Date: 20010522
Docket: 1999-790-IT-G
BETWEEN:
KENNETH DAVID KLEIN,
Appellant,
and
HER MAJESTY THE QUEEN,
Respondent.
Reasons for Judgment
Lamarre, J.T.C.C.
[1] This is an appeal under the Income Tax Act ("Act") against an assessment made by the Minister of National Revenue ("Minister") for the appellant's 1996 taxation year. In assessing the appellant, the Minister disallowed a business investment loss in the amount of $103,257 claimed by the appellant for that year and treated it simply as a capital loss.
[2] The parties have filed an Agreed Statement of Facts, which reads as follows:
1. On April 17, 1986 Jasag Investments Ltd. (Jasag) was incorporated in Manitoba. Shortly after incorporation Jasag purchased and [sic] undivided ½ interest in the lands, buildings, and assets of a motel and small car wash operated in Winnipeg Mb. The owner of the remaining undivided ½ interest was Greenwise Ltd. (Greenwise) an unrelated corporation.
2. The practical way for Jasag and Greenwise to operate the motel and car wash assets was as a partnership, and the day to day management and operations of the motel and car wash were carried on by them under the firm and business name of Motel 75 under an oral partnership agreement until Feb 28, 1991.
3. The Motel 75 operations had been experiencing serious financial difficulties for some time and the business required additional capital and management to survive. Effective Feb., 28, 1991 all the shares in Jasag were sold to the Appellant for $4.00. The vendors and purchaser of the shares were unrelated and dealt at arm's length. The Appellant was and continues to be the sole shareholder and director of Jasag since Feb., 28, 1991.
4. In contemplation of the purchase of Jasag's shares by the Appellant, on Feb., 27, 1991 the oral partnership agreement was replaced with a written agreement between Greenwise, and Jasag, and the Appellant was also made a party thereto.
5. Under the partnership agreement the partners Greenwise and Jasag were to provide for loans to the partnership of approximately $300,000.00 to be used to preserve and improve the motel real estate and in particular to pay substantial outstanding realty taxes, utility bills, repairs to the buildings and other debts. Greenwise was to loan and did loan $200,000.00. Jasag had no money and no equity in any assets and no net worth. For that reason and other valid business reasons, the Appellant was made a party to the agreement and was required to personally loan and did loan the sum of $100,000.00 to the partnership in lieu of a contribution by Jasag. The Appellant loaned a total of $103,257.00 to the partnership under the agreement.
6. The financial statements of Motel 75 prepared by independent auditors from April 30, 1991 and each year thereafter contain an auditors [sic] note confirming the details of the loan by the Appellant and state "4. Due to K.D. Klein In lieu of a capital contribution from Jasag Investments Ltd. as required by an agreement between the partners, the contribution was advanced to the partnership by K.D. Klein. The advance is non-interest bearing."
7. Jasag and Greenwise employed a manager to manage the Motel. Financial difficulties again occurred and on September 19, 1995 default under a secured debenture occurred and the secured creditor appointed an interim receiver-manager to replace the manager employed by the partners and to receive and disburse all funds received from the motel operations.
8. Greenwise and the Appellant had more than $300,000.00 in loans invested in Motel 75. In addition to the loans Greenwise and Jasag had accumulated considerable equity and together with the Appellant had invested much effort in Motel 75, and both before as well as after the default and appointment of the receiver-manager, efforts were made by them to remedy the default or in the alternative to find a purchaser of the Motel 75 operation and car wash, but their efforts were unsuccessful.
9. The secured creditor proceeded with mortgage sale proceedings by holding a court ordered and supervised public auction of the Motel operations and assets on December 20, 1995.
10. The public auction was unsuccessful and on January 4, 1996 the court issued a Notice of Application For Final Order of foreclosure which granted the owners Jasag and Greenwise and every other person having an interest in the motel assets a period of one month after service of the Notice on them to take proceedings to contest the foreclosure or to pay the arrears or otherwise remedy the default under the debenture.
11. The appellant was out of the country and was not served, and on February 19, 1996 the court ordered that the Appellant be served by substitutional service by registered mail with a copy of the court ordered Notice of Application For Final Order of Foreclosure dated January 4, 1996, which was served by registered mail sometime after February 21, 1996.
12. The motel assets continued to be owned by Greenwise and Jasag and managed by the receiver-manager until sometime after March 21, 1996 in accordance with the terms of the Notice of Application For Final Order of Foreclosure being the date which was one month after the date that the Appellant was served with the Notice by substitutional service and on that date the motel assets of Jasag were transferred by operation of law.
13. After the final order of foreclosure became effective, the Appellant waited approximately one month until Jasag's fiscal year end on April 30th 1996 for an accounting of funds received and disbursed during the Motels [sic] operation and by the receiver-manager on the final disposition of all the motel assets but never received same. Thereafter the Appellant made inquiries that showed there would not be any funds available from operations or the disposition of the motel assets to be applied towards his indebtedness.
14. Jasag and Greenwise for a considerable time in 1996 both before and after the Notice of Final Order of Foreclosure became effective performed the necessary business activities for going out of business such as, sales tax returns, employees [sic] earnings slips, severance slips, dealing with outstanding claims and accounts receivable and payable, preparing bookkeeping records for Jasag's April 30 1996 fiscal year end, etc.
15. The Appellant claimed the loaned sum of $103,257.00 as non-capital loss of other years in his 1996 tax return. In 1996 the Appellant established that this loan was not recoverable and was therefor [sic] a bad debt. The Respondent reassessed this sum as a bad debt under 50(1)(a) and therefor [sic] a capital loss from a loan made to Motel 75.
16. Jasag was a Canadian controlled private corporations [sic] (ccpc) and small business corporations [sic] (sbc) per 248(1) at all material times. The respondent admits that Jasag was a ccpc and a sbc but only until September 19 1995. Greenwise was a ccpc and a sbc per 248(1) at all material times.
Facts
[3] In his testimony, the appellant said that he made a conscious decision to lend the money directly to the Motel 75 partnership as opposed to lending it through his own corporation, Jasag, one of the partners in the partnership. Indeed, when the appellant bought the Jasag shares in February 1991, Jasag had no money, no equity and no bank account and the appellant did not know if it had any pending contingent liabilities. The appellant was concerned with ensuring that the money he lent be used in the partnership and not claimed by anyone else. This is why he did not open a bank account for Jasag but rather deposited the money directly into the partnership.
[4] The Partnership Agreement filed as Exhibit A-4 states the following in paragraph 8:
8. The partners [Greenwise and Jasag] shall loan to the partnership the following amounts without interest to be secured by way of a second real property mortgage, to be registered against the lands and to be payable pro rata to the partners at such time as the partnership assets are sold or the partners unanimously agree, but not otherwise:
a) Greenwise or Green shall loan to the partnership on or before the 1st day of March, 1991, the sum of $200,000.00;
b) Klein shall loan to the partnership on or before the 1st day of March, 1991, the sum of $100,000.00;
[5] The financial statements of the partnership show a long-term debt of $103,257 due to the appellant personally. A note to the financial statements indicates that "in lieu of a capital contribution from Jasag Investments Ltd. as required by an agreement between the partners, the contribution was advanced to the partnership by K.D. Klein. The advance is non-interest bearing" (Exhibit A-7).
[6] Although the Partnership Agreement states that he was to have the general care, control and management of the partnership business and assets (Exhibit A-4, paragraph 14), the appellant testified that he moved from the province of Manitoba to the province of Ontario in the fall of 1991. He stated that his involvement with the partnership was that of an absentee partner once he left the province of Manitoba. Consequently, he did not have much input into the operation of the partnership's business or into the preparation of the financial statements, particularly in 1995 and 1996. According to the appellant, it was Greenwise, the other partner -- with which he had few discussions between 1991 and 1995 -- that made decisions for the partnership. According to the appellant, he was never advised that the partnership's business activities had ceased in September 1995, when the receiver-manager was appointed. He eventually received the Notice of Appointment of a receiver-manager by the secured creditor, which notice was filed as Exhibit A-9. Even at that time, it was not clear to the appellant that the business had been closed down. The appellant said that in 1991, before he invested $100,000 in the partnership, the business had experienced similar financial difficulties, the debenture holder having started proceedings under his mortgage. At that time, the appellant had had to obtain an injunction to prevent the debenture holder from proceeding.
[7] A mortgage sale of the assets used in the partnership's business held by the secured creditor on December 20, 1995, was unsuccessful. The partnership's financial statements for the period ended September 18, 1995 (date of the appointment of a receiver-manager by the creditor) showed no cash available, no accounts receivable and low inventory on the balance sheet. Still, the appellant claims that he did not realize that Greenwise, the other partner, would not refinance the business until the final order of foreclosure was issued in February 1996. The appellant himself was asked to contribute more money to the partnership in the fall of 1995, but he was not interested in investing any more in that venture.
Arguments of the parties
[8] Counsel for the respondent submits that the appellant chose for business reasons to lend money directly to the partnership as opposed to lending money through his corporation, Jasag. It is the respondent's position that a loan to a partnership does not qualify as an allowable business investment loss within the meaning of paragraph 39(1)(c) of the Act, which reads as follows:
SECTION 39: Meaning of capital gain and capital loss.
(1) For the purposes of this Act,
. . .
(c) a taxpayer's business investment loss for a taxation year from the disposition of any property is the amount, if any, by which the taxpayer's capital loss for the year from a disposition after 1977
(i) to which subsection 50(1) applies, or
(ii) to a person with whom the taxpayer was dealing at arm's length
of any property that is
(iii) a share of the capital stock of a small business corporation, or
(iv) a debt owing to the taxpayer by a Canadian-controlled private corporation (other than, where the taxpayer is a corporation, a debt owing to it by a corporation with which it does not deal at arm's length) that is
a small business corporation,
. . .
SECTION 50: Debts established to be bad debts and shares of bankrupt corporation.
(1) For the purposes of this subdivision, where
(a) a debt owing to a taxpayer at the end of a taxation year (other than a debt owing to the taxpayer in respect of the disposition of personal-use property) is established by the taxpayer to have become a bad debt in the year . . .
and the taxpayer elects in the taxpayer's return of income for the year to have this subsection apply in respect of the debt or the share, as the case may be, the taxpayer shall be deemed to have disposed of the debt or the share, as the case may be, at the end of the year for proceeds equal to nil and to have reacquired it immediately after the end of the year at a cost equal to nil.
[9] Pursuant to paragraph 39(1)(c), a taxpayer may claim a business investment loss from the disposition of a property that is, in particular, a debt owing to the taxpayer by a Canadian-controlled private corporation that is a small business corporation. According to counsel for the respondent, a debt that is owed by a partnership is not a debt owed by a Canadian-controlled private corporation.
[10] In the alternative, the respondent submits that Jasag did not qualify as a small business corporation as of September 1995, when the receiver-manager took over the partnership's business on behalf of the debenture holder. A small business corporation is defined in subsection 248(1) as follows:
"small business corporation" - "small business corporation", at any particular time, means, subject to subsection 110.6(15), a particular corporation that is a Canadian-controlled private corporation all or substantially all of the fair market value of the assets of which at that time is attributable to assets that are
(a) used principally in an active business carried on primarily in Canada by the particular corporation or by a corporation related to it,
(b) shares of the capital stock or indebtedness of one or more small business corporations that are at that time connected with the particular corporation (within the meaning of subsection 186(4) on the assumption that the small business corporation is at that time a "payer corporation" within the meaning of that subsection), or
(c) assets described in paragraphs (a) and (b),
including, for the purpose of paragraph 39(1)(c), a corporation that was at any time in the 12 months preceding that time a small business corporation, and, for the purpose of this definition, the fair market value of a net income stabilization account shall be deemed to be nil. . . .
[11] According to the respondent, the assets of Jasag ceased to be used in an active business on September 19, 1995, and therefore Jasag ceased to be a small business corporation at that time. Accordingly, when the appellant was deemed to have disposed of his debt in 1996 (at the end of 1996, the year in which the notice of foreclosure took effect), Jasag no longer qualified (and did not qualify in the 12 months preceding the end of 1996) as a small business corporation. Therefore, counsel for the respondent submits that the requirements of paragraph 39(1)(c) are not met and that the loss does not qualify as a business investment loss.
[12] The appellant submits that the loan made by the appellant to the partnership was made on behalf of Jasag, in lieu of a capital contribution from Jasag, as required by the Partnership Agreement. The appellant relies on The Partnership Act of Manitoba, R.S.M. 1987, c.P30, as it read in the years at issue, which states the following in sections 2, 3, 6 and 12:
Saving for rules of equity and common law.
2(2) The rules of equity and of common law applicable to partnership continue in force, except so far as they are inconsistent with the express provisions of this Act.
Definition of partnership.
3 Partnership is the relation which subsists between persons carrying on a business in common, with a view of profit; but the relationship between members of an incorporated company or association is not a partnership within the meaning of this Act.
Meaning of firm.
6 Persons who have entered into partnership with one another are for the purposes of this Act called collectively a firm, and the name under which their business is carried on is called the firm name.
Liability of partners.
12 Every partner of a firm is liable jointly and severally with the other partners, for all debts and obligations of the firm incurred while he is a partner. . . .
[13] According to the appellant, the partnership cannot in law owe any money to the appellant. The partners, i.e. Jasag and Greenwise, are the ones liable for the debts incurred by the partnership. Consequently, it can be argued that the loan by the appellant to the partnership was in fact and in law owed by the corporate partners, Jasag and Greenwise.
[14] With respect to the issue of whether Jasag qualified as a small business corporation at the time the appellant was deemed to have disposed of his debt in 1996, the appellant submits that Jasag continued to own and remained the owner of its share of the assets used in Motel 75 partnership - which were being managed by the receiver-manager - and retained full rights to pay the mortgage arrears and, consequently, to employ the managers of Motel 75 as Jasag and Greenwise saw fit, until the month of February 1996. According to the appellant, Jasag was a small business corporation up until the month of February 1996 when there was a foreclosure involving the assets used in the partnership and the partnership was automatically terminated. The debt owing to the appellant by Jasag became a bad debt within the meaning of subsection 50(1) in 1996, in which year Jasag was still a small business corporation. The appellant therefore claims that he suffered a business investment loss within the meaning of paragraph 39(1)(c) of the Act.
Analysis
[15] There is no dispute that the appellant incurred a capital loss in 1996. The sole issue in the present appeal is whether the loan in the amount of $103,257 from the appellant to the Motel 75 partnership resulted in a debt owing to the appellant by a Canadian-controlled private corporation that was a small business corporation.
[16] The first point raised by the respondent is that the debt involved is the debt of a partnership and not of a Canadian-controlled private corporation.
[17] Under the applicable Manitoba legislation, a partnership is a contractual relation that subsists between persons carrying on a business in common (see section 3 of The Partnership Act, of Manitoba, supra). As leading commentators on English law have stated:
The legal view of a firm is very different: in English law, the firm is not generally recognised as an entity distinct from the partners composing it. (R.C. I'Anson Banks, Lindley & Banks on Partnership, 17th ed. (London: Sweet & Maxwell, 1995) at 32.
[18] According to this view, a partnership is not a separate, independent entity or body distinct from the partners composing it. In the Income Tax Act also, a partnership is understood as lacking legal personality. Indeed, paragraph 96(1)(a) of the Act requires income to be calculated "as if the partnership were a separate person". Then there is paragraph 96(1)(f), which requires partnership income to be apportioned among the individual members in accordance with their partnership interests. It is the individual partners who are liable to pay tax on the income of the partnership. In Madsen v. Canada, [2000] F.C.J. No. 2139 (F.C.A.), Linden J.A. stated the following at paragraphs 16 and 17:
. . . In my view, the foregoing 'regime' implies nothing more than a notional construct for calculating a taxpayer's tax liability. It is a purely administrative convenience necessary to sustain the Act's view of the partnership as a conduit or vehicle for taxpayers.
. . .
17 In this way, the fiction of a partnership as an entity separate from the partners is temporary and does not extend to colour the true legal nature of transactions at the time they are entered into by a partnership. The characterization of legal relationships is generally left to established principles of partnership law. This approach was most recently affirmed by this Court in Adams v. Canada (appeal by Robinson) [See Note 11 below]. . . .
________________
Note 11: [1998] F.C.J. No. 397 (F.C.A.).
[19] Lord Lindley and Banks express as follows the consequences flowing from the legal view of partnership, at pp. 19-20:
. . . the firm is not an entity distinct from the individuals composing it and the partners collectively cannot acquire rights or incur obligations. The rights and liabilities of a partnership are the rights and liabilities of the partners and are enforceable by and against them individually. The principle is stated by the civilian lawyers thus: Si quid societati debetur singulis debetur et quod debet societas singiuli debent. (If anything is owed to the partnership, it is owed to the individual members and the individual members owe what is owed by the partnership).
[20] In Green v. Hertzog, [1954] 1 W.L.R. 1309, Lord Lindley described the ramifications of a partnership's having no separate legal personality in the following terms:
The law, ignoring the firm, looks to the partners composing it; any change amongst them destroys the identity of the firm; what is called the property of the firm is their property, and what are called the debts and liabilities of the firm are their debts and their liabilities.
[21] The same theory can be derived from The Partnership Act of Manitoba where it is clearly stated in section 12 that "every partner of a firm is liable jointly and severally with the other partners, for all debts and obligations of the firm incurred while he is a partner".
[22] The legal view of a partnership, which is adopted by the provincial legislation, clearly states that the partnership itself does not have the capacity to be indebted. The debt of the partnership is owed by the partners, in the present case Jasag and Greenwise.
[23] Clause 39(1)(c)(iv)(A) of the Act states that a business investment loss relates to "a debt owing to the taxpayer by a Canadian-controlled private corporation . . . that is a small business corporation".
[24] The question now remains as to whether Jasag, which owed the debt to the appellant, was a Canadian-controlled private corporation that was a small business corporation in 1996, the year the debt was disposed of, i.e. the year the debt became a bad debt.
[25] It is not questioned that Jasag was a Canadian-controlled private corporation. The respondent is, however, of the view that Jasag was not a small business corporation after September 19, 1995, when a receiver-manager was appointed by a secured creditor. The respondent submits that the assets of Jasag ceased to be used in an active business at that time and Jasag therefore ceased to be a small business corporation.
[26] It is agreed by the parties in the Agreed Statement of Facts that the interim receiver-manager was appointed by the secured creditor to replace the manager employed by the partners and to receive and disburse all funds received from the motel operations (paragraph 7). It is also agreed that the motel assets continued to be owned by Greenwise and Jasag (the two partners) and managed by the receiver-manager until sometime after March 21, 1996 in accordance with the terms of the Notice of Application for Final Order of Foreclosure (paragraph 12). Nor does the respondent dispute the fact that Greenwise was a small business corporation at all material times.
[27] In order for a corporation to qualify as a small business corporation, subsection 248(1) requires, in particular, that all or substantially all of the fair market value of the assets of the corporation be used principally in an active business carried on by that particular corporation.
[28] As evidenced by paragraph 1 of the Agreed Statement of Facts, it would appear that Jasag's only asset was the one-half interest in the lands, buildings and assets of a motel and car wash operated under the name of Motel 75.
[29] Whether these assets were used primarily in an active business carried on by Jasag is a question of fact, dependent on the circumstances of this particular case (see The Queen v. Rockmore Investments Ltd., 76 DTC 6156 (F.C.A.)).
[30] In the present appeal, it appears that the receiver-manager was appointed by a secured creditor (see Notice of Appointment to Debtor, Exhibit A-9), pursuant to the terms of a debenture with respect to which there had been a default in payment, as receiver and manager of all the partners' assets, property and undertaking with such powers as were contained in the appointment letter. That appointment letter was not filed in evidence nor was the debenture that led to the appointment of the receiver-manager, so it is difficult to establish with certainty the extent to which the receiver-manager could exercise his powers.
[31] It may not be crystal clear from the Agreed Statement of Facts and the documents filed in evidence whether or not an active business ceased to be carried on as of the date the receiver-manager was appointed on September 19, 1995. However, it is admitted by the parties that the interim receiver-manager was appointed to replace the manager employed by the partners and to receive and disburse all funds received from the Motel 75's operations. In my view, this is certainly an indication that the Motel 75's operations were still being actively carried on and that the receiver-manager was there to operate the business in lieu of the former manager appointed by the partners.
[32] Furthermore, it is agreed by the parties that the partners, Greenwise and Jasag, had invested much effort both before and after the default and the appointment of the receiver-manager in attempting to avoid or remedy the default, or in the alternative, in finding a purchaser for the Motel 75 operation and car wash. It is also agreed that Motel 75's assets continued to be owned by Greenwise and Jasag but managed by the receiver-manager until sometime after March 21, 1996.
[33] In my view, this is an indication that the receiver-manager was acting not only as an agent for the secured creditor but also as an agent of the debtor partners for the purposes of managing the business, as is frequently the case in common law with a privately appointed receiver-manager (see F. Bennett, Receiverships (Toronto: The Carswell Company Limited, 1985), Chapter 1, "5. Personal Liability of Receiver and Manager", pp. 6-7).
. . . Under many security instruments, the receiver and manager is a "double agent". He is appointed by the security holder to take possession and realize, while at the same time he is deemed to be the agent of the debtor for the purposes of managing the business and contracting with third parties.17
__________________
17 See Chapter 5, "2.(b) Status of Privately Appointed Receiver and Manager".
[34] Although I am fully aware that the filing of the security instrument giving rise to the appointment of the receiver-manager would have been more than helpful, particularly to establish the presence of a deemed agency clause, I find that the facts agreed upon by the parties are sufficient to enable me to conclude that an active business was still being carried on on behalf of the debtor corporations Jasag and Greenwise until sometime after March 21, 1996.
[35] I must add here that it strikes me that the respondent did not challenge the fact that the other partner, Greenwise, was a small business corporation at all material times. Although this may have been agreed upon by the respondent in relation to other facts or with respect to other operations carried on by Greenwise, no evidence was put before me to differentiate the cases of Greenwise and Jasag. Besides, it is worth remembering that, under The Partnership Act of Manitoba, Greenwise is jointly and severally liable with Jasag for the debt owed to the appellant. I did not find anything in the Partnership Agreement that would negate that joint liability. As a result, it can be said that the debt owed to the appellant was also owed by Greenwise, a Canadian-controlled private corporation that was a small business corporation at all material times (as agreed by the respondent).
[36] In summary, I conclude that both Jasag and Greenwise qualified as small business corporations within the meaning of the Act at some point in the 12 months preceding the time the appellant's debt was disposed of, at the end of 1996. Consequently, I conclude that the appellant incurred, in 1996, a capital loss from the disposition of a property that was a debt owed to him by Jasag and Greenwise, both Canadian-controlled private corporations that were small business corporations at some point in the year 1996.
[37] As a result, the appellant is entitled to claim a business investment loss in the amount of $103,257 for his 1996 taxation year, pursuant to paragraph 39(1)(c) of the Act.
[38] The appeal is allowed with costs.
Signed at Ottawa, Canada, this 22nd day of May 2001.
"Lucie Lamarre"
J.T.C.C.