Walls v. The Queen, 96 DTC 6142, [1996] 2 CTC 14 (FCTD), rev'd 2002 SCC 47

Pinard J.T.C.C.: — These appeals are brought pursuant to subsection 172(2) of the Income Tax Act (the “Act”). The plaintiffs were reassessed by the Minister of National Revenue (the “Minister”) with respect to their 1984 and 1985 taxation years on losses claimed by virtue of their being partners in Fraser Storage Park Partnership (the “Partnership”).

Pursuant to my Order dated August 17, 1995, these four cases were heard together on the same evidence. The four statements of claim and defences are identical on each related file. The only difference is that two actions pertain to the plaintiff Walls and two actions pertain to the plaintiff Buvyer. On each of those pairs, one action is for the 1984 taxation year and one is for the 1985 taxation year.

In July of 1983, Fraser Storage Park Ltd. (“FSPL”) was incorporated pursuant to the laws of British Columbia. One-third of the issued shares of FSPL were owned by Victor Bolton through a holding company. In the fall of 1983, FSPL agreed to purchase a mini-warehouse located in the municipality of Matsqui, B.C., from Twin Builders Ltd. for stated con- sideration of $1,180,000. Title to the mini-warehouse was transferred to FSPL in December of 1983. Raymond Matty and Victor Bolton carried out the negotiations relating to that purchase on behalf of FSPL. In October of 1983, the Partnership was founded, with the General Partner being Brem Management Ltd. (“Brem”) and the Founding Partner being Matty Developments Ltd. Raymond Matty and Victor Bolton each owned 50% of the shares of Brem, and Raymond Matty owned all of the shares of Matty Developments Ltd. On October 13, 1983, FSPL entered into an interim agreement to sell the mini-warehouse to Brem on behalf of the Partnership for $2,200,000 payable by way of $1 in cash and the balance by way of agreement for sale with interest payable at 24% per annum to FSPL. Raymond Matty and Victor Bolton negotiated the purchase and sale of the mini-warehouse on behalf of both FSPL and the Partnership. The “transfer of an estate in fee-simple” between Twin Builders (1979) Ltd. and FSPL, with respect to the mini-warehouse, as well as the Agreement for Sale of the mini-warehouse between FSPL and Brem on behalf of the Partnership were all registered on December 30, 1983.

The plaintiffs were both limited partners in the Partnership. In 1984, due to a depressed real estate market, the plaintiffs claimed it was impossible to obtain conventional financing with respect to projects such as the purchase of the mini-warehouse. If financing could be obtained, the general rule was that the lender would require substantial equity in the project and full recourse financing. The Partnership generated losses on the miniwarehouse which were allocated to the plaintiffs and the other partners on a pro rata basis. The plaintiffs accordingly deducted their proportionate share of the aforesaid losses for income tax purposes.

The Minister reassessed the plaintiffs with respect to their 1984 and 1985 taxation years and reduced their losses from the Partnership. The defendant admits reducing the Partnership’s losses by reducing the purchase price of the subject mini-warehouse property on the basis that the fair market value of the property was $1,180,000, not $2,200,000. The Minister reduced the related interest expense by eliminating interest on debt in excess of $1,180,000 and reducing interest on the basis that the interest rate of 24% on debt in the amount of $1,180,000 was excessive (at trial, however, the defendant admitted that the 24% interest rate above is a reasonable rate of interest for the purpose of these appeals). The plaintiffs filed notices of objection but the Minister, by notification of confirmation, confirmed the notices of reassessment, hence the present appeals.

The relevant provisions of the Act read as follows:

9. (1) Income. - Subject to this Part, a taxpayer’s income for a taxation year from a business or property is the taxpayer’s profit from that business or property for the year.

18. (1) General limitations. - In computing the income of a taxpayer from a business or property no deduction shall be made in respect of (a) general

limitation. - an outlay or expense except to the extent that it was made or incurred by the taxpayer for the purpose of gaining or producing income from the business or property;

20(1) Deductions permitted in computing income from business or property. — Notwithstanding paragraphs 18(l)(a), (b) and (h), in computing a taxpayer’s income for a taxation year from a business or property, there may be deducted such of the following amounts as are wholly applicable to that source or such part of the following amounts as may reasonably be regarded as applicable thereto:

(c) interest. — an amount paid in the year or payable in respect of the year (depending upon the method regularly followed by the taxpayer in computing his income), pursuant to a legal obligation to pay interest on

(i) borrowed money used for the purpose of earning income from a business or property (other than borrowed money used to acquire property the income from which would be exempt or to acquire a life insurance policy),

(ii) an amount payable for property acquired for the purpose of gaining or producing income therefrom or for the purpose of gaining or producing income from a business (other than property the income from which would be exempt or property that is an interest in a life insurance policy),

67. General limitation re expenses. — In computing income, no deduction shall be made in respect of an outlay or expense in respect of which any amount is otherwise deductible under this Act, except to the extent that the outlay or expense was reasonable in the circumstances.

69. (1) Inadequate considerations. - Except as expressly otherwise provided in this Act, (a) where a taxpayer has acquired anything from a person with whom

he was not dealing at arm’s length at an amount in excess of the fair market value thereof at the time he so acquired it, he shall be deemed to have acquired it at that fair market value;

96. (1) General rules. - Where a taxpayer is a member of a partnership, his income, non-capital loss, net capital loss, restricted farm loss and farm loss, if any, for a taxation year, or his taxable income earned in Canada for a taxation year, as the case may be, shall be computed as if (a) the partnership were a

separate person resident in Canada;

251. (1) Arm’s length. - For the purposes of this Act, (a) related persons shall

be deemed not to deal with each other at arm’s length; and (b) it is a question of fact whether persons not related to each other were at a particular time dealing with each other at arm’s length.

The plaintiffs submit that the interest expense incurred by the Partnership was not “excessive and unreasonable” as alleged by the Minister and, accordingly, paragraph 18(l)(a) is irrelevant because the interest expense was made for the purpose of gaining or producing income from a business. The plaintiffs further contend that paragraph 20(1 )(c) and section 67 of the Act contain the proviso that expenses in general and interest expenses in particular are deductible to the extent they are “reasonable” or “reasonable in the circumstances” and since the Partnership and FSPL were at arm’s length, and having regard to the terms of the agreement between FSPL and the Partnership, the interest expense was both “reasonable” and “reasonable in the circumstances”.

With respect to the sale price of the subject property as reflected in the Agreement for Sale and the Minister’s reliance on paragraph 69(1 )(a) of the Act, the plaintiffs argue that the price of $2,200,000 represented the fair market value of the property at the material time, and further, that the Partnership was dealing at arm’s length with FSPL.

The defendant submits that the Partnership did not carry on business with a reasonable expectation of profit and therefore, the losses from the storage park operation are not losses from business and cannot be deducted pursuant to paragraph 18(l)(a) by the partners (to the extent of their proportionate interest in the Partnership). This reasoning did not form the basis for the original notices of assessment but is proposed as an alternative argument for upholding the assessments of this trial. For this reason, the defendant accepts that it has the onus of proof of the facts that would support the contention (see Smythe v. Minister of National Revenue (sub nom. Day v. Minister of National Revenue), [1967] C.T.C. 498, 67 D.T.C. 5334 (Ex. Ct.), and Pollock v. R. (sub nom. Pollock v. Canada), [1994] 1 C.T.C. 3, [1994] 2 C.T.C. 385. 94 D.T.C. 6050 (F.C.A.)).

In the alternative, the defendant submits that the Minister correctly determined the amount of the plaintiffs’ losses from the Partnership on the basis that the amount of interest claimed by the Partnership on the debt to FSPL was unreasonable in the circumstances pursuant to paragraph 20(1 )(c) and section 67 of the Act and the fair market value of the miniwarehouse was $1,180,000 at the time that it was acquired by Brem on behalf of the Partnership from FSPL. The Minister alleges that Brem and the Partnership were not dealing at arm’s length with FSPL pursuant to section 251 of the Act and, therefore, Brem was deemed to have acquired the property on behalf of the Partnership at the fair market value.

The reasonable expectation of profit test is dealt with in the Supreme Court of Canada decision of Moldowan v. R. (sub nom. Moldowan v. Minister of National Revenue), [1978] 1 S.C.R. 480, [1977] C.T.C. 310, 77 D.T.C. 5213. At pages 485 and 486, the Court states:

There is a vast case literature on what reasonable expectation of profit means and it is by no means entirely consistent. In my view, whether a taxpayer has a reasonable expectation of profit is an objective determination to be made from all of the facts. The following criteria should be considered: the profit and loss experience in past years, the taxpayer’s training, the taxpayer’s intended course of action, the capability of the venture as capitalized to show a profit after charging capital cost allowance. The list is not intended to be exhaustive. The factors will differ with the nature and extent of the undertaking: R. v. Matthews [(1974), 74 D.T.C. 6193]. One would not expect a farmer who purchased a productive going operation to suffer the same start-up losses as the man who begins a tree farm on raw land.

In applying these criteria to the subject storage park operation, I agree with counsel for the defendant that the first test, profit and loss experience, is not particularly helpful in this case. The enormous increase in the expenses of the storage park, which resulted from the Interim Agreement, the Services Agreement and the Management Agreement, introduced an element into the profit and loss calculation which did not exist prior to 1983. During each year from 1984 to 1986 inclusive, the Partnership was obligated to pay the following under the terms of the latter agreements: $528,000 of interest annually on the $2,200,000 purchase price of the property; $140,000 per year in fees under the Services Agreement; $50,000 per year in management fees; and, 50% of the annual net operating profit (profit before taking into account the financing and service fee payments). Therefore, at a minimum, the Partnership would have to pay $718,000 annually over and above the cost of actual operation of the storage park. Any of these amounts which were not paid were to be accrued as part of the Operating Loan and would bear interest at 24%. Any determination of future profitability would have to take these expenses into account and comparison with previous years, when these expenses did not exist, would not be appropriate.

In my view, the key factor to be considered is the capability of the venture as capitalized to show a profit after charging capital cost allowance. The only capital that entered this venture was the Partnership unit subscription fees that totalled $1,431,000 over three years. Of this amount, $428,993 went to pay the costs of the offering, leaving just over a million dollars to be paid in semi-annual instalments. The partners were not liable for any other contributions. Even before the charging of capital cost allowance, the storage park was assured of large losses in the first three years and it was reasonable to expect that these losses would continue thereafter, although to a reduced extent. Obviously, the main factor in the initial large losses was the interest payable on the Agreement for Sale which was set at $2,199,999 on a purchase price of $2,200,000. The only means of reducing the interest payments on the Agreement for Sale would have been to pay down the amount owing, which would have required additional capital. Considering the additional annual expenses which resulted from the Services and Management Agreements payable over and above the cost of actual operation of the storage park, and given that in October 1983 the storage park’s actual gross rental revenue before taking into account any expenses was only about $160,000, it was inevitable that the Partnership would accumulate a rapidly increasing debt to FSPL.

An amount of debt accumulation of some $1,115,000 by the end of 1986, in addition to the Agreement for Sale debt of $2,200,000, was outlined in the pro forma financial projections prepared by Raymond Matty and his accountant and was included in the Partnership Offering Memorandum. It was suggested by Raymond Matty that the storage park operation could be expected to produce profits after 1986 because the Operating Loan and the Agreement for Sale were going to be refinanced and a portion of the debt would be carried at a low interest rate by FSPL. However, the other portion of the debt, a first mortgage for 80% of the value of the property at the time, was to be financed at market rates. Significant financing expenses would still have to be met by the Partnership after 1986. No account was taken of how the Partnership would deal with the accumulated debt at the end of the period for which FSPL had agreed to carry the second mortgage, when market rate financing would have to be found. With respect to the rental rate and vacancy rate assumptions made in the attachment to the pro forma financial projections included in the Partnership Offering Memorandum, the projections called for rental rates of $6.75 per square foot and a vacancy rate of 30% in 1984. Given the supply of storage park space that then existed in the Matsqui Sumas Abbotsford region, steadily increasing rental rates and declining vacancy rates do not appear to be reasonable in light of the actual rental rate which was $5.50 per square foot in late 1983 and the vacancy rate which was about 50%. Furthermore, these projections, which were described by Raymond Matty as optimistic, were made during the second year that the local economy had been in a serious recession. In fact, even with the refinancing of the Partnership debt at the end of 1986, the Partnership recorded a loss before depreciation of approximately $23,000 for the year ending December 31, 1987. The actual rental rates remained around their 1983 level for several years, according to Raymond Matty, and the vacancy rate declined, but not to the extent forecasted.

As things stood, the Partnership was unable to make a profit because it was effectively under capitalized. No plan existed to raise additional capital to reduce the debts of the Partnership. The inability of the venture as capitalized to show a profit, even before taking capital cost allowance, is a clear indication that the Partnership did not have a reasonable expectation of profit.

With regard to the remaining criteria stated by the Supreme Court of Canada in Moldowan (supra), neither Raymond Matty, Victor Bolton nor the plaintiffs had any previous experience running a storage park. The intended course of action was stated to be to increase the occupancy of the storage park and increase the income from it in order to realize its “inherent value” but no details of how this was to be done were given. Finally, the storage park operation in this case was a “going operation” at the time it was purchased by the Partnership in 1983. There is no basis for claiming that the losses incurred relate to a start-up period.

Given all the circumstances, it appears to me that the Partnership did not carry on business with a reasonable expectation of profit. Rather, it was set up as a tax shelter, with the intention that the operation of the storage park would give rise to large initial losses in order to provide the limited partners with tax claims. Both Raymond Matty and the plaintiff Robert Buvyer confirmed that the reduction of tax was a major reason for the existence of the shelter. The Partnership Offering Memorandum details the anticipated losses for the first four years and the tax reduction that would result for taxpayers in the 50.5% marginal tax bracket.

Tax Deferral Benefits: Each $26,500.00 investment will produce estimated tax deferral benefits equal to $23,643.00 over the 1983-1986 period, leaving an after-tax cost of approximately $2,857.00 for an investor with a 50% marginal tax rate.

I believe that the reduction of tax in this case was the sole reason for the existence of the shelter. In the case of Moloney v. R. (sub nom. Moloney v. Canada), [1992] 2 C.T.C. 227, 92 D.T.C. 6570, the Federal Court of Appeal considered the case of a tax shelter arrangement and stated the following, at pages (C.T.C. 227-28) (D.T.C. 6570):

While it is trite law that a taxpayer may so arrange his business as to attract the least possible tax (see Duke of Westminster’s Case, [1936] A.C. 1), it is equally clear in our view that the reduction of his own tax cannot by itself be a taxpayer’s business for the purpose of the Income Tax Act. To put the matter another way, for an activity to qualify as a “business” the expenses of which are deductible under paragraph 18(1 )(a) it must not only be one engaged in by the taxpayer with a reasonable expectation of profit, but that profit must be anticipated to flow from the activity itself rather than exclusively from the provisions of the taxing statute.

"18(1) In computing the income of a taxpayer from a business or property no deduction shall be made in respect of (a) an outlay or expense except to the

extent that it was made or incurred by the taxpayer for the purpose of gaining or producing income from the business or property;"

The evidence in this case indicates that the only financial advantage that could reasonably have been expected by a purchaser of a limited partnership unit in this arrangement would have been by way of tax refunds as a result of claiming the inevitable losses from the arrangement. In a recent decision, Enno Tonn et al. Tonn v. R. [1996] 1 C.T.C. 205, 95 D.T.C. 6001 (F.C.A.), the Federal Court of Appeal reconfirmed the suitability of the common law test in Moldowan to such situations:

As a common law formulation respecting the purposes of the Act, the Moldowan test is ideally suited to situations where a taxpayer is attempting to avoid tax liability by an inappropriate structuring of his or her affairs. One such situation is the attempted deduction of an expense incurred to gain a tax refund. [1]

In light of all the evidence, I am satisfied that the defendant has succeeded in establishing that the Partnership did not carry on business with a reasonable expectation of profit. Therefore, the losses from the management of the mini-warehouse or the storage park operation are not losses from business and cannot be deducted by the plaintiffs to the extent of their proportionate interest in the Partnership. Given that conclusion, it will not be necessary to deal specifically with any of the other arguments raised in this matter.

For all the above reasons, the plaintiffs’ appeals will be dismissed with costs.

The plaintiff’s appeal is dismissed with costs.

Appeals dismissed.