[1] This appeal raises a question as to the extent to which the determination of the profit or loss of a partnership for the purposes of the Income Tax Act, R.S.C. 1985, c. 1 (5^th supp.), must adhere to an accounting principle adopted by the managing partner under the authority of a term in the partnership agreement.

Facts

[2] On August 10, 1992, Mr. E.P. Toothe and Mr. Barry A. Sawyer, both residents of The Commonwealth of the Bahamas, formed a partnership that was to be governed by Bahamian law. Nothing in this case turns on Bahamian partnership law (but in any event it must be assumed that Bahamian partnership law is substantially the same as Canadian partnership law, there being no evidence to the contrary).

[3] At all material times, Mr. Toothe was the Managing Partner of the Partnership. According to the Partnership agreement, the business of the Partnership included the purchase and sale of stocks and bonds, and was to be carried on in the Bahamas. Clause 2 of the Partnership agreement prohibited the Partnership from carrying on business in Canada or in certain other countries. Pursuant to clause 15 of the Partnership agreement, the office of the Partnership was located in the offices of Mr. Toothe in Nassau.

[4] Clause 7 of the Partnership agreement fixed December 31 as the fiscal year end of the Partnership, and provided that the Partnership's financial statements were to be prepared by the Managing Partner or the Partnership "on a consistent basis in accordance with generally accepted accounting principles for each fiscal year". It also provided that, for purposes of determining profits, losses, distributions of capital and returns of capital, the financial statements of the Partnership as prepared in accordance with the Partnership agreement would "be conclusive".

[5] On September 3, 1992, there were two outstanding units of the Partnership owned by Mr. Toothe and Mr. Sawyer. On that date the Partnership acquired from P.T. Limited, a Bahamian corporation, a number of zero coupon bonds in exchange for 1,798 newly issued units of the Partnership, so that the total number of outstanding Partnership units was 1,800. The bonds were described as follows:

Issuer of Bonds

Maturity

Date

Maturity Value

(¥)

Maturity Value

($US)

Tokio Marine & Fire Insurance

31/03/97

1,000,000

Mitsui Marine & Fire Insurance

29/03/02

59,000,000

Sumitomo Marine & Fire Insurance

31/03/03

54,000,000

Nippon Marine & Fire Insurance

31/03/98

20,000,000

Yasuda Marine & Fire Insurance

31/03/98

13,000,000

147,000,000

British Gas International Finance

4/11/21

7,500,000

[6] Generally, the market value of a zero coupon bond before its maturity date is less than its value at maturity because it cannot yield a return to the holder unless it is purchased at a discount. It is common ground that the market value on September 3, 1992 of the British Gas bonds was 9.34% of their maturity value (U.S.$700,500), and the market value of all of the bonds acquired by the Partnership was approximately U.S.$1,800,000, which was equal to U.S.$1,000 for each Partnership unit then outstanding.

[7] On September 3, 1992, after the Partnership had acquired the bonds, Mr. Bernick and six other individuals purchased from P.T. Limited its 1,798 Partnership units for US$1,000 per unit. Mr. Bernick purchased 1,620 of the units for US$1,620,000. Although Mr. Bernick's units represented 90% of the Partnership units then outstanding, clause 10 of the Partnership agreement limited his voting rights to 50%.

[8] The Partnership agreement permitted the Managing Partner to make all decisions relating to the preparation of the Partnership financial statements. Mr. Toothe, apparently acting in accordance with that mandate, decided that the Partnership's zero coupon bonds would be shown on the Partnership's financial statements as having a cost equal to their maturity value.

[9] The Partnership completed a number of transactions in the years 1992 to 1994, including the disposition of the British Gas bonds at their market value from time to time, which ranged from 10% to 14% of maturity value. Because the Partnership's balance sheets showed the British Gas bonds at their maturity value, the Partnership's statements of profit and loss reflected a loss on each sale of British Gas bonds. The losses comprised part of the Partnership's total losses for those years, as set out in the financial statements of the Partnership.

[10] The financial statements of the Partnership were the subject of an unqualified audit opinion rendered by a Canadian chartered accountant, who was also a partner of the Partnership, having acquired 36 units at the same time as Mr. Bernick acquired his 1,620 units. The audit opinions for each year are similar. For example, the 1992 opinion states, among other things, that the "financial statements present fairly, in all material respects, the financial position of the partnership as at 31 December, 1992 and the results of its operations and the changes in its financial position for the period then ended in accordance with generally accepted accounting principles".

[11] Mr. Bernick, in filing his income tax returns for 1992, 1993 and 1994, claimed deductions for his 90% share of the reported losses of the Partnership, converted to Canadian funds. The deductions were $2,468,903 for 1992, $2,708,523 for 1993 and $2,189,920 for 1994.

[12] After an income tax audit, the Minister concluded that, for Canadian income tax purposes, the Partnership's gain or loss on the sale of the British Gas bonds should have been determined on the basis that the cost of the bonds to the Partnership was their market value when acquired by the Partnership (9.34% of their maturity value). Based on that reasoning, the Minister reassessed to reduce Mr. Bernick's share of the 1992 Partnership loss to $4,152, to disallow the 1993 and 1994 Partnership losses and replace them with a profit of $553,916 for 1993 and a profit of $136,595 for 1994.

[13] The Minister also imposed penalties on Mr. Bernick under subsection 163(2) of the Income Tax Act of $391,341 for 1992, $510,898 for 1993 and $364,332 for 1994.

Mr. Bernick's appeal to the Tax Court of Canada

[14] Mr. Bernick appealed the reassessments to the Tax Court of Canada. He gave oral evidence in the Tax Court. The chartered accountant who gave the audit opinions referred to above did not give evidence. Mr. Bernick relied mainly on the expert opinion of Mr. Darryl Butler, C.A., a licensed member of the Bahamas Institute of Chartered Accountants who, since 1984, has practised as a chartered accountant in Nassau with the firm of Butler and Taylor, one of the member firms of Moore Stephens International Limited.

[15] Mr. Butler's opinion was that it was "proper and acceptable" for the Partnership to prepare its financial statements on the basis that the cost of its zero coupon bonds was their maturity value, rather than their acquisition cost or their fair market value. According to his report, he reached that conclusion for a number of reasons. First, the Partnership is not a statutory body and is not obliged to disclose its affairs publicly. Second, the partners, as the only users of the financial statements of the Partnership, fully understood the situation and so would not have been not misled by the chosen accounting method. Third, the chosen accounting method was not inconsistent with the Partnership agreement, which left the matter of financial statements to the discretion of the Managing Partner. Mr. Butler's oral evidence indicated that he had also assumed that the British Gas bonds were long term investments, a factual premise that was found by the Judge to be incorrect. Mr. Butler was not asked to opine on whether the chosen accounting method resulted in an accurate picture of the Partnership's profits.

[16] The Crown presented the expert accounting evidence of Daniel P. Thornton, PhD, FCA, a professor of financial accounting at Queen's University. His opinion was that the Partnership's income from trading in British Gas bonds during the relevant period was between U.S.$46,625 and U.S.$140,875 under Canadian, U.S. or international generally accepted accounting principles, and that any determination of Partnership income outside that range would be misleading. He characterized as "ridiculous" the proposition that the Partnership suffered a loss from its transactions in British Gas bonds. The following appears at page 4 of his report:

The appellant's recording of the bonds at their face (maturity) value is not an acceptable accounting practice under any circumstances. Besides being contrary to GAAP, it gives the ridiculous result that the Partnership cannot avoid recognizing a loss on the bonds unless it holds them for 29 years. If it holds them for 29 years, the Partnership breaks even when it receives the maturity value in the year 2021; however, no rational investor would leave $7,500,000 sitting idle, earning zero interest, for any length of time, let alone 29 years. Thus, this method of accounting produces results that do not faithfully represent the results of the Partnership's trading activities.

[17] Mr. Bernick's appeal to the Tax Court of Canada was dismissed, except that the penalties were reduced to $100 for each year: Bernick v. Canada, [2003] 4 C.T.C. 2494, 2003 D.T.C. 839 (T.C.C.). Mr. Bernick now appeals to this Court.

Issues in this appeal

[18] The main submission for Mr. Bernick is that the Minister is bound as a matter of law to accept the computation of the losses of the Partnership as presented in its audited financial statements. It is submitted in the alternative that the Minister's reassessments apply a provision of the Income Tax Act that does not apply to the Partnership.

[19] Mr. Bernick initially appealed the reduced penalty, and the Crown cross-appealed to argue that the penalty should not have been reduced. However, the Crown discontinued its cross-appeal before the hearing, and Mr. Bernick did not pursue his appeal of the reduced penalty. For that reason, I will not comment on penalties.

Analysis

[20] My analysis of the principal submission for Mr. Bernick begins and ends with the judgment of Mr. Justice Iacobucci, writing for the Supreme Court of Canada in Canderel Limited v. Canada, [1998] 1 S.C.R. 147, and in particular the following summary of principles as set out in paragraph 53 of his judgment (case references omitted):

(1) The determination of profit is a question of law.

(2) The profit of a business for a taxation year is to be determined by setting against the revenues from the business for that year the expenses incurred in earning said income [...].

(3) In seeking to ascertain profit, the goal is to obtain an accurate picture of the taxpayer's profit for the given year.

(4) In ascertaining profit, the taxpayer is free to adopt any method which is not inconsistent with

(a) the provisions of the Income Tax Act; (b) established case law principles or "rules of law"; and

(5) Well-accepted business principles, which include but are not limited to the formal codification found in GAAP, are not rules of law but interpretive aids. To the extent that they may influence the calculation of income, they will do so only on a case-by-case basis, depending on the facts of the taxpayer's financial situation.

(6) On reassessment, once the taxpayer has shown that he has provided an accurate picture of income for the year, which is consistent with the Act, the case law, and well-accepted business principles, the onus shifts to the Minister to show either that the figure provided does not represent an accurate picture, or that another method of computation would provide a more accurate picture.

[21] I take from this summary that an accounting method is not acceptable for income tax purposes unless it results in an accurate determination of income, and is not inconsistent with the Income Tax Act, established rules of law, or well accepted business principles. By that standard, the accounting method adopted by the Partnership in this case is fatally flawed by its inaccurate result.

[22] The obvious consequence of the accounting method adopted for the Partnership is that if the Partnership were to sell the British Gas bonds at market value at any time prior to their maturity in 2021, the sale price would be less than their maturity value. It is equally obvious that the consistent application of the accounting approach adopted for the Partnership would result in the Partnership's statements of profit and loss representing every sale of British Gas bonds as resulting in a loss, even if the Partnership is wealthier after selling all the bonds than it was when it acquired them.

[23] The Judge observed, at paragraph 42 of his reasons, that the accounting method adopted for the Partnership was "so out of whack with economic reality" that it did not meet the underlying fundamental criterion of accuracy in reporting income. I must agree with the Judge's conclusion on that point. I note also that the Judge's comments are consistent with the opinion of the Crown's expert, who as indicated above characterized the Partnership's chosen accounting method as "ridiculous".

[24] In this context, "accuracy" means reasonable accuracy, bearing in mind that any computation of profit may involve estimates and judgment calls relating to timing, allocation, estimates of value, and other such matters that accountants are often called upon to make. Thus, for example, if I were to accept for the sake of argument the opinion of Mr. Thornton that the Partnership's income from trading in British Gas bonds was an amount between U.S.$46,625 and U.S.$140,875, then theoretically, any accounting method that resulted in a computation of income within that range could be sufficiently accurate to meet the "accuracy" criterion in Canderel. For the reasons explained above, the accounting method adopted by the Partnership fails that test quite hopelessly.

[25] Counsel for Mr. Bernick did not attempt to defend the Partnership's accounting method on the basis that it was accurate. Rather he argued that, since the accounting method adopted by the Partnership was not inconsistent with the Income Tax Act or with any established legal principle relating to the computation of income, and conformed to the only set of business principles that could possibly be applied (namely, the principles relied upon by Mr. Butler in reaching the conclusion that the financial statements of the Partnership were "proper and acceptable"), Mr. Bernick was entitled as a matter of law to use that accounting method in reporting his share of the Partnership losses for Canadian income tax purposes.

[26] Essentially, counsel for Mr. Bernick was reading the fourth principle from Canderel as though accuracy is irrelevant, or alternatively that consistency with the Income Tax Act, established legal principles, and applicable business principles is sufficient to establish "accuracy" for income tax purposes. I am unable to accept either interpretation of Canderel. In my view, an accounting method that cannot possibly produce an accurate result can never meet the Canderel standard.

[27] However, even if Canderel is read as counsel for Mr. Bernick suggests, the evidence in this case falls short of establishing conformity with applicable business principles. The only evidence on that point is the opinion of Mr. Butler, which the Judge declined to rely on because it was based in part on the premise that the British Gas bonds were long term investments of the Partnership. The Judge found that premise to be false because the British Gas bonds constituted inventory to be traded in the short term, a factual conclusion that was well supported by the evidence.

[28] For these reasons, I conclude that there is no merit in the principal submission made for Mr. Bernick.

Alternative argument: subsection 96(8) of the Income Tax Act

[29] Counsel for Mr. Bernick argued that the accounting method adopted by the Minister in issuing the reassessments under appeal is in substance an application of paragraph 96(8)(b) of the Income Tax Act, which imposes a "lower of cost or market" rule for determining the cost of inventory of certain foreign partnerships. Of course, counsel for Mr. Bernick is correct to say that the Minister was not entitled to apply paragraph 96(8)(b) to the Partnership, because the Partnership had no Canadian partners before December 21, 1992 (see subsection 44(1) of S.C. 1994, c. 21).

[30] This argument must also fail because, according to the record, the Minister did not rely on paragraph 96(8)(b) in determining the profits and losses of the Partnership for purposes of issuing the reassessments under appeal.

[31] The Minister computed the Partnership's profit on each sale of British Gas bonds as the difference between the proceeds of sale and the Partnership's acquisition cost of the bonds sold, which the Minister determined to be the market value of the bonds when they were acquired (9.34% of their maturity value). That method of determining the acquisition cost of the bonds is based on the well established principle of income tax law that the cost of property acquired by a taxpayer is the amount of money or the value of the consideration given in exchange for the property (see, for example, The D'Auteuil Lumber Company Limited v. The Minister of National Revenue, [1970] Ex. C.R. 442).

[32] In this case, the consideration given by the Partnership for the bonds consisted of units of the Partnership. As the bonds acquired on September 3,1992 (which included the British Gas bonds) comprised substantially all of the Partnership property when the bonds were acquired, it was reasonable to conclude that the value of the consideration paid by the Partnership for all of the bonds was equal to their market value when acquired which, in the case of the British Gas bonds, was 9.34% of their maturity value.

Conclusion

[33] For these reasons, I would dismiss this appeal with costs.

"Karen R. Sharlow"

J.A.

"I agree

A. J. Stone"

"I agree

Marc Nadon"

FEDERAL COURT OF APPEAL

NAMES OF COUNSEL AND SOLICITORS OF RECORD

DOCKET: A-343-03

STYLE OF CAUSE: HENRY BERNICK

Appellant

and

HER MAJESTY THE QUEEN

Respondent

PLACE OF HEARING: TORONTO, ONTARIO

DATE OF HEARING: MAY 10, 2004

REASONS FOR JUDGMENT : SHARLOW J.A.

CONCURRED IN BY: STONE J.A.

NADON J.A.

DATED: MAY 12, 2004

APPEARANCES:

Vern Krishna, Q.C.

Barry S. Wortzman, Q.C. FOR THE APPELLANT

Ms. S. Patricia Lee

Mr. James Rhodes FOR THE RESPONDENT

SOLICITORS OF RECORD:

Borden Ladner Gervais LLP

Ottawa, Ontario

Shibley Righton LLP

Toronto, Ontario FOR THE APPELLANT

Morris Rosenberg

Deputy Attorney General of Canada FOR THE RESPONDENT

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