Lee v. Agence du revenu du Québec, 2020 QCCQ 780, aff'd sub nomine Seica v. Agence du revenu du Québec, 2021 QCCA 1401

For their 2005 and 2006 taxation years, the taxpayers purchased franchises for the non-exclusive right to distribute the software licences in specified territories (comprising, for each purchase, software purchased for $150,000 and a membership right for $10,000) and financed those acquisitions with notes bearing interest at 9.38% under which recourse was limited to revenues generated from the franchises. The ARQ denied the interest claimed on the notes for 2005 and 2006 on the basis that the investors could extinguish their obligations under the notes for $160,000 by surrendering their franchise and that there in fact had been an agreement that all that was required of the investors was to make three interest payments totalling $45,000 for the acquisition of their respective franchises (so that the purported $160,000 obligation was a sham).

In rejecting this position and finding that the claimed interest was deductible, Fournier JCQ (at paras. 497-498, 504, TaxInterpretations translation):

[W]here the franchisee opts to exit the franchise three years after its acquisition, it is fair to state that the franchisee’s investment will be limited to the payment of only $45,000, and no more.

This does not, however, invalidate the contracts and the legal effects they produce. …

In the absence of a conclusion that the promissory notes subscribed for the purchase of the … franchises constitute shams, the resulting legal effects must be respected.

A tax shelter, for the initial (2003/2004) years assessed by the ARQ, entailed the sale by a corporation (“Prospector”) to over 200 investors of software licences. Following an adverse determination by the ARQ for those years, the design of the tax shelter was changed, and for the subsequent years (2005-2010) investors were sold franchises for the non-exclusive right to distribute the software licences in specified territories. After further pressure from the ARQ, the notes issued by investors for the franchises were full recourse rather than limited recourse notes. Drouin had reversed a CRA reassessment of some investors’ 2008 taxation years made on the basis that no business was carried on. Prospector obtained a tax shelter registration number for the 2005 and 2006 years, but not the other years.

After finding that the software licences acquired in 2003 and 2004 clearly were tax shelters (as defined in the Quebec equivalent of s. 237.1) given the description in the marketing materials of the (Class 12) deductibility of the licence costs and their financing with limited recourse debt representing prescribed benefits (so that the failure to obtain a tax shelter number resulted in a denial of the claimed deductions), Fournier JCQ turned to the franchises purchased in 2005 and 2006 (comprising, for each purchase, software purchased for $150,000 and a membership right for $10,000) and financed with notes bearing interest at 9.38% under which recourse was limited to revenues generated from the franchises, and found that these constituted tax shelters for essentially the same reasons, and that they also were tax shelter investments, and that the licences were computer tax shelter properties, as defined under the Quebec equivalents of ITA s. 143.2(1) and Reg. 1100(20.2). Accordingly, their CCA claims were denied on that basis notwithstanding the tax shelter registrations (the revenues generated were nil). Furthermore, two of the taxpayers had not filed the prescribed forms reporting the tax shelter numbers.

For the 2007 and subsequent taxation years, the taxpayers argued that they satisfied the numerical tests for those years because the cost of their acquisition of the property (being a single franchise property for these purposes comprised of the software licence and the membership right) included all the interest they had covenanted to pay. After referring to the definitions of “cost” in Coast Capital Savings and Stirling, and in rejecting this argument, Fournier JCQ stated (at para. 547, TaxInterpretations translation):

The term "cost" must therefore be assimilated to the price that the taxpayer agreed to pay to acquire the property, excluding other expenses incurred in respect of the property, including interest payable on money borrowed by the taxpayer to acquire the property.

In also rejecting the single property argument, Fournier JCQ stated (at paras 551-552):

[T]he assets acquired under the … franchise agreement must be considered separately for tax shelter determination purposes because they have different tax characteristics. The software suite is a Class 12 property while the membership right is an eligible capital property with different rates of depreciation.

… The definition of tax shelter contained in TA section 1079.1 … militates in favour of an individual analysis of the property in question in order to determine whether or not it qualifies as a tax shelter.

Accordingly, the Class 12 CCA claims for those years respecting the cost of the software were also denied, whereas the eligible capital amounts claimed for the membership right were deductible.

The ARQ did not lose heart with the victory by a representative investor in a tax shelter in Drouin (where CRA unsuccessfully argued that no business was carried on) and, for the same tax shelter and for the same year (as well as other years) was successful before the Court of Quebec in having most of the claimed deductions denied. For two of the years, there was a prescribed benefit in the form of limited recourse debt, which resulted in all the deductions being denied under the Quebec equivalent of ITA s. 231.7(6) as no tax shelter registration had been made. For two subsequent years, such registration had been made, but there nonetheless were tax shelter investments under Quebec equivalent of s. 143.2, so that the limited recourse nature of the debt again resulted in CCA denials under that provision and the equivalent of Reg. 1100(20.1).