Bohumil J. Janicek v. Minister of National Revenue, [1992] 1 CTC 2281, 92 DTC 1265

Garon, T.C.C.J.:—In this case, the appellant appeals reassessments dated June 23, 1988 in respect of the 1982, 1983 and 1984 taxation years and a reassessment dated May 5, 1989 for his 1985 taxation year. By these reassessments, the respondent increased the appellant's income derived from a limited partnership by the name of Janicek Associates by the following amounts in respect of the taxation years indicated below:

At the conclusion of oral argument the Court strongly suggested to counsel for the respondent that the reply to the notice of appeal be amended so as to reflect the new position adopted by the respondent with respect to the quantum of the partnership losses in the years in issue and the nature of the legal submissions advanced to support the reassessments in question. The key submission in the original reply to the notice of appeal reads as follows:

8. He submits that the appellant's net partnership income was properly reassessed in accordance with section 96 of the Income Tax Act in each of the 1982, 1983, 1984 and 1985 taxation years and that there exist no provisions in the Income Tax Act pursuant to which the appellant may deduct any amounts as reserves therefrom.

As a result, a substituted reply to the notice of appeal dated November 16, 1990 was filed with the Court on behalf of the respondent. This reply was followed by the filing by the appellant of a document entitled "Appendix to Notice of Appeal" dated February 11, 1991. These written pleadings were succeeded at the end of May 1991 first by the respondent's memorandum of argument and subsequently by the appellant's argument dated June 28, 1991. About a month later counsel for the respondent indicated that she would not respond to the appellant's argument.

After this extended oral hearing, new written pleadings and the memoranda of argument of the parties it would appear that most of the facts are not in dispute.

The appellant, who acted for himself at the hearing of these appeals, was at all material times the general partner in Janicek Associates, a limited partnership formed under the laws of Ontario. A partnership agreement dated August 28, 1984 was filed with the Court where it is indicated that the parties are the appellant, who is designated as the General Partner”, Cyril B. Benson who is described the Representative Limited Partner" and " Each and every Person who is accepted to be a Limited Partner in the partnership formed by this agreement (herein collectively with the Representative Limited Partner called the Limited Partners)". The appellant testified that the limited partnership had been in existence since 1981 following the registration of the required declaration with the Ministry of Consumer and Commercial Relations of the Government of Ontario. Incidentally, there is a reference in one of the exhibits to a partnership agreement dated September 1, 1981 as amended. At the hearing of these appeals, the parties were content to refer to the partnership agreement dated August 28, 1984 as if it has been in force in its present wording as of 1982. In these reasons I I will be referring only to the partnership agreement as it read on August 28, 1984. Declarations of change listing the partners' names, addresses and contributions registered in July 1984 and at undisclosed dates subsequently under the Limited Partnership Act were filed with the Court. The year-end of the partnership was January 31.

For the purposes of these appeals, the following clauses of this partnership agreement dated August 28, 1984 should be noted:

2.1 The parties agree to and do hereby form in accordance with this Agreement and the Partnership Act a limited partnership under the name and style of:

JANICEK ASSOCIATES

2.2 The partnership shall carry on the business of conducting basic and applied research in geophysical prospecting and the business of reducing to practice, which shall include designing and developing computer software, the suitable results of this research with view to sale of rights in or arising out of this research (the “ Principal Business”).

2.3 The Partnership shall derive substantially all of its revenue from carrying on the Principal Business.

2.4 The Partnership may occasionally carry on a business other than the Principal Business and may utilize some of its funds for such purpose provided that in the opinion of the Representative Limited Partner such business and use of funds is appropriate and shall not adversely affect the interest of any Limited Partner.

2.5 It is expressly agreed and understood that the Partnership, when it commences, shall be a continuation of a general partnership which was formed by the first and the second party to this Agreement and which began on the 1st day of September, 1981, and has continued since and until the commencement of the Partnership.

2.7 The fiscal year end of the Partnership shall be January 31.

3.1 Partnership Interest means a Partner's total rights and obligations under this agreement, in particular the right to allocations of Net Income, Net Loss, Taxable Income, Tax Credit, and cash distribution from the Partnership and the obligation to contribute to the partnership.

3.4 For greater clarity, in this article a Limited Partnership Interest means numerically an amount equal to the sum of Capital contribution and Premium of a Limited Partner.

For the purpose of calculating the sharing ratio, that is, the allocation of Net Income, Net Loss, Taxable Income, Tax Credit, and cash distributions from the Partnership, and other purposes, at any time:

a) the General Partner's interest in the Partnership shall be fifty one hundredths (51%) of the Entire Partnership Interest;

b) the aggregate of all the Limited Partnership Interests shall be forty nine hundredths (49%) of the Entire Partnership Interest.

At any time any allocation

a) to the General Partner shall be 51% of the total of that allocation, and

b) to a Limited Partner shall bear the same ratio to the total of that allocation as

does this Limited Partnership Interest to the Entire Partnership Interest.

3.9 A Limited Partnership Interest may be obtained only by payment of no less than $2,000.

4.1 The General Partner shall establish and maintain a separate account for each partner to which shall be credited the amount of each Partner's share of Capital, Net Income, and all other amounts to which the Partners are entitled and to which Net Loss and all distributions to Partners will be charged. No interest shall be payable on such accounts.

5.1 The General Partner's contribution shall be his unlimited liability as General Partner.

5.2 Each Limited Partner shall make a Capital contribution to the Partnership of no less than $2,000.

5.3 The liability of each Limited Partner for the debts and losses of the Partnership is limited to the amount of his Capital contribution to the Partnership only, as set out in the Partnership Act.

5.4 The Net Income, Net Loss, Taxable Income and Tax Credit of the Partnership shall be allocated amongst the Partner's accounts on December 31 in proportions that obtain for that day according to article 3.4.

6.1 The General Partner shall have full and exclusive power and authority on behalf of the Partnership to carry out the Partnership Business and to the extent deemed necessary by the General Partner hold the Partnership assets for the benefit of the Partnership, and shall do all acts deemed by the General Partner to be necessary, appropriate, or incidental to the Partnership Business pursuant to section 2.4, including but not limited to the power and authority to:

(a) purchase, lease or otherwise acquire equipment and premises in connection with the Partnership Business;

(b) retain or employ professional, technical, and other advice and assistance in the conduct of the Partnership Business;

(c) open a bank account for and in the name of the Partnership with full and exclusive signing authority on behalf of the Partnership;

(d) pay costs and expenditures reasonably incurred by the Partnership;

(e) borrow money for the financing of the Partnership Business, execute the evidence of indebtedness, and secure the payment of the sum so borrowed and mortgage, pledge, or assign in trust all or any part of the Partnership;

(f) cause the Partnership to guarantee a loan made to a Limited Partner the proceeds of which are paid to the Partnership and provide security for such guarantee.

6.2 The General Partner shall:

(a) above all but not neglecting his other duties, direct and supervise scientific research pursuant to article 2.2;

(b) provide overall management and planning;

(c) be under the duty to manage and operate the day to day affairs of the Partnership;

(d) take in and account for income from the Partnership Business;

(e) make distributions in accordance with this Agreement;

(f) pay costs and expenditures reasonably incurred by the Partnership;

(g) make annual reports and such other reports to the Limited Partners as provided for in this Agreement;

(h) purchase and maintain insurance on the tangible assets of the Partnership;

(i) maintain books and records as provided for in this Agreement.

The General Partner in exercising his powers and discharging his duties shall act honestly and in good faith with view to the best interest of the Partnership and shall exercise the care, diligence and skill that a reasonably prudent person would exercise in comparable circumstances.

6.3 The General Partner may contract with any person to carry out any of the duties of the General Partner and may delegate to such person any power and authority of the General Partner hereunder, but no such contract of delegation shall relieve the General Partner of any of his obligations hereunder.

6.4 No person dealing with the Partnership shall be required to inquire into the authority of the General Partner to take any action or make any decision on behalf of or in the name of the Partnership.

6.5 The General Partner shall have unlimited liability for the liabilities and obligations of the Partnership.

6.9 The General Partner shall be reimbursed by the Partnership for all expenses reasonably and properly incurred by him in conducting the Partnership Business including administrative overhead and the cost of such professional, technical, and other assistance, service and advice as he shall consider necessary.

6.10 The General Partner may borrow up to $12,000 per annum from the Capital for his personal expenses. No interest shall be paid on the proceeds of such loans.

7.1 Subject to the provisions of the (Limited) Partnership Act, the liability of a Limited Partner shall be limited to the total amount of his capital contributions.

7.2 Limited Partners, whether named in the Declaration or in any notice to amend the Declaration, shall not become Limited Partners until the time of registration of the Declaration or registration of a notice to amend the Declaration, as the case may be, in the Province of Ontario.

10.1 It is hereby irrevocably agreed and understood that the R & D Performer shall be engaged by the Partnership for the sum of $300,000 in lawful money of Canada. The said sum shall be paid first out of revenues, next, if they are insufficient, out of Capital, and lastly, if still necessary, by the General Partner personally.

10.2 The payment under article 10.1 shall be made on or before the first day of January 1982 by a promissory note payable on demand with compound interest thereon from the date of presentment for payment at the rate of 15% per annum to the order of B.J. Janicek, who shall hold it as trustee for the R & D Performer. The payment required herein shall be and remain a primary obligation of the Partnership.

10.3 Should the R & D Performer be not engaged by the Partnership before the 31st day of January 1987, the said sum and interest thereon shall become absolutely a personal property of trustee B.J. Janicek, a party to this agreement.

11.8 The provisions of this Agreement are in effect as of the first day of September, 1981.

The appellant was the only witness at the hearing of these appeals. The appellant is a physicist by training. He gave in part the following explanations about the origin of the partnership:

Soon afterwards I developed an obsession with a certain problem with physics and I devoted myself completely to it. About ten years later the idea crystallized sufficiently until I realized there is an opportunity to make profit out of the technology for applications of the ideas. I have organized a limited partnership for that purpose to obtain financing to accomplish the presentation and sale of technology for applications. So this partnership agreement has been developed over a number of years.

Transcript of October 12, 1990, page 6, lines 6 to 16.

It was disclosed that there are at present ten limited partners; four of them have outstanding notes. The amount paid up to date is $95,000 and the total capital that was promised pursuant to the partnership agreement was $352,700. In this connection, it is worth noting that one limited partner, Mrs. Erika Power agreed in a promissory note dated June 23, 1984 to pay $200,000 seven years after date to the partnership, Janicek Associates. However, her contribution at the time of hearing amounted to only $13,600 and it would appear that no additional contribution would be forthcoming. The appellant considers the outstanding amount either as a doubtful debt or a bad debt.

The appellant commented as follows with respect to his own remuneration:

Now the limited partners have agreed that I should be compensated for my time, that I should have some sort of security just in case the whole effort will fail. It was realized I would have to work on this full-time. The amount of compensation to myself is sort of a contract between myself and the limited partnership is $300,000 evidenced by this promissory note.

The promissory note to which reference is made reads as follows:

PROMISSORY NOTE

This note replaces a note payable to B.J. Janicek and made on Dec. 30, 1981, which is hereby cancelled.

JANICEK ASSOCIATES promise to pay to the order of Bohumil J. Janicek on demand the sum of three hundred thousand dollars in lawful money of Canada ($300,000) pursuant to article 10 of the Partnership Agreement among B.]J. Janicek and C.B. Benson and other limited partners, without interest before presentment for payment and to bear interest after presentment at the rate of 15% per annum, compounded daily until paid.

FOR VALUE RECEIVED.

Dated at Ottawa this 23rd of January, 1983.

Janicek Associates

per

General Partner

The appellant said this in relation to the promissory note:

"I have not made full demand on the note yet but in practice as the money will come in I used whatever was possible, what was not needed strictly for the business I used for my personal and living expenses." [Transcript of October 12, 1990, page 10, lines 11 to 15.]

The appellant clearly stated that he used the money received from the capital contributed by the limited partners in part for business expenses and in part for personal or living expenses. He estimated that out of the $95,000 that he received from the limited partnership over a period of seven years beginning with the 1982 taxation year about 20 per cent was used for business expenses such as the purchase of equipment and the payment of fees to lawyers and 80 per cent was allocated to him for his living expenses. The appellant would have received close to $80,000 over a period of seven years for his personal purposes. He said that the amounts he used for personal expenses "were in a way loans from the partnership to myself. I am entitled with the partnership agreement to make such loans.” However, no promissory notes or other documentation were tendered in evidence in support of this statement.

It was finally agreed by the parties that the partnership incurred a loss in the amounts hereinafter set out opposite each of the years in issue:

During the years in issue, the partnership had only one employee for half a year beginning in 1982 and terminating in 1983. The appellant confirmed that pursuant to the partnership agreement he owned at the relevant time 51 per cent of the business of the limited partnership and that he did not make any capital investment in the partnership. He brought to the partnership his scientific knowledge and he has been working full-time on the project. There are four other partners who are physics university professors who are consulted from time to time by the appellant. It was also disclosed that the invention is in the process of being patented and that the business prospects of the partnership depend on the quality of the invention.

In the adjustments to income schedule that was part of the appellant's income tax return for 1985 the amount of $54,000 was termed "Salary of R&D Performer (to myself indirectly)" but the appellant testified that he received only $6,423. The latter figure is mentioned at the bottom of the same schedule as representing the difference between the "salary of R&D Performer plus 1984 Reserve" minus the “New Reserve" and a small amount covering certain expenses. On this schedule he computed his net income from the partnership at $6,423. The latter figure represents the amount of money which was effectively received by the appellant from the partnership in 1985. The appellant asserted that the reserve deducted in the computation of income from the partnership was provided by paragraphs 12(1)(b) and (c) and paragraph 12(1)(g) of the Income Tax Act. The same method of calculation of his income for the other three years in issue was followed by the appellant in the material that was filed with his returns for the same years. For the years 1982, 1983 and 1984 the appellant arrived at a net income of $2,722, $6,189 and $6,539 respectively. The evidence is not altogether clear as to the amounts contributed by the limited partners that were made available to the appellant for his personal or living expenses, more particularly in the years 1983 and 1984. At one point, the appellant stated that he received from the partnership approximately $10,000 and $15,000 in 1983 and 1984 respectively that he could use for personal purposes.

The appellant explained in this way why he computed his income from the partnership in the fashion he did and in particular why he thought fit to show the total remuneration to which he was entitled even if the major part thereof was not received by him in the year in question.

The partnership had no income, there is no question about that, but I personally had no income. I disagree with it because it would jeopardize some money I am hoping to see in future in case the partner [the reference must be to a“ "patent"] will not be granted or something like this and we will not be able to make business profit. I am expecting compensation from my partners for time and effort.

[The words in brackets added.]

The second reason was I am still depending on the limited partners. I like to be on good standing with them. If Revenue Canada has asked them for some additional money which I would rather see pay to me than to Revenue Canada. So these were two reasons why I didn't want the employees of Revenue Canada to say on audit that it appeared that I had no personal income from the partnership. [Transcript of October 12, 1990, page 35, line 24 to page 36, line 14].

He added this with reference to the advantage of not being required to pay income tax: "But it is a small advantage compared to the fact it jeopardizes payment, it makes the obligation of the partnership to pay me some money later on less real, which is the situation.” [Transcript of October 12, 1990, page 37, lines 2 to 5.]

Submissions of the Parties

The appellant set out in paragraphs 11, 12 and 13 of the notice of appeal his views about the questions in issue and his submission in relation thereto:

11. The primary question is: What is the nature of the said benefit (at 6 and 7 above) within the Act and during the initial no-profit period of the firm’s activities.

12. Two secondary questions are: If the benefit, or its part, was income of the Appellant, was he permitted by the Act to deduct as a reserve the amounts that, at material time, had their source in

(i) not existing capital;

(ii) the capital agreed to be contributed at a fixed future time to the firm's capital.

Not income

13. Whether the benefit so conferred upon the appellant is viewed as a lump-sum payment or as payments of salary, the Appellant submits that it was not his income but a receipt of capital. According to Lindley:

Where, however, a salary is expressed to be payable to a partner irrespective of whether any profits are made by the partnership, and the partners, in a year in which the partnership makes no profit, pay such out of their own pockets, it is thought that the salary cannot be treated as profit, and must be a capital receipt of the salaried partner. (Law of Partnership, 1979, 14th ed., page 870, note 49.)

The above-mentioned paragraph 11 is completed by paragraphs 6 and 7 of the notice of appeal which read thus:

6. The Appellant is the firm’s only general partner. Under the Agreement he is entitled to 51% of profits and liable for at least 51% of losses of the firm.

The Appellant is also entitled to receive preferentially $300,000 from the firm’s profits or, should they be insufficient, from its capital. The appellant is not obligated to and did not contribute any money to the firm’s capital.

7. Therefore, as long as the firm is a going concern, the potential benefit conferred by the said entitlement is 49% of the sum, that is, $147,000. The amount arises from an arm's length relationship between the limited partners and the Appellant. There are ten limited partners forming the firm at present.

The position of the respondent is couched in paragraphs 10, 11 and 12 of the substituted reply to notice of appeal.

10. He submits that the amounts allocated by the partnership to be paid or payable as "salary" to the Appellant in its 1982, 1983, 1984 and 1985 fiscal periods were correctly included in the Appellant's income for those taxation years as income from business pursuant to section 9 and paragraph 12(1)(b) of the Act as those amounts were received or receivable by the Appellant in those years.

11. He submits that the receipt of the said amounts by the Appellant was not doubtful with the result that the Appellant is not entitled to a reserve for doubtful debts pursuant to paragraph 20(1)(l) of the Act nor were the said amounts bad debts within the meaning of paragraph 20(1)(p) of the Act.

12. He further submits that, should this Court find that the Appellant was entitled to a reserve for doubtful accounts in any of the 1982, 1983, 1984 or 1985 taxation years, the amount of the reserve, for each year is to be included in income for the subsequent year pursuant to paragraph 12(1)(d) of the Income Tax Act.

Analysis

It was common ground at the hearing of these appeals that the amounts paid to the appellant by the partnership during the years in issue do not constitute salary or income from employment since the appellant being a partner in the limited partnership of Janicek Associates cannot be an employee of the said partnership.

I am also of the view on the evidence that the appellant was not carrying on business independently of or apart from the limited partnership in relation to the conduct of his scientific activities. There was only one business carried on here and that business was conducted by the limited partnership, Janicek Associates. Since the partnership incurred a loss in each of the years in issue, the appellant could not have had income from business from this source. Quite the contrary, the appellant sustained as a partner 51 per cent of the total loss of the partnership in accordance with sections 9 and 96 of the Income Tax Act. The appellants loss is obviously a business loss.

I shall now advert to the respondent's submission formulated in paragraph 10 of the substituted reply to the notice of appeal to the effect that “the amounts allocated by the partnership to be paid or payable as salary to the appellant” in the years in issue were correctly included in the appellant's income as income from a business for these years.

It will be recalled that the amounts shown as allocated to the appellant as salary were in the amounts of $16,000, $48,000, $48,000 and $54,000 for the years 1982, 1983, 1984 and 1985 respectively and that by his reassessments, the respondent added the amounts of $5,104 for 1982, $16,661 for 1983, $14,356 for 1984 and $16,457 for 1985 to the amounts of income declared by the appellant which were $6,907 for 1982, $7,449 for 1983, $7,345 for 1984 and $6,945 for 1985. It follows from these data that the amounts included by the respondent in the appellant's income by the reassessments in issue represent therefore, except for 1982, about half of the amounts shown as allocated by the partnership to the appellant as salary.

Be that as it may, I have already indicated that having regard to the evidence only one business had been carried on here and that business was carried on by the partnership. Since it is admitted that a loss from business had been sustained by the partnership in each of the years in issue, it is therefore obvious that the appellant in relation to the activities of the partnership could not have been in receipt of income from a business in the years in question. These comments are sufficient to dispose of the respondent's submission found in paragraph 10 of the substituted reply to the notice of appeal.

Since I have rejected the respondent's main submission that these amounts allocated or shown to be allocated to the appellant by the partnership were income from a business and since it has not been argued on behalf of the respondent that these amounts could constitute income from a source other than business I do not have to characterize from an income tax viewpoint the nature of the amounts contributed by the limited partners that were in fact allocated to the appellant for his living or personal expenses. However, if I were compelled to determine the nature of the amounts received by the appellant from the capital of the partnership, I would be inclined to the view that these amounts are income from a non-specified source within the purview of paragraph 3(a) of the Income Tax Act. In effect, the better view of the evidence is that these amounts would not have been made available to the appellant if he had not carried out for some reason in the years in issue the required scientific activities on behalf of the partnership. In a real sense, these amounts paid the appellant constituted compensation of some sort for his work.

Viewed in this way, I am therefore not disposed to accept, although my views on the matter have no bearing on the outcome of these appeals, the appellant's suggestion in the context of the Income Tax Act, that these amounts made available by the partnership for his personal or living expenses are, as far as the appellant is concerned, a capital receipt, as they are for the partnership, representing the proceeds of loans made to the appellant by the partnership. It is true that article 6.10 of the partnership agreement, reproduced earlier in these Reasons, allows the general partner to borrow without interest up to $12,000 per annum from the capital of the partnership for his personal expenses. However, as noted earlier, no documentation evidencing the appellant's indebtedness to the partnership has been filed with the Court nor has any other evidence been adduced tending to establish the likelihood of the existence of a debtor-creditor relationship between the appellant and the partnership in relation to the moneys paid by the partnership to the appellant. Moreover, these amounts have been described as salary by the appellant in the material accompanying the income tax returns. Also, the appellant himself at certain points in his evidence seems to consider these amounts as some sort of compensation. There is the further point that the appellant as a general partner, has appointed himself as the “ R&D Performer" under article 10.1 of the partnership which provides under the heading "Compensation" for the payment of a sum of $300,000 out of the capital of the partnership if revenues are insufficient. On the whole of the evidence I leaned against considering these amounts as proceeds of loans or as a capital receipt with respect to the general characterization of the amounts made available to the appellant for his personal or living expenses.

In view of the preceding observations it is also apparent, in my view, that these amounts made available to the appellant for his living or personal expenses cannot be income from property. While these amounts can be traced back in a general way to certain rights, which are property, granted by the partnership agreement but in my view the more immediate source of these amounts is the labour performed by the appellant on the partnership's account.

I have already indicated that these amounts were not capital receipts nor were they income from employment from business or from property. As I said earlier, I am of the view that these amounts are income from a source.

As to the portion of the total amounts that are stated as allocated to the appellant as salary on the adjustments to income schedules (filed with his income tax returns), but which amounts were not in fact distributed or made available in any way to the appellant, I simply consider these statements in these schedules in light of the explanations given the appellant as being devoid of any legal significance and consequences. The appellant thought that these statements might protect his own position in the future in his dealings with the limited partners. Moreover, it may be inferred from the evidence that these statements could be considered by the appellant or the limited partners to be of some benefit to the latter partners from the standpoint of deductions that they may claim in computing their income. These statements misrepresent the reality of the situation because these moneys were not "allocated" to the appellant. The accrual method of accounting for computing income referred to in paragraph 12(1)(b) of the Act could not be used as such method applies generally speaking to income from business or property in respect of property sold and services rendered. The cash method of accounting would then be applicable.

I shall make brief comments on paragraphs 11 and 12 of the substituted reply to the notice of appeal. First I do not understand why the respondent in paragraph 11 of the reply speaks of “the receipt of the said amounts" when referring to the amounts “allocated” by the partnership as salary since the evidence is clear that only a small portion of these amounts were received by the appellant. It is to be noted that this substituted reply to the notice of appeal was prepared after the conclusion of the hearing of these appeals with therefore the benefit of any evidence that may have adduced at the trial and of the elaborate discussions that took place in the course of the hearing. In view of the conclusions at which I have arrived earlier, I do not have to consider the matter of the appellants entitlement to a reserve under the circumstances. Furthermore, should these amounts shown as allocated by the partnership to the appellant that were not allocated de facto to the appellant in the years in issue be viewed as income, I would be of the opinion that the cash method of reporting income would be applicable with respect thereto with the result that these amounts would be required to be included in the appellants income when received by the latter.

In the result, I conclude that there was no valid basis for the addition by the reassessments in issue to the appellants income of the amounts indicated earlier.

Before concluding, I should also mention that in computing the appellants income for the years in issue, the respondent should deduct (the entitlement to such a deduction has been recognized in a sort of way by the respondent in the alternative relief sought in subparagraph 13(2) of the substituted reply to the notice of appeal) the appellants share of the partnership's losses, which share is shown below opposite the year hereinafter set out:

For these reasons, the appeals are allowed and the assessments are referred back to the respondent for reconsideration and reassessment on the following basis:

(a) the amounts indicated below opposite the years hereinafter mentioned should not be included in the appellant's income:

(b) the amounts hereinafter listed should be deducted from the appellant's income in respect of the years indicated below as representing his share of the partnership's losses: