Citation: 2008TCC101
Date: 20080220
Docket: 2006-2259(IT)G
2006-2260(IT)G
BETWEEN:
MARY LYNNE TESAINER
and SILVANO TESAINER,
Appellants,
and
HER MAJESTY THE QUEEN,
Counsel for the Appellants: Richard van Banning
Counsel for the Respondent:
Margaret J. Nott
REASONS FOR JUDGMENT
(Delivered
orally from the bench on
January 18, 2008, in Toronto, Ontario.)
McArthur J.
[1] These appeals are from reassessments by the
Minister of National Revenue for the Appellants 1992, 1993 and 1995 taxation
years. The appeals were heard on common evidence. The evidence consisted of a
common Book of Documents, a Partial Statement of Agreed Facts and the testimony
of Silvano Tesainer. The partial Statement of Agreed Facts reads as follows:
1. The Appellants, Silvano Tesainer and Mary
Lynne Tesainer, are spouses (the “Appellants”). The years under appeal are the 1992, 1993 and 1995 taxation years.
2. The issues are:
(a) for the 1992 and 1993 taxation years,
whether the Appellants are entitled to deduct interest expense amounts in
connection with money they borrowed to invest in a limited partnership;
(b) for the 1995 taxation year, with respect
to a payment received by the Appellants in that year from the settlement of a
lawsuit in which the Appellants, among others, were plaintiffs, whether the
payment was received by the Appellants as a return of capital which reduced the
ACB of their partnership interest (as contended by the Minister) or was a
payment of compensation or damages or otherwise which did not reduce their ACB
(as contended by the Appellants).
Background Facts:
3. In December 1998, the Appellants each
acquired limited partnership units in American Diversified Realty Fund. The
name American Diversified Realty Fund was subsequently changed to Fenix
Development Partnership (“Fenix”).
4. Fenix acquired an interest in real
property in Mississauga, Ontario in 1988 or 1989 on which it
intended to construct a commercial and industrial building.
5. In 1989, the promoters of Fenix ran into
difficulties with the Ontario Securities Commission, and after 1991, Fenix no
longer owned any interest in real estate and was no longer active in the
business for which it was formed."
Interest Expenses
6. In 1989, the Appellants borrowed $100,000
from the Toronto Dominion Bank (the “Bank”), which amount was used by the Appellants,
as to $50,000 each, to acquire limited partnership units in Fenix.
7. In and for the 1992 taxation year, the Appellants
each paid $4,006 to the Bank in interest on the $50,000 borrowed by each of
them in 1989 and used by them to purchase partnership units in Fenix.
8. In and for the 1993 taxation year, the Appellants
each paid $3,266 to the Bank in interest on the borrowings from the Bank.
Characterization of Settlement Proceeds
9. In 1992, the Appellants, along with other
Fenix limited partners commenced a lawsuit against the law firm handling the
private placement of the Fenix Limited partnership units (the “Lawsuit”).
10. During 1994 examinations for discovery were
conducted and the plaintiffs filed a motion for summary judgment (which was not
heard because the case was settled).
11. In April 1995, the Lawsuit was settled and
Minutes of Settlement were signed. Under the Minutes of Settlement, the
plaintiffs in the Lawsuit (including the Appellants) received $3,850,000. After
payment of legal fees, approximately $3,200,000 net was available to be distributed
to the plaintiffs.
12. In June 1995, the Appellants, together,
received $98,278.75 as their share of the said net settlement proceeds, or
$49,139.38 each.
13. In 1995, following the settlement of the Lawsuit,
the Fenix Partnership was dissolved.
Partnership ACB
14. The parties do not, for the purposes of
this litigation, dispute that, prior to the receipt of the settlement payment
in June 1995, the adjusted cost base to Mr. Silvano Tesainer of his partnership
interest in Fenix was ($12,679), that is, negative $12,679 as set out in
Schedule B to the letter from Ms. Santiago of CRA to the Appellant and
dated May 21, 1999.
15. The parties do not, for the purposes of
this litigation, dispute that, prior to the receipt of the settlement payment
in June 1995, the adjusted cost base to Mrs. Mary Lynne Tesainer of her
partnership interest in Fenix was $349 as set out in Schedule B to the letter
from Ms. Santiago of CRA to the Appellant dared June 25, 1999.
[2] In the testimony of
Mr. Tesainer, in addition to
the above agreed facts, he added that he and his wife purchased their limited
partnership interest for capital appreciation and to earn income over the long
term. This was corroborated by the limited partnership agreement which provided
that capital could not be withdrawn from their investment for 15 years, and
then only in a limited amount. A total of 93 partners invested in the project,
and 74 of those, including the Appellants, participated in the lawsuit against
the law firm that had acted for Fenix in its dealings with the securities
commission. The remaining 19 partners did not participate.
[3] The Respondent set out its "Basis of
Reassessment" on objection as follows:
The taxable capital gain assessed was the result of an out-of-court
settlement reached regarding the Fenix partnership with respect to wrongful
advice against the law firm handling the private placement of the limited
partnership units.
…
Only the taxpayers that receive proceeds from the litigation were
reassessed because of the various tax implications arising from the
distribution of the funds as well as different tax attributes available for use
by the individual partners. In the calculation of the adjusted cost base of
the partnership interest, it includes any loss incurred by the partnership from
any sources. In this regard, the capital loss incurred by the partnership in
1991 on the disposition of the property under section 79 foreclosure was
included under paragraph 53(2)(c) of the Income Tax Act,
resulting in a negative adjusted cost base.
[4] In a status report to those 74 litigating
partners, their solicitors advised them by letter dated January 11, 1995 that:
I am writing to update you on the status of your
lawsuit. The summary judgment motion is scheduled to be heard by Justice
Farley on February 17, 1995. Briefly, on the motion we are seeking, (a) return
of the $3,263,000 invested collectively by you and other Fenix investors,
judgment interest, punitive damages and further directions from the court.
Also, on April 20, 1995, their solicitors wrote
advising them that the action was settled for a net of approximately $3.2
million to be divided amongst the group of 74. As stated, the limited
partnership had not been active since 1991 and it was dissolved in May 1995.
[5] The parties agree that prior to the
settlement payment, the adjusted cost base of their partnership interest was a
negative $12,679. The Book of Documents includes an offering memorandum and a
limited partnership agreement, both very lengthy, and several related documents
in a statement of claim. The statement of claim is an action by Fenix together
with the 74 limited partners. They made the following claim against the law
firm:
The plaintiffs
claim as follows:
1. The individual plaintiffs claim the amount of their
investment, being a total of $3,261,000 in accordance with Schedule A of the
claim."
2. The Plaintiff, Fenix, claims $3,261,000 together with
damages in the amount of $3,500,000.
All of the plaintiffs claimed lost profits of over $4
million and punitive damages of $5 million, together with interest. The
settlement received was $3,850,000 and, after legal fees, approximately
$3,200,000 was distributed amongst the group of 74.
[6] The Appellants' primary position was that
the settlement payment of $98,280 was not a return of their capital investment
in Fenix and that as a result, paragraph 53(2)(c) of the Income
Tax Act does not apply. They added that to be taxable, the situation has to
fit a provision of the Act and that it does not. The payment was
compensation or damages or otherwise, but was not capital that reduced the
adjusted cost base. Further, that paragraph 53(2)(c) of the Act
does not apply because the section refers to a distribution of capital, or at
least it infers that. In the present case, there was no distribution of
capital and there could not have been because the character of the settlement
amount was a conglomeration of items. Further, Mr. Tesainer testified that the
amount received in settlement, was a payment for lost profits, and the
partnership did not provide for a return of capital.
[7] With regard to the second issue, the Appellants'
position is that they borrowed $100,000 from the Toronto-Dominion Bank to earn
income from Fenix. They each paid interest on this loan of $4,006 in 1992 and
$3,266 in 1993, and it is deductible under paragraph 20(1)(c) of the Act.
[8] The Respondent emphasized that the findings
of Charron J. of the Supreme Court of Canada, in Tsiaprailis v. The
Queen,
and in particular, two determinative questions: (i) what was the payment
intended to replace, and (ii) would the replaced amount have been taxable in
the recipients' hands? In answer to these questions, counsel for the Respondent
concludes that the payments were capital and paragraph 53(2)(c) applies.
[9] With respect to the interest issue, the Respondent
concluded that there was no possibility of a resumption of activities of the
limited partnership after 1991. In fact the land upon which the intended
project was to be built had been sold through power of sale by the mortgagee;
the source of income had disappeared and therefore, the interest was not
deductible.
[10] I will first deal with the primary and most
difficult issue being whether the payments were on account of capital or
damages or otherwise. Did they replace the Appellants' capital contributions to
the limited partnership or were they paid to compensate the Appellants for loss
of an investment or other matters? The lump sum was paid after a lawsuit was
commenced, and on the eve of the scheduled hearing for summary judgment on
behalf of the Appellants. It was probably a compromise.
[11] The Respondent relies, for the most part,
on the Statement of Claim filed by the plaintiffs, which primarily, or at least
as a first matter, claims for the amount of their investment which the Respondent
said would be a capital amount. Counsel for the Respondent further refers to
the letter of January 11, 1995, where the law firm acting on behalf of the 74
partners who instituted the lawsuit stated: "We are seeking a return of
$3,263,000 you invested" along with prejudgment interest and punitive
damages.
[12] In the letter to the Appellants of April
20, 1995, that law firm advises that the action was settled for $3.2 million
after expenses. The letter continues, stating in the penultimate paragraph:
Some of you have received letters from Revenue Canada indicating
that it will treat settlement amounts as reducing the adjusted cost base of
your partnership interest which would likely result in a capital gain. On a
general level, this means that the settlement payment to you could be reduced
as much as 30 per cent after deduction of capital gains. As we have advised
the steering committee, however, there is a tenable position at law that such
amounts, being general damages for losses of your investment, are not subject
to capital gains or other tax.
It went on to encourage the Appellants to consult
their own tax advisers. The lawsuit, of course, does not limit its claim to the
amounts invested; it includes interest, punitive damages and expenses.
[13] It is clear that the Appellants' primary
claim was for their capital investment in the real estate project. The Book of
Documents contains a statement presumably from the law firm acting on their
behalf which indicates a return of part of their original investment. It
appears to be a statement of trust funds settlement:
Available for distribution:
$3,206,000
Amount invested by Silvano and Mary Tesainer, 100,000
Total amount invested by all ... 3,263,000
Tesainers’ percentage 3.06
Proportionate share of settlement funds 98,278
[14] In Bourgault Industries Ltd. V. The
Queen,
Woods J. considered documentary evidence over viva voce evidence in
deciding the character of a settled amount. She found it was clear from the
lawsuit briefs and memoranda that the taxpayer was claiming for loss of profits.
Her decision was upheld in its entirety by the Federal Court of Appeal. In Bourgault,
the taxpayer had received a lump sum which he reported as capital gain and Woods
J. found that the lump sum was compensation for loss of profits and was income.
In Tsiaprailis, supra, the Appellant received a lump sum payment
representing her entitlements to past benefits, which were found to be taxable
income because the payment replaced defaulted payments that would have been
taxable if they had been paid in a timely manner.
[15] In the present
appeals, the issue is not
whether the settlement received by the Appellants is capital or income, but
whether it is capital or something else and non‑taxable. The Appellants,
in effect, submit that the payment was not a distribution of capital because it
was a negotiated compromise and a commingling of perhaps several items.
[16] In summary, the Appellants state the settlement payment
cannot be capital because: (i) the limited partnership agreement does not provide
for the return of capital; (ii) it could not be a partnership payment because
all partners did not participate; (iii) the partnership had no intention of
receiving capital; (iv) it was a negotiated compromise settlement, not a return
of capital; (v) the payment came from the law firm, not from the partnership; (vi)
the payment was for loss of future benefits; and (vii) the payment does not fit
into the scheme of paragraph 53(2)(c) of the Income Tax Act.
[17] The Respondent states, in part, that it is
capital because: (i) it replaced the Appellants' capital investment and placed importance
on the Tsiaprailis; (ii) the Appellants' lawsuit was for the amount of
their investment; (iii) they claimed the return of their $100,000 and received
$98,300; (iv) the documentary evidence clearly points to it being a return of
capital; and (v) the partnership agreement was in reality at an end in 1991.
[18] I believe that had the Appellants invested
$10,000 rather than $100,000, the settlement amount would have been closer to
the $10,000 range. While it is a difficult decision, I find on balance that the
character of the payment is closer to the return of capital than payment of
compensation for something else, be it damages or otherwise, and it does fit
within paragraph 53(2)(c).
[19] With respect to
whether the Appellants
entitled to deduct interest expense payments 1992 and 1993, having found as a
fact that the business purpose of the limited partnership came to an end for
all practical purposes in 1991, the source of income came to an end, and the
interest payments were not pursuant to a legal obligation to pay interest on
borrowed money used for the purposes of earning income from business or
property in those years in accordance with paragraph 20(1)(c).
[20] The following comment of Deschamps J. of
the Supreme Court of Canada in the decision Moufarrège v. Quebec (Deputy Minister of Revenue) applies equally to the present case.
Deschamps J. was referring to the appeal in Bronfman Trust v. The Queen.
… the current rather than the original use that is relevant in
assessing the deductibility of interest payments.
Also, he commented
on the decision of the Supreme Court of Canada in Stewart v. Canada, as follows:
Stewart did not alter the principle that when a
reasonable expectation of income disappears, so does the right to a deduction.
…
Finally, the Court
states:
With regard to the shares, the company in question is
bankrupt, and nothing in the record indicates a possibility of resumption of
activities, so here too the source of income has disappeared even though the
company has not been dissolved.
[21] For these reasons, the appeals are
dismissed with costs. The formal judgment will include a recommendation that a
request by Mr. and Mrs. Tesainer under the fairness provisions with respect to
interest be given favourable consideration because of an unreasonable 10-year
delay in the reassessing.
Signed at Ottawa, Canada,
this 20th day of February,
2008.
“C.H. McArthur”
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