Richard K.G. Stursberg v. Her Majesty the Queen, [1991] 2 CTC 261, 91 DTC 5607

Reed, J.:—The issue in this case involves the proper interpretation of subparagraph 53(2)(c)(v) of the Income Tax Act, R.S.C. 1952, c. 148 (am. S.C. 1970-71-72, c. 63) (the "Act") and whether it is applicable to the facts of this case. That provision reads:

53.(2) In computing the adjusted cost base to a taxpayer of property at any time, there shall be deducted such of the following amounts in respect of the property as are applicable:

(c) where the property is an interest in a partnership,

(v) any amount received by the taxpayer after 1971 and before that time as, on account or in lieu of payment of, or in satisfaction of, a distribution of his share (other than a share under an agreement referred to in subsection 96(1.1)) of the partnership profits or partnership capital.

[Emphasis added.]

Facts

There is no dispute concerning the facts. The plaintiff is a partner in a general partnership called the "Kanvan Group" ("the partnership"). The partnership was formed in 1981 to purchase certain land, to develop a multiple unit residential building ("MURB") on that land, and to earn rental income from the land and building.

The partnership agreement contained a clause which allowed a partner to reduce his partnership interest if a third party was willing to acquire the amount by which the withdrawing partner wished to reduce his interest:

28A. In the event that any Partner ("Withdrawing Partner") wishes to withdraw from the Partnership or reduce his Partnership Interest and concurrently therewith a person ("New Partner") wishes to become a member of the Partnership to the extent of the Reduction Amount (as defined below) the Withdrawing Partner may give to the Partnership 30 days' notice in writing ("Notice") (which may be waived by all the Partners) stipulating the amount by which the Withdrawing Partner wishes to reduce his Partnership Interest which amount may be the whole of his Partnership Interest ("Reduction Amount”) and stipulating the identity of the proposed New Partner. Provided that the New Partner has tendered his certified cheque or bank draft to the Partnership in full payment of his Capital Contribution in respect of his Partnership Interest equal to the Reduction Amount and the New Partner has become a party to this agreement, then thirty days after the Notice has been deemed to be received by the Partnership under the terms of this agreement (“Effective Date") the Partnership will pay in cash to the Withdrawing Partner the aggregate of the following 3 amounts:

(a) his Capital Contributions and Supplementary Capital Contributions;

(b) his share of net profits or net losses of the Partnership up to the Effective Date; and

(c) his share of the value of the assets of the Partnership as of the Effective Date;

such amounts in the ratio that the Reduction Amount bears to the whole of his Partnership Interest. The Partnership will calculate the share of profits and losses of the Withdrawing Partner up to and including the Effective Date. In the event that the Withdrawing Partner and the Partnership are unable to agree to the Reduction Amount, that matter will be referred to a single arbitrator under the Arbitration Act of British Columbia whose decision shall be final and binding. If the Reduction Amount of a Partner is equal to his Partnership Interest and forthwith after the Partnership has paid to the Withdrawing Partner the full amount in satisfaction of the Reduction Amount, he will withdraw from and cease to be a member of the Partnership for all purposes. When the Partnership has paid all amounts owing to a Withdrawing Partner in satisfaction of the Reduction Amount, the other Partners will indemnify him in respect of any liability he may have in excess of his Partnership Interest after deducting the Reduction Amount and the Withdrawing Partner and the Partnership will do such things and enter into such documents as may be necessary or desirable to reduce the Withdrawing Partner's liability accordingly and for greater certainty the Withdrawing Partner's liability under any mortgage granted by the Partnership will be reduced by the Reduction Amount.

This clause was included in the partnership agreement at its inception, to allow the partners flexibility regarding the liquidity of their interest. It was not inserted specifically for the purpose of governing the transaction which is now in issue. Another clause, number 35, set out the applicable provisions which would govern when a partner completely withdrew membership in the partnership.

On February 7, 1983, the partners waived the 30-day notice requirement provided for in paragraph 28A of the agreement and consented to a reduction of the plaintiff's partnership interest from 40 per cent to 15 per cent. At the same time an increase of the partnership interest held by WBG Development Ltd. from 10 per cent to 35 per cent was approved. (The plaintiff was president of WBG Development Ltd. and held all the voting rights in the company, although he had no beneficial interest in the company.) Cheques in the amount of $162,500 were simultaneously deposited by WBG Development Ltd. to the credit of the partnership and issued by the partnership to the plaintiff. An amount of $269,812 representing 25/40th of the plaintiff's 40 per cent share of the partnership's losses was transferred in the books of the partnership from the plaintiff to WBG Development Ltd. This transaction affected only the adjusted cost base of the partnership interests of the plaintiff and WBG Development Ltd. and their percentage participation and voting rights in the partnership. The negative adjusted cost base of the plaintiff's partnership interest was $104,551.72 as of February 7, 1983. There was no change in the overall capital of the partnership or in the capital contribution accounts of the other partners, nor was there any change in the adjusted cost base of their partnership interests. No benefit arose to the other partners or to the partnership from the amount of $162,500 paid by WBG Development Ltd.

Respective Position-Tax Court Decision

The defendant, acting through the Minister of National Revenue ("the Minister") assessed the plaintiff's 1983 tax return by including in his income a taxable capital gain of $133,525.86. The basis for this assessment was the Minister's characterization of the plaintiff's receipt of the $162,500 as the receipt of proceeds from the disposition of a portion of his partnership interest which disposition gave rise to a taxable capital gain. The taxpayer asserts that two transactions were involved and that the second, the receipt by him of the $162,500, was receipt of a distribution of part of his share of the partnership capital. It is argued that as such it falls into subparagraph 53(2)(c)(v) of the Income Tax Act and is not to be treated as a capital gain, but as giving rise to a recalculation of the adjusted cost base of his partnership interest.

The plaintiff appealed the Minister's assessment to the Tax Court. The Tax Court found the transaction to be in substance a sale by the plaintiff of part of his partnership interest. The Court held that the plaintiff had disposed of a 25 per cent interest in the partnership, resulting in a capital gain. Mogan, T.C.J. stated at pages 2344-45 (D.T.C. 2344-45):

Applying the law concerning form and substance, I find that the appellant sold a 25 per cent interest in the Partnership to WBG on or about February 7, 1983. Although the form of the transaction was a surrender of a 25 per cent Partnership interest by the appellant to the Partnership and the acquisition of a 25 per cent Partnership interest by WBG from the Partnership, the substance of the transaction was a Sale from the appellant to WBG outside the Partnership. I accept the argument of the respondent's counsel that the Partnership was used simply as a conduit in that transaction.

Arguments

Before me, the argument shifted somewhat. While arguments were made that the substance of the transaction and not its form should be considered (i.e., that there was really one transaction and not two) it was also argued that subparagraph 53(2)(c)(v) was not, in any event, applicable to the payment of the funds by the partnership to the plaintiff because a distribution of partnership capital had not occurred. Counsel for the Minister argues that a distinction must be made between a distribution of partnership profits or capital and a disposition by a partner of part of his or her partnership interest which may concomitantly lead to a reduction of that partner's share in the partnership capital.

In this case, counsel argues that the transaction involved the disposition by the taxpayer of part of his partnership interest and not a distribution of partnership capital because: there was no change in the overall capital account of the partnership; there was no contribution of capital made to the partnership; what occurred was simply a substitution of capital by one individual for that previously contributed by another. Counsel argues that inherent in the concept “distribution” is a division among a number, on a proportionate basis [1] , and not merely a transaction which effects one member of the group. She argues that a "disposition" does not necessarily mean that a sale has to occur; a taxpayer can dispose of a capital asset otherwise than by sale. There is apparently no jurisprudence directly on point. However, I find counsel's argument compelling. A distinction must be drawn between a disposition of a partnership interest and a distribution of partnership capital or income covered by subparagraph 53(2)(c)(v). And, as counsel for the defendant argues, this distinction should be assessed in the context of the Act as a whole and by reference to the principles on which it is based. One of those principles is that gains should normally be taxed in the year in which they are made. Subparagraph 53(2)(c)(v) is an exemption relating to negative adjusted cost base calculations that operates within the parameters of the other provisions of the Act and general principles on which it is based. It is argued that the exemption allowed by that subparagraph is to facilitate the continual fluctuations that occur in day-to-day partnership dealings, to allow for the admission of a new partner without treating the existing partners as having disposed of part of their partnership interests.

The plaintiff takes some comfort from Revenue Canada's Interpretation Bulletin IT-338R of May 28, 1979, which discusses the applicable treatment to ACBs as a result of a new partner joining a partnership:

In circumstances where the applicable provincial law and the partnership agreement provide for a continuation of an existing partnership on the admission of a new partner, the effect on the existing partners' ACB will depend on whether the new partner made a direct contribution to the partnership or whether he purchased his partnership interest from one or more of the existing partners. Where the transaction is outside the partnership (the new partner buys his interest from one or more existing partners) it will result in a disposition or part disposition of one or more of the existing partners’ partnership interests. In the event of a part disposition, the ACB of an existing partner's partnership interest is reduced by the amount determined pursuant to section 43 to be the ACB to the partner of the part so disposed of. If the incoming partner makes a contribution of capital to the partnership, there is no disposition of the existing partners' partnership interests nor is there any adjustment to the ACB of these interests. This will be so even if part of the contribution made by the incoming partner is credited to the existing partners’ capital accounts for accounting purposes. For tax purposes, the cost of the new partner's partnership interest will be equal to the fair market value of the assets contributed or the amount elected pursuant to the provisions of subsection '97(2).

[Emphasis added.]

Counsel for the defendant referred to an analysis, and particularly comments on Revenue Canada's Interpretation Bulletin, set out by L.A. Eddy, in “Partnership Interest Disposition", Report of Proceedings of the Thirty-Third Tax Conference, Canadian Tax Foundation, 1981 at pages 530-32:

Sale of an Interest

Direct Sale

In the simplest of situations, when a partner disposes of his partnership interest by way of sale he treats the transaction for income tax purposes as he would the disposition of any other item of capital property (assuming that the partnership interest is capital property to the partner) and he computes his capital gain or loss on disposition by reference to the proceeds of disposition and the adjusted cost base of his partnership interest.

Indirect Sale

An alternative method of sale is sometimes taken by a member of a partnership when disposing of only a part of a partnership interest in order to defer the recognition of any gain in respect of that interest. This alternative method involves the contribution of capital by the new incoming partner into the partnership and a withdrawal of capital by the partner who is effectively decreasing his participation.

It is quite common, of course, for a partner to effectively dispose of part of his partnership interest by “watering” the value of his interest (and also that of other partners) in a situation where a new partner is to be admitted to the partnership and they wish to increase the value of the assets within the partnership at the same time. In such an instance, the new partner may be admitted by being required to make a contribution to the capital accounts of the partnership with the funds so contributed remaining in the partnership. I believe it is fair to state that in such an instance it should not be found that the existing partners can be said to have disposed of a part of their partnership interest even though, as a result of the admission of the new partner, their profit-sharing ratios will change. They simply now have a smaller portion of a larger pie.

I believe it would be fair to find this result even in an instance where the capital contributed by the new partner is credited either wholly or in part to the capital accounts of the existing partners, since a book entry crediting a partner's capital account does not necessarily represent proceeds of disposition to the partner. This position is accepted by Revenue Canada as evidenced in paragraph 3 of Interpretation Bulletin IT-338R.

I do, however, become concerned where the funds contributed by the new partner are not left within the partnership but, rather, are immediately withdrawn by one or more of the existing partners. I believe that where a transaction involving the exchange of funds is clearly the sale of a part of a partnership interest by one or more existing partners to either a newly admitted partner or a partner who wishes to increase his participation and the arrangement is structured using the partnership as a conduit vehicle for the flow-through of funds (in an attempt to avoid a realization of a capital gain), it should be found that a partial disposition of a partnership interest has taken place and the capital gain should be taxed accordingly. The reason this type of transaction might appear to work is to be found in the fact that a partnership interest is the one item of capital property for which the adjusted cost base can go into negative balance without triggering the deemed realization of a capital gain. However, I believe, if challenged, the courts may well find that the passing of the funds through the partnership was merely a sham intended to convert what was really a direct sale of a part interest into some other type of transaction to defer the recognition of any capital for income tax purposes.

While it is unfortunate that Revenue Canada's comments in Interpretation Bulletin IT-338R appear to condone this type of transaction, a careful reading of IT-338R will disclose that their comments do not extend to a situation where the other partners) withdraw funds either immediately or within a short time period thereafter

and it may well be that they would take a dim view of this type of transaction.

[Emphasis added.]

Counsel for the defendant adopts this argument and asks that I do likewise. As I have already indicated, I find counsel for the defendant's argument compelling. I do not think a "distribution" of partnership capital as contemplated by subparagraph 53(2)(c)(v) occurred in this case.

The plaintiff initially raised a second issue: the characterization of certain municipal levies and whether they were a capital outlay or an expense of earning income. The appeal on this issue was not pursued before me. For the reasons given the plaintiff's action will be dismissed. The defendant shall receive her costs of the action.

Appeal dismissed.