Tax Court of Canada Judgments

Decision Information

McCoy v. The Queen

Court (s) Database	Tax Court of Canada Judgments
Date	2003-05-15
Neutral citation	2003 TCC 332
File numbers	1999-4555(IT)G
Judges and Taxing Officers	Donald G.H. Bowman
Subjects	Income Tax Act

Decision Content

Citation: 2003TCC332

Date: 20030515

Docket: 1999-4555(IT)G

BETWEEN:

ALAN McCOY,

Appellant,

and

HER MAJESTY THE QUEEN,

Respondent.

REASONS FOR JUDGMENT

Bowman, A.C.J.

[1] This appeal is from an assessment for the appellant's 1995 taxation year. At issue is the appellant's right to deduct $73,850 as his share of a loss which he claims was incurred by a limited partnership of which he was a member.

[2] Although the trial lasted about 15 days the essence of the transactions giving rise to the litigation can be summarized briefly.

[3] In 1994 Edward Furtak, who was then living in Bermuda, developed through his Bermuda corporation, Trafalgar Research (Bermuda) Ltd. ("Trafalgar Research"), a software package consisting of 34 programs to be used in trading currency and financial futures contracts. The software package was called MarketVision and it was owned by a subsidiary of Trafalgar Research, Trafalgar Capital Ltd. ("Trafalgar Capital"), another Bermuda corporation. I shall refer to them collectively as Trafalgar.

[4] A number of limited partnerships were formed among which was Trafalgar II Limited Partnership ("Trafalgar II" or "the partnership"). In February 1995 it acquired an 18.18% interest in MarketVision for a stated consideration of $10,000,000. Subsequently, on December 31, 1995 this was raised to a 22.07% interest for a stated consideration of $12,140,000. This figure was 22.07% of $55,000,000 which was said to be the value of 100% of MarketVision. A valuation had been received from a firm, emc partners, indicating a value in the range between $55,500,000 and $59,980,000.

[5] The consideration of $12,140,000 for the software was to be satisfied by a promissory note in the amount of $8,619,400 maturing December 1, 2005 and the balance of $3,520,600 in cash.

[6] The appellant bought 150 units in Trafalgar II for $150,000. This amount was payable as follows:

On closing (Dec. 31, 1995)	$19,500
Cash on March 15, 1996	$ 7,500 plus interest of $150
Cash on June 15, 1996	$16,500 plus interest of $750
Promissory note due Oct. 30, 2005 bearing interest at 9% per annum	$106,500

[7] In other words 29% or $43,500 cash at or shortly after closing and 71% by way of promissory note due about ten years after closing. This ratio was the same as that between cash and promissory note on the acquisition of the software by Trafalgar II.

[8] The relationship between Trafalgar Research, its subsidiary Trafalgar Capital, and the partnership was governed by a somewhat complex agreement under which Trafalgar was required to trade commodities and futures contracts in a certain volume and to share the profits with Trafalgar II. It was to use a portion of the proceeds received on the sale of the software for its trading purposes.

[9] In 1995 the partnership reported a loss based substantially on capital cost allowance ("CCA") on the software and the appellant claimed his pro rata share of that loss.

[10] The Minister of National Revenue disallowed this loss and many grounds are advanced.

(a) Trafalgar and Trafalgar II were not dealing at arm's length and under section 69 of the Income Tax Act the software was deemed to have been acquired at its fair market value which the respondent says is a small fraction of the $55,000,000 price.

(b) The note given by the partnership was contingent and cannot enter into the computation of the consideration.

(d) The partnership had no reasonable expectation of profit.

(f) The promissory note was a limited recourse amount within the meaning of section 143.2 of the Income Tax Act.

(g) The software was not acquired for the purpose of gaining or producing income and was therefore not depreciable property by reason of paragraph 1102(1)(c) of the Income Tax Regulations.

(h) The appellant's share of the loss claimed exceeds his "at-risk amount" (subsection 96(2.2)).

(i) The software was leasing property and accordingly the partnership claim is limited to the income otherwise determined before CCA from the property.

[11] The facts summarized above require elaboration but I do not propose to do so in the sort of detail in which the evidence was presented. I believe that the resolution of this case depends upon a determination of three or four relatively simple and straightforward issues. It is important to emphasize at the outset that the Minister allowed the partnership no deduction for CCA and therefore denied the appellant's claim for a loss from the partnership. This is consistent with the assumption that the software was not acquired for the purpose of gaining or producing income and was therefore not depreciable property. It is also consistent with the REOP assumption, an argument which counsel for the respondent did not exactly abandon in so many words. He alluded to it and moved on to something else, in light of the Supreme Court of Canada's decision in Brian J. Stewart v. The Queen, 2002 DTC 6969. The other assumptions (fair market value, reasonableness, contingency, at risk, limited recourse) all would generally allow the appellant something (although I should recognize that the respondent contends that by combining subsection 143.2(8) and subsections 96(2.1) and (2.2) one achieves an at-risk amount of minus $201,178 (subject to section 257 discussed below) and therefore no deduction). The appellant does not allege that the Minister did not act on all 79 of the assumptions pleaded and so I must accept that he did. However it seems hard to believe that the Minister would have had the mental agility to base an assessment upon such a potpourri of contradictory and inconsistent assumptions.

A. The acquisition of the partnership interest

[12] The appellant was an investment broker with the stock broking firm Midland Walwyn during the relevant time. In December 1995 he bought 150 units of an Ontario limited partnership (Trafalgar II). The general partner of Trafalgar II was an Ontario company TSLP Management Inc., all of the shares of which were owned by Capital Vision Inc., an Ontario corporation registered as a limited market dealer in Ontario. All of the shares of Capital Vision Inc. were owned by a Toronto lawyer, Greg Coleman, who was also the sole director and president of TSLP Management Inc.

[13] The limited partners were the investors, including the appellant.

[14] The price for the partnership interest was $150,000, payable as follows:

- on closing (December 31, 1995): cash $19,500;

- a promissory note for $130,500, of which $7,500 was payable on March 15, 1996, $16,500 by June 15, 1996 and the balance of $106,500 by October 30, 2005. On the first two instalments of the note interest was payable in the amount of $150 and $750.

[15] The result was that by June 15, 1996 the appellant had paid $43,500 in cash and the remainder was covered by the promissory note which matured on October 30, 2005.

[16] The promissory note given by the appellant to the partnership contained the following terms.

PROMISSORY NOTE

December 31, 1995

Toronto Ontario

MATURITY DATE: October 30, 2005

FOR VALUE RECEIVED, the undersigned (the "Maker") acknowledges itself, himself or herself, as the case may be, indebted to and promises to pay to Trafalgar II Limited Partnership (the "Holder"), on the dates specified below at 225 Richmond Street West, Suite 400, Toronto, Ontario, M5V 1W2 (or at such other place as the Holder may from time to time designate in writing to the Maker), the principal sum of $870 in lawful money of Canada (the "Principal Sum") for each unit of limited partnership interest (a "Unit") of Trafalgar II Limited Partnership (the "Partnership") subscribed for by the Maker and accepted by the Holder pursuant to the Partnership's Offering Memorandum dated September 1, 1995, being 150 Units together with interest thereon as set forth herein.

The Principal Sum together with interest shall be due and payable by the Maker the Holder as follows:

(a) $50 per Unit plus $1 interest payable on March 15, 1996;

(e) $710 per Unit plus interest on October 30, 2005.

The principal sum from time to time outstanding shall bear interest from and after the date hereof at the rate of nine percent (9%) per annum, compounded annually both before and after demand, default, maturity and judgment with interest on overdue principal and interests at the same rate until the date of payment in full. The Maker shall pay all accrued and unpaid interest on the principal amount outstanding from time to time, annually, in arrears, on or before January 30 of each year, commencing on January 30, 1996.

...

The Maker hereby consents to the assignment of this promissory note to Trafalgar Capital Ltd. ("Trafalgar Capital") as security for an amount owing from the Holder to Trafalgar Capital under an acquisition note dated December 30, 1994 in the amount of $10,000,000 and hereby directs the Holder to remit to Trafalgar Capital one hundred percent (100%) of the Maker's share of Distributable Cash (as such term is defined under the offering memorandum of the Holder dated September 1, 1995) until all interest then owed by the Maker under this promissory note has been paid, and thereafter to remit to Trafalgar Capital 45% of the Maker's Distributable Cash until all principal then owed by the Maker under this promissory note has been paid.

B. The software

[17] MarketVision is a suite of software programs for trading currency and financial futures markets. It was developed by Edward Furtak, a Canadian who resided in Bermuda, through his company Trafalgar Research. He graduated in 1989 from McMaster University in Hamilton and has developed something of an expertise in technical analysis of financial and securities markets as well as considerable proficiency with computers. On the witness stand he came across as an articulate person with clear abilities as a salesman.

[18] MarketVision was a suite of application software programs which instructs money managers when to buy and sell currency and financial futures contracts. It was designed to analyse statistical data on currency and financial futures markets and to generate trading decisions on the basis of that analysis.

[19] Futures trading involves the purchase of futures contracts which are essentially agreements to buy a commodity for delivery in the future at a specific price determined at the time the agreement is entered into.

[20] The type of analysis used by MarketVision is called technical analysis and is to be distinguished from fundamental analysis. The report of Mr. Jim Horvath, a professional business valuator with Deloitte & Touche, contains not only a useful definition of these terms but also a clear description of just what futures trading is. It is relatively short and I reproduce in full the portion of his report that deals with futures trading, but without the footnotes.

3.2 Futures Trading

The following summarizes the relevant background relating to futures trading and futures trading software. This information has been obtained from various sources including articles, published interviews, discussions with industry participants and regulators, and various websites, as outlined in the scope of review.

A futures contract is defined by the Commodities Futures Trading Commission ("CFTC") as "an agreement to purchase or sell a commodity for delivery in the future: (1) at a price that is determined at initiation of the contract; (2) which obligates each party to the contract to fulfil the contract at the specified price; (3) which is used to assume or shift price risk; and (4) which may be satisfied by delivery or offset." Futures trading include non-financial commodities such as grains, meats and metals, and financial commodities such as interest rates (US Treasury Bonds), currency, and stock indices.

Futures contracts are bought on margin. Margin is defined by the National Futures Association ("NFA") as: "An amount of money or deposited by both the buyers and sellers of futures contracts to ensure performance of the terms of the contract (the making or taking delivery of the commodity or the cancellation of the position by a subsequent offsetting trade). Margin in commodities is not a down payment, as in securities, but rather a performance bond."

Leverage is the term that is used to describe "the ability to control large dollar amounts of a commodity with a comparatively small amount of capital." As discussed below (section 3.4), leverage in a managed futures investing context has a further meaning.

The NFA provides the following example of the arithmetic of futures trading and leverage in its publication, A Guide to Understanding Opportunities and Risks in Futures Trading, page 14:

"For example, assume that in anticipation of rising stock prices you buy one June S & P stock index futures contract at a time when the June index is trading at 1200.

Also assume that your initial margin requirement is $15,000. Since the value of the futures contract is $250 times the index, each one-point change in the index represents a $250 gain or loss.

An increase of five per cent in the index, from 1200 to 1260, would produce a $15,000 profit (60 x $250). Conversely, a 60-point decline would produce a $15,000 loss. In either case, an increase or decrease of only five per cent in the index would, in this example, result in a gain or loss equal to 100 per cent of the $15,000 initial margin deposit."

The reduction in account equity from the peak to the low point resulting from a trade or series of trades is also referred to as a drawdown.

Analysis of futures markets by futures investors (and related trading approaches) can be generally classified as either

• Technical Analysis; or

• Fundamental Analysis.

Technical Analysis is defined by the NFA as "an approach to analysis of futures markets which examines patterns of price change, rates of change, and changes in volume of trading, open interest and other statistical indicators." Technical analysts do not consider underlying fundamental factors such as economic conditions, but instead analyze the patterns or trends such as those described above, usually in the form of a chart. A trading approach or style based on technical analysis is sometimes referred to as mechanical trading, or systematic trading. Indications to buy, sell or hold, based on technical analysis or indicators, are often referred to as signals. The individual variables within a system are referred to as parameters.

Fundamental Analysis is defined by the CFTC as the "study of basic, underlying factors which will affect the supply and demand of the commodity being traded in futures contracts." A trading approach or style based on fundamental analysis is often referred to as discretionary trading.

Many futures investors elect to place their funds in a managed futures funds account, where the authority for trading is exercised and is under the management of a broker, or trader. In the US, such advisors/fund managers are regulated, and are required to be registered with the CFTC. The term Commodity Trading Advisor ("CTA") is used to describe such an advisor/manager. The term CTA is defined by the CFTC as "individuals or firms that, for pay, issue analyses or reports concerning commodities, including the advisability of trading in commodity futures or options."

CTAs, managed futures funds accounts, and the concept of leverage in a managed futures funds context are discussed in more detail below (subsection 3.4).

C. The acquisition of the software by Trafalgar II

[21] Trafalgar Capital, Trafalgar Research (sometimes collectively called "Trafalgar") and the partnership Trafalgar II entered into an agreement made as of 24 February 1995 called the Software Acquisition and Pledged Trading Capital Agreement (the "Software Acquisition Agreement").

[22] In view of the importance of this agreement in governing the relations between the partnership and the Bermuda companies I am reproducing below what appear to be some of the more salient provisions.

WHEREAS Trafalgar Research has developed and Trafalgar Capital is the exclusive owner of an undivided 73.82% interest in and to the Computer Programs;

AND WHEREAS the Partnership wishes to purchase and Trafalgar Capital wishes to sell an undivided 18.18% interest in and to the Computer Programs;

AND WHEREAS in partial payment of the purchase price for the Computer Programs, the Partnership intends to execute and deliver to Trafalgar Capital the Acquisition Note;

AND WHEREAS Trafalgar and the Partnership have agreed to form a joint venture for the purposes of exploiting the Computer Programs;

AND WHEREAS in furtherance thereof, the Partnership and Trafalgar Capital have agreed to make the Computer Programs available to generate trading instructions for financial futures contracts, and Trafalgar Research has agreed to allow the Pledged Trading Capital to be traded pursuant to the instructions generated by the Computer Programs;

AND WHEREAS Trafalgar and the Partnership have agreed to actively solicit third party capital to be traded using the Computer Programs;

NOW THEREFORE in consideration of the sum of one dollar ($1.00), and other good consideration, now paid by each of the parties hereto to the other (the receipt and sufficiency or which is hereby acknowledged), the parties hereto hereby covenant and agree as follows:

1. DEFINITIONS

1.01 For the purpose of this Agreement, the following terms shall be deemed to have the following meanings:

(a) "Acquisition Note" means the promissory note given by the Partnership to Trafalgar Capital pursuant to section 2.02 of this agreement, in the form attached as Appendix "A" hereto;

...

(i) "Capital Additions" means the additional trading capital pledged by Trafalgar pursuant to section 5 of this agreement;

...

(k) "Computer Programs" means MarketVision, a suite of application software programs, developed by Trafalgar Research, which instruct money managers when to buy and sell currency and financial futures contracts, as more particularly described in Appendix "B" hereto, together with all Enhancements, Derivative Works and Maintenance Modifications;

...

(q) "Losses" means any and all loss, damage, claim, demand, deficiency, cost and expense, including interest, compound interest and legal fees on a solicitor and his or her own client basis;

...

(u) "Pledge Agreement" means the agreement dated as of the date hereof amongst the Partnership, Trafalgar Capital and each Limited Partnership, pursuant to which each Limited Partner has pledged his or her Units as security for the performance of the Partnership's obligations under the Acquisition Note;

(v) "Pledged Trading Capital" means the capital to be pledged by Trafalgar Research for a period of 15 years pursuant to section 4 of this agreement and the Capital Additions;

(w) "Purchase Price" means the purchase price paid by the Partnership to Trafalgar Capital for the Computer Programs, as determined in accordance with section 2.02 of this agreement;

...

(z) "Third Party Capital" means all capital which is not Pledged Trading Capital and which is traded using the Computer Programs;

(aa) "Third Party Trading Profits" means all revenues generated and retained by Trafalgar Capital through the use of the Computer Programs and any Third Party Capital, including Third Party Management Fees, less Third Party Brokerage Fees;

(ab) "Trading Profits" means all revenues generated by Trafalgar Capital by the use of the Computer Programs and the Pledged Trading Capital, less Trading Report Fees, Trafalgar Management Fees and Brokerage Fees;

(ac) "Trading Report" means each futures contract trading instruction (a buy instruction and sell instruction together constituting one trading instruction) generated by the Computer Programs in respect of the Pledged Trading Capital;

(ad) "Trading Report Fee" means the US$20.00 payable by Trafalgar to the Partnership for each Trading Report acquired from the Partnership by Trafalgar Capital, payable in Canadian dollars at an exchange rate equal to the greater of (i) CDN$1.40 or US$1.00, and (ii) the prevailing exchange rate at the time such payment is made;

...

2. AGREEMENTS OF PURCHASE AND SALE

2.01 In consideration of the payment of the Purchase Price, and of the fulfilment of the other obligations of the Partnership hereunder, Trafalgar Capital hereby sells, assigns and transfers to the Partnership a 18.18% undivided interest, in perpetuity, in and to the Computer Programs.

2.02 The Purchase Price for the Computer Programs shall be $10,000,000, payable by the Partnership to Trafalgar Capital as follows:

(a) as to $◘by delivery of cheque or bank draft upon the execution of this agreement; and

(b) as to the balance of the Purchase Price, by delivery of:

(i) the executed Acquisition Note;

(ii) Promissory Notes in the aggregate amount of $◘; and

(iii) the irrevocable direction of each Limited Partner to the Partnership and Trafalgar Capital authorizing the Partnership to pay 45% of net partnership income to Trafalgar Capital in payment of the principal on the Promissory Notes and the Acquisition Note.

2.03 Upon execution of this agreement, Trafalgar Capital shall deliver to the Partnership four complete copies of the source code of the Computer Programs, of which:

(a) two shall be in machine readable form on a machine readable storage medium suitable for long-term storage and compatible with either MacIntosh or IBM PC computer systems; and

(b) two shall be in human readable form with annotations in the English language on bond paper suitable for long-term archival storage.

3. FORMATION OF JOINT VENTURE

3.01 The parties hereto agree to form a joint venture, the purposes of which shall be to engage in the trading of financial futures contracts using the Pledged Trading Capital and the Computer Programs and to actively solicit third Party Capital to be traded using the Computer Programs, all in accordance with the terms and conditions of this agreement.

3.02 The term of the joint venture shall commence upon the Closing and continue until November 30, 2009.

3.03 Upon written notice by either the Partnership or Trafalgar, given not less than 60 days prior to the expiry of the term of this agreement and the joint venture and any extensions thereto, the term of this agreement and the joint venture shall be extended for an additional ten (10) years.

4. CONTRIBUTION OF PLEDGED TRADING CAPITAL

4.01 Upon Closing, Trafalgar shall direct that the Pledged Trading Capital be deposited in an interest bearing account (the "Account") at the Bank.

4.02 The Account shall be in the name of Trafalgar Research and shall require two signatures, one of which shall be that of the General Partner of the Partnership, and the other of which shall be designated by Trafalgar, in order to withdraw or transfer funds from the Account.

4.03 Trafalgar Research hereby grants to the Partnership a security interest in and to the Pledged Trading Capital, which interest shall ensure that Trafalgar fulfils its obligations under this agreement. The foregoing security interest shall terminate upon the withdrawal of the Pledged Trading Capital in accordance with section 4.06 of this agreement.

4.04 The Pledged Trading Capital deposited in the Account by Trafalgar shall be equal to 95% of the net proceeds of the Offering to Trafalgar (being the gross proceeds of the offering less the actual out-of-pocket expenses (to a maximum of $100,000) incurred by Trafalgar for the purpose of the Offering and the sale of the Computer Programs to the Partnership), payable by Trafalgar as follows:

(a) as to 24.14% on Closing;

(b) as to 20.69% on or before June 15, 1995;

(d) as to 20.69% on or before March 15, 1996; and

(e) as to 17.24% on or before June 15, 1996.

4.05 Subject to section 5 of this agreement, all interest paid by the Bank on the Pledged Trading Capital shall be paid to Trafalgar Research.

4.06 On or after February 1, 2009, and notwithstanding any extensions to the term of this agreement pursuant to section 3.03 of this agreement, Trafalgar Research shall be entitled to withdraw all of the Pledged Trading Capital.

4.07 The Partnership and Trafalgar Capital acknowledge that notwithstanding the terms of this agreement, Trafalgar Research shall remain the legal owner of the Pledged Trading Capital.

5. CAPITAL ADDITIONS

5.01 Until such time as Trafalgar delivers to the Partnership written confirmation that all principal and interest owing under the Acquisition Note has been paid in full, 30% of the interest paid to Trafalgar Research pursuant to section 4.05 of this agreement shall be deemed to be Capital Additions and shall be added to the Pledged Trading Capital.

5.02 Subject to section 7.09 of this agreement, fifty percent (50%) of all amounts paid by the Partnership to Trafalgar Capital in 1995 as interest on the Acquisition Note shall be deemed to be Capital Additions and shall be added to the Pledged Trading Capital.

5.03 Until such time as Trafalgar delivers to the Partnership written confirmation that all principal and interest owing under the Acquisition Note has been paid in full, 30% of the Trading Profits paid to Trafalgar Research pursuant to section 7.05 of this agreement shall be deemed to be Capital Additions and shall be added to the Pledged Trading Capital.

5.04 All amounts paid to Trafalgar Capital by the Partnership pursuant to the Software Agreement in respect of principal on the Acquisition Note shall be deemed to be Capital Additions, and shall be added to the Pledged Trading Capital.

5.05 All Capital Additions added to the Pledged Trading Capital shall be subject to the terms and conditions set out in this agreement in respect of the Pledged Trading Capital.

6. THIRD PARTY CAPITAL

6.01 Throughout the term of this agreement, Trafalgar and the Partnership shall actively solicit Third Party Capital to be traded using the Computer Programs.

6.02 The Partnership and Trafalgar shall negotiate in good faith a standard form of agreement (a "Third Party Agreement") to be executed by third parties in respect of management fees and allocation of revenues generated from Third Party Capital, and Trafalgar shall not enter into any other agreement in respect of Third Party Capital and the Computer Programs without the prior written consent of the Partnership, which consent may not be unreasonably withheld.

6.03 Subject to the terms of any Third Party Agreement, all Third Party Capital shall be deposited in one or more accounts (the "Third Party Accounts") at the Bank, and in no case shall any Third Party Capital be commingled with Pledged Trading Capital.

7. TRADING

7.01 Trafalgar Capital shall manage the affairs of the joint venture and, in furtherance of that obligation, shall buy and sell financial futures contracts:

(a) using the Pledged Trading Capital in strict accordance with the Trading Reports; and

(b) subject to the terms of any Third Party Agreement, using Third Party Capital in accordance with the Trading Reports.

7.02 In conducting trades using the Pledged Trading Capital, Trafalgar Capital shall not leverage the Pledged Trading Capital at a ratio higher than four to one (4:1) based upon the initial Pledged Trading Capital plus annual net Capital Additions.

7.03 For each futures contract bought and sold using the Computer Programs and the Pledged Trading Capital, Trafalgar shall pay the Partnership a Trading Report Fee, and Trafalgar Capital shall be entitled to a Trafalgar Management Fee.

7.04 Until such time as Trafalgar delivers to the Partnership written confirmation that all principal and interest owing under the Acquisition Note has been paid in full, Trafalgar Capital shall buy no less than 2,850 Trading Reports per year for each $1,000,000 in leveraged Pledged Trading Capital.

7.05 Until such time as Trafalgar delivers to the Partnership written confirmation that all principal and interest owing under the Acquisition Note has been paid in full, the Partnership shall receive 80% of all Trading Profits, and the balance of Trading Profits shall be paid to Trafalgar Research.

7.06 After Trafalgar delivers to the Partnership written confirmation that all principal and interest owing under the Acquisition Note has been paid in full, the Partnership shall receive 20% of all Trading Profits, and the balance of Trading Profits shall be paid to Trafalgar Research.

7.07 Trafalgar Research acknowledges that in the event that Trading Profits are less than the aggregate of Trading Report Fees, Trafalgar Management Fees and Brokerage Fees, Trafalgar Capital shall be obligated to pay from the Pledged Trading Capital all Trading Report Fees to the Partnership and all Brokerage Fees to the Broker.

7.08 In the event that Trafalgar Capital is obligated to deposit a portion of the Pledged Trading Capital with the Broker, the Broker shall be notified in writing by Trafalgar Capital that all payments and transfers from the account established by the Broker which are not made directly to the Account shall require at least two signatures, one of which shall be that of the General Partner.

7.09 Notwithstanding any other term of this agreement, in the event that the Pledged Trading Capital is reduced to less than 9.5% of the outstanding principal on the Acquisition Note:

(a) Trafalgar Capital shall immediately cease all trading using the Pledged Trading Capital, notify the Partnership in writing forthwith and not recommence trading without the explicit written consent of the Partnership, which consent may be unreasonably withheld; and

(b) until such time as the Pledged Trading Capital is greater than 9.5% of the outstanding principal on the Acquisition Note, one hundred percent (100%) of all amounts paid by the Partnership to Trafalgar Capital in 1995 as interest on the Acquisition Note shall be deemed to be Capital Additions and shall be added to the Pledged Trading Capital.

7.10 Until such time as Trafalgar delivers to the Partnership written confirmation that all principal and interest owing under the Acquisition Note has been paid in full, the Partnership shall receive 18.18% of Third Party Trading Profits, and the balance of Third Party Profits shall be paid to Trafalgar Capital.

7.11 After Trafalgar delivers to the Partnership written confirmation that all principal and interest owing under the Acquisition Note has been paid in full, the Partnership shall receive 3.64% of all Third Party Trading Profits, and the balance of Trading Profits shall be paid to Trafalgar Capital.

...

10. REPRESENTATIONS AND WARRANTIES

10.01 Each of Trafalgar Capital and Trafalgar Research hereby represent and warrant to the Purchaser that the following representations and warranties are true and correct as of the date hereof, and each acknowledges that the Partnership is relying on such representations and warranties in connection with the performance of its obligations under this agreement:

...

(n) Until all principal and interest owing under the Acquisition Note have been paid in full, the Computer Programs will generate at least 2,850 Trading Reports per year per $1,000,000 in leverage Pledged Trading Capital and, between the date hereof and November 30, 2004, will generate an average annual return of no less than 18% on leveraged Pledged Trading Capital.

10.02 The representations and warranties set out in section 10.01 above shall survive and continue in full force and effect for the benefit of the Partnership until five years after the expiry or termination of this agreement, including all amendments, extensions and renewals thereof.

...

11. INDEMNIFICATION

...

11.02 Each of Trafalgar Capital and Trafalgar Research shall indemnify and save harmless the Partnership for and from and against any Losses suffered by it as a result or any inaccuracy in or breach or any representation or warranty by Trafalgar Capital or Trafalgar Research, or the failure of Trafalgar Capital or Trafalgar Research to fulfil any condition or perform any covenant as provided herein.

...

11.05 In the event that Trafalgar breaches the terms of section 7.03 of this agreement, or in the event that the Computer Programs do not achieve an average annual return of at least 16% on leveraged Pledged Trading Capital in the period between January 1, 1995 and December 31, 2004, the Partnership shall have the right, but not the obligation, to replace a majority of the board of directors of Trafalgar Capital with nominees of the Partnership.

[23] The original Software Acquisition Agreement contemplated an acquisition by the partnership of an 18.18% interest in MarketVision and defined "unit" to mean one of the 10,000 units of limited partnership interests in Trafalgar II and a purchase price of $10,000,000. An amending agreement made as of 31 December 1995 amended the definition of unit to mean one of 12,140 units of limited partnership interests and raised the percentage interest to be acquired by Trafalgar II to 22.07% and raised the purchase price to $12,140,000.

[24] The Acquisition Note referred to in the agreement reads as follows:

ACQUISITION NOTE

December 31, 1995

Toronto, Ontario

MATURITY DATE: December 1, 2005

FOR VALUE RECEIVED, the undersigned (the "Maker") acknowledges itself indebted to and promises to pay to Trafalgar Capital Ltd. (the "Holder") on the dates specified below at 225 Richmond Street West, Suite 400, Toronto, Ontario, M5V 1W2 (or at such other place as the Holder may from time to time designate in writing to the Maker), the principal sum of $8,619,400 (the "Principal Sum") in lawful money of Canada, together with interest thereon as set forth herein.

The Principal Sum plus all accrued and unpaid interest thereon shall be due and payable by the Maker to the Holder in full on December 1, 2005. Notwithstanding the foregoing, in the event that the Maker is capitalized pursuant to the offering made pursuant to the offering memorandum (the "Offering Memorandum") of the Holder dated January 10, 1995, and any amendments thereto, the payment terms of this note shall be amended to reflect the terms of the capitalization made pursuant to the Offering.

In the event that the Maker defaults in payment of any sum due hereunder, and fails to correct that default within 30 days of receiving written notice from the Holder, the Principal Sum then outstanding together with accrued but unpaid interest may, at the Holder's option, be accelerated and immediately become due and payable in full, with interest thereon from such date at the rate as specified herein.

So long as the Maker is not in default in the making of any payment due hereunder, it shall have the right to prepay at any time and from time to time all or any part of the Principal Sum then outstanding, and any interest thereon, without notice, bonus or penalty, provided that the right of the Maker to make any such prepayments shall be conditional upon payment by the Maker to the Holder of all accrued and unpaid interest owing in respect of the Principal Sum to the date of any such prepayment.

The provisions of this promissory note shall enure to the benefit of the Holder (who may not transfer, assign, pledge or otherwise encumber this promissory note without the express written consent of the Maker, which consent may be unreasonably withheld) and shall be binding upon the Maker and its successors and assigns. The Maker hereby waives presentment, protest, demand, notice of protest and notice of dishonour of this promissory note and expressly agrees that this promissory note and any payment due hereunder may be extended from time to time by the Holder without in any way affecting the liability of the Maker.

This promissory note is issued by the Maker and accepted by the Holder as partial payment of the consideration due under a software agreement dated January 30, 1995 amongst the Maker, the Holder and Trafalgar Research (Bermuda) Ltd., and this promissory note is subject to the terms and conditions of that agreement.

This promissory note shall be governed by and construed in accordance with the laws of the Province of Ontario and the laws of Canada applicable therein.

Executed at Toronto, Ontario this 31st day of December, 1995.

TRAFALGAR II LIMITED

PARTNERHSIP, by its General

Partner, TSLP MANAGEMENT INC.

Per:

__________(signed)_____________

Greg Coleman - President

[25] By a document made as of December 31, 1995 called "Assignment of Promissory Notes" Trafalgar II assigned to Trafalgar Capital the promissory notes given to it by the limited partners. This document is in my view an important link in the chain of transactions with which this case is concerned and therefore it is reproduced in full.

ASSIGNMENT OF PROMISSORY NOTES

THIS AGREEMENT made as of the 31st day of December, 1995

AMONGST:

TRAFALGAR II LIMITED PARTNERSHIP, a limited partnership formed pursuant to the laws of the Province of Ontario (hereinafter referred to as the "Partnership")

OF THE FIRST PART

-AND-

TRAFALGAR CAPITAL LTD., a company formed under the laws of Bermuda (hereinafter referred to as the "Vendor")

OF THE SECOND PART

-AND-

EACH PARTY who has been or from time to time may be accepted as a limited partner in the Partnership, or who is a successor to any such party (hereinafter individually referred to as a "Limited Partner" and collectively referred to as "the Limited Partners")

OF THE THIRD PART

WHEREAS the Partnership has acquired from the Vendor an undivided interest in MarketVision, a suite of application software programs (the "Computer Programs"), pursuant to the terms of a software acquisition and pledged trading capital agreement (the "Software Acquisition Agreement") dated as of February 24, 1995, and amended by agreement dated as of December 31, 1995;

AND WHEREAS pursuant to the terms of the Software Acquisition Agreement, the Partnership has executed and delivered to the Vendor an acquisition note (the "Acquisition Note") in the principal amount of $9,300,000.00;

AND WHEREAS the Partnership has accepted subscriptions from Limited Partners for 12,140 limited partnership units in the Partnership, and, in partial fulfilment of the subscription price for such units, each Limited Partner has executed and delivered to the Partnership a promissory note in the principal amount of $900 per unit (collectively, the "Promissory Notes");

AND WHEREAS in full satisfaction of the purchase price for the Computer Programs, the Partnership wishes to assign to the Vendor all of the right, title and interest of the Partnership in and to the Promissory Notes;

NOW THEREFORE in consideration of the payment of the sum of One Dollar ($1.00), and other good and valuable consideration, the receipt of which is hereby acknowledged, and of the premises and mutual covenants contained herein, the parties hereto agree as follows:

1. The Partnership hereby assigns and transfers to the Vendor all of the right, title and interest of the Partnership in and to the Promissory Notes.

2. Each of the Limited Partners shall pay to the Vendor, at 225 Richmond Street West, Suite 400, Toronto, Ontario, M5V 1W2, or at such other address as the Vendor may designate from time to time, all amounts, including all principal and interest, payable by each Limited Partner to the Partnership pursuant to the terms of the Promissory Note.

3. In consideration of the assignment of the Promissory Notes from the Partnership to the Vendor, the Vendor hereby releases and discharges the Partnership from all liability under the Acquisition Note.

4. Each Limited Partner hereby irrevocably directs the Partnership to pay to the Vendor 100% of such Limited Partner's share of Distributable Cash (as defined in the partnership agreement of the Partnership), on a quarterly basis, until all of the interest owing under the Limited Partner's Promissory Note is paid in full, and thereafter to pay to the Vendor 45% of such Distributable Cash, again on a quarterly basis, until all principal owing under such Promissory Note has been paid in full.

5. The Vendor may not further assign, transfer, pledge, hypothecate, grant a security interest in or otherwise encomber the Promissory Notes without the express written consent of the Partnership and each of the Limited Partners, which consent may be unreasonably withheld.

6. In the Event that a Limited Partner sells, transfers or assigns his or her units in the Partnership, such Limited Partner shall also be entitled to assign or transfer his or her Promissory Note, provided that:

(a) such transfer is made in accordance with the terms of the Partnership Agreement; and

(b) the transferee assumes all of the obligations under the Promissory Note.

7. Nothing contained herein shall be construed as making any Limited Partner liable to the Vendor for any amount greater than that owed under such Limited Partner's Promissory Note, nor as releasing or limiting the liability of the Partnership from any other liabilities to the Vendor under the Software Acquisition Agreement.

8. This agreement shall enure to the benefit of and be binding upon the parties hereto and their respective heirs, executors, administrators and other legal representatives, successors and assigns.

9. This agreement shall be governed by and construed in accordance with the laws of the Province of Ontario and the laws of Canada applicable therein, and the parties hereto attorn to the jurisdiction of the courts of the Province of Ontario.

10. This agreement may be executed in two or more counterparts, with the same effect as if all parties hereto had signed the same document. This agreement may also be adopted in any subscription forms, transfer and assignment form or similar instruments signed by a Limited Partner or his attorney, with the same effect as if such Limited Partner had executed a counterpart of this agreement. All counterparts and adopting instruments shall be construed together and shall constitute one and the same agreement.

IN WITNESS WHEREOF this agreement has been executed as of the date and year first above written.

	TRAFALGAR II LIMITED PARTNERSHIP, by its General Partner TSLP MANAGEMENT INC.
Per:	___________(signed)________________ Greg Coleman - President
	TRAFALGAR CAPITAL LTD.
Per:	___________(signed)________________ Edward Furtak - President
	LIMITED PARTNERS, by their agent and attorney, TSLP MANAGEMENT INC.
Per:	___________(signed)________________ Greg Coleman - President

[26] I shall refer later to this document but at this point there are several observations that ought to be made.

(a) One of the recitals speaks of a principal amount of $9,300,000 under the Acquisition Note. The Acquisition Note uses the figure $8,619,400.

(b) Another recital speaks of the limited partners giving promissory notes to the partnership for $900 per unit. The principal amount under the promissory notes was $870.

(c) In the promissory notes the limited partners consent to their assignment to Trafalgar Capital "as security" for the amount owing from the holder [Trafalgar II] under an Acquisition Note dated December 30, 1994 in the amount of $10,000,000. Leaving aside the fact that the Acquisition Note was dated December 31, 1995 and not December 30, 1994 and the amount of $10,000,000 is wrong it is clear in clauses 1 and 3 of the Assignment of Promissory Notes document that the assignment is absolute and not by way of security. Indeed under clause 3 the assignment has the result of releasing and discharging the partnership from all liability under the Acquisition Note. I have reproduced above a number of clauses of the Software Acquisition Agreement. Clauses 5.01, 5.03, 7.04, 7.05, 7.10 and paragraph 10.01(n) all specify serious and fundamental changes in the commercial relations between Trafalgar Capital and Trafalgar II when principal and interest under the Acquisition Note are paid off. Yet that is precisely what clause 3 of the Assignment of Promissory Notes says happened on December 31, 1995.

(d) Clause 6 of the Assignment of Promissory Notes provides that if a limited partner sells, transfers or assigns his or her units in Trafalgar II such limited partner is entitled to assign or transfer his promissory note provided the transfer is made in accordance with the terms of the partnership agreement and the transferee assumes all obligations under the note.

To speak of assigning or transferring the promissory note by the limited partner (the obligor under the note) is not really appropriate. What clause 6 does is to permit a limited partner to have his or her obligation under the promissory note assumed by someone else and Trafalgar Capital is consenting in advance to what is in essence a novation. It seems clear to me that the effect of clause 6 is that if a limited partner "transfers" the promissory note to a third party the original limited partner is released from his or her obligation under the note. Counsel for the appellant referred to National Trust Co. v. Mead, [1990] 2 S.C.R. 410, and Paramount Life Insurance Co. v. Torgerson Development Corp., 51 Alta. L.R.(2d) 59, in support of the view that notwithstanding the "assignment or transfer" of the promissory note to a third party the original debtor remains liable under it. In National Trust Co. v. Mead the Supreme Court of Canada stated at page 427:

A novation is a trilateral agreement by which an existing contract is extinguished and a new contract brought into being in its place. Indeed, for an agreement to effect a valid novation the appropriate consideration is the discharge of the original debt in return for a promise to perform some obligation. The assent of the beneficiary (the creditor or mortgagee) of those obligations to the discharge and substitution is crucial. This is because the effect of novation is that the creditor may no longer look to the original party if the obligations under the substituted contract are not subsequently met as promised.

Because assent is the crux of novation it is obvious that novation may not be forced upon an unwilling creditor and, in the absence of express agreement, the court should be loath to find novation unless the circumstances are really compelling. Thus, while the court may look at the surrounding circumstances, including the conduct of the parties, in order to determine whether a novation has occurred, the burden of establishing novation is not easily met. The courts have established a three-part test for determining if novation has occurred. It is set out in Polson v. Wulffsohn (1890), 2 B.C.R. 39 as follows:

1. The new debtor must assume the complete liability;

2. The creditor must accept the new debtor as principal debtor and not merely as an agent or guarantor; and

3. The creditor must accept the new contract in full satisfaction and substitution for the old contract.

I do not see how any effect can be given to clause 6 if it does not mean that an assumption by a third party of the obligations under the note results in the release of the original limited partner. I am aware that the burden of establishing a novation and the consequent release of the original debtor is a heavy one. Nonetheless it is clear in my view that the intent in clause 6 is that the original debtor be released in the event of an assignment of the promissory note.

D. The offering memorandum

[27] The offering memorandum summarizes what was being offered to the limited partners. It carefully cautions the potential investors that the units are speculative, that they have no market and probably cannot be resold, that the investors might lose their entire investment and that there is no assurance that the business will be operated successfully. It advises the investors to consider the merits of the investment in addition to the expected income tax benefits.

[28] A few passages from the offering memorandum will suffice.

Investment	Investors will become limited partners in Trafalgar II Limited Partnership, an Ontario limited partnership. The Partnership has acquired up to an 18.18% undivided interest in *MarketVision*, a suite of application software programs which instructs money managers when to buy and sell currency and financial futures contracts. The Computer Programs will be used by the Partnership and Trafalgar Capital to conduct trades over a 15 year period with the Pledged Trading Capital. (See "Structure of the Offering")
Software	*MarketVision* is designed to analyze statistical data on currency and financial futures markets and to generate trading decisions on the basis of that analysis. In historical simulations from 1989-1994, *MarketVision* generated average annual returns in excess of 32%. During the same period, the average return for 97 International Fund Managers was 30%. (See "Business Plan of the Partnership"). *MarketVision* is currently being used to trade more than $6 million in leveraged trading funds in Bermuda.
...
Joint Venture	The Partnership and Trafalgar Capital, the owners of the computer Programs, will form a joint venture to engage in the trading of financial futures contracts using the Computer Programs.
Trading Fund	Under the terms of the Pledged Trading Capital Agreement, Trafalgar Research has pledged $2,000,000 of its own capital, locked in for a 15 year period, to be traded using the Computer Programs. Using a conservative leverage factor of 4:1, the funds pledged by Trafalgar Research will allow the Partnership to derive income from a $8,000,000 trading fund. In the event that less than the maximum offering is achieved, the capital pledged by Trafalgar Research will be reduced pro rata.
Revenues from Trades	Trafalgar Capital will pay the Partnership US$20.00 for each trade generated by the Computer Programs. Until the Acquisition Note has been paid in full, Trafalgar Capital has agreed to purchase at least 2,850 Trading Reports each year per $250,000 in Pledged Trading Capital.
Revenues from Trading Profits	Until the Acquisition Note has been paid in full, Trafalgar Capital will pay the Partnership 80% of Trading Profits. Thereafter, Trafalgar Capital will pay the Partnership 20% of such profits. Trafalgar Research has represented and warranted that the Computer Programs will generate average Trading Profits of no less than 19% per year over the first ten years of the investment.
Revenues from Third Party Capital	The Partnership and Trafalgar Capital will also actively solicit third party capital to trade using the Computer Programs. Until the Acquisition Note has been repaid in full, Trafalgar Capital will pay the Partnership its pro rata share of 80% of Third Party Profits. Once the Acquisition Note has been paid in full, Trafalgar will pay the Partnership its pro rata share of 20% of Third Party Profits. To date, the Partnership and Trafalgar Capital have raised more than $2,000,000 in Third Party Capital.

Cash Flow Analysis Per $1,000 Unit
		1995	1996	Total
	CASH PER Unit
	Closing	$ 130	$ 0	$ 130
	Post-dated Payments	$ 0	$ 160	$ 160
	Interest on Post-dated Payments	$ 0	$ 6	$ 6
	TOTAL	$ 130	$ 166	$ 296

	INCOME TAX DEDUCTIONS
	Capital Cost Allowance	$ 500	$ 500	$1,000
	Interest on Promissory Note	$ 0	$ 6	$ 6
	TOTAL	$ 500	$ 506	$1,006

	INCOME TAX SAVINGS	$ 266	$ 269	$ 535

	LESS CASH INVESTED	$ 130	$ 166	$ 296

	CASH SURPLUS	$ 136	$ 103	$ 239

	Notes: (1) Assumes marginal Ontario tax rate of 53.19% for 1995 and 1996. (2) Assumes taxation year end of December 31st. (3) Assumes no earnings in period shown. (4) Assumes 1995 interest on Promissory Note paid from Partnership revenues.

[29] The offering memorandum contains a section of over five pages of "Canadian Income Tax Considerations". In evidence also is an opinion by Fraser & Beatty, a large and well-known law firm, that this section is a "fair and adequate summary of the significant income tax consequences under the laws of Canada of acquiring, holding and disposing of Units" of the partnership. I shall not reproduce the section. It is the usual restrained and careful exposition of the relevant provisions of the Income Tax Act with the usual disclaimer. It contains a lengthy discussion of the at-risk rules. There are only one or two portions that I will set out.

There is also a question of whether the existence and nature of the Acquisition Note somehow impacts on the "at-risk" rules. In our view, the fair market value (and the reasonableness of the acquisition price) will more likely affect the available deduction from income of the Partnership, and as such the Acquisition Note should not be an "at-risk" issue. Indeed, this issue is dealt with under the heading "Computation of Income" below.

...

The Partnership intends to claim capital cost allowance in respect of the Computer Programs on the basis that the Computer Programs constitute computer software other than systems software (as defined in the Regulations) and is therefore a Class 12 asset. If the Computer Programs constitute a Class 12 asset, the Partnership will be entitled to claim capital cost allowance at the rate of 100%, subject to the half year rule. In our opinion, the Computer Programs qualify as a Class 12 asset for purposes of the Regulations made pursuant to the Act. To the extent that the acquisition cost of the Computer Programs is reasonable, capital cost allowance is deductible by the Partnership over two years as described above.

Investors should consider the reasonableness of the acquisition cost of the Computer Programs (See "The Appraisal").

[30] Obviously the court is not bound by the legal opinions found in prospectuses and offering memoranda but it is interesting that the lawyers identified what in my view is one of the major issues in this appeal, reasonableness.

[31] In addition to the offering memorandum prospective investors were given a brochure about Trafalgar II called "Understanding This Investment". It is a somewhat less formal description of the investment than is contained in the offering memorandum. The following appears in the Executive Summary.

...

The Business

The Partnership has acquired an undivided 18.18% interest in Market Vision from Trafalgar Capital Ltd., a Bermuda company indirectly owned by Mr. Furtak. The Partnership paid for its interest in Market Vision by way of cash and acquisition note.

The Partnership and Trafalgar Capital have entered into a joint venture to use Market Vision to conduct trades in financial futures contracts. The capital ($2,000,000) needed to make the trades will be provided by Trafalgar Research (Bermuda) Ltd., Mr. Furtak's operating company. Trafalgar Research has agreed to lock in that capital of a minimum of 15 years.

The Partnership and Trafalgar Capital will also actively market the use of Market Vision to other global fund managers, who collectively control approximately $40 billion in assets and many of whom operate trading companies and investment pools in Bermuda.

Economics of the Investment

The Partnership is paid a trading report fee each time that Market Vision generates a trading recommendation for the locked-in trading fund. Trafalgar Capital has guaranteed that these trading report fees will be sufficient to pay all interest on the acquisition note.

Until the acquisition note has been paid in full, Trafalgar Capital will also pay the Partnership 80% of all trading profits generated by Market Vision and the trading fund. Thereafter, the Partnership will receive 20% of trading profits. The Partnership will also be entitled to a portion of profits from any third party capital traded using Market Vision.

Projected Revenues

In rigorous historical simulations, Market Vision generated annual profits of approximately 34%, slightly higher than the five year average of 97 international funds (Source: Managed Account Reports). Even if the annual return generated by Market Vision is significantly less than in the simulations, the Partnership will still pay off the Acquisition Note and also generate significant revenue for limited partners:

Annual Profit Generated by MarketVision	Years Until Note Paid in Full	Annual Pre-Tax Revenue Per $1,000 Unit Thereafter
15%	14	$336
20%	9	$375
25%	7	$414
30%	6	$456
35%	5	$490

...

Revenues from Trades

Trafalgar Capital will pay the Partnership US$20.00 for each trade generated by the computer programs. Trafalgar Capital has represented and warranted that until the Acquisition Note has been paid in full, Trafalgar will purchase at least 2,850 trading reports per year per $250,000 in trading capital. Revenues from the sale of trading reports to Trafalgar Capital will be sufficient to pay all of the interest on the Acquisition Note.

Revenues from Profits

Until the Acquisition Note has been paid in full, Trafalgar Capital will pay the Partnership 80% of net trading profits. Thereafter, Trafalgar Capital will pay the Partnership 20% of such profits. Trafalgar Research has represented and warranted that the software will generate average trading profits of 19% per year over the first ten years of the investment.

Revenues from Third Party Capital

The Partnership and Trafalgar Capital will also actively solicit third party capital to trade using the computer programs. Until the Acquisition Note has been repaid in full, Trafalgar Capital will pay the Partnership its pro rata share of 80% of third party trading profits. Once the Acquisition note has been paid in full, Trafalgar will pay the Partnership its pro rata share of 20% of such profits.

Cash Flow Analysis Per $150,000 Investment
			1995	1996	TOTAL
	CASH Per $150,000 Investment
	Closing		$19,500	$0	$19,500
	Post-Dated Payments		$0	$24,000	$24,000
	Interest on Post-Dated Payments		$0	$900	$900
	TOTAL		$19,500	$24,900	$44,400

	INCOME TAX DEDUCTIONS
	Capital Cost Allowance		$75,000	$75,000	$150,000
	Interest on Promissory Note		$0	$900	$900
	TOTAL		$75,000	$75,900	$150,900

	INCOME TAX SAVINGS		$39,892	$40,371	$80,263

	LESS CASH INVESTED		$19,500	$24,900	$44,400

	CASH SURPLUS		$20,392	$15,471	$35,863

	Cash on Cash Return		205%	162%	181%

	*** Certain assumptions apply. Please see the offering memorandum of the Partnership for full details.
Promissory Note		The Promissory Note given by each investor bears interest at the rate of 9% per annum. All interest on the promissory note is payable by January 30 of each year in respect of the previous fiscal year. The Promissory Note is secured by the investment and may be repaid at any time prior to November 30, 2009 without notice, bonus, penalty. At closing, the Partnership will assign the promissory notes to Trafalgar Capital to pay for the computer programs. It is projected that the principal and interest on the note will be paid out of the revenues generated from the use of the computer programs and the trading fund.

[32] On this document are a large number of handwritten notes and calculations made by Mr. McCoy.

[33] It is useful before I continue to make a few brief observations on these documents.

(a) Clearly, Mr. McCoy was concerned about the economics of the investment and the guarantee of the income for ten years.

(b) An important ingredient in the economics of the investment was the anticipated tax savings in the first two years. This is obvious from the cash flow analysis reproduced above.

(c) The cash flow projections were decidedly rosy. Indeed it is stated in the document Understanding This Investment that Trafalgar Capital "has represented and warranted that the software will generate average trading profits of 19% over the first ten years of the investment". The Software Acquisition Agreement in paragraph 10(n) says that "between the date hereof and November 30, 2004, [the computer programs] will generate an average annual return of no less than 18% on leveraged Pledged Trading Capital". It goes on to say that until the Acquisition Note is paid in full Trafalgar will purchase 2,850 trading reports per $250,000 in trading capital and that the revenue from the sale of trading reports will be sufficient to pay all of the interest on the Acquisition Note. The only problem about this assertion is that the Acquisition Note was paid off on December 31, 1995 by the assignment of the promissory notes of the limited partners.

(d) The representation and warranty that average trading profits of 19% (or 18% depending on which document you look at) will be generated means that it is anticipated that principal and interest under the promissory notes will never come out of the investors' pockets because of the remedy in clause 11.02 of the Software Acquisition Agreement.

[34] Continuing then with the recital of facts the sanguine projections did not materialize and while the partnership exists it is not particularly economic.

[35] For example, in the financial statements for the quarter ending September 30, 1996 losses of $460,816.58 are reported and the Pledged Trading Capital Balance is reduced from $1,883,463.74 to $1,612,262.54. On February 14, 1997 the appellant received a quarterly partners' statement showing that his net revenue for 1996 was $154.69 of which $73.65 was applied to his principal owing under the note.

[36] For 1997 the financial statement shows a loss of $3,499,387 but the individual T5013 (Statement of Partnership Income) shows the appellant's income as $6,762.11.

[37] For the period ending March 31, 1998 the summary of trading results shows a loss for the quarter ending March 31, 1998 of $53,567 and since the commencement of the business of $802,846.

[38] I shall not go though the financial statements in detail. What is obvious is that each year the Pledged Trading Capital is diminished. For 1998 there is a loss of $1,596,074 and for 1999 a profit of $419,468.

[39] Over the years the revenues of the partnership are substantially attributable to the trading report fees which appear to have come out of the Pledged Trading Capital. This fact explains the erosion of the Pledged Trading Capital.

[40] At a meeting of the partners of the Trafalgar partnership on May 27, 1998 overhead slides were used to describe the difficulties that the partnerships were experiencing and the reasons. Three of the slides are sufficient to describe the state of affairs.

Current Situation

Cumulative Trading Losses - $ (952,626)

• DAX	$ (513,836)
• FTSE	$ (169,821)
• S & P	$ (146,710)
• Currencies	$ (54,326)
• Interest Rates	$ (67,933)
Total	$ (952,626)

How Did We Get Here?

• Significant change in the overlap between European and North American markets

• Volatility has Increased Significantly

• Resulted in cumulative losses in both DAX and FTSE such that Equity Management programs removed all European programs from trading

Why are the Pledged Trading Capital Balances so Low?

• Interest charges, Report Fees and Management fees have depleted the Pledged Trading Capital

• Trafalgar has voluntarily re-contributed these amounts until trading has recovered (denoted as "Other Amounts" in the reports to investors)

[41] The erosion of the Pledged Trading Capital of course meant that there was less capital to trade. This meant that there was less potential to make trading profits or, conversely, less chance to lose money.

[42] The evidence does not, however, permit me to attribute the poor performance in the trading activities either to a defect in the programs or any incompetence or mismanagement on the part of Trafalgar Capital. The mid and late 1990s were turbulent days marked by large profits and losses, turbulent stock markets and excessive optimism, grandiose expectations from huge mergers and acquisitions and fortunes being made and lost.

E. The fair market value of MarketVision

[43] I shall now embark on the rather difficult task of dealing with the question of the value of the software. This issue occupied a number of days at trial. The respondent's position is that the $55,000,000 value upon which the price was determined is excessive.

[44] The appraisal report of emc partners concluded that the computer programs had a fair market value of between $55,000,000 and $59,980,000. This report was not put in evidence as an expert witness report. The person who prepared it, Michael Ozerkevich, was called as a witness but not as an expert. His evidence was brief. He agreed that he was not an accredited appraiser but that he had done in excess of 275 software appraisals of which about one-third or one-half were in connection with software tax shelters. His cross-examination by counsel for the respondent was perfunctory. I allowed his appraisal to be introduced as an exhibit not as evidence of the value of the software but as a document that was before the vendor and purchaser and that formed part of the material on which the price was based.

[45] I do not regard it as affording any proof of the value of the software.

[46] Mr. Richard Wise was called by the appellant and he introduced as his expert opinion a review appraisal which was essentially a commentary on the emc report. His conclusion was that the emc valuation was appropriate and reasonable. He stated:

In our Opinion, based on our review and analysis as described herein:

• The work reviewed within the context of the requirements applicable to that work, namely, the development of an opinion by EMC as to the fair market value of the Computer Programs, was generally complete;

• The data used appear to be adequate and relevant;

• The valuation approach adopted and method applied under the valuation approach are appropriate; and

• The analyses, opinions and conclusions in the EMC Report are appropriate and reasonable.

[47] Mr. Wise is one of Canada's most experienced, highly qualified and respected business valuators. Nonetheless I do not think that his testimony concerning the methodology used by emc partners is sufficient to give the emc report the sort of evidentiary weight or value necessary to establish in this court the conclusions expressed in the report. One expert cannot put in another expert's report and make it evidence: Hallatt et al. v. The Queen, 2001 DTC 128. Forming an expert opinion of value involves a number of procedures, whether the property being valued is real estate, shares of a corporation, a partnership interest or, as here, software. The meaning of fair market value is too well known to require repetition but for an expert's opinion to carry any weight he or she must set out facts from which the opinion may be formed, the determination of premises and assumptions and the articulation of conclusions flowing from the facts selected and from the premises or assumptions.

[48] Each of these steps requires that the expert bring to bear his or her experience and judgement and that each of these components used in arriving at a conclusion be tested by cross-examination.

[49] It may well be, as Mr. Wise says, that the methodology used by emc conforms to traditionally accepted standards but if the underlying premises, assumptions and selection of facts cannot be tested the conclusions can be given no weight.

[50] The experts called by the respondent were experienced and well qualified. I have quoted above from the report of Mr. Jim Horvath. Mr. Horvath's conclusion was the following:

Valuation Conclusion

Based upon the scope of my review, and my research, analysis and experience, and subject to my major assumptions and limitations of scope, it is my opinion that the fair market value, as at February 24, 1995, of a 100% ownership interest in MarketVision is in the range of $35,000 to $175,000. If a specific value is required, I suggest the approximate mid-point of the foregoing range, being $100,000.

It is my opinion that the fair market value, as at February 24, 1995 of a 22.07% ownership interest in MarketVision was in the range of $6,000 to $23,000, which reflects a partial interest discount in a range of 20% to 40%. If a specific value is required, I suggest the approximate mid-point of the foregoing range, being $15,000.

In arriving at my opinion of value, I relied in part on the findings relating to MarketVision contained in a report prepared by Mr. Robert Pardo ("Pardo"), dated August 28, 2002 ("Pardo Report"). I have spoken with Mr. Pardo and reviewed his relevant qualifications and am satisfied that he is well qualified on the subject matter of futures trading software, and the futures trading industry.

My opinion of value is further based upon the information supplied to me, and is subject to the "Major Assumptions" outlined herein. The accompanying report, including schedules and appendices, is an integral part of this valuation and provides a summary of my findings and the methodology leading to my opinion of value.

[51] I shall come back to Mr. Horvath's reasoning in a moment, but in light of Mr. Horvath's reliance on Mr. Pardo's report I shall mention it briefly. Mr. Robert Pardo is a successful and recognized Commodity Trading Advisor ("CTA"). He was not specifically asked to determine the fair market value of MarketVision which he refers to as MV, although in fact he does express an opinion on the fair market value. In his letter to counsel for the respondent he stated:

Specifically, you have asked me to comment and provide information and analysis related to the following items:

• Viability of MV;

• Profitability of MV;

• Evaluation of MV development methodology including the Historical Simulation methodology and results; and

• Evaluation of marketability of MV.

[52] The concluding portion of his report is as follows:

5.22 How Likely Is the MV Suite to Produce Real-Time Profits?

The Likelihood that any trading system will produce real-time profits is a function of its robustness. The more robust the trading model and the more exhaustive and accurate the trading simulation, the more likely the trading model is to produce real-time profits.

In my opinion, the MV Suite of trading programs is deficient in virtually every measure of robustness.

Since the MV Suite of trading models does not exhibit great robustness nor is the historical simulation all that exhaustive or accurate, it is my opinion that it is unlikely to produce real-time profits for any great length of time - if ever.

Since the MV Suite of trading models is lacking in the documentation that is required to maintain, improve and update the trading models, I would judge it to be not maintainable as the basis for a professional trading platform.

5.23 Is the MV Suite Business Plan Viable?______________

The MV Suite is not a robust trading platform suitable for successful professional money management as a CTA.

• It is highly unlikely that it will produce lasting trading profits, and if it does, they will be at a significantly lower rate than as documented for the MV Suite;

• Because the research and development that created the MV Suite was done poorly, the MV Suite trading models exhibit many of the features of non-robust trading systems; hence, they are unlikely to produce real-time profits;

• Due to the additional transaction costs attached to each trade by the MV Suite trade signal cost, what trading capital there is, is most likely to be depleted within a rather short time frame;

• Due to lack of US registrations, the US capital pool is closed to the MV Suite;

• The information presented regarding the performance of the MV Suite and the credentials of its developer are inadequate and hence, would be unlikely to generate interest from potential investors;

• The information as documented will certainly not create interest from large and institutional investors; and

• Because of the lack of credibility of the MV Suite and of its developer, it is highly unlikely that the MV Suite Business Plan will ever attract any significant outside trading capital.

Consequently, I would conclude that MV Suite Business Plan is not viable.

6. Conclusion

The substandard credibility of the MV Suite and its developer would preclude access to an audience with CTAs, institutional investors, large investors or any type of successful, professional money manager.

As at the Evaluation Date, investors seeking to invest in managed futures would consider the many profitable, well established CTAs and money managers with real-time track records, before they would even consider MV.

If, I were asked as a CTA or as a professional trading system developer and marketer if I were interested in acquiring or working with the MV Suite of trading systems I would decline.

At the Evaluation Date, there were any number of viable alternatives in the form of good quality commercially available trading systems from reputable and credible vendors with established track records available on a license basis at prices ranging from $1,000 to $3,000. There were also any number of equally credible, reputable and profitable trading advisory services that ranged in price from $722 to $12,000 a year. See Appendix D - Marketing a Trading System for details.

If I were asked to recommend MV to colleagues, potential investors or trading system purchasers, I would decline to do so, due to its lack of documentation, robustness and credibility.

In summary, the MV Suite of trading systems falls short of even the minimum standards by which most professional traders, CTAs, money managers or marketers of trading systems would judge it.

As someone who has sold a number of commercial trading systems to individual investors for prices between $1,000 and $25,000, I would be hard pressed to sell anyone the entire MV Suite for $500. However, given what I know about the MV Suite, I would be both morally and professionally prohibited from selling it to anyone.

Based on my experience in completing large scale consulting projects for some of the largest professional trading firms in the world, it is my opinion that no institutional investor would give more than a moment's attention - if that - to something documented as poorly and researched as carelessly as the MV Suite.

As a trading system developer and a profitable CTA who has established a relationship with one of the largest and longest standing CTAs in the world - Dunn Capital Management - it is very unlikely that any CTA would give consideration to the deployment of the MV Suite to trade for themselves or their customers.

You have asked for my professional opinion as a CTA, professional trading system developer and expert in the design, testing and optimization of trading systems to assess the value of the MV Suite. In my very considered opinion as detailed in this document, I conclude that as of February 1995 the MV Suite has no market value.

[53] There is something disquietingly surreal about a case where one party bases its purchase on a value of $55,000,000 and the other party contends that the property has no value. To add to the confusion the same party who says that the property is worthless puts forward expert evidence that a 100% interest in the software had a value in the range of $35,000 to $175,000 and a 22.07% interest in the range of $6,000 to $23,000 if one applies a partial interest discount of 20% to 40%. The same party, however, (the respondent) has alleged in the reply that the fair market value of MarketVision (presumably 100%) was approximately $525,000. Where this figure comes from is anybody's guess. The respondent did not seek to support it.

[54] Mr. Horvath criticized on several grounds the valuation made by Mr. Ozerkevich on which the $55,000,000 purchase price was based.

(a) The historical simulation on which the valuation was based was flawed, in that the representative test period was not sufficiently long leading to unrealistic conclusions and overly optimistic expectations. The period actually used was 69 months except for the DAX 30 futures contract which was tested over a 2.75 year period.

(b) It contained "curve fitting" and over optimisation. In essence these two concepts mean about the same thing: fitting historical data to achieve the most favourable result. The danger of this is particularly inherent in the use of historical data in the testing.

(d) There was no out of sample testing - i.e. testing of the software in time periods that were not used in the development of the software.

(e) The historical simulation was based on an unrealistic assumption as to the amount of the commission and slippage, giving rise to unrealistic profits. Slippage is the amount the market moves from the time an order is placed and the time it is filled.

(f) The 4:1 leverage of the Pledged Trading Capital was, in Mr. Horvath's view, excessively risky. The Pledged Trading Capital was, at least initially, $2,000,000. It was therefore represented to the investors that the partnership would be able to derive income from an $8,000,000 trading fund. I asked some of the witnesses whether leveraging a $2,000,000 fund on a 4:1 basis meant a total of $10,000,000 or a total of $8,000,000. No one seemed to be particularly clear on just what it meant. In any event as noted above the Pledged Trading Capital kept being eroded to pay the interest and the trading report fees.

[55] Mr. Hovarth also expressed the view that the Acquisition Note was contingent because it was to be funded on trading profits. This is a legal conclusion the correctness of which I need not determine because the Acquisition Note was fully satisfied on December 31, 1995 by the assignment of the individual promissory notes given by the investors to the partnership. There is no doubt that the obligations under the Acquisition Note disappeared the moment they came into existence. The more pertinent question is whether the assignment of the individual promissory notes given to the partnership by the partners constituted a payment equal to the face amount of the notes. I shall deal with this question below.

[56] Mr. Horvath's criticisms of MarketVision, of the testing methods used in developing it and the procedures used in the emc report no doubt have some validity. I do not think the evidence supports a value for MarketVision of $55,000,000; neither, however, do I think that the respondent's evidence supports the nominal or nil value assigned to it by Mr. Horvath and Mr. Pardo. Had the programs produced the sort of income that was so optimistically predicted in 1995 it is doubtful that anyone would have questioned the price or the business acumen of the people who entered into the deal. The business landscape is strewn with the cadavers of megadeals that have gone catastrophically sour. I need not mention them by name. They are legion and will be familiar to anyone who reads the business section of the newspapers. Yet when the deals were consummated they were hailed euphorically and the corporate movers and shakers who pulled off these spectacular mergers and acquisitions, sometimes with less analysis than went into the launching of MarketVision, were acclaimed as financial geniuses. When a year or so later the structure falls to the ground the Monday morning quarterbacks shake their heads and ask "How could they have been so stupid? Surely, it must have been obvious that the deal had the seeds of disaster in it from the outset."

[57] My common sense tells me that where a group of businessmen and professionals with sufficiently high incomes that they find tax shelters attractive are prepared to invest substantial amounts of cash for property that they reasonably expect will yield income (including amounts sufficient to pay the principal and interest on their promissory notes) and will produce a tax advantage that the promoters, armed with a favourable opinion from a major law firm, say will result, it is as unreasonable to say that the property was worth nothing or virtually nothing as it is to say that it was worth $55,000,000. Fair market value is in some measure a function of perception at the time whether we are talking about real estate in boom times in the late 1980s, stocks in 1929 before the crash or exotic tulips during the period of tulipmania in 17th century Holland. In that perception irrational or overly optimistic expectations may play a part. A cold blooded analysis five years after the event, and after the rosy predictions have proved to be wrong, may be scientifically defensible but it may not reflect the true state of the market at the time. For this reason I am not prepared to treat the valuations by the Crown's experts as determinative. On a balance of probabilities they do tend to support the view that the value of $55,000,000 is high, a result to which common sense would have led unaided by expert opinions. In light of the conclusions reached below, however, I do not propose to put a precise figure on the value of MarketVision. Indeed, the evidence does not permit me to do so.

[58] In light of the conclusion that I have reached and the basis upon which I propose to dispose of this appeal it is not necessary that I deal with all of the issues raised by the respondent or the assumptions pleaded. Some however need to be.

1. Did Trafalgar II acquire the interest in MarketVision for the purpose of gaining or producing income?

[59] Unquestionably it did. The predictions may have been unduly optimistic but objectively the program was intended to make a profit and it might well have done so.

[60] When one asks what the purpose of a limited partnership is in entering into a transaction one must determine whose purpose one must look to. Legally the general partner is in charge of running the business of the partnership and the limited partners are prohibited from interfering in the operations of the partnership or they lose their limited liability. Theoretically therefore in ascertaining the purpose of the partnership the first enquiry must be to the general partner TSLP Management Inc., or its president, Greg Coleman.

[61] Mr. Coleman's evidence is unequivocal that as the president of the general partner he intended and expected the enterprise to be profitable. I am aware that intention and purpose are not the same. Intention is subjective. Purpose, while it may involve a subjective element, must be largely determined on the basis of objective considerations. It is impossible if one looks at the material that was presented to the investors to conclude that the earning of income was not a purpose of the partnership. The only limited partner called was Mr. McCoy. He is an experienced and astute businessman. If his purposes are relevant he obviously looked on the investment as an opportunity to make money even though a more important purpose was the tax write off.

[62] I mentioned the REOP test at the beginning of these reasons. It is an aspect of the question of the purpose of gaining or producing income from a business or property. I do not think the REOP test can possibly apply to justify denying the partnership (and therefore the partners) any CCA on the software. The question is how much.

2. Were the vendor of the software (Trafalgar) and the purchaser (the Trafalgar II partnership) dealing at arm's length?

[63] This is relevant for the purposes of section 69 because if a taxpayer acquires anything from a person with whom the taxpayer is not dealing at arm's length at an amount in excess of the fair market value the taxpayer is deemed to have acquired it at its fair market value.

[64] Under section 251 of the Income Tax Act, related persons are deemed not to deal with each other at arm's length and it is a question of fact whether unrelated persons deal with each other at arm's length. In the French version of the Income Tax Act the concept of not dealing with a person at arm's length is expressed in the words "avoir un lien de dépendance".

[65] Trafalgar Research and Trafalgar Capital, the vendors, were controlled by Edward Furtak. He was not related to the partnership, whether we look at the collectivity of the partners or at the general partner (cf. Chutka v. The Queen, 2001 DTC 5093. This case was commented on in Deptuck v. Canada, 2003 FCA 177, and in Brown v. Canada, 2003 FCA 192). Therefore the question remains whether the vendors and the partnership were in fact not dealing with each other at arm's length.

[66] The authorities relating to the concept of arm's length were reviewed in the case of RMM Canadian Enterprises Inc. et al. v. The Queen, 97 DTC 302 at pages 310-311.

The expression "at arm's length" was considered by Bonner, J. in McNichol where, at pages 117 and 118, he discussed the concept as follows:

Three criteria or tests are commonly used to determine whether the parties to a transaction are dealing at arm's length. They are:

(a) the existence of a common mind which directs the bargaining for both parties to the transaction,

(b) parties to a transaction acting in concert without separate interests, and

The common mind test emerges from two cases. The Supreme Court of Canada dealt first with the matter in M.N.R. v. Sheldon's Engineering Ltd. At pages 1113-14 Locke, J., speaking for the Court, said the following:

Where corporations are controlled directly by the same person, whether that person be an individual or a corporation, they are not by virtue of that section deemed to be dealing with each other at arm's length. Apart altogether from the provisions of that section, it could not, in my opinion, be fairly contended that, where depreciable assets were sold by a taxpayer to an entity wholly controlled by him or by a corporation controlled by the taxpayer to another corporation controlled by him, the taxpayer as the controlling shareholder dictating the terms of the bargain, the parties were dealing with each other at arm's length and that s. 20(2) was inapplicable.

The decision of Cattanach, J. in M.N.R. v. TR Merritt Estate is also helpful. At pages 5165-66 he said:

In my view, the basic premise on which this analysis is based is that, where the "mind" by which the bargaining is directed on behalf of one party to a contract is the same mind that directs the bargaining on behalf of the other party, it cannot be said that the parties were dealing at arm's length. In other words where the evidence reveals that the same person was "dictating" the "terms of the bargain" on behalf of both parties, it cannot be said that the parties were dealing at arm's length.

The acting in concert test illustrates the importance of bargaining between separate parties, each seeking to protect his own independent interest. It is described in the decision of the Exchequer Court in Swiss Bank Corporation v. M.N.R.. At page 5241 Thurlow, J. (as he then was) said:

To this I would add that where several parties - whether natural persons or corporations or a combination of the two - act in concert, and in the same interest, to direct or dictate the conduct of another, in my opinion the "mind" that directs may be that of the combination as a whole acting in concert or that of any of them in carrying out particular parts or functions of what the common object involves. Moreover as I see it no distinction is to be made for this purpose between persons who act for themselves in exercising control over another and those who, however numerous, act through a representative. On the other hand if one of several parties involved in a transaction acts in or represents a different interest form the others the fact that the common purpose may be to so direct the acts of another as to achieve a particular result will not by itself serve to disqualify the transaction as one between parties dealing at arm's length. The Sheldon's Engineering case [supra], as I see it, is an instance of this.

Finally, it may be noted that the existence of an arm's length relationship is excluded when one of the parties to the transaction under review has de facto control of the other. In this regard reference may be made to the decision of the Federal Court of Appeal in Robson Leather Company Ltd. v. M.N.R., 77 DTC 5106.

To this discussion I would add one other quotation from M.N.R. v. Sheldons Engineering, Ltd., 55 DTC 1110 where Locke, J., in commenting on the expression, said at p. 1113:

The expression is one which is usually employed in cases in which transactions between trustees and cestuis que trust, guardians and wards, principals and agents or solicitors and clients are called into question. The reasons why transactions between persons standing in these relations to each other may be impeached are pointed out in the judgments of the Lord Chancellor and of Lord Blackburn in McPherson v. Watts, 1877, 3 A.C. 254. These considerations have no application in considering the meaning to be assigned to the expression in s. 20(2).

I do not think that in every case the mere fact that a relationship of principal and agent exists between persons means that they are not dealing at arm's length within the meaning of the Income Tax Act. Nor do I think that if one retains the services of someone to perform a particular task, and pays that person a fee for performing the service, it necessarily follows that in every case a non-arm's-length relationship is created. For example, a solicitor who represents a client in a transaction may well be that person's agent yet I should not have thought that it automatically followed that there was a non-arm's-length relationship between them.

The concept of non-arm's length has been evolving. The most significant advance has been in the Swiss Bank Corporation et al. v. M.N.R., 72 DTC 6470, where it was held that where a group of persons, otherwise at arm's length, acted in concert to direct the acts of a third person they were not dealing at arm's length with that person.

[67] The respondent's basis for saying that Trafalgar and the partnership were not dealing at arm's length is set out in paragraphs 9ll) and mm) of the reply, which read:

ll) Trafalgar Research, Trafalgar Capital, TSLP and the other four partnerships did not have opposing interests, but acted in concert when negotiating the terms and the sale of the partnership units in Market Vision;

mm) Trafalgar Research, Trafalgar Capital, TSLP and the other four partnerships were not dealing at arm's length.

[68] The respondent did not repeat the allegation in part C of the reply but I think the point is in issue. It was dealt with in the evidence and in argument.

[69] Trafalgar and the partnership were in my view dealing at arm's length. There was no control exercised by either party over the other. There was no common mind. The statement that the parties did not have opposing interests but "acted in concert" is either incorrect or does not lead to the conclusion that the parties were not at arm's length. Obviously one must consider the matter at the partnership level rather than at the partners' level. This view is confirmed by Deptuck v. Canada (supra), and Brown v. Canada (supra).

[70] Mr. Furtak and the partnership, acting through the general partner as represented by Mr. Coleman, each had their own interests - Mr. Furtak wanted the money and the partnership wanted the software which it was anticipated would yield income and also carry with it tax benefits. The evidence of Mr. Coleman was that there was a good deal of bargaining between him and Mr. Furtak about the price. To say that the parties acted in concert is not meaningful in this context. All it means is that both parties wanted to get the deal done. If that is the sort of "acting in concert" that results in parties to a transaction not dealing at arm's length then no business transaction between independent persons would ever be at arm's length. Even if we were to assume that Mr. Furtak and Mr. Coleman were indifferent as to whether the ultimate price was $40,000,000, $55,000,000 or $75,000,000 - and there is no basis in the evidence for such an assumption - whatever else it might prove it does not prove that they were not at arm's length.

[71] I have therefore concluded that the vendors and the partnership Trafalgar II were dealing at arm's length in the purchase of the software.

3. The at-risk and limited recourse rules

[72] The respondent has raised as a basis for the disallowance of the claim for CCA on $55,000,000 by the partnership and the resulting loss by the partners the limited recourse rules in section 143.2 and the at-risk rules in subsections 96(2.1) and (2.2). A useful discussion of how these rules apply to investments in software tax shelters is found in an article by Timothy S. Wach in the Canadian Tax Journal, Software Investments: Is the Candle Still Worth the Game?

[73] Mr. Wach summarizes a typical computer software investment at pages 2:2 to 2:4 (footnotes omitted).

An Overview of the Typical Structure

A typical computer software investment could be expected to take the following structure:

1) A partnership is formed to acquire and exploit computer software by reproducing, marketing, and selling the software.

2) Investors acquire interests in the partnership, usually through a combination of cash and one or more promissory notes. Alternatively, the investors may contribute cash and assume debt previously or subsequently incurred by the partnership. In either case, the structure of any "long-term" debt of the investors will be potentially subject to the proposed limited recourse debt rules, and therefore will have to be full recourse to the investor, and will ordinarily be structured to mature within 10 years and to bear interest at a rate at least equal to the prescribed rate under the Act in order to qualify for the exclusion from those rules for debt described in proposed subsection 143.2(7). As well, in order to so qualify, the investor will in fact have to pay that interest annually, or within 60 days of the end of each taxation year.

3) The partnership will acquire computer software from an arm's-length, third-party vendor. The acquisition price will be paid with a combination of cash raised form the investors and debt. As indicated above, the debt may take the form of an assignment of the investor notes, if any, provided by investors on the acquisition of their partnership interests, or debt of the partnership that is then assumed by the investors, if the financing of their partnership interests took that form.

4) The partnership will often engage the vendor, or a party related to the vendor ("the distributor"), to market, distribute, and sell copies of the software and to perform any enhancements or upgrades necessary or advisable and to provide technical support for the software. The distributor will earn a fee in exchange for providing these services to the partnership. The distributor or the vendor of the software will normally also provide representations in the software acquisition and distribution agreements with the partnership relating to such matters as the state and quality of the software, the sales and support activities to be undertaken, and expected sales levels for the software.

5) The partnership will claim CCA to the maximum extent permitted, thereby writing off the cost of the software over two years. This will ordinarily result in losses for tax purposes for the partnership and the investors for the first two fiscal periods of the partnership.

6) The partnership revenues will exceed its deductions in subsequent fiscal periods, giving rise to taxable income for the investors in the partnership.

As mentioned previously, the investor debt must be structured to ensure that the proposed limited recourse debt rules do not apply to effectively reduce the cost of the software to the partnership or to restrict the flow of losses out of the partnership to the investors in the first two fiscal periods of the partnership. Accordingly, any debt owing by the investors should be structured to ensure that it qualifies for the specific exclusion from the limited recourse debt rules, as previously described. As well, the partnership generally may not be indebted or it will suffer the combined effects of proposed subsections 143.2(6) and (8), effectively reducing the cost of the software to the partnership by the amount of the indebtedness of the partnership for as long as that indebtedness is outstanding. The structures involving investor debt incurred on the subscription for partnership units that is assigned to a software vendor in payment for software and partnership debt incurred on an acquisition of software that is assumed by investors are designed to navigate through these rules.

The structure of the relationships among the parties must also be sensitive to the potential application of the so-called at-risk rules in subsections 96(2.1) to (2.7). Accordingly, for example, the investors may not be indebted to the partnership or any party with whom the partnership does not deal at arm's length, or, if an investor is so indebted, it will be necessary to ensure that the debt is eliminated (for example, by having it assigned absolutely to a third-party vendor of software, without recourse by the software vendor to the partnership) before the end of the first fiscal period of the partnership. Otherwise, restriction of losses flowing from the partnership to the investor may occur as a result of the application of the at-risk rules.

[74] The rules are obviously a type of anti-avoidance provision and are designed to ensure that limited partners and investors in tax shelters (which MarketVision is) are not permitted to deduct losses that as a realistic economic matter will not actually or potentially hit them in the pocket book. If the way the investment is structured results in the true cost being only the cash that the investor has put at risk it is unnecessary to consider the application of rules that achieve that result in any event. If the mischief that an anti-avoidance rule is designed to cure has already been eliminated by the way the transaction is set up there is no need to consider whether the rule might have operated to prevent the mischief if the inherent structure of the deal had not already done so.

[75] What I cannot accept is the Crown's attempt to combine subsections 96(2.1) and (2.2) with section 143.2.

[76] The respondent contends that if we read subsections 96(2.1) and (2.2) together with subsection 143.2(8) the result is to reduce the appellant's at-risk amount to zero.

[77] The respondent's contention that the at-risk amount is reduced to zero is based on the following calculation:

	Item	Amount ($)	Section
Start with	Cost of Appellant's units of T2	150,000	s. 96(2.2)(a)
Reduce to	Cost as revised under s. 143.2(6)	43,500	s. 96(2.2)(a)
Plus	Income for the fiscal period ended 1995 from T2	0	s. 96(2.2)(b)
Less	Debt owing to Trafalgar Capital at the end of 1995, excluding amounts already affected by s. 143.2(6)	24,000	s. 96(2.2)(c)
Less	Promissory Note, even though owing to a non-arm's length party (Trafalgar Capital), is not subtracted because it has already been affected by s. 143.2(6)	N/A	s. 96(2.2)(d)
Less	Benefit of guaranteed 18% average annual return	142,339	s. 96(2.2)(d)
Less	Benefit of guaranteed purchase of number of Trading Reports by Trafalgar Capital @ US$20 per report ($638,400 CDN x 10 years x 1.24% Appellant's pro rata share)	78,879	s. 96(2.2)(d)
At-risk amount		0

[78] Since I have decided that it is unnecessary to consider the application of subsection 96(2.2) and section 143.2 I can deal very briefly with the calculation.

[79] Apart from the fact that this calculation reaches the anomalous not to say absurd result that the appellant's at-risk amount is minus $201,178[1] and even the cash put up by the appellant is eliminated from his at-risk amount, I think the calculation is flawed for several reasons.

(a) The debt owing to Trafalgar at the end of 1995 ($24,000 because of the assignment of the notes) does not further reduce the at-risk amount under subsection 96(2.2)(c) because Trafalgar and the partnership are at arm's length.

(b) The $142,339 is arrived at as follows, as set out in the respondent's written argument.

5. Trafalgar Capital and Trafalgar Research represent and warrant an average annual return of no less than 18% on leveraged Pledged Trading Capital through November 30, 2004. An annual return of 18% would be, on $8 million, $1,440,000. According to Horvath's report, an average annual return of 18% over ten years is the equivalent of a total return of 180% over ten years, or $14,400,000. T2 was entitled to only 80% of this amount, being $11,520,000. The Appellant's benefit from his 1.24% pro rata share (150 out of 12,140 total partnership units) of this amount totals $142,339 CDN.

Even if paragraph 96(2.2)(d) applied simply totalling up the payments that might be made over ten years is no way of determining the "amount or benefit" regardless of whether the software independently yields a profit of 18% per annum. These mathematical calculations are unedifying. I note that Mr. Horvath did not present value the figure which he arrived at even though he said that the present value of the ten year Acquisition Note was virtually nil.

(c) The same objection can be made to the $78,879 which is simply the total of the trading report fees to be made over ten years. In addition to all of the other objections, the trading report fees were payable only so long as the Acquisition Note was not paid off. It was paid off on December 31, 1995.

[80] Since this case was argued the Federal Court of Appeal has rendered its decision in the case of Peter Brown v. Canada (supra). It is useful to consider what guidance it affords in this case. That case involved, as does this one, CCA on software. Judge Rip found that the partnership and the vendor of the software were not dealing at arm's length, with the result that section 69 applied to reduce the purchase price of the software to its fair market value. Judge Rip determined the fair market value to be about one half of the purchase price. The Federal Court of Appeal did not disturb his findings on these two points. Judge Rip held that the appellant's only at-risk amount was the cash component of the purchase price of the appellant's units of the partnership ($4,000 per unit). He held however that the cost of the appellant's units represented by his assumption of the proportionate share of the acquisition note ($6,000 per unit) was not at risk.

[81] The Federal Court of Appeal modified this part of the judgment to reduce the at-risk amount to $2,000. The basis for this conclusion was that under certain subsequent partnership amending agreements the partners could exchange their units for $8,000. Thus the true economic risk to the partners was not the $4,000 cash they invested but the difference between the $10,000 cost and the $8,000 they could dispose of their units for. If they exercised their right of retraction the most they could be out of pocket at the end of the day was $2,000.

[82] The Crown had argued that in addition to the $8,000 per unit payable upon the exercise of the right of retraction the partner was entitled to receive shares of the vendor, American Software Corporation, and therefore the at-risk amount was further reduced by the value of the shares. The Federal Court of Appeal did not accept the argument because the value of the shares was unascertainable.

[83] There are some significant differences between the Brown case and this one. For one thing, I have concluded that the vendors and the partnership were dealing at arm's length. For another the determination of the at-risk amount is a quite different exercise because of the right of retraction in the Brown case.

[84] The Federal Court of Appeal decision contains however a very helpful analysis of portions of the at-risk rules. As Rothstein J. said at paragraph 37:

Broadly speaking, the At-Risk Rules of the Income Tax Act restrict limited partners' losses from a limited partnership for income tax purposes to their capital at risk.

4. Is the software leasing property within the meaning of Regulation 1100(17) so that the claim for CCA is limited by Regulation 1100(15)?

[85] Regulation 1100(17) defines "leasing property" of a taxpayer or partnership as depreciable property

where such property is owned by the taxpayer or the partnership, whether jointly with another person or otherwise, if, in the taxation year in respect of which the expression is being applied, the property was used by the taxpayer or the partnership principally for the purpose of gaining or producing gross revenue that is rent, royalty or leasing revenue ...

[86] The profits of the joint venture in which the partnership expected to share were profits from trading futures contracts. By no stretch of the imagination can this be called rent, royalty or leasing revenue.

5. Was the amount owing under the Acquisition Note contingent?

[87] The basis of the Crown's argument is that an obligation is contingent if no liability will come into existence until the occurrence of an event that might or might not happen. The legal premise on which the argument is based is unassailable: Winter v. IRC, [1961] 3 All E.R. 855 at 859; Wawang Forest Products Ltd. v. R., 2002 CarswellNat 528.

[88] There is, however nothing in the Acquisition Note to justify the conclusion that it was contingent. The fact that the obligee under the note also had certain obligations under the acquisition agreement vis-à-vis the obligor does not make the note contingent, whatever else its effect might be.

[89] Whether the Acquisition Note is contingent or not is, however, irrelevant because the note was paid off immediately. Whatever contingency the note might have been subject to, if any, disappeared when the obligation was fully satisfied.

[90] In the respondent's written argument it is also contended that the partners' promissory notes were contingent. This point is not made anywhere in the reply to the notice of appeal and the appellant had no obligation to attempt to meet the argument. In any event, on its face, the appellant's promissory note was not contingent.

[91] The respondent argues that the notes become contingent because of the warranty of the 18% return and the guarantee of payment of a certain number of trading report fees given to the partnership under the Software Acquisition Agreement. The obligation under the promissory notes to pay principal and interest does not depend upon Trafalgar living up to its commitments under the Software Acquisition Agreement even though the partnership might have had a cause of action against Trafalgar.

[92] Counsel for the respondent argues however that the "contingency" which he contends attached to the Acquisition Note as a result of the various obligations, representations and warranties given to the partnership by Trafalgar were, after the extinguishment of the Acquisition Note by the assignment of the partners' promissory notes, transferred to the partners' promissory notes. I do not think that this is correct as a matter of law but out of respect to counsel for the respondent and because the point is an important one I shall set out his written argument in full.

b) The Promissory Notes

96. The considerations in analyzing whether the Promissory Notes were contingent are as follows:

• The warranties given by Trafalgar Capital and Trafalgar Research in the Software Acquisition and Pledged Trading Capital Agreement had a time limit: "Until all principal and interest owing under the Acquisition Note have been paid in full ..." (clause 10.01). Pursuant to the Assignment of Promissory Notes by T2 to Trafalgar Capital, T2 was arguably discharged of all liability under the Acquisition Note. For the T2 offering to live up to its marketing, the guarantees had to remain in effect although the assignment and release took place.

Coleman testified that the references to "Acquisition Note" in the S.A. and PTS Agreement should have been to the Promissory Notes of T2's limited partners. According to Coleman's testimony, despite the assignment by T2 of the Promissory Notes to Trafalgar Capital, the warranties remained in force.

Coleman contradicted the terms of a key document in the T2 offering-the Software Acquisition and Pledged Trading Capital Agreement. Coleman through TSLP Management was a party to the contract. The terms of the Promissory Note cannot be determinative where the parties do not or cannot respect other relevant agreements;

A-2, Tab 7, Software Acquisition and Pledged Trading Capital Agreement, § 10.01(n)

A-2, Tab 12, Assignment of Promissory Notes, page 2, paragraph 3 Transcript, October 3, 2002, page 604, lines 9-22

• The contradiction by Coleman, given its significance, casts doubt on whether the liability of the limited partners was ever intended to be enforced;

• If the warranties remained in effect, then the liability to pay the debt under the Promissory Note was contingent. We will show this below;

• If an 18% average annual rate of return was not achieved, T2 could appoint the majority of the board of directors of Trafalgar Capital. The new board could cancel the debt or extend its due date; and

A-2, Tab 7, Software Acquisition and Pledged Trading Capital Agreement, clause 11.05

• The Appellant did not have a clear intention to repay the Promissory Note when it would become due.

Transcript, October 2, 2002, page 393, lines 3-9

c) If the Guarantees Remain in Effect

97. In determining contingency, what matters is the connection between the guarantees given by Trafalgar Capital and Trafalgar Research and the debt, if any, of the limited partners to Trafalgar Capital.

Huang & Danczkay Ltd v. MNR, 2000 CarswellNat 1951 at paragraph 19 (FCA)

98. In Brown, a case similar to the present appeal, a liability that was subject to a guarantee in another contract did render the liability contingent.

Brown v. R, 2001 CarswellNat 2574 (TCC) (appeal pending)

99. There, an acquisition note was subject to the terms of a software agreement. The software agreement contained a representation clause whereby the vendor warranted that certain video games transferred to a partnership would have a minimum level of sales. The software agreement provided that the representation clause induced the partnership to enter into that agreement.

Brown, supra, at paragraphs 154, 158, 172, 179

100. The Tax Court held that the representation clause was a term of the software agreement as it induced the Partnership to enter the software agreement. The failure to fulfill this term would give rise to an action for breach of contract.

Brown, supra, at paragraphs 167, 171, 174 and 189

101. The Court therefore held:

... that all the evidence shows that the liability represented by the Acquisition Note was subject to the Representation clause, among other provisions of the Software Agreement and Amendments No. 1, 2, and 3. The liability on the Acquisition Note was a contingent liability.

Brown v. R., supra, at paragraphs 171, 174 and 189

102. As with the vendor in Brown, Trafalgar Capital (and Trafalgar Research) represented and warranted a certain minimum annual return on the Pledged Trading Capital and the number of Trading Reports to be purchased. As with the software agreement and representation clause in Brown, in the Software Acquisition and Pledged Trading Capital Agreement, Trafalgar Capital and Trafalgar Research acknowledge that T2 relied on those representations and warranties in entering into that agreement.

A-2, Tab 7, Software Acquisition and Pledged Trading Capital Agreement, dated February 24, 1995, § 10.01(n)

103. The debts of the limited partners of T2 were subject to the warranties, given by Trafalgar Capital and Trafalgar Research, and are therefore contingent obligations.

[93] I do not think that these considerations establish that the promissory notes were contingent. They remained absolute on their face. The Acquisition Note was extinguished by the assignment of the partners' notes.

[94] Counsel for the respondent referred to the decision of Rip J. in Brown v. The Queen, 2001 DTC 1094. The Federal Court of Appeal has rendered its decision on this appeal and I have already discussed that case. Moreover, the facts in these software tax shelter cases all differ in greater or lesser degree. However counsel referred to the fact that Rip J. found that the Acquisition Note in the Brown case was subject to the representation clause in the software agreement, as amended and that therefore the liability on the Acquisition Note was contingent. In this case the Acquisition Note was subject to the Software Acquisition Agreement but the Acquisition Note was paid off.

[95] I do not think that Mr. Coleman's belief that the references in the Software Acquisition Agreement should have been to the partners' promissory notes can alter the legal relationship created by the documents. One cannot ignore the legal effect of a document or attribute to it a meaning that differs from its wording just because one party happens to think it should have said something else. To accept the respondent's argument would be a bold new departure in the law of rectification of contracts.

[96] The promissory notes were in my view not contingent. However, as I discussed elsewhere in this judgment they were capable of being transferred by the partners to some other entity and the partners could effectively escape liability under them.

[97] I come finally to what I think are the most relevant questions in this litigation.

[98] Was it reasonable for the partnership to claim CCA on the basis of a purchase price of $12,140,000? The answer to this question requires a determination of the true cost to the partnership of the software. The obvious starting point is the cash that was paid, $3,520,600.

[99] What else was paid? The Acquisition Note for the principal sum of $8,619,400 existed for a split second until it was paid off and replaced by the partners' promissory notes. The question is not whether those notes were contingent. They were not. The real question is: What were those notes worth?

[100] I do not think that the full face value of the promissory notes due in 2005 can be taken into account in determining the cost to the partnership of the software for several reasons.

(a) The limited partners could get rid of their liability under the notes by assigning them to a third party and having the third party assume the obligation. The third party could be a shell company of a man of straw.

(b) Under clause 11.05 of the Software Acquisition Agreement if the software does not achieve an average trading profit of at least 16% on the leveraged pledged trading capital in the period from January 1, 1995 to December 31, 2004 the partnership has the right to replace the board of directors of Trafalgar Capital. This right may as a practical matter have little value but if the partnership were to take over the board of directors of Trafalgar Capital it would be a formidable obstacle to Trafalgar collecting on the promissory notes.

(c) The above two reasons are probably sufficient to justify serious doubts about the value of the partners' notes. There is however one further point that I am having difficulty articulating because my view is based more on my commercial and common sense instincts than on a strictly logical or legal analysis. It is nonetheless a significant misgiving and I shall therefore endeavour to state the reason for my concerns.

There is something very peculiar about these notes and indeed about this aspect of the overall arrangement. Normally if a person buys property for, say, $1,000 and gives the vendor $400 cash and a promissory note for $600, with interest at a commercial rate and a maturity date some years in the future, it would never be suggested that the cost of the property was anything other than $1,000. It is not the practice to present value the note. The price is what it is stated to be and the fact that it is partly represented by a promissory note does not mean that the cost to the purchaser or the proceeds to the vendor should be reduced.

Is that what we have here? I think not. We have an Acquisition Note that is tied to a complex agreement between the vendor and the partnership under which the vendor obligates itself to engage in trading activities and pay trading report fees that it is intended will pay off the principal and interest under the Acquisition Note and yield a profit. That note disappears as soon as it is signed. It is replaced by notes that are not obligations of the partnership, the purchaser of the property, but of the individual partners. It is a matter of satisfying the partnership's obligations under the Acquisition Note by the vendor's acceptance of property. As it happens the property is notes given by the partners to the partnership but it could as easily have been any other item of property and that property has to be valued (Cf. Gold Coast Selection Trust Limited v. Humphrey (Inspector of Taxes), [1948] A.C. 459 at 472).

Some of the obligations under the agreement disappear with the disappearance of the Acquisition Note, but some do not. The vendor, Trafalgar, nonetheless goes on making payments to the partnership as if the Acquisition Note were still in existence. The only way it can make these payments is by dipping into the fund called the Pledged Trading Capital which was supposed to be used for trading purposes. The original source of that fund was, as it happens, the very cash the partners put up when they bought their partnership units. It is coming back to them through the partnership as income and is being applied against principal and interest under the notes.

The fact that the parties appear to have disregarded the legal effect of the disappearance of the Acquisition Note leads to the conclusion that they did not expect the partners' notes to be enforced and recognized that if any attempt were made to do so there would be defences.

For these reasons, I do not see how it can reasonably be considered that these notes have a value equal to their face amount when they are inextricably connected with obligations, real or assumed, by the holder. It would be naïve to assume that Trafalgar could demand payment of the notes at maturity and expect to receive a cheque by return mail. Any attempt to enforce payment of the notes would be met by a myriad of defences.

[101] While the value of the promissory notes of the partners that were assigned to Trafalgar in satisfaction of the Acquisition Note must be taken into account in determining the cost to the partnership of the software, for the reasons given above I question what their value is, if any. However the parties must be given an opportunity of dealing with the question of value.

[102] The disposition of the case in which I do not rely upon the at-risk rules or the limited recourse rules is premised upon the view that the obligations under the Acquisition Notes disappeared on December 31, 1995. If that assumption is wrong and the obligations of Trafalgar continued as if the Acquisition Notes had not been paid off then I would have had to consider to what extent the at-risk and limited recourse rules affected the cost of the software or the loss deductible by the partners. The manner in which the case has been disposed of achieves substantially the result that would have been achieved by the application of those rules.

[103] Section 80 of the Income Tax Act was not argued and so I shall mention it only in passing. It contains a rather complex code relating to the effect of settling a debt at less than the amount for which it was issued. One effect is to reduce the capital cost of depreciable property by the "forgiven amount". It strikes me that where the Acquisition Note in the amount of $8,619,400 is extinguished by the assignment of promissory notes due ten years later that are of questionable value it is arguable that the capital cost of the depreciable property otherwise determined for which the Acquisition Note was issued should be reduced by the difference between the face amount of the Acquisition Note and the value of the promissory notes. However section 80 was not argued and I make no further comment.

[104] The proper disposition of this appeal in my view is to allow it and refer the assessment back to the Minister of National Revenue for reconsideration and reassessment on the basis that the cost to Trafalgar II of the 22.07% of MarketVision was $3,530,600 plus the value if any on December 31, 1995 of the partners' promissory notes that were assigned to Trafalgar. If the parties can agree on the value I would ask that the court be informed and the figure can be incorporated in the formal judgment. If the parties cannot agree on the value of

the notes I am prepared at the request of counsel to reopen the case to hear further representations and, if necessary, evidence on this point. I am also prepared to hear submissions on costs.

Signed at Ottawa, Canada, this 15th day of May 2003.

"D.G.H. Bowman"

A.C.J.

CITATION:

2003TCC332

COURT FILE NO.:

1999-4555(IT)G

STYLE OF CAUSE:

Between Alan McCoy and

Her Majesty The Queen

PLACE OF HEARING

Toronto, Ontario

DATES OF HEARING

September 30 to October 11, 2002 and January 15 to January 20, 2003

REASONS FOR JUDGMENT BY:

The Honourable D.G.H. Bowman

Associate Chief Judge

DATE OF REASONS FOR JUDGMENT:

May 15, 2003

APPEARANCES:

Counsel for the Appellant:

Clifford L. Rand, Esq.

David Muha, Esq.

Counsel for the Respondent:

David W. Chodikoff, Esq.

Bobby Sood, Esq.

COUNSEL OF RECORD:

For the Appellant:
	Name:	Clifford L. Rand, Esq.

Firm:

Wildeboer Rand Thomson Apps & Dellelce

Toronto, Ontario

For the Respondent:

Morris Rosenberg

Deputy Attorney General of Canada

Ottawa, Canada

[1] The respondent's calculations arrive at a negative amount of $201,178 which the respondent says means nil. There is arguably some justification for this in section 257 which deems negative amounts or numbers arrived at by an algebraic formula to be nil unless otherwise provided. The at-risk rules do not involve an algebraic formula. Fortunately the somewhat arcane question of a negative at-risk amount is something that can be left to another day.

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