The Queen v. Boorman, 77 DTC 5338, [1977] CTC 464 (FCTD)

Collier, J:—At the end of the hearing of this action in Dawson Creek, BC on July 27, I dismissed the plaintiff’s appeal. I said written reasons would be given. They now follow.

The Minister of National Revenue appeals to this Court from a judgment of the Tax Review Board. There is, in my view, no point of general legal or tax significance. The tax revenue at stake is miniscule. The result is, however, of importance, from a tax point of view and in principle, to the defendant. The decision, I am told, will affect the defendant’s partners. Why the plaintiff chose to appeal was not really satisfactorily explained to me. Expenditures of time and money to taxpayers generally have been incurred. The point of my comments will, I trust, become more clear when the factual background is recounted.

The defendant is a surgeon. At the relevant times he and other doctors were partners in the practice of medicine at Dawson Creek. They had a clinic there. For the years 1970-1973 inclusive certain moneys were paid to two doctors who had been partners in the business. It has never been disputed by the defendant or remaining partners, or by the retired partners,* [1] that the amounts so paid are taxable as income. Everyone agrees on that. The difference of view is as to who pays the tax: the remaining partners, or the recipients. Put another way: whose income is it?

The Minister prefers not to put the issue that way. It is said that what really happened is this. The moneys paid to the retired partners are in the nature of a capital expense vis-a-vis the remaining partners. That capital expense cannot be deducted by them from their income. Whether the tax gatherer chooses to tax it (once more in effect) in the hands of the recipients is not before this Court.

The amounts of taxable dollars involved are as follows:

The Minister’s assessment, as nearly as I can determine, arose this way. One of the retired partners was a Dr Thorkelson. He did not include in his income the amounts paid to him or, if he did include them, the Minister assessed or reassessed and excluded them. The Minister then reassessed the defendant and the remaining partners by adding into their incomes their respective shares of the payments made. The Tax Review Board held the Department was wrong in so doing. That decision was apparently unsatisfactory to it.

At the conclusion of this trial I came to the same conclusion as the Board. I am told the evidence before me was, for all practical purposes, the evidence before the Board.

The clinic began in 1961. The defendant, Dr Thorkelson and a Dr Aylward had been carrying on individual medical practices. A partnership was formed. Each doctor contributed his accounts receivable. The partners agreed that each would be repaid, by a formula, for that contribution. Final payment was made within 18 months.

A private company, Professional Investments Limited, was incorporated in 1962. The company became the owner of all the physical assets (premises, equipment, etc). There were lease agreements with the partnership. Early on in this history then, the partnership had no Capital assets in the usual sense of that term. Its only real asset, at any time, were accounts receivable (fees for services rendered to patients by the partners or employees). The value of that “asset” depended, of course, on the continuation of the business and the collecting of the accounts.

The partners had several written partnership agreements. The latest one is dated January 1, 1967 (Exhibit 1). It is the document relied on by the Minister to support the assessment. Partnership agreements, written or oral, can be changed from day to day. The changes or variations need not, of course, be in writing.* [2] In construing any agreement the background and facts which existed at the time of its execution are relevant considerations.

As of January 1, 1967 there were no “capital” assets in this partnership. There was, for example, no investment or equity in premises, furniture, equipment, medical library, or the like. The partnership operated, for business and tax purposes, on a cash basis. It did not, until the advent of the “new” Income Tax Act, even list or record its accounts receivable in its books or financial statements.

The evidence before me indicates the intention of the partners, as of January 1, 1967, was to agree on certain matters in respect of the bringing in of partners and the retirement, withdrawal or death of partners. When a new partner came in, he was to share in profits equally. Because he may not have contributed much, or at all, to the accounts receivable at the time of admission, an arbitrary formula was to be used whereby he became entitled to share in those pre-existing receivables. The formula meant he pocketed, for a certain time, less than his full share of profits. But he paid tax only on what he received. The other partners, in effect, received more than equal shares. They, in turn, paid tax on the amounts they actually received.

In fact, the above arrangement was carried out. Tax was paid accordingly.

I turn to what the partners intended should happen on withdrawal, death or retirement. In the absence of any formula or different agreement, the departed partner would be entitled to an equal share of the profits of the partnership as of the date of departure. In actuality, this meant that he would eventually receive his share of the accounts rendered, but not paid, at the time of leaving. Payments could go on for a long time, depending on the rate of collection. The parties felt this was unsatisfactory. Again they agreed on an arbitrary formula. It was based on previous earnings. The intention was that the moneys so paid were income to, and taxable in the hands of, the departed partner.

The intentions were not put to the test for some time. Dr Thorkelson withdrew in 1969. He asked that any payments to him be deferred until after January 1, 1970. A Dr Galliford withdrew in 1971. I add that the new Act came into force in 1972.7 [3]

I leave what the partners intended and what they orally agreed to. I go to the document they signed. Paragraph 33 deals with admission of new partners:

33. New partners may be admitted to the partnership upon the consent in writing of not less than three-quarters ( /4) of the partners and upon admission shall be deemed to be full partners in the same manner as though they were parties to this agreement and they shall subscribe their names to this agreement and this agreement and any amendments hereto shall continue to be in full force and effect and binding upon all parties. New partners shall pay to the partners of the partnership at the time of admission jointly, the sum of Ten Thousand ($10,000.00) Dollars, provided that if the new partner shall have been employed by the partnership on a salary for a period of eighteen (18) months, the new partner shall pay to the partners the sum of Seven Thousand Five Hundred ($7,500.00) Dollars and if any partner shall have been employed by the partnership on salary for a term of two (2) years or more, the new partner shall pay the sum of Five Thousand ($5,000.00) Dollars.

Paragraph 28 had set out a certain amount to be paid by one partner to five other partners. It also provided for payment of $7,500 by Dr Galliford to the other six partners. The amounts were to be paid out of their shares of profits. The paragraph began:

The first six parties hereto shall be deemed to have contributed the capital of the partnership in equal shares except as follows: . . .

Nowhere in the agreement is “the capital of the partnership” described or defined.

Paragraphs 23, 24 and 25 dealt with death or withdrawal from the partnership:

23. Upon the death or retirement of any partner or partners the remaining partners shall purchase the interest of the deceased or retiring partner or partners. The interest of the deceased or retiring partner shall be paid in four (4) equal instalments, the first instalment to be paid forthwith upon the death or retirement of the partner and the remainder in three (3) equal annual instalments on the anniversary date of the death or retirement. Provided, however, that if the partners are required by the terms of this agreement to purchase the interest of more than two deceased or retiring partners at any time, the effective date of purchase shall be the date of death or retirement, but the payment of the interest of any deceased or retiring partner in excess of two shall be postponed and shall be paid consecutively according to the date of death or retirement. The first payment to be paid one (1) year following the date of the final payment to a prior deceased or retiring partner.

24. The parties hereto mutually convenant and agree that upon the death of any one or more of them, the survivor or survivors shall purchase and the estate of the deceased partner or partners shall sell, the interest of the deceased in the partnership to the survivor or survivors. There shall be no benefit of survivorship between the partners and the personal representatives of any partner who dies shall be entitled to the share of such partner. The value of the interest of the deceased partner shall be arrived at in accordance with the provisions of the next following paragraph.

25. Upon the death or retirement of any partner, his interest in the partnership shall be calculated in the following manner:

1. His average annual income from the partnership during the preceding three (3) years or during the period that he was a member of the partnership, whichever is less, shall be reduced by twenty-five (25%) per cent.

2. One-tenth (1/10) of the amount arrived at by the preceding calculation shall be multiplied by the number of years that such deceased or retiring partner has been a member of the partnership up to a maximum of ten

(10) years.

Provided, however, that the value of the interest of a deceased or retiring partner shall not be less than the amount the deceased or retiring partner paid to become a partner.

The plaintiff contends that the proper construction of the relevant paragraphs of Exhibit 1 is as follows. Each partner to the agreement contributed in some manner to the capital of the partnership. Each then held equal “shares”. New partners paid $5,000 to $10,000 (depending on their former status) for an equal “share”. When a partner withdrew or died, the remaining partners purchased or bought back the former partner’s share or interest. The monetary valuation was calculated according to paragraph 25. The amount paid by the remaining partners was, to them, a capital expense. It cannot be deducted from income.* [4]

Some confusion has arisen because of the manner in which the payments to the former partners were recorded in the financial statements of the partnership. In the statement of income, they were listed as an expense: “separation payment to retiring partner”. As Mr Stewart testifed, it would have been quite simple, and more accurate, not to have debited the item as an expense, but to have allocated it as income to the former partners.

In my view, the amounts in question are not “capital expense” to the defendant and his continuing partners. They were income, but income to the recipient. When the relevant provisions of Exhibit 1 are fairly construed, in the light of the actual facts existing at all relevant times, it is clear that there was no purchase (or buying back) by the remaining partners of any asset, “capital” or otherwise. What was being done was a distribution of income, calculated on an arbitrary basis.

The assessing error here was in confining the decision solely to the partnership agreement. The Department’s construction of the document and its terms was made without regard for the facts which existed at the time the agreement was drawn, and for those same facts which persisted into the years in question.! [5]

In my view, the same result flows here as in MNR v Wahn, [1969] SCR 404; [1969] CTC 61; 69 DTC 5075. The taxpayer in that case withdrew from a law firm where he had been a partner. He started his own business. The agreement with the former partners contained terms in respect of withdrawal or retirements. The taxpayer sought to classify certain moneys received as on account of capital. The Supreme Court of Canada held the amounts to be income, taxable in the hands of the recipient, and not in the hands of the former partners (pp. 423-5 [76-7, 5084-5]):

Here again I find myself unable to agree with the view taken in the Court below. In order to ascertain the nature of the amount allocated to the respondent out of the profits of the firm from which he had withdrawn, the partnership agreement must be construed as written. It was obviously drawn up with great care and special consideration was given to the fiscal consequences of the provisions for payments to a withdrawing partner or to the estate of a deceased partner. In the latter case it is provided that payment will be made by the firm of “a sum equal to the income tax payable by the estate in respect of the said profits” (viz the profits so allocated). This shows clearly that it was not the intention that the remaining partners should bear the income tax on the part of the 1962 profits allocated to the respondent. However, such would be the result of treating the amount as a capital payment. Respondent would be getting it free from income tax but the amount allocated to him out of the 1962 profits would be added to the share of the remaining partners because, on the assumption that the sum allocated is a capital payment, the whole amount of the 1962 profits would have to be apportioned among the partners instead of the portion remaining after deducting the amount allocated to the respondent. This is clearly what was never intended and I fail to see on what basis the agreement should be given an effect other than that which was undoubtedly intended.

It is contended that what is said in the agreement respecting income tax cannot override the provisions of the Act. This is quite true but does Inot mean that what is said is not to be taken as expressing the intention of the parties. I find it obvious that the intention was that the payment to a withdrawing partner should be an allocation of profits. It is true that the fact that a payment is measured by reference to profits may not prevent it from being of a capital nature but there must be something to show that such is the true nature of a payment. In the present case, I can find nothing tending to indicate that it is so. On the contrary, clause 18 provides clearly that a withdrawing partner has no interest in the capital assets of the firm.

”18. The amounts hereinbefore provided to be paid to a withdrawing, retiring or expelled partner or to the estate of a deceased partner shall be accepted by the withdrawing, retiring or expelled partner or by the estate of the deceased partner in full satisfaction of all claims or demands which he or it may have against the partnership.”

It must also be noted that when respondent was admitted to the partnership, he was not required to make and did not make, at that time or at any other time, any contribution to capital account. Under such circumstances it is only natural that the agreement was not intended to compel the other partners to pay a substantial capital sum for the privilege of retaining assets to which respondent had not contributed. Concerning goodwill, it is significant that the agreement contains no provision intended to secure it to the remaining partners as against a withdrawing partner although such provision is made for the case when a partner retires because of age or ill health. In such case, clause 17 of the agreement provides for a retiring allowance subject to the condition that he shall not “in any way compete with the continuing partnership”. It is thus clear that the matter of goodwill was considered in the drafting of the partnership agreement. The wording of the provision for the allowance to a withdrawing partner shows that it was not intended to be a capital payment for goodwill but an allocation of profits and this is conclusive evidence that it is income of the recipient as was held by this Court in MNR v Sedgwick, [1964] SCR 177; [1963] CTC 571.

Much was said of The Partnerships Act (RSO 1960, c 288) but I can find nothing in it which would compel us to hold that the amount allocated to the respondent is anything else than what the agreement intends it to be, namely a share of the 1962 profits. Sections 32 and 33 clearly show that it may be lawfully stipulated that a partnership will continue after the withdrawal of a partner and Section 43 implies that payments to a withdrawing partner may be governed by the stipulations of the partnership agreement.

As always, the facts of two cases are never precisely the same. But the Wahn case, in my view, supports the interpretation I have outlined of the agreement among the partners here.

The appeal of the Minister is dismissed. The Minister shall pay to the defendant all his reasonable and proper costs* [6] in connection with this appeal.