Hanson v. The Queen, 95 DTC 311, [1993] 2 CTC 3125 (TCC)

Mogan, T.C.C.J.:— In June 1980, the appellant subscribed for a unit in a limited partnership called "Omni Drilling Rig Partnership No. 1". The purchase price of the unit was $100,000. Upon subscription, the appellant paid $26,000 in cash and delivered his promissory note in the amount of $74,000 to the general partner, Omni Drilling Ltd. Every unit in the limited partnership was sold on the same terms. To finance its operations, the limited partnership had assigned to the Royal Bank of Canada all of the promissory notes received from its unit holders. In October 1980, pursuant to a refinancing agreement, all of the promissory notes were held as security by three financial institutions: the Royal Bank, Canadian Commercial Bank, and Roynat Inc.

In September 1982, the Alberta Court of Queen’s Bench issued an order dissolving Omni Drilling Rig Partnership No. 1 and appointing a receiver of the undertaking, property and assets of the partnerships. In November 1982, The Royal Bank, the Canadian Commercial Bank and Roynat Inc. commenced an action against the general partner and all limited partners with respect to the promissory notes which were held as security by the financial institutions. The appellant acted on his own behalf in defending the action by the three banks but almost all of the other limited partners (more than 80 in number) retained the Calgary law firm, Code Hunter, to defend their common interests. Examinations for discovery, settlement discussions and other proceedings consumed the time from November 1982 to the summer of 1985.

In 1982, there had been a "cash call” to each unit holder for $16,500 by the limited partnership or its bankers and the appellant had paid that call reducing his liability on his note from $74,000 to $57,500. Ultimately, the three banks and those limited partners represented by Code Hunter settled their dispute. According to the appellant's testimony, those limited partners made payments in the range of $23,000 to $30,000 per unit depending on particular circumstances in full settlement of the bank claims. In May 1986, the appellant settled his dispute with the three banks by paying $15,000 and receiving an appropriate release from each bank.

Although the limited partnership unit was held in the appellant's name and he was sued by the three banks in respect of that unit, he had a 50 per cent partner and was therefore a beneficial owner of only one-half of what I have referred to as his limited partnership unit. When filing his income tax return for 1986, the appellant deducted a business loss in the amount of $5,836.80 which he computed as follows:

When issuing a reassessment for 1986, the Minister of National Revenue disallowed the claimed deduction of $5,836.80. Also, the Minister regarded the appellant as having realized a gain of $21,250 on the settlement of a debt within the meaning of subsection 80(1) of the Income Tax Act. The Minister computed that gain as follows:

The appellant commenced the appeal herein against the reassessment for 1986 and elected the informal procedure. The two issues are whether the appellant is entitled to deduct a business loss of $5,836.80 with respect to the payment he made to settle the claims by the three banks; and whether he benefited from a form of debt forgiveness or gain on settlement of a debt within subsection 80(1) when he settled with the three banks.

It appears on the basis of simple arithmetic that the appellant and his coowner of the unit suffered a financial loss as a consequence of their investment in the limited partnership. They made a down payment of $26,000; they paid a cash call of $16,500; and they paid $15,000 to settle the claims of three banks which were the assignees of the promissory note. Therefore, they were out of pocket of $57,500 with respect to the cost of a partnership unit with no evidence that they had received any profit from the partnership. In the reply to notice of appeal, the Minister of National Revenue computed the adjusted cost base (“ACB”) of the partnership unit acquired by the appellant and his co- owner as follows:

I do not necessarily accept the above computation of ACB (and it may not be relevant to the issues herein) but it does confirm my impression that there were no profits for the partnership to distribute.

On the first issue concerning the appellant's claimed business loss of $5,836.80, that amount cannot be a business loss unless the $15,000 settlement payment to the banks (the appellant's half share being $7,500) was a current expense. The $15,000 paid to the banks was clearly a capital outlay and not a current expense because it was a further and final payment in respect of the purchase price of the appellant's limited partnership unit. That amount of $15,000 increased the cost of the limited partnership unit (capital property) but it was not the kind of current expense which could be deducted in computing income under paragraph 18(1)(a) of the Income Tax Act, R.S.C. 1952, c. 148 (am. S.C. 1970-71-72, c. 63) (the "Act") in the year when it was paid or incurred. Also, the amount of interest ($336.80) paid by the appellant to his co-owner in 1986 was not an expense incurred for the purpose of gaining or producing income from business or property because the limited partnership was dissolved by court order in September 1982 and the receiver appointed at that time had disposed of the partnership property. There was no partnership business after 1982.

On the second issue (whether there was any debt forgiveness under subsection 80(1)), the appellant put forward a number of arguments: that the debt evidenced by the promissory note was not an ascertainable amount; that the promissory note could not be endorsed because it did not meet the conditions of the Bills of Exchange Act, R.S.C. 1970, c. B-5 [now R.S.C. 1985, c. B-4]; that there may not have been value received for the subscription price; that the act of substituting a new general partner had the effect of terminating the original limited partnership, and the appellant has not been a partner since such act of substitution. These are interesting arguments of commercial law which I might have had to consider in depth but for the fact that Fred Bauman, one of the limited partners, did not settle with the three banks. Their claim against him went to trial in the Alberta Court of Queen's Bench.

In reasons for judgment dated June 16, 1986, Royal Bank v. Bauman (1986), 46 Alta. L.R. (2d) 68, 72 A.R. 89 (Q.B.), Mr. Justice Virtue of the Alberta Court of Queen's Bench held in favour of the three banks and awarded judgment against Fred Bauman for the full amount owing in his promissory notes. In particular, Virtue, J. stated in part at pages 76-77, 82 (A.R. 95-97, 99):

I find that the defendant was a fully informed knowledgeable and sophisticated participant when he subscribed to become a limited partner in the venture. When he did so the defendant not only signed the subscription form, but provided three post-dated cheques, aggregating $52,000, a "promissory note" for $148,000, for the balance of his capital contribution, a personal financial worth statement and, of prime importance, a broadly worded power of attorney with "full power of substitution". It is clear from his evidence that the defendant knew that the indebtedness he had undertaken was to be assigned to the plaintiffs as security for loans to be made to the partnership and that the partnership was proceeding immediately to commence and carry on business. The defendant intended to become a limited partner and to have all of the advantages of partnership including the right to share in profits, to have the return of his capital if things went well and to have the income tax benefits which he expected would flow to him from his participation. He knew that he would lose his profits and capital if things went badly. He understood he was to become a limited partner and that was his intention. Throughout the years 1980, 1981 and 1982 he understood he was a limited partner. That was his intention and it remained so until July of 1982 when drilling activity dropped off and a cash call was made upon the limited partners pursuant to the terms of the limited partnership arrangement.

In my opinion the power of attorney signed by the defendant on June 20, 1980 appointing Omni Drilling Ltd. “with full power of substitution as his true and lawful attorney and agent" was sufficiently worded to authorize Omni Drilling Ltd. to substitute 219395 Alberta Ltd. as agent. I am further of the opinion that the power of attorney was sufficient to empower the agent to participate in selecting 219395 Alberta Ltd. as general partner and to execute on behalf of the defendant the partnership agreement, the certificate and notice of amendment and to take the other actions that brought the limited partnership into being with 219395 Alberta Ltd. named as general partner.

An assignee of a debt, unlike the holder in due course of a promissory note, takes subject to all the equities between the assignor and the debtor. Here I find there are no equities which prevent Omni Drilling Rig Partnership No. 1 from recovering on the debt evidenced by the "promissory note". As assignee of that debt the plaintiffs are entitled to recover from the defendant. In addition, the defendant as a limited partner, is liable to the partnership and its assignees the plaintiffs, for the payment of that same indebtedness as the unpaid portion of his capital contribution under his agreements with the partnership as well as under section 56 and subsection 62(1) of the Partnership Act, R.S.A. 1980, c. P-2.

It appears from the amounts referred to in the above reasons for judgment of Virtue, J. that Fred Bauman owned two units in the limited partnership. There was no evidence in this appeal that the appellant's defences against the three banks were or would have been any stronger than the defences of Fred Bauman. Therefore, I conclude that the three banks had a legally enforceable claim against the appellant for the unpaid balance ($57,500) owing with respect to his promissory note. On the evidence herein, there is no doubt that the claim by the three banks against the appellant was settled once and for all when he paid $15,000 to the banks and received their releases in exchange.

Turning to subsection 80(1) of the Income Tax Act, the relevant words are:

80(1) Where at any time in a taxation year a debt. . .of a taxpayer. . .is settled or extinguished. , .by the payment of an amount less than the principal amount of the debt. . . the amount by which . . . the principal amount thereof. . . exceeds the amount so paid . . . shall be applied

(a) to reduce, in the following order. . . .

Applying those words to the facts of this appeal, I find (i) that the appellant had a debt of $57,500 to the three banks as assignees of his promissory note;

(ii) that the debt was settled or extinguished by the appellant's payment of $15,000 in exchange for releases from the three banks; and (iii) that the principal amount of the debt ($57,500) exceeded the settlement payment ($15,000) by $42,500. Therefore, the amount to be applied under subsection 80(1) to reduce certain losses or to reduce the cost of certain property was $42,500. And because the appellant was the beneficial owner of only 50 per cent of the limited partnership unit in his name, the amount to be applied to the appellant under subsection 80(1) is $21,250. For the above reasons, the appeal is dismissed.

Appeal dismissed.