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Citation: 2004TCC328
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Date: 20040623
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Docket: 2001-3463(IT)G
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BETWEEN:
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SUPER WEST HOMES INC.,
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Appellant,
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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
Hershfield J.
[1] This is an appeal of a
reassessment disallowing a net capital loss carry forward in
computing the Appellant's taxable income for 1999. An
allowable capital loss had been reported for 1998 in the amount
of $1,648,974.00 and the full amount of such loss was carried
forward to 1999 as a net capital loss pursuant to section 111 of
the Income Tax Act (the "Act").
[2] The allowable capital loss giving
rise to the carry forward arose from an indebtedness owed to the
Appellant by 628774 Ontario Inc. ("Ontario Inc.").
The debt was incurred to enable Ontario Inc. to fund an
investment in a convention centre project organized and operated
as a limited partnership of which Ontario Inc. was the general
partner. In 1998 the debt was determined to have become a bad
debt and the Appellant elected to have paragraph 50(1)(a)
of the Act apply. The effect of the election is that the
debt is deemed to have been disposed of in 1998 for nil proceeds.
The Respondent does not dispute that the debt became bad in that
year. Indeed, the parties acknowledged that the only issue in
this appeal was whether the debt was incurred for the purpose of
gaining or producing income from property or business pursuant to
subparagraph 40(2)(g)(ii).
[3] Subparagraph 40(2)(g)(ii)
of the Act provides that the loss on disposition of a debt
is nil "unless the debt ... was acquired by the taxpayer for
the purpose of gaining or producing income from a business or
property ...".
[4] The Appellant asserts that the
debt was an interest-bearing loan made by it to Ontario Inc. An
executed loan agreement was tendered at the hearing. The loan
agreement on its face purports to have been signed in September
of 1989 when funds were first advanced. It provides for loans by
the Appellant to Ontario Inc. for up to $5,000,000.00 repayable
on demand and bearing interest at 12% per annum plus a standby
fee of one-half of the management fee earned by Ontario Inc. The
management fee, to which Ontario Inc. was entitled, was an annual
fee equal to the greater of $100,000.00 or the sum of 2% of gross
revenues plus 10% of net profits. The total funds advanced by the
Appellant to Ontario Inc. was $2,198,632.00.
[5] The Respondent argued that the
circumstances surrounding the emergence of the loan agreement
coupled with abundant evidence that it had not been given effect
to prior to making the election under subsection 50(1), raised
such doubts as to its timely existence as to warrant a finding
that the Appellant has not met its burden of proof to establish
that the loan was made pursuant to it at the inception of the
loan. The executed loan agreement did not emerge until after
the election was made under subsection 50(1). Its terms had
never been given effect to. For years the loan had been reflected
on books and records as non-interest-bearing. No payments on the
debt, principal or interest, were ever made. The Respondent also
argues in the alternative that even if the loan agreement did
exist in 1989, the Appellant has not met its burden of proof to
establish that the agreement was intended to have legal effect
when the funds were advanced. If the Appellant cannot establish
on the balance of probability that the loan agreement was
intended to have legal effect, the subject debt will not be
established to have been incurred for the purpose of gaining or
producing income.
[6] In response to the
Respondent's position and its portrayal of the evidence, the
Appellant has put reliance on the historical context of the loan
and of its dealings. That historical context was attested to by
two witnesses called on behalf of the Appellant. Frank Carinci, a
principal of the Appellant and Rolf Fiege, the lawyer for the
Carinci family interests, both gave evidence supporting the
timely existence of the loan agreement. Frank Carinci who signed
the agreement on behalf of both parties also attested to the
intention of the parties to be legally bound by its terms.
[7] The Appellant's evidence falls
readily into two parts. Firstly, there is evidence that addresses
the making and late emergence of the loan agreement and,
secondly, there is evidence as to the contextual explanation of
accounting and reporting errors concerning the interest-bearing
nature of the loan. I will deal firstly with the evidence that
addresses the making and late emergence of the loan
agreement.
[8] Mr. Fiege testified that he had
sent a draft loan agreement to Dominic Carinci following a
discussion with him in about July of 1989 as to the need to
address a concern raised by Dominic's brother Frank. The
concern was that the Appellant was owned 50-50 by the two
brothers but the interest in the convention centre project was
indirectly held by seven family trusts: a four-sevenths interest
was held for Dominic's children and a three-sevenths interest
was held for Frank's children.[1] Mr. Fiege prepared a draft loan
agreement on the understanding that it had to provide for
interest to alleviate Frank's concern that funds to which he
was indirectly entitled would disproportionately benefit
Dominic's family. This was portrayed by both witnesses as a
very important issue from the outset of the convention centre
project.
[9] Mr. Fiege testified that he
provided the draft loan agreement on outdated memorandum
stationery. The Appellant places great emphasis on this as it
enabled pinpointing the time that the draft agreement was sent.
That is, Mr. Fiege was able to testify that the stationery
used corroborated the July 23rd, 1989 date of the correspondence
enclosing the draft loan agreement. It also corroborated his
recollection of when the draft agreement would have been sent to
Dominic. It should also be pointed out that the executed loan
agreement is on the original outdated stationery sent by Mr.
Fiege to Dominic. That original document contained alternative
interest provisions and Mr. Fiege's evidence was to the
effect that the document was sent as a draft and intended only to
illustrate choices as to how a loan agreement might be framed. He
never heard anything again from either brother with respect to
the execution of a loan agreement until after audit questions
were raised following the claiming of the bad debt loss carryover
in 1999.
[10] Frank testified that Dominic sent the
draft agreement to him and that he, Frank, crossed out one of the
alternative interest provisions, made one other amendment,
deferring interest payments for three years,[2] and signed the loan agreement as
the signing officer for both the borrower and lender.[3] He was very firm that
he executed the agreement on the date written on the agreement
and that he sent it back to Dominic intending, and on the
understanding, that the agreement as signed would govern the
terms of the loan. This was a long-term project and monies
indirectly belonging 50-50 between the brothers should be
accounted for with interest to reduce the disproportionate
benefit to Dominic's side of the family.
[11] It seems at that point that the loan
agreement was put in a miscellaneous file in Dominic's office
and it never surfaced until audit questions concerning the 1999
loss carryover claim arose. Even the claim of the loss in 1998
was not based on the subject loan being interest-bearing per
se although the financial statements filed with the 1998 tax
return noted, for the first time, that some related party loans
were interest-bearing. The accountant took the position that the
loan was a source of income on the basis that the subject loan
enhanced the income potential of the Appellant in respect of
other related property. Such basis for asserting that the loss is
not subject to subparagraph 40(2)(g)(ii) was abandoned
presumably when the loan agreement surfaced during the audit of
the 1999 year. While the emergence of the loan agreement at that
time is suspicious, counsel for the Appellant argues that the
motivation for an interest-bearing loan from the inception of the
advances is essentially unimpeachable. He adds that for me to
find otherwise would require that I find either that the lawyer
participated in a scheme to facilitate backdating the loan
agreement and kept 10-year old stationery around to help
advance such a scheme or that the agreement was kept around,
unsigned for some ten years, presumably in expectation that one
day it would be necessary to execute. Counsel for the Appellant
suggests both such findings would not be justified.
[12] I turn now to the evidence that speaks
to the contextual explanation of accounting and reporting errors
concerning the interest-bearing nature of the loan.
[13] Real estate development projects
typically financed by the Appellant were short-term projects
undertaken by related companies for resale and were indirectly
owned 50-50 by the brothers: Dominic and Frank. As stated, the
Appellant was also owned 50-50 by the two brothers at least until
1994 when Dominic died. It was asserted then that it was not
necessary and not the practice to charge interest on loans to
related companies. Accordingly, such loans were recorded and
treated as non-interest-bearing. Since the accountants were
unaware of the loan agreement and its terms, the subject loan was
erroneously treated as all other related company loans were
treated.[4] If I
accept that there was a credible reason to have an
interest-bearing loan, I am then urged to accept that the loan
agreement was signed in 1989 with the intent to be bound so that
the accounting contradictions must then be taken as being in
error. Records prepared in error should not be taken as evidence
that the loan agreement did not exist at the time and on the
terms asserted.
[14] While at this point I might well
proceed to consider the evidence and arguments relied on by the
Respondent which themselves are sufficient to dispose of the
appeal, the circumstances surrounding the subject loan warrant
further comment.
[15] The convention centre project was
undertaken in 1989 on lands held by the seven family trusts
established in favour of the seven children of Frank and Dominic.
The lands were leased to a limited partnership formed to
undertake this new project. As noted, Ontario Inc. was the
general partner of the limited partnership. It was owned by the
seven family trusts. As well, each of the seven trusts had an
equal limited partnership interest in the limited partnership.
There were no other partners.
[16] The limited partnership agreement of
January 1989 sets out the initial capital contributions which
bore interest at 18% per annum. Each family trust as a limited
partner initially contributed capital of $200,000.00 to the
limited partnership. Ontario Inc., as general partner, made
an initial capital contribution of $3,500.00 plus approximately
$99,000.00 by a transfer of assets to the limited partnership.
However, capital accounts changed dramatically by 1992. An
amendment and restatement of the limited partnership agreement in
January 1992 (documenting a restructuring of the limited
partnership) shows that Ontario Inc.'s capital account at
that time was in excess of $4,000,000.00 and that the capital
account of each family trust was only some $68,000.00. Mr. Fiege
testified that some of the addition to Ontario Inc.'s capital
account was due to the accounting treatment of the advances made
by Ontario Inc. to the limited partnership. That is, he suggested
that the advances made by Ontario Inc. (that were financed by the
subject loans from the Appellant) had been capitalized.[5]
[17] The limited partnership agreement
provided for an allocation of profits and losses on the basis of
.25% to the general partner (Ontario Inc.) and 14.25% to each
family trust. Such allocation is said to be in accordance with
participating interests which are defined to include capital
contributions. The step-up in Ontario Inc.'s capital accounts
noted above may have been the basis for allocating a greater
share of partnership losses to Ontario Inc. but no direct
evidence was tendered as to changes to profit and loss
allocations under the limited partnership agreement prior to the
1992 restructuring of the limited partnership. Mr. Fiege did
testify however and exhibits confirmed that Ontario Inc.'s
allocated losses for fiscal 1992 (ending prior to the January
1992 restructuring) were assigned to a new limited partner
introduced on the restructuring. The amount of the losses
assigned was $1,800,000.00, an amount seemingly higher than the
initial .25% allocated to Ontario Inc. Such allocation and
assignment of losses were said to have reduced Ontario Inc.'s
capital account. Also as part of the 1992 restructuring there
were transfers of advances to Ontario Inc. from related parties
that were said to have further reduced Ontario Inc.'s capital
account.[6] Any
remaining capital account amount credited to Ontario Inc. was
offset with a .25% interest in the restructured limited
partnership which interest was transferred for nominal
consideration to the new general partner.
[18] I note at this point that the
restructuring in January of 1992 was required as the limited
partnership was in financial difficulty.[7] The development of the convention
centre that included a banquet facility and was ultimately to
include a hotel complex was not proceeding as planned and to the
extent that it was up and running it was not making money. The
1992 restructuring facilitated the bringing in of a new arm's
length investor. That investor required that the lands leased to
the partnership by the family trusts be transferred to the
limited partnership. The investor advanced $2,200,000.00 to the
partnership to fund this land purchase. As well, additional
limited partnership units were issued to the new investor for
nominal consideration with the result being that he owned 50% of
the outstanding limited partnership interests. The other 50%
continued to be held by the seven family trusts. A new general
partner was introduced. The shareholders of the new general
partner were the new investor as to 50% and the two brothers,
Frank and Dominic, as to 25% each. Ontario Inc. lost its interest
in the partnership as well as its management role which was
assumed on the same terms by the new general partner. [8]
[19] In June of 1997 the new investor
acquired all of the limited partnership interests held by the
family trusts for the sum of $2,200,000.00. That is, from early
1992 to mid-1997 the 50% equity in the limited partnership owned
by the family trusts appreciated by $2,200,000.00. I would note
that this growth to the family trusts in the proportions held
would be as planned in the initial structuring of the project.
That is, the initial structuring evidences a freeze in favour of
the family trusts in the proportions in which they held limited
partnership interests for which they contributed equal amounts of
money and in the proportions that they owned the lands originally
leased to the limited partnership. I note that the
"success" of the freeze might arguably be partly
attributable to the Appellant's advancing, on an unsecured
basis, funds intended for a project the appreciation on which was
designed to go to family trusts. I do not mean to suggest any
slight of hand or inappropriate tax planning in respect of the
freeze but in effect what has happened (ignoring comments that
might be made in respect of the shuffling that occurred on the
restructuring in 1992) is that the Appellant's investment has
been lost and as value was recouped over time it attributed to
the beneficiaries of the freeze.[9] That is, not only was the "use" value
of the funds advanced by the Appellant (that is, the
"interest" value on the principal amount advanced)
benefiting the two brothers' families disproportionately but
the principal amount advanced, as things turned out, has
effectively benefited the two families disproportionately as
well. That was apparently not of concern to Frank in 1992 when
nothing was done to protect against it happening even though at
that time it was foreseeable. Not protecting the Appellant's
principal loan amount in this case suggests that the need to
preserve proportionality of interests between the brothers was
not as compelling as suggested at the hearing. It was not as
compelling as advancing the objectives of the freeze.[10] I cannot be asked to
rely on the compelling reason for the loan having interest as
being very compelling if no attention was paid to the principal
amount of the loan.
[20] This leads me now to address some of
the telling factors relied on by the Respondent in its argument
that the Appellant had not met its burden of proof on the issue
before me.
[21] Most troublesome to the Appellant's
position is that it never received a payment under the loan
agreement even on one occasion where there were clearly monies
payable to it. Ontario Inc. received a management fee from the
limited partnership in 1993. Counsel for the Appellant in
responding to undertakings given at the examination for discovery
confirmed that a payment was made in 1993 in respect of
management fees earned by Ontario Inc. while it was still a party
to the management agreement with the limited partnership. The
amount paid was some $43,000.00. No part of this was ever paid
over to the Appellant as expressly required under the loan
agreement. By 1993, deferral of the interest payments on the
loan, as provided in the loan agreement, had ended. Still, no
interest payments or stand-by fee payments were made. If the
interest on the loan was there to adjust for disparate family
holdings and such adjustment was of such importance to Frank, the
fact that such provisions were ignored or forgotten undermines
the logic of Appellant counsel's argument. I cannot be asked
to rely on the compelling reason for the loan having interest as
being very compelling if it was so quickly and readily forgotten
or ignored without explanation.
[22] Troublesome as well of course is that
records were consistently maintained on the basis that the loans
were non-interest-bearing. I am not satisfied that I can ignore
such inconsistencies on the basis of their being in error. The
following observations bear on this question.
[23] Frank testified that his
responsibilities were construction related. He was the guy on the
ground, while Dominic's function was mainly managerial.
Dominic handled all office, legal and accounting matters. Frank
stated that in regards to accounting or legal documentation he
relied 100% on whatever his brother's decision was and after
his brother's death he relied totally on the accountants and
lawyers, yet, he alone made handwritten amendments to the draft
loan agreement which he alone signed. The finality of Frank
making these changes without further discussion does not seem
characteristic. It was uncharacteristic for him to unilaterally
make final and binding commitments and sign a sophisticated loan
agreement.
[24] Throughout his evidence Frank referred
to the importance of the loan agreement, how it was a solution to
a problem, yet he did not follow up on the loan agreement. Even
after his brother's death he did not mention the loan
agreement to his accountants or lawyers. He did not confirm the
amount of the loan with accountants to be sure interest was being
accrued in accordance with the agreement.[11] These inconsistencies underline
that signed or not it was unlikely that the loan agreement can be
taken as having been sent to Dominic for implementation as a
binding agreement. Such intention would surely be manifested
somewhere. Dominic as someone who worked with his lawyer and
accountant regularly was not, by putting the agreement away in an
obscure file and ignoring it, evidencing any acknowledgement or
understanding of its being a definitive or operative resolution
of Frank's concerns. To the contrary, it evidences that the
agreement was in abeyance regardless that it might have been
signed.
[25] As to documentary inconsistencies
supporting the Appellant's position the following gives a
snapshot of the situation.
[26] One month after the loan agreement was
signed, a Directors' resolution of the Appellant approving
the financial statements was signed by Frank. Similar resolutions
were signed each year thereafter up to and including 1997. The
approved statements all described related party advances or
affiliated corporation loans as non-interest-bearing. All tax
returns between 1989 and 1997 included the approved financial
statements. Although not an officer of the Appellant until
1994,[12] the
evidence is that Dominic was at all times prior to his death
responsible for all accounting matters and as such he was aware
that the debt was classified on these statements as
non-interest-bearing, contrary to its description in the loan
agreement. This does not help advance the argument that all these
statements were in error. To the contrary, it evidences that the
agreement, even if signed as attested to, was not intended to be
given effect. The evidence suggests that it was to be considered
at a future time and given effect on such terms as would best
resolve Frank's concerns based on how things unfolded. For
example, when the project needed help and Frank and Dominic
became shareholders of the new general partner, the need for the
agreement arguably disappeared. It seems probable then that the
agreement signed in 1989, and I accept Frank at his word that it
was signed in 1989,[13] was, more likely than not, effectively subject to an
implied condition precedent that never occurred. That implicit
condition precedent was that the agreement would be resorted to
only if some other resolution of Frank's concern did not present
itself as circumstances permitted or required. I can only assume
that the reason that neither brother paid any attention to
whether the loan agreement was complied with was because it was
not intended to be complied with from inception to the time the
debt was determined to be a bad debt. I can find no basis to
support the Appellant's necessary contention that there was
an intention to impose an obligation on Ontario Inc. to pay
interest on or derive any income from the subject loan at the
inception of it or, as it turned out, at any time after that. The
Respondent's alternative position as set out in paragraph [5]
of these Reasons is the correct position on the facts as I find
them.
[27] Accordingly, the appeal is dismissed,
with costs.
Signed at Ottawa, Canada, this 23rd day of June 2004.
Hershfield J.
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