Tax Court of Canada Judgments

Docket: 2001-3463(IT)G

BETWEEN:

SUPER WEST HOMES INC.,

Appellant,

and

HER MAJESTY THE QUEEN,

Respondent.

____________________________________________________________________

Appeal heard on April 21, 2004 in Toronto, Ontario

Before: The Honourable Justice J.E. Hershfield
Appearances:
Counsel for the Appellant:	Warren J.A. Mitchell, Q.C. Matthew G. Williams
Counsel for the Respondent:	Eric Noble

____________________________________________________________________

JUDGMENT

          The appeal from the assessment made under the Income Tax Act for the 1999 taxation year is dismissed, with costs, for the reasons set out in the attached Reasons for Judgment.

Signed at Ottawa, Canada, this 23rd day of June 2004.

"J.E. Hershfield"

Hershfield J.

Citation: 2004TCC328

Date: 20040623

Docket: 2001-3463(IT)G

BETWEEN:

SUPER WEST HOMES INC.,

Appellant,

and

HER MAJESTY THE QUEEN,

Respondent.

REASONS FOR JUDGMENT

Hershfield J.

[1]      This is an appeal of a reassessment disallowing a net capital loss carry forward in computing the Appellant's taxable income for 1999. An allowable capital loss had been reported for 1998 in the amount of $1,648,974.00 and the full amount of such loss was carried forward to 1999 as a net capital loss pursuant to section 111 of the Income Tax Act (the "Act").

[2]      The allowable capital loss giving rise to the carry forward arose from an indebtedness owed to the Appellant by 628774 Ontario Inc. ("Ontario Inc."). The debt was incurred to enable Ontario Inc. to fund an investment in a convention centre project organized and operated as a limited partnership of which Ontario Inc. was the general partner. In 1998 the debt was determined to have become a bad debt and the Appellant elected to have paragraph 50(1)(a) of the Act apply. The effect of the election is that the debt is deemed to have been disposed of in 1998 for nil proceeds. The Respondent does not dispute that the debt became bad in that year. Indeed, the parties acknowledged that the only issue in this appeal was whether the debt was incurred for the purpose of gaining or producing income from property or business pursuant to subparagraph 40(2)(g)(ii).

[3]      Subparagraph 40(2)(g)(ii) of the Act provides that the loss on disposition of a debt is nil "unless the debt ... was acquired by the taxpayer for the purpose of gaining or producing income from a business or property ...".

[4]      The Appellant asserts that the debt was an interest-bearing loan made by it to Ontario Inc. An executed loan agreement was tendered at the hearing. The loan agreement on its face purports to have been signed in September of 1989 when funds were first advanced. It provides for loans by the Appellant to Ontario Inc. for up to $5,000,000.00 repayable on demand and bearing interest at 12% per annum plus a standby fee of one-half of the management fee earned by Ontario Inc. The management fee, to which Ontario Inc. was entitled, was an annual fee equal to the greater of $100,000.00 or the sum of 2% of gross revenues plus 10% of net profits. The total funds advanced by the Appellant to Ontario Inc. was $2,198,632.00.

[5]      The Respondent argued that the circumstances surrounding the emergence of the loan agreement coupled with abundant evidence that it had not been given effect to prior to making the election under subsection 50(1), raised such doubts as to its timely existence as to warrant a finding that the Appellant has not met its burden of proof to establish that the loan was made pursuant to it at the inception of the loan. The executed loan agreement did not emerge until after the election was made under subsection 50(1). Its terms had never been given effect to. For years the loan had been reflected on books and records as non-interest-bearing. No payments on the debt, principal or interest, were ever made. The Respondent also argues in the alternative that even if the loan agreement did exist in 1989, the Appellant has not met its burden of proof to establish that the agreement was intended to have legal effect when the funds were advanced. If the Appellant cannot establish on the balance of probability that the loan agreement was intended to have legal effect, the subject debt will not be established to have been incurred for the purpose of gaining or producing income.

[6]      In response to the Respondent's position and its portrayal of the evidence, the Appellant has put reliance on the historical context of the loan and of its dealings. That historical context was attested to by two witnesses called on behalf of the Appellant. Frank Carinci, a principal of the Appellant and Rolf Fiege, the lawyer for the Carinci family interests, both gave evidence supporting the timely existence of the loan agreement. Frank Carinci who signed the agreement on behalf of both parties also attested to the intention of the parties to be legally bound by its terms.

[7]      The Appellant's evidence falls readily into two parts. Firstly, there is evidence that addresses the making and late emergence of the loan agreement and, secondly, there is evidence as to the contextual explanation of accounting and reporting errors concerning the interest-bearing nature of the loan. I will deal firstly with the evidence that addresses the making and late emergence of the loan agreement.

[8]      Mr. Fiege testified that he had sent a draft loan agreement to Dominic Carinci following a discussion with him in about July of 1989 as to the need to address a concern raised by Dominic's brother Frank. The concern was that the Appellant was owned 50-50 by the two brothers but the interest in the convention centre project was indirectly held by seven family trusts: a four-sevenths interest was held for Dominic's children and a three-sevenths interest was held for Frank's children.[1] Mr. Fiege prepared a draft loan agreement on the understanding that it had to provide for interest to alleviate Frank's concern that funds to which he was indirectly entitled would disproportionately benefit Dominic's family. This was portrayed by both witnesses as a very important issue from the outset of the convention centre project.

[9]      Mr. Fiege testified that he provided the draft loan agreement on outdated memorandum stationery. The Appellant places great emphasis on this as it enabled pinpointing the time that the draft agreement was sent. That is, Mr. Fiege was able to testify that the stationery used corroborated the July 23rd, 1989 date of the correspondence enclosing the draft loan agreement. It also corroborated his recollection of when the draft agreement would have been sent to Dominic. It should also be pointed out that the executed loan agreement is on the original outdated stationery sent by Mr. Fiege to Dominic. That original document contained alternative interest provisions and Mr. Fiege's evidence was to the effect that the document was sent as a draft and intended only to illustrate choices as to how a loan agreement might be framed. He never heard anything again from either brother with respect to the execution of a loan agreement until after audit questions were raised following the claiming of the bad debt loss carryover in 1999.

[10]     Frank testified that Dominic sent the draft agreement to him and that he, Frank, crossed out one of the alternative interest provisions, made one other amendment, deferring interest payments for three years,[2] and signed the loan agreement as the signing officer for both the borrower and lender.[3] He was very firm that he executed the agreement on the date written on the agreement and that he sent it back to Dominic intending, and on the understanding, that the agreement as signed would govern the terms of the loan. This was a long-term project and monies indirectly belonging 50-50 between the brothers should be accounted for with interest to reduce the disproportionate benefit to Dominic's side of the family.

[11]     It seems at that point that the loan agreement was put in a miscellaneous file in Dominic's office and it never surfaced until audit questions concerning the 1999 loss carryover claim arose. Even the claim of the loss in 1998 was not based on the subject loan being interest-bearing per se although the financial statements filed with the 1998 tax return noted, for the first time, that some related party loans were interest-bearing. The accountant took the position that the loan was a source of income on the basis that the subject loan enhanced the income potential of the Appellant in respect of other related property. Such basis for asserting that the loss is not subject to subparagraph 40(2)(g)(ii) was abandoned presumably when the loan agreement surfaced during the audit of the 1999 year. While the emergence of the loan agreement at that time is suspicious, counsel for the Appellant argues that the motivation for an interest-bearing loan from the inception of the advances is essentially unimpeachable. He adds that for me to find otherwise would require that I find either that the lawyer participated in a scheme to facilitate backdating the loan agreement and kept 10-year old stationery around to help advance such a scheme or that the agreement was kept around, unsigned for some ten years, presumably in expectation that one day it would be necessary to execute. Counsel for the Appellant suggests both such findings would not be justified.

[12]     I turn now to the evidence that speaks to the contextual explanation of accounting and reporting errors concerning the interest-bearing nature of the loan.

[13]     Real estate development projects typically financed by the Appellant were short-term projects undertaken by related companies for resale and were indirectly owned 50-50 by the brothers: Dominic and Frank. As stated, the Appellant was also owned 50-50 by the two brothers at least until 1994 when Dominic died. It was asserted then that it was not necessary and not the practice to charge interest on loans to related companies. Accordingly, such loans were recorded and treated as non-interest-bearing. Since the accountants were unaware of the loan agreement and its terms, the subject loan was erroneously treated as all other related company loans were treated.[4] If I accept that there was a credible reason to have an interest-bearing loan, I am then urged to accept that the loan agreement was signed in 1989 with the intent to be bound so that the accounting contradictions must then be taken as being in error. Records prepared in error should not be taken as evidence that the loan agreement did not exist at the time and on the terms asserted.

[14]     While at this point I might well proceed to consider the evidence and arguments relied on by the Respondent which themselves are sufficient to dispose of the appeal, the circumstances surrounding the subject loan warrant further comment.

[15]     The convention centre project was undertaken in 1989 on lands held by the seven family trusts established in favour of the seven children of Frank and Dominic. The lands were leased to a limited partnership formed to undertake this new project. As noted, Ontario Inc. was the general partner of the limited partnership. It was owned by the seven family trusts. As well, each of the seven trusts had an equal limited partnership interest in the limited partnership. There were no other partners.

[16]     The limited partnership agreement of January 1989 sets out the initial capital contributions which bore interest at 18% per annum. Each family trust as a limited partner initially contributed capital of $200,000.00 to the limited partnership. Ontario Inc., as general partner, made an initial capital contribution of $3,500.00 plus approximately $99,000.00 by a transfer of assets to the limited partnership. However, capital accounts changed dramatically by 1992. An amendment and restatement of the limited partnership agreement in January 1992 (documenting a restructuring of the limited partnership) shows that Ontario Inc.'s capital account at that time was in excess of $4,000,000.00 and that the capital account of each family trust was only some $68,000.00. Mr. Fiege testified that some of the addition to Ontario Inc.'s capital account was due to the accounting treatment of the advances made by Ontario Inc. to the limited partnership. That is, he suggested that the advances made by Ontario Inc. (that were financed by the subject loans from the Appellant) had been capitalized.[5]

[17]     The limited partnership agreement provided for an allocation of profits and losses on the basis of .25% to the general partner (Ontario Inc.) and 14.25% to each family trust. Such allocation is said to be in accordance with participating interests which are defined to include capital contributions. The step-up in Ontario Inc.'s capital accounts noted above may have been the basis for allocating a greater share of partnership losses to Ontario Inc. but no direct evidence was tendered as to changes to profit and loss allocations under the limited partnership agreement prior to the 1992 restructuring of the limited partnership. Mr. Fiege did testify however and exhibits confirmed that Ontario Inc.'s allocated losses for fiscal 1992 (ending prior to the January 1992 restructuring) were assigned to a new limited partner introduced on the restructuring. The amount of the losses assigned was $1,800,000.00, an amount seemingly higher than the initial .25% allocated to Ontario Inc. Such allocation and assignment of losses were said to have reduced Ontario Inc.'s capital account. Also as part of the 1992 restructuring there were transfers of advances to Ontario Inc. from related parties that were said to have further reduced Ontario Inc.'s capital account.[6] Any remaining capital account amount credited to Ontario Inc. was offset with a .25% interest in the restructured limited partnership which interest was transferred for nominal consideration to the new general partner.

[18]     I note at this point that the restructuring in January of 1992 was required as the limited partnership was in financial difficulty.[7] The development of the convention centre that included a banquet facility and was ultimately to include a hotel complex was not proceeding as planned and to the extent that it was up and running it was not making money. The 1992 restructuring facilitated the bringing in of a new arm's length investor. That investor required that the lands leased to the partnership by the family trusts be transferred to the limited partnership. The investor advanced $2,200,000.00 to the partnership to fund this land purchase. As well, additional limited partnership units were issued to the new investor for nominal consideration with the result being that he owned 50% of the outstanding limited partnership interests. The other 50% continued to be held by the seven family trusts. A new general partner was introduced. The shareholders of the new general partner were the new investor as to 50% and the two brothers, Frank and Dominic, as to 25% each. Ontario Inc. lost its interest in the partnership as well as its management role which was assumed on the same terms by the new general partner. [8]

[19]     In June of 1997 the new investor acquired all of the limited partnership interests held by the family trusts for the sum of $2,200,000.00. That is, from early 1992 to mid-1997 the 50% equity in the limited partnership owned by the family trusts appreciated by $2,200,000.00. I would note that this growth to the family trusts in the proportions held would be as planned in the initial structuring of the project. That is, the initial structuring evidences a freeze in favour of the family trusts in the proportions in which they held limited partnership interests for which they contributed equal amounts of money and in the proportions that they owned the lands originally leased to the limited partnership. I note that the "success" of the freeze might arguably be partly attributable to the Appellant's advancing, on an unsecured basis, funds intended for a project the appreciation on which was designed to go to family trusts. I do not mean to suggest any slight of hand or inappropriate tax planning in respect of the freeze but in effect what has happened (ignoring comments that might be made in respect of the shuffling that occurred on the restructuring in 1992) is that the Appellant's investment has been lost and as value was recouped over time it attributed to the beneficiaries of the freeze.[9] That is, not only was the "use" value of the funds advanced by the Appellant (that is, the "interest" value on the principal amount advanced) benefiting the two brothers' families disproportionately but the principal amount advanced, as things turned out, has effectively benefited the two families disproportionately as well. That was apparently not of concern to Frank in 1992 when nothing was done to protect against it happening even though at that time it was foreseeable. Not protecting the Appellant's principal loan amount in this case suggests that the need to preserve proportionality of interests between the brothers was not as compelling as suggested at the hearing. It was not as compelling as advancing the objectives of the freeze.[10] I cannot be asked to rely on the compelling reason for the loan having interest as being very compelling if no attention was paid to the principal amount of the loan.

[20]     This leads me now to address some of the telling factors relied on by the Respondent in its argument that the Appellant had not met its burden of proof on the issue before me.

[21]     Most troublesome to the Appellant's position is that it never received a payment under the loan agreement even on one occasion where there were clearly monies payable to it. Ontario Inc. received a management fee from the limited partnership in 1993. Counsel for the Appellant in responding to undertakings given at the examination for discovery confirmed that a payment was made in 1993 in respect of management fees earned by Ontario Inc. while it was still a party to the management agreement with the limited partnership. The amount paid was some $43,000.00. No part of this was ever paid over to the Appellant as expressly required under the loan agreement. By 1993, deferral of the interest payments on the loan, as provided in the loan agreement, had ended. Still, no interest payments or stand-by fee payments were made. If the interest on the loan was there to adjust for disparate family holdings and such adjustment was of such importance to Frank, the fact that such provisions were ignored or forgotten undermines the logic of Appellant counsel's argument. I cannot be asked to rely on the compelling reason for the loan having interest as being very compelling if it was so quickly and readily forgotten or ignored without explanation.

[22]     Troublesome as well of course is that records were consistently maintained on the basis that the loans were non-interest-bearing. I am not satisfied that I can ignore such inconsistencies on the basis of their being in error. The following observations bear on this question.

[23]     Frank testified that his responsibilities were construction related. He was the guy on the ground, while Dominic's function was mainly managerial. Dominic handled all office, legal and accounting matters. Frank stated that in regards to accounting or legal documentation he relied 100% on whatever his brother's decision was and after his brother's death he relied totally on the accountants and lawyers, yet, he alone made handwritten amendments to the draft loan agreement which he alone signed. The finality of Frank making these changes without further discussion does not seem characteristic. It was uncharacteristic for him to unilaterally make final and binding commitments and sign a sophisticated loan agreement.

[24]     Throughout his evidence Frank referred to the importance of the loan agreement, how it was a solution to a problem, yet he did not follow up on the loan agreement. Even after his brother's death he did not mention the loan agreement to his accountants or lawyers. He did not confirm the amount of the loan with accountants to be sure interest was being accrued in accordance with the agreement.[11] These inconsistencies underline that signed or not it was unlikely that the loan agreement can be taken as having been sent to Dominic for implementation as a binding agreement. Such intention would surely be manifested somewhere. Dominic as someone who worked with his lawyer and accountant regularly was not, by putting the agreement away in an obscure file and ignoring it, evidencing any acknowledgement or understanding of its being a definitive or operative resolution of Frank's concerns. To the contrary, it evidences that the agreement was in abeyance regardless that it might have been signed.

[25]     As to documentary inconsistencies supporting the Appellant's position the following gives a snapshot of the situation.

[26]     One month after the loan agreement was signed, a Directors' resolution of the Appellant approving the financial statements was signed by Frank. Similar resolutions were signed each year thereafter up to and including 1997. The approved statements all described related party advances or affiliated corporation loans as non-interest-bearing. All tax returns between 1989 and 1997 included the approved financial statements. Although not an officer of the Appellant until 1994,[12] the evidence is that Dominic was at all times prior to his death responsible for all accounting matters and as such he was aware that the debt was classified on these statements as non-interest-bearing, contrary to its description in the loan agreement. This does not help advance the argument that all these statements were in error. To the contrary, it evidences that the agreement, even if signed as attested to, was not intended to be given effect. The evidence suggests that it was to be considered at a future time and given effect on such terms as would best resolve Frank's concerns based on how things unfolded. For example, when the project needed help and Frank and Dominic became shareholders of the new general partner, the need for the agreement arguably disappeared. It seems probable then that the agreement signed in 1989, and I accept Frank at his word that it was signed in 1989,[13] was, more likely than not, effectively subject to an implied condition precedent that never occurred. That implicit condition precedent was that the agreement would be resorted to only if some other resolution of Frank's concern did not present itself as circumstances permitted or required. I can only assume that the reason that neither brother paid any attention to whether the loan agreement was complied with was because it was not intended to be complied with from inception to the time the debt was determined to be a bad debt. I can find no basis to support the Appellant's necessary contention that there was an intention to impose an obligation on Ontario Inc. to pay interest on or derive any income from the subject loan at the inception of it or, as it turned out, at any time after that. The Respondent's alternative position as set out in paragraph [5] of these Reasons is the correct position on the facts as I find them.

[27]     Accordingly, the appeal is dismissed, with costs.

Signed at Ottawa, Canada, this 23rd day of June 2004.

"J.E. Hershfield"

Hershfield J.

CITATION:

2004TCC328

COURT FILE NO.:

2001-3463(IT)G

STYLE OF CAUSE:

Super West Homes Inc. and Her Majesty the Queen

PLACE OF HEARING:

Toronto, Ontario

DATE OF HEARING:

April 21, 2004

REASONS FOR JUDGMENT BY:

The Honourable Justice J.E. Hershfield

DATE OF JUDGMENT:

June 23, 2004

APPEARANCES:

Counsel for the Appellant:

Warren J.A. Mitchell, Q.C. Matthew G. Williams

Counsel for the Respondent:

Eric Noble

COUNSEL OF RECORD:

For the Appellant:

Name:

Warren J.A. Mitchell Matthew G. Williams

Firm:

Thorsteinssons, Toronto

For the Respondent:

Morris Rosenberg Deputy Attorney General of Canada Ottawa, Canada

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