, it would be more stringently
applied or would be a more onerous burden to overcome where the parties who created
the documentation were seeking to discredit it in court, especially where professionals
were involved in the preparation, or the parties actions were generally questionable.
For example, in Pallan v. M.N.R. ((1989), [1990] 1 C.T.C. (N.S.) 2257, 90 D.T.C. 1102
(T.C.C.) [Pallan cited to C.T.C. (N.S.)]), Christie A.C.J.T.C. described this increased bur-
den as follows:

It must be understood that if taxpayers create a documented record of
things said and done by them, or by them in concert with others, to achieve a
commercial purpose and then seek to repudiate those things with evidence of
allegations of conduct that is morally blameworthy in order to avoid an unan-
ticipated assessment to tax, they face a formidable task. And that task will
not be accomplished, in the absence of some special circumstance, an exam-
ple of which does not occur to me, by their oral testimony alone. That evi-
dence must be bolstered by some other evidence that has significant persua-
sive force of its own (at 2264).

See also Molinaro, supra note 96; Paxton v. M.N.R. (1996), 97 D.T.C. 5012 at 5018, 206
N.R. 241 (F.C.A.); Al Meghji & Gerald Grenon, An Analysis of Recent Avoidance
Cases in Report of Proceedings of Forty-Eighth Tax Conference, 1996 Tax Conference
(Toronto: Canadian Tax Foundation, 1997) 66:1 at 66:39-40. Care should be taken in re-
lying on these decisions following the Pallan approach, as this concept of having vary-
ing degrees within the balance of probabilities test was specifically rejected in F.H. (su-
pra note 97) by the Supreme Court of Canada. Rothstein J. stated the following on be-
half of the Court:

Like the House of Lords, I think it is time to say, once and for all in Canada,
that there is only one civil standard of proof at common law and that is proof
on a balance of probabilities. Of course, context is all important and a judge
should not be unmindful, where appropriate, of inherent probabilities or im-
probabilities or the seriousness of the allegations or consequences. However,
these considerations do not change the standard of proof. I am of the respect-
ful opinion that the alternatives I have listed above should be rejected for the
reasons that follow (ibid. at para. 40).

98 See e.g. Fortin v. M.N.R. (1996), [1998] 2 C.T.C. (N.S.) 2163, 97 D.T.C. 950 (T.C.C.).

150 (2010) 55 MCGILL LAW JOURNAL ~ REVUE DE DROIT DE MCGILL

the finding that the documents do constitute a sham; rather, a court is
simply finding that the testimony alleging a sham has not met the burden
of proof to be admitted into evidence. In such cases, the documents will
necessarily be taken as truly representing the facts since there will be no
other admitted evidence to the contrary.