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Citation: 2003TCC93
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Date: 20030909
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Docket: 96-2573(IT)G, 96-2737(IT)G,
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97-653(IT)G, 97-749(IT)G, 98-806(IT)G
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98-2507(IT)G, 99-2414(IT)G
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BETWEEN:
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PAT HAYES, PHILIP HAYES, STEPHEN STEPHENS,
GORDON REZEK, AND MURIEL SCOTT
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Appellants,
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and
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HER MAJESTY THE QUEEN,
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Respondent.
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REASONS FOR JUDGMENT
Miller J.
[1] In the early-1980s to the
mid-1990s, a number of people in southern Ontario became involved
in a form of investment known as convertible hedging. A common
fact in their involvement was that they received advice from
Maguire & Associates, a business engaged in financial and tax
consulting. The Appellants, who had varying degrees of
understanding of this complex investment strategy, were led to
believe the strategy was a win-win situation. They understood
this meant they would win from the cash flow generated by the
strategy and from an increase in the value of their investment,
and also from tax refunds if they incurred losses. These cases
are about the tax treatment to be afforded these convertible
hedge strategies.
[2] At the outset, I should mention
that the conundrum in applying tax principles to the financially
innovative strategy of convertible hedging is that tax laws have
not necessarily kept apace with the ingenuity of the financial
community. It is therefore appropriate, when viewing the
transactions through the tax looking glass, that the focus not be
so finely adjusted as to preclude a broad, common sense, but
equally innovative, approach to the application of our tax laws.
A square peg does fit in a round hole if the round hole is big
enough.
[3] While normally I prefer
delineating the issues at the outset, in this case, I believe it
would be beneficial to appreciate the nature of the transactions
and the particular circumstances of each Appellant before more
explicitly setting forth the issues. I intend, therefore, to
organize this decision in the following manner. I will first set
out the mechanics of a convertible hedge based primarily on the
expert evidence of Professor Eric Kirzner and Mr. Richard Norman
Croft, as well as on information gleaned from one of the Maguire
consultants, Mr. Harry Johannes Sildva. This will clarify
not just the concept of a hedge, but also the concepts of margin
requirements and the mark to market approach to valuing a
portfolio. I will go over a couple of actual hedging
transactions. It is unnecessary to illustrate every hedge of
every Appellant, though I did hear evidence of all of them. I
will review each Appellant's situation relying primarily on
their own evidence. The issues and my findings can then be
presented in a manner which flows from this background and
review.
[4] The nature of the issues has
shifted somewhat over the many months and years these appeals
have been in the system. This has resulted in consequential
changes in the tax positions proposed by each side, from the
positions taken at the time of the original assessments. I am
satisfied that none of these changes have resulted in the
Respondent attempting to increase any assessment. However, the
changes have led to an Appellant proposing to bring a greater
amount into income in a particular year than is proposed by the
Respondent. In such a situation, the Appellant would be prepared
to have that appeal dismissed.
Background on convertible hedging
[5] The Appellants presented two
experts: Professor Kirzner, in the area of corporate and
investment finance, and Mr. Croft, in the area of investment
counselling and portfolio management, specifically as pertaining
to convertible hedges. It is primarily from these experts that I
intend to paint a general picture of the strategy developed by
Mr. Maguire.
[6] The convertible hedge consists of
two positions, a short position and a long position. The short
position is the sale of common stock of a security with borrowed
stock. While this is an awkward concept for the legally trained
to get a grip on, it is an acceptable means in the financial
marketplace for facilitating short sales. The brokerage house
holds common stock for its clients in street name; such shares
are not identified as being held by any particular customer. So,
when an investor wishes to sell short, the broker uses that
source of common stock held in street form to make a sale for its
client. This is what is meant by the client "borrowing
stock" to sell. The client has an obligation to cover that
short position, or in other words, to return the stock at some
point in the future. The advantage of this arrangement, in a
convertible hedge, is that the investor can use the proceeds from
that short sale to finance a long acquisition, and consequently
to earn income, for example, on a dividend from a form of
preferred share.
[7] This leads to the second aspect of
the convertible hedge - the acquisition of the long position.
This refers to the purchase by the investor of a security
convertible into the same security sold short. If the convertible
security is convertible into exactly the same number of shares
sold short, this is considered a fully hedged position or a
one-to-one position. This does not necessarily mean the
convertible security is convertible on a one-to-one basis as the
conversion rate may vary. For example, a short sale of 10,000
shares may be fully hedged by a purchase of 5,000 convertible
preferred shares, convertible on a two-for-one basis.
[8] There are a number of types of
convertible securities available in the convertible hedge
strategy: convertible preferred shares, convertible debentures,
warrants and rights. The key similarity is that they all have two
elements attached to them: first, an option on the underlying
security, and second, an ability to earn income. For example, on
a convertible debenture, there is both the option to convert into
common stock and an interest-producing feature. With a
convertible preferred share, again an option to convert combined
with the income-producing feature of the preferred dividend. With
a warrant or right, the income-producing feature is the interest
from a treasury bill acquired with the funds from the short sale
of the underlying stock.
[9] The costs involved in a
convertible hedge (or frictions, as Professor Kirzner called
them) are the rental fee on the borrowed stock sold short,
compensatory dividends on the borrowed stock (this refers to any
dividends on the borrowed stock for which the short seller must
compensate the lender) and commissions or fees. There are two
avenues for producing income or gains on the convertible hedge:
the first, a positive cash flow, being the difference between the
income (interest or dividends) on the one hand, and the costs
just described on the other; second, the increase in value of the
convertible hedge itself arising from the market direction. In a
downward market, that is the underlying stock is falling in
value, the convertible hedge will gain. This is as a result of
the underlying common stock falling faster than the convertible
security, due to the characteristics of that convertible
security. Neither of the experts referred to a tax refund from
the potential deductibility of losses on the disposition of a
short or long position as in any way forming part of the gain or
income in a convertible hedge.
[10] The convertible hedge is commonly
initiated through contingent orders. This means that the purchase
of one security and sale of a separate security are contingent on
both sides being executed at a limit price. The price is the
difference between the value of the two securities. The
securities cannot be identical to constitute a contingent order.
The broker would accept contingent orders on a best efforts
basis, so that if the broker is unable to put the entire position
in place in one fell swoop, it is still acceptable to put
something less in place as long as it still meets the price
requirements. This is distinguishable from an all or nothing
direction to a broker, where no part of a position can be put in
place unless it all can be put in place; this would be a less
likely approach. One reason a broker cannot fully complete a
position is because the stock being sold short does not meet the
up-tick rule. This rule, imposed by all exchanges, requires that
if you are going to sell a stock short, the last sale price of
the stock has to be higher than the next to last sale. In other
words you can only sell short in an upward swing. If the broker
cannot fill the position at once, then the position may be legged
in; that is, put in place in portions over time. Mr. Croft went
through an example involving Mr. Hayes legging in on his Trilon
hedge.
[11] There was considerable testimony of
risk in a convertible hedge. Clearly, neither the broker nor
investor wants to be exposed, and indeed a convertible hedge
strategy minimizes exposure in relation to the value of the
underlying common stock. Although, as Mr. Croft indicated, the
risk to the investor, though seemingly low, is not. This is
because the entire amount of the actual outlay of a few thousand
dollars, for a hedge position involving stock valued
significantly higher, is at risk. For example, Mr. Rezek made a
$3,000 payment for a short sale of Laidlaw common stock of
approximately $613,000 and a long purchase of Laidlaw convertible
preferred of approximately $616,000. His maximum amount at risk
was his $3,000, his whole investment, ignoring for the
time being the impact of a positive cash flow from the
convertible hedge.
[12] Returning then to a convertible hedge
that is legged in, this necessarily means that there will be
times when the investor is in a naked position; that is, one side
or other of the hedge is not fully covered. Professor Kirzner
referred to this as a temporal risk. If any event occurred during
that period that significantly impacted that stock, the result
could be much greater than simply the outlay of the investor.
Professor Kirzner indicated that time does not affect the degree
of risk, as the unforeseen event can occur at any time. However,
the exposure to the risk obviously is greater the longer a naked
position is held. I was referred to no examples in the situations
before me of any unforeseen event occurring, and indeed Professor
Kirzner could only think of a couple of cases in the last forty
or fifty years when there had been a short squeeze, one of the
events which might expose an investor in a convertible hedge to
risk.
[13] One cannot discuss risk in these
investments without understanding the mechanics of margin
requirements. Rules with respect to margin requirements are set
by the Investment Dealers Association and stock exchanges, and
are also subject to the review of the Securities Commission.
Margin is akin to a secured loan. The broker allows the investor
to borrow from the broker part of the cost of the investment to
support a purchase. This is usually done by the broker providing
a debit balance in the investor's account. The margin
requirements ensure that the broker's capital is protected.
Short positions are always margined. The general margin
requirement in a short position is for the investor to have
150 per cent of the market value of the underlying stock
sold short in the investor's account. So, for example, if an
investor sells 1,000 Alcan shares short at $8 a share ($8,000
proceeds) he needs to supply an additional $4,000 cash to meet
the 150 per cent margin requirement. If the share price drops to
$5 a share, requiring margin of only $7,500, instead of the
initial $12,000 requirement, the investor could withdraw $4,500
from the account. Normally the short positions are marked to
market daily for purposes of ensuring compliance with these
margin requirements. This simply means the brokers track the fair
market value of the stock sold short on a daily basis.
[14] In the acquisition of a long position,
the margin rules permit financing of 50 per cent, so again
using the 1,000 Alcan shares at $8, the investor need only
provide a cheque for $4,000. The investor has in his account
stock valued at $8,000 plus a loan with the broker of $4,000 -
the position is fully margined. Again, changes in the value of
the stock would impact that margin requirement.
[15] When a short position and a long
position are put together in a convertible hedge transaction, the
combination takes on different characteristics
vis-à-vis margin requirements. The margin
requirements are much lower. If a short position is fully covered
by the ownership of the underlying stock no additional margin
is required. This is the same if the long position is held in
another individual's account, if that other account has
guaranteed the account of the investor who holds a short
position. If an account is undermargined, the broker can make a
margin call on the investor, looking to the investor to top up
the account. Typically, this would not happen on a convertible
hedge as the investor would always have put up the capital in the
form of the convertible security to cover a worst case
scenario.
[16] For the most part, this overview has
concerned the convertible hedge where just one individual is
involved. In many of the convertible hedges in these appeals,
there is another party. That other party, a relative, has always
provided a guarantee. In the event an investor disposes of one
component of the convertible hedge, it is the guarantee that
allows the broker to continue to not insist on the more stringent
margin requirements just outlined. It is this facilitating of the
margin requirement, combined with the broker permitting the
client to use the proceeds on a short sale to acquire a
convertible security that, according to Mr. Croft, makes the
convertible hedge unique. Professor Kirzner referred to the other
party (the 'Guarantors' or individually the
"Guarantor' - Gloria Fahrngruber, Patricia Hayes, Terry
Stephens and Patricia Scott) as holding naked positions; that is,
not hedged positions, though he went on to acknowledge that if
both parties were treated as a single entity the resulting
position would be a convertible hedge. Further, Professor Kirzner
confirmed Mr. Sildva's evidence that entering into
transactions which result in the Guarantor stepping into the
shoes of the investor on one side of the convertible hedge, were
conducted to create a tax benefit. The tax benefit is the tax to
be refunded on the deductibility of the loss created by the
investor's disposition of one component of the convertible
hedge.
[17] It is useful to go through the first
example of the convertible hedge at this point, which is
illustrated on Appendix "A" attached.
[18] This is a Laidlaw convertible hedge
entered into by Gordon Rezek. In referring to the Appendix, the
areas shaded in grey represent the resulting positions after
transactions have taken place. On April 27, 1988, Mr. Rezek sold
short 30,704 Laidlaw common shares and coincidently bought 10,100
Laidlaw preferred shares. On May 20, 1988, Mr. Rezek sold the
10,100 convertible preferred shares and Ms. Fahrngruber
bought 10,100 Laidlaw convertible preferred shares. The result
was that Mr. Rezek held a short position in Laidlaw commons and
Ms. Fahrngruber held a long position in Laidlaw convertible
preferreds, convertible into 37,709 commons. Viewing the
components separately, Mr. Rezek's sale created a $138,431
loss in his account - the tax benefit Professor Kirzner alluded
to. In August 1988, Ms. Fahrngruber then converted the
convertible preferreds into 30,709 Laidlaw common shares (note
that there was a five share discrepancy from what Mr. Rezek held,
so Ms. Fahrngruber simply sold the five shares). This left
Mr. Rezek and Ms. Fahrngruber in what was referred to
as a common-common position. The experts agreed that taken
together there was absolutely no economic benefit to this
position. It was clear that a common-long/common-short position
cannot be held in one account, as they would simply cancel each
other out.
[19] Before getting into the evidence from
each of the Appellants, it is useful to review the evidence from
both a Maguire associate, Harry Sildva, and a broker who handled
convertible hedges for Mr. Maguire, Peter W. McCrodon.
Evidence of Harry Sildva
[20] Mr. Harry Sildva's evidence was
common to all appeals before me. He worked in Mr. Maguire's
office from January 1986 to December 1989 and was able to provide
details of how these convertible hedges were handled by Maguire
& Associates. Mr. Sildva has an MBA from the University of
Toronto as well as having completed a variety of specialized
courses in public finance, public accounting, options and
securities. At Maguire & Associates, he had advised clients
on hedge opportunities and was instrumental in creating the form
of reports provided by the Maguire office. It was Mr. Sildva who
generated the cash flow projections for the various hedges
recommended by Mr. Maguire. He described Mr. Maguire as providing
the tax consulting side of hedges. Mr. Sildva handled the
administrative side of the hedges as well as later becoming adept
in finding opportunities, relying very much on his computer
skills. In 1989, he went to Richardson Greenshields as a broker,
taking some clients with him. In 1992, he joined First Marathon
as a broker and continued to handle hedged positions as well as
investment advice generally.
[21] Mr. Sildva's understanding of the
convertible hedge strategy conforms to the explanation provided
by the experts described earlier, although Mr. Sildva emphasized
the advantages of the tax-cushioning effect on a loss on a short
position. He viewed his clients as wanting to be aggressively
involved in the market and wanting to reduce tax. On
cross-examination, Mr. Sildva acknowledged that the strategy
itself was not aggressive, but the crystallizing of the loss on
the losing side was. Any further investment objectives he left
for the brokers to discuss with the clients.
[22] Mr. Sildva recalled meeting with Mr.
Rezek and discussing tax preparation, tax strategies and the
convertible hedge market. He indicated he would have referred Mr.
Rezek to a broker to open a hedge account. He acknowledged the
use of the term "win/win" by which he meant making
money in a downward market and having a positive cash flow with a
tax cushion in an upward market.
[23] In going over Mr. Rezek's Laidlaw
convertible hedge, Mr. Sildva acknowledged that he recommended to
Mr. Rezek entering into cross-guarantees with Gloria Fahrngruber
as it would allow him to crystallize a loss on one side of his
hedge, which Mr. Sildva believed to be deductible on Mr.
Rezek's tax return. As Mr. Sildva indicated, they were doing
December year end tax planning early. He referred to this as an
adventure in the nature of trade loss. Mr. Sildva acknowledged
that the ability to get $138,000 tax deductible loss on just a
few thousand dollars investment was one of the reasons he got
into this industry.
[24] Mr. Sildva met with Gloria Fahrngruber
and discussed the convertible hedging strategy and guarantees
with her, indicating how the guarantees would enable the use of
margin in each account to cover transactions in the other
account. He also introduced her to a broker. In involving Gloria
through her acquisition of a long position in Laidlaw and the
provision of a guarantee, Mr. Sildva explained this left Mr.
Rezek exposed on the short position; that is, speculating on the
downside. Mr. Sildva suggested that Gloria, on the other hand,
was speculating on the upside, without having to invest any
money, because of the margin excess in Mr. Rezek's account.
As Mr. Sildva stated:
... we have Client A and Client B. One of them will do well in
a scenario. The other will do well in another scenario, and there
can only be one of two scenarios that will unfold, if you were to
look at a strict analysis of it.
So I would always have one happy customer.
[Transcript page 1278 lines 7-13]
[25] Mr. Sildva confirmed that Gloria was
concerned about being taxed on dividends she could not access. He
eventually took steps to close Gloria Fahrngruber's
activity in the market as he sensed there might have been a
change of heart. She only was involved in the one transaction -
the Laidlaw convertible hedge.
[26] Although Ms. Fahrngruber did not enter
any investments herself, in Mr. Rezek's other two
hedges, Royal Bank and Westcoast, Mr. Sildva suggested that Ms.
Fahrngruber's account may have been relied upon when
Mr. Rezek's was undermarginalized.
[27] Mr. Sildva prepared Mr. Rezek's tax
returns for 1988 and 1989. In the statement of business income
and expenses in each year, Mr. Sildva indicated that the type of
business was "speculation", claiming Mr. Rezek was
engaged in an adventure in the nature of trade. In 1992, he
recorded Mr. Rezek's gain on the disposition of part of his
Laidlaw short position as a capital gain. Mr. Rezek's
holdings were not shown in his tax returns as inventory. A copy
of a subsection 39(4) election signed by Mr. Rezek for 1992
dated April 1993 was produced as an exhibit.
[28] Mr. Sildva's contact with Mr. Hayes
was not while he was at Maguire's, but while he was a broker
in 1993 with First Marathon. He handled transactions involving
the Ivaco and Dofasco convertible hedge, though confirmed he only
spoke to Mr. Hayes and never with Mrs. Hayes.
[29] He also confirmed that he prepared the
synopses of convertible hedges which Maguire & Associates
sent to its clients. A synopsis would provide the following
information:
- description of
short position with price;
- description of
long position with price;
- conversion
ratio;
- hedge fee;
-
commission;
-
treasury bill yield if applicable ;
-
spread; and
-
multi-month cash flow projection.
For example, on the Laidlaw hedge, Mr. Sildva's
projections indicated that for an investment of $8,349 to acquire
the Laidlaw short and long position, the investment would yield a
cash flow return over eight months of $6,190, or approximately a
75 per cent return on investment. These synopses were normally
sent to the investor along with a cover letter from Maguire &
Associates which read as follows:[1]
The attached synopsis summarizes your recently transacted
trade in the Laidlaw Transport B convertible hedge, and forecasts
the cash flow to be generated by the trade on the assumption that
the position is maintained and the income and expense parameters
do not substantially vary. We will, of course, be looking for
profitable opportunities to unwind this position as soon as
conditions are favourable to doing so.
I trust you find this of some value and the annexed
tax-deductible invoice #20858 to your satisfaction.
There was evidence that all Appellants, except Mrs. Hayes,
received such letters from Maguire & Associates.
[30] Mr. Sildva also emphasized that the
conversion feature was critical:
A. The
convertibility feature is everything in this case.
Q. Is critical?
A. Yes, because that
affects the marginability of the account, and once it passes,
then the margin changes drastically.
Q. You don't
have a hedge?
A. Exactly.
[Transcript page 1383, lines 18 to 25]
Evidence of Mr. McCrodon, the broker
[31] Turning to Mr. McCrodon, although he
had limited contact with the Appellants, having handled only one
hedge for each of the Hayes, a transfer of accounts for Mrs.
Scott, and opening accounts for the Stephens, he had handled many
other Maguire convertible hedges during the years under appeal.
Mr. McCrodon worked as a broker for Nesbitt Thomson from
1979 to 1989. He indicated that 90 per cent of his revenue during
the years 1983 through 1989 came from Mr. Maguire's
convertible hedging clients.
[32] Mr. McCrodon's usual practice with
Maguire clients was to receive advice from Mr. Maguire to set up
an account for a new client. Most of Mr. McCrodon's
contact with the client was by phone or mail. Whenever he
executed a trade, he would send a duplicate copy of the
transaction to Mr. Maguire. The hedges would be initiated
either by Mr. McCrodon suggesting certain hedges to Mr. Maguire
within parameters determined by Mr. Maguire, or by Mr. Maguire
contacting Mr. McCrodon to see if he could accommodate hedges
identified by Mr. Maguire. As Mr. McCrodon handled more of these
he was able to track their potential viability.
[33] Mr. McCrodon went through the hedge he
handled for the Hayes which is outlined in Appendix
"B". This is the second hedge I wish to describe.
[34] Mr. McCrodon described the opening
position of Mr. and Mrs. Hayes as follows:
Q. Looking at these
two statements here, can you tell me whether this is something
that you would have done as a convertible hedge?
A. Yes. It looks
like it, because they're for the same month end, to start
with. One of them has a long position in Hiram Walker Resources,
8½ percent debenture, which is a convertible debenture,
with a large debit in the - in the account as a net balance.
And the other - the other account has a short position in Hiram
Walker Resources common shares, with a large credit in the
account.
And since these are offsetting positions, convertible to common,
I would identify it as a convertible hedge.
Q. Now, you also
have in front of you document 2.3. And 2.3 is a document which
simply summarizes a lot of the information contained in the
broker statements.
In the middle portion under Philip Hayes' account is the
activity in Mr. Hayes' account and in the right-hand
portion, under Patsy Hayes' account, is the activity in her
account.
Do you see that, sir?
A. Yes, I do.
Q. So when we look
at the first two unshaded lines under 30th July of 1985, you see
that those are the two trades that you've just been looking
at in the broker statements?
A. Yes, I do
Q. Now, can you
explain to us how this would have been initiated?
A. It would have
been initiated like any other convertible hedge. We would have
determined that the Hiram Walker Resources debenture was at an
attractive premium relative to the common shares and that it
would make a good convertible hedge candidate. And then we would
have proceeded to establish the long position with an offsetting
short position.
Q. We've heard
the expression, contingent orders. Are you familiar with
that?
A. Yes.
Q. And can you tell
me how or whether they apply to these circumstances?
A. I can't
remember exactly in this circumstance if we used a contingent
order. My practice was to do so whenever possible, because it
limits the risk in the trade.
There are circumstances where you can't use a contingent
order, because the long position might be a new issue position,
for example. And you know, you may know the price, but you may
have had to make a commitment to it before you actually were in
receipt of it and were able to short sale the common against
it.
I don't know what the specific circumstances here were, but
most of the time we were able to put in a contingent order.
[Transcript page 2114, line 18, to page 2116, line
23]
[35] Mr. McCrodon also stated that in
initiating a hedge, the two tickets for a buy and sell would be
sent to the trading desk clipped together with an indication of
the amount of spread. He explained that in August the warrants in
the Hayes' convertible hedge were stripped from the debenture
to be traded separately but the position remained fully hedged.
From February 11 to February 18, he described the Hayes'
transactions as replacing the debenture and warrants position
with a convertible preferred share position, remaining as of
February 18 in a fully hedged position. On April 22, 1986,
Mr. McCrodon put through a cross-order, that is, a single
transaction from the same firm, for Philip Hayes to buy 4,650
commons to cover his short position and for Patricia Hayes to
sell 4,650 commons. This was done at market price. On April 30,
Philip Hayes traded his convertible preferreds for 4,650 common
shares. At this point, the Hayes held offsetting positions in a
common-common manner.
Evidence of Gordon and Gloria Rezek
[36] Mr. Rezek worked as a sales
representative for 27 years, a job he was doing in the years
under appeal, 1988 and 1989. In 1987, Mr. Rezek met
Gloria Fahrngruber. By late spring of 1988, Ms. Fahrngruber
and Mr. Rezek moved in together in Mr. Rezek's home. Ms.
Fahrngruber paid Mr. Rezek $500 a month rent, representing
approximately one-third of the household costs. In 1992, Mr.
Rezek sold the home and they moved into a new home, carrying on
the same arrangement until February 1993 when they were married.
For the years 1988 to 1992, Mr. Rezek and Ms. Fahrngruber held no
joint bank accounts, no assets jointly, transferred no property
between themselves, each had their own car, had their own phone
line and on vacation shared the costs.
[37] In 1987, Mr. Rezek became aware,
through a fellow employee, Mr. Larry Hillman, of a financial
advisor, Mr. Harry Sildva. Mr. Rezek met with Mr. Sildva to
find out more about making money. From his meeting with
Mr. Sildva he believed there was a form of win-win
investment strategy. By this he meant he would earn income,
receive a tax benefit or both. This was the extent of
Mr. Rezek's understanding of the investment strategy. He
had a high school education and had no familiarity with the
financial investment environment.
[38] Mr. Rezek believed he could enter the
market with as little as a $3,000 investment. He understood that
he was required to open a broker account, which he did with
Walwyn Stodgell in the spring of 1988. Mr. Sildva made all the
arrangements. At that time, May 3, 1988, there was no one else
authorized on the account nor any Guarantor of Mr. Rezek's
account.
[39] On April 27, 1988, Mr. Rezek, through
the auspices of Mr. Sildva, made two transactions for which he
paid, again through Mr. Sildva, $3,000; he sold short 30,704
Laidlaw common shares for $612,925 and coincidentally bought
10,100 Laidlaw convertible preferred shares for $615,506. This is
the convertible hedge described earlier in the background of
convertible hedges. Mr. Rezek entered into these transactions
without any discussion with Ms. Fahrngruber. He believed these
transactions represented the win-win situation. He did not
understand what a short sale was nor how a convertible hedge
worked. His intent, as he put it, was simply to make money. He
paid a $600 commission on these transactions.
[40] Subsequent to these transactions, he
did discuss with Ms. Fahrngruber the possibility of her
guaranteeing his account. This was on the recommendation of Mr.
Sildva, as it would allow for greater investment opportunities.
Having heard of Mr. Sildva from Mr. Rezek and Mr. Hillman, and
upon the encouragement of Mr. Rezek, Ms. Fahrngruber contacted
Mr. Sildva and arranged to meet him, which she did in May 1988.
She came away from that meeting also with the impression that she
could be in a win-win situation - make money and save taxes. She
was advised by Mr. Sildva to open an account with Walwyn which
she did on May 17, 1988, after having checked on both Maguire and
Sildva through the Better Business Bureau and Ontario Securities
Commission. On May 17, she signed a form opening her account. At
the same time, both she and Mr. Rezek signed guarantees,
guaranteeing to the broker each other's account. Neither
Mr. Rezek nor Ms. Fahrngruber had a detailed understanding
of the nature of the guarantee. Ms. Fahrngruber signed it on the
advice of Mr. Sildva that it would allow her greater investment
opportunities.
[41] On May 20, Mr. Rezek sold his 10,100
Laidlaw preferreds for $477,075. He did not discuss this with Ms.
Fahrngruber. This resulted in a loss on the disposition as
described earlier of $138,000, which Mr. Rezek claimed on his
1988 tax return, resulting in a tax refund of approximately
$80,000 received in early 1990. Mr. Rezek confessed to not
appreciating the tax intricacies of the situation. He had his
return prepared by Mr. Sildva. At this point, in May 1988 Mr.
Rezek held only a short position in Laidlaw. Although he sold
preferreds for $477,075, he understood he could not take the
funds out of his account because as he put it "Gloria's
account offset that".
[42] On May 20, Gloria Fahrngruber acquired
10,100 Laidlaw convertible preferred shares. She did not put up
any money for this investment but indicated her understanding was
that she could do so because of her guarantee. Upon receipt of a
statement, she realized she owed $477,375 for the shares. This
was all being arranged by Mr. Sildva. In August 1988, Ms.
Fahrngruber converted the preferred shares to common shares. She
also sold five shares but had no idea why. She left everything to
Mr. Sildva.
[43] Mr. Rezek acknowledged that he had been
made aware of the risks from a review of risks set out in the
broker's hedge agreement. The risks were identified as
follows:[2]
0
Contingent orders can only be taken on a best efforts basis.
There may be liquidating problems.
0
Forced conversions may result in lost premiums. Forced buy-backs
will result in further commission charges.
0
Supply of shares can be affected by a tender offer.
0
Conversions can take time and cause buy-ins on short positions
while the security is being converted.
0
Dividends which will be charged for the short positions can be
increased unexpectedly.
Mr. Rezek was led to believe these would never happen. Ms.
Fahrngruber had a similar understanding.
[44] As a result of Ms. Fahrngruber's
investment, she was subjected to tax on dividends on the Laidlaw
convertible preferred shares. She expressed her displeasure to
Mr. Rezek about the additional tax burden and requested that he
reimburse her for any additional tax. She blamed him for getting
into this Laidlaw investment which was only causing her an
additional tax obligation. She was not able to access the
dividends which were simply credited to her account, but never
paid to her. Mr. Rezek consequently had Mr. Sildva's office
determine how much more tax she was having to pay, and reimbursed
her this amount.
[45] In November 1988, Ms. Fahrngruber
signed an option account. The form indicated she was not involved
in a partnership, she did not hold the account jointly with
anyone and no one else had authority on the account. It also
indicated that the account was exclusively for hedge trading.
[46] Mr. Rezek subsequently entered into two
more convertible hedges involving Westcoast and Royal Bank stock
but without any involvement of Ms. Fahrngruber. He did not
know whether she was doing anything similar with such stock. In
fact, she was not. She had no involvement with either the
Westcoast or Royal Bank convertible hedge. The only stock she
ever held was the long position in the Laidlaw securities. Mr.
Rezek believed the Royal Bank and Westcoast convertible hedges
were the same as the Laidlaw investment.
[47] When Mr. Sildva left Maguire to go to
Richardson Greenshields, Mr. Rezek moved his account to that
firm. In February 1992, Mr. Rezek acquired an additional 1,000
shares in Laidlaw stock. He had no idea why. At the same time,
Ms. Fahrngruber sold 1,000 shares and likewise had no idea why.
There was some discrepancy as to whether the next transaction
took place in February 1995 or 1994 but at that time the Laidlaw
shares were transferred from Ms. Fahrngruber to Mr. Rezek. There
was no payment by Mr. Rezek for these shares. He did not
understand why this was done but acknowledged the effect was to
bring his account balance from a deficit position to a nil
position. Ms. Fahrngruber's account was reduced by the
corresponding amount. Ms. Fahrngruber testified that she had
pressured Mr. Sildva to do something about her ongoing losing
investment, as all she believed she was getting was an additional
tax burden. There was no win-win.
[48] During the years 1988 to 1994, both Mr.
Rezek and Ms. Fahrngruber had their tax returns completed by Mr.
Sildva. Ms. Fahrngruber recalled being billed for that service,
but could recall no other fees from Mr. Sildva. She indicated
that she had no knowledge of Mr. Rezek's bills from Mr.
Sildva. They were his business. She could not concern herself
with Mr. Rezek's situation.
[49] My overall impression of Mr. Rezek and
Ms. Fahrngruber is that they got into an investment strategy
neither of them quite understood. They were naive. They wanted to
make money and save taxes. They saw others doing it and they
wanted to derive similar benefits. They took great pains to
emphasize the independence of each other's investments to the
point they both testified they barely discussed what they were
doing in that regard.
[50] Mr. Rezek has two years under appeal,
1988 and 1989. His position in those years is that he acted
independently from Ms. Fahrngruber, was entitled to losses
arising from the disposition of one component of a convertible
hedge and was entitled to mark to market inventory.
Evidence of Philip and Patricia Hayes
[51] Mr. Hayes was a machinist by trade but
developed considerable expertise in computer applications in
industry, to the point he not only offered sales and support
services but actually made software programs. He also taught in
this area to students and teachers alike. It was not until the
late 1980s, however, that he went into business for himself as a
part owner of a mould shop (Protech), which provided materials to
the automotive industry. His annual income jumped considerably,
once in his own business, from the $20,000 to $50,000 range while
working for others throughout the 1970s and 1980s, to in excess
of $200,000 annually from Protech.
[52] Mr. Hayes had a keen interest in
investing. He started exploring the stock market in the late
1970s and read voraciously about mining stocks, penny stocks,
warrants, options and the like. He took home-study courses
through the Money Lender. He read the Northern Miner, Financial
Post and the Globe and Mail to glean all he could about the
financial sector. He described in detail his understanding of
options. He further advised how he assessed stocks by determining
certain ratios (price to earnings, price to sales and price to
book value), by considering the current market environment and by
reviewing a corporation's history and past performance.
[53] In 1968, Mr. Hayes married Patricia
Hayes. She was a secretary, office manager and bookkeeper. She
had taken a four-year secretarial course, which she upgraded in
1985. She worked for 14 years in retail before her current office
position. She had no investment experience prior to the
transactions in issue before me. As far as the hedging
transactions go, she knew her husband was handling these
transactions on her behalf and, therefore, she took no active
part. According to Mrs. Hayes, Mr. Hayes researched the
investments and did what he felt would benefit them both.
[54] The Hayes described their handling of
their financial affairs as joint, both their chequing and savings
accounts being held jointly. Mrs. Hayes' income went to cover
the daily family expenses while Mr. Hayes covered the bigger
ticket items such as the mortgage. Mrs. Hayes wrote most of the
cheques and dealt with the banking.
[55] Mr. Hayes was made aware of Jack
Maguire through his brother who worked at Eaton's, where Mr.
Maguire also worked in the early 1980s. Mr. Maguire worked
in the Finance Department. Mr. Hayes wanted an accountant to do
his tax returns, but wanted someone knowledgeable in the market.
In his first meeting with Mr. Maguire in 1981, he discussed his
objectives of developing his retirement fund. Though Mrs. Hayes
did not meet with Mr. Maguire, she confirmed that her
objective was to likewise build a retirement fund for herself and
her husband. Mr. Hayes was impressed with Mr. Maguire's
market knowledge. They discussed the concept of convertible
hedging.
[56] Mr. Hayes described a short sale and
distinguished it from an option. His view was that a convertible
hedge strategy could best meet his objective of building a
portfolio, and having a positive cash flow, in a manner that
minimized risk. As he stated, it was difficult to make a mistake.
His modus operandi in acquiring a hedge was to call Mr.
Maguire, go over the numbers provided by Mr. Maguire, then
go over them with the broker and say yea or nay, depending on his
knowledge of the company, the projected cash flow and the
liquidity. By liquidity, Mr. Hayes meant whether the stock was
highly traded. Mr. Hayes believed that the greater volume
meant greater opportunity to get out of the hedge or unwind the
hedge. Mr. Hayes acknowledged that he would not assess a hedge
the same way as a regular investment, primarily due to the
minimal risk inherent in a hedge. In his words, the hedge
investment was "always in balance". He emphasized
several times the lower risk and positive cash flow of the hedge
investment.
[57] While he understood that Mr. Maguire
extolled the benefits of the tax effect, Mr. Hayes indicated he
was not concerned about the tax write-off - it was not part of
his strategy. Given his level of understanding of the
investments, I am satisfied he appreciated the concept of
business loss and capital gain, but I also accept his most
credible evidence that tax benefits were not a motivating
factor.
[58] Both Mr. and Mrs. Hayes completed a
number of forms to open accounts with brokers; this involved new
client application forms, guarantees, margin accounts and account
opening forms. The general theme with respect to the completion
of these forms was that the Hayes would receive them already
filled in, for the most part, by someone at the broker's
office. Mrs. Hayes spent little time, if any, reading or
reviewing the forms as she considered them simply standard
documents. She confessed to not understanding most of what it was
she signed. She described her understanding of the guarantee of
her husband's account with First Marathon in the following
terms: "If he slipped town, I would be
responsible".
[59] Mr. Hayes spent more time going over
the forms but likewise did not study them extensively. He
appreciated the cross-guarantees allowed for increase leverage on
an account as well as serving as a cross-guarantee in case of
financial disaster. His wife's securities could neutralize
the liabilities in his account. In both Mr. and Mrs. Hayes'
forms, they each answered no to the question on the form of
whether the client was a corporation, trust or partnership. Also
they each answered 'no' on the forms to whether anyone
else had authority on their individual accounts.
[60] Mr. Hayes went through a number of his
hedging transactions. First was the Laidlaw hedge. Mr. Maguire
would provide a projected cash flow for a hedge before Mr. Hayes
would go ahead. Once a transaction was entered, Mr. Maguire
would then provide a summary of the completed transactions. The
Laidlaw hedge involved a short sale of Laidlaw common along with
a purchase of Laidlaw warrants. Mr. Hayes would check the
conversion ratio, the warrant expiry date, the exercise price,
the rate of return on the Treasury Bill into which he would put
the funds from the short sale (less the costs of the warrants),
the dividend rate he would owe on the short side and the rental
fee (these latter two amounts representing the expense side of
maintaining the position). The bottom line on Laidlaw was an
outlay of $8,349, with an income from the Treasury Bills of
$10,098, and expenses of $1,800 dividends and $2,100 rental,
resulting in a net $6,150 cash flow on his $8,349 investment over
an eight-month period. That covered the cash flow side, but Mr.
Hayes also acknowledged that when he abandoned the Laidlaw
warrants in August 1987, he believed he lost $76,450. Also upon
his purchase to cover his short position of February 1987, he
lost $46,200.
[61] Mrs. Hayes, coincidentally with Mr.
Hayes' purchase to cover his short position, entered a short
sale at the same price plus commission. On April 22, 1987, she
entered two more short sales of Laidlaw warrants and three
purchases of Laidlaw convertible preferreds. As at April 22, Mr.
Hayes held a long position of 10,000 Laidlaw warrants and Mrs.
Hayes held a short position of 10,000 Laidlaw warrants, a short
of 15,000 Laidlaw common and a long of 7,400 Laidlaw convertible
preferreds. Mrs. Hayes likewise abandoned the warrants in August
1987 resulting in a $178,175 gain or income, coincidentally with
Mr. Hayes' abandonment of his warrants which triggered his
$76,450 loss. In August 1988, Mrs. Hayes closed out her position
altogether resulting in a $60,875 loss. Her net income or gain
from Laidlaw was $117,299 compared with Mr. Hayes' overall
loss of $122,650.
[62] Mr. Hayes went through other
convertible hedges involving bonds or convertible preferred
shares rather than warrants. Of Mr. Hayes' sixteen hedges
presented in the documents at trial, Mrs. Hayes held similar
positions in seven of them. In six of those (Trans World, Walker,
Trilon, Guardian, Placer and Alcan), Mr. and Mrs. Hayes ended up
in an inactive hedge, being one holding a common stock short
position and the other a common stock long position. This was the
completely neutral situation described earlier, as any dividend
on one side would be offset by compensatory dividends on the
other, and any increase in value on one would be offset by a
corresponding decrease in the other. Mr. Hayes maintained
that his objective was always the same, whether or not his wife
was involved - it simply made no difference. To him it was a cash
flow investment. And the cash earned was never taken out but
always reinvested.
[63] With respect to the Maguire invoices,
Mr. Hayes explained that Maguire billed on three basis: first, a
one time fee of $600 for entering a hedge transaction; second, a
fee on disposition of 15 per cent of the return on investment,
not on the cash flow return but the increase realized on
disposition; and third, a year end fee of 15 per cent of any tax
savings resulting from a loss. As well, a fee was charged for
preparation of tax returns. As Mrs. Hayes paid most bills, she
acknowledged that she would have written the cheques for the
purposes of Maguire's fees.
[64] Both Mr. and Mrs Hayes had Mr. Maguire
prepare their returns. Both indicated they did not understand the
tax intricacies but had confidence in Mr. Maguire. Mrs.
Hayes did not know what the election on disposition of Canadian
securities was that Mr. Maguire filled in and signed on her
behalf. They had confidence notwithstanding Mr. Hayes'
indication that in the early 1990s, he was becoming increasingly
frustrated with Mr. Maguire's failure to communicate about
their tax situation. His returns were not being filed on a timely
basis due to what he believed were ongoing negotiations between
Mr. Maguire and Revenue Canada. He even approached his
company's accountants to assist in extricating him from the
tax dispute. Mr. Hayes' frustration and emotion was evident
in describing this stage of the matter - he was feeling harassed
and threatened and helpless to control the situation. This was
happening at a time when his business fortunes as an owner of a
company were on the rise. He was desperate.
[65] Though Mr. Hayes was taken through all
his hedging transactions on cross-examination, it is unnecessary
to repeat all such detail here. The key points garnered from that
testimony are: Maguire would initiate transactions within a hedge
(rolling within a hedge) involving both Mr. and Mrs. Hayes'
position, as long as it was within Mr. Hayes' parameters;
Mrs. Hayes had no contact with Mr. Maguire; Mr. Maguire would
attend to housecleaning of the accounts by moving credit balances
on stock from one account to the other netting each other out;
all investments came from the Hayes' joint bank accounts;
some hedges were successful, others were not; Mr. Maguire
conducted some transfers without Mr. Hayes' knowledge; the
broker conducted transfers between Mr. and Mrs. Hayes'
account for failure to pay fees.
[66] Mr. Hayes is appealing 1984, 1985,
1986, 1991, 1992, 1993 and 1994 on the basis that he acted
independently from Mrs. Hayes, he is entitled to losses on
dispositions of one component of the convertible hedge and he is
entitled to mark to market inventory. Mrs. Hayes is appealing
1989, 1992 and 1993 on the basis she acted independently from Mr.
Hayes and she is entitled to capital versus income treatment.
Evidence of Stephen Stephens and Terry Stephens
[67] Mr. Stephens provided an extensive
background of his work career from 1977 to the present. He has a
mechanical engineering degree and has obtained considerable
certificates in various computing applications. His work was
primarily in a project engineer capacity, often requiring
considerable travel. He has at various times worked as a plant
manager, production quality manager and operations manager. He
has dabbled in a couple of businesses himself, one particularly
of note, was a partnership with his then girlfriend and since
wife, Terry Taylor in 1981. This was an Amway business. Mr.
Stephens contributed $700 and Ms. Taylor $300, though they each
described it as a 50-50 partnership. It only lasted one year. Mr.
Stephens and Ms. Taylor married in 1983.
[68] Mr. Stephens had limited financial
background. He was familiar with Canada Savings Bonds, RHOSPs and
RRSPs. Mrs. Stephens worked as a teller for many years, but
likewise had limited investing experience. Mr. and
Mrs. Stephens each maintained a separate bank account as
well as having a joint chequing account for the normal monthly
expenses. They also had a rainy day account which was in Mrs.
Stephens' name.
[69] Mr. Stephens first met Mr. Maguire on
the recommendation of his sister in early 1982 for the purpose of
preparing his 1981 tax return. Mr. Stephens was impressed with
Mr. Maguire's tax knowledge as well as with his understanding
of money-making opportunities. Mr. Maguire introduced the
convertible hedging idea to Mr. Stephens describing it as a
win-win situation. Mr. Stephens acknowledged that he understood
the concept at the time Mr. Maguire explained it, but one hour
later was hard pressed to describe it himself. His understanding
of the win-win was that you could make profits, and even if you
lost, you could claim a refund on your tax return. Mrs. Stephens
indicated that Mr. Stephens described it to her as a win-win-win
in the following terms: you could invest without having to put up
any of your own money; you could invest in Canadian companies; if
you lost, you would receive a tax benefit.
[70] Mrs. Stephens was comfortable with
investing through Mr. Maguire as her husband clearly had
confidence in him. She personally never met Mr. Maguire and only
recalled once talking to a broker. Both Mr. and Mrs. Stephens saw
the convertible hedge as an opportunity to make money, Mr.
Stephens appreciating the lower risk of losing money.
[71] Mr. Stephens indicated a hedge would be
initiated usually by a call from Mr. Maguire, though occasionally
Mr. Maguire would simply go ahead. Mr. Stephens would next
get a call from the broker. He would tell the broker that if Mr.
Maguire initiated it, then it was okay to proceed.
[72] Both Mr. and Mrs. Stephens signed a
number of forms to accommodate their hedge investments. These
included standard new client application forms and account
opening forms, cross-guarantees and a trading authorization. The
new client forms stipulated the account was not a corporation or
partnership account. Mr. Stephens understood the guarantee was
similar to co-signing a loan. Mrs. Stephens had a similar
understanding and recognized that if her account had funds and
Mr. Stephens did not, her account would guarantee his. Neither of
them understood the margin account forms, but saw the document as
a mere formality. Both signed trading authorization forms making
each an agent of the other. Mrs. Stephens explained Mr. Stephens
had authority as her agent.
[73] Mr. Stephens borrowed $10,000 to make
his original investment with Mr. Maguire. He paid $10,500 to
RBC Dominion Securities for the Falconbridge hedge in October
1985. He paid Mr. Maguire $600 for initiating this hedge. The
funds came from his personal account. When he received Mr.
Maguire's report of the Falconbridge hedge he was shocked to
see the magnitude of the numbers involved. On October 8, he sold
short 7,500 Falconbridge common shares for $129,618 and bought
long 1,500 Falconbridge warrants for $41,393. On October 15,
he bought a Treasury Bill for $100,055. All these transactions
were instigated by Mr. Maguire. Mr. Stephens' premiums for
this hedge was approximately $12,000, being the difference
between the short sale proceeds and the combined costs of the
long position and the Treasury Bill. On December 23, 1985, Mr.
Stephens purchased 7,500 Falconbridge commons to cover his short
position for $446,365, resulting in a $16,746 loss. On the same
day, Mrs. Stephens entered a short sale of Falconbridge
commons for proceeds of $146,135. She understood this was done to
facilitate Mr. Stephens' trade. She was likewise alarmed at
the amount when she received her trading slip. With respect to
the $16,000 loss, Mr. Maguire wrote to Mr. Stephens advising him
of a tax saving of approximately $6,500 on the loss.
[74] The next trade was November 11, 1986,
when Mr. Stephens reinstated his short position of 7,500
Falconbridge commons for $132,087. On the same day Mrs. Stephens
covered her short position for $132,287, realizing a $13,847 gain
or profit. At this point, Mr. Stephens was back in a fully hedged
position. On February 5, 1987, Mr. Stephens sold his 1,500
Falconbridge warrants for $31,750 realizing a $9,643 loss. Mrs.
Stephens bought 1,500 Falconbridge warrants at a cost of $32,000
which she immediately converted to 7,500 Falconbridge commons
stock putting her and Mr. Stephens in a common-common
position. This continued to December 30, 1988, when each disposed
of their position, Mr. Stephens at a $78,037 loss and Mrs.
Stephens at a $79,625 gain. I am satisfied neither Mr. nor Mrs.
Stephens had any direction whatever over these transactions.
[75] Of the five convertible hedges in which
Mr. Stephens was involved, only in one (Ivaco) did Mrs. Stephens
not have any corresponding interest. In the other four, Mr. and
Mrs. Stephens ultimately held a common-common position.
[76] Mr. Stephens received a number of
letters from brokers requesting additional margin. He never quite
understood what they were getting at, so usually sent these
requests on to Mr. Maguire. Occasionally, he would call the
broker. The broker would sometimes indicate a trade the next day
would resolve the issue. Mr. Stephens never intended to pay
anything further in response to these inquiries. In a March 29,
1990 Burns Fry request, Mr. Stephens feared legal action was
being considered, so he tried to contact Mr. Maguire, but without
success.
[77] In 1993, matters came to a head with
Burns Fry threatening to close accounts, including those of
Guarantors, if certain fees were not paid. Mr. Stephens
submitted the fee too late, and the Stephens' accounts were
indeed closed. This caused the disposition of Falconbridge and
Placer positions held by the Stephens. The disposition of Mr.
Stephens' Placer common shares at $379,556 resulted in a
$129,376 loss, while the disposition of Mrs. Stephens' Placer
common long position at $379,556 resulted in a $162,392 gain.
[78] Mr. Stephens maintained he had no
intention to enter any of these transactions with Mrs. Stephens
as a business partner. There was no agreement to split profits -
any profits he made were re-invested through Mr. Maguire. He
entered the Ivaco hedge without any involvement of his wife. He
viewed such a hedge no differently from those in which he relied
on the guarantee of his wife's account.
[79] In March 1989, RBC requested the
transfer of $176,922 from Mrs. Stephens' account to Mr.
Stephens' account. Mrs. Stephens signed a letter authorizing
that transaction because, as she put it, she was a partner in a
marriage not a partner in a business.
[80] With respect to Mr. Maguire's
preparation of the Stephens' tax returns, it was clear the
Stephens' did not know how they were being handled.
Mr. Stephens realized that his 1987 and 1988 returns were
late, but was told by Mr. Maguire not to worry as he was entitled
to a refund. In Mr. Stephens' 1987 returns, specifically his
statement of income and expense, it showed the type of business
as 'Speculation', and a net loss of $73,904. No amount
was shown as inventory. In 1988, his loss was reported as
$230,188, with a capital gain of $79,615 being attributed from
Mrs. Stephens on the Falconbridge disposition. It is unnecessary
to go through the returns of the other years under appeal as the
issues were similar.
[81] Mr. Stephens' position before the
Court has changed in a number of respects from his position at
the time of filing. In his position before Court, he claims both
a mark to market and fair market value adjustment for the years
under appeal. Also, the amount of business income or losses have
been modified for some of the years. Likewise the
Respondent's position has changed from the assessment stage
to the Court stage. This has resulted in the rather unusual
position for 1990 of Mr. Stephens' taxable income at the time
of filing being significantly less than his taxable income at the
time of his Court appearance. The Respondent's assessment of
taxable income has likewise increased, though not by so much.
Evidence of Muriel and Patricia Scott
[82] Mrs. Muriel Scott graduated in nursing
from McGill University in 1950. She worked as a nurse on a
part-time basis until 1970 when she commenced full-time
employment at a North York hospital. In 1982, she opened a
nursing agency (Carecor) in Toronto where she worked until
retirement in 1994. In 1980 Mrs. Scott took a 16-hour course
on financial planning although the course did not deal with
hedges, warrants or options. She indicated she was separated and
needed to take care of her future.
[83] Mrs. Scott first met Mr. Maguire in
1982. She retained him to prepare her 1981 tax returns. In late
1983, Mr. Maguire suggested to Mrs. Scott that she consider
convertible hedge investments. She made her first such investment
in Husky Oil in December 1983 relying on $10,000 of borrowed
funds. She always had sufficient funds thereafter in her account
to maintain her investments. She exhibited a good basic
understanding of the hedge strategy and particularly, that it was
set up to generate a positive cash flow, which is what she
wanted. She understood the costs involved related to fees,
rentals, interest on borrowed funds and compensatory dividends,
and that the income was derived from dividends. She did not
recall being advised of any tax benefits in this strategy. While
she understood in Court, that as well as making money from the
cash flow, there was a possibility of profit or loss on the
closing of the hedge, she did not fully appreciate this at the
time she was investing.
[84] The usual routine in Mrs. Scott's
establishment of a convertible hedge was that Mr. Maguire would
contact her to explain the trade, and go over the expected cash
flow. She would decide, based on the premium, and as she put it,
the end result to be generated. She never discussed the
investment with her daughter, Patricia. She does not recall there
ever being a discussion about risk. Mr. Maguire would then
contact the broker who in turn would contact Mrs. Scott to
finalize the arrangements.
[85] According to Mrs. Scott, the broker
required her to sign a number of forms, including a new account
application, guarantee, margin account form, standard option
agreement (which she later requested to be cancelled) and a
trading authorization form in which her daughter Pat was
designated as her agent. Mrs. Scott's overall approach to the
forms was that, although she would quickly review them for
accuracy, she saw them simply as standard broker requirements.
With respect to the guarantee, she understood Pat was
guaranteeing her liabilities, but was assured from discussions
with Mr. Maguire this would never be a problem - and it was not.
Mrs. Scott always believed the account opening forms, even though
in Pat's name, related only to her accounts, only her
investments.
[86] The parties summarized 16 of Mrs.
Scott's investments in a schedule and she was questioned on
every one of them. These investments were initiated from 1983 to
1992. Mrs. Scott's daughter Pat, was involved in just five of
the convertible hedges, all initiated in 1987 or earlier (Husky,
Cambridge, Alcan, Placer Developments and Falconbridge).
[87] It was clear from her testimony that
Patricia Scott was involved in her mother's investment simply
to facilitate those investments. She believed she had no risks,
with no potential gain or loss. It would cost her nothing. She
presumed the signing of various account opening forms was simply
a broker requirement. Though she read the forms and understood
they would be binding, she signed simply to accommodate her
mother. Similarly, with respect to letters to brokers, she would
just sign what Mrs. Scott prepared for her to sign. She referred
all correspondence on the investments to her mother, and
ultimately provided her mother's address for mailing
purposes. Most correspondence she never even saw. She never
received any payment from the investments that she considered
hers. She reported dividend income on her tax returns until it
was determined this was an error, and thereafter it was all
recorded to her mother.
[88] With respect to specific hedges, Mrs.
Scott invested in convertible preferred hedges, warrant hedges
and convertible debenture hedges. For example, her first hedge in
Husky in 1983 involved convertible preferred shares, which she
bought long coincidentally with the short sale of Husky common
shares at a premium of approximately $12,000. Mr. Maguire
estimated a cash flow on this particular hedge in 1984 of
approximately $3,300. In June 1985, Mrs. Scott sold the 3,000
convertible preferred shares and Patricia Scott acquired 3,000
convertible preferreds at the same price, which two days later
were converted to common shares. Mrs. Scott and her daughter
maintained this short common-long common position until 1987 when
Mrs. Scott covered her short position and Patricia sold her long
position. Mrs. Scott referred to the common-common holdings
as an inactive hedge. There was a loss of approximately $12,500
combined in these transactions. Mrs. Scott acknowledged this was
not a good hedge.
[89] In December 1986, Mrs. Scott entered a
warrants' hedge with the short sale of 10,000 Cambridge
Shopping Centre common shares and the acquisition of 10,000
Cambridge warrants. In January 1987, there was a covering
purchase in Mrs. Scott's account and coincidently, a short
sale in Patricia Scott's account of 10,000 commons. At this
point until 1992, Mrs. Scott and her daughter held a
common-common position, likewise referred to by Mrs. Scott as an
inactive hedge. Mrs. Scott claimed all dividends and expenses
arising from these holdings, indicating Patricia as her agent on
her tax returns.
[90] In July 1987, Mrs. Scott entered a
rights hedge acquiring 10,000 Falconbridge rights for $61,850 and
coincidently selling short 10,000 Falconbridge common shares for
$250,630. In October, the long position shifted to Patricia's
account by the sale of the 10,000 rights by Mrs. Scott for
$27,956 and the acquisition of 10,000 Falconbridge commons by
Patricia Scott for $191,850. They maintained this common-common
position until the end of 1989 when Mrs. Scott covered the short
and Patricia Scott sold the long, both at $370,000.
[91] Mrs. Scott maintained both a short
margin account and a margin account. From a review of the Laidlaw
hedge entered in 1988 for just a few months, it appears that only
the short margin account was used for the convertible hedging
transactions, as a Laidlaw warrants acquisition which had nothing
to do with convertible hedge was held in the separate margin
account.
[92] It is unnecessary to go through all the
other convertible hedges in detail, other than to highlight a few
facts from some of them:
- Mrs. Scott claimed
a $31,650 loss on the sale of 10,000 Alcan warrants in November
1986. Also in November 1986, Patricia acquired 10,000 Alcan
common shares. Mr. Maguire charged Mrs. Scott a 15 per cent
benefit surcharge on the tax saving from the $31,650 loss.
- The Minnova hedge
took 3½ months to set up in 1988 before the position was
fully hedged and was then held for five years before being
collapsed for a gain of $3,688; throughout that period the hedge
also generated some positive cash flow.
- Federal Industries
was a convertible debenture hedge entered in November 1989. In
October 1991, Mrs. Scott substituted one convertible debenture
for another. She realized a gain on her short position, resulting
in an overall gain hedge of $10,245. She could not generalize as
to whether her gains were normally on the long or short position,
as she maintained she was more interested in the cash flow.
- The Placer hedge
was held in a common-common position between Mrs. Scott and
Patricia Scott from 1987 to 1999. Mrs. Scott's explanation
was that this was done due to the uncertainty of how it was to be
treated for tax purposes.
[93] Mrs. Scott left the preparation of her
tax returns to Mr. Maguire. She had no idea how dividends or
capital gains were calculated. In her 1989 return, specifically
the statement of income and expenses from business, she listed
Market Speculation as the type of business. Nothing was shown in
the schedule for inventory.
[94] Mrs. Scott is appealing the 1984, 1985,
1986, 1987, 1988, 1990, 1991, 1992 and 1993 taxation years on the
basis that she was not in a partnership with her daughter, the
losses incurred on specific components of the convertible hedge
were deductible and that she is entitled to mark to market
inventory.
[95] Issues and Findings
(a) Were the
Appellants' gains or losses on their investments on capital
account or were they income from a business either due to
engaging in an adventure in the nature of trade or due to
carrying on a business?
In all cases the gains or losses on "investments",
which I shall shortly clarify, were income from a business,
arising from engaging in an adventure in the nature of trade.
(b) What constituted the
business, the adventure in the nature of trade - stock
transactions or convertible hedging transactions?
The adventure in which the Appellants engaged was investing in
convertible hedges, which I find are property for purposes of the
Income Tax Act.
(c) Were the adventures carried on with a
partner or through an agent?
The adventures were neither carried on as a partnership nor
through an agent, with the exception of Mrs. Scott. They were
engaged in either singly by an Appellant, where the convertible
hedge was held in one account, or jointly by the Appellant and
the Guarantor, where the convertible hedge was held in two
accounts. Other than Mrs. Scott and her daughter, who were
in an agency relationship, the remaining Appellants were joint
adventurers with their respective Guarantors.
(d) What tax treatment is to be accorded the
convertible hedges: specifically, the determination of when
income or losses arise in the convertible hedge and in whose
hands; the taxation of the cash flow element of the convertible
hedge; the treatment of the Appellants' positions subsequent
to the wind-up of a convertible hedge; and the reliance on the
mark to market method of inventory valuation?
The income or loss from the disposition of a convertible hedge
held in two accounts occurs at the time of the event which
results in neither an Appellant nor Guarantor holding a position
with a conversion feature. The gain or loss is on income account
and is to be divided equally between the two co-adventurers.
Prior to the disposition of the convertible hedge, no disposition
of a component of the convertible hedge constitutes a disposition
for tax purposes.
For the Hayes', and Stephens' appeals, the income and
expense of the convertible hedge (the cash flow), is taxable or
deductible in the hands of the co-hedgor holding the component
yielding the income or expense. In Mr. Rezek's and Mrs.
Scott's case the net cash flow is taxable in his or her hands
alone.
Based on my finding that the convertible hedge is property, it
is the convertible hedge itself that is the inventory and not the
individual components of the hedge. Applying subsection 10(1) to
these adventures in the nature of trade, none of the Appellants
computed income in the years prior to December 20, 1995, by
valuing the inventory, the convertible hedge, at the lower of
cost or market. Therefore, subsection 10(1) applies to preclude
any of the Appellants from relying on the lower of cost or market
inventory valuation method, vis-à-vis the holding of a
convertible hedge. Also, no Appellant is eligible to write down
inventory of individual stock after the unwinding of a
convertible hedge.
After the disposition of the convertible hedge, the investor
and the Guarantor holding common-common positions hold a taxable
nothing. The common-common position in two accounts may, as a
hedge, be considered as a property but it is not a source for tax
purposes.
(e) What is the effect of the subsection
39(4) election by Mrs. Hayes and Mrs.
Scott?
The
convertible hedge itself, as a separate identifiable investment,
does not fall within the definition of securities as contemplated
by subsection 39(4), so the election is ineffective for the
determination of capital or income treatment on the disposition
of the convertible hedge itself. Mrs. Hayes disposed of no other
property in the year under appeal to which the election would
apply.
(f) How are unused compensatory dividends to be treated for
tax purposes?
Unused compensatory dividends cannot be deducted nor
capitalized.
(a) Issue:
Were the Appellants' gains or losses on their
investments on capital account or were they income from a
business either as a result of engaging in an adventure in the
nature of trade or as a result of actually carrying on a
business?
Appellants' Position
[96] The Appellants argue that they were
engaged in trades in one of three ways: first, as a speculator,
an adventurer in the nature of trade such as Gordon Rezek;
second, as a trader, such as Philip Hayes, Stephen Stephens and
Muriel Scott; and third, on account of capital, such as Patricia
Hayes. Appellants' counsel reviewed the various badges that
are traditionally considered in categorizing income or capital:
length of ownership, nature of the property, frequency of
transactions, knowledge of the individual, degree of financing
and intention to enter a scheme for profit-making. He talked
about an evolutionary chain, placing Mr. Rezek at the beginning
of that chain as a speculator and Mr. Hayes further along
that chain as a trader, based primarily on volume of
transactions. Mrs. Hayes never got on to the evolutionary chain
as she, according to Mr. Shaw, held her positions more as
investments rather than in a profit-making scheme.
[97] Mr. Shaw distinguished the trader from
the speculator based on volume and the "amount of
methodology" which he attempted to clarify as being a
"consistency of patterns, the way in which you get the
volume".
Respondent's Position
[98] In other aspects of these appeals, the
Respondent has relied on Schultz v. The Queen[3] and Carter v. The
Queen[4]
as providing binding authorities for certain propositions. In
those two cases, which I will review more thoroughly in my
analysis, gains from convertible hedging transactions were held
to be on income account. The Respondent has indeed throughout
these appeals taken the position that income treatment is
appropriate. However, because I requested argument on the capital
issue, the Respondent has now suggested it is open to me, because
this is a matter of law, to consider, based on the evidence, that
the Appellants had only a capital intention.
[99] Mr. Hayes wished to build a portfolio
of hedges, not an indication of a profit-making scheme from quick
flips. Mrs. Scott, according to Mr. Gluch, clearly viewed hedges
as an investment, and, like Mr. Hayes, she was in it primarily
for the cash flow. To a lesser extent, so was Mr. Stephens.
Analysis
[100] There are two steps in the classification of the
nature of the income in these appeals. The first step is the
distinction between income and capital. I only get to the second
step if I determine the answer to the first step is that these
transactions were on income account. The second step is whether
the income from a business is as a result of being engaged in an
adventure in the nature of trade (a speculator), or as a result
of carrying on a business (a trader). The answer to the second
inquiry has a bearing on both the partnership issue and the
inventory issue.
[101] As I have previously mentioned, the parties only
addressed the issue of capital versus income as it relates to Mr.
Rezek, Mr. Hayes, Mr. Stephens and Mrs. Scott because I asked
them to do so. Neither side was claiming, apart from the possible
application of subsection 39(4), that these Appellants' gains
from their convertible hedging activities were on capital
account. The analysis struck me as incomplete without that basic
starting point, and although now I am satisfied that the gains on
the convertible hedges were not on capital account, I believe the
exercise of exploring that issue has been helpful. As a question
of law, the issue was open for me to consider. I will be brief
however in my reasons on this first step.
[102] The definition of 'business' in section
248 reads as follows:
"business" includes a profession, calling, trade,
manufacture or undertaking of any kind whatever and, except for
the purposes of paragraph 18(2)(c), section 54.2,
subsection 95(1) and paragraph 110.6(14)(f), an adventure
or concern in the nature of trade but does not include an office
or employment;
In the decision of Friesen v. The Queen,[5] the Supreme Court of
Canada reviewed the factors which have been used by the courts in
determining whether a taxpayer was engaged in an adventure in the
nature of trade or was dealing with a capital transaction. The
overriding requirement to find an adventure in the nature of
trade is that it involves a scheme for profit-making. The
other considerations identified by the majority are:
(i) intention at the time of
acquisition of the property;
(ii) nature of the
taxpayer's business compared to the endeavour involved;
(iii) nature of the property and use
made by it; and
(iv) use of borrowed money.
From the dissenting decision of Iacobucci J., on which there
was no disagreement on this issue, the conduct of the taxpayer
compared to a dealer in such property was added as a
consideration.
[103] Although there was some evidence, as pointed out
by Mr. Gluch, that some of the parties intended a longer term
investment, their conduct and the nature of the property belies
such an intention. The convertible hedge strategy was a scheme of
profit-making.
[104] The strategy was marketed as a win-win. One side
of that equation dealt with tax savings, which has been held by
cases to not, of itself, constitute a business (see for example
Moloney v. The Queen[6], Loewen v. Canada[7] and Whent v. The
Queen[8]) but the other side of the win-win equation
involves two elements. One is the cash flow generated by the
convertible hedges while held, and the other is the increased
value of the hedge itself on wind-up. That increased value
depends very much on market fluctuations, but it is absolutely
clear from the experts' testimony and the Appellants'
testimony that this was the integral element of the venture. This
is best summarized in Mr. Maguire's standard correspondence
to his clients,[9]
delivered shortly after the convertible hedge is established:
... We will, of course, be looking for profitable
opportunities to unwind this position as soon as conditions are
favourable to doing so.
The increase in the spread is the profit from the venture. The
Appellants, with the exception of Mrs. Hayes perhaps, all had
sufficient information to be aware of this at the time they
acquired the convertible hedges.
[105] Mr. Hayes, more knowledgeable than any of the
other Appellants as to how these strategies worked, might talk in
terms of building a hedge portfolio, but that simply goes to
volume, not to a long term holding of numerous hedges as a
typical investor in a long position would hold an ordinary stock
portfolio. Of Mr. Hayes eight convertible hedges, in which Mrs.
Hayes was involved, six were collapsed in less than one year and
two in the year following the year of investment. Of his many
solo convertible hedges, only one was held for more than a few
months. This conduct is indicative of an intent to be involved in
a profit-making scheme, not long-term capital investments.
[106] Similarly, Mrs. Scott, while concentrating on the
cash flow generated by the convertible hedge, with the exception
of the Minnova hedge, did not hold the convertible hedge
positions for any lengthy period of time. This is not surprising,
as the nature of the convertible hedge itself is such that
immediately upon acquisition, the market is tracked for a
profitable unwinding. This was common to all Appellants who held
convertible hedges. That was what Maguire & Associates was
doing for them.
[107] Although none of the Appellants worked in a
related industry, this is an insignificant factor in the overall
determination. As far as using financing for the venture, some
Appellants did indeed borrow to make their initial outlay,
however, more telling is that all the Appellants relied on the
more generous margin requirements to implement the convertible
hedge. This was the very key to the success of the convertible
hedge, to the point that the Guarantors were led to believe they
could "invest" with no personal financial
contribution.
[108] Taken in their totality, the intentions of the
Appellants at the time they acquired the convertible hedge, their
conduct, the method of financing and the very nature of the
convertible hedge itself point overwhelmingly to a scheme for
profit-making, an adventure in the nature of trade and,
therefore, income from a business.
[109] The next step is more problematic although it was
not vigorously pursued by either side. At what stage in the
evolutionary chain, to use Mr. Shaw's line, does an
adventurer, a speculator, turn into a trader, someone who is
carrying on a business? By its very term, the adventurer in a
nature of trade is not carrying on a business, although the
income derived from the adventure is considered income from a
business due to the definition in the Income Tax Act. This
distinction was clearly enunciated by Jackett, P. in Tara
Exploration and Development Co. Ltd. v. M.N.R.[10]
... I have concluded that the better view is the words
"carried on" are not words than can aptly be used with
the word "adventure". To carry on something involves
continuity of time or operations such as is involved in the
ordinary sense of a "business". An adventure is an
isolated happening. One has an adventure as opposed to carrying
on a business.
Justice Major reinforces this view in Friesen where he
indicated, "by definition an adventurer in the nature of
trade is neither a stock-in-trader nor does he 'carry on'
a business".
[110] Mr. Shaw suggested that there is something more
than just the volume of adventures that makes the difference. I
agree. Yet I remain unclear as to exactly what he intended by
referring to the methodology of the trader. I see no difference
between what Mr. Hayes did and what Mr. Rezek did
vis-à-vis the methodology of the transactions. Both
engaged Maguire & Associates and a broker to implement,
monitor, adjust and ultimately wind-up the convertible hedge.
Granted, Mr. Hayes could discuss the hedge more knowledgeably
with Mr. Maguire and the broker than Mr. Rezek, but he had no
more control over the actual mechanics than Mr. Rezek. Also, Mr.
Hayes maintained more detailed records, including his own
schedules of the convertible hedges, but this personal
record-keeping had no bearing on the operation of the convertible
hedge itself.
[111] None of the Appellants earned their livelihood
from convertible hedging, so that is not a factor which supports
a finding that any of them carried on a business. None of them
held themselves out in the financial marketplace as traders. None
had business plans. None had business premises dedicated to these
transactions. None had the trappings of dedicated phone lines or
business cards. None kept financial statements of a business.
None advertised. None employed any staff. None incurred operating
expenses other than the expenses directly incurred as part of the
convertible hedge itself. None entered into any contract with
third parties beyond what an ordinary investor would enter, apart
perhaps from the guarantees. But again, that went to the very
essence of the nature of the convertible hedge, not to the
determination of carrying on a business. There must be some
additional element of commerciality beyond volume to take an
adventurer from the status of speculator to the status of someone
carrying on a business. I can find no elements of such
commerciality with any of the Appellants. While that finding
alone might be sufficient to find none of them were traders, I
wish to comment on the volume of adventures of the Appellants and
how that also influences my findings.
[112] Mr. Rezek engaged in three convertible hedges over
two years. Mr. Hayes engaged in 16 convertible hedges over nine
years. Mr. Stephens engaged in six convertible hedges over three
years. Mrs. Scott engaged in 16 convertible hedges over 10 years.
The evidence was consistent amongst the Appellants that the
convertible hedge would be instituted by a phone call with
Maguire & Associates and a follow-up call with a broker.
There might be some activity during the life of the convertible
hedge involving shifting positions or disposing of positions.
Finally, there would be a call with each of Maguire &
Associates and the broker on wind-up of the convertible hedge,
although there was also some evidence that the wind-up could
occur without any involvement of the Appellant. This is not a
description of extensive business activity in connection with any
one particular convertible hedge. It is also definitely not
voluminous when looking at the total number of an Appellant's
convertible hedges over the period of time an Appellant was
engaged in the convertible hedging strategy. Even if one accepted
that volume alone is the determination of when an adventure
becomes trading, there is no magic number when an adventurer can
be presumed to be a trader. But common sense suggests to me that
not even Mr. Hayes, nor Mrs. Scott, handled such a volume of
these convertible hedges that they could be viewed as carrying on
a business. When I compare them to the recent phenomenon of the
day trader, they pale significantly. The day trader might deal in
dozens of securities a day, not a handful over a number of years.
No, the Appellants would have had to engage in considerably more
activity than the Appellants before me to satisfy me they were
carrying on a business. They were engaged in a scheme of
profit-making and are caught by the broad definition of
business in the Income Tax Act. But none of them were
carrying on a business.
(b)
Issue:
What constituted the adventure in the nature of
trade - stock transactions or convertible hedging
transactions?
Appellants' Position
[113] The Appellants' counsel emphasized on more
than one occasion that I must be guided by what is real. As he
referred me to cases such as Shell Canada Limited v. The
Queen[11] and The Queen v. Singleton,[12] it was clear his
reality was a legal, as opposed to an economic, reality. Legal
transactions must be respected. They ought not be recharacterized
based on tax motivation. The Appellants concluded the legal
reality theme with the submission that the fact a transaction may
produce a result which is deemed repugnant is not in and of
itself a reason for the Court to disregard it.
[114] The Appellants point to the various documents and
transactions and insist they represent legal rights and
obligations and have legal and binding effect. For example, a
Guarantee contractually binds a Guarantor in accordance with its
terms. It cannot be ignored. Likewise, a disposition of a stock
is a transaction that took place. It has an effect on the person
disposing of it. It has ramifications. It cannot be deemed
away.
[115] So, in effect, Appellants' counsel parses the
convertible hedge into its component parts and concludes the
Appellants were engaged in separate, identifiable stock
transactions each producing its own legal and tax result, and to
find otherwise is to ignore the legal realities.
Respondent's Position
[116] The Respondent's position is that the
convertible hedge, whether in one account or two accounts is only
disposed of when it is closed. For example, when Gloria
Fahrngruber acquired Laidlaw convertible preferred shares
coincidentally with Mr. Rezek disposing of Laidlaw convertible
preferred shares, the convertible hedge continued in the two
accounts. They were packaged in a bundle that could not be
unravelled. The cash flow was determined from the convertible
hedge as a package. Similarly, the gain or loss is not to be
determined upon the shifting of positions; the move from one
account to another should have no tax impact. The impact is upon
the wind-up of the convertible hedge, being what the Appellants
initially purchased.
[117] The Respondent suggested the convertible hedge
could be viewed as a capital asset which produced income. Indeed,
the Respondent went so far as to argue that the convertible hedge
could fit within the definition of property contained in
subsection 248(1) of the Act. Although not acknowledging
that a short position standing alone is a right that constitutes
property, the combination of the short and long positions do
constitute property. And it was that property that was the
subject matter of the Appellants' adventures.
Analysis
[118] This is where the round hole of taxation
principles must expand to accommodate the square peg of financial
innovation: where what is real in law is not so restrictively
interpreted as to deny a result that meshes economic and legal
reality. The Income Tax Act provides this opportunity
through its definition of 'property', which reads:
"property" means property of any kind whatever
whether real or personal or corporeal or incorporeal and, without
restricting the generality of the foregoing, includes
(a) a
right of any kind whatever, ...
This is not only the broadest of definitions, it invites a
non-restrictive approach - property of any kind whatever, right
of any kind whatever. This is not surprising in a taxing statute
that taxes income from property and proceeds from disposition of
property. The net is cast as widely as possible.
[119] What then are the characteristics of a convertible
hedge that would justify its characterization as property? I
would suggest it is the rights implicit in the convertible hedge.
As well as the Income Tax Act definition it is interesting
to note Black's Law Dictionary definition of
'property':
1. The right
to possess, use, and enjoy a determinate thing;
2. Any
external thing over which the rights of possession, use, and
enjoyment are exercised.
It further defines "thing" to include "any
subject matter of ownership within the sphere of proprietary or
valuable rights". The characteristics of a convertible hedge
then which fall within these very broad approaches to property
are the characteristics of having rights. Again referring to
Black's Law Dictionary, a 'right' includes the
following definitions:
1. Something
that is due to a person by just claim, legal guarantee, or moral
principle.
2. A power,
privilege, or immunity secured to a person by law;
3. A legally
enforceable claim that another will do or will not do a
given act;
4. The
interest, claim, or ownership that one has in tangible or
intangible property.
[120] The right or rights must derive from the
convertible hedge itself and not just from the accumulation of
independent rights of components of the convertible hedge. The
right to convert for example is a right attached to the long side
of a convertible hedge. It exists whether or not it is a
component of a convertible hedge. Similarly, the right to cover a
short position at a time which would yield a favourable result is
not dependent on the short position being part of a convertible
hedge. These are both rights imbedded in the convertible hedge
and arguably can be viewed together to constitute property. But
the right which only arises from the convertible hedge itself,
and consequently satisfies me that the convertible hedge is
property, is the right to rely on one component of the
convertible hedge to satisfy the margin requirements of the other
component, whether this be in a single account or through the
auspices of a Guarantor's account. The experts'
description of the convertible hedge, combined with the evidence
of Mr. Sildva and Mr. McCrodon confirmed that the brokerage
houses' agreement with those engaged in convertible hedges
included a provision to waive the usual strict requirements for
margin, and accept that a convertible long position was in and of
itself sufficient margin for the short position. This was
critical to the operation of the convertible hedge, and it was
something the investor was able to rely upon in the arrangement
with the broker. It was, I would suggest, a legally enforceable
claim that the broker would provide margin on this basis. In
summary, the convertible hedge consists of components containing
rights; it also, by its very essence, creates a right particular
to the convertible hedge alone. The convertible hedge meets the
broad Income Tax Act definition of property.
[121] That conclusion alone is not sufficient to justify
a finding that it is "property" which constitutes a
source for tax purposes. The characterization of something as
property must fit within the scheme of the Act to catch it
in taxation's net. There are many rights which would be
property pursuant to the Act's broad definition, yet
would not easily be pegged as "property as a source" as
contemplated in section 3. The property must be viewed in
context, and the context of the convertible hedge property is
property of an adventure in the nature of trade, a business. The
business is the source.
[122] Having determined that one can legally justify
reference to the convertible hedge as a separate
identifiable thing, a property for purposes of the Income Tax
Act, I want to review whether the witnesses, both
experts' and laymen's, understanding supports this
position. I believe it does. All witnesses referred to the
convertible hedge as if it was a thing of its own accord. This
may be a reflection of the limitations of language, but when
combined with the following features, it leads me to the
conclusion that the convertible hedge was viewed as a stand-alone
investment constituting a business, by virtue of being an
adventure in the nature of trade.
[123] With the exception perhaps of Mr. Rezek and Mrs.
Hayes, I am satisfied that all Appellants understood that the
profit from the convertible hedge arose in two ways - from cash
flow while holding the convertible hedge, and from an increase in
the value of the spread from the time an Appellant laid out an
amount to establish the convertible hedge (the spread) to the
time of the wind-up of the convertible hedge. The experts
confirmed these were the upsides of the convertible hedge. This
is what the investment was all about. Mr. Hayes, particularly,
was not motivated by the tax consideration aspect of Mr.
Maguire's win-win rallying call. It was the convertible hedge
itself that would yield his return.
[124] The Appellants also understood that the cash flow
was not a one-sided determination - it was a net determination.
The analysis from Mr. Maguire's office showed both the income
from the long side and the expense on the short side. The cash
flow was from the convertible hedge, not just from one
component.
[125] It was evident from Mr. and Mrs. Stephens'
reaction to the receipt of their first trading slips and other
reporting information, that they were alarmed at the size of the
numbers. Mr. Stephens put in just a few thousand dollars yet he
was receiving confirmation of hundreds of thousands of dollars of
investments. In his view, his investment was only a few thousand
dollars, which accords to the investment being the convertible
hedge itself. This position was also supported by the expert, Mr.
Croft, in his discussion of risk. The idea that the convertible
hedge investment was low risk was not how Mr. Croft described it,
for, as he indicated, the investor puts up a few thousand dollars
and that whole amount, the investor's whole investment may be
lost. This is how he put it:
Q. And I put it to
you that the risk that an investor was exposed to in a
convertible hedge position, particularly the way these hedges
were orchestrated, set up, was at best or at most the
premium?
A. You're
absolutely correct in that, but when you talk about low risk, I
mean, in theory, you could lose the entire premium, which
you've put up.
So in theory, the investment you've made, you could lose your
entire investment.
[Transcript page 2010 lines 7 to 13.]
[126] Professor Kirzner had a somewhat different
assessment of risk, referring to the temporal risk described
earlier. This does suggest that the two components of a
convertible hedge are viewed separately for purposes of assessing
this temporal risk. However, the risk is only apparent when a
position is legged in, leaving one side exposed to some degree in
a naked position; the position is not fully hedged - in other
words, there does not yet exist a full-blown convertible hedge.
Once a convertible hedge has come into being, the temporal risk
disappears. I do not see this position as a significant departure
from the view that the convertible hedge, once in place, is a
separate property with its own characteristics. Certainly, the
investors' evidence was that they never felt that anything
more than their outlay in the convertible hedge was at risk. And
indeed there were no instances of an investor ever losing even
all of that outlay.
[127] I conclude it was a common view that the
investment was the convertible hedge itself. This is consistent
with the finding that the convertible hedge is a property, and it
is that property which is the subject of the Appellants'
adventure, the Appellants' business.
[128] I wish to briefly tie in this finding of a
convertible hedge as property with my finding of an adventurer
rather than a trader. For how does one trade in convertible
hedges? How transferable is this property? There is no exchange
for convertible hedges. They are disposed of by being unwound.
Nothing in the definition of property requires transferability as
a requisite ingredient. It is difficult to conceptualize carrying
on a business of trading in convertible hedges. Yet, there is no
such difficulty in viewing transactions involving the convertible
hedge as an adventure in the nature of trade. They exist
in a commercial trading environment; indeed, they are a financial
product of that very environment, though they cannot be traded as
such. By their very nature, they are destined to remain as
adventures in the nature of trade. This expression seems aptly
suited to this particular application.
(c) Issue:
Were the Appellants' adventures carried on with
a partner or through an agent?
[129] Given the Federal Court of Appeal's decisions
in Schultz[13] and Carter,[14]it is not surprising that
counsel spent the majority of their time arguing the partnership
issue. Having found the Appellants' adventures were engaging
specifically in convertible hedges, as opposed to stock
transactions, the significance of the partnership issue, as will
soon be evident, is somewhat diminished.
Appellants' Position
[130] The Appellants' position is that in none of
the Appellants' situations do the essential elements of a
partnership exist. The Appellants' own evidence, combined
with the effect of the documents entered into by them and the
views held by third parties with whom they dealt, lead to the
only reasonable inference that no partnership existed.
[131] Mr. Shaw maintained that the partnership position
collapses when the trades constituting the convertible hedges are
closely scrutinized. He broke the convertible hedges down into
categories: transactions by one investor, with which these
appeals are not concerned; combined trades, with no subsequent
trades, effectively what I will call solo convertible hedges (23
of them); combination trades with subsequent trades, being the
convertible hedges with the involvement of a Guarantor (16 of
them); and not an initial combination trade, but where the short
and long positions were open in two different accounts (two of
the Hayes' convertible hedges). Neither of the first two
categories was assessed as being carried on in partnership. The
16 convertible hedges in the third category were so assessed. Of
those 16 convertible hedges, 15 went into a common-common
position, a combined position that can by its very nature not
yield any profit.
[132] With respect to the solo convertible hedges, Mr.
Shaw suggested that the Guarantor, and he used Gloria Fahrngruber
as an example, still provided financial support and yet those
hedges were not assessed as being part of the partnership. So she
uses alleged partnership property in convertible hedges not being
assessed as part of a partnership. This does not jive with
section 8 of the Partnership Act of Ontario, which does
not bind a party to such credit arrangements unless specifically
authorized by the other party. In effect the partnership mould
does not fit.
[133] In dealing with the convertible hedges in which a
subsequent trade triggers an immediate common-common position,
Mr. Shaw makes the point that if the partnership only arises upon
the Guarantor engaging in a subsequent trade, and the effect of
that subsequent trade is to be put in a common-common position,
then how can it possibly be said that there is any common intent
to profit. There is indeed no possibility to profit - there can,
therefore, be no partnership.
[134] Mr. Shaw also gives the example of the Husky
convertible hedge of Mrs. Scott in which the Crown assessed
Mrs. Scott as being in a partnership with her daughter in 1984,
yet the first involvement of Patricia Scott in a subsequent trade
was in 1985. Up to that point, Mrs. Scott could not have been
seen as being in a partnership as the Crown did not allege
partnership in any solo convertible hedges. Yet, once a
subsequent trade occurs with her daughter, a partnership is
somehow backdated to the previous year. Again, the partnership
mould does not fit. Mr. Shaw maintains it is simply a
result-driven conclusion. A similar example was given with
respect to Mr. Rezek's Laidlaw convertible hedge.
[135] The Appellants argue that the partnership does not
commence until there is a partnership activity, and if the
activity which commences a partnership immediately brings the
alleged partnership to an end, it cannot be considered a
partnership. All the Guarantor is doing is providing
financing.
[136] The Appellants view the Respondent's attempt
to find a husband and wife as a commercial partnership as a guise
for circumventing Parliament's expressed refusal to tax
families as a unit. There is no denying the husband and the wife
are in a partnership of marriage, but this does not in any way
imply a business partnership.
[137] The Appellants went through some considerable case
law, commencing with Continental Bank of Canada v. The
Queen,[15]
which was relied upon for the proposition that there must be a
partnership agreement which governs the affairs of the
partnership. Part of that agreement must be to share profits.
There is no evidence of any such agreement according to the
Appellants. They further rely on Continental Bank for the
proposition that if the sole reason for the creation of a
partnership is to obtain a benefit from a tax loss, this is not
sufficient to constitute the formation of a partnership with a
view to profit.
[138] The approach Mr. Shaw urges me to accept is that
established in Backman:[16]
... Whether a partnership has been established in a particular
case will depend on an analysis and weighing of the relevant
factors in the context of all the surrounding circumstances. That
the alleged partnership must be considered in the totality of the
circumstances prevents a mechanical application of a checklist or
a test with more precisely defined parameters.
The Appellants referred to the following evidence to support
the position there is no partnership:
(i) the Appellants never
intended to be partners;
(ii) they never shared
profits;
(iii) the documents, specifically the
account-opening forms, denied partnership; and
(iv) third parties such as brokers did
not consider the Appellants as carrying on a partnership.
[139] In connection with the guarantees, the
Appellants' position is that they were a means of financing
only, and would have to be recharacterized as redundant if I am
to find a partnership existed.
[140] Finally, on the partnership issue, the Appellants
had to deal with the Schultz and Carter decisions.
Mr. Shaw took two approaches to this argument; first, that they
are distinguishable on the facts; and second, that they were
decided prior to today's new paradigm based on
Shell,[17]
Singleton,[18] Stewart v. The Queen[19] and Walls and Buvyer
v. The Queen.[20] This new paradigm requires that the Court look to the
real legal transactions in relationships, and not focus on
economic realities. If there is more than one version of what
took place, the Court should not be driven to accept the version
that denies tax advantages.
[141] As far as factual distinctions go, a key
difference, according to the Appellants, is that in
Schultz and Carter the evidence was clear the
transactions were undertaken for income-splitting purposes. There
is no such evidence in these appeals. Also, those cases dealt
with convertible hedges where the opening positions were in two
separate accounts. We are faced with that situation in only two
of the many cases before me. Also, unlike the Appellants'
circumstances, in Schultz there were no solo convertible
hedges, or, more significantly, no solo convertible hedges which,
upon a subsequent trade involving a Guarantor, allegedly becomes
a partnership. As Mr. Shaw put it, "you are a single or a
self hedger right up until the millisecond before the alleged
shift".
[142] Finally, in addressing the agency issue, the
Appellants argue that agency is likewise only a way to circumvent
the fundamental principle that families are not taxed as a unit.
The Appellants suggest I cannot find agency where the parties
deny it. To do so, other than in the case of Muriel Scott, would
deny the real relationships with third parties and also render
the guarantees redundant.
Respondent's Position
[143] The Respondent classified the convertible hedges
as either one account or two account convertible hedges;
subcategories were unnecessary. But the convertible hedge,
whether in one or two accounts, has to be viewed together as a
capital asset, the disposition of which produces income.
[144] Relying on Backman v. Canada[21] and Spire
Freezers,[22]
the three elements required for a partnership are: a business,
carried on in common, with a view to profit. The Schultz
case determined that all elements were in evidence in the
convertible hedge arrangement before it. The same, according to
Mr. Gluch, applies in the convertible hedges before me. These
cases are not significantly distinguishable from the
Schultz and Carter cases.
[145] The general principles relied upon by Mr. Gluch in
asserting this position are:
(i) one partner may run a
partnership's affairs for the other partners: there is no
need for an equal role (Continental Bank);
(ii) the element of intent is a
question of fact (Spire Freezers); and
(iii) a partnership exists not because
of the familial relationship but because the couple were in the
convertible hedge together.
[146] Although one partner was more active, that is not
sufficient to deny partnership, especially where the intent
gleaned from their conduct points to the common view to
profit.
Analysis
[147] I agree with Mr. Shaw that legal realities cannot
be ignored for the sake of surrendering to the economic realities
of the situation. He suggested this could be the only
justification for the finding of a legal partnership - it accords
with economic realities. I suggest a corollary in Mr. Shaw's
new paradigm, and that is, where the legal realities, absent
sham, can be interpreted in more than one way, one of which is
consistent with the economic realities, then decisions should be
based on the interpretation where the legal and economic
realities mesh. The Respondent maintains that indeed the legal
reality is that the convertible hedge strategies were carried on
in partnership. The Appellants argue that the legal reality of
the convertible hedge is that of two independent investors
engaging in their own stock transactions albeit guaranteeing each
other's accounts as a means of providing financial support.
With respect, I believe each side is attempting to force the
square peg into the round hole. The reason, I suggest, is because
relying on conventional applications of legal principles to
unconventional financial strategies is simply inadequate. To
overlap the whole business with the application of tax
principles, governed by a piece of legislation that has never
been praised for its simplicity, complicates an already complex
situation. I do not find that the convertible hedge strategy was
carried on in partnership as a business in common with a view to
profit. I also do not find the convertible hedge strategy was
implemented by two independent investors. What is real, both
legally and economically, is that Mr. Rezek, Mr. Hayes,
Mr. Stephens and Mrs. Scott invested in convertible
hedges, an identifiable separate investment vehicle, a scheme.
The Guarantors assisted with the financing of that investment by
providing guarantees, supported by the very stock which was part
of the adventure: the Guarantors very much became a part of the
scheme of profit-making. With the exception of Patricia
Scott, they were joint adventurers, and for a period of time,
however brief, had an ownership interest in the convertible
hedge. My reasons for coming to this conclusion are as
follows.
[148] I have already found that none of the Appellants
were carrying on a business, but received business income from
the disposition of their convertible hedges as an adventure in
the nature of trade. A partnership is the relation that subsists
between persons carrying on a business in common with a view to
profit. As I have indicated, there is a distinction under
taxation principles between "carrying on a business"
and "engaging in an adventure in the nature of trade".
Although the Appellants' adventures were not isolated, as
most of them did engage in more than one convertible hedge with a
second person, a string of adventures over a period of time does
not, in these appeals, constitute carrying on business for tax
purposes. Does it though, constitute carrying on business in
common with a view to profit for purposes of partnership law? I
do not believe so.
[149] The starting point is the definition of business
in the Partnership Act of Ontario which includes every
trade, occupation and profession. There is no reference to an
adventure in the nature of trade. The acquisition and disposition
of convertible hedges is neither an occupation nor profession in
the ordinary meaning of those words. What is left to consider is
whether such activity constitutes a trade. The separate
components of the convertible hedge involve trading, and the
convertible hedge itself is acquired and disposed of in a trading
environment though, as previously established, the convertible
hedge itself is not traded. Can there be a business in a product
you cannot trade? Where is the market for the convertible hedge?
How is it advertised? What do the owners of the business do,
apart from some limited communication with an advisor and broker?
While the answers might raise scepticism in the idea that
convertible hedging activity is a business, the Federal Court of
Appeal in Schultz[23] has provided a sufficiently broad meaning
of the word to rebut these concerns, as it stated:
... Lindley & Banks on Partnership ... concludes at
page 8, that "virtually any activity or venture of a
commercial nature ... will be regarded as a business for this
purpose". Again, in Smith v. Anderson ... expressed
the view that, ...
anything which occupies the time and attention and labour of a
man for the purpose of profit is business. It is a word of
extensive use and indefinite signification.
In my view, the trading transactions here in issue
constituted a "business" as defined in the Ontario
statute.
It is apparent that the Federal Court of Appeal did not
consider the convertible hedge as a separate asset, being the
very subject matter of the alleged "business", but
viewed "trading transactions" separately, and
consequently well within the ambit of the term "trade".
The distinction, I suggest, does not go to the issue of business
as much as to the issue of carrying on the business.
[150] Presuming then that the very commerciality of the
convertible hedge, being a product of the financial marketplace,
justifies there being a business, was it carried on in common
with a view to profit? In Continental Bank, little
activity was required to find a business was carried on, though,
in that case, there was a business being carried on prior to the
partnership, and although no new business was created during the
partnership, it was sufficient that the existing business was
carried on. In the cases before me, I would have to find that Mr.
Rezek, Mr. Hayes, Mr. Stephens and Mrs. Scott were all
carrying on a business and that business was continued by a
partnership upon the involvement of the Guarantor. As noted, I
have not found any of them individually were carrying on a
business, though they were each engaged in a scheme for
profit-making for tax purposes.
[151] In commercial terms can one have a business
without carrying on a business? Certainly that is exactly what is
contemplated in tax terms given the Act's definition
of "business" to include an adventure in the nature of
trade. There are situations, such as this, where business is not
occasioned by being carried on; it is occasioned by being an
adventure. I suggest that all the factors reviewed in determining
the issue of trader or adventurer are equally pertinent in a
commercial consideration of what is meant by carrying on a
business. What is required is an expenditure of time, energy and
labour, and trappings of a commercial enterprise, which are
non-existent with these Appellants. There was no business being
carried on to be continued to be carried on in the form of a
partnership.
[152] This raises an interesting dilemma. If there was a
partnership when did it commence? I agree with the Appellants
that no partnership could have existed until the Guarantor
acquired a component of the convertible hedge. The Respondent
suggests that the partnership existed for all of the convertible
hedges at the time the Guarantor opened accounts and signed the
guarantees. Yet the Respondent has not assessed any of the
Appellants' solo convertible hedges, entered into after the
Guarantors signed account-opening documents, as forming part of
the partnership. Only when the Guarantor is introduced to the
solo convertible hedge by acquiring a component of the
convertible hedge does the Respondent treat the convertible hedge
as being in a partnership from the outset. The evidence from the
Appellants was that they did not view their solo convertible
hedges as any different from the convertible hedges in which a
Guarantor ultimately held a component. Neither was carried on in
a partnership.
[153] Given there was no partnership agreement, and
there was an expressed intent of the parties that they were not
in partnership, to find the partnership started when the
Respondent suggests would require conduct of the parties
overwhelmingly pointing to that finding. Their conduct is more
consistent with a finding that, if there was a partnership, it
did not commence until the partnership acquired a component of
the convertible hedge. Prior to that, the only conduct the
Respondent could rely upon would be the execution of the
account-opening form and guarantee. Yet the signing of such forms
by the Guarantor contained an express declaration this was not
done in partnership. The conduct of the Guarantor at that
time was consistent with the position that they were
establishing independent accounts supported by guarantees from
their respective relative. An equally probable view of their
activities, and certainly the most likely view in
Pat Scott's case, was that they simply signed what was
necessary, not for establishing a partnership, but for providing
the required margin support to assist their spouse or mother,
with their investment. Their subsequent conduct is not sufficient
to effectively backdate a partnership to a date when no
partnership was intended, nor can be inferred. If there was a
partnership, it could not have commenced until the Guarantor
acquired a component of the convertible hedge.
[154] The conduct of the Appellants and the Guarantor at
the time the Guarantor acquired a component of the convertible
hedge likewise does not support a finding of partnership. Apart
from the Hayes' two convertible hedges that they opened
together in two accounts, in every other convertible hedge
involving a Guarantor, the acquisition by the Guarantor of a
component of the convertible hedge occurred coincidentally with
an Appellant's disposition, which triggered a tax loss.
Indeed, Mr. Sildva's evidence was quite blunt. This is why
they did it - this is why he got into the business. To trigger an
$80,000 tax refund, in Mr. Rezek's case, on a few
thousand dollars investment was enticing. But how can it be this
event which commenced the alleged partnership? Justice Bastarache
pointed out in Continental Bank:[24]
... Lindley & Banks on Partnership makes the
following observation:
... if a partnership is formed with some other predominant
motive [other than the acquisition of profit], e.g., tax
avoidance, but there is also a real, albeit ancillary, profit
element, it may be permissible to infer that the business is
being carried on "with a view of profit". If, however,
it could be shown that the sole reason for the creation of a
partnership was to give a particular partner the
"benefit" of, say, a tax loss, when there was no
contemplation in the parties' minds that a profit ... would
be derived from carrying on the relevant business, the
partnership could not in any real sense be said to have been
formed "with a view of profit".
[155] With respect to the element of a partnership
requiring a view to profit, there could have been no
contemplation in the Guarantors' minds that there would be
any profit from the business purportedly carried on by the
Appellants, because in the majority of the convertible hedges in
which the Guarantors became involved, it was known at the time of
their involvement that the convertible hedge was to be unwound
(disposed of) in the near future at a loss. Also, the
parties went into a common-common position, with no possible
economic benefit to that combined position, shortly after the
so-called commencement of the partnership. Knowing the
convertible hedge was to be unwound at a loss does not however
preclude a finding the Guarantor joined a scheme of
profit-making, an adventure in the nature of trade. For, unlike
the more stringent law that has developed around partnerships for
tax purposes, there are less well-defined principles as to how to
treat a scheme of profit-making. When a Guarantor entered the
fray by acquiring a component of the convertible hedge, and thus
became a part owner of the convertible hedge, the Guarantor
joined a scheme already in process. The Guarantor intended, as
the conduct was masterminded by Mr. Maguire, that the convertible
hedge stay alive. The scheme of profit-making required this, as
the scheme involved the three elements of net cash flow, gain on
the spread and tax refunds from losses. The Guarantor joined a
scheme: the Guarantor did not initiate a partnership.
[156] Some examples will assist in appreciating the
timing of the Guarantor's actions. First, look at Mr.
Rezek's one and only convertible hedge in two accounts. On
May 20, 1988, he sold his long position of Laidlaw for a $138,431
loss, coincidentally with Ms. Fahrngruber acquiring a long
position. Less than three months later, Ms. Fahrngruber converted
her position into common, resulting in the two of them holding a
common-common position. At this point, the change in the spread
for Mr. Rezek's initial outlay for acquiring the convertible
hedge had gone down approximately $2,600 - the convertible hedge
lost that amount on wind-up. That loss was in fact locked in at
the time Ms. Fahrngruber acquired her long position. There
was no opportunity for profit in the "business" of
acquiring and disposing of convertible hedges.
[157] This is even more evident in the example of the
Stephens' Alcan hedge (see Appendix "C"). When
Terry Stephens acquired 8,000 common Alcan shares in December
1986, coincidentally with Steven Stephens selling his 8,000 Alcan
warrants, the Stephens' immediately went into a
common-common position, one with no opportunity for any economic
gain. Mrs. Stephens' very action of acquiring a component of
the convertible hedge immediately terminated the convertible
hedge. Put in terms of an alleged partnership, her very act of
commencing the partnership simultaneously terminated the
partnership. Put in terms of an adventure, her actions were the
final necessary ingredient in her husband's adventure, and by
taking such action she became part of it, however briefly. There
are similar examples in Mrs. Scott's convertible hedges.
[158] There are as well a few examples (a minority)
where the acquisition of the Guarantor of a component of the
convertible hedge does trigger a gain on the convertible hedge.
(Bear in mind this is always accompanied by the alleged loss on
the side of the Appellant disposing of a component of the
convertible hedge.) For example, on the Stephens'
Falconbridge hedge, Mrs. Stephens acquired 10,000
Falconbridge common shares on October 27, 1987, and Mr. Stephens
sold 10,000 Falconbridge rights on October 28, triggering a
"loss" of $33,894 on Mr. Stephens' sale, but also
triggering a gain on the spread, on the convertible hedge, as
these transactions put the Stephens' into a common-common
position. This signifies a termination of the convertible hedge.
So, while in this case there was a gain on the convertible hedge
itself, the coincidental impact of Mrs. Stephens entering
into the convertible hedge was to put herself and her husband in
an immediately non-economic common-common position, a position
with no possibility of profit. This is not even for a moment a
business being carried on in partnership for profit.
[159] The foregoing is the essence of my reasons for
concluding a partnership does not exist in any of the
Appellants' cases. There are a couple of other factors,
however, which are supportive of this position. First, a
fundamental element of a partnership is a partnership contract
and no such contract can be inferred from the Appellants'
conduct. There remains too much vagueness from the conduct to
identify with any certainty the commencement date of the
partnership, the capital contributions and the arrangement for
sharing of profits, if any. To find a partnership agreement
existed I would have to find that the very mechanics of the
convertible hedge itself was the totality of the partnership
agreement. That is, if a convertible hedge is established in two
accounts it follows there is a partnership agreement. This may be
what the Respondent wants me to take from the Schultz and
Carter cases. I do not find those cases go that far, and I
will have more to comment on that shortly.
[160] Another factor to consider is the import of the
cross-guarantees. Without these guarantees there could be no
two-account convertible hedge, although obviously a solo
convertible hedge was still possible. There are two ways to view
the guarantees. One, as the Respondent contends, as supporting
the notion that the Appellants and Guarantors were, as partners,
jointly responsible for the partnership's liabilities. The
other, as the Appellants contend, as supporting the notion that
the guarantees evidence no partnership, as partners are liable
for partnership obligations without the necessity of a guarantee.
The guarantees went to the margin requirements, and in effect
significantly reduced the margin required in either the
Appellants' or 'Guarantors' accounts. It was a means
of providing financial support. I do not consider the guarantees
on balance as providing any support for a finding that a
partnership was carrying on a business. They were certainly part
of the convertible hedge strategy but are more consistent with a
wife assisting a husband in a financial adventure, as something a
spouse does as part of their marriage, rather than as a
commercial partnership. As Associate Chief Judge Christie put it
in Sedelnick Estate v. M.N.R:[25]
... Where there is no evidence of the existence of an express
partnership agreement between husband and wife then in the
absence of some special reason, which I cannot at the moment
foresee, the existence of such a partnership should not be
inferred from the conduct of the parties if that conduct is
equally consistent with conduct arising out of the community of
interests created by the marriage. ...
[161] It comes now to deal with the Federal Court of
Appeal decisions in Schultz and Carter, which the
Respondent emphasized are indistinguishable from the cases before
me, binding me to find that a partnership existed with the
consequential tax treatment sought by the Respondent. As already
indicated, the Federal Court of Appeal found the trading
transactions constituted a business, given the broadest
definition of that term, and proceeded to determine the business
was carried on in common with a view to profit. The trading
transactions to which the Federal Court of Appeal referred were
the separate stock transactions. They do not appear to have been
presented with the argument that the transactions of the business
were transactions in convertible hedges. This does, I would
suggest, put a different spin on the use of the term
"trade", for the determination of whether or not a
business exists. It was unnecessary then for the Federal Court of
Appeal to distinguish the "carrying on of a business"
from the "engaging in an adventure in the nature of
trade". The facts before me support the latter.
[162] A comparison of the facts in Schultz with
the facts before me do establish some significant
differences:
(i) The Schultz's agreed to consult
Mr. Maguire about income splitting. In all the cases before me,
the Guarantor dealt with Maguire, if at all, separate from the
Appellant. There was no evidence that such discussion involved
meeting any income-splitting objective. The evidence, apart from
Pat Scott, suggested the discussion centred on the
Guarantors engaging in their own investments. Their subsequent
conduct supports a coordination with their spouse's
investments, yet does not preclude an intention of a longer term
holding of a common stock.
(ii) The Schultz's case involved the issue
of an investment club strategy as well as the convertible hedging
issue. No such background was present in any of the current
appeals, which might have established a compelling backdrop for
the finding of a partnership.
(iii) In Schultz, all positions were started with
husband selling short and spouse buying long. In only two of the
many convertible hedges before me was that the case. In the vast
majority, the Appellant would acquire the solo convertible hedge.
Only as a result of "tax planning" was the Guarantor
introduced to assume a component of the convertible hedge. If the
Guarantor never took a component of the convertible hedge, the
Appellant would continue to be treated separately as sole owner
of the convertible hedge.
(iv) In Schultz, there was no example of Mrs. Schultz
ever selling short - she always took the long position. There are
several examples of the Guarantors before me taking short
positions, with the accompanying incidence of expenses.
(v) In Schultz, all payments for the
acquisition of the convertible hedge came from a joint account.
Not so for all the Appellants before me. Some had to borrow the
initial outlay. Some funded it from their own account.
(vi) In Schultz, there appeared to be no evidence of
independent dealings. Indeed, Mrs. Schultz was the driving force
and Mr. Schultz simply went along. Apart from Pat Scott,
there was evidence of some independent dealing with all of the
Guarantors.
(vii) In Schultz, there were no solo convertible hedges,
nor evidence of non-hedging investment. There are many solo
convertible hedges amongst the Appellants before me, as well as
some evidence of independent investing.
(viii) In both Schultz and Carter, it was determined that neither
had any reasonable expectation of profit from their own
transactions viewed independently from their respective
cross-Guarantors. That is not the case here. Mr. Rezek, Mr.
Hayes, Mr. Stephens and Mrs. Scott all expected profits from
their convertible hedge activities, whether held in one account
or two. This is a key distinction. In Schultz and Carter the
arrangement could only make economic sense as a partnership, as a
business being carried on jointly. The Guarantor in the case
before me did not introduce a profit element, that, until their
involvement, did not exist. The parties always intended to profit
from their adventure in the convertible hedge.
(ix) In Schultz, it was indicated Mrs. Schultz's
account was used to pay for Dr. Schultz losses. While margin
support was provided by the Guarantors before me, I had no
evidence of any payment from the Guarantors to pay for
losses.
[163] Yes, the Schultzs and Carters were engaged in
similar convertible hedging strategies through the auspices of
Maguire & Associates, but the circumstances appear to have
been quite different from the facts of the cases before me. It is
these distinctions, more so than Mr. Shaw's suggested new
paradigm, that allow me to depart from the findings of
Schultz and Carter. Yet, the departure is
legalistic only, as I concur with the findings in those decisions
to the extent that I too believe there existed a coordinated
scheme for profit-making. I just do not believe it has
sufficient trappings of partnership to characterize it as such. I
see it more as an individual engaged in an adventure in the
nature of trade, and where appropriate, engaging a second
individual in that same adventure.
[164] For these reasons, I do not feel that the
Schultz and Carter cases bind me to a finding of
partnership in every case of a two account convertible hedge.
Only if the facts fit. In the cases before me, the facts do no
fit.
[165] The Supreme Court of Canada in the Backman
case directed courts in the following manner, in considering the
issue of partnership:
[26] Courts must be pragmatic in their approach to the
three essential ingredients of partnership. Whether a partnership
has been established in a particular case will depend on an
analysis and weighing of the relevant factors in the context of
all the surrounding circumstances. That the alleged partnership
must be considered in the totality of the circumstances prevents
the mechanical application of a checklist or a test with more
precisely defined parameters.
In applying this common sense approach, I am satisfied the
circumstances of these Appellants' convertible hedges do not
justify a finding of partnership.
[166] Given my finding on this issue, it is unnecessary
for me to review the question of agency. The Respondent and the
Appellants, however, have agreed that in the case of Mrs. Scott,
Patricia Scott acted as an agent. Patricia Scott's
involvement in her mother's convertible hedge was quite
different from any of the other parties. I accept the agreement
between the parties that indeed an agency relationship existed in
the Scotts' situation. In all other two account convertible
hedges, the Appellant and Guarantor were co-adventurers in
convertible hedging.
(d) Issue
[167] Based on my findings thus far, what tax
treatment is to be accorded the convertible hedges,
specifically:
(i) determination of when the income or
losses on the convertible hedge arise;
(ii) in whose hands the income and losses
are taxable;
(iii) the taxation of the cash flow generated during
the convertible hedge;
(iv) the tax treatment of the Appellant's
position subsequent to the wind-up of a convertible hedge;
and
(v) the reliance on the lower of cost or market
method of inventory valuation both during and after the
convertible hedge.
Appellants' Position
[168] The Appellants' overriding view is that
the tax treatment to be afforded the Appellants should not be
results driven, but should present the fairest picture of the
Appellants' profits over the years in question, in accordance
with their legal positions.
[169] The ability of a taxpayer to avail him or
herself of the provisions of subsection 10(1) of the Income
Tax Act depend on the nature of the business carried on by
the taxpayer. The Appellants point out that traders, that is
those carrying on business, are eligible for the lower of cost or
market treatment, and in certain circumstances so are
adventurers. Those circumstances are set out in the amending
provisions of subsection 70(1) c. 19, S.C. 1998 the
"inventory amending provisions" as follows:
History: S. 10(1) was amended by S.C. 1998, c.19, s.
70(1), applicable
(a) to
taxation years that end after December 20, 1995;
(b) in
respect of a business that is an adventure or concern in the
nature of trade, to taxation years of a taxpayer that end before
December 21, 1995, except where
(ii) the
taxpayer's filing-due date for the year is after December 20,
1995, or
(ii) the taxpayer
has valued the inventory of the business for the purpose of
computing income for the year from the business at an amount that
is less than the cost at which the taxpayer acquired the
property, which valuation is reflected in a return of income,
notice of objection or notice of appeal filed or served under the
Act before December 21, 1995; and
(c) in
respect of a business that is an adventure or concern in the
nature of trade, to fiscal periods of a partnership that end
before December 21, 1995, except where
(i) the
filing-due dates of all of the members of the partnership for
their taxation years that include the end of the fiscal period
are after December 20, 1995, or
(ii) the
partnership has valued the inventory of the business for the
purpose of computing income for the fiscal period from the
business at an amount that is less than the cost at which the
partnership acquired the property, which valuation is reflected
in a return of income, notice of objection or notice of appeal
filed or served under the Act before December 21, 1995 by
any member of the partnership.
[170] Mr. Shaw acknowledges that should I find the
Appellants were not carrying on business, but were only engaged
in adventures in the nature of trade, then, apart from Mrs.
Scott, who may be eligible due to compliance with this section
just cited, the Appellants would not be able to avail themselves
with the mark to market method of inventory valuation.
[171] The Appellants then go on to argue that the
inventory is represented by the two separate components of the
convertible hedge, that is, both the long position and the short
position can be separately identified as inventory. The
Appellants put forth the proposition that both the long position
and the short position in securities held in a business of
transacting in securities are inventory. And relying on The
Queen v. Friedberg,[26] maintains that the two positions do not lose their
identity as separate components, certainly in the commodity
futures market.
[172] Mr. Shaw, in arguing the short position in
the convertible hedge scenario is inventory, had to first
establish that the short position is property. He did so by
describing the short position as embodying a right, albeit a
negative right, but one which can be valued. He cast the property
net widely to cover any sort of interest a person may have,
including this negative right.
[173] In determining the most accurate picture of
the Appellants' profit, Mr. Shaw offers guidelines from
the Supreme Court of Canada comments in Canderel Limited v.
The Queen,[27] specifically:
... Generally speaking, the courts are free, in the absence of
contrary legislation or established rules of law, to assess the
taxpayer's computation of income in accordance with
well-accepted business principles. Obviously, this will require
an assessment in each case of which of these principles apply to
the particular circumstances which present themselves. However,
it is not for the court to decide that one principle is
paramount, or applicable to the exclusion or subordination of all
others by saying that it has been elevated to the status of a
rule of law which is to be applied in all situations. That is
exclusively within the province of Parliament, and the
willingness of Parliament to exercise this power is exemplified
by s. 18(9) and by countless other codifications in the Act of
what would otherwise likely be considered well-accepted business
principles: see Symes, supra, at pp. 723-725.
...
... However, when no specific legal rule has been developed,
either in the case law or under the Act, the taxpayer will
be free to calculate his or her income in accordance with
well-accepted business principles, and to adopt whichever of
these is appropriate in the particular circumstances, is not
inconsistent with the law, and, as I shall elaborate upon below,
yields an accurate picture of his profit for the year. The simple
application by a court of one or another well-accepted business
principle to a particular case or cases, moreover, will not
ordinarily amount to the elevation of that principle to the
status of a "rule of law". In general, the Minister
will not be entitled to insist that one method supported by
business practice and commercial principles be employed over
another, equally supported method, unless, as I will develop
below, the method chosen by the taxpayer fails to yield an
accurate picture of his or her income for the taxation year.
Respondent's Position
[174] The Respondent's position, based on a
partnership analysis, does not fully address some of these
matters. However, it is clear that the Respondent never viewed an
Appellant and Guarantor as holding separate positions. The
positions should always be netted. Only this approach yields the
fairest picture of possible profit.
[175] The Respondent agrees with the Appellants'
analysis of subsection 10(1) of the Income Tax Act as it
applies to traders, or in its limited application to those
engaged in an adventure in the nature of trade. The Respondent
suggests that the Appellants were not traders, a suggestion with
which I have already concurred. The only Appellant who, as an
adventurer, possibly qualifies is Mrs. Scott due to her form of
reporting for 1989, 1990 and 1991, in which certain stock were
marked to market. Yet, Mr. Rhodes makes three arguments: first,
he argues that her reliance on the marked to market method in
those years was limited to only certain stock, and, therefore,
cannot pertain to any other stock in later years. Second, in a
convertible hedge, the inventory is the convertible hedge itself,
that is the property to be marked to market, not the component
parts. Third, with respect to short positions, he argues that
they are not property and, therefore, not inventory. He relies on
the proposition from the The Queen v. Dresden Farm Equipment
Ltd.[28] case that the taxpayer must have a
property interest in the inventory for it to be considered as
inventory. Also citing Tip Top Tailors Limited v.
M.N.R.,[29]
Mr. Rhodes goes on to argue that a "debt is neither an asset
nor an investment - even though it may be exposed to the risk of
variable value". The short position is not a negative right,
as suggested by Mr. Shaw, but is more in the nature of a
debt, an obligation to the lender of the security to return that
security. Even if short positions were considered property, the
application of subsection 10(1) of the Act is inapplicable
as rather than valuing at the lower of cost or market, the
alleged properties are being valued at the higher of cost at
market.
Analysis
(i) When is the convertible
hedge disposed of for the purposes of determining the income or
loss on a convertible hedge?
[176] The adventure in which the Appellants engaged, the
business for tax purposes, is convertible hedging - acquiring and
disposing of convertible hedges. The acquisition cost of the
convertible hedge is the spread at the time the convertible hedge
is fully established. The proceeds of disposition of the
convertible hedge are determinable upon the unwinding of the
convertible hedge. The timing of that unwinding depends on the
nature of steps taken to unwind. In all of the convertible hedges
in which a Guarantor was involved, the unwinding was by the
action of going into a common-common offsetting position. That
action may have been by converting or subscribing to common from
the convertible security; it may have been by an abandonment of
the convertible security; it may have been by coincidental
purchase and sales in two separate accounts. What is significant
is that there is an occurrence resulting in a common-common
position, and that unwinds the convertible hedge, in effect
disposes of the convertible hedge. After that point in time there
is no scheme of profit-making; it is acknowledged there is
no possibility of a profit. There is certainly no adventure in
convertible hedging. What is there? Two people holding identical
offsetting positions in a hedge, co-owners of a hedge if you
will.
[177] Can the proceeds from the unwinding be identified
with certainty? Yes. It is a matter of comparing the spread on
acquisition of the convertible hedge with the spread at the time
of wind-up. The mathematical calculation is accomplished by
comparing all proceeds from the disposition of components of the
convertible hedge against all outlays for acquisitions of
components of the convertible hedge, occurring during the life of
the convertible hedge. This can be seen by referring to Appendix
"D", a reproduction of part of Tab 4 of Exhibit
5.3.
[178] If one simply adds all the amounts in column G and
column L, representing the outlays and intakes on the components
of the convertible hedge, one reaches a positive $6,971. This
represents the increase in the spread, or the gain on the
convertible hedge. The Respondent declared that a notional
disposition was necessary to determine this amount, as there is
no actual subsequent disposition of the two positions once they
went common-common. I suggest that it does not matter that there
is no subsequent disposition for purposes of calculating the gain
or loss from the convertible hedge, as that calculation should
take place on the actual disposition of the convertible hedge,
which is in the case of the co-adventurers at the time they went
common-common. In the example in Appendix "D" that
would be on July 2, 1987, notwithstanding Mrs. Scott and her
daughter continued to hold a common-common position
thereafter.
[179] With respect to the convertible hedges held in
just one account, in all but two of them, the convertible hedge
is unwound by actions that completely dispose of both components
of the convertible hedge. Again, this is accomplished in a number
of ways including a conversion, or a coincidental purchase to
cover the short position and sale of the long position. In the
single account convertible hedge it is readily ascertainable what
terminated the convertible hedge and when. The difference in the
spread is also calculable on the same basis as for the
two-person-account convertible hedge.
[180] In only two cases, the Hees stock held by Mr.
Hayes and Mrs. Scott, did the Appellants hold a position, in both
cases a long position in Hees warrants, subsequent to the
disposition of the convertible hedge. In both those cases, the
warrants were abandoned in the year following the unwinding of
the convertible hedge. However, the gain or loss on the
convertible hedge is still determinable, as in all other cases,
at the time of unwinding, by the same mathematical formula. It is
inappropriate to make such a calculation when the warrants are
actually abandoned. At the time the warrants are abandoned by Mr.
Hayes and Mrs. Scott there is no gain or loss attributable to the
warrants: the cost of the warrants at the time of unwinding the
convertible hedge would be zero and the proceeds on abandonment
are likewise zero.
[181] An aspect of these cases critical to the
Appellants is whether alleged losses, incurred during the life of
the convertible hedge, on a disposition of a particular component
of the convertible hedge, are deductible to the Appellants. The
simplest example to review is Mr. Rezek's Laidlaw convertible
hedge. Looking again at Appendix "A", we can determine
the loss in the convertible hedge was $2,880, relying on the
method I have previously outlined; that is, the income and
outlays of both co-adventurers in convertible hedging up to the
date of disposition of the convertible hedge being August 12,
1988. On May 20, 1988, Mr. Rezek claims a loss on the sale of the
long component of the convertible hedge. But the convertible
hedge has not actually collapsed. It continues in two accounts.
In the life of the convertible hedge there has been no
disposition. In tax terms this can perhaps be described as a
rollover of the convertible hedge from a single account to a dual
account convertible hedge. The co-adventurer, Gloria Rezek, has
now joined Mr. Rezek in his convertible hedge adventure. The
property forming the substance of the adventure, the convertible
hedge itself, has not changed; it has not been disposed of. There
is simply no disposition for tax purposes until the subject
matter of the adventure has been disposed of. This does not
ignore the legal realities as Mr. Shaw might proclaim. Indeed, it
is the legal reality.
[182] The Appellants were engaged in a
profit-making scheme, an adventure in convertible hedging.
The documents, their actions and, yes, the economics all point to
this conclusion. To pluck one legal transaction out of the
context of this adventure and tax it separately is not correct
within the scheme of the Income Tax Act. This is not a
matter of one accounting method being preferable to another; it
is a matter of identifying what is to be captured by the
provisions of the Income Tax Act - what is taxable. And
what is taxable is the subject matter of the adventure - the
convertible hedge.
[183] Subsections 3(a) and 9(2) of the Income Tax
Act read:
3 The
income of a taxpayer for a taxation year for the purposes of this
Part is the taxpayer's income for the year determined by the
following rules:
(a) determine
the total of all amounts each of which is the taxpayer's
income for the year (other than a taxable capital gain from the
disposition of a property) from a source inside or outside
Canada, including, without restricting the generality of the
foregoing, the taxpayer's income for the year from each
office, employment, business and property,
...
9(2) Subject to section 31, a
taxpayer's loss for a taxation year from a business or
property is the amount of the taxpayer's loss, if any, for
the taxation year from that source computed by applying the
provisions of this Act respecting computation of income from that
source with such modifications as the circumstances require.
[184] There must be a source and the loss must be from
that source, business or property. The source in these cases is
the convertible hedge adventure, the business for tax purposes -
it is not stock trading. This is an entirely different situation
from either the Ludco or Singleton cases, where in
the latter it was determined that separate events must be viewed
independently for an appropriate application of the Act.
In the cases before me the separate components must be viewed
together as only together do they constitute the business, the
source to be taxed. I am not in any way derogating from the
principles enunciated in Mr. Shaw's new paradigm;
indeed, I am relying on them to determine the true legal reality
of the situation before me.
(ii) In whose hands is the gain
or loss in the two-account convertible hedge taxable?
[185] I have determined that in the two-account
convertible hedge the parties involved were co-adventurers, with
the gain or loss from the convertible hedge determinable upon the
wind-up of the convertible hedge. The wind-up is triggered by the
parties taking their convertible hedge position to a completely
equally offsetting common-common position. The scheme for
profit-making convertible hedge becomes a hedge with no
possibility of profit. If one position goes up, the other goes
down in an exactly equivalent amount. This reflects an equal
ownership position in the convertible hedge just ended and in the
hedge just started.
[186] Not having appreciated the somewhat complicated
legal niceties of their positions, the Appellants would not have
had any agreement as to who was to claim the income or loss from
the disposition of the convertible hedge. They accounted for each
component separately, which I have found is inappropriate for
taxing purposes. I cannot point to any purported agreement as to
the sharing, if any, of the income or loss from the disposition
of the convertible hedge. It just was not contemplated by the
Appellants. Therefore, as the co-adventurers did not have an
explicit agreement as to who was entitled to the income or loss,
the best evidence to rely upon in apportioning the income or loss
on wind-up is to regard the result of the wind-up itself, the
result being the exactly equal common-common positions. I
determine that the income or loss on wind-up therefore is
likewise to be shared equally. That best reflects what the
parties agreed to by implication from their actions.
(iii) How is the cash flow, generated
throughout the holding of the convertible hedge, taxed?
[187] With respect to the tax treatment of the cash flow
(the income from the long position versus the expenses on the
short position during the convertible hedge's life), it is
only the two-account convertible hedges that are at issue. Does
the reasoning for finding equal treatment on wind-up pertain
similarly to the treatment to be afforded to the cash flow? Is it
to be a net determination divided equally between the
co-adventurers based on their equal positions on wind-up? Only, I
would suggest, if there is no agreement to the contrary. It is
one thing to determine an ownership interest of property in an
adventure in the nature of trade at the time of the disposition
of such property, based on the resulting position from the
disposition: it is quite another to find on that basis alone that
the co-adventurers agreed to be treated equally in every
respect throughout the duration of the ownership of the property,
especially where the ownership may have been initiated in only
one party's hands. In reality, with the exception of Gloria
Fahrngruber, each of the co-adventurers regarded the income
or expense from the component of the convertible hedge held by
him or her as particular to him or her. There was no sharing of
the respective income or expense. Unlike a partnership, where the
rules are clear as to the allocation of the income and expense,
the adventure in the nature of trade is less certain, especially
so when the co-adventurers are uncertain legally as to the status
or nature of their adventure. Without appreciating that they were
dealing with a separate property, they agreed, by their actions,
to record separately the income or expense from the separate
components. I am aware of nothing that precludes one
co-adventurer from agreeing to take the expense and the other the
income from the property during the adventure, though still
agreeing on the disposition of the property on wind-up to share
the profits or losses from such disposition equally. The fact
alone of co-ownership of the convertible hedge as part of an
adventure in the nature of trade, does not in and of itself,
imply an equal sharing of the net cash flow, especially where the
co-adventurer's actions indicate otherwise. Unlike the
situation upon winding-up of the convertible hedge, where the
co-adventurers actions point to an equal position, there is not
sufficient evidence to make a similar finding of an equal sharing
of the net cash flow.
[188] There is though a separate agreement with respect
to the cash flow in the case of Gordon Rezek. Ms. Fahrngruber
objected to paying tax on dividends, which, as far as she was
concerned, she never received. Mr. Rezek agreed to pay her
ensuing tax liability. This arrangement suggested the parties
intended that only Mr. Rezek accounts for the net cash flow. In
his appeal, therefore, the net cash flow is to be taxed solely in
his hands. Of course, as Mrs. Scott and her daughter were in an
agency relationship, the net cash flow is taxable solely in Mrs.
Scott's hands.
(iv) How are the Appellants to be
taxed on their stock holdings after the unwinding of the
convertible hedge, where they are left in a common-common
position?
[189] This requires an examination of their status at
that point. It would be difficult to suggest that once an
Appellant unwound the convertible hedge and simply sat on the
stock for a period of time that his or her activity has moved
along Mr. Shaw's evolutionary chain from adventurer to
trader. No, if anything, the Appellant has defied evolution and
headed back towards capital property treatment. There is no
evidence of any of the Appellants engaging in significantly
greater stock trading transactions once a convertible hedge has
ended.
[190] On all the indices of an adventurer in the nature
of trade versus capital property reviewed earlier, the
Appellant's actions are not sufficient once they are in a
common-common position to qualify even as an adventurer. The
adventure of convertible hedging certainly has ended - has a new
adventure begun? No. There was no evidence that going into a
common-common position was considered by any of the Appellants as
entering a scheme for profit-making. The sentiment was
unanimous that this position, by its very nature, gave rise to no
possible economic benefit. As Mrs. Scott called it, an inactive
hedge. Also, all Appellants held the common-common position for
some considerable period of time. There was no incentive for any
quick disposition. Neither was there any evidence of any
income-splitting intention at the time of going common-common.
Indeed, in a couple of Mr. Hayes' common-common positions
with Mrs. Hayes, it was he who held the long income producing
position and Mrs. Hayes who held the short expense side position.
Finally, there were not a great many common-common positions even
held by any of the Appellants, and with respect to those few
positions there was little, if any, ongoing activity. They were
simply left untouched.
[191] This leads me to the conclusion that once the
convertible hedge ended by going into a common-common position,
not only did the convertible hedge adventure come to an end, no
new adventure started. The Appellant and Guarantor held a
common-common hedge as capital property.
[192] Mr. Shaw says, just as with the convertible hedge,
the common-common position represents two separate identifiable
positions - naked long in one account and naked short in the
other. Mr. Gluch, however, argues that no, these individuals
remain in a partnership. I reject both notions. Just as there was
no partnership in the convertible hedge, as there was no business
being carried on, there is no partnership in the common-common
hedge. There is neither an adventure in the nature of trade. As
already made clear, there is zero possibility of any economic
gain. What is left is the simple ownership of capital property.
And just as I found the convertible hedge was a property, so too
do I find the common-common hedge is a property. There exists a
right of each individual in the common-common hedge to call for
and rely on the margin support of the other. The significant
difference, of course, from the convertible hedge, where the
scheme is entered with a view to profit, is that there is no
possibility of profit in the common-common hedge.
[193] The holders of the common-common hedge hold the
property, the common-common hedge, together, completely equally,
not as partners, nor as co-adventurers, but simply as co-owners
of capital property. The common-common hedge cannot by its
very nature ever be considered a source of income. It is a
position, according to the experts and broker, that could not be
held in one account, as the two components would simply cancel
each other out. In two accounts it is effectively a taxable
nothing. What happens from a tax perspective when one side or the
other deals with the component held? Nothing. Neither side
can "cash in" its position without the proceeds
remaining in the account to continue to provide the necessary
margin support for the other side. In effect, the hedge
continues. Indeed, it is absurd to imagine, with these
Appellants, that one position would be closed out without the
coincidental closing of the other. The legal reality of a
common-common position is the co-ownership of a hedge, something
that yields, for tax purposes, no tax impact. It just does not
belong on the list of sources identified in section 3 of the
Act.
[194] As there is no source, there can likewise be no
taxable income nor deductible expenses arising from the
common-common position prior to disposition. There is no net cash
flow. There will always be a zero result on the co-owned
common-common hedge. One side cannot deduct compensatory
dividends while the other brings taxable dividends into income;
that ignores the legal and economic reality that this hedge is
not a source of income and not caught up in the scheme of the
Act.
(v) Can an Appellant rely on the lower
of cost or market method of inventory valuation during or after
the convertible hedge?
[195] There are two aspects of inventory write-down with
which these cases deal; first, the inventory of the adventurers
in convertible hedging; second, the inventory outside the
convertible hedge. I have dealt with those engaged in convertible
hedging and found them to be adventurers. I have also found the
property in their adventure is a separate property of the
convertible hedge - that is the inventory. I have also determined
that once the position becomes a common-common hedge, that the
individuals co-own the hedge as capital property, but it is
not a source for tax purposes.
[196] With this background, the starting point is a
review of subsection 10(1) of the Actand the
inventory amending provisions.[30] Section 10(1) reads:
10(1) For the purpose of computing a
taxpayer's income for a taxation year from a business that is
not an adventure or concern in the nature of trade, property
described in an inventory shall be valued at the end of the year
at the cost at which the taxpayer acquired the property or its
fair market value at the end of the year, whichever is lower, or
in a prescribed manner.
Mrs. Scott is the only one in the potential position of
adopting the mark to market method, as only she valued stock less
than cost, and reflected that in returns of income before
December 21, 1995, namely, in her 1989, 1990 and 1991 returns.
None of the other Appellants can raise this argument. Mr. Hayes
may have completed a return on this basis, but it was past the
critical time of December 21, 1995.
[197] I look first then to Mrs. Scott's treatment of
her stock as inventory while such stock was held as part of the
convertible hedge. The key distinctions between this situation
and the commodity future situation of Friedberg[31] is that although the
Federal Court of Appeal referred to the commodities' spread,
it did not view the spread as in and of itself the property at
issue. The legs of the spread were considered as separate
holdings and consequently, could be, and were, separately
afforded the lower of cost or market treatment. It is interesting
to note the Supreme Court of Canada's comment in this case
that:
... Similarly, while we recognize that the "lower of cost
or market" method advocated by the respondent suggests that
unincurred losses can be deducted in the calculation of income,
no unincurred losses were deducted by the respondent on the facts
of this case. Accordingly we need not determine the income tax
validity of this implication of the "lower of cost or
market" method in this case. ...
[198] The convertible hedge is not the same as the
commodity future contracts. The convertible hedge is a property
that by its nature demands the marked to market method to be
applied to the whole, not separately to the components. From the
evidence of the experts, the broker, and the Maguire associate,
it appears that the value of the spread can be determined at any
point in time. It is that value that is to be compared to the
opening cost of the spread, the opening cost of the convertible
hedge, in determining what additions or deductions are to be made
from income by way of inventory adjustment. To be clear on what
is intended I refer to the Labatt convertible hedge held by Mrs.
Scott in 1992 which she disposed of in 1993. In 1992, she claimed
a fair market adjustment of the Labatt short position of $16,828,
representing the difference in her short sale proceeds and the
December 31, 1992 fair market value of the Labatt common stock
(as the value of the stock increased, that increased value
represents a decrease in the short position value for inventory
purposes). On the long side, the Labatt convertible shares
increased $10,000 in value over costs, so she relied on the lower
of cost to determine no change in inventory value on the long
side. In accounting for each position separately, she records
therefore the alleged $16,828 loss on the short side only. This,
however, does not reflect the appropriate change in inventory
value of the convertible hedge itself, if the convertible hedge
is considered the inventory. The change would be the difference
between the opening spread position (approximately $12,000) and
the spread position at December 31, 1992 (approximately $4,500) -
in effect a $7,500 difference. That is the true reflection of the
changed inventory position.
[199] Continuing to use the Labatt stock as the example,
is Mrs. Scott entitled to claim the approximate $7,500
adjustment, relying on the fact that she reported certain
individual stocks on the mark to market method in 1989, 1990 and
1991? Let me repeat the pertinent words of the inventory amending
provisions, in that it applies except where:
... the taxpayer has valued the inventory of the business for
the purpose of computing income for the year from the business
...
Mrs. Scott did not, in 1989, 1990 or 1991, value the inventory
of the convertible hedging business, being the convertible hedge
as a separate property, at an amount less than cost. She did
value some separate components of the hedge, but as it has been
seen, that leads to an altogether different result than if the
convertible hedge inventory itself had been valued. Mrs. Scott
did not value the inventory of the business of adventuring in
convertible hedges at less than cost at any time. She did not do
so, as she simply did not appreciate that was the nature of the
inventory with which she was dealing. She marked certain stock to
market in 1989, 1990 and 1991 on the basis she was engaged in
separate stock transactions. Her reliance, therefore, on
subsection 10(1) of the Act in years subsequent to 1989,
1990 and 1991 must be limited to the business arising as a result
of adventures in separate stock transactions, not the business of
adventuring in convertible hedges. An adventure in the
sophisticated financial form of convertible hedges is distinct
from an adventure in the stock market in stock trading
transactions.
[200] In reviewing Mrs. Scott's claims for an
inventory adjustment the following adjustments involve stock that
was at the time of the adjustment part of the convertible hedge,
and therefore for the foregoing reasons not eligible for
adjustment:
|
Stock
|
Year
|
|
Husky
|
1984
|
|
Cambridge
|
1986
|
|
Minnova
|
1988, 1990, 1991, 1992
|
|
Federal Industries
|
1990, 1991
|
|
Ivaco/Dofasco
|
1990, 1991, 1992, 1993
|
|
Memmotec
|
1991, 1992, 1993
|
|
Labatt
|
1992
|
[201] I turn now to Mrs. Scott's stock for which she
seeks an inventory adjustment at a time when such stock was no
longer part of convertible hedge, being:
|
Stock
|
Year
|
|
Husky
|
1985
|
|
Westar
|
1987, 1988
|
|
Falconbridge
|
1988
|
|
Hees
|
1990
|
|
Cambridge
|
1991
|
|
Canhorn
|
1993
|
|
Horsheim
|
1993
|
|
Cascades
|
1993
|
|
Placer
|
1993
|
Four of the stock which Mrs. Scott attempts to adjust (Husky,
Falconbridge, Cambridge and Placer) were held in common-common
positions with her daughter, her agent. As the parties have
agreed this case was an agency relationship, (as opposed to a
co-owner of the common-common hedge with her daughter). It is as
if Mrs. Scott held both sides in her own name. The evidence was
clear that a broker would not permit one account to hold
offsetting positions - they would simply cancel each other out.
That, I find, must be the effect of the agency relationship in
Mrs. Scott's case. She legally holds nothing; there is
nothing to write down, nothing to tax. That leaves the long
positions in Westar, Hees, Canhorn and Horsham and the short
position in Cascades. As I have found that after the wind-up of
the convertible hedge, no Appellant was engaged any longer in an
adventure in the nature of trade, the long positions held by Mrs.
Scott were simply held by her as capital: inventory adjustments
are not available.
[202] That leaves only the short position in Cascades.
If a short position is not property, it cannot be inventory. If a
short position is property, then based on my previous analysis of
the status of Mrs. Scott outside her convertible hedges, that is,
that she simply holds capital property, then I would find this
type of property held by her would likewise be capital and,
therefore, not inventory. It is therefore unnecessary for me to
go through the exercise of determining whether or not a short
position is property for inventory purposes, as whether it is or
is not, Mrs. Scott would not be in a position to claim it as
inventory.
(e) What is the effect of
the subsection 39(4) of the Income Tax Act elections
purportedly filed by Mrs. Hayes and Mrs. Scott?
Appellants' Position
[203] The Appellants maintain that both Mrs. Hayes and
Mrs. Scott filed valid subsection 39(4) elections: Mrs. Hayes
filed hers in July 1996, with the filing of her 1992 return and
Mrs. Scott filed her election in March 1991 for her 1990 taxation
year. In keeping with Mr. Shaw's position that components of
both a convertible hedge and a common-common hedge are to be
viewed separately, he argues that any gains arising from either
Mrs. Hayes' or Mrs. Scott's stock dispositions after 1992
and 1990, respectively, should be on capital account. Late
elections in these cases do not constitute retroactive tax
planning and are perfectly valid.
Respondent's Position
[204] Mr. Rhodes declares that both Mrs. Hayes' and
Mrs. Scott's elections are invalid as they are both filed too
late. It is not open to a taxpayer to see which way the wind
blows on security holdings and then file a subsection 39(4)
election for past years. If a return is filed late, then even
though the election is filed with the return, it is likewise late
and there is no provision for a late-filed election.
Mr. Rhodes did recognize that it is a rebuttable presumption
that because there is no provision for filing an election late,
then the taxpayer simply cannot make an election.
Analysis
[205] Firstly, with respect to Mrs. Hayes, the only
property to which her subsection 39(4) election, if valid, would
apply in the taxation years under appeal would be the property
disposed of in 1992. Such a property, at that time, was part of a
common-common hedge, which, as previously indicated, is not a
property capable of increasing in value and, therefore, not
subject to tax. The election is meaningless for such
property.
[206] I reach a similar conclusion with respect to stock
dispositions arising from Mrs. Scott's common-common
positions held with her daughter, her agent. As I found earlier,
such positions are a taxable nothing. It appears the only such
disposition in an assessment year is the Cambridge stock in
1992.
[207] Having found that individual stock dispositions
after the unwinding of the convertible hedge are not part of an
adventure in the nature of trade, but are on capital account, a
subsection 39(4) election is redundant.
[208] It then only remains to determine whether a
subsection 39(4) election applies to the unwinding or disposition
of the convertible hedge itself. I do not believe it does.
Subsection 39(4) reads:
Except as provided in subsection (5), where a Canadian
security has been disposed of by a taxpayer in a taxation year
and the taxpayer so elects in prescribed form in the
taxpayer's return of income under this Part for that
year,
(a) every
Canadian security owned by the taxpayer in that year or any
subsequent taxation year shall be deemed to have been a capital
property owned by the taxpayer in those years; and
(b) every
disposition by the taxpayer of any such Canadian security shall
be deemed to be a disposition by the taxpayer of a capital
property.
It refers specifically to a Canadian security which is defined
pursuant to subsection 39(6) as:
For the purposes of this section, "Canadian security" means a
security (other than a prescribed security) that is a share of
the capital stock of a corporation resident in Canada, a unit of
a mutual fund trust or a bond, debenture, bill, note, mortgage,
hypothecary claim or similar obligation issued by a person
resident in Canada.
[209] A convertible hedge, not surprisingly, is not part
of such a definition. Any gain or loss incurred by Mrs. Scott on
the disposition of a convertible hedge is on income account,
unaffected by any subsection 39(4) election. It becomes
unnecessary for me to determine the question of the validity of
the elections.
(f) How are unused
compensatory dividends to be treated for tax purposes?
Appellants' Position
[210] The Appellants point out that the effect of
subsection 260(5) of the Income Tax Act along with
paragraph 82(1)(a) is to only allow the deductibility of
compensatory dividends made by an Appellant up to the amount of
taxable dividends received by the Appellant. Any excess
compensatory dividends should intuitively be added to the cost
base of the short position. Mr. Shaw in effect maintained this
was the only sensible result, and he relies on Professor
Kirzner's explanation of frictions, expenses of the
convertible hedge, as evidence of a well-accepted principle
to that affect.
Respondent's Position
[211] The Respondent's position was that the rules
in section 260 and paragraph 82(1)(a) are exhaustive,
and because paragraph 82(1)(a) does not deal with the
excess compensatory dividends one can only fall back on
subsection 260(6) which imposes a blanket prohibition on the
deduction of the compensatory dividends, thus denying any
deduction directly or indirectly of unused compensatory
dividends. There are no well-established principles to support
the Appellants' positions and certainly Professor
Kirzner's evidence does not go that far.
Analysis
[212] The relevant provisions are subparagraph
82(1)(a)(ii) and subsections 260(5) and (6) which
read as follows:
82(1) In computing the income of a taxpayer
for a taxation year, there shall be included
(a) the
aggregate of
...
(ii) the amount, if any, by which
(A) the total of all
amounts received by the taxpayer in the year from corporations
resident in Canada as, on account of, in lieu of payment of or in
satisfaction of, taxable dividends, other than an amount included
in computing the income of the taxpayer because of subparagraph
(i) or (i.1)
exceeds
(B) where the taxpayer is
an individual, the total of all amounts paid by the taxpayer in
the year that are deemed by subsection 260(5) to have been
received by another person as taxable dividends,
plus
...
260(5) For the purposes of this Act, any amount
received (other than an amount received as proceeds of
disposition or an amount received by a corporation under an
arrangement where it may reasonably be considered that one of the
main reasons for the corporation entering into the arrangement
was to enable it to receive an amount that would otherwise have
been deemed by this subsection to be a dividend)
(a) under a
securities lending arrangement from a person resident in Canada,
or a person not resident in Canada where the amount was paid in
the course of carrying on business in Canada through a permanent
establishment as defined by regulation, or
...
as compensation for a taxable dividend paid on a share of the
capital stock of a public corporation that is a qualified
security shall, to the extent of the amount of that dividend, be
deemed to have been received as a taxable dividend on the share
from the corporation.
260(6) In computing a taxpayer's income under Part I
from a business or property
(a) where the
taxpayer is not a registered securities dealer, no deduction
shall be made in respect of an amount that, if paid, would be
deemed by subsection (5) to have been received by another person
as a taxable dividend; and
(b) where the
taxpayer is a registered securities dealer, no deduction shall be
made in respect of more than 2/3 of that amount.
Prior to June 1989, subsection 260(6) read:
260(6) In computing the income of a taxpayer under Part
I from a business or property, no deduction shall be made in
respect of an amount that, if paid, would be deemed by subsection
(5) to have been received by another person as a taxable
dividend.
I interpret these provisions as limiting the ability of a
borrower of securities to deduct compensatory dividends only as
against taxable dividends received. Any excess compensatory
dividends are not addressed in clause 82(1)(a)(ii)(B). The
Appellants say it is both intuitive and a well-established
principle that such unused portion is to be added to the cost
base of the short position. The Respondent says such unused
compensatory dividends are simply subject to subsection 260(6) of
the Act, which makes them non-deductible. I agree with the
latter position.
[213] To accept the Appellants' positions flies
contrary to subsection 260(6), as an increase in the cost
base of the shares sold short would reduce the income gain on
covering the short position. In effect, capitalizing the unused
compensatory dividends defers a direct deduction from income to a
later year. This is what subsection 260(6) specifically
prohibits.
[214] Obviously, the situation cannot arise when an
Appellant and Guarantor are in a common-common position as
compensatory dividends will always equal dividends received on
the long position. So it is only in the convertible hedge
scenario or a naked short scenario where unused compensatory
dividends may arise. I appreciate Mr. Shaw's reliance on what
may seem intuitive or what might make the most common sense.
However, this does not lead to a finding to a
well-established principle. I am not satisfied there is any
such well-established principle notwithstanding Mr. Rezek may
have accounted for unused compensatory dividends in that fashion.
Failing that, I am left with clear prohibitory language in
subsection 260(6). Unused compensatory dividends cannot be
deducted nor capitalized.
Conclusions
[215] The difficulty with these cases is the shortcoming
of personal property and commercial laws in defining late
twentieth-century financial arrangements, compounded by tax
principles that require clarity and certainty for their proper
application. So, Mr. Shaw well asked, repeatedly, what is real? I
have attempted to determine what is real for tax purposes. What
legal position did the Appellants hold? What did they dispose of?
When? How were they to be taxed? As there are 26 taxation years
under appeal in these appeals I find it expedient to simply
provide conclusions to these questions. I will then go through
one Appellant, Mr. Rezek, by way of example to illustrate
the effect of these conclusions. This should enable the parties
to redraft their reconciliation schedules for all Appellants. The
conclusions are as follows:
1. A convertible hedge is a
separate identifiable property.
2. The Appellants'
dealings in convertible hedges were adventures in the nature of
trade engaged in solely by an Appellant in a single account
convertible hedge and, with the exception of Mrs. Scott, engaged
in jointly with the Guarantor in a two-account convertible hedge
- co-adventurers not partners.
3. Mrs. Scott and her
daughter were in an agency relationship, requiring all cash flows
as well as any income or losses on the disposition of convertible
hedges to be solely for Mrs. Scott's account. As an
individual cannot hold a common-common position, such position
between Mrs. Scott and her agent daughter simply cancel each
other out for all purposes.
4. The only gain or loss
on a convertible hedge is the increase or decrease in the spread,
calculated by determining the difference between all income on
short sales versus outlays on long purchases during the life of
the convertible hedge.
5. The convertible hedge
is wound-up or disposed of in the case of the two-account
convertible hedge, when the two accounts first go into a
common-common position, not when there is a disposition of a
common-common position.
6. The disposition of the
two-account convertible hedge results in a gain or loss to be
divided equally between the co-adventurers.
7. There are no taxable
dispositions from a source during the life of the convertible
hedge triggering either a deductible loss or income or capital
gain. The only source is the convertible hedge itself. To be
clear, and by way of example, Mr. Rezek did not incur a $138,000
loss on his Laidlaw stock.
8. Other than in Mrs.
Scott's and Mr. Rezek's appeals, the income and expense
arising during the life of the convertible hedge (the net cash
flow) is allocable to the Appellant or Guarantor in accordance
with their respective holdings in the short or long position. It
is not to be netted and divided equally, nor netted and allocated
to just one of the co-adventurers, except in Mr. Rezek's
case, where it is to be netted and allocated entirely to Mr.
Rezek. For the sake of completeness, any income or expense from a
credit or debit balance in an account arising from transactions
making up the convertible hedge, notwithstanding such income or
expense arises after the disposition of the convertible hedge,
shall likewise be treated as income or expense of the account
holder. Such income or expense is distinguishable from income or
expense arising from a common-common hedge.
9. A common-common hedge
in two accounts is a property owned equally by two people (who
are neither in partnership nor engaged in an adventure in the
nature of trade), with no possibility of an income or decrease in
value - it remains constantly at zero, resulting in neither any
gain or loss on disposition, nor any income or expense while
held. It is not a source for tax purposes.
10. None of the Appellants are
eligible to write-down inventory.
11. Subsection 39(4) does not apply to
the convertible hedge or the common-common hedge.
12. Unused compensatory dividends
cannot be added to the cost base of shares sold short for
purposes of determining any resulting gain.
13. Should the application of any of
the foregoing conclusions:
(i) result in any greater tax
liability than assessed to an Appellant in any particular
taxation year, the appeal for that year is simply dismissed;
(ii) result in a lesser tax
liability to an Appellant in a particular taxation year than
sought by the Appellant, the appeal is allowed to reflect such
lesser tax liability.
[216] To illustrate the effect of these conclusions the
following is an indication of the consequences flowing to Mr.
Rezek for 1988:
(i) He experienced a business
loss on the disposition of the Laidlaw convertible hedge of half
of $2,880.48 (Ms. Fahrngruber experiencing the other half).
(ii) He incurred no deductible
loss of $138,431 on the sale of 10,100 Laidlaw stock.
(iii) The dividend income attributable
to Mr. Rezek from Laidlaw stock was that arising while he held
the Laidlaw preferred shares from April 27 to May 20, and while
Ms. Fahrngruber held the Laidlaw preferred shares from May 20 to
August 12.
(iv) The compensatory dividends on the
Laidlaw short position are attributable to Mr. Rezek up to August
12 (the start of the common-common position).
(v) There was no dividend income or
expense arising from the Laidlaw common-common hedge after the
establishment of that hedge on August 12.
(vi) Mr. Rezek had a $1,300 business
loss on the disposition of the Royal Bank convertible hedge.
[217] For Mr. Rezek's 1989 appeal the following
consequences flow:
(i) There is no dividend income
or expense arising from the Laidlaw common-common hedge. Only the
management fee of $9,660 which related to a purported benefit
arising during the convertible hedge, is deductible.
(ii) Mr. Rezek had a $3,789
business loss on the disposition of the Westcoast convertible
hedge.
(iii) Mr. Rezek is entitled to no fair
market value adjustment of inventory of $193,054.
[218] This one example illustrates the effect of my
findings. I do not believe it is necessary to go through the
remaining 24 taxation years under appeal. The parties should be
able to sort that out. The exercise does bring home however the
significant impact these findings will have on Mr. Rezek and the
rest. Particularly of concern is the alleged "management
fee" paid to Mr. Maguire for the illusory tax benefits. This
may not be considered by Mr. Rezek, in hindsight, as money well
spent. The enticement, as Mr. Sildva put it, of significant tax
refunds on minimal dollar investments is not real - legally or
economically. Regrettably, well-intentioned, yet perhaps naive,
investors saw the convertible hedge for something more than what
it was. What it was, was an investment property with a potential
positive cash flow and a potential to increase in value over a
relatively short period. Mr. Hayes certainly understood this. It
was not, however, a guarantee of a significant tax refund.
[219] As is clear from comments throughout this
judgment, I am of the view our taxation laws must exhibit
sufficient elasticity to accommodate novel financial arrangements
without having to resort either to relying entirely on economic
realities, or to deeming legal relationships that in fact do not
exist. So I have approached questions such as what is property
and what is a source with both an eye to the true legal nature
and an eye to adaptability of tax laws to the moving target of
financial innovation.
[220] I would like to thank counsel for their diligence,
cooperation and thoroughness in their preparation and
presentation of the matters before me. The appeals have been most
capably argued.
[221] Some appeals are dismissed due to the
circumstances set forth in item 13(i) of paragraph 215. The
remaining appeals are allowed and the assessments are referred
back to the Minister for reconsideration and reassessment in
accordance with these reasons. Although there was some suggestion
at the conclusion of the trial as to the possibility of argument
on costs, I do not find that will be necessary. I award costs to
the Respondent on the basis of 75 per cent of the costs
calculated in accordance with the Court's tariff. While the
Respondent has been substantially successful in the appeals, I
have not accepted their major argument regarding the existence of
partnerships. It is for that reason I am awarding less than the
full tariff.
Signed at Ottawa, Canada, this 9th day of September, 2003
Miller J.
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