development as a complement to Mr. Langille’s business
of providing residential and light commercial concrete foundations.
[4]
In early 1999, Mr.
Langille was introduced to Sheldon Leard, the general manager of a company,
Can-do Construction, and a subsequently incorporated company, Trev‑Cor
Trading Inc. (“Trev-Cor”), which operated out of offices in Dartmouth, Nova Scotia. Eventually Mr. Leard invited
Alland to participate in a deal involving the purchase and sale of liquidated
goods. The first deal involved an amount of $2,000 being advanced to Trev‑Cor.
After this initial deal, these trades became more frequent. Altogether Alland
participated in approximately 42 or 43 such trades during the period February
1999 to May 2000, only five of these trades were documented by promissory notes
made by Trev‑Cor. Each of these inventory trades was characterized by
Alland advancing funds to Trev‑Cor so that Trev‑Cor could purchase
liquidation, bankruptcy and overstocked items and then re-sell the goods at a
profit. Upon completion of a deal, Alland’s initial advance would be returned
to it, plus a share of the net gain from the inventory trade, which corresponded
to Alland’s proportionate advance as compared to the total size of the trade.
Depending on the particulars of each deal, Alland would make its decision
whether or not to participate.
[5]
Typically Mr. Langille
would have no contact with the vendor of these goods or the buyer, although he
made numerous inquiries to ascertain the identities. He was not directly involved
in the general logistics of each deal such as the transportation, warehouse
storage costs or insurance. Mr. Langille stated that in the course of a trade
he would make inquiries in respect to items being purchased, shipment handling
and location details. Many trades were arranged through “finders” in the United States, who had located a potential trade opportunity. When
“finders” were involved, they arranged the trade specifics such as
transportation and so forth. Mr. Langille testified that he was never provided
with any information concerning these “finders” except for their first names.
[6]
Mr. Langille testified
that when Alland participated in a trade, after deduction of expenses and costs,
Alland would share in a profit split according to the percentage of funds it
had initially invested in that specific deal. As Alland became more involved in
the trades, Mr. Langille wanted more details about the specifics of each deal.
Except for the promissory notes representing five trades, most of the dealings
between Alland and Trev‑Cor were completed without much formality. Mr.
Langille would generally receive a phone call informing him of a potential
trade and he would then drop by Trev‑Cor’s office to meet with Mr. Leard
to get the particulars. He tried to educate himself on the business by ordering
a book and conducting research on the internet. In addition, he had previously
taken export/import classes at Dalhousie University.
[7]
Mr. Langille met in
person with Mr. Leard at least twice a week and they were conversing so often
by telephone that Mr. Langille purchased a second cell phone to
accommodate the frequency of these calls. He assisted in relocating Trev‑Cor’s
office space by finding a new building that provided additional warehouse
space. He also suggested that Trev‑Cor hire Alland’s accountant because
Mr. Langille wanted a specific paper trail to document these deals. He
testified that he was involved with Trev‑Cor’s activities such as finding
employees for the office and the warehouse and advice on whether deals should
or should not be completed.
[8]
Mr. Langille testified
specifically about three trades which detailed his involvement in Trev‑Cor
on behalf of Alland. One of these trades concerned a container of leather
jackets and, as typically occurred in other trades, a buyer had been secured at
the time Alland decided to participate. Upon inspection of the jackets, the buyer
was reluctant to close the transaction because the jackets had no linings. Mr.
Langille’s evidence was that he was involved in discussions with Mr. Leard
concerning solutions that would salvage this transaction. A decision to have
linings sewn into the jackets appeased the buyer and rescued the transaction.
[9]
In another trade involving pine
plywood from the state of Georgia, Mr. Langille testified that he persuaded Mr.
Leard not to get involved in the trade. On this trade Mr. Leard had already
spoken with the owner or the manager of Piercey's Supplies as a potential buyer
of the plywood, but Mr. Langille had concerns about the lamination of the
plywood and in particular the risk of delamination. Although Mr. Langille
testified that the deal "sounded great" from an economic perspective,
he testified that he also thought that bringing this plywood to Nova Scotia was
a big problem. Alland and Mr. Leard chose not to get involved with that deal
basically on Mr. Langille’s recommendation.
[10]
In Alland’s last transaction
with Trev‑Cor, Mr. Langille was involved in determining the price at
which to buy liquidation inventory, consisting of sweaters from Scotland. At Mr. Langille’s request, Alland’s accountant
travelled to Scotland to value these sweaters. Although the
trade was not completed, Mr. Langille was prepared to travel to Wisconsin to meet with the potential buyer.
[11]
Underlying all of this
evidence is the fact, which is undisputed by the Respondent, that Trev‑Cor
used the funds advanced from Alland to perpetrate a fraud on the company. It is
also undisputed that the Appellant was unaware that Trev‑Cor was
conducting a fraudulent “pyramid” scheme in which Mr. Leard convinced
individuals to invest in the purchase of liquidation and bankruptcy inventory
which was to be resold to buyers at a profit. The evidence suggests most of
these transactions did not occur but Mr. Leard maintained the facade of a
legitimate business by renting warehouse and office space filled with
employees, storing boxes of various samples of merchandise at the premises and
generally giving the appearance of a fast-paced and thriving business
operation. This was simply an artificial and deceptive front behind which Mr.
Leard could operate. Given this background, it is difficult to ascertain with
any certainty whether Trev‑Cor, in any of the 42 or 43 inventory trades
in which Alland participated, actually purchased and sold the items as Mr.
Langille believed, or if the items were bought and sold at a loss. According to
Mr. Langille’s evidence, in the early trades Trev‑Cor did pay returns of
up to 382% of the amount advanced by Alland.
[12]
Several key assumptions
were relied upon by the Respondent in the Reply to the Notice of Appeal at
paragraph 9:
…
(d)
at all material times Alland’s principal business
activity was the investment of funds in an unrelated corporation, namely,
Trevcor;
(e)
the funds from Alland to Trevcor allowed Trevcor
to conduct business operations and to provide an investment return to Alland;
(f)
at all material times Alland reported its income
as being derived from investments;
(g)
Alland was not involved in the day-to-day
operations of Trevcor;
(h)
Alland was not involved in the control or
management of Trevcor;
(i)
Alland was not involved in any joint venture
with Trevcor;
(j)
Alland was unaware that during the time in
question, Trevcor used the investment funds from Alland to conduct a fraudulent
pyramid scheme; and
…
[13]
The issue is whether
Alland is carrying on a specified investment business. This will ultimately
determine whether Mr. Langille can claim the unrecoverable loans made to Alland
as a business investment loss in the 2000 taxation year.
[14]
The Respondent assumed
that Alland was carrying on a business (assumption 9(d)) but that the
principal business activity was the investment of funds. According to the
Respondent, the return from the investment was income from property for the
purposes of the definition of specified investment business, pursuant to
subsection 125(7) of the Income Tax Act (the “Act”). The
Respondent’s position is that Alland’s participation in these trades consisted
of passive investments or as counsel described them “… a series of high-risk
loans with variable returns based on the outcome of Trev‑Cor’s tradings,
if in fact any of them occurred” (Transcript, page 159). Although the Respondent
also argued that Alland could not be a small business corporation according to
the definition because the relevant business of Trev-Cor was not carried on
primarily in Canada, I do not accept that the business of Trev-Cor, which is the
only business with (alleged) activity outside Canada, can be attributed to
Alland. The Respondent asserted that Trev-Cor was entering into purchase and
sale transactions outside Canada. However, other than this assertion, there
is scant evidence that, in fact, any transactions actually occurred either
inside or outside Canada. All or most of these deals belong to the
deceptive hoax that Mr. Leard was perpetrating on the Appellant and other
individuals. Alland’s business is not the business of Trev-Cor. In addition, Alland
cannot be in the business of defrauding itself (Kleinfelder v. M.N.R.,
91 DTC 913).
[15]
Mr. Langille’s position
is that any income arising from Alland’s participation in the trades was income
from the underlying trading activities jointly carried on with Trev‑Cor
and as such the income was in the nature of business profits rather than income
from property.
Analysis
[16]
The relevant portions
of subsection 125(7) define “specified investment business” as follows:
… a business … the principal purpose of
which is to derive income (including interest, dividends, rents and royalties)
from property …
[17]
“Active business”, as
it applies in this appeal, is defined at subsection 248(1) as:
… any business carried on by the
taxpayer other than a specified investment business …
[18]
Again at subsection
248(1) a small business corporation is defined as:
… a particular corporation that is
a Canadian-controlled private corporation all or substantially all of the fair
market value of the assets of which at that time is attributable to assets that
are
(a) used principally in an active business carried on
primarily in Canada by the particular corporation or by a corporation related
to it, …
[19]
The definition of small
business corporation is relevant in the context of the definition of business
investment loss which includes a capital loss from the disposition of “… a debt
owing to the taxpayer by a Canadian-controlled private corporation” that
generally is a small business corporation at the time of the loss.
[20]
The issue, as I have
outlined it, involves an analysis of the “character of the income” in relation
to these inventory trades. This analysis, which will determine whether Alland
was a specified investment business, will take two different approaches because
of the nature of this appeal:
(1)
assuming that the
arrangements between Alland and Trev-Cor created the legal rights and economic
relationships as Mr. Langille believed them to be at that time; or
(2)
recognizing that the
arrangements were simply part of an elaborate fraud that Mr. Leard and
Trev-Cor were perpetrating on Mr. Langille and Alland.
I
have concluded that from the perspective of either approach, any income arising
from the trades cannot be characterized as income from property. It follows
that Alland was not engaged in a specified investment business as alleged by
the Respondent. Since the Respondent has assumed that Alland was engaged in a
business, this conclusion implies that Alland was a small business corporation
and entitles the Appellant to treat his unrecoverable loans to Alland as
business investment losses.
[21]
If the approach is premised
on the inventory trades being bona fide, then the issue is whether
Alland had a passive creditor-like interest in the trades where its income
would be akin to interest, dividends, royalties or rent and therefore income
from property, or whether Alland’s interest was in the capacity of a joint
venture or some other direct interest in each of the inventory trades, where
the income originates from the sale of the underlying inventory and therefore
could not be characterized as income from property, as the term is used in the Act.
[22]
Except for five of the
42 or 43 trades which were documented by promissory notes, there was no written
agreement respecting the relationship between Mr. Langille, Alland and
Trev-Cor. In Johnston v. The Queen, 2000 DTC 1864, which considered a taxpayer that had
been subject to a similar fraud as Mr. Langille by the same perpetrator,
Sheldon Leard, all of the transactions were documented by promissory notes. Only
five of the transactions in the present appeal were documented by promissory
notes. In addition, the parties in Johnston had
entered into a joint venture agreement setting forth the terms of their
relationship, while no written agreement exists in the present appeal. The
Respondent pointed out that, in the present appeal, Mr. Langille advanced
funds to Trev-Cor through his company, Alland, rather than advancing them
directly to Trev-Cor. Bell J. in Johnston affirmed
the principle that a taxpayer could not be treated as carrying on a business of
defrauding itself. However, Bell J. concluded that, since a corporate co‑venturer
defrauding the taxpayer could be considered to be carrying on the active
business of defrauding others, the taxpayer’s loss resulted in an allowable
business investment loss because it arose from a loan made to a small business
corporation.
[23]
The decision in Johnston,
which was affirmed by the Federal Court of Appeal, makes some interesting
comments, based on the evidence, in coming to its conclusion that the venture “
… was one in name only with absolutely no business
activity giving it any status or legitimacy” (page 1873). It is clear that Bell
J. considered it important that the Appellant in Johnston had made no inquiries
in respect to the transactions or generally to any aspect of the alleged
venture, did not seek financial information or statements, provided no
assistance to the venture and had no knowledge and made no inquiries respecting
the contribution and involvement of Mr. Leard’s corporation in the alleged
venture. By contrast in the present appeal, the evidence supports quite the
contrary conclusions. Clearly Mr. Langille was constantly in pursuit of
information and knowledge concerning all aspects of each trade in which he
participated. Although he was not always successful in obtaining the
information, such as the full names of the buyers, finders and vendors, he
continued in his repeated attempts to convince Mr. Leard to provide proper
paper trails for these trades and successfully convinced Mr. Leard to
engage Alland’s own accountant in an attempt to properly catalogue these
trades. The lines of communication between Mr. Leard and Mr. Langille
were so incessant over this period that Mr. Langille was forced to
purchase a separate cell phone to deal with these calls which began as
early as 5:30 in the morning and continued all day. He made several weekly
visits to Trev-Cor’s premises in addition to the constant daily phone
communication. He often inspected samples of merchandise while at the premises.
In fact, at one point Mr. Langille was actually involved in the successful
location of alternate office and warehouse facilities for Trev-Cor to use. He
had discussions and offered suggestions for improving costs and expenses and
hiring of staff. As the trades became more frequent so did their communication.
Mr. Langille testified that he attempted to gain more knowledge of each
and every trade. Before choosing to participate in transactions, he met
personally with Mr. Leard to obtain information and knowledge so that he
could make an informed decision. His level of involvement in some of these
alleged trades, again if we consider them bona fide, was extensive.
He was successful in persuading Mr. Leard to side-step a proposed trade
respecting Georgian plywood because of potential delamination problems. In one
of the last trades, his accountant, Andrew Hunter, traveled to Scotland to
check on and confirm sweater samples.
[24]
Mr. Langille was
actively engaged in soliciting trades, acquiring knowledge about expenses,
looking at samples, interest in remedying the accounting records of Trev-Cor
and daily communication with Mr. Leard. The evidence supports my conclusion
that Alland was completely immersed, to the extent Mr. Leard permitted, in the
trades in which it participated all with a view to a profit on those trades.
The degree of uncertainty associated with Alland’s participation in the trades
is further evidence of engagement in an active business within the marketplace.
Alland was not an investor in Trev-Cor but rather it was a participant with
Trev‑Cor in those trades in which it decided to engage. Alland stood to
gain a percentage of the net profit from those trades and therefore the income
flows from the underlying purchase and sale of the liquidated merchandise
rather than from a property right.
[25]
I agree with the
Appellant’s position that the return to Alland was not income from property because
Alland was a co-venturer with Trev-Cor and thus the income retains the
character of the underlying inventory trades. I also agree that since this type
of return would have existed at a minimum in 37 or 38 of 42 or
43 transactions that Alland’s principal purpose is not to derive income
from property.
[26]
The Respondent’s position
is that no joint venture existed between Alland and Trev-Cor because their
relationship did not meet all of the requirements that a joint venture
apparently must possess as addressed in the Nova Scotia case, Graham v.
Central Mortgage and Housing Corporation and Bras D’Or Construction Ltd.,
(1973), 43 D.L.R. (3d) 686 (N.S.S.C.) (“C.M.H.C.”). As is
often the case in this Court, counsel for the Respondent cited a decision of
another Court dealing with provincial laws that, by happenstance, uses similar
terminology applicable to taxation matters under the Act. Not a moment
was “wasted” by the Respondent’s counsel explaining to this Court why a
decision of the Nova Scotia Supreme Court dealing with the joint and several
liability of a mortgage lender has relevance to the case at bar. In the present
appeal, we are, after all, concerned with whether Alland is entitled to
character flow through from the underlying trades. The Respondent’s logic from
the oral argument would seem to be that if a party does not satisfy the test to
be held jointly liable under Nova
Scotia law that they are not
entitled to character flow through. Since I have concluded that the C.M.H.C.
criteria are satisfied in any event, I do not need to decide whether it would
have any relevance to the instant case if its criteria were not satisfied. I
will, however, say the following with respect to C.M.H.C. If a
contractual interest in a business enterprise does not cause a taxpayer to be a
direct owner of the business enterprise, then in respect of that enterprise I
believe it is doubtful that a taxpayer could be said to receive business income
on a flow through basis. Indirect ownership through partnerships also permits
character flow through, but is addressed under special provisions of the Act.
I understand a joint venture to be a form of direct co‑ownership of an
underlying venture. Thus, to the extent C.M.H.C. may be an authority for
considering when a person may be a direct co‑owner of an underlying
enterprise under Nova Scotia law, which law I assume would govern the
contractual relations of Alland and Trev-Cor, then I agree that this case may
have some bearing on the question at hand. By its own facts, however, C.M.H.C.
must be read as creating at best a necessary but not sufficient condition for
character flow through. The income of C.M.H.C. in that case would appear to
have been unambiguously interest income in spite of the fact that it was held
to be a joint venture participant. I do not think the Respondent would argue
that since C.M.H.C. was in a joint venture that its income from mortgage loans
was somehow transformed into something other than interest.
[27]
According to the
Respondent, Alland did not meet the following three elements for establishing a
joint venture:
1.
there was no contractual
basis;
2.
Alland had no joint
property interest in the inventory purported to be the source of the joint
venture income; and
3.
Alland had no control
or management rights in the enterprise.
[28]
In respect to the first
factor, no contractual basis, the Respondent submits that, assuming there were
third parties involved in these trades, there would be no meeting of minds
unless a contract existed between Trev-Cor and all other participants,
including Alland. If I did have evidence of the involvement of third parties,
in all or some of the trades in which Alland participated, I am not certain
that Trev-Cor and Alland could not have entered into a contractual relationship
giving rise to a joint venture, whether written or oral, where third parties
participated in some manner. Alland chose to participate in any given trade by
contractually agreeing to fund a particular portion of the trade. Trev-Cor then
agreed to fund the balance and if it chose to handle its portion of the funding
by engaging third parties to do so, I do not see how Trev-Cor’s decision to
involve third parties would impact upon the ability of Alland to enter a joint
venture with Trev-Cor.
[29]
In respect to the
second factor, joint ownership, I believe that the Respondent has
inappropriately focussed on the inventory property as the subject matter of the
joint venture when in fact it is the actual gain arising from these trades that
involves the joint ownership aspect. Because Trev-Cor is the participant that
buys and sells the inventory property in its own name, the Respondent views
Alland as having no property interest in the subject matter of the joint
venture. However, after Alland conducted its investigations and decided on a
percentage participation in a trade, it contributed cash to finance this trade
and Trev-Cor (either on its own or with third parties) contributed the balance
of the cash. Once pooled, Alland retained its ownership interest in the cash
that it had contributed. In return for this cash contribution, Alland and
Trev-Cor may be viewed as each having a property interest in the gains from the
trades. Even if I am wrong in this view, the case of C.M.H.C. supports a
conclusion that Alland has a sufficient joint property interest in the subject
matter of the joint venture (again assuming the bona fide existence of
one). In C.M.H.C., the Court concluded that C.M.H.C. had a joint
property interest where it advanced mortgage funding to a sub‑developer.
Alland did not make cash advances without the creation of some legal rights
with respect to such advances, which would ultimately extend to a claim on the
assets of the joint venture in the event of a particular trade not proceeding.
Again this is all premised on the basis of the bona fides of the
transactions. Assuming, arguendo,
that a joint venture did exist, if a trade did not go through after the
inventory property had been purchased then interest holders of the joint
venture would have recourse against, or a claim on, the inventory property at
some level of priority. If such a joint property interest satisfied this
requirement in C.M.H.C., I do not see why it should not satisfy the
requirement in the case at bar.
[30]
The analysis of the
third factor, control and management rights, can be analyzed by adopting two
different approaches. If the 42 or 43 trades are viewed in aggregate as
potentially one single joint venture, then Alland’s complete discretion to
participate or not, in each individual trade by supplying cash, could be viewed
as satisfying the factor of mutual control and management. Each time Alland
decided to participate or not in a trade, despite Trev-Cor carrying out the
actual trade, Alland retained significant control with respect to its
participation in a trade.
[31]
If, on the other hand,
each trade in which Alland participated is viewed from the perspective of being
a separate joint venture between Alland and Trev‑Cor, can we still
conclude Alland enjoyed mutual control and management where the trades were
entirely presented to Alland prior to its decision to participate? I have
evidence before me that, in at least three instances, Alland exercised a
significant degree of control over a trade. These three incidents involved
rectifying the leather jacket trade by arranging for sewing in linings to
satisfy the buyer, persuading Mr. Leard to abandon the Georgian plywood
trade and Mr. Langille’s involvement in the Scottish sweater deal. Each of
these trades involved discussions between Mr. Langille and Mr. Leard
respecting the ultimate outcome or completion of the trade. This is evidence of
a hands-on involvement that a passive investor would not possess. It also
suggests that Alland had considerable persuasive abilities and control over,
not only the direction of a particular trade, but also, the ultimate
participation of Trev-Cor in a trade with or without Alland.
[32]
With only five of the
42 or 43 trades documented by promissory notes, whether the remaining 37 or 38
trades give rise to either one or 37 or 38 joint ventures as discussed
previously, Alland’s principal purpose would be the participation in such joint
venture(s) and thus not the deriving of income from property. In the 37 or 38
trades, under the fiction that they were bona fide, since Alland had
direct ownership in the venture, the income it derived would not have been
income from property. On balance this outweighs the five trades documented by
promissory notes and thus is Alland’s principal purpose. This conclusion is not
altered either by the fact that Trev-Cor entered into these alleged trades to
perpetrate a fraud on Alland and Mr. Langille or by the fact that only some or
perhaps none of the trades actually occurred.
[33]
This leads me to an
analysis of the trades from the perspective of these trades being part of an
elaborate fraudulent scheme. Counsel for both Appellant and Respondent
acknowledged that these trades were part of a scheme and that none of them may
have occurred. They argued that taxation consequences should flow from the
legal and economic arrangements as Mr. Langille and Alland believed them to be
at the time, including treating the trades as if they were generating income
and as if that income would be of the same character it would have been had the
trades been legitimate.
[34]
The definition of
specified investment business references a determination of what the principal
purpose of a business may be. Bowman J. (as he was then) made the following
instructive comments with respect to this determination in Ed Sinclair
Construction & Supplies Ltd. et al. v. M.N.R., 92 DTC 1163, at
page 1165:
In determining the "principal purpose" of a
business carried on by a corporation the stated object of the person who
carries it on is not necessarily the only, or even the most important,
criterion. Of critical importance is what the corporation in fact does and what
its sources of income are [Ben Barbary Company Limited v. M.N.R., 89 DTC
242 at 244]. …
[35]
From the perspective of
this decision, it would appear to be more appropriate to examine the principal
purpose of Alland based on the facts as they actually existed rather than as
they appeared to be. From this perspective would it be reasonable to conclude
that Alland was deriving income from property when its “principal purpose” was
to enter into transactions by which it was being defrauded? In fact, to the
extent that such a fraud is successful, then potentially Alland’s principal
purpose would ensure it either had no income at all or that it incurred a loss.
Even if the principal purpose of Alland could be considered to be deriving
income, when the principal source of such income is designed to ultimately
fail, acknowledging the fraud suggests that the source of any income would be
the re‑shuffling of advances from other participants within the pyramid
scheme. Therefore in reality it is not income at all or at least not from sales
of inventory. With respect to the 37 or 38 undocumented trades, re-shuffling
such payments from other participants cannot convert them into income from
property in any context. If a genuine transaction would not give rise to income
from property, the same transaction will not through alchemy give rise to
income from property when the intention of one of the parties participating in
those transactions is to defraud the other. According to the decision in Kleinfelder,
such payments would not be considered business income from the joint venture
perpetrating the fraud. However, since the Respondent has assumed that Alland
was carrying on business activities independently from any joint venture
enterprise, such payments here could presumably be business income from such a
business. (See Friesen v. Canada, [1995] T.C.J. No. 922.)
[36]
With respect to the
trades documented by promissory notes, it is questionable whether even interest
payments could be made to a victim of a fraudulent pyramid scheme when the
origin of those payments are re-shuffled contributions from other like victims.
However, given my conclusion with respect
to the 37 or 38 trades that were undocumented, whether or not the five
trades documented by promissory notes would have given rise to income from property
will not disturb my overall conclusion that Alland's principal purpose was not
to derive income from property.
[37]
In summary, the appeal
of Alland Developments Incorporated is withdrawn, without costs, by consent of
the parties. The appeal of Lyman Langille is allowed, with costs.
Signed at Ottawa, Canada, this 6th
day of March 2009.
“Diane Campbell”
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