Citation: 2007TCC289
Date: 20070514
Docket: 2003-2745(IT)G
BETWEEN:
BRIAN ELLIS,
Appellant,
and
HER MAJESTY THE QUEEN,
Respondent.
REASONS FOR JUDGMENT
Bowie
J.
[1] The appellant
was president, CEO and a director of eDispatch.com (“the company” or “eDispatch”),
a software development company, during the period between August 21, 1998 and
the end of December 2000, at which time he left the company for reasons related
to his health. The principal issue in these appeals is whether certain losses
that he suffered on dispositions of shares of the company in the taxation years
2000 and 2001 were on income or on capital account. There is also an issue as to the
Appellant’s claim that he is entitled to deduct from his income in the 2000
taxation year the amount of $51,180.00 that he paid as fees to Ernst &
Young, a firm of chartered accountants, to obtain professional advice.
[2] The appellant
and the company entered into a written contract of employment in August 1998.
It provided that Mr. Ellis would be paid $125,000.00 per year, which he
testified was about one half of the amount that could be considered appropriate
remuneration for the position. Upon signing the contract, he was granted 75,000
stock options at an exercise price of $0.75, the fair market value of the
shares at that time. These options were fully vested. In addition, he was
granted a further 300,000 options, 25% of which would vest on each of March 31,
1999, September 30, 1999, March 31, 2000 and September 30, 2000. The agreement
also provided for a further 150,000 options to be granted to him on March 31,
1999, provided the employment relationship subsisted at that time. These were
in fact granted to him on May 28, 1999, at an exercise price of $0.90, which
was the then current fair market value of the shares. The appellant and the
company entered into an amendment to the employment contract on April 1, 2000.
His annual salary was increased to $250,000.00. He was not given any additional
stock options at that time.
[3] On April 28,
1999, the company issued shares and warrants through a brokered private
placement. One condition of this financing arrangement would have precluded Mr.
Ellis from disposing of any shares during the following 90-day period. In the
latter months of 1999 and the first few months of 2000, the company entered
into two more private placement arrangements that raised $12,000,000 and
$31,500,000 respectively. As part of the first of these, the directors and
officers agreed not to dispose of any shares of the company during the period
ending on May 10, 2000. This agreement was subject to the single exception
that the directors and officers were permitted to sell, in the aggregate,
500,000 common shares of the company, through the underwriter, as the offering
had been oversubscribed (the “Greenshoe opportunity”). The Greenshoe opportunity
was divided among the senior managers, and Mr. Ellis took advantage of his pro
rata share of it on November 3, 1999 by exercising 109,000 options and
selling all those shares to the underwriters on the same day. This gave rise to
a benefit to him of $301,150.00, being the difference between the option price
that he paid and the then fair market value of the shares, which was $3.55. On
November 8, 1999, he was granted a further 120,000 options at an exercise price
of $3.25.
[4] The third
private placement also was oversubscribed. The underwriting agreement on this
occasion also provided a Greenshoe opportunity, and the Appellant again took
advantage of his full pro rata share of it. Although the underwriting
agreement of January, 2000 required that the officers and directors of the
company undertake not to transfer any shares during the period of 180 days
following the closing date, that is until mid-August, Mr. Ellis was able under
this Greenshoe opportunity to exercise 155,000 options and to sell the
resulting shares. He exercised the options and sold the shares to the
underwriters on February 17, 2000 at $12.30 per share, giving rise to a benefit
to him of $1,788,975.00. The benefits arising out of the transactions of
November 3, 1999 and February 17, 2000 were taxable under the special
provisions of sections 7 and 110 of the Income Tax Act dealing
with stock options. There is no issue between the parties as to that.
[5] When the lock-up
period following the last underwriting ended on August 13, 2000, the appellant
had received a total of 472,500 vested options, 264,000 of which he had
exercised, selling the resulting shares in the two Greenshoe opportunities. He
had 208,500 options that remained unexercised. Of these, 71,500 had an exercise
price of $0.75, 77,000 had an exercise price of $0.90, and 60,000 had an
exercise price of $3.25. On August 28, 2000, he exercised a further 148,500
options, with a resulting stock benefit of $1,310,100.00, which again was
taxable in his hands under sections 7 and 110 of the Act. He testified
that he exercised these options with the intention of entering into what was
called in the evidence a monetization contract.
[6] It is not
necessary for me to go into the details of the various forms of monetization
contracts that have been devised, beyond saying that they are, generally,
strategies developed for use by people who would like to have the monetary
value of certain shareholdings made available to them, while at the same time
not being seen to dispose of those shares in the market place. Towards this
end, Mr. Ellis sought the advice of Ernst & Young, chartered accountants,
to explore for him an effective way to monetize the shares that he was in a
position to acquire under his remaining unexercised options. Ernst & Young
did recommend a strategy to him, and determined that of the various financial
institutions that might collaborate in such a contract, the CIBC offered the
most favourable terms. Mr. Ellis testified that he did not proceed with this
proposed monetization contract, however, primarily because the cost of
implementing it proved to be too high and because it would have left him with
the downside risk if the shares declined in value.
[7] The evidence is
unclear as to exactly when the appellant instructed Ernst & Young to
explore monetization as a possible strategy for him, and also as to when that
firm made its recommendation to him. It is clear, however, that the market
price of eDispatch shares underwent a rapid decline between August and December
2000. He did not enter into a monetization contract. Instead, he held these
148,500 shares for almost 16 months, until December 21, 2001, when he sold them
at the then market price of $0.40 per share. I shall return to that advice, and
specifically to the issue whether the appellant may deduct the cost of it in
computing his income for the taxation year 2000.
[8] The appellant
suffered from severe health problems during the year 2000, one result of which
was that he was asked by the board of directors to relinquish his position as
president, CEO and a director of the company. He did this in mid‑December
2000, after which time he held no office in the company, although he was
nominally retained as a consultant for one year. He was paid consulting fees
during that year, but his advice was virtually never sought by management. He
kept in touch with some of the senior managers, however, and he maintained an
interest in the company’s fortunes throughout 2001. It was his view at the end
of 2000 that the decline in the value of the stock was an overreaction on the
part of the market and that the true value of the company would see the share
price recover to something in the range of $5.00 to $6.00 in the coming months
if the company followed its strategic plan. In September 2001, the company was
taken over by a company called Air IQ, a move that the appellant had opposed
unsuccessfully. At that point, he concluded that the share price was not likely
to recover, and so, on the advice of his accountants, he sold the shares
acquired through the exercise of 148,500 options in August 2000, in order
to realize the inevitable loss on them before the 2001 yearend.
[9] Mr. Ellis also
made a number of purchases and sales of shares of the company between May 1999
and the end of 2000 that did not involve the exercise of options. His first
purchase was of 51,000 shares in May 1999. That came about as the direct result
of the decision of the board of directors to hire him as president and CEO. He
replaced the founder of the company in that role, and one of his first tasks
was to orchestrate the departure of his predecessor. That required arranging
for the disposition of his substantial shareholding, and this was done by the
company acquiring it and selling it to the employees on a pro rata basis
at approximately $0.50 per share. As a senior manager, the appellant was
entitled to acquire 51,000 shares at that price, and he did so in May 1999. He
testified that, as the new president and CEO, it was important for him to show
his confidence in the company and his commitment to it, which he did by this
purchase. He transferred 7,105 of these shares to his RRSP in December 1999,
and a further 927 on April 5, 2000. He also purchased 5,000 eDispatch shares on
the market on April 5, 2000, and a further 5,000 on each of May 31 and
June 2 of that year. The Appellant’s evidence with respect to these purchases
was to the effect that he made them to show to the securities market that he,
as the president and CEO, had confidence in the company, and that he considered
the shares to be fairly priced at around $10.00. The 15,000 shares that he
bought on the market in May and June were purchased at between $8.00 and
$10.00, the price having declined by some 70% since its high point of
about $32.00 in March 2000.
[10] Between six and
seven months later, in the latter half of December 2000, Mr. Ellis sold
57,229 of the shares that he had acquired through purchases in the market for
aggregate proceeds of $71,997.00, an average of $1.26 per share. His evidence
was that he was extremely angry at the way he had been treated by the company
when he was forced out, and that he wanted the world to know that. The December
sales were intended to make this known, although by that time he was no longer
an insider, and so was not required to report his transactions to the B.C. Securities
Commission.
[11] Mr. Taylor has
conveniently summarized the appellant’s acquisitions and dispositions of the
non-option shares in the following table.
Date
|
Purchase or transfer
|
Number of shares
|
Proceeds
|
Cost
|
Gain/Loss
|
May 1999
|
Purchase
|
51,000
|
-
|
$26,236
|
-
|
Dec. 1999
|
Transfer to RRSP
|
7,105
|
$13,500
|
($3,655)
|
$9,845
|
|
Balance
|
43,895
|
|
$22,581
|
|
Apr. 5, 2000
|
Transfer to RRSP
|
927
|
$13,488
|
($477)
|
$13,011
|
|
Balance
|
42,968
|
|
$22,104
|
|
Apr. 5, 2000
|
Purchase
|
5,000
|
-
|
$80,285
|
-
|
May 31, 2000
|
Purchase
|
5,000
|
-
|
$53,500
|
-
|
June 2, 2000
|
Purchase
|
2,100
|
-
|
$18,745
|
-
|
June 2, 2000
|
Purchase
|
2,900
|
-
|
$24,715
|
-
|
|
Balance
|
57,968
|
-
|
$199,349
|
-
|
Dec. 19, 2000
|
Sale
|
(20,000)
|
$31,075
|
($68,779)
|
($37,704)
|
Dec. 28, 2000
|
Sale
|
(14,529)
|
$15,975
|
($49,965)
|
($33,990)
|
Dec. 28, 2000
|
Sale
|
(22,700)
|
$24,947
|
($78,064)
|
($53,117)
|
|
Balance
|
739
|
-
|
$2,541
|
-
|
The appellant reported the gains in his two transfers to
his RRSP on capital account.
[12] Mr. Ellis also
purchased and sold shares of a number of companies other than eDispatch during
2000 and 2001. In total he reported 16 sales in 2000 and 20 in 2001. Details of
these were put into evidence, and none of the transactions are remarkable. In
the aggregate, his gains from these transactions in 2000 were $67,211.11, and
his losses in 2001 were $100,596.50. His transactions were made with advice from
a stockbroker, and on the advice of his accountants, he reported the gains and
losses on capital account. Nothing in the evidence suggests that any of these
should be considered to be trading transactions rather than investments.
Issues
[13] There is no issue
in this case as to the taxation of the gains that the Appellant made on the
exercise of his stock options. These were declared and taxed under the special
provisions in sections 7 and 110 of the Act that apply to the exercise of
stock options. The jurisprudence recognizes that although the exercise of stock
options gives rise to a gain that will be taxed under those sections in the future
when the shares are sold, it is also the beginning of a second event for tax
purposes – one that may be on either capital or income account, depending on
the circumstances surrounding the acquisition, holding and selling of the
shares acquired by exercise of options. In this case, the appellant sold the
shares acquired through the exercise of stock options in November 1999, and
again in February 2000, on the same day that those options were exercised, and
at the same price, with the result that there was no second event in either of
those cases. Those were the Greenshoe sales.
[14] The first issue concerns
the exercise by the appellant of 148,500 options on August 28, 2000, and the
subsequent sale of the shares in December 2001 at a substantial loss. Although
he testified that he intended when he bought these shares to realize their
value through a monetization contract, he in fact did not do so. Instead he
held the shares for almost a year and a half as their value declined from their
price of $9.65 on the date the options were exercised to $0.40 on December 21
2001, when he sold them on the advice of his accountants. He reported the loss,
some $1,373,625, as a capital loss, also with advice from his accountants. Only
later, in his Notice of Objection to his assessment for the 2001 taxation year,
did he first take the position that the exercise of these options was an
adventure in the nature of trade, and so ought to be treated as being on income
account. The reasons advanced by his counsel for now taking this position are threefold.
First, he says that he was that it was his intention to realize the value of
the stock through a monetization contract as soon as he could after the
exercise of options. Second, he says that as an insider he had knowledge of the
company and its affairs that was not available to other investors. Third, he
argues that under his contract of employment much of his remuneration came in
the form of stock options, and that his transactions in the stock should
therefore be considered to be on income account.
[15] The second issue
concerns the acquisition and subsequent sale on the market of 57,229 shares of
eDispatch. 51,000 of these were the shares acquired by the appellant from the
holding of the former president and CEO whom he replaced. The other 6,229 were
part of the 15,000 bought by him on the market between April and June 2000. The
loss on their sale in December, 2000 amounted to $106,776.00. The appellant
reported this loss on capital account when he filed his return for the year
2000. In his Notice of Objection for that year he took the position that the
purchase and subsequent sale of those shares was an adventure in the nature of
trade, giving rise to a non-capital loss.
[16] The third issue concerns
the appellant’s claim to deduct fees paid to Ernst & Young of $51,180.00 in
computing his income for the taxation year 2000, either under section 9 of the Act
as an amount expended for the purpose of gaining or producing income, or under
paragraph 20(1)(bb), which provides a deduction in these terms:
20(1) Notwithstanding paragraphs 18(1)(a), 18(1)(b)
and 18(1)(h), in computing a taxpayer's income for a taxation year from
a business or property, there may be deducted such of the following amounts as
are wholly applicable to that source or such part of the following amounts as
may reasonably be regarded as applicable thereto
(a) …
(bb) an amount other than a
commission paid by the taxpayer in the year to a person
(i) or advice as to the advisability of
purchasing or selling a specific share or security of the taxpayer, or
(ii) or services in respect of the
administration or management of shares or securities of the taxpayer,
if that person's principal business
(iii) is advising others as to the
advisability of purchasing or selling specific shares or securities, or
(iv) includes the provision of services in
respect of the administration or management of shares or securities.
[17] In Rajchgot v.
The Queen,
the Federal Court of Appeal said this in respect of a taxpayer who had
initially reported his gains and losses in respect of certain shares on capital
account, and then in a subsequent year, when he had significant losses as the
share price declined, started to report the losses on income account:
A taxpayer who
wants to change his reporting status in circumstances where it becomes more tax
efficient to do so bears a heavy onus.
[18] The appellant’s
position with respect to the losses that he incurred in disposing of his
eDispatch shares is that they result in each case from an adventure in the
nature of trade, and are therefore on income account. The questions of
principle that arise, then, are these:
(1) Whether the [appellant] dealt with the [shares] purchased
by him in the same way as a dealer would ordinarily do, and
(2) whether the nature and quantity of the subject-matter of
the transactions may exclude the possibility that its sale was the realization
of an investment, or otherwise of a capital nature, or that it could have been
disposed of otherwise than as a trade transaction.
[19] In my view, it
cannot be said that the appellant dealt with any of these shares as a dealer
would have done. His own evidence was that his obligation to the company and to
the shareholders did not permit him to be seen as lacking confidence in the
future value of the company’s shares. He explored the possibility of a
monetization contract so that he could have the immediate benefit of the value
of the block of 148,500 shares without being required to report a sale to the B.C.
Securities Commission, and thus being seen by the market as expressing
pessimism for the company’s future. As I have said, the timing of his
instructions to Ernst & Young in that regard is not clear from the
evidence, but it is clear that he exercised the options without having a
definite plan in place to carry out the monetization that he said was his
immediate goal. This is in marked contrast to the two occasions on which he
exercised options in order to take advantage of the Greenshoe opportunities. On
November 3, 1999, and again on February 17, 2000, he exercised the options and
made the sales the same day. Clearly, he did not exercise the options until the
arrangements for sale were completed. His plans on August 28, 2000 were much
less definite, and in fact, he eventually chose not to enter into any
monetization contract at all. Any sale at that point would have been
inconsistent with his position as president, CEO and a director of the company,
and of course it would have had to be reported. This, at a time when the share
price was in rapid decline between September and December, 2000, would
undoubtedly have sent a very negative message to the market. The appellant’s
evidence as to this specifically was:
… when a CEO
or a CFO of a public company starts selling stock, it sends a clear negative
message to the market, and typically is worse than frowned upon, it’d tank the
stock.
The
Greenshoe sales, he said, were an exception to this general rule; the market
accepted such sales as being appropriate, occurring as they did, by definition,
in the context of an oversubscribed, and therefore very successful, public
offering of the shares.
[20] Even taking his evidence of intention at its highest,
it does not establish that he was looking to sell these shares for a quick
profit. What he really wanted to do was to realize the difference between the
option price and the market price, and immediately monetize the value at the
time of exercising the options, without either gain or loss. This would have effectively
produced the same result as he achieved on the two earlier occasions when he
sold shares on the day he bought them. There would have been no opportunity for
either profit or loss from the shares after the purchase, because under the
monetization contract that he envisioned either the bank, or some third party,
would have been the one to profit, or to lose, when the share price rose or
fell. In short, entering into the monetization contract that he envisioned
immediately following the exercise of the options would have negatived any
possibility of dealing with the shares as a trader would do.
[21] Even after
December 2000, when he was no longer an insider, and so was no longer under
restraints as to dealing with the shares, Mr. Ellis’ treatment of the 148,500 option
shares was more consistent with an investment than with an adventure in the
nature of trade. He held on to the shares, not in the likelihood that he could
turn a profit, but apparently in hopes that they would recover some value, even
as he was disposing of 57,229 other eDispatch shares at a fire-sale price for
what he said were emotional rather than rational reasons.
[22] Mr. Ellis
testified that his purchases of shares, both the block of 51,000 that he bought
in May 1999 and the 15,000 that he bought between April and June, were intended
to show the market that he had confidence in the company, its shares and its
future. As a new CEO, he wanted to send that message to the market, and that
was the motivation for his first purchase. His market purchases amounting to
15,000 between April and June 2000 were made as the market price declined from
its high of about $32.00 in March through $16.00 in April to $8.35 when he
bought the last of that block on June 2, 2000. It is quite inconsistent with
his stated intention of demonstrating confidence in the underlying worth of the
stock to say now that he bought it as the beginning of an adventure in the
nature of trade. It is notable, too, that the appellant invested his own RRSP
funds in the company’s shares in December 1999 and again in April 2000. This is
far more consistent with an investment intention than with participation in an
adventure in the nature of trade.
[23] Counsel for
the appellant relied on a number of trial judgments to support his contention
that these transactions were adventures, but of course all such cases must
inevitably turn on their own particular facts. In Lager v The Queen,
Justice Lamarre was dealing with a situation in which the taxpayer had
purchased a large number of shares with borrowed money, and had no intention of
keeping the shares after the loan fell due in three years. She found the
purchase to be speculative. In the present case there is no such evidence from
the appellant. McNair J. found in Pollock v. The Queen
that there were numerous transactions in the shares of four different companies
of which the taxpayer was an insider, and that stock options were his only real
form of remuneration. In contrast, Mr. Ellis effectively has only three
transactions that he would like to characterize as adventures; purchases in May
1999, at the end of August 2000, and on May 31 and June 2, 2000. His other
purchases involved same-day sales at the same price. By April 2000, his salary
had been doubled to $250,000 per annum, which he considered to be appropriate
remuneration for his position. In Street v. The Queen,
Christie A.C.J. made the important finding of fact that the appellant
purchased the shares with the intention to dispose of a substantial portion of
them early to liquidate debt. He had sold 5,000 of the 8,000 shares within 12
weeks.
[24] There are, of
course, as many different fact situations as there are cases, but as Rip J. (as
he then was) said in Rajchgot v. The Queen:
The critical factor in determining
whether a taxpayer’s acquisition of a property is for the purpose of investment
or business is the intention of the taxpayer at the time of the acquisition of
the property. Intention is to be ascertained from the appellant’s whole course
of conduct.
… It is not the lack or presence
of one or more factors that will determine whether a transaction is on capital
or income account; it is the combined force of all the factors that is
important. …
In my view, the factors that
I have referred to, taken in their totality, point to an investment intention
on the part of the taxpayer rather than a business.
[25] In summary, neither the appellant’s expressed
intention to monetize the shares immediately, nor the subject matter, shares of
a company of which he was a senior executive, tends to support the view that he
was engaged in an adventure in the nature of trade when he exercised the 148,500
options in August 2000. As to the non-option shares, his expressed motive for
buying them and the nature of the subject matter both are inconsistent with the
theory that they were purchased for purposes of an adventure in the nature of
trade. I find that the Minister was correct to characterize the appellant’s
losses as being on capital account.
[26] The appellant
argues that what is described in the Amended Notice of Appeal as the “Financial
Advice Fee” of $51,180.00 should be deductible in computing his income for the
taxation year 2000 as an expense to be taken into account under section 9 of
the Act. Such deductions are limited by the specific provisions of
paragraph 18(1)(a):
18(1)
In computing the income of a taxpayer from a business or property no
deduction shall be made in respect of
(a) an outlay or expense except to
the extent that it was made or incurred by the taxpayer for the purpose of
gaining or producing income from the business or property;
The
appellant did not put into evidence either his instructions to Ernst &
Young, or their written advice to him, other than to say in his oral evidence
that he asked them for advice as to a monetization strategy. Ernst and Young’s
billings to the appellant describe the services this way in the interim bill of
September 9, 2000:
Services provided with respect to
negotiating and analyzing the equity monetization contract with CIBC and with
respect to our tax analysis of this matter: including meetings and review of
stock options;
The
final account dated December 18, 2000 describes the service as:
Advice
and assistance with restructuring personal wealth to assist in investing in
diversified portfolio including borrowing against a forward exchange contract
with, a put option;
Of
the advice actually given by Ernst & Young, only one page was introduced
into evidence, and that by the respondent. It sheds little more light than the
above descriptions from the billings on the nature of the services. The
appellant has not established that the Ernst & Young billing was incurred
to assist him in gaining or producing income from the property in question. It
seems that it was really incurred to assist him in liquidating the investment
without being seen to do so. I find that these amounts would not have
been deductible under section 9 of the Act, even if I had found that the
appellant had been engaged in an adventure in the nature of trade. Nor were
they incurred for the purpose of gaining or producing income from the shares
themselves.
[27] Nor are these
fees deductible under paragraph 20(1)(bb). It does not appear to me that
the services of Ernst & Young had anything to do with advice as to the
purchase or sale of specific shares. Mr. Ellis consulted Ernst & Young, he
said, to seek out for him a monetization arrangement that would permit him to,
in effect, cash out his options, without being seen to do so. He had only
eDispatch shares in mind, and it was not as to the advisability of buying or
selling them, or for assistance in administration or management of the shares that
he sought help from Ernst & Young. Their function was simply to obtain a
monetization arrangement in respect of the shares. If the terms of the CIBC
contract had been more to his liking then he would have contracted with it
directly, and it might have been in the position of administering the shares,
but Ernst & Young would not. Moreover, the deduction is available only if
the concluding part of paragraph 20(1)(bb) is satisfied, that is
if that person's
principal business
(iii) is advising others as to the
advisability of purchasing or selling specific shares or securities, or
(iv) includes the provision of services in
respect of the administration or management of shares or securities.
The
only evidence that the Appellant could point to as to the principal business of
Ernst & Young was this extract from a letter of March 17, 2003 from Ernst
& Young Corporate Finance Inc. to the Canada Customs and Revenue Agency:
A
further review of the invoices dated September 29, 2000 and December 18, 2000
from Ernst & Young indicates that a significant portion of the work was
performed by the Investment Advisory Services Department, accordingly, the fees
should be deductible as investment counsel fees pursuant to paragraph 20(1)(bb)
of the Act. Please note Ernst & Young Investment Advisory Services is a
separate corporation which provides financial advice regarding the provision of
services in respect of the administration or management of shares or
securities. Services include comparative analysis of financial institution
products and contractual offerings to conclude which product provided the
maximum return on investment and costs.
(Exhibit A-1 Tab 24, pages 1-2)
The
accuracy of this excerpt is not something that was either agreed to when the
documents were admitted into evidence on consent,
or established by a witness. In any event, a perusal of the invoices in
question indicates nothing of the kind referred to in this letter. Both
invoices are on letterhead that reads:
ERNST
& YOUNG Ernst & Young L.L.P.
Chartered Accountants
Vancouver, British Columbia
They
both contain the notation:
Remit
To;
Ernst
& Young L.L.P.
Chartered
Accountants
The appellant’s cheques in
payment of the invoices are payable simply to:
Ernst
& Young
The
evidence is simply insufficient to bring either the advice or its author within
the words of paragraph 20(1)(bb), and so the appeal must fail on this
issue as well.
[28] The appeals are dismissed, with costs to the
respondent.
Signed at Ottawa, Canada, this 14th day of May, 2007.
“E.A. Bowie”