Signum Communications Inc. v. The Queen, 88 DTC 6427, [1988] 2 CTC 239 (FCTD)

Martin, J.:—The plaintiff, Signum Communications Inc., is the successor, by way of several amalgamations, of McConnell Advertising Company Limited (McConnell). At issue in this matter is whether McConnell, which was one of the limited partners of the limited partnership known as Tertius Film Investors Limited and Company, can claim as a deduction against its taxable income the amounts which it claims to be its proportionate share of the partnership losses for its taxation years ending November 30, 1975 and November 30, 1976. The defendant submits that the plaintiff may only claim an amount equal to the capital invested in the partnership on the “at risk" principle. The plaintiff has claimed as its share of the partnership losses for 1975 and 1976 the sums of $111,870 and $6,296 respectively. The Minister has disallowed all but $2,500 which he submits is the amount of capital invested by the plaintiff in the partnership and thus the amount "at risk".

On October 31, 1974, McConnell became a limited partner in the partnership which was formed for the purpose of investing in holding and exploiting motion picture films. It executed a partnership agreement paying to the partnership $2,500 of the total capital contribution of $18,250 and, at the same time, paid to Quadrant Films Limited the sum of $47,500 to be deposited or held as security for a loan by Quadrant to the partnership.

Counsel for the plaintiff submits that McConnell's capital contribution to the partnership was $50,000 and not the $2,500 as determined by the Minister. He says that the full $50,000 was at risk, that the substance of the agreement between McConnell and the partnership called for a capital outlay by McConnell of $50,000, that articles 2.03, 8.05 and 8.06 effectively treat the capital investment of the limited partners as the aggregate of their capital contributions and their guarantee liability, that McConnell's auditors recorded the cost of McConnell's capital investment in the partnership to be $50,000 and, finally, that the purpose of having a portion of McConnell's investment in the form of security for a guarantee was to permit a return of that investment without contravening section 14 of The Limited Partnerships Act, R.S.O., c. 247.

I see no merit to any of these submissions. The $47,500 payment was in support of McConnell's guarantee of a portion of Quadrant's loan to the partnership. The fact that it was never intended to be a contribution to the capital of the partnership is clear when one considers the admitted purpose of having it paid as security for a guarantee rather than as capital contributed in the same way as the $2,500 payment. Section 14 of The Limited Partnerships Act prohibits the return of contributed capital during the continuation of the partnership. The guarantee device employed by the plaintiff would, as submitted by counsel for the plaintiff, allow the return of the $47,500 without contravening section 14 of The Limited Partnerships Act for the simple reason that the $47,500 was not a part of the contributed capital.

The fact that the $47,500 may have been at risk to cover debts of the partnership cannot give it the quality of a capital contribution any more than a loan to the partnership can be considered as a part of its capital. The fact that McConnell’s auditors characterized the amount paid out as security for a guarantee as capital invested in the partnership is irrelevant and, in my view, inaccurate.

As to the submission that articles 2.03, 8.05 and 8.06 treat the capital investment of a limited partner as the aggregate of his capital contribution and his guarantee liability I simply do not agree. Merely to state the proposition demonstrates that the agreement clearly distinguishes between a partner's capital contribution and his guarantee. Although, in my view, it is of no significance to the issue before me whether the $47,500 does or does not form a portion of the plaintiff's contribution to the capital of the partnership, I find that the plaintiff's contribution was $2,500.

During 1974 and 1975 the partnership acquired three motion pictures at a total capital cost of over $2 million. After allowing for the disposition of certain percentage interests in the films acquired, the partnership claimed a capital cost allowance of $804,214 in respect of its fiscal year ending December 31, 1974 and $45,037 in respect of its fiscal year ending December 31, 1975. These allowances claimed gave rise to losses for income tax purposes of $816,650 for 1974 and $45,958 for 1975.

McConnell claimed its proportionate ($2,500/$18,250) share of the partnership losses, $111,870 for 1974 and $6,296 for 1975, and deducted these amounts from its taxable income for its taxation years ending November 30, 1975 and November 30, 1976. By notices of reassessment dated June 23, 1980 the Minister disallowed all but $2,500 of the losses claimed.

Counsel for the defendant does not dispute the fact that subsection 96(1) of the Income Tax Act calls for the computation of profits and losses of a partnership as if the partnership were a separate person and that paragraph 96(1)(g) permits the individual partners to claim their share of any partnership losses. What counsel do not agree upon is what constitutes the plaintiff's share of the partnership losses for the plaintiff's 1975 and 1976 taxation years. Counsel for the Minister submits that the plaintiff can only claim as its share of the partnership losses an amount equal to its capital contribution i.e. $2,5000. Counsel for the plaintiff says there is no basis in the Income Tax Act for restricting the plaintiff's share of the partnership losses to an amount equal to the amount of its capital contribution.

In support of his contention that the plaintiff's share of the partnership losses cannot exceed its contribution to the partnership capital counsel for the defendant cited C. Ralph Lipper v. The Queen, [1979] C.T.C. 316; 79 D.T.C. 5246, and Jacques Y. Paquin v. M.N.R. [1974] C.T.C. 2181; 74 D.T.C. 1142. The former case is cited as authority for the proposition that a partner's capital account can never be put in a deficit position and the latter case for the proposition that a partner's claim for his share of a partnership's opera tional loss may never exceed the amount of capital which the partner has contributed to the partnership. These two cases, together with Lawrence H. Mandel v. The Queen, [1978] C.T.C. 780; 78 D.T.C. 6518, appear to have formed the basis of the "at risk" principle which has been invoked by the defendant.

In the Lipper case, Mr. Justice Addy accepted expert evidence to the effect that a partner's capital account cannot be shown to be in a deficit position. I have no such evidence in this case and know of no reason why a partner's capital account cannot be shown to be in a deficit position. Indeed the only evidence with respect to the capital account which I do have are the partnership financial statements which show the account to be in a deficit position.

The so called “at risk” principle sought by the defendant to be applied in this case was disapproved of by Mr. Justice Le Dain in The Queen v. Nahum Gelber, [1983] C.T.C. 381; 83 D.T.C. 5385 (F.C.A.), in which decision he said, with respect to capital cost allowance which might be claimed by a taxpayer:

The degree to which an investment is at risk is not, in the absence of a provision in the Act or the regulations to that effect, a valid criterion as to what is capital cost.

Under the provisions of subsection 96(2.1) to subsection 96(2.7) of the Income Tax Act the "at risk” principle was incorporated but these provisions were not contained in the Act in 1975 and 1976 nor were there any similar provisions which would limit the plaintiff’s share of partnership losses to the amount which it had contributed to the partnership capital. These restrictive provisions were added to section 96 after the 1986 House of Lords' decision in Reed (H.M. Inspector of Taxes) v. Young, [1986] B.T.C. 242 (H.L.), in which case a limited partner was allowed to claim as deductions against her taxable income her share of the partnership losses even though they exceeded her contribution to the partnership capital.

There being no provision in the Act or the Regulations at the relevant times which would limit the plaintiff's claim for partnership losses to the amount of its capital investment in the partnership I can see no reason why it should be limited to that amount.

Counsel for the defendant has raised a further objection to the plaintiff's claim. He submits that the partnership agreement is silent on how losses resulting from the application of capital cost allowance should be borne and that the agreement between the partners, that they should be borne proportionately to the capital contributions of the partners, is an agreement which is made only for the purpose of artificially or unduly reducing the amount of taxes that the parties would otherwise have to pay and should be set aside under the provisions of section 245 of the Act.

I agree with counsel that articles 8.04 to 8.06 of the partnership agreement provide for the calculation of profits or losses without reference to capital cost allowance as defined by the Income Tax Act. I suspect that the omission of capital cost allowance from the profit or loss calculations was because the capital cost allowance deduction is an optional one and the person drafting the partnership agreement did not want to include capital cost allowance in the mandatory clause relating to deductions but instead wished to leave it as an optional deduction to be taken as and when the circumstances would be most advantageous.

The fact that the partnership agreement is silent on the use of capital cost allowance in calculating the partnership profits or losses is of no conse quence in this matter because there is a clear record by way of the financial statements from which it can be inferred that capital cost allowance was to be used in the first years of the partnership's operations in calculating the profits or losses of the partnership and that any profits or losses resulting would be divided among the partners in accordance with their proportional contribution to the capital of the partnership.

Because this agreement can be inferred from the course of the partnership's dealings and reflected in its financial statements over the years or implied because of the apparent acquiescence by the partners in that allocation over the years, sections 20 and 24 of The Partnerships Act, R.S.O. 1970,

c. 339, apply to establish the fact that the capital cost allowance was to have been taken in the early years of the partnership's operations and that the losses resulting were to have been shared by the partners in proportion to their contribution to the partnership's capital.

I do not agree that section 245 has any application to the facts of this case. That there was a large loss in the first year of the operations of the partnership was due primarily to the fact that under incentive legislation the cost of the motion pictures of a partnership could be written off in one year. This gave rise to $804,214 of the total loss of $816,650 for the partnership year ending December 31, 1974. Under the then existing legislation the resultant loss could be claimed by the individual partners. The fact that the partners agreed that the losses would be shared in proportion to their contributions to the capital of the partnership enabled the plaintiff to claim $2,500/$18,250 of the loss or $111,870 which it applied as a deduction against its taxable income.

I can see nothing in that transaction which artificially or unduly reduced the plaintiff's income within the meaning of section 245. The loss was available as a result of a government incentive programme. The loss was properly calculated by the partnership and claimed by the individual partners. The only objection the defendant can make is to the allocation of the losses among the partners. In my view the allocation on the basis of the capital contributed is a normal and usual method of allocating profits and losses within a partnership. It is true that there may be other methods of allocating the profits or losses but I can see nothing in the formula employed by the partners in this matter which would warrant the disallowance by the Minister of the resultant deductions made by the plaintiff from its 1975 and 1976 taxable income.

Finally the defendant claims that the plaintiff cannot claim as a deduction any amount of the partnership losses in excess of its capital contribution to the partnership because any such deduction would be a reduction or postponement of the tax that might otherwise have been or become payable under the Income Tax Act within the meaning of section 103 of the Act. By virtue of section 103 counsel for the defendant submits that the plaintiff's share of the partnership losses should be limited to $2,500 and that amount is the share which, under the circumstances, is reasonable. I do not agree with counsel's submission. The loss, as I have already indicated, arose because of the application of the capital cost allowance permitted by the government's incentive programme to encourage investment in the Canadian film industry. It would be unthinkable that the partners would not take advantage of that loss when completing their own income tax returns. They were entitled to share the loss but if the method which they chose to allocate or share the loss was unreasonable the Minister was entitled to intervene and direct (in effect) that it be shared in a reasonable manner.

If, for example, the partners had agreed that the entire loss of $816,650 for 1974 should have been allocated to the plaintiff there would be grounds for a re-allocation under section 103 because, prima facie, that would not be a reasonable sharing of the loss. However when there is a rational, reasonable and normal formula employed in the allocation of the losses, as there was in this case where they were allocated in proportion to the capital contributed, there are no grounds on which the Minister can invoke the provisions of section 103.

As I can find no valid reason why the plaintiff should not be able to claim as a deduction from its taxable income in its 1975 and 1976 taxation years the share of the losses of the partnership which it did claim I direct that the plaintiff's appeal against the Minister’s reassessments for its 1975 and 1976 taxation years be allowed with costs, that the Minister’s reassessments be vacated and that the plaintiff's tax returns for its 1975 and 1976 taxation years be referred back to the Minister for reassessment pursuant to these reasons.

Appeal allowed.