Cote (Succession De) v. R., [1996] 1 CTC 2862, 96 DTC 2057

Dussault J.T.C.C.: — These appeals were heard on common evidence. [1] The case concerns business losses apparently incurred by a company doing business under the corporate name CRAB ENR. (“Crab”) during the fiscal years ending on May 31, 1986 and May 31, 1987. The losses recorded in Crab’s financial statements for those fiscal years were respectively $198,438 and $87,905. The deduction of the share of those losses claimed by each of the appellants was disallowed by the Minister of National Revenue (“the Minister”).

Jacques Côté’s appeal (92-1383(IT)G) was for his 1986 taxation year and concerned the disallowance of a deduction of $39,687 in respect of his share of Crab’s loss for the 1986 fiscal year.

Marcel Bédard’s appeal (92-1385(IT)G) was also for his 1986 taxation year and also concerned the Minister’s disallowance of a deduction of $39,688 in the same respect.

Paul Roy’s appeals (92-1390(IT)G) were for 1986 and 1987 taxation years and concerned the Minister’s disallowance of deductions in the amounts of $39,688 and $21,976 respectively in respect of his share of Crab’s losses for the fiscal years ended during those same years.

Marc-André Anctil’s appeal (92-2365(IT)G) concerned the determination of a loss of $39,688 for his 1986 taxation year. Two other appeals (92-1391(IT)G) were for his 1987 and 1988 taxation years. The appeal for 1987 concerned the disallowance of the deduction of a $21,976 loss for the year and a disallowance of a loss carry-over of $39,688 from 1986. The appeal for 1988 related to the disallowance of a deduction in respect of the carry-over of the minimum tax from 1987.

The appellants’ position was that a partnership was initially formed in 1984 to invest in a corporation by the name of C-Line Canada Inc. (“C- Line”) incorporated for the purpose of developing a French version, “C- Français”, of a computer language called “C-English” and that the funds advanced or the sums repaid the fiscal year that corporation were reflected in its financial statements for the fiscal year ending on May 31, 1986.

The appellants further contended that a more elaborate partnership agreement was signed on December 12, 1986. On the same day, acting for and on behalf of Crab, named in that agreement, the partners entered into an agreement with C-Line in which they undertook to reimburse the latter and pay the development expenses of the “C-Français” program as billed at a rate of 20 per cent each, in consideration of a royalty of 50 per cent of the profits realized through the marketing of that same program. The appellants claimed that the amounts thus reimbursed or paid by Crab between June 1, 1986 and May 31, 1987 corresponded to those indicated in its financial statements for the year ending on the latter date.

As no income appears on Crab’s financial statements for the years ended May 31, 1986 and May 31, 1987, the appellants claimed their share of the expenses stated as business losses, as indicated above.

Alternatively, the appellants claimed a business loss as resulting from a deduction to which Crab was entitled under paragraph 20(1 )(b) of the Income Tax Act (“the Act”) arising from the purchase of an eligible capital asset, that is the entitlement to the royalty of 50 per cent of C-Line’s potential profits from the marketing of “C-Français”.

The respondent contended for her part that no partnership existed between the appellants prior to December 12, 1986 and that C-Line’s expenses relating to the development of “C-Français” were, both before and after that date, financed in large part out of funds advanced not by a company, but rather by the appellants themselves personally as shareholders or directors of C-Line. The respondent thus claimed that the corporate agreement dated December 12, 1986 as well as the agreement between C-Line and those individuals acting for and on behalf of Crab had no commercial or economic reality and that they had been orchestrated in order to enable the appellants to claim a business loss which they could not otherwise have claimed. [2]

According to the respondent, C-Line had in fact practically ceased all activity respecting the development of “C-Français” in December 1986 and its activities had to that point been financed in the aforementioned manner. Thus, the expenses imputed to a corporation or to Crab in reality reflected those incurred by C-Line directly. According to the respondent, the partnership agreement and the agreement with C-Line constituted after the fact arrangements that had their origin in correcting entries in C-Line’s books and in the subsequent preparation of financial statements which did not correspond to the reality. The respondent thus contended that the alleged company Crab formed on December 12, 1986 “was never formed for the purpose of operating a business for the development of software or anything else” [3] and that it “never operated a business since the business in which [it] claimed to want to enter had already ceased to exist in December 1986”. The respondent therefore contended that Crab had “apparently [been] formed on December 12, 1986 ... [that it] had no reasonable expectation of earning a profit from the operation of the business” [4] and that it “had not incurred expenses and if those expenses had been incurred, [that] they were not incurred for the purpose of earning income from a business or property”. [5]

The evidence revealed that C-Line was initially incorporated on June 5, 1984 as 133192 Canada Inc. That name was amended on August 20 of that same year to C-Line Canada Inc. On September 17 following, Jacques Côté, Jean-Marie Côté, Marc-André Anctil, Paul Roy and Marcel Bédard signed a handwritten agreement prepared by Mr. Bédard the only two paragraphs of which read as follows:

Having regard to the fact that Guy Nadeau has defaulted in his obligation to supply money to C-Line Canada in proportion to the shares which he holds in the company, he will be deleted accordingly and Marcel Bédard is invited to join the other partners as an equal partner.

However, the partners by the same occasion undertake to combine their efforts and to invest the necessary money in the development of the company for the distribution of C-English in Canada and to ensure if possible the creation of C-Français.

[Translation.]

According to Marc-André Anctil’s testimony, the primary purpose in incorporating C-Line was to develop the computer language “C-Français” using as a basis “C-English”, which was already at the marketing stage in the United States, so as to eventually secure the Francophone market in Quebec and Europe. The sale of “C-English” in Canada was also considered. According to him, the agreement, which he described as an incomplete basic document, was above all intended to “put matters in order” between the signatories.

The evidence revealed that C-Line indeed undertook the development of “C-Français” and that it hired research staff as well as administrative staff in order to do so. Furthermore, a grant was made to it by the Quebec Department of Communications to continue its research; a part of that grant, however, was received by the company in 1985 and 1986 only. In fact, the work relating to the development of “C-Français” continued until December 1986, when the last employee was laid off. Apart from the funds generated by the sale of a certain number of copies of “C-English”, for which C-Line had obtained exclusive distribution rights in Canada, and those corresponding to the portion of the grant received, the company financed its activity out of the money from the subscription of shares of its capital stock and from advances made by its principal shareholders and directors, including the appellants. A number of documents filed in evidence such as sets of cheques indeed established that substantial sums were advanced to C-Line by the appellants personally. In the case of Marcel Bédard, an investment company belonging to him, 93617 Canada Inc., also advanced sums to C-Line. The advances thus made were spread from June 1, 1984 to September 13, 1990, the largest amounts having been advanced until March 1987. C-Line’s financial statements for the fiscal period ending May 31, 1986 indicate moreover that a sum of $134,661 was owed to the shareholders for the fiscal period that ended in 1985, but that no amount was due in this respect for the period that ended in 1986. However, note 12 to those financial statements shows that, during the 1986 fiscal year, C-Line conducted transactions with a company, which was not named in any way, for a total amount of $198,438:

Sales - Services: $177,438

Recovered portion of administrative expenses: $ 21,000

However, this amount of $198,438 is that which appears in Crab’s financial statements for the fiscal period that ended May 31, 1986, on the one hand, as a contribution of the partners and, on the other hand, as development expenses ($177,438) and administrative expenses ($21,000) for a net loss of the same amount. I point out here that the financial statements for C-Line’s 1986 fiscal year were dated April 15, 1987, whereas those of Crab were dated April 24, 1987. Moreover, nothing in the evidence makes it possible to establish any real contribution of funds to Crab by its partners or a corresponding outlay of funds from Crab to C-Line. There was no cheque or other document of any kind making it possible to establish the reality of the transactions presented in the financial statements. Thus, with respect to Crab’s fiscal year ending on May 31, 1986, there was absolutely no evidence confirming what the financial statements prepared nearly one year later claimed. The evidence adduced does not make it possible to show on a balance of probabilities that any partnership had ever existed between the appellants since 1984 or, what is more, that any activity whatever in the nature of a business could have been carried on by such a partnership during a fiscal year that allegedly ended on May 31, 1986. My conclusion on this point is that the commercial activity in respect of the sale of “C-English” as well as the research activities concerning “C-Français” were undertaken by C-Line exclusively. These activities were financed in particular through advances by its shareholders and directors personally and, in one case, also by an investment company. I consider that the expenses incurred by C-Line and financed in part out of these advances transformed into partner contributions to Crab then into expenses of that alleged company were not consistent with the reality and that they were organized after the fact. The evidence adduced by the respondent to establish the reconciliation of the amounts in issue merely confirmed this conclusion. Except for the financial statements mentioned for C-Line and Crab and prepared by the same person, the evidence revealed no intention on the appellants’ part to operate a business in a partnership. The mere use of the term “partners” in the agreement of September 17, 1984 was insufficient for this purpose. It was supported by no other evidence. Nor was there any indicator whatever, such as employees, offices, stationery, documents, invoices, bank accounts, cheques, etc., of the existence of a company without a name or which used Crab’s business name. The appellants did invest in C-Line, but, in my view, they did so directly and not through an alleged company, which furthermore allegedly had some sort of business activity which could constitute the operation of a business either independently or as a partner of C-Line.

This conclusion leads me to treat the appellants’ 1987 taxation year and the loss claimed as resulting from Crab’s activities during the fiscal period that ended on May 31, 1987. Additional elements should be pointed out here. Moreover, certain events which occurred during that year confirm my conclusion respecting 1986.

I shall first note that the evidence revealed no change in the manner of proceeding with the financing of C-Line’s activities. For the years in issue, the advances were always made personally and directly by the appellants to C-Line, except for Marcel Bédard whose advances were always made by his investment company, with the exception of an advance of $25,000 made personally by him to C-Line on March 11, 1987.

It was stated above that a partnership agreement was entered into on December 12, 1986 by the four appellants and the fifth individual creating the company Crab and that another agreement was also entered into on the same day between C-Line and those same five persons acting for and on behalf of Crab. Those agreements were filed as Exhibits A-6 and A-7 respectively. The explanations provided by the appellants Marc-André Anctil and Marcel Bédard respecting the purpose and effect of those agreements, more particularly that between C-Line and Crab, were in part confused and contradictory.

From what I could understand of Marc-André Anctil’s explanations, the purpose of the agreement with C-Line was so that Crab, the partners of which were C-Line’s majority shareholders, could purchase C-Line’s assets and liabilities, at least in part, in order to pursue the development of “C- Français” in which C-Line’s minority shareholders no longer wanted to take part. According to Marcel Bédard, although C-Line was unable to push the development of “C-Français” any further in the fall of 1986 considering the development of “C-English” in the United States, the shareholders were still justified, in particular because of the sales projections for “C-English”, in believing that continuing research on “C- Français” could eventually have extraordinary repercussions given the exclusive world distribution rights to that software held by C-Line.

It is important at this stage to reproduce certain clauses of the two aforementioned agreements. First of all, with respect to the partnership agreement, [6] the preamble, which “forms an integral part hereof”, [7]

provides as follows:

WHEREAS the parties hereto (hereinafter called “the partners” and individually “the partner”) have agreed to carry on their business as a partnership in the Province of Quebec under the business name stated below and in accordance with the provisions stated below in this partnership agreement;

WHEREAS the company “C-Line Canada Inc.” is a legally incorporated company and requires additional financial resources which will have to be invested in the development of the C-Français program, the trademark of which was registered on 19 under number and of which the company “C-Line Canada Inc.” is the true owner;

WHEREAS the parties hereto wish to associate with each other in order to pay the development expenses of the C-Français program, to enter into an agreement with the company “C-Line Canada Inc.” for it to market and sell that C-Français program and to earn royalties from the sale and marketing of that C-Français program.

Articles 2.1 and 2.2 then state the following:

2.1 Creation of the partnership CRAB ENR.

The partnership CRAB ENR., described in the preamble above, is hereby created and constituted as of the twelfth day of December 1986.

2.2 Activities of the partnership CRAB ENR.

The partnership is organized for the purpose of paying to the company “C-Line Canada Inc.” all the development expenses of the C-Français program until it is finally marketed.

[Translation.]

Moreover, the agreement between C-Line (called “the Company”) and the five individuals mentioned, including the appellants, acting for and on behalf of Crab (called “the Parties of the Second Part”) [8] provides in particular as follows:

1. The Company remains the owner of the C-Français program, will continue developing the said program and retains exclusive rights to market that program.

2. THE PARTIES OF THE SECOND PART shall reimburse and pay to the Company the development expenses of the C-Français program billed by the Company to the PARTIES OF THE SECOND PART.

3. Each partner acting pursuant hereto for and on behalf of the partnership CRAB ENR. undertakes to pay 20 per cent of the total amount of the invoices transmitted monthly by the Company to the PARTIES OF THE SECOND PART.

4, The development expenses of the C-Français program which the PARTIES OF THE SECOND PART undertake to reimburse to the Company upon receipt of detailed invoices with vouchers received from the Company are as follows:

(a) all the salaries and expenses relating directly to the development of the C-Français program;

(b) an additional charge of 10 per cent of the costs enumerated at paragraph 4(a) above; and

(c) the administrative expenses of a fixed amount of $3,500 per month including the rent, telephone, insurance and office furniture, etc.

5. In consideration of the reimbursement of the expenses for the development of the C-Français program by the PARTIES OF THE SECOND PART until that program is finally developed, the Company shall pay to the PARTIES OF THE SECOND PART, once that program has been developed, a royalty of 50 per cent of the total profit which it realizes through the marketing of the C-Français program....

In C-Line’s financial statements dated April 19, 1988 [9] for the fiscal year ended on May 31, 1987, it was noted that the shareholders’ advances had amounted to $75,767 at the end of fiscal 1987 (compared to nil at the end of fiscal 1986). Note 9 to the financial statements indicates that C-Line had conducted the following transactions with a company:

1987/1986

Sales/Services: $59,9051 $177,438

Portion of administrative expenses: $28,000 / $21,000

In Crab’s financial statements dated April 20, 1988 [10] for the fiscal year ended on May 31, 1987, the same two elements appear under the heading expenses for the year, that is $59,905 as “development expenses” and $28,000 as “administrative expenses”, which, given the absence of revenue, resulted in a net loss of $87,905 for the fiscal year. Only two appellants, Paul Roy and Marc-André Anctil, claimed their share of that loss in 1987 for an amount of $21,976 each, as indicated above. [11]

With the aid of a number of documents and statements from various sources, Robert Matte, an auditor with Revenue Canada, was able to complete a reconciliation and explain the results reported in the financial statements of C-Line and Crab for both the 1986 and 1987 fiscal years. Counsel for the appellants objected to the filing in evidence of certain documents used by Mr. Matte in his audit work, in particular documents respecting the grant made to C-Line, certain reports on the subject provided to the authorities by C-Line, as well as work sheets which Mr. Matte stated that he had obtained from Clément Gosselin, C.A., who had prepared the financial statements for both C-Line and Crab. These documents were used by Mr. Matte to determine precisely C-Line’s expenses relating to the development of “C-Français” relative to general expenditures and in particular were used to establish the premiums for C-Line. I do not believe that these documents are necessary to decide the present issue, so I do not have to rule on the merits of the objection.

However, to grasp the significance of the aforementioned amounts found in the financial statements of C-Line and Crab, it is important for me to refer to the “Summary of Transactions Entered in the Owed to Shareholders Account” [12] prepared by Mr. Matte following a detailed analysis of that account in C-Line’s books. It may be seen from this document that the balance owed to shareholders on May 31, 1985, which was $134,661, increased to $197,111 before disappearing completely on May 31, 1986 as a result of a correcting entry of $198,438 to offset the development expenses of $177,438 and administrative expenses of $21,000 which appear as expenses in Crab’s financial statements for the fiscal year ending May 31, 1986. The same amount of $198,438, it should be recalled, was entered as a contribution from the partners in Crab for the same fiscal year. Lastly, let us also recall that the two amounts of $177,438 and $21,000 appear in note 12 to C-Line’s financial statements for the same period under the heading “Transactions Between Related Parties” as “Sales - Services” and “Recovered Portion of Administrative Expenses” respectively.

For the fiscal year ended May 31, 1987, it may be observed from the same document (Exhibit 1-15) that new advances totalling $165,000 were made to C-Line by its shareholders. The advances reduced to $163,673 by a first correcting entry were then reduced to $87,905 by a second entry, that is the equivalent of the amount of the transactions with Crab indicated in C-Line’s financial statements as “Sales - Services” ($59,905) and “Recovered Portion of Administrative Expenses” ($28,000). [13] As a result of these entries, the balance of the shareholders’ advances was only $75,768 at the end of fiscal 1987, which corresponds to the dollar with the balance indicated in C-Line’s financial statements. In the financial statements prepared for Crab for the same fiscal year, the amount of $87,905 first appears as a contribution from the partners for the same period. The amounts of $59,905 and $28,000 were indicated respectively as outlays for “development expenses” and “administrative expenses”. Once again, as there was no income, the net loss for the fiscal year was indicated as $87,905. Only the appellants Paul Roy and Marc-André Anctil claimed their share of this loss at a rate of 25 per cent each, that is an amount of $21,976.

As I have emphasized above, the evidence showed that C-Line ceased the development of “C-Français” at the end of December 1986, when the last employee, the computer specialist Vincent Talbot, was laid off. In these circumstances, I consider that the partnership agreement and the agreement between C-Line and Crab dated December 12, 1986 had no economic reality. C-Line’s expenses relating to the development of “C- Français” were refinanced during the 1987 fiscal year as they had been during fiscal 1986 and even previously through advances granted by the shareholders, of which Crab was clearly not one since it did not exist. The partnership agreement of December 12, 1986 further stipulates that the partnership was formed only starting on that date. [14] The transformation of the shareholders’ advances in C-Line into a contribution from partners in Crab then into the latter’s “development expenses” and “administrative expenses” was therefore completely artificial, in my view, and cannot be allowed. If anyone wishes to state that a partnership using the style Crab was created on December 12, 1986, it must be observed that it never existed in any concrete form apart from the document on which the agreement was recorded. Just as for the 1986 fiscal year, the evidence provided no indication that it actually existed. Moreover, how can it be claimed that such a partnership could have had fiscal years one of which, that is 1986, preceded its existence and another which, that is 1987, began prior to its founding. In addition, as the evidence does not make it possible to trace any transaction, transfer of funds or activity whatever on Crab’s part, even starting on December 12, 1986, one can only conclude that this partnership did not exist or, at the very least, supposing that it might have existed, that it did not carry on any activity that might be described as constituting the operation of a business. Even if one wanted to claim that there had subsequently been novation between the parties stemming from the creation of Crab and from the agreement with C-Line under which Crab had purchased the right to a 50 per cent royalty in consideration of the reimbursement and payment of C-Line’s expenses, it remains that it was the latter and not Crab which operated the business and incurred the expenses. In light of the considerations stipulated, the analysis would lead to the simple conclusion that it was Crab which, starting on December 12, 1986, must be considered as an investor in C-Line and not that it operated a business itself. The purpose of Crab’s creation, as indicated in the partnership agreement, was to “pay” to C-Line the development expenses of the “C-Français” program until it was finally marketed. [15] Merely paying the expenses incurred by C-Line was insufficient to constitute the operation of the business. Thus, even under this condition, no deduction could be allowed in respect of the purchase of an eligible capital asset.

In these circumstances, I shall merely describe the whole of the operation as what is called a sham in the classic sense of the term as stated by Lord Diplock in Snook v. London & West Riding Investments Ltd., [1967] 1 All E.R. 518 (U.K.) at pages 528 and 529. In the judgment of the Supreme Court of Canada in Stubart Investments Ltd. v. R. (sub nom. Stubart Investments Ltd. v. The Queen), [1984] 1 S.C.R. 536, [1984] C.T.C. 294, 84 D.T.C. 6305, at page 572 (C.T.C. 306; D.T.C. 6314), Estey J. cited Lord Diplock’s remarks on this point. Ultimately, this is an operation comprising elements:

..which are intended by them to give to third parties or to the court the appearance of creating between the parties legal rights and obligations different from the actual legal rights and obligations (if any) which the parties intend to create.

The least one can ultimately say in the instant case is that Crab never operated a business and never incurred real expenses. Its alleged losses were not losses and may not be claimed by the appellants. The correcting entries in C-Line’s books and the presentation of financial statements by Crab cannot alter after the fact the true relations between C-Line and its shareholders, who simply invested in the former in the form of advances.

Having regard to this conclusion, the decisions to which counsel for the appellants referred, more particularly the decision in Continental Bank of Canada v. R. (Continental Bank of Canada v. Canada), [1995] 1 C.T.C. 2135, 94 D.T.C. 1858, certainly cannot apply. Is it necessary to recall that every exercise in tax planning must precede and not follow the events. I will simply add that the decisions cited by counsel for the respondent, more particularly those in Malkin v. Minister of National Revenue, [1942] C.T.C. 135, 2 D.T.C. 587 (Exch.). Adam v. Minister of National Revenue, [1985] 2 C.T.C. 2383, 85 D.T.C. 667 (T.C.C.). and Société Immobilière SSQ Inc. v. Minister of National Revenue}, [1993] 1 C.T.C. 2029, 93 D.T.C. 273 (T.C.C.) appear to me material in supporting my decision to dismiss the appeals respecting the 1986 and 1987 taxation years. These were indeed cases in which the taxpayers had tried to alter the consequences of certain transactions after the fact.

As to Marc-André Anctil’s appeal for his 1988 taxation year, the dismissal of his appeal for the 1987 taxation year means that no minimum tax was payable for 1987, so that the deduction in respect of such a tax for 1988 is void and the Minister was justified in disallowing it.

As a result of the foregoing, all the appeals are dismissed with costs to the respondent. However, since these appeals were heard on common evidence, those costs will be limited to the costs of a single appeal in respect of the preparation of the hearing and of the hearing itself.

Appeals dismissed.