Date: 20010522
Docket: 1999-790-IT-G
BETWEEN:
KENNETH DAVID KLEIN,
Appellant,
and
HER MAJESTY THE QUEEN,
Respondent.
Reasons for Judgment
Lamarre, J.T.C.C.
[1]
This is an appeal under the Income Tax Act
("Act") against an assessment made by the
Minister of National Revenue ("Minister") for the
appellant's 1996 taxation year. In assessing the appellant,
the Minister disallowed a business investment loss in the amount
of $103,257 claimed by the appellant for that year and treated it
simply as a capital loss.
[2]
The parties have filed an Agreed Statement of Facts, which reads
as follows:
1. On April 17, 1986 Jasag Investments Ltd. (Jasag) was
incorporated in Manitoba. Shortly after incorporation Jasag
purchased and [sic] undivided ½ interest in the
lands, buildings, and assets of a motel and small car wash
operated in Winnipeg Mb. The owner of the remaining undivided
½ interest was Greenwise Ltd. (Greenwise) an unrelated
corporation.
2. The practical way for Jasag and Greenwise to operate the
motel and car wash assets was as a partnership, and the day to
day management and operations of the motel and car wash were
carried on by them under the firm and business name of Motel 75
under an oral partnership agreement until Feb 28, 1991.
3. The Motel 75 operations had been experiencing serious
financial difficulties for some time and the business required
additional capital and management to survive. Effective Feb., 28,
1991 all the shares in Jasag were sold to the Appellant for
$4.00. The vendors and purchaser of the shares were unrelated and
dealt at arm's length. The Appellant was and continues to be
the sole shareholder and director of Jasag since Feb., 28,
1991.
4. In contemplation of the purchase of Jasag's shares by
the Appellant, on Feb., 27, 1991 the oral partnership agreement
was replaced with a written agreement between Greenwise, and
Jasag, and the Appellant was also made a party thereto.
5. Under the partnership agreement the partners Greenwise and
Jasag were to provide for loans to the partnership of
approximately $300,000.00 to be used to preserve and improve the
motel real estate and in particular to pay substantial
outstanding realty taxes, utility bills, repairs to the buildings
and other debts. Greenwise was to loan and did loan $200,000.00.
Jasag had no money and no equity in any assets and no net worth.
For that reason and other valid business reasons, the Appellant
was made a party to the agreement and was required to personally
loan and did loan the sum of $100,000.00 to the partnership in
lieu of a contribution by Jasag. The Appellant loaned a total of
$103,257.00 to the partnership under the agreement.
6. The financial statements of Motel 75 prepared by
independent auditors from April 30, 1991 and each year thereafter
contain an auditors [sic] note confirming the details of
the loan by the Appellant and state "4. Due to
K.D. Klein In lieu of a capital contribution from Jasag
Investments Ltd. as required by an agreement between the
partners, the contribution was advanced to the partnership by
K.D. Klein. The advance is non-interest bearing."
7. Jasag and Greenwise employed a manager to manage the Motel.
Financial difficulties again occurred and on September 19, 1995
default under a secured debenture occurred and the secured
creditor appointed an interim receiver-manager to replace the
manager employed by the partners and to receive and disburse all
funds received from the motel operations.
8. Greenwise and the Appellant had more than $300,000.00 in
loans invested in Motel 75. In addition to the loans Greenwise
and Jasag had accumulated considerable equity and together with
the Appellant had invested much effort in Motel 75, and both
before as well as after the default and appointment of the
receiver-manager, efforts were made by them to remedy the default
or in the alternative to find a purchaser of the Motel 75
operation and car wash, but their efforts were unsuccessful.
9. The secured creditor proceeded with mortgage sale
proceedings by holding a court ordered and supervised public
auction of the Motel operations and assets on December 20,
1995.
10. The public auction was unsuccessful and on January 4, 1996
the court issued a Notice of Application For Final Order of
foreclosure which granted the owners Jasag and Greenwise and
every other person having an interest in the motel assets a
period of one month after service of the Notice on them to take
proceedings to contest the foreclosure or to pay the arrears or
otherwise remedy the default under the debenture.
11. The appellant was out of the country and was not served,
and on February 19, 1996 the court ordered that the
Appellant be served by substitutional service by registered mail
with a copy of the court ordered Notice of Application For Final
Order of Foreclosure dated January 4, 1996, which was served by
registered mail sometime after February 21, 1996.
12. The motel assets continued to be owned by Greenwise and
Jasag and managed by the receiver-manager until sometime after
March 21, 1996 in accordance with the terms of the Notice of
Application For Final Order of Foreclosure being the date which
was one month after the date that the Appellant was served with
the Notice by substitutional service and on that date the motel
assets of Jasag were transferred by operation of law.
13. After the final order of foreclosure became effective, the
Appellant waited approximately one month until Jasag's fiscal
year end on April 30th 1996 for an accounting of funds
received and disbursed during the Motels [sic] operation
and by the receiver-manager on the final disposition of all the
motel assets but never received same. Thereafter the Appellant
made inquiries that showed there would not be any funds available
from operations or the disposition of the motel assets to be
applied towards his indebtedness.
14. Jasag and Greenwise for a considerable time in 1996 both
before and after the Notice of Final Order of Foreclosure became
effective performed the necessary business activities for going
out of business such as, sales tax returns, employees
[sic] earnings slips, severance slips, dealing with
outstanding claims and accounts receivable and payable, preparing
bookkeeping records for Jasag's April 30 1996 fiscal year
end, etc.
15. The Appellant claimed the loaned sum of $103,257.00 as
non-capital loss of other years in his 1996 tax return. In 1996
the Appellant established that this loan was not recoverable and
was therefor [sic] a bad debt. The Respondent reassessed
this sum as a bad debt under 50(1)(a) and therefor [sic] a
capital loss from a loan made to Motel 75.
16. Jasag was a Canadian controlled private corporations
[sic] (ccpc) and small business corporations [sic]
(sbc) per 248(1) at all material times. The respondent admits
that Jasag was a ccpc and a sbc but only until September 19 1995.
Greenwise was a ccpc and a sbc per 248(1) at all material
times.
Facts
[3]
In his testimony, the appellant said that he made a conscious
decision to lend the money directly to the Motel 75 partnership
as opposed to lending it through his own corporation, Jasag, one
of the partners in the partnership. Indeed, when the appellant
bought the Jasag shares in February 1991, Jasag had no money, no
equity and no bank account and the appellant did not know if it
had any pending contingent liabilities. The appellant was
concerned with ensuring that the money he lent be used in the
partnership and not claimed by anyone else. This is why he did
not open a bank account for Jasag but rather deposited the money
directly into the partnership.
[4]
The Partnership Agreement filed as Exhibit A-4 states the
following in paragraph 8:
8.
The partners [Greenwise and Jasag] shall loan to the partnership
the following amounts without interest to be secured by way of a
second real property mortgage, to be registered against the lands
and to be payable pro rata to the partners at such time as the
partnership assets are sold or the partners unanimously agree,
but not otherwise:
a) Greenwise or Green shall loan to the partnership on or
before the 1st day of March, 1991, the sum of $200,000.00;
b) Klein shall loan to the partnership on or before the 1st
day of March, 1991, the sum of $100,000.00;
[5]
The financial statements of the partnership show a long-term debt
of $103,257 due to the appellant personally. A note to the
financial statements indicates that "in lieu of a capital
contribution from Jasag Investments Ltd. as required by an
agreement between the partners, the contribution was advanced to
the partnership by K.D. Klein. The advance is non-interest
bearing" (Exhibit A-7).
[6]
Although the Partnership Agreement states that he was to have the
general care, control and management of the partnership business
and assets (Exhibit A-4, paragraph 14), the appellant
testified that he moved from the province of Manitoba to the
province of Ontario in the fall of 1991. He stated that his
involvement with the partnership was that of an absentee partner
once he left the province of Manitoba. Consequently, he did not
have much input into the operation of the partnership's
business or into the preparation of the financial statements,
particularly in 1995 and 1996. According to the appellant, it was
Greenwise, the other partner -- with which he had few discussions
between 1991 and 1995 -- that made decisions for the partnership.
According to the appellant, he was never advised that the
partnership's business activities had ceased in September
1995, when the receiver-manager was appointed. He eventually
received the Notice of Appointment of a receiver-manager by
the secured creditor, which notice was filed as Exhibit A-9. Even
at that time, it was not clear to the appellant that the business
had been closed down. The appellant said that in 1991, before he
invested $100,000 in the partnership, the business had
experienced similar financial difficulties, the debenture holder
having started proceedings under his mortgage. At that time, the
appellant had had to obtain an injunction to prevent the
debenture holder from proceeding.
[7] A
mortgage sale of the assets used in the partnership's
business held by the secured creditor on December 20, 1995, was
unsuccessful. The partnership's financial statements for
the period ended September 18, 1995 (date of the appointment of a
receiver-manager by the creditor) showed no cash available, no
accounts receivable and low inventory on the balance sheet.
Still, the appellant claims that he did not realize that
Greenwise, the other partner, would not refinance the business
until the final order of foreclosure was issued in February 1996.
The appellant himself was asked to contribute more money to the
partnership in the fall of 1995, but he was not interested in
investing any more in that venture.
Arguments of the parties
[8]
Counsel for the respondent submits that the appellant chose for
business reasons to lend money directly to the partnership as
opposed to lending money through his corporation, Jasag. It is
the respondent's position that a loan to a partnership does
not qualify as an allowable business investment loss within the
meaning of paragraph 39(1)(c) of the Act, which
reads as follows:
SECTION 39: Meaning of capital gain and capital
loss.
(1) For the purposes of this Act,
. . .
(c)
a taxpayer's business investment loss for a taxation year
from the disposition of any property is the amount, if any, by
which the taxpayer's capital loss for the year from a
disposition after 1977
(i) to which subsection 50(1) applies, or
(ii) to a person with whom the taxpayer was dealing at arm's
length
of any property that is
(iii) a share of the capital stock of a small business
corporation, or
(iv) a debt owing to the taxpayer by a Canadian-controlled
private corporation (other than, where the taxpayer is a
corporation, a debt owing to it by a corporation with which it
does not deal at arm's length) that is
a small business corporation,
. . .
SECTION 50: Debts established to be bad debts and shares of
bankrupt corporation.
(1) For the purposes of this subdivision, where
(a)
a debt owing to a taxpayer at the end of a taxation year (other
than a debt owing to the taxpayer in respect of the disposition
of personal-use property) is established by the taxpayer to have
become a bad debt in the year . . .
and the taxpayer elects in the taxpayer's return of income
for the year to have this subsection apply in respect of the debt
or the share, as the case may be, the taxpayer shall be deemed to
have disposed of the debt or the share, as the case may be, at
the end of the year for proceeds equal to nil and to have
reacquired it immediately after the end of the year at a cost
equal to nil.
[9]
Pursuant to paragraph 39(1)(c), a taxpayer may claim a
business investment loss from the disposition of a property that
is, in particular, a debt owing to the taxpayer by a
Canadian-controlled private corporation that is a small business
corporation. According to counsel for the respondent, a debt that
is owed by a partnership is not a debt owed by a
Canadian-controlled private corporation.
[10] In the
alternative, the respondent submits that Jasag did not qualify as
a small business corporation as of September 1995, when the
receiver-manager took over the partnership's business on
behalf of the debenture holder. A small business corporation is
defined in subsection 248(1) as follows:
"small business corporation" -
"small business corporation", at any particular time,
means, subject to subsection 110.6(15), 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,
(b) shares of the capital stock or indebtedness of one or
more small business corporations that are at that time connected
with the particular corporation (within the meaning of subsection
186(4) on the assumption that the small business corporation is
at that time a "payer corporation" within the meaning
of that subsection), or
(c) assets described in paragraphs (a) and
(b),
including, for the purpose of paragraph 39(1)(c), a
corporation that was at any time in the 12 months preceding that
time a small business corporation, and, for the purpose of this
definition, the fair market value of a net income stabilization
account shall be deemed to be nil. . . .
[11] According
to the respondent, the assets of Jasag ceased to be used in an
active business on September 19, 1995, and therefore Jasag ceased
to be a small business corporation at that time. Accordingly,
when the appellant was deemed to have disposed of his debt in
1996 (at the end of 1996, the year in which the notice of
foreclosure took effect), Jasag no longer qualified (and did not
qualify in the 12 months preceding the end of 1996) as a small
business corporation. Therefore, counsel for the respondent
submits that the requirements of paragraph 39(1)(c)
are not met and that the loss does not qualify as a business
investment loss.
[12] The
appellant submits that the loan made by the appellant to the
partnership was made on behalf of Jasag, in lieu of a capital
contribution from Jasag, as required by the Partnership
Agreement. The appellant relies on The Partnership
Act of Manitoba, R.S.M. 1987, c.P30, as it read in the years
at issue, which states the following in sections 2, 3, 6 and
12:
Saving for rules of equity and common law.
2(2) The rules
of equity and of common law applicable to partnership continue in
force, except so far as they are inconsistent with the express
provisions of this Act.
Definition of partnership.
3
Partnership is the relation which subsists between persons
carrying on a business in common, with a view of profit; but the
relationship between members of an incorporated company or
association is not a partnership within the meaning of this
Act.
Meaning of firm.
6
Persons who have entered into partnership with one another are
for the purposes of this Act called collectively a firm, and the
name under which their business is carried on is called the firm
name.
Liability of partners.
12
Every partner of a firm is liable jointly and severally with the
other partners, for all debts and obligations of the firm
incurred while he is a partner. . . .
[13] According
to the appellant, the partnership cannot in law owe any money to
the appellant. The partners, i.e. Jasag and Greenwise, are the
ones liable for the debts incurred by the partnership.
Consequently, it can be argued that the loan by the appellant to
the partnership was in fact and in law owed by the corporate
partners, Jasag and Greenwise.
[14] With
respect to the issue of whether Jasag qualified as a small
business corporation at the time the appellant was deemed to have
disposed of his debt in 1996, the appellant submits that Jasag
continued to own and remained the owner of its share of the
assets used in Motel 75 partnership - which were being
managed by the receiver-manager - and retained full rights
to pay the mortgage arrears and, consequently, to employ the
managers of Motel 75 as Jasag and Greenwise saw fit, until the
month of February 1996. According to the appellant, Jasag was a
small business corporation up until the month of February 1996
when there was a foreclosure involving the assets used in the
partnership and the partnership was automatically terminated. The
debt owing to the appellant by Jasag became a bad debt within the
meaning of subsection 50(1) in 1996, in which year Jasag was
still a small business corporation. The appellant therefore
claims that he suffered a business investment loss within the
meaning of paragraph 39(1)(c) of the Act.
Analysis
[15] There is
no dispute that the appellant incurred a capital loss in 1996.
The sole issue in the present appeal is whether the loan in the
amount of $103,257 from the appellant to the Motel 75 partnership
resulted in a debt owing to the appellant by a
Canadian-controlled private corporation that was a small
business corporation.
[16] The first
point raised by the respondent is that the debt involved is the
debt of a partnership and not of a Canadian-controlled
private corporation.
[17] Under the
applicable Manitoba legislation, a partnership is a contractual
relation that subsists between persons carrying on a business in
common (see section 3 of The Partnership Act, of Manitoba,
supra). As leading commentators on English law have
stated:
The legal view of a firm is very different: in English law,
the firm is not generally recognised as an entity distinct from
the partners composing it. (R.C. I'Anson Banks, Lindley
& Banks on Partnership, 17th ed. (London:
Sweet & Maxwell, 1995) at 32.
[18] According
to this view, a partnership is not a separate, independent entity
or body distinct from the partners composing it. In the Income
Tax Act also, a partnership is understood as lacking legal
personality. Indeed, paragraph 96(1)(a) of the Act
requires income to be calculated "as if the
partnership were a separate person". Then there is
paragraph 96(1)(f), which requires partnership income to
be apportioned among the individual members in accordance with
their partnership interests. It is the individual partners who
are liable to pay tax on the income of the partnership. In
Madsen v. Canada, [2000] F.C.J. No. 2139 (F.C.A.), Linden
J.A. stated the following at paragraphs 16 and 17:
. . . In my view, the foregoing 'regime' implies
nothing more than a notional construct for calculating a
taxpayer's tax liability. It is a purely administrative
convenience necessary to sustain the Act's view of the
partnership as a conduit or vehicle for taxpayers.
. . .
17
In this way, the fiction of a partnership as an entity separate
from the partners is temporary and does not extend to colour the
true legal nature of transactions at the time they are entered
into by a partnership. The characterization of legal
relationships is generally left to established principles of
partnership law. This approach was most recently affirmed by this
Court in Adams v. Canada (appeal by Robinson) [See Note 11
below]. . . .
________________
Note 11: [1998] F.C.J. No. 397 (F.C.A.).
[19] Lord
Lindley and Banks express as follows the consequences flowing
from the legal view of partnership, at pp. 19-20:
. . . the firm is not an entity distinct from the individuals
composing it and the partners collectively cannot acquire
rights or incur obligations. The rights and liabilities of a
partnership are the rights and liabilities of the partners and
are enforceable by and against them individually. The principle
is stated by the civilian lawyers thus: Si quid societati
debetur singulis debetur et quod debet societas singiuli
debent. (If anything is owed to the partnership, it is owed
to the individual members and the individual members owe what is
owed by the partnership).
[20] In
Green v. Hertzog, [1954] 1 W.L.R. 1309, Lord Lindley
described the ramifications of a partnership's having no
separate legal personality in the following terms:
The law, ignoring the firm, looks to the partners composing
it; any change amongst them destroys the identity of the firm;
what is called the property of the firm is their property, and
what are called the debts and liabilities of the firm are their
debts and their liabilities.
[21] The same
theory can be derived from The Partnership Act of Manitoba
where it is clearly stated in section 12 that "every
partner of a firm is liable jointly and severally with the other
partners, for all debts and obligations of the firm incurred
while he is a partner".
[22] The legal
view of a partnership, which is adopted by the provincial
legislation, clearly states that the partnership itself does not
have the capacity to be indebted. The debt of the partnership is
owed by the partners, in the present case Jasag and
Greenwise.
[23] Clause
39(1)(c)(iv)(A) of the Act states that a business
investment loss relates to "a debt owing to the taxpayer by
a Canadian-controlled private corporation . . . that is a small
business corporation".
[24] The
question now remains as to whether Jasag, which owed the debt to
the appellant, was a Canadian-controlled private
corporation that was a small business corporation in 1996, the
year the debt was disposed of, i.e. the year the debt became a
bad debt.
[25] It is not
questioned that Jasag was a Canadian-controlled private
corporation. The respondent is, however, of the view that Jasag
was not a small business corporation after September 19, 1995,
when a receiver-manager was appointed by a secured creditor. The
respondent submits that the assets of Jasag ceased to be used in
an active business at that time and Jasag therefore ceased to be
a small business corporation.
[26] It is
agreed by the parties in the Agreed Statement of Facts that the
interim receiver-manager was appointed by the secured creditor to
replace the manager employed by the partners and to receive and
disburse all funds received from the motel operations (paragraph
7). It is also agreed that the motel assets continued to be owned
by Greenwise and Jasag (the two partners) and managed by the
receiver-manager until sometime after March 21, 1996 in
accordance with the terms of the Notice of Application for Final
Order of Foreclosure (paragraph 12). Nor does the respondent
dispute the fact that Greenwise was a small business corporation
at all material times.
[27] In order
for a corporation to qualify as a small business corporation,
subsection 248(1) requires, in particular, that all or
substantially all of the fair market value of the assets of the
corporation be used principally in an active business carried on
by that particular corporation.
[28] As
evidenced by paragraph 1 of the Agreed Statement of Facts, it
would appear that Jasag's only asset was the one-half
interest in the lands, buildings and assets of a motel and car
wash operated under the name of Motel 75.
[29] Whether
these assets were used primarily in an active business carried on
by Jasag is a question of fact, dependent on the circumstances of
this particular case (see The Queen v. Rockmore Investments
Ltd., 76 DTC 6156 (F.C.A.)).
[30] In the
present appeal, it appears that the receiver-manager was
appointed by a secured creditor (see Notice of Appointment to
Debtor, Exhibit A-9), pursuant to the terms of a debenture with
respect to which there had been a default in payment, as receiver
and manager of all the partners' assets, property and
undertaking with such powers as were contained in the appointment
letter. That appointment letter was not filed in evidence nor was
the debenture that led to the appointment of the
receiver-manager, so it is difficult to establish with certainty
the extent to which the receiver-manager could exercise his
powers.
[31] It may
not be crystal clear from the Agreed Statement of Facts and the
documents filed in evidence whether or not an active business
ceased to be carried on as of the date the receiver-manager was
appointed on September 19, 1995. However, it is admitted by the
parties that the interim receiver-manager was appointed to
replace the manager employed by the partners and to receive and
disburse all funds received from the Motel 75's operations.
In my view, this is certainly an indication that the Motel
75's operations were still being actively carried on and that
the receiver-manager was there to operate the business in
lieu of the former manager appointed by the partners.
[32]
Furthermore, it is agreed by the parties that the partners,
Greenwise and Jasag, had invested much effort both before and
after the default and the appointment of the receiver-manager in
attempting to avoid or remedy the default, or in the alternative,
in finding a purchaser for the Motel 75 operation and car wash.
It is also agreed that Motel 75's assets continued to be
owned by Greenwise and Jasag but managed by the receiver-manager
until sometime after March 21, 1996.
[33] In my
view, this is an indication that the receiver-manager was acting
not only as an agent for the secured creditor but also as an
agent of the debtor partners for the purposes of managing the
business, as is frequently the case in common law with a
privately appointed receiver-manager (see F. Bennett,
Receiverships (Toronto: The Carswell Company Limited,
1985), Chapter 1, "5. Personal Liability of Receiver and
Manager", pp. 6-7).
. . . Under many security instruments, the receiver and
manager is a "double agent". He is appointed by the
security holder to take possession and realize, while at the same
time he is deemed to be the agent of the debtor for the purposes
of managing the business and contracting with third
parties.17
__________________
17 See Chapter 5, "2.(b) Status of Privately
Appointed Receiver and Manager".
[34] Although
I am fully aware that the filing of the security instrument
giving rise to the appointment of the receiver-manager would have
been more than helpful, particularly to establish the presence of
a deemed agency clause, I find that the facts agreed upon by the
parties are sufficient to enable me to conclude that an active
business was still being carried on on behalf of the debtor
corporations Jasag and Greenwise until sometime after March 21,
1996.
[35] I must
add here that it strikes me that the respondent did not challenge
the fact that the other partner, Greenwise, was a small business
corporation at all material times. Although this may have been
agreed upon by the respondent in relation to other facts or with
respect to other operations carried on by Greenwise, no evidence
was put before me to differentiate the cases of Greenwise and
Jasag. Besides, it is worth remembering that, under
The Partnership Act of Manitoba, Greenwise is jointly
and severally liable with Jasag for the debt owed to the
appellant. I did not find anything in the Partnership Agreement
that would negate that joint liability. As a result, it can be
said that the debt owed to the appellant was also owed by
Greenwise, a Canadian-controlled private corporation that was a
small business corporation at all material times (as agreed by
the respondent).
[36] In
summary, I conclude that both Jasag and Greenwise qualified as
small business corporations within the meaning of the Act
at some point in the 12 months preceding the time the
appellant's debt was disposed of, at the end of 1996.
Consequently, I conclude that the appellant incurred, in 1996, a
capital loss from the disposition of a property that was a debt
owed to him by Jasag and Greenwise, both Canadian-controlled
private corporations that were small business corporations at
some point in the year 1996.
[37] As a
result, the appellant is entitled to claim a business investment
loss in the amount of $103,257 for his 1996 taxation year,
pursuant to paragraph 39(1)(c) of the Act.
[38] The
appeal is allowed with costs.
Signed at Ottawa, Canada, this 22nd day of May 2001.
"Lucie Lamarre"
J.T.C.C.
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