Beaubier T.C.J.:
1 These appeals were heard on common evidence in Toronto, Ontario on May 14 and 15, 1997.
2 The Appellants testified and called John R. McDougall, Mrs. McDougall's husband; Catherine Sharpe, Mrs. McDougall's daughter; Michael Tilley, C.A.; and Michael Fraser, C.A., Mrs. Fraser's son. The Respondent did not call any witnesses.
3 The Appellants are sisters. They were reassessed for their 1991 and 1992 taxation years. Mrs. Fraser was reassessed:1. To increase the amount of her taxable dividend income by $11,438 for 1991 and $37,309 for 1992.
2. To allow corresponding increases in her entitlement to federal dividend tax credits in each year.
1. To disallow a deduction claimed for interest expense of $18,301 in 1991 and $59,693 in 1992 and correspondingly to reduce the amount of taxable dividend income by $11,438 and $37,309 respectively.
2. To decrease corresponding federal dividend tax credits claimed in each year.
4 The Respondent served Requests to Admit on each Appellant and the following was admitted in respect to each Appellant:
1. At all material times Norma C. Fraser (“Mrs. Fraser”) was the sister of Diana C. McDougall (“Mrs. McDougall”).
2. Mrs. Fraser was married to Donald R. Fraser (“Mr. Fraser”) in or about 1956. The Frasers became involved in divorce proceedings in or about 1991. By Judgment dated July 11, 1991, a copy of which is attached hereto under Tab 1, Mr. Justice Malone of the Saskatchewan Court of Queen's Bench ordered that Mr. Fraser should recover the amount of $707,750 from Mrs. Fraser. (With the exception of the date of commencement of the divorce proceedings and that the judgment of Mr. Justice Malone speaks for itself.)
3. At all material times, Mrs. McDougall was married to John R. McDougall (“Mr. McDougall”).
4. On September 5, 1991, Mrs. McDougall borrowed the amount of $707,000 from the Royal Bank of Canada.
5. In 1991, Mrs. Fraser, Mrs. McDougall and Mr. McDougall (the “Partners”) formed a partnership known as the Dellow Group Partnership (the “Partnership”). Upon formation of the Partnership, partnership units were issued to the Partners in the following proportions: Mrs. Fraser - 50%; Mrs. McDougall - 47.6%; and Mr. McDougall - 2.4%. (Except more specifically, Mrs. Fraser was issued 105 Class A Units, Mrs. McDougall was issued 100 Class B Units and Mr. McDougall was issued 5 Class C Units of the Partnership.)
6. On or about December 30, 1991, each of the Partners transferred their shares in S.H. Dellow Holdings Limited (the “Holding Company”), which owned S.H. Dellow Limited (the “Operating Company”) to the Partnership pursuant to subsection 97(2) of the Income Tax Act.
7. Prior to the transfer described above, the common shares of the Holding Company were owned in the following proportions: Mrs. Fraser - 50%; Mrs. McDougall - 47.6%; and Mr. McDougall - 2.4%. (Except more specifically Mrs. Fraser owned 105 common shares, Mrs. McDougall owned 100 common shares and Mr. McDougall owned 5 common shares).
8. In the 1991 and 1992 taxation years, the only income of the Partnership consisted of dividends declared by the Holding Company.
9. In respect of the 1991 and 1992 taxation years, the Partners agreed to allocate the Partnership's taxable dividend income as follows:
| 1991 | |
| Mrs. Fraser | $6,300.00 |
| Mrs. McDougall | $24,300.00 |
| Mr. McDougall | $300.00 |
| 1992 | |
| Mrs. Fraser | $14,700.00 |
| Mrs. McDougall | $73,694.00 |
| Mr. McDougall | $700.00 |
10. Mrs. Fraser filed income tax returns for her 1991 and 1992 taxation years, copies of which are attached hereto under Tabs 2 and 3, respectively.
11. Mrs. McDougall filed income tax returns for her 1991 and 1992 taxation years, copies of which are attached hereto under Tabs 4 and 5, respectively.
12. By concurrent Notice of Reassessments dated June 13, 1994 the Minister of National Revenue (the “Minister”) reassessed Mrs. Fraser's 1991 and 1992 taxation years so as to increase the amount of taxable dividend income included in the computation of her income by the amounts of $11,438.00 and $37,309.00, respectively, and to allow corresponding increases in the federal dividend tax credit claimed in each of those years. Reconstructed copies of the said Notices of Reassessments in respect of Mrs. Fraser, which were mailed to Mrs. Fraser on or about June 13, 1994 and received by her shortly thereafter, are attached hereto under Tabs 6 and 7, respectively.
13. By concurrent Notices of Reassessment dated June 13, 1994 the Minister reassessed Mrs. McDougall's 1991 and 1992 taxation years so as to disallow a deduction claimed in respect of interest expense in the amount of $18,301.00 and $59,693.00, respectively, and so as to reduce the amount of taxable dividend income included in the computation of her income by the amounts of $11,438.00 and $37,309.00, respectively, and to decrease the corresponding federal dividend tax credit claimed in each of those years. Reconstructed copies of the said Notices of Reassessment in respect of Mrs. McDougall, which were mailed to her on or about June 13, 1994 and received by her shortly thereafter, are attached hereto under Tabs 8 and 9, respectively.
14. In so reassessing Mrs. Fraser and Mrs. McDougall, the Minister calculated that a reasonable allocation of the Partnership's taxable dividend income for the years 1991 and 1992 was as follows:
| 1991 | |
| Mrs. Fraser | $15,450.00 |
| Mrs. McDougall | $14,714.00 |
| Mr. McDougall | $736.00 |
| 1992 | |
| Mrs. Fraser | $44,547.00 |
| Mrs. McDougall | $42,426.00 |
| Mr. McDougall | $2,121.00 |
(Except that the Appellants deny that the Minister's allocation was reasonable in the circumstances.)
15. Mrs. Fraser filed Notices of Objection to the reassessments in respect of her 1991 and 1992 taxation years with the Department of National Revenue. Copies of Mrs. Fraser's said Notices of Objection are attached hereto under Tabs 10 and 11, respectively.
16. Mrs. McDougall filed Notices of Objection to the reassessments in respect of her 1991 and 1992 taxation years with the Department of National Revenue. Copies of Mrs. McDougall's said Notices of Objection are attached hereunder Tabs 12 and 13, respectively.
17. The Minister confirmed his reassessments in respect of the 1991 and 1992 taxation years of Mrs. Fraser and Mrs. McDougall by Notification of Confirmations dated December 15, 1994, copies of which are attached hereto under Tabs 14 and 15 respectively.
5 Because Mrs. McDougall's appeal is the key to the determination of Mrs. Fraser's appeal, the Court notes that the following assumptions contained in paragraph 15, of the Reply to the appeal of Mrs. McDougall were established either by admission or in the evidence.
(a) by Judgment dated July 11, 1991, Norma C. Fraser (“Mrs. Fraser”) was ordered to pay her estranged husband, Donald Reid Fraser (“Mr. Fraser”) the amount of $707,750.00;
(b) on August 27, 1991, S.H. Dellow Limited issued a collateral mortgage in support of a $707,000.00 loan from the Royal Bank to the Appellant;
(c) on September 5, 1991, the Dellow Group Partnership (the “Partnership”) was formed by the Appellant, Mrs. Fraser, and John Robert McDougall (“Mr. McDougall”);
(d) at all material times, Mrs. Fraser was the appellant's sister, and Mr. McDougall was the husband of the Appellant;
(e) upon formation of the Partnership, partnership units were issued to the partners in the following proportions: 50% to Mrs. Fraser; 47.6% to the Appellant; and 2.4% to Mr. McDougall;
(h) on September 5, 1991 Mrs. Fraser withdrew the amount of $707,000.00 from the Partnership to enable her to make a matrimonial settlement with Mr. Fraser, and the Partnership was back to having assets of $210.00;
(i) the partnership units issued upon formation of the Partnership, as described in subparagraph (e) above, remained the same and did not fluctuate;
(j) on or about December 30, 1991, each of the partners rolled their shares in a holding company, S.H. Dellow Holdings Limited (“Dellow Holdings Limited”), which owned an operating company, S.H. Dellow Limited (“Dellow Limited”), into the Partnership pursuant to subsection 97(2) of the Act;
(l) in the 1991 and 1992 taxation years, the only income of the Partnership consisted of dividends declared by Dellow Holdings Limited;
(m) there was no business activity in the Partnership other than the receipt of dividends from Dellow Holdings Limited and the subsequent distribution of those dividends to the partners;
(n) the members of the Partnership did not deal with each other at arm's length;
(o) the partners agreed to allocate the Partnership's taxable dividend income for the 1991 and 1992 taxation years among its partners as follows:
| Partner | 1991 | 1992 |
|---|
| Mr. Fraser | $6,300.00 | $14,700.00 |
| Mrs. McDougall (the Appellant) | 24,300.00 | 73,694.00 |
| Mr. McDougall | 300.00 | 700.00 |
6 When the partners subscribed to the partnership, they paid a total of $210 in cash for their units. On September 5, 1991 Mrs. McDougall's capital account in the partnership was credited with the amount of $707,000. Mrs. Fraser withdrew the same sum from the partnership to satisfy Mr. Fraser's judgment. The result of these two transactions was that Mrs. McDougall's capital in the partnership was increased by $707,000 and Mrs. Fraser's capital in the partnership was reduced by $707,000. But the units each owned in the partnership were not changed.
7 All of the witnesses, except Mr. Tilley, testified about Mr. Fraser. The evidence is consistent that from about 1962 until Mrs. Fraser paid him the $707,750 ordered by the Court of Queen's Bench of Saskatchewan, he had every intention of taking over the Dellow corporations and putting Mr. and Mrs. Stanley H. Dellow and their daughters, Mrs. Fraser and Mrs. McDougall out of those corporations by two means: The first was to exercise rights of a minority shareholder to go back into the history of the two family corporations and review every corporate transaction which related to the family and recover any money possible from the various family members, including Mr. McDougall who was the operating manager of S.H. Dellow Limited in its latter years. The second was that Mr. Fraser, a former Mississauga lawyer who was highly experienced in condominium, corporate and development work, would, by any means, get the various Dellow family members and Mr. McDougall out of the corporations and develop the land on which S.H. Dellow Limited operated its building supply and concrete block business into a condominium. All of the members of the family who testified confirmed these experiences with Mr. Fraser and expressed belief that he could and would do these things. The Court accepts their testimony and the fact that their belief was well based and sincere. Furthermore, the Court accepts as fact that Mr. Fraser could and would do these things even if it meant destroying everything with no profit whatsoever to himself. It is for this reason that Mrs. McDougall, Mr. McDougall and Mrs. Fraser formed the partnership after the property judgment which awarded Mr. Fraser $707,750. The $707,750 was the court's estimate of one-half of the value of Mrs. Fraser's interest in Dellow Holdings Limited. Based upon the award to Mr. Fraser and the fear of the McDougalls and Mrs. Fraser as to what Mr. Fraser might do if he acquired an interest in Mrs. Fraser's shares in Dellow Holdings Limited as a result of execution on the judgment, the partnership was formed. It was done on legal advice. Mrs. McDougall borrowed $707,000 from the Royal Bank of Canada and paid it into the partnership as capital. Then Mrs. Fraser withdrew $707,000 from her capital in the partnership in September, 1991 and paid Mr. Fraser the money due on the judgment. The partnership was intended to carry on various businesses. It has always made a profit and had a reasonable expectation of profit. However, the recession that hit Toronto affected Dellow Limited very badly and its business has gone steadily downhill since then. It stopped making concrete blocks about two years ago and it is now for sale. All of the members of the partnership appear to be in their 60's.
8 The Respondent is of the view that Mrs. McDougall and Mrs. Fraser were not active participants in the business of the partnership. Unfortunately, Dellow Limited was unable to generate as much cash as the parties expected. Therefore, the partnership did not form any new business entities as was planned. Mrs. McDougall did not have any other assets with which to repay the loan to the Royal Bank of Canada and it has not been paid down. Insofar as there was any activity in the partnership, the three members of the partnership were equally active. But business activity has been so slow since the partnership's formation that its resources have been used to allow Mr. McDougall to keep Dellow Limited operating.
9 The Respondent alleges that the interest on the loan, which was deducted by Mrs. McDougall, was not incurred directly or indirectly to earn income from business or property. In addition, the Respondent is of the view that the partnership did not use the amount of $707,000 for income producing activities or in the course of carrying on the business of the partnership.
10 A well known tactic of corporate raiders is to get a minority position in a corporation or partnership and then litigate it into submission. The subject's business resources and its entire business activities can be neglected or consumed in carrying out such litigation. In the Court's view, the Appellants had good reason to fear that Mr. Fraser would take this course of action. The evidence of this is overwhelming. Mr. Fraser was a lawyer experienced in these fields of law. He had the intent and expressed it. He had no employment. He could do this litigation himself or he could have other lawyers do it for him.
11 On the evidence before the Court, Dellow Limited owned the business, land and buildings in Mississauga, Ontario. It was managed by Mr. McDougall. Dellow Holdings Limited owned the shares in Dellow Limited and also owned the vehicles operated by Dellow Limited. In essence, it was also managed by Mr. McDougall. Mr. and Mrs. McDougall owned one-half of the shares of Dellow Holdings Limited and Mrs. Fraser owned the other half of the shares of Dellow Holdings Limited. There is no evidence as to whether or not Mrs. Fraser applied for a loan. Mrs. McDougall went to Regina, Saskatchewan and supported her sister, Mrs. Fraser, throughout the divorce and property trials which lasted a number of days. It is obvious that if a commercial loan was to be made in respect to the partnership, Mrs. McDougall was the logical borrower. Her husband is the man who had run the corporations for a number of years. Her loan from the Royal Bank of Canada was supported by a collateral mortgage from Dellow Limited to the Royal Bank of Canada. Ostensibly, it was “to purchase shares”. The Court recognizes this as a very short and simple, if inaccurate, description of what in fact occurred.
12 The loan raised Mrs. McDougall's capital interest in the partnership to a substantial level above that of Mrs. Fraser. As it turned out, the major viable assets in the partnership are still the shares in Dellow Holdings Limited. In 1991, the shares were the immediate prospective assets from which the income of the partnership would initially come. Other investments were expected to follow.
13 Paragraphs 6.4 and 6.5 of Article VI of the Dellow Group Partnership Agreement read as follows:
Article VI Profits, Losses and Distributions
6.4 Allocation of Net Income or Loss. The Financial Income or Financial Loss for each fiscal year of the Partnership shall be allocated to the current accounts of the Partners in proportion to their respective Capital Contributions at the date as of which the allocation is made.
6.5 Distributions. Each Partner shall be entitled to receive distributions from the Partner's current account as and when determined by Unanimous Resolution of the Partners from time to time out of monies derived by the Partnership from all sources in excess of the Partnership's current operating capital requirements, after payment of all operating expenses and after taking all appropriate reserves and the amount per Unit of each such distribution shall be determined by the Partners at the time of declaration. The Partners may declare in their absolute discretion distributions on any of the Units in priority to or after distributions, if any, which may be declared or paid on any other Units in the same amounts or in such differing amounts as they may decide, together with or wholly to the exclusion of any other of the said Units.
14 Essentially, the issue between the parties is whether or not the partners' unanimous resolution that Mrs. McDougall be allocated and paid sufficient to pay the interest on her loan of $707,000 over and above the normal proportionate distribution based upon units is reasonable in the circumstances, within the meaning of subsection 103(1.1) of the Income Tax Act which reads as follows:
Where two or more members of a partnership who are not dealing with each other at arm's length agree to share any income or loss of the partnership or any other amount in respect of any activity of the partnership that is relevant to the computation of the income or taxable income of those members and the share of any such member of that income, loss or other amount is not reasonable in the circumstances having regard to the capital invested in or work performed for the partnership by the members thereof or such other factors as may be relevant, that share shall, notwithstanding any agreement, be deemed to be the amount that is reasonable in the circumstances.
15 There is no evidence that Dellow Limited has a major franchise such as a Home Hardware or Canadian Tire. It was an independent manufacturer and retailer of building supplies. About two years ago it ceased manufacturing concrete blocks and now it merely retails building supplies. At all times it appears to have dealt with the retail trade and small builders. If a commercial investment banker were to invest capital in a small business, it would require a preference such as the partnership has granted to Mrs. McDougall for her capital. This very ordinary commercial requirement of an extra return to the investor of extra capital was agreed to by the partners from the beginning. While it was not in writing, that is the reason for paragraph 6.5, and the partners adhered to that agreement. They had expected more income from the partnership. Had Dellow Limited's business turned out better, Mrs. McDougall could have received extra compensation, new businesses could have been developed and all of the partners could have comfortable incomes. That is far from the case at present.
16 The gist of the testimony on behalf of the Appellants is that their only incomes were from the partnership. Had Mr. Fraser obtained a minority interest, it is clear that he would have litigated to inquire into all of the past dealings of the corporations with family members. There appear to have been very few minutes. The dividends paid out by the corporation were the only projected initial income of the partnership. Those dividends and the income and energies of the partnership would have been expended in litigating with Mr. Fraser. Thus, the purpose for which Mrs. McDougall's borrowed and invested capital was to facilitate carrying on the partnership's businesses by avoiding lengthy litigation. It was commercially expedient to adopt that course and it succeeded. The result was that her capital account in the partnership increased well above that of the other partners.
17 In the Court's view, in 1991 and 1992, the amount of taxable dividend income allocated to each Appellant by the partners is reasonable in view of the investment of capital by Mrs. McDougall, the withdrawal by Mrs. Fraser, and of the income available to the partnership. The amount of income allocated by the Minister for each of those years is unreasonable having regard to the commercial realities of Mrs. McDougall's investment, the security for that investment, and the normal requirements of an investor of capital in a small enterprise such as that carried on by the partnership.
18 On the same basis the Court finds that the interest expenses claimed by Mrs. McDougall in respect to her 1991 and 1992 taxation years were amounts paid in the year by her pursuant to a legal obligation to pay interest on borrowed money used for the purpose of earning income from a business or property.
19 The appeals are allowed and the reassessments of the Minister of National Revenue are vacated.
20 Each Appellant is awarded her party and party costs throughout in respect to these appeals.
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