Citation: 2009 TCC 295
HER MAJESTY THE QUEEN,
REASONS FOR JUDGMENT
 These appeals
concern the disallowance of losses by the Minister of National Revenue (the
“Minister”) in respect to the 1992 to 1996 taxation years for Francis O’Dea and
Sean O’Dea and in respect to the 1994 to 1996 taxation years for Geoffrey
Bailey and John Rankin. In addition to the disallowance of the losses, the
Minister imposed gross negligence penalties with respect to Francis O’Dea
and Sean O’Dea.
 All of the
Appellants in these appeals were limited partners in the Proshred Florida/Georgia
Limited Partnership (the “Partnership”). Geoffrey Bailey also purchased
units in the Kilrush Limited Partnership (the “KP Partnership”), which was
a limited partner in the Partnership. The Appellants are representative of a
total group of 17 limited partners who purchased limited partnership units in
the Partnership and/or the KP Partnership. Both the Partnership and the KP
Partnership were established by the O’Deas and were registered as limited
partnerships on August 29, 1988 and May 1, 1994, respectively. Both the
Partnership and the KP Partnership were registered tax shelters under the Income
Tax Act (the “Act”).
 In respect to the
relevant taxation years, the Minister determined that the Appellants were not
entitled to deduct the losses from the Partnership and/or KP Partnership.
These losses were denied on the primary basis that the long-term promissory
notes, being one of the vehicles which all of the investors utilized to pay for
their purchase of partnership units, were limited recourse amounts within
subsection 143.2(1) of the Act because the interest on these notes was
not paid by the Appellants or was not paid within 60 days of each taxation year‑end
as required under subsection 143.2(7). This had the effect of reducing each
investors’ cost of their units, thereby reducing the at-risk amount for each
investor under subsection 96(2.2) of the Act and correspondingly reducing,
by the same amount, the Appellants’ entitlement to deduct their respective
losses under subsection 96(2.1) of the Act. In addition, the Minister’s
assessments were based on a determination that the Partnership was not a valid
partnership and that certain expenses were unsupported and lacked credibility.
 I heard evidence
from three of the Appellants, Francis O’Dea, Sean O’Dea and Geoffrey Bailey, as
well as Glenn Fraser, a chartered accountant with Fraser, Cellucci &
Associates (now Taligent Group Inc.), that provided accounting services to the
entire group of companies involved in these appeals. The Respondent relied on
the testimony of the auditor, Gino Casciano.
 The Appellants,
Francis and Sean O’Dea, are brothers who together created the Proshred mobile
document shredding business in the mid-1980’s. Proshred Holdings Limited
(“PHL”) was incorporated in Ontario on March 19, 1987 and operated the Proshred
business through franchises in both Canada and the United States (“U.S.”) during the relevant years under
 As part of the
franchising aspect of the business, PHL operated a centralized service bureau
(the “Service Bureau”) that provided certain administrative services and functions
to its franchisees in Canada and the U.S. The Service Bureau was maintained through a call centre
located in Canada which took orders,
maintained client accounts, including collections and remittances and provided
accounting services for the franchisees in both countries. In return for these
services, each of the franchisees paid a licensing fee based on the
franchisee’s gross revenue (the “Licensing Fees”). To facilitate the U.S.
operations, PHL operated in that country through Proshred Inc. (“PI”), a wholly
owned U.S. subsidiary, which held all of the licensing rights to operate the
Service Bureau for the franchisees in the U.S.
 Francis O’Dea was
the Chairman of PHL and President of PI; Sean O’Dea was the President of PHL.
They have extensive business backgrounds dating back to the mid-1970’s and both
have been involved with other companies, including the establishment of the
widely known Second Cup business. They initially expanded the Proshred business
through limited partnerships, which were profitable for investors, before pursuing
expansion through franchising operations. Sean O’Dea was primarily responsible
for developing the franchises.
 Although PI held
the licensing rights to operate the Service Bureau in the U.S., it did not carry on
any operational activities (Master Licence Agreement, dated March 28, 1990,
Joint Book of Documents, Tab 7). According to Francis O’Dea, PI was “just
a shell” (Transcript, page 34).
of the Proshred Business:
 After consulting
with various professional advisors in 1994, PHL decided to expand into the U.S. market using the
structure of a limited partnership. On April 29, 1994, PI sold its licensing
rights to operate the Service Bureau for the territories of Florida and
Georgia (“F/G Licensing Rights”) to another U.S. corporation, PC Holdings Inc.
(“PC Holdings”). Peter Charlton, a Chartered Accountant and CPA, was the
sole shareholder of PC Holdings. He also acted as a consultant for PHL in Canada and was intimately
involved with the accounting and financial strategies of PHL. The Original Purchase
Contract dated April 29, 1994 between PI, PHL and PC Holdings for the F/G
Licensing Rights listed a sale price of $3.4 million with payment from PC
Holdings to PI to be made by way of a promissory note.
 According to Francis
O’Dea, PC Holdings acquired the F/G Licensing Rights because Peter Charlton
recognized the potential of the Proshred business in the U.S. However, later in his
testimony, Mr. O’Dea stated that the intention in selling the F/G Licensing
Rights to PC Holdings was “… to create this partnership in order to expand the
Proshred Florida/Georgia territories and this was the mechanism for doing
that.” (Transcript, page 32)
 Shortly after, on
May 2, 1994, PC Holdings sold the F/G Licensing Rights to Proshred General
Partner Inc. (“Proshred GP”), a company incorporated under the laws of Ontario as a wholly owned
subsidiary of PHL. Proshred GP was the only general partner of the Partnership
and held a 0.1% interest in the Partnership. Proshred GP purchased the F/G
Licensing Rights on behalf of the Partnership and issued a promissory note in the
amount of $3.6 million to PC Holdings for payment of the F/G Licensing
 Also on May 2, 1994,
Proshred GP entered into the following additional agreements with PHL on behalf
of the Partnership:
Service Bureau Management Contract, under which PHL agreed to manage the
service bureau for the Florida and Georgia franchises on behalf of the Partnership;
Cash Flow Deficiency Agreement (“CDA”), under which PHL agreed to supplement
any cash flow deficiency to enable the Partnership to pay operating expenses
and make distributions to its limited partners;
Startup Services Agreement (“SSA”), under which PHL would be responsible for
the initial setting up and development of the franchise territories in Florida
and Georgia; and
Franchise Completion Agreement (“FCA”), under which PHL would be responsible
for completing the development of the franchise territories in Florida and Georgia.
 Throughout this
period PHL continued to operate the Service Bureau for all of the franchises in
both Canada and the U.S.,
including those in Florida and Georgia, even though PI held the licensing rights to operate the
Service Bureau in the U.S. This continued despite the fact that the F/G Licensing
Rights were later acquired by PC Holdings, and then by Proshred GP, which
purchased the F/G Licensing Rights on behalf of the Partnership.
of the Partnership Units:
 In the fall of 1994,
a total of 4,950 units of the Partnership (the “Units”) were offered pursuant
to an Offering Memorandum dated September 26, 1994, which was amended and
reissued on December 7, 1994. The purchase price was $1,000.00 per Unit,
payable in three components: a cash payment of $120 per Unit, a short-term
promissory note of $152.73 per Unit, payable with 9% interest on January 2,
1995 (the “ST Note”) and a long-term promissory note of $727.27 per Unit,
payable on December 31, 2019, with interest due and payable annually at the
rate equal to “prime plus one” (the “LT Note”). The principal amount of all of
the LT Notes totalled $3.6 million. This purchase price structure was
determined after seeking the advice of various legal and accounting
 While the typical
investor purchased Units by a cash component, an ST Note and an LT Note,
the O’Deas each paid for their Units by an LT Note and a mid-term note payable
on August 30, 1999, with interest due and payable annually at the rate equal to
“prime plus one” (“MT Note”). The MT Notes represented the value, that the
O’Deas would have paid by the cash component and the ST Note, had they
purchased their Units according to the price structure prescribed under the
Offering Memorandum. In their testimony, they could not recall why they used MT
Notes instead of the cash component and ST Note.
 The Appellants acquired
their respective number of Units as follows:
ST Note or MT
(or LT Note)
Note: Amounts for O’Deas
do not equal the “totals” - these were the amounts found on the notes at tabs
21 and 22 of the Joint Book of Documents.
Note: The Partnership’s
documents referred to the LT Note as the LP Note.
 Not all of the
Partnership’s 4,950 Units were acquired by individual investors. The KP
Partnership acquired the outstanding 2,559 units on December 30,
1994. As payment, the KP Partnership issued a short-term promissory note with
an annual interest rate of 9% but no fixed terms of repayment (“KP ST Note”),
and a long-term promissory note (“KP LT Note”), under the same terms as the LT
Notes of the other limited partners. It did not pay a cash component. The KP ST
Note and KP LT Note were not submitted into evidence.
 The ownership of a
unit in the KP Partnership entitled the owner on a pro rata
basis to an undivided proportionate interest in the rights, benefits, profits
and losses of a Unit in the Partnership. The only assets of the KP Partnership,
during the years under appeal, were the Units it held in the Partnership.
 On April 24, 1995, Mr.
Bailey acquired 97 units in the KP Partnership at the price of $1,000.00 per unit,
by a payment consisting of a cash component, a short‑term note payable on
January 1, 1996 and a long-term note payable on December 31, 2019.
 Approximately $1.35
million in cash would have been raised as a result of the offering, if all of
the Units had been fully subscribed with a subscription price that included the
cash component. However, there were 3,849 units for which no cash was received
because both the O’Deas and the KP Partnership did not pay this cash component.
As a result $1.05 million of the anticipated $1.35 million potential cash
component was not raised. Despite the Appellants’ contention that the purpose
of the Partnership was to finance the U.S. expansion, aside from the MT Notes of the O’Deas and the
ST Notes from Mr. Bailey and Mr. Rankin, the Partnership received no principal
amounts on any of the Notes.
Notes, MT Notes, LT Notes and the Payment of Interest:
 In respect of the
purchase of their Units, Mr. Bailey and Mr. Rankin paid the cash component to
the Partnership. They also paid the ST Notes, with interest, to the Partnership
on January 2, 1995.
 Both O’Deas
testified that their MT Notes were paid in full with interest as required on or
before August 30, 1999. However, they did not make interest payments on these
notes during the relevant taxation years.
 The Appellants
relied heavily on the evidence of Glenn Fraser with respect to their contention
that the requisite interest payments were in fact made by the limited partners
in respect to the KP ST Note, the KP LT Note and the LT Notes during the
 Although Mr. Fraser
was not involved with the structuring of the Partnership or the KP Partnership,
his firm, Fraser Celluci, was hired by PHL to do the bookkeeping and accounting
for the entire Proshred group of companies. Under the firm’s engagement, they
were responsible for preparing the annual working paper files for the taxation
years beginning in 1995 and for filing the annual Partnership Information
Returns with CRA for both the Partnership and KP Partnership. The firm did not
prepare the financial statements.
 According to Mr.
Fraser, interest on the KP ST Note was paid every year by cheque and therefore
the Partnership had received payment by cheque from the KP Partnership in
satisfaction of the KP ST Note. Subsequent statements indicate that the
Partnership recognized the interest income accordingly. However a review of the
Partnership’s bank account statements confirmed that those statements did not
disclose any deposits during the relevant years. In fact the Partnership’s
account had been inactive since December 31, 1995. He suggested that the
cheques “… might have been deposited in the Proshred Holdings’ bank account”
(Transcript, page 265).
 With respect to the payment of interest on
the LT Notes, including the KP LT Note, article 4.04(a) of the Restated Limited Partnership (Schedule
“A” of the Offering Memorandum, Tab 5, Joint Book of Documents) provided:
(a) A distribution shall be made in each Fiscal Year to the Limited
Partners in an amount equal to interest due on the L.P. Note in respect of that
Fiscal Year, to be paid on or before December 31st of that Fiscal Year. At the
direction of the Limited Partner that distribution may be paid directly to the
holder of the L.P. Note in satisfaction of the Limited Partner’s obligations to
pay interest thereon;
 According to the Appellants,
distributions were made according to article 4.04(a). Although article
4.03 stated that distributions should be made from the gross revenues of the
Partnership, the distributions were made by way of drawings from each limited
partner’s capital account. The amounts made in distributions in each taxation
year are consistent with the continuity schedule from 1994 to 1997 of the
Equity, ACB and at-risk amounts for each limited partner.
 According to the Appellants, interest
on the LT Notes was paid by the limited partners via journal entries in each of
the relevant taxation years (Tab 2, Exhibit A-2). Mr. Fraser stated that
the entries were prepared within sixty days of the subsequent year‑end,
since the working papers for the financial statements were submitted to the
accounting firm within forty‑five to sixty days of the subsequent year.
 The Appellants stated that the Partnership had
later assigned the LT Notes to PC Holdings in satisfaction of the $3.6 million
promissory note that it owed to PC Holdings in respect to the F/G Licensing
Rights. However, the limited partners did not sign a direction or authorization
permitting the Proshred GP or the Partnership to pay the LT Notes directly or
to pay the interest owing or to permit the KP Partnership to pay the LT Notes
directly to any other third party. It is true, however, that the form of the
LT Notes contained the following provision: “funds from the long term note
would be paid over to a third party for services that are owing and performed
on behalf of the Partnership”. Other than this, there was no evidence that the
Partnership had assigned any of the LT Notes.
 Mr. Fraser dealt with Mr. Charlton and
followed his direction and guidance in the course of his work for the Proshred
companies. Although Mr. Fraser was not familiar with any of the relevant
Agreements, he stated that he would have taken direction from Mr. Charlton
in making the required journal entries. In respect to journal entries he
… part of the journal entries would have been prepared
by us and part of the journal entries would have bee [sic] provided to us.
By one of the professional firms.
(Transcript, page 219)
 On March 31, 1997 Mr. Fraser wrote a memorandum
to Mike Kecskemeti, another employee with his firm, which stated that the
interest in respect to the LT Notes was deemed to be paid on January 1, 1996
for the 1995 year‑end. (Exhibit A-1, Tab 55)
 Mr. Fraser testified that his phrasing “interest
was deemed to be paid” meant that “it was to be paid”. (Transcript pages 252-254)
 With respect to the journal entries documented
at Exhibit A-2, Tab 2, Mr. Fraser admitted the following:
(1) that he printed them from the computer system at his office one
week prior to the hearing;
(2) that he did not recall who actually prepared the entries;
(3) that there was nothing in the documents to indicate when the
entries were made;
(4) that the entries were “not proper” because, although they
reference a year, they contain no exact date (Transcript, page 276); and
(5) that, although there was a list of journal entries that could
support a general ledger, they were not the original journal entries that were
part of the books and records of the Partnership (Transcript, page 279).
 At the time of the audit, Mr. Casciano was
not provided with any evidence that interest on the LT Notes had been paid. He
expected to see journal entries reflecting the interest amounts on the LT Notes,
which were allegedly later assigned to PC Holdings, as well as entries relating
to the non-resident withholding tax. Although he was not provided the journal
entries, contained at Tab 2, Exhibit A-2, during the audit, he stated that the
reassessments would have remained unchanged because the journal entries at Tab
2 were not dated and there were no purported entries for 1994 and 1995.
Similarly, even if the working papers at Tab 1, Exhibit A-2, had been provided
during the audit, the reassessments would also remain unchanged because they
were “… just produced for the purpose of preparing the
financial statements, but it certainly doesn't demonstrate that any books and
records were kept”.
(Transcript, page 363).
business, expenses and corresponding losses:
 Unlike the Canadian operation, the
Florida/Georgia operation was not successful and the Partnership was unable to
meet its U.S. projections. The Partnership never made
sufficient revenue to cover the amount of debt it owed to PHL as a result of
the fees it incurred under the various Agreements (management fees owing to
PHL, $3.6 million loan payable to PC Holdings and the payments to PHL under the
SSA and the FCA).
 Sean O’Dea was involved with the preparation of
the financial projections, (Exhibit R-2), disclosed in the Offering Memorandum,
which was used to promote the initial sale of the Units in the Partnership to
potential investors. He confirmed that the Proforma Statement was prepared
prior to the formation of the Partnership. According to the forecasts in the
Proforma Statement, the Partnership would have received $521,136.00 in service
bureau fees in 1996. The sole revenue source for the Partnership was from these
service bureau fees. In determining the projected service bureau fees, Sean
O’Dea considered the anticipated sales in Florida and Georgia. The projections contained in the Offering Memorandum anticipated that
total gross shredding sales for Florida and Georgia in 1996 alone would total approximately $3.8
million. In comparison, after eight years of operations, the total gross
shredding sales for all of Canada totalled only $4.3 million.
Sean O’Dea admitted that his projected revenue level for Florida and Georgia, after only two years, exceeded the level achieved
in Canada after a full nine years of operations.
However, he pointed out that PHL had begun franchising the business in Canada during the latter years and that after only three
years of operations, PHL was making approximately $2 million annually in gross
shredding sales. The projections in both the Proforma Statement and the
Offering Memorandum were consistent.
 Sean O’Dea testified that he reviewed the
Offering Memorandum including the tax disclosure section at page XIII of
the Offering Memorandum, which was prepared by the accounting advisors,
Mintz & Partners. At page iii of the Offering Memorandum (Tab 5, Joint Book
of Documents) it stated:
Ownership of Partnership
Units is intended to provide Limited Partners with the opportunity to receive
cash distributions from the Partnership which will be applied to pay down the
L.P. Notes, may provide a cash return, and in the meanwhile provide sufficient
cash to cover income tax at the top marginal rate on any income allocated from
the Partnership less any interest paid on the L.P. Notes and to provide certain
allowable income tax deductions which will shelter other income. See “Tax
Francis O’Dea testified that he
understood this to mean that “… the service bureau revenue will be recorded in
the books of the partnership and that distributions from that revenue stream
will be paid out to the partners” (Transcript, page 56). However, the
Partnership failed to earn enough revenue to make the annual interest
distributions to its limited partners.
 The Partnership incurred significant losses in
its operations for the years ending on December 31, 1994, 1995 and 1996. These
losses were then allocated to its limited partners, including the KP
Partnership, during those years. The KP Partnership then re-allocated
those losses to its own limited partners on a pro rata basis.
 The Partnership’s Statement of Loss, for the
year ended December 31, 1994, shows “start-up fees” of $950,000.00 which were
deducted by the Partnership as an expense for services rendered by PHL under
the SSA. The Partnership’s Statement of Operations, for the years ended
December 31, 1995 and 1996, shows that franchise completion fees in the amounts
of $1.3 million and $500,000.00 were deducted as an expense for the cost of
developing the franchises in Florida and Georgia and allegedly incurred by PHL under the FCA.
The relevant parts of Clauses 2 and 3 of
the SSA read as follows:
2. PHL estimates that
the foregoing costs and expenses to be incurred by it up to December 31st, 1994 in the provision
of the items listed in paragraph 1 hereof and of such other services related to
the startup of the business in the Territory will be approximately $950,000.
PHL undertakes to provide to the Limited Partnership a statement of such
expenses showing the various classes of expenditure with reasonable particularity
as soon as may conveniently be done after the calendar year-end.
3. The Limited
Partnership undertakes … to reimburse PHL for the said startup costs and
expenses out of the proceeds of the sale of limited partnership units …
Similarly, the relevant parts of Clauses
2 and 3 of the FCA read as follows:
2. PHL estimates that
the foregoing completion costs and expenses to be incurred by it on behalf of
the Partnership in the two year period from January 1st, 1995 to December 31st, 1996 in the provision
of the completion services indicated in paragraph 1 hereof and of such other
services related to the completion of the development of the business of the
Partnership in the Territory will be approximately $1,800,000. PHL undertakes
to provide to the Limited Partnership a statement of such expenses showing the
various classes of expenditure with reasonable particularity as soon as may
conveniently be done after the 1996 calendar year-end.
3. The Limited
Partnership undertakes to reimburse PHL for the said completion costs and
expenses without interest out of funds received from the Service Bureau
 Pursuant to the SSA, the Partnership would
reimburse PHL the amount of $950,000.00, which was the approximate cost related
to setting up the various franchise territories. Similarly, the FCA required
the Partnership to reimburse PHL for expenses incurred in 1995 and 1996 in
further development of these territories, for which the fee was set at $1.8
million. With respect to these payments, Francis O’Dea testified that it was “…
the cost that we thought it would be and that would be reimbursed” (Transcript,
page 81). If the costs incurred by PHL, in meeting its obligations pursuant to
the SSA and FCA, exceeded the amounts of $950,000.00 and $1.8 million
respectively, Francis O’Dea testified that PHL would be responsible for
those additional costs and would not pass those costs on to the Partnership.
 Although the agreements stated that PHL would
provide the Partnership with a statement of the actual costs and expenses that
were incurred, Francis O’Dea admitted that, to his knowledge, it was never
done. However, the Appellants contend that the various documents provided
under Tab 69 of the Joint Book of Documents contain all of the required
invoices and receipts related to the costs and expenses that PHL incurred under
the SSA and FCA.
 Mr. Casciano concluded that the expenses
deducted by the Partnership, purportedly relating to expenses under the SSA and
FCA, for the years ending 1994, 1995 and 1996, lacked credibility and that the
legitimate expenses would have been “Significantly reduced. Virtually nil.”
(Transcript, page 378). He also determined that the documents at Exhibit R-5,
which provided a statement of expenses totalling $3,275,000.00 incurred by PHL
on behalf of the Partnership between 1993 and 1996, contained a margin of
$740,221.00 that was clearly not an expense but which was added to enable the
statement to equal the $3,275,000.00 figure. He also had concerns that the 1993
expenses were being reimbursed by the Partnership to PHL in 1994.
 When the audit commenced in June 1999, Mr.
Casciano wrote to the Partnership requesting various documentation. No
accounting records or a general ledger were provided in response to this request.
Intermittently during the audit, he did receive some handwritten and undated
adjusting and closing entries and reconciliations for a PHL inter-company
account and some, but not all, of the Partnership’s bank statements. Mr.
Casciano concluded that this information did not demonstrate proof of proper
record keeping and consequently, he was unable to verify the reporting
revenues, expenses and the Limited Partners’ losses from the information
provided to him during the audit.
 With respect to the documents at Tab 1, Exhibit
A-2, Mr. Casciano stated that up until a week before the hearing, he had never
seen the documents at pages 2, 3, 4, 5, 6, 12, 13, 16, 17, 19 and 20. With
respect to the documents at pages 1, 8, 18, 21 and 22, he had seen similar
documents but not the exact documents as those produced in Exhibit A-2. With
respect to the documents at pages 9, 10, 11, 14 and 15, he saw those during the
course of the audit.
 Similarly, Mr. Fraser’s evidence respecting
whether or not the Partnership maintained independent books and records or a
general ledger was inconsistent. During the hearing, Mr. Fraser first said that
the Partnership maintained its general ledger and that its books and records
were kept at the offices of PHL. However, he later admitted that he did not
recall whether the Partnership had independent books and records and also
admitted that the Partnership did not have an independent accounting system.
 Francis O’Dea admitted that the Appellants were
unable to produce bank statements for the Partnership, other than the bank
statement covering December 29, 1995 to December 31, 1996 (Tab 52, Joint
Book of Documents). He also admitted that the PHL bank account had been
inactive since at least December 1995.
Francis and Sean
O’Dea and Geoffrey Bailey:
 Francis O’Dea was instrumental in planning the
Partnership’s expansion and actively promoting the sale of Partnership’s Units
to potential investors. Although Mr. O’Dea testified that he was more concerned
with expansion of the business and not the tax consequences, he did admit that
he “presumably” knew that a limited partner could only deduct the full losses
if the ST Note was paid. Francis O’Dea claimed full deductions for losses
notwithstanding that he had not paid any cash component or subscribed to or paid
on a ST Note in the relevant taxation years. He admitted that, as of
December 31, 1996, he owed the Partnership $245,454.00, representing the
subscription price of his MT Note (Transcript, page 93). (Note: In contrast,
Tab 21 lists the Principal amount on the MT Note as $246,069.00.) However, on
re-examination he stated that it was only shortly prior to the hearing that he
became aware of the possibility of problems with respect to the MT Note and the
deductibility of losses.
 The LT Notes required that interest be paid at a
rate equal to “prime plus one”, “calculated half yearly not in advance and
payable annually on December 31st in each year.” (Tab 21, Joint
Book of Documents). Francis O’Dea testified that he was aware that interest on
the LT Notes must be paid within 60 days of year‑end as per the Offering
Memorandum and the tax shelter rules contained in the Act. He testified
that he gave direction to Mr. Fraser to ensure that this interest was paid and
he believed that interest on these notes was paid by the limited partners
through journal entries. Sean O’Dea’s evidence was essentially the same in
respect to the interest payments on the LT Note. In particular he knew that if
interest was not paid on a loan, the amount of loss deductible by a limited
partner would also be limited.
 Mr. Bailey, a physician in Newfoundland, was a limited partner of the Partnership, as well
as a limited partner of the KP Partnership. He viewed his participation as a
long-term investment which he hoped would be profitable. Before purchasing
units he read the Offering Memorandum for each of the Partnerships. His
subscription price for his units was in accordance with the purchase price
structure under the Offering Memorandum. With respect to the payments on the LT
Note, he had this to say:
A. I understood the payments were to
flow from the earnings from the service bureau and make interest payments to
cover the long-term note and any principal payments that -- if there was
adequate income at that point, to make principal payments in the early part of
the investment and then as the investment proceeded, payments on the principal
as well over the course of the long-term note which was to be concluded in
2019, I believe.
(Transcript, page 180)
 With respect to interest on the LT Note owed to
the Partnership, he stated:
I haven't paid
interest on the long-term note. It was -- on my understanding it was to be
paid through income generated by the Limited Partnership and in the absence of
that amount of money there was another deficiency agreement between Proshred
Holdings to provide loans to cover the interest payments in short-term
intervals until there was sufficient cashflow through the Partnership to pay
With respect to the taxation years in
issue, Mr. Bailey received certain documents from the Partnership for the
purpose of filing his tax returns that led him to believe that interest was
duly paid on his LT Note.
 The Minister reassessed Francis O’Dea, Sean O’Dea,
Mr. Bailey and Mr. Rankin in July of 2000 (the “Reassessments”). The
Reassessments disallowed all of the partnership losses that each of the
Appellants claimed for the taxation years of 1994, 1995 and 1996. The Minister
also disallowed any partnership losses that the O’Deas sought to carry back to
1992 and 1993. The Reassessments were primarily based on the application of the
limited recourse rules under section 143.2 of the Act, which reduced
each of the Appellant’s at‑risk amounts under subsection 96(2.2) and
their entitlement to the partnership losses under subsection 96(2.1) of the Act.
The Minister also determined that the Partnership was not a valid
partnership and, further, that the Partnership should not be entitled to claim
expenses that it allegedly incurred under the SSA and FCA. In addition,
penalties under subsection 163(2) of the Act were imposed on the O’Deas.
 1. Does
subsection 143.2(7) of the Act apply to the MT Notes, the LT Notes,
the KP ST Note and the KP LT Note to deem them limited recourse amounts so that
the Minister would be permitted to reopen the statute-barred years pursuant to
2. If the Appellants are entitled to deduct the losses, are
Francis and Sean O’Dea entitled to carry back their partnership losses to the
1992 and 1993 taxation years?
3. If the Notes are not limited recourse amounts under
Is the Minister
statute-barred from reassessing the Appellants in regard to the respective
Is the Minister
statute-barred from reassessing the Appellants on any other basis?
4. Aside from the determination of whether the Notes are
limited recourse amounts under section 143.2, are the Appellants entitled to
deduct their respective partnership losses based on the following:
(a) Was the Partnership a sham and/or a valid partnership for the
purposes of section 96 of the Act?
(b) Is the Partnership entitled to deduct all of the expenses that it
alleges it incurred during the relevant taxation years such that the Appellants
would be entitled to deduct their respective losses in this regard?
5. Are Francis and Sean O’Dea liable for gross negligence penalties as
assessed by the Minister under subsection 163(2) of the Act?
The Position of the Appellant and the
Respondent on the Main Issues:
 The Minister issued the Reassessments, in
respect of the 1994 to 1996 taxation years (and for the O’Deas, also the 1992
and 1993 taxation years), during July 2000. Therefore, the Appellants argue that
the Reassessments were issued after the statutory limitation period under subsection
152(4) of the Act.
 The Respondent’s position is that the Minister
is entitled to open otherwise statute‑barred years pursuant to subsection
143.2(15) of the Act to enable the Minister to assess to give effect to
section 143.2. The Respondent’s position is
that none of the taxation years are statute‑barred to the extent that the
Appellants’ entitlement to partnership losses are reduced by the deemed limited
recourse amounts under subsection 143.2(7). The Respondent submits that the MT
Notes, the LT Notes, the KP ST Note and the KP LT Note are deemed to be limited
recourse amounts under subsection 143.2(7) because the Appellants and the KP Partnership
did not pay interest on the Notes issued to the Partnership. Alternatively, the
Respondent submits that interest was not paid on the Notes within 60 days of
year‑end. The Respondent also submits that the KP ST Note is deemed a
limited recourse amount under subsection 143.2(7) because there were no bona
fide terms of repayment. With respect to Mr. Bailey, the Respondent also
argues that he did not pay interest on his long-term note to the KP Partnership.
 If subsection 143.2(7) does not apply to the
Notes, the Minister will not be able to rely on subsection 143.2(15) to open
the statute-barred years and in that event, the Respondent argues that the Minister
would not be barred from reassessing the Appellants pursuant to subsection
152(4) of the Act. The Respondent argues that the expenses under the SSA
and FCA did not relate to the provision of the service bureau functions of the
Partnership. The Partnership, in claiming expenses that did not belong to it,
made representations attributable to neglect, carelessness or wilful default.
Since the in-depth knowledge of the directing minds of the Partnership, Francis
and Sean O’Dea, could be attributed to all of the Appellants, the Respondent
contends that all of the Appellants made misrepresentations on their returns
which allow the Minister to reassess those years pursuant to subsection 152(4)
of the Act.
Application of subsection
143.2(7) to the Notes:
 In respect to Mr. Bailey and Mr. Rankin, the
Respondent admits that they paid the cash component of their purchase price of
the Units. The Respondent also admits that they paid their ST Notes to the
Partnership, with interest, on January 2, 1995.
 During the hearing, Francis and Sean O’Dea
conceded that they did not pay cash for the purchase of their Units and instead
of the cash component and an ST Note, they each issued an MT Note to the
Partnership. Both O’Deas assert that they paid the principal and interest
of the MT Note on the due date, August 30, 1999. However, Francis and Sean
O’Dea admit that they did not make any interest payments on their MT Notes
during each of the relevant taxation years under appeal. The O’Deas conceded
that their at-risk amounts should have been reduced by the amount of their MT
Notes pursuant to paragraph 96(2.2)(c) and subsection 96(2.1) of the Act.
 The Respondent argued that the KP ST Note did
not reflect a bona fide arrangement for repayment for the Units and
that, even if it did, interest on the KP ST Note was not paid within 60 days of
year‑end. The loan payable amount under the KP ST Note was therefore a
limited recourse amount under subsection 143.2(7) of the Act.
 The Respondent denies that the LT Notes,
including the KP LT Note, created a valid obligation for the Appellants or the
KP Partnership to pay the Partnership. The Respondent contends that interest on
the LT Notes was not paid by the Appellants and the KP Partnership, as required
pursuant to the terms of the Notes. Alternatively, if interest was paid, the
Respondent’s position is that this interest was not paid within 60 days of the
year‑end of the Partnership in each of the relevant taxation years.
 The Appellants contend that the LT Notes were
assigned by the Partnership to PC Holdings to satisfy the debt owed by the
Partnership to PC Holdings. In addition, the Appellants contend that
interest was paid within 60 days via journal entries.
The Validity of
 If subsection 143.2(7) does not apply to the
Notes, the Respondent contends that subsection 152(4) can be used to open the
otherwise statute-barred years, so that the Minister can reassess the
Appellants to disallow the partnership losses based on the validity of the Partnership.
 The Respondent contends that, since the sole
purpose of the Partnership was to provide tax losses to its investors, the
Partnership was a sham. Even if the Partnership was not a sham, the Respondent
argues that the Partnership was not a valid partnership for the purposes of the
Act. The Respondent denies that the Partnership was carrying on a business
at any time. Therefore, the Partnership did not constitute a valid partnership
pursuant to the laws of Ontario, which governs partnerships. If the
Partnership is not a valid partnership, then the Appellants are not entitled to
any of their partnership losses flowing from the Partnership and/or KP
 The Appellants’ argument is that the Partnership
carried on a valid business in the relevant taxation years and, as a result, it
incurred losses in each of those years, all of which could be allocated to the
Appellants, proportionate to their respective Unit holdings in the Partnership,
pursuant to section 96 of the Act. The Appellants assert that the
Partnership was in the business of providing, for a fee, service bureau
functions to the Proshred franchisees in Florida and Georgia with a view to a profit.
The Deduction of Partnership
 If subsection 143.2(7) does not apply to the
Notes, and if the Partnership was a valid one, the Respondent’s position is
that the Partnership was not entitled to deduct the expenses, relating to
payments made to PHL under the SSA and FCA, because these expenses were not
incurred by the Partnership for the purpose of gaining or producing income.
 The Appellants submitted invoices detailing
expenses purportedly relating to the start-up services costs and the franchise
completion costs (Tab 69, Joint Book of Documents). However, the Respondent
denied the validity of these invoices. During the hearing, the Appellant
conceded that a number of these invoices did not in fact relate to the
Partnership and were not incurred in the relevant period or that they related
to personal expenses.
Penalties Levied Against the O’Deas:
 The Respondent contends that the O’Deas, as the
directing minds of the Proshred group of companies, knowingly or in
circumstances amounting to gross negligence participated in or made false
statements or omissions in their income tax returns in respect to the relevant
taxation years. However the Appellants, Francis and Sean O’Dea, argue that
since they relied on the advice of financial and legal advisors in forming the
Partnership and carrying out the transactions relevant to the issues under
appeal, they should not be liable for the penalties imposed pursuant to
 I have attached, as Schedule “A” to my reasons,
diagrams submitted by both counsel outlining the transactions which occurred in
1. Does subsection 143.2(7) of the Act
apply to the MT Notes, the LT Notes, the KP ST Note and the KP LT Note
to deem them limited recourse amounts so that the Minister would be permitted
to reopen the statute-barred years pursuant to subsection 143.2(15)?
 Counsel for both the
Appellants and Respondent agree that if subsection 143.2(7) applies to the
MT Notes, the LT Notes and the KP ST Note and KP LT Note, then no taxation year
will be statute‑barred pursuant to subsection 143.2(15), in respect
to the Reassessments made under section 143.2 of the Act.
 Subsection 143.2(15) permits
the Minister to reopen and reassess any statute‑barred taxation year, as
may be necessary, if the assessment relies on the provisions of section 143.2. Subsection
subsections 152(4) to (5), such assessments, determinations and
redeterminations may be made as are necessary to give effect to this
However, the application of subsection 143.2(15)
is limited to the Minister’s Reassessments made under section 143.2 of the Act,
with respect to the disallowance of the partnership losses, resulting in the
reduction of the Appellants’ at-risk amounts by the deemed limited recourse
amounts of their LT Notes, the MT Notes of the O’Deas, the KP ST Note
and the KP LT Note.
 Section 143.2 provides
the limited recourse rules applicable to tax shelter investments. It is
undisputed that the Partnership and the KP Partnership are both registered
as tax shelters pursuant to subsection 237.1(1) and that the Appellants’
investments in the partnerships are tax shelter investments within the meaning
of section 143.2.
 Subsection 143.2(7) deems the unpaid
principal of certain long‑term debt under a tax shelter investment to be
a limited recourse amount unless the stipulated exceptions apply. For the relevant
years under appeal, this provision states:
Repayment of indebtedness
143.2.(7) For the purpose of this section, the unpaid principal of an indebtedness is deemed to be a limited-recourse amount unless
143.2.(7)(a) bona fide arrangements, evidenced in writing, were made, at the time the indebtedness arose, for repayment by the debtor of the indebtedness and all interest on the indebtedness within a reasonable period; and
143.2.(7)(b) interest is payable at least annually, at a rate equal to or greater than the lesser of
(i) the prescribed rate of interest in effect at the time the indebtedness arose, and
(ii) the prescribed rate of interest applicable from time to time during the term of the indebtedness,
and is paid in respect of the indebtedness by the debtor no later than 60 days after the end of each taxation year of the debtor that ends in the period.
 If the MT Notes, the LT
Notes, the KP LT Note and the KP ST Note are deemed to be limited recourse
amounts pursuant to subsection 143.2(7), because they do not fall within the
exceptions, then the adjusted cost base of the Appellants’ interest, together
with the KP Partnership’s interest in the Partnership, will be reduced by the
principal amount of those Notes pursuant to subsection 143.2(6). Consequently,
the at-risk amount of each Appellant will be correspondingly reduced pursuant
to subsection 96(2.2). This will limit the entitlement of each Appellant to
deduct their respective share of the Partnership losses under subsection 96(2.1).
Similarly, Mr. Bailey’s entitlement to his share of losses flowing from
the KP Partnership will be limited because the KP Partnership’s share of losses
from the Partnership will be limited by the principal amount of the KP ST Note
and the KP LT Note.
 In Tolhoek v. The
Queen, 2007 DTC 247 (T.C.C.), I concluded that the word “and” between
provisions (a) and (b) in subsection 143.2(7) meant that if the indebtedness
fails in either paragraph, it will be deemed to be a limited recourse amount.
The Respondent related this provision to the MT Notes, the LT Notes, the KP ST
Note and the KP LT Note. The position of the Respondent is that firstly, the KP
ST Note is a limited recourse amount that affects the at-risk amount of the KP Partnership
because there were no bona fide terms of repayment. Secondly, the
Respondent argues that paragraph (b) of subsection 143.2(7) will apply to deem
the MT Notes and the LT Notes, including the KP LT Note, to be limited recourse
amounts because interest on these Notes was not paid by the Appellants and the
KP Partnership or if it was paid, the interest was not paid within 60 days
 With respect to the MT Notes issued by the
O’Deas to the Partnership, in lieu of the cash component and the ST Note
component, both Francis and Sean O’Dea conceded that they made no payments
on these notes until August 1999 and by this concession, those notes are
deemed limited recourse amounts under subsection 143.2(7). This will reduce
their at-risk amounts by the principal amounts of their MT Notes pursuant to
paragraph 96(2.2)(c) and subsection 96(2.1) and, correspondingly, limit
their entitlement to the Partnership losses.
 In respect to the
Respondent’s first argument that the KP ST Note is a limited recourse
amount pursuant to subsection 143.2(7), in Tolhoek, which was affirmed
by the Federal Court of Appeal on April 7, 2008, I held that taxpayers must
demonstrate the presence of the following constituent elements under paragraph
(a) of subsection 143.2(7) to avoid the application of the limited recourse
rules: bona fide arrangements, evidenced in writing, made at the time
the indebtedness arose, made for the purposes of the repayment of debt and all
interest and finally that the arrangements were made within a reasonable period.
addition, as addressed at paragraphs  to  and  to  of Tolhoek,
the proper approach for determining the existence of a bona fide debt
should be a two step analysis:
 … first, the terms of the arrangement
should be identified, and second, the indicia of bona
fides should be examined in order to determine if a genuine, good faith
arrangement existed. …
 The Appellants
acknowledge that the KP Partnership did not pay a cash component for its
purchase of the Partnership’s Units. The route of a cash component and an ST
Note taken by the other partners (aside from the O’Deas) was entirely booked,
in the case of the KP Partnership, to the KP ST Note. The terms of this note,
according to Mr. Fraser’s evidence, consisted of 9% interest with no fixed
repayment date. The KP ST Note was not submitted into evidence and without the
note, apart from Mr. Fraser’s evidence, I have no way of ascertaining the
exact terms of the note. The Appellants’ assertion, that various financial and
working papers of the Partnership support a conclusion that amounts
representing principal and interest were paid by the KP Partnership in each
year, does not in fact substantiate that such payments were made. Instead they
show only that the KP ST Note was on the Partnership’s 1994 Balance Sheet and
that it reappeared again in the 1995 and 1996 Balance Sheets at reduced
 There are a number of
problems that prevent a conclusion that a bona fide arrangement existed
between the KP Partnership and the Partnership. Most importantly, there is no
evidence of bona fide arrangements for repayment of the debt. Apart from
the financial statements, there is no evidence to support a conclusion that
principal and/or interest was ever paid on the KP ST Note, and in particular, there
were no records of any receipt of cash or cheques by the Partnership. I am not
swayed by Mr. Fraser’s testimony because it was vague, inconsistent and at
times contradictory. He first testified that the Partnership did receive payment
by cheque but after a review of the Partnership’s bank statements, he confirmed
that there were no deposits to support his testimony in the relevant years. At
this point in his evidence, he suggested that the cheque may have been
deposited instead into PHL’s account. Again I was not provided with the
supporting documentation if this in fact is what occurred. In addition, without
the KP ST Note I have no actual evidence that this loan was in writing as
required by paragraph 143.2(7)(a). According to Mr. Fraser’s
evidence, the note had no fixed date of repayment and without that there is no
evidence that the KP Partnership had a bona fide obligation to repay the
 Clearly the KP ST Note
does not meet the requirements of paragraph (a) of subsection 143.2(7) and, as
a result, it must also be deemed to be a limited recourse amount.
respect to the Respondent’s second position on payment of the interest on the
LT Notes, including the KP LT Note, at paragraphs  to  of Tolhoek v.
The Queen,  F.C.J. No. 538, I outlined the proper approach to be
taken in determining whether interest was paid pursuant to
 I believe that it is critical that interest was paid
pursuant to a "bona fide
arrangement". As I concluded under paragraph 143.2(7)(a), I do not
find circular flow of money, in itself, to be offensive provided the indicia
of bona fides are otherwise present; nor do I have a
problem with the off-setting journal entries which were completed in 1998. The
authorities are compelling and the decision of Bonner J. in Armstrong v. Canada (Minister of
National Revenue, M.N.R.), (1987) 88 DTC 1015, has been cited with
approval in many cases.
affirming my conclusions, the Federal Court of Appeal in Tolhoek
highlighted, at paragraph 47, the requirement under paragraph 143.2(7)(b) that:
… a failure to pay
interest in respect of any year in which the [indebtedness] will result
in the principal amount of that indebtedness being deemed to be a limited‑recourse
In addition, the Federal Court of Appeal at
paragraph 59 stated:
 … As previously indicated, the intention on the part of the
promoters to structure the tax shelter in such a way as to avoid the provisions
of section 143.2 is irrelevant. If the specific and technical aspects of the
structure do not, in fact, bring about the intended result, then the scheme
must fail. …
 In Tolhoek, I
concluded that recording an interest payment by way of a journal entry was not
by itself offensive to section 143.2. The Federal Court of Appeal agreed with
my further conclusion that payments via journal entries may on their own be
sufficient to establish that the requirements have been complied with pursuant
to subsection 143.2(7). Against this background, I will now review the
arrangements to determine whether, based on the facts, I can conclude that
interest on the LT Notes and the KP LT Note was paid.
 Originally interest was
to be paid by the Partnership through distributions from gross revenue. However,
this approach had to change when there was insufficient revenue in each year to
comply with this provision. The Appellants submit that the interest, payable by
each limited partner on their LT Notes (and by the KP Partnership on the KP LT
Note), was in fact paid via journal entries, whereby interest was credited with
a corresponding reduction to each limited partner’s capital account.
 The Appellants submitted
various documents to support their position including the following: the LT
Notes, working papers, spreadsheets showing the calculation of equity, adjusted
cost base and at-risk amounts of each partner which also purported to show that
such distributions to each partner were made in 1994, 1995 and 1996, the
audited financial statements for the years ending 1994 and 1995 and the
unaudited financial statements for 1996 to show the Partnership recognized the
interest income, journal entries maintained by Mr. Fraser and the
Partnership Information Return, filed for the year 1996 to show that
drawings were made from the capital accounts of the partners. It should be
noted that the Partnership Information Returns for 1994 and 1995 do not show
similar drawings from the capital accounts.
 The evidence of the
O’Deas and of Mr. Bailey was that all of the limited partners paid interest on
their LT Notes via journal entries. Mr. Bailey testified that he received
documentation from the Partnership indicating to him that the interest had been
paid on the LT Notes. However, none of the referenced documentation was
submitted into evidence.
 Based on the evidence
before me, I cannot conclude that interest was in fact paid on the LT Notes,
including the KP LT Note. The evidence raises suspicions as to whether the
journal entries were actually made during the time period that the Appellants
allege they were made. Although Mr. Casciano requested the accounting books and
records of the Partnership, they were never provided to him. Mr. Fraser was
responsible for maintaining these records for the entire Proshred group of
companies. He referred many times to these journal entries which he stated he
made for the Partnership. However, he was confused as to whether the
Partnership ever had its own accounting system or its own books and records. His
evidence was unclear and certainly never straightforward. Just one week prior
to the hearing, the Appellants provided these journal entries to the
Respondent. If they had been properly recorded at the appropriate times, it
should have been relatively easy for Mr. Fraser to produce them for Mr.
Casciano when they were requested during the audit. I was given no adequate
explanation for why this did not occur.
 The journal entries
consist of those purportedly made in the Partnership’s books (Tab 2, Exhibit
A-2), those purportedly made in the PHL books (Tab 2, Exhibit A-2) and those
purportedly made in the PI books (Tab 2, Exhibit A‑2). The
Appellants assert that these journal entries, and in particular those made in
1996, 1997 and 1998, reflect interest payments by the limited partners. The
Appellants’ position is that the LT Notes, including the KP LT Note, which
total $3,600,000.00, were assigned to PC Holdings in payment of the Note that
the Partnership owed to PC Holdings for the purchase of the service bureau
licensing rights. The Appellants’ position also relies on the terms of the
Offering Memorandum and clause 4.04 of the Limited Partnership Agreement which
stated that a distribution was to be made to the limited partners in amounts
equal to the interest due on their LT Notes, which could be paid directly to
the holder of these notes. These agreements went on to state that, where there
was insufficient cash available to make these distributions, the Partnership
was to fund such distributions out of the proceeds of the Cash Flow Loans. As
per the CDA, if the Partnership had insufficient funds to make these
distributions for interest payments, then PHL would provide the Partnership
with sufficient Cash Flow Loans to cover the required distributions. The
Appellants therefore assert that the journal entries reflect that interest
distributions were made to the limited partners from funds borrowed from PHL.
While these journal entries recognized a loan payable to PHL, it debited the
“Equity” account. The journal entry of $324,000.00 was to reflect a 9% interest
payable on $3,600,000.00, the total amount of the LT Notes. Drawings from the
capital accounts of the limited partners and recorded in the Partnership
Information Returns were to reflect those amounts debited to the Partnership’s
Equity account by the journal entries. However, these documents show only that
drawings were made in 1996, but no drawings were made in 1994 or 1995 and no
evidence was provided for years subsequent to 1996. The Appellants also submit
that those entries on the books of PHL reflect that the Interest Distributions
were paid directly to PC Holdings in the form of a “Loan Receivable – PC
Holdings”. The LT Notes were allegedly assigned from the Partnership to PC
Holdings to satisfy the $3,600,000.00 note owed by the Partnership. Journal
entries made in the books of PI reflect that interest income accrued each year
on the $3,400,000.00 note receivable by PI from PC Holdings for the
purchase of the F/G Licensing Rights. However, there were no journal entries to
show that there was any assignment of the notes by PC Holdings to PI.
 There are a number of concerns which I have with
the Appellants’ assertions. The form of the LT Notes indicates that interest
was to be calculated half yearly not in advance and payable annually on
December 31 in each year. The Appellants submit that there were no journal
entries in 1995 because the Interest Distributions were made in January 1996.
However, this violates the provision contained in the LT Notes that interest be
paid annually on December 31 of each year. The Appellants also assert that
the Interest Distributions were made in 1994 and that this same amount was
recognized as interest income by the Partnership in its 1994 financial statements.
However, there were no journal entries at all to reflect interest payments for
1994. Subsection 143.2(7) is clear that the payment of interest must occur
for every taxation year of indebtedness (as established in Tolhoek). A
failure of the payment in any one year will result in the principal amount of
indebtedness being deemed a limited recourse amount under this provision. The
LT Notes, although signed on different dates, were signed prior to December 31,
1994. As a result, a payment of interest to recognize the indebtedness in 1994
should have been made in respect to these notes. The admissions by Mr. Fraser
concerning these journal entries are summarized at paragraphs 32 and 33 of my
reasons. Although the Appellants seek to use Mr. Fraser’s testimony to support their
contention that interest payments were made on the LT Notes, these
admissions clearly have the opposite effect. Instead of putting to bed a host
of questions concerning these journal entries, the admissions simply reinforced
the lingering doubt I had after hearing Mr. Fraser’s testimony.
 In response to the Respondent’s argument that the LT
Notes were never properly assigned to PC Holdings, the Appellants were unable
to produce any evidence that the limited partners executed any type of assignment
or direction to have the Interest Distributions paid directly to the assignee.
Both the Service Bureau Agreement and Limited Partnership Agreement provide for
the assignment of the Notes subject to the endorsement of each limited partner
and that, with the direction of the limited partners, the Interest
Distributions could be paid directly to the holder of the notes, other than the
Partnership. However, Mr. Bailey testified that he never signed an
authorization or direction relating to his LT Note. The Appellants relied on
the actual form of the LT Notes to support the assignment, which included the
that and the undersigned understands and acknowledges that this Note will be
assigned by the payee ONLY to a corporate third party in satisfaction of moneys
owing for services performed for and the business acquired by the Limited
Partnership, and it may not be further assigned or otherwise dealt with without
the consent of the Limited Partners expressed by an Ordinary Resolution as aforesaid;
A-2, Tabs 16, 18, 21 and 22)
Even if this passage supports that the LT
Notes were effectively assigned to PC Holdings, the Appellants failed to
prove that an assignment or direction had been executed by the limited partners
for the Interest Distributions to be paid directly to PC Holdings. The
Appellants may have been able to prove the assignment with the testimony of Mr.
Charlton, the principal of PC Holdings, together with the general ledger of PC
Holdings. Without these, the Appellants are simply unable to establish that
these notes were assigned to PC Holdings and, correspondingly, that PC Holdings
recorded investment income during the relevant taxation years.
 Even if I accepted the Appellants’ arguments
with respect to the assignment of the LT Notes and the direct payment of the
Interest Distributions to PC Holdings, I still have no evidence that
payments were actually made. The journal entries prove that, in each year,
$324,000.00 was transferred in Interest Distributions but there were no
subsequent matching entries to show that interest was paid to either the
Partnership or PC Holdings or that interest income was recognized by either of
those entities. These missing items leave gaping holes in the accounting
records and, consequently, fail to show the critical connections which are
essential to the Appellants’ position. The recording of “Loan Payable –
PC Holdings” does not, on its own, indicate that interest was paid. It
proves only that PHL recorded an accruement of the interest as a loan payable
in its books. The term “paid” used in paragraph 143.2(7)(b) cannot be
synonymous with the term “accrued”.
 There are also two inconsistencies with the
Appellants’ argument that the Partnership’s financial statements show that
interest income was recognized in the taxation years 1994 to 1996. First, the
amount of interest income in these years, $1,775.00 in 1994, $60,190.00 in 1995
and $58,136.00 in 1996, do not match the purported Interest Distributions of
$324,000.00. Second, the onus is on the Appellants in respect to this issue and
if they are going to assert that the interest has been paid directly to PC
Holdings, then they must provide satisfactory evidence that establishes that
the interest income was recognized by PC Holdings, and not by the Partnership.
Although Mr. Bailey testified that he received documents and statements from
the Partnership that informed him about interest that was “payable or due” on
the LT Note, for the KP Partnership and the Partnership, this evidence does not
equate to interest being paid (Transcript page 201).
 Although I have reviewed in detail the various
documents that were submitted as exhibits to support the intended compliance
and in particular these purported journal entries, I am simply unable to
conclude that this circular flow of funds, by way of loans receivable and loans
payable, constitute the payment of interest which is contemplated within the
meaning of paragraph 143.2(7)(b). Since the arrangements do not withstand
careful scrutiny, as per the Federal Court of Appeals directions in Tolhoek,
they cannot be legally binding.
 Even if I had concluded that the Appellants and
the KP Partnership had paid interest on the LT Notes, the Appellants would
still have had the onus of proving that interest had been paid within 60 days
of each year‑end in 1994 to 1996. There was insufficient evidence in
respect to this issue to allow me to conclude that interest had been properly
paid. Interest in each year would have to be paid within 60 days of year‑end
or by March 31 of each subsequent taxation year during the periods of
indebtedness. The journal entries that record the Interest Distributions among
PHL, the Partnership and PC Holdings are undated except for the year in which
they were purportedly made. Mr. Fraser’s evidence was that he would have
made the necessary entries for the Partnership within the first
60 days of any subsequent year in order to meet the March 31 deadline for
filing the Partnership Information Returns. However, he never testified that
this was actually completed in respect to the entries of 1996, 1997 and 1998.
On this basis alone, I am being asked to assume that these entries represent
the interest payments for 1995, 1996 and 1997 and that they were made prior to
March 1 in each subsequent year. That is something I am not prepared to do.
 In addition, Mr. Fraser admitted that he wrote a
memorandum (Exhibit A‑1, Tab 55) to one of his staff, dated March
31, 1997 that stated in part:
As you are aware, the
Proshred Florida/Georgia Limited Partnership had long term notes receivable
from Limited Partners. The notes were assigned to PC Holdings to eliminate
the partnership liability to PC Holdings on purchase of the rights for the
Service Bureau from PC Holdings. The partnership guaranteed a cash flow to
Limited Partners to pay their portion of the interest on the long term note
receivable. Since the partnership is cash short, it has used the cash flow
deficiency agreement with PHL to fund the interest on the notes.
The interest was
deemed to be paid on January 1, 1996 for the 1995 year end. As a result we
need to reflect this amount in two areas:
PHL – Cash Flow Loan
Equity & A+ - risk calculation.
(Exhibit A-1, Tab 55) (emphasis
The phrase “interest was deemed to be
paid” indicates that interest for the 1995 year‑end was not in fact paid
on January 1, 1996. This memorandum shows only that Mr. Fraser was requesting
one of his staff to recognize this “deemed” payment of interest, approximately
one year and 90 days later on March 31, 1997. This clearly suggests that the
journal entries were not made at the appropriate time and lends support to my
suspicions that in fact these entries did not coincide with the actual
occurrences but rather were produced in a subsequent period.
 Even if I were able to conclude that these
entries did in fact represent that interest payments were duly made within 60
days of the 1995, 1996 and 1997 year‑ends, I have no evidence that the
interest for 1994 was paid prior to March 1, 1995. Mr. Fraser stated that
he was not involved with the preparation of financial documentation for the
Partnership prior to 1995 and therefore he could not provide evidence with
respect to entries or interest payments for the 1994 year.
 Since there is insufficient evidence to
establish that interest on the LT Notes and the KP LT Note was duly paid
by the Appellants and the KP Partnership within 60 days of 1994, 1995 and
1996 year‑ends, the LT Notes are deemed also on this basis to be limited
recourse amounts pursuant to subsection 143.2(7). With respect to my earlier
finding that the KP ST Note is deemed to be a limited recourse amount, the KP
ST Note together with the KP LT Note are both deemed to be limited recourse
amounts, reducing the at‑risk amount of the KP Partnership to nil
pursuant to subsection 96(2.2). Since the KP Partnership will not be entitled
to deduct any of the Partnership losses, Mr. Bailey will not be entitled
to deduct any of the Partnership’s losses that were originally assigned to him
through the KP Partnership.
 Since the Appellants and the Respondent agreed
that, if subsection 143.2(7) applied to the Notes, then no taxation year in
respect to this issue would be statute-barred and, based on my conclusions
respecting these notes, subsection 143.2(15) will apply to allow the
Minister to reopen and reassess these otherwise statute-barred years with
respect to the partnership losses claimed by the Appellants with regard to
their LT Notes, the MT Notes of the O’Deas, the KP ST Note and KP LT Note.
 Therefore, Francis and Sean O’Deas’ entitlement to
deduct losses from the Partnership is reduced to nil, based on my conclusions
with respect to their MT Notes and LT Notes, since the principal amounts
of these Notes made up the entire amount of their adjusted cost base of their
Units. In respect of Mr. Bailey, his entitlement to deduct Partnership losses
is reduced by his LT Note and the losses allocated to him from the KP
Partnership. In respect of Mr. Rankin, his entitlement to deduct Partnership
losses is reduced by his LT Note. As a result, the conclusions above do
not affect Mr. Bailey and Mr. Rankin’s entitlement to deduct losses from the
Partnership proportionate to their cash payments and the principal amount of
their ST Notes.
2. If the Appellants are entitled
to deduct the losses, are Francis and Sean O’Dea entitled to carry back
their partnership losses to the 1992 and 1993 taxation years?
 Since the O’Deas are not entitled to claim any
of the Partnership losses, this issue is effectively resolved.
3. If the Notes are not limited
recourse amounts under section 143.2:
(a) Is the Minister statute-barred from reassessing the Appellants
in regard to the respective Notes?
 Since the MT Notes, the LT Notes, the KP ST Note
and the KP LT Note are deemed as limited recourse amounts under section 143.2,
the Minister is not statute-barred to reassess in regard to the respective
Notes, pursuant to subsection 143.2(15).
(b) Is the Minister statute-barred from reassessing the Appellants
on any other basis?
 Since the O’Deas’ entitlement to losses has been
reduced to nil by the application of section 143.2, I need only address the
effect of section 152 as it relates to Mr. Bailey and Mr. Rankin. The remaining
issues respecting the validity of the Partnership and the deductibility of
those Partnership expenses are still relevant for determining whether the
entitlement of Mr. Bailey and Mr. Rankin to the Partnership’s losses
should be further reduced. The Respondent relies on subsection 152(4) to argue
that the statute‑barred years should be reopened with respect to the
remaining issues. Therefore, I will consider the application of subsection
152(4) as it applies to Mr. Bailey and Mr. Rankin.
 According to subsection 152(4), if Mr. Bailey
and Mr. Rankin “made any misrepresentation that is attributable to neglect,
carelessness or wilful default …” then the Respondent would be permitted to
reassess outside the normal assessment period of three years.
 The Federal Court of Appeal in Venne v. The
Queen, 84 DTC 6247, held that a misrepresentation that is
attributable to neglect under subparagraph 152(4)(a)(i) is established if
a taxpayer fails to exercise reasonable care.
 In deducting their share of Partnership losses,
Mr. Bailey and Mr. Rankin relied on the Partnership’s Offering Memorandum,
which included various professional opinions regarding the tax consequences and
the validity of the deductibility of the Partnership expenses. Mr. Bailey
testified that he in fact received Partnership statements which informed him of
the amount of partnership losses that he could deduct in his personal income
tax returns. These individuals were involved as limited partners. They were not
the directing minds nor were they involved in the initial structuring details.
I believe they were acting in a reasonable and prudent manner in placing
reliance on the various professional opinions before making a decision to
invest and should not be held to a higher standard. To do so would be to insist
that they must personally investigate the technicalities of the various
structures and arrangements of public offering documents. Therefore their
reliance on the statements received from the Partnership will not amount to a
failure to exercise reasonable care in filing their returns and, consequently,
in respect to the additional assessments, other than those made pursuant to section 143.2,
the Minister will not be permitted to apply subsection 152(4) to reopen
these taxation years in respect to Mr. Bailey and Mr. Rankin.
4. Aside from the determination of
whether the Notes are limited recourse amounts under section 143.2, are the
Appellants entitled to deduct their respective partnership losses based on the
Partnership a sham and/or a valid partnership for the purposes of section 96 of
Is the Partnership entitled to deduct all of the expenses that
it alleges it incurred during the relevant taxation years such that the Appellants
would be entitled to deduct their respective losses in this regard?
 Because of my conclusions in the preceding three
issues, I do not need to address this issue at all. However, based on the
evidence, the submissions by counsel and the case law, I would have concluded
that the Partnership was not a sham because there was no evidence of a common
intention among investors to deceive the Minister with respect to the true
nature of the Partnership (see Continental Bank Leasing Corp. v. Canada,  S.C.J. No. 63; Stubart Investments
Ltd. v. Canada, 10 D.L.R. (4th) 1 (S.C.C.); 2530‑1284 Québec
Inc. et al. v. The Queen, 2008 DTC 3245 (T.C.C.), affirmed 2008 FCA 398 [Faraggi];
Snook v. London and West Riding Investments Ltd.,  1 All E.R. 518
(H.L.)) On the other hand, it does not satisfy the essential elements of a
partnership under the relevant partnership law because the Partnership was not
carrying on a business with a view to a profit (see Partnerships Act,
R.S.O. 1990, c. P.5; Backman v. Canada,  S.C.J. No. 12; Spire
Freezers Ltd. et al. v. The Queen, 2001 DTC 5158 (S.C.C.)); Continental
Bank, supra). The Partnership held only the legal rights to the F/G Licensing
Rights and throughout it was PHL that operated the service bureau functions.
The Partnership never earned a profit and was never able to recoup any of the
significant losses it incurred. The transactions were structured so that it was
virtually impossible for the Partnership revenues to meet the debt levels and
consequently there was no intention to earn a profit even as an ancillary
purpose. Therefore, the limited partners of the Partnership would not have been
entitled to deduct any losses from the Partnership, because it was not a valid
partnership under section 96 of the Act. In addition, the Partnership
would not be entitled to deduct expenses if it is not a valid partnership.
5. Are Francis and Sean O’Dea
liable for gross negligence penalties as assessed by the Minister under
subsection 163(2) of the Act?
 The Minister levied penalties against Francis and
Sean O’Dea pursuant to subsection 163(2) because, as the principals of the
Proshred group of companies, they were in the best position to know that the
Partnership losses were not deductible and therefore made or acquiesced in the
making of false statements in respect to their returns in the relevant years.
The Respondent argued that the O’Deas claimed losses which were otherwise
restricted by subsections 143(2.2) and 96(2.2) and misrepresented that the
Partnership carried on a business when in fact it was established to acquire
 In Venne, Justice Strayer of the Federal
Court of Appeal, at page 6256, held that the requirement of “gross negligence”
under subsection 163(2) of the Act, in contrast to the level of
“neglect” required under subsection 152(4), involves a greater degree of
…“Gross negligence” must be
taken to involve greater neglect than simply a failure to use reasonable care.
It must involve a high degree of negligence tantamount to intentional acting,
an indifference as to whether the law is complied with or not. …
 In 410812 Ontario Limited v. The Queen,
 T.C.J. No. 176, at paragraph 9, Bowman A.C.J. (as he was then),
concluded that the general principle applied by the Court with respect to
subsection 163(2) is as follows:
9 If any broad principle can be deduced from the
multiplicity of cases decided under subsection 163(2) of the Income Tax Act
it is that courts are reluctant to sanction the imposition of gross negligence
penalties unless evidence of a high degree of negligence is clearly
 Similarly, Justice Bowman in Klotz v. The Queen,
2004 DTC 2236, at paragraph 68, emphasized that gross negligence “… connotes a much greater degree of negligence
amounting to reprehensible recklessness”. Carelessness or a failure to exercise
due diligence is not enough to warrant the imposition of gross negligence
 In particular, Justice Bowman held, in Farm
Business Consultants Inc. v. The Queen, 95 DTC 200, at pages 205 and
206, that the taxpayer must be given the benefit of the doubt when assessing
… Moreover, where a penalty is imposed
under subsection 163(2) although a civil standard of proof is required, if a
taxpayer's conduct is consistent with two viable and reasonable hypotheses, one
justifying the penalty and one not, the benefit of the doubt must be given to
the taxpayer and the penalty must be deleted. …
 Francis and Sean O’Dea are both experienced
businessmen with extensive business experience. They were also the directing
minds of the Proshred group of companies and the Partnership. They were
involved in the expansion of the Proshred business and both had read and signed
the Offering Memorandum and were aware of its contents and its disclosure
relating to tax consequences. Francis O’Dea had to be involved with the
intimate details of the structure of the Partnership as he was the individual
that promoted it to potential investors by using the Offering Memorandum. Sean O’Dea
was responsible for the operations of the Proshred business and for formulating
the projections relating to the profitability of the Partnership.
 While the conduct of the O’Deas may warrant a
finding of “negligence” or lack of reasonable care, it would not automatically
justify a penalty under subsection 163(2). The gross negligence penalties under
subsection 163(2) should be levied only in exceptional circumstances where the
taxpayer has exhibited “reprehensible recklessness”.
 Similarly to the facts in Klotz, the O’Deas
testified that they relied on various professional advisors and, following the Klotz
decision, I conclude that the O’Deas’ carelessness with respect to verifying
the necessary information does not amount to gross negligence. Although their
suspicions should have been raised based on their business background, their
conduct does not meet the requisite threshold of reprehensible recklessness.
 Although the O’Deas were cross-examined
extensively regarding their understanding of the at-risk rules and the
non-payment of their MT Notes, it is doubtful that they “knowingly, or under
circumstances amounting to gross negligence” deducted the full amount of the
Partnership losses allocated to them with the full understanding that it might
not be allowed under the Act. I am not convinced based on the facts that
the O’Deas knew that interest was not being paid on their LT Notes when they
looked to deduct losses from the Partnership. Their conduct falls short of the
requisite behaviour required to assess gross negligence penalties because it
does not cross the threshold into the realm of cavalier, reprehensible or
intentional as suggested by the case law.
 In summary, my conclusions are as follows:
(1) Although the reassessments were made outside the normal
reassessment period, because subsection 143.2(7) applies to deem the Notes
(with the exception of the ST Notes of Mr. Bailey and Mr. Rankin) limited
recourse amounts, the Minister is permitted pursuant to subsection 143.2(15) to
reassess those statute-barred years for all Appellants. This reduces the cost
of the Partnership Units for each of the Appellants and effectively reduces
their at-risk amounts and entitlement to deduct their corresponding losses
under subsection 96(2.1) of the Act, by the principal amounts of each of those
(2) The long‑term promissory notes of the Appellants, the LT
Notes, are deemed to be limited recourse amounts under subsection 143.2(7)
because the Appellants did not prove that interest was paid on their notes nor
that it was paid within 60 days of the end of each taxation year.
(3) The MT Notes of Francis and Sean O’Dea are also deemed to be
limited recourse amounts under subsection 143.2(7) because the O’Deas, by their
own admission, did not pay interest on those notes within 60 days of the end
of each taxation year. Therefore, the Partnership losses of Francis and Sean
O’Dea shall be further reduced by the principal amount of their MT Notes
which were issued to the Partnership. As a result of my conclusions respecting
the MT Notes and the LT Notes, the O’Deas’ entitlement to deduct any of the
Partnership’s losses is reduced to nil.
(4) The long-term note issued by the KP Partnership to the
Partnership, the KP LT Note, like the other long-term notes issued by the
limited partners, is also deemed to be a limited recourse amount. The
partnership losses that were allocated by the KP Partnership to Mr. Bailey will
also be accordingly reduced. In addition, the short-term note issued by the
KP Partnership, the KP ST Note, is deemed to be a limited recourse amount
under subsection 143.2(7) because it was not a bona fide loan and the
interest was not paid within 60 days of the end of each taxation year.
Therefore Mr. Bailey’s entitlement to deduct losses will be reduced by the
amount of his LT Note to the Partnership and any amount flowing to him in
respect of his KP Partnership holdings.
(5) Mr. Rankin’s potential to deduct losses will also be reduced by
the amount of his LT Note.
(6) The Minister will not be permitted to apply subsection 152(4) to
reopen the taxation years of Mr. Bailey and Mr. Rankin. Consequently, their
ability to deduct Partnership losses other than losses associated with their LT
Notes and Mr. Bailey’s KP ST Note and KP LT Note, will be unaffected.
(7) Penalties under subsection 163(2) of the Act levied
against the O’Deas are to be deleted.
(8) If the parties cannot settle the issue of costs within 60 days of
the date of the within Reasons, they may contact the Court to obtain dates for
the filing of written submissions.
Signed at Vancouver, British Columbia, this 1st day of June 2009.