MDS Health Group Ltd. v. The Queen, 96 DTC 1324, [1995] 2 CTC 2526 (TCC), aff'd 97 DTC 5009 (FCA)

O’Connor J.T.C.C.:-This appeal was heard in Toronto, Ontario on June 15 and 16, 1995 pursuant to the general procedure of this Court.

Issue

The principal issue is whether the Minister of National Revenue ("Minister”) was correct in including in the appellant’s income for its 1986 taxation year an amount of $991,025. This in turn will depend on whether an amount of $1,500,000 (U.S.) received by the appellant from a partnership shortly after entering into the partnership agreement represents solely a capital interest in the partnership or consideration (other than an interest in the partnership) received as proceeds for the transfer of certain technology to the partnership.

There was a subsidiary issue of whether the terms of a waiver granted by the appellant with respect to the timing of the reassessment in this matter was sufficient to permit such reassessment. This issue was not vigorously pursued and in any event, in my opinion, the waiver was adequate.

Testimony was given by Wilfred G. Lewitt, the chief executive officer of the appellant during the relevant period and by J. Alex Milburn, a chartered accountant called as an expert by the appellant. Testimony for the respondent was given by L.S. Rosen, a chartered accountant called as an expert. These experts also submitted written reports.

Facts

The most salient facts are set forth in a document entitled ’’respondent’s partial statement of facts”, filed as Exhibit R-1. These facts were either agreed to by counsel for the appellant or proven to the satisfaction of the Court by the evidence. For consistency purposes I have modified the document so as to refer to the partners as "MDS" and "P-E Canada", to MDS’s technology division as "Sciex" and to P-E Canada’s U.S. parent as ”P-E Parent”. So far as material it reads as follows:

1. MDS, incorporated April 17, 1969, is a public corporation engaged in medical lab services and the research and development of scientific equipment. Sciex is its instrumentation technology division.

2. P-E Parent, a U.S. company, is the world’s largest manufacturer of analytical instrumentation for chemical analysis which it distributes world wide and P-E Canada is its Canadian subsidiary.

Development and Deduction of Costs of Elan Technology

3. Sciex had developed Elan technology as part of a qualifying R&D project after MDS acquired Sciex in 1981. The first Elan system was introduced in 1983. There were no sales in 1983. Seven units were sold in 1984 and 22 units were sold in 1985....

4. Sciex had substantially deducted the costs of developing the technology as a current expense for tax purposes as follows....

5. As these expenses had been substantially deducted for tax purposes, the tax cost of the Elan technology was zero.

Joint Venture

6. As Sciex had the technology and P-E Parent the world wide marketing ability, they decided to enter [sic] a joint venture in October 1986. Both parties agreed that the Elan technology was worth at least $3M U.S.

7. The parties entered [sic] a series of agreements on October 31, 1986 to develop, manufacture and market analytical instrumentation using mass spectrometry, operating under the name of Perkin Elmer (PE) SCIEX Instruments (the "partnership”). These included: a joint venture agreement...; a distribution agreement; a manufacturing agreement; a services agreement; a technology licensing agreement; and a trademark agreement. P-E Canada and the appellant were the partners named in the agreement and P-E Parent signed as a party to it.

(Paragraphs 8, 10 and 11 of the document were not totally agreed to by the appellant but it is clear from the evidence that MDS contributed to the partnership technology valued at $3,000,000 (U.S.), P-E Canada contributed $1,500,000 (U.S.) and five days after the partnership agreement MDS withdrew $1,500,000 (U.S.) from the partnership pursuant to section 11.2 of the partnership agreement. Paragraph 7 above refers to a "joint venture agreement". It contained elements of both a partnership and a joint venture but for convenience the agreement shall be referred to as a partnership agreement.)

9. The transaction was reflected as follows in the partners’ capital accounts: Reporting for Tax Purposes

	MDS ($Can)	P-E ($Can)
Nov. 1/86	$4,147,350	$2,073,675
Nov. 6/86 Withdrawal	$2,073,675
of capital
Balance	$2,073,675	$2,073,675

12. The appellant filed an election pursuant to subsection 97(2) of the Income Tax Act, R.S.C. 1952, c. 148 (am. S.C. 1970-71-72, c. 63) (the "Act") which indicated that $3,000,000 (U.S.) in technology had been transferred at an agreed amount of $1.

13. …

D. Ongoing Capital Contributions and Operations

14. Operating profits were enjoyed by the partnership but as expected deficits resulted from ongoing research and development expenses. Capital was contributed equally by the parties to fund the deficit from ongoing research. The contributions were equal.

16. These contributions of sustaining capital were made equally by the parties to the research and development program. Much of this research was being done by MDS.

17. The equipment was manufactured by Sciex. Pursuant to the purchase agreement, Sciex sold Elan to the partnership at 57.5 per cent of U.S. list in year 1, 55 per cent in year 2 and Sciex’s Standard costs [plus] 12 per cent for each subsequent year.... The partnership in turn sold the equipment to PE Parent at 65 per cent of list. PE Parent then distributed the equipment world wide. The partnership made money by the difference between the manufacturing cost and the selling price. Operations and continuing research were financed by these profits and sustaining capital contributions of the partners....

The most relevant provisions of the partnership agreement are the following. This agreement refers to P-E Canada simply as P-E.

2.1 Formation. P-E and Sciex hereby form, as of the date hereof, the partnership as a general partnership pursuant to the provisions of the Partnership Act, Ontario. The name under which the partnership will conduct business shall be Perkin- Elmer/Sciex Instruments and the partners shall forthwith cause the partnership to be registered under that name under the applicable laws of all relevant jurisdictions.

2.3 Scope of Business. The scope of the business of the partnership (defined for convenience as the Field in section 1.4) shall be: research, development, manufacture, and commercialization of Plasma\Mass Spectrometry, Ion Trap Spectrometry, Liquid Chromatography\Mass Spectrometry, Mass Spectrometry\Mass Spectrometry and other hyphenated Mass Spectrometry instrument systems for sale into, but only into, the J-V Markets. The partnership may, subject to the limitations set forth in this agreement, exercise such general powers as may be necessary to further its business within this scope of business, including, without limitation, the incurrence of indebtedness and the pledging of its assets to secure its indebtedness. The partnership shall not engage in any business other than that described in this section 2.3, without the written consent of the partners.

4. Respective Interests of the Partners;

Initial and Sustaining Capital Contributions

4.1 Sciex Initial Contribution. Sciex hereby contributes to the partnership an exclusive, worldwide, royalty-free license for use within the Field of its technology and intellectual property, including the Elan Technology, which is of application within the Field, now existing and as may be developed during the continuance of the partnership. Said license is more fully described and set forth in the Sciex technology license agreement. Sciex and the partnership shall elect that the said license be transferred by Sciex pursuant to subsection 97(2) of the Income Tax Act, Canada, at a nominal consideration.

4.2 P-E and P-E Parent Initial Contributions. P-E hereby contributes to the partnership the sum of U.S. $1,500,000. Reference is made hereby to the additional contribution of P-E & P- E Parent in the technology license agreement. P-E shall not be entitled to draw on this capital contribution.

4.3 Warranty and Indemnity....

4.4 Valuation of Initial Contributions and Equity Interests. For purposes of the partners’ capital accounts, P-E’s and P-E Parent’s initial contribution under section 4.2 is valued at U.S. $1,500,000 and Sciex’s net contribution under section 4.1 is valued at U.S. $3,000,000. Each of Sciex and P-E shall receive a 50 per cent equity interest in the partnership in consideration of their initial contributions.

4.5 Sustaining Contributions. During each of the partnership’s first three fiscal years, each partner will contribute capital of U.S. $500,000, plus additional sustaining capital contributions as the management committee may deem necessary pursuant to section 5.2.

4.6 Related Agreements. As of the date of this agreement, the partnership has executed, and the management committee of the partnership has approved unanimously the partnership’s execution of, the services agreement, the distribution agreement, the purchase agreement, and the technology license agreement. As of the date of this agreement, P-E has executed the distribution agreement, and the technology license agreement, and Sciex has executed the services agreement, the purchase agreement and the technology license agreement. P-E Parent has executed, with the unanimous approval of the management committee, the services agreement, the distribution agreement and the technology license agreement.

8. Funding

Subject to sections 4 and 5.2 hereof, the partners shall pay funds to the partnership, as a contribution to capital, in such amounts as are necessary to fund the partnership’s net cash requirements as reflected in each annual business and financial plan of the partnership. At least 30 days prior to the commencement of each fiscal quarter of the partnership, the management committee shall notify the partners of the partnership’s capital requirements to fund cash requirements, based on a reasonable estimate of budgeted expenses, revenues, and cash flows during each quarter. Each partner shall advance a portion of the total requirements proportionate to such partner’s equity interest in the partnership within 30 days after the date of such notice, provided that funding shall not be required earlier than the first day of the fiscal quarter for which such notice is given.

11. Allocation of Income and Losses; Distributions

11.1 Income and Losses. All net income and net losses of the partnership shall be allocated to the partners in accordance with their respective equity interests.

11.2 Distributions. Distributions shall be made by the partnership at such times in such amounts as the management committee may determine. Any distributions by the partnership to the partners shall be made in proportion to their respective equity interests. Notwithstanding the foregoing, Sciex shall be entitled to an initial distribution by way of return of capital of $1,500,000 immediately after the making of the initial contributions pursuant to section 4.

Other relevant provisions are sections 12 and 13 which may be summarized as follows.

Section 12 provides that the partnership was to continue for a period of 15 years and thereafter for an unlimited number of additional five-year periods unless either partner gives notice of its intention not to renew for such five-year period. Section 12 further provides for termination by either partner where there is a disagreement over a fundamental issue. Section 12 also provides for termination by either partner where there is a material breach of the partnership agreement or any of the related agreements, where there is a change of control of a partner or the other partner becomes insolvent, etc.

Section 13 provides for an orderly winding up of the affairs of the partnership where the partnership agreement expires or is terminated. On providing for a distribution of assets of the partnership, section 13.2 provides that each partner and P-E Parent shall receive from the other partner and P-E Parent as applicable and retain in perpetuity a licence on the same terms as that granted to the partnership for use only within the J-V Markets. This expression, which is also mentioned in section 2.3 of the partnership agreement is a defined term which in effect placed several restrictions on what markets the parties could sell to.

Submissions of the appellant

The principal submissions of the appellant may be summarized as follows:

A partnership was chosen as the appropriate vehicle for bona fide commercial reasons. The choice of a partnership was arrived at early on in the negotiation process. The basic structure proposed was a Canadian partnership between MDS and P-E Canada.

The partnership was intended to be a 50/50 equal interest partnership from the outset. The technology of MDS was valued by the partners at $3,000,000 (U.S.). Counsel submits that hence P-E Canada was required to contribute $3,000,000 (U.S.) cash resulting in a $6,000,000 (U.S.) capitalization for the partnership.

Counsel submits further that since P-E Canada’s initial contribution was only $1,500,000 (U.S.), the partners rectified the imbalance in capital by allowing MDS to temporarily withdraw $1,500,000 (U.S.). However, pursuant to section 4.5 of the partnership agreement, MDS was required to contribute the $1,500,000 (U.S.) over the following three years. Such contribution would be matched by contributions from P-E Canada in order to maintain equal capital contributions.

Counsel’s submission is that on the transfer of the property to the partnership MDS, because of the election filed pursuant to subsection 97(2) of the Income Tax Act, had proceeds of disposition of $1.

Appellant’s counsel referred to Haro Pacific Enterprises Ltd. v. Canada, [1990] 2 C.T.C. 493, 90 D.T.C. 6583. In that case the plaintiff transferred to a partnership, properties worth $1,900,000 (U.S.). The other partner contributed $950,000 in cash. An election was filed pursuant to subsection 97(2) whereby it was agreed that the properties were being transferred by the taxpayer in return for a partnership interest. Approximately five days after the transfer, the plaintiff was paid $950,000 by the partnership. The evidence adduced on behalf of the taxpayer made it clear that there was no other reason for this transfer except as payment in consideration of the plaintiff’s transferring of the properties to the partnership. The Federal Court found that the consideration received for the transfer was both a partnership interest and the $950,000 cash received by the taxpayer a few days after the transfer and, accordingly the $950,000 was included in determining the plaintiff’s proceeds of disposition of the property.

Appellant’s counsel argues that the Haro case can be distinguished on the basis that MDS was required, pursuant to section 4.5 of the partnership agreement, to recontribute the $1,500,000 (U.S.) within the following three years. Counsel states that the relationship between the $1,500,000 (U.S.) extracted and the requirement to recontribute the $1,500,000 (U.S.) is evidenced by a letter written by MDS to Canadian Patents and Development Limited dated July 11, 1986. This letter reads:

RE: ELAN LICENSE AGREEMENT-YOUR FILE NO. 435-7950-1

With reference to our meeting on July 9 in your offices and the above file, I am writing to request consent for a sublicense under the ELAN license agreement.

As we discussed, SCIEX is currently negotiating a joint venture arrangement with a large U.S. corporation (USCO). Under this arrangement USCO will market current and future products based on the pool of SCIEX developed technology for a designated market area, as outlined in the enclosed chart.

While the arrangement has not as yet been consummated, the required agreements are now being drafted and I expect the deal will be signed during the third week in August. As part of the closing documentation it is expected that evidence of your consent to the proposed sublicense under the ELAN license agreement we have with CPDL, will be required.

The need for this arises because the arrangement envisages a sublicense to be issued by MDS Health Group Ltd. to the joint venture’s Canadian partnership under the sublicensing rights contained in section 2A of the ELAN license agreement. This section grants the rights to sublicense "related companies" which are defined to be companies over which there is effective control. As the joint venture partnership will be 50 per cent owned by SCIEX and 50 per cent by USCO, it would appear to fall just outside of this requirement for a sublicense.

It should be noted that, while this sublicense to the joint venture’s Canadian partnership is required, the partnership will license back to MDS the rights to manufacture and SCIEX will continue to manufacture in Canada.

As we discussed at our meeting, there is under negotiation a capitalization arrangement that would flow through an amount from USCO to SCIEX that would be subsequently invested in the joint venture Canadian partnership for research and development. This does not relate specifically to the ELAN but rather to the complete pool of technology and the designated market area.

[Emphasis added.]

It should also be noted that the sublicense will be on terms and conditions similar to those of the CPDL license and that any license to manufacture outside Canada, therefore, could only be achieved with the prior written permission of CPDL. Please call me should you require further explanation or information regarding this.

Counsel submits that the foregoing (especially the emphasized paragraph) clearly demonstrates the nexus between the moneys withdrawn and the moneys to be put into the partnership during the following three years.

Counsel concludes that the appellant’s withdrawal of the $1,500,000 (U.S.) and the minimum required capital contribution of $1,500,000 (U.S.) (provided for in section 4.5 of the joint venture agreement) are part of a composite transaction and are an integral part of the initial financing arrangements between the parties.

After reviewing numerous authorities on the theory of substance over form, counsel submitted that the substance of the transaction leads to this conclusion. He adds that the partnership was an ongoing viable commercial arrangement not a "roll and run" transaction.

Submissions of the respondent

Respondent’s counsel submits that the issue is whether the $1,500,000 (U.S.) which the appellant became entitled to receive as of October 31, 1986, and did receive shortly thereafter, was consideration received in excess of the amount elected and is to be included in income by virtue of paragraph 85(1 )(b) of the Act.

Subsection 97(1) of the Act obliges the partnership to pay fair market value for any property transferred to it by a partner. Unless the transaction qualifies for a rollover, the transfer of property by a partner to a partnership is a disposition which takes place at fair market value.

Subsection 97(2) of the Act permits a taxpayer to defer all or a portion of tax arising on the disposition. However, to the extent the taxpayer receives consideration in excess of the elected amount the rollover is not available.

Counsel for respondent submits that the reasoning in Haro applies in this case and that the appellant was properly taxed on the $1,500,000 (U.S.). In counsel’s written argument she states, inter alta:

(a) As a result of the agreement between the parties, MDS became entitled to a partnership interest and the receipt of $1,500,000 (U.S.) in cash at the time its technology was transferred. The cash of $1,500,000 (U.S.) was received within a few days of closing.

(b) Cash or the entitlement to receive cash is consideration (and for accounting purposes, the appellant recognized the $1,500,000 (U.S.) receipt from the partnership as revenue).

(c) For tax purposes, the entitlement to receive $1,500,000 (U.S.), resulted in

revenue to the extent that this consideration exceeded the elected amount of $1 because:

(i) The appellant had fully deducted the costs associated with the development of the Elan technology as research and development expenses with the result that the cost of the technology for tax purposes was zero.

(ii) The technology could have been rolled over to the partnership tax free so long as consideration other than the partnership interest received at the time of transfer did not exceed $1—a nominal amount which had to be elected as the tax cost of the asset transferred was zero.

(iii) The appellant transferred its technology into the partnership and pursuant to the agreement immediately became entitled to an interest in the partnership and $1,500,00 (U.S.) in cash.

(iv) As the appellant became entitled to the receipt of cash of $1,500,000 (U.S.) at the time the transaction took place, the elected amount could not be less than the value of that consideration. Paragraph 85(1 )(b) of the Act applied to bump the elected amount to the value of the boot-$1,500,000 (U.S.), which was included in the appellant’s income pursuant thereto. Appellant Had No Obligation to "Repay" amount withdrawn

(f) The appellant’s main objective in calling expert [sic] from Ernst & Young was to distinguish itself from Haro by suggesting that it had an obligation to ’’reinvest" the cash it received. This suggestion is contradicted by the terms of the Joint Venture Agreement (which imposed no obligation to repay the initial capital contribution withdrawn and contained no terms on which the appellant to reinvest the cash withdrawn. What the provision did make clear was that the right to withdraw the initial capital contribution made by P-E Canada, belonged to the appellant alone.

(g) The appellant did not book a liability to make capital contributions of $500,000 per year for three years in its books of account;

(h) The appellant does not go so far as to characterize the purported distinction as a "liability". It now calls it a "commitment", not to "repay" but to "reinvest".

(i) The allegation that there was a commitment which was met or could have been met by funding future research is incorrect and irrelevant because:

(i) The cash, which P-E Canada contributed to the partnership as partnership was available to the appellant alone;

(ii) There is nothing in the joint venture agreement which ties the purchase price for the partnership interest (the "initial contribution") to an obligation to make sustaining contributions to ongoing research. Having made the initial contribution each was entitled to its partnership interest. While both parties committed to make sustaining contributions on an equal basis, nothing in the contract ties this obligation to the initial capital contributions and the partnership interest. There was no liability to reinvest the initial capital withdrawn. Once in the appellant’s pocket it could be used as it wished.

(iii) Following the appellant’s submission to its logical conclusion conflicts with the evidence. If we assume that each contributed $1,500,000 (U.S.) at the outset and then contributed equally to ongoing research, at the end of three years there would have been $6,000,000 (U.S.) contributed to the venture. Yet P.E. would have contributed $1,500,000 (U.S.) to the ongoing research, while Sciex would have simply repaid its capital withdrawal and contributed nothing to the ongoing research.

(iv) The obligation of each party to pay an equal amount for ongoing research was a responsibility of each partner separate and apart from the right of the appellant to withdraw cash at the outset. Contributions of capital were made on an ongoing basis to fund research as required.

(v) ...

(vi) That contributions were ongoing, unrelated to the $500,000 (U.S.) and exceeded the $500,000 (U.S.) "commitment" shows that the two matters are quite separate. Had the expenses been made in the year for R&D and the appellant not borne its equal share of the cost of the ongoing research, P.E. would have been able to enforce the right to equal contribution under contract.

(vii) Review of the capital accounts show that the partners consistently contributed equal amounts to fund ongoing research, that these amounts were determined by operations and that the benefit arising from the development of new research became an asset of the partnership, increasing its value of the partnership interests of both partners.

(viii) Tax law considers the tax results of a "transaction" in a "taxation year". The fact that a disposition of an asset gives rise to proceeds which permits taxpayers to invest further in the particular enterprise or in a different enterprise does not effect [sic] the taxability of proceeds when the entitlement arises on a disposition. Once received, MDS could do with the proceeds as it wished.

(ix) Even if the sustaining capital contributions were funded out of the $1,500,000 (U.S.) the appellant received (the appellant did not "use or enjoy the funds" but set the money aside in a safe, so that it earned no interest and was not touched until it was "reinvested" in the partnership), the appellant still enjoyed a benefit equal to $1,500,000 (U.S.), in that, as a result of this transaction MDS had the money in hand. It did not have to draw upon its own sources of funds or borrow to pay the amount to fund ongoing research and development (unlike its partner, who did not receive $1,500,000 (U.S.) at the outset and had to contribute or borrow the money).

(x) There is no evidence of an obligation.

(xi) If there was an obligation of this magnitude owed to the partnership it was certainly material to it and should have been reflected as a receivable in its balance sheet.

The amount of $1,500,000 (U.S.) was properly included in computing income for the tax purposes in the appellant’s 1986 taxation year because the appellant elected $1, while it became entitled to receive, and did receive, consideration far in excess of that amount. This transaction, like Haro, is based on a premise which Madame Justice Reed aptly characterized as “artificial in the extreme" in Haro. Subsection 97(2) and paragraph 85(1)(b) of the Act apply to prevent the deferral of income to the extent consideration had been received.

Analysis

The appellant seeks to distinguish this appeal from the decision in Haro on the basis that in Haro there was no obligation to recontribute the moneys initially withdrawn. He points out that in the present case there was an obligation on Sciex in section 4.5 of the partnership agreement to recontribute the amount of $1,500,000 (U.S.). Although there is no specific commitment to so recontribute the said sum the appellant argues that because of the capital structure and financing of the partnership there was clearly a nexus between the amount withdrawn and the amounts sub- sequently contributed.

Although the issues have been ably argued by both counsel for the appellant, I have concluded that the submissions of the respondent better reflect the true nature of the transaction. In the first place, there is no indication in the partnership agreement that the $1,500,000 (U.S.) withdrawn must be recontributed. Secondly, the continuing obligation to inject $1,500,000 (U.S.) by each partner over a period of three years, in my opinion, simply relates to the additional funding which each party was obliged to make to pay for the costs of research and development. Note that section 4.2 of the partnership agreement refers to "initial contributions" referring to $1,500,000 (U.S.) and the technology and section 4.5 refers to "sustaining contributions". Nothing in the partnership agreement connects the $1,500,000 (U.S.) withdrawn by MDS to the "sustaining contributions". Thirdly, there are no accounting records of any entity showing the liability or obligation of MDS to recontribute the $1,500,000 (U.S.). This amount may not have been material for MDS but it was so for the partnership. Fourthly, in fact the additional contributions made by each partner show no correlation to the $1,500,000 (U.S.) withdrawn. For example, the amounts contributed were not 3 x $500,000 (U.S.) for each partner but rather were instalments contributed from time to time in different amounts, totalling more than $1,500,000 (U.S.) for each partner. Fifthly, although the lengthy testimony given by Wilfred G. Lewitt was credible, in the most important aspect of this case-i.e., the alleged obligation to recontribute the $1,500,000 (U.S.) withdrawn, neither the terms of the partnership agreement nor the subsequent contributions in varying amounts, support his interpretation. The letter of July 11, 1986 to Canadian Patents & Development Limited is not persuasive and moreover is not reflected in the partnership agreement. Sixthly, the expert accounting evidence, if anything, indicates that in the year in question (1986) the most acceptable treatment of a transfer of technology to a partnership was a recognition of a gain by the transferring partner.

The subsection 97(2) rollover is only available when all partners are Canadian. There was some suggestion by counsel for the respondent that this may not have been the case-because of the considerable involvement in the overall venture of P.E. Parent, a U.S. corporation. In view of my conclusion above I need not address this issue.

In conclusion, for all of the above reasons, the appeal is dismissed, with costs.

Appeal dismissed with costs.