Om. P. Chhabra v. Her Majesty the Queen, [1988] 1 CTC 84, 88 DTC 6015

Cullen, J.: —This is an appeal by way of statement of claim from notices of reassessment issued by the Minister of National Revenue (the Minister) for the tax years 1976,1977, 1978 and 1979. The reassessments are in respect of the plaintiff's interest on property located in Orinda, California.

The plaintiff is a Canadian citizen. He was involved in a “joint enterprise" with a nephew, Inder Chabra, a resident of California and a U.S. citizen. In 1974 the plaintiff and Inder Chabra purchased a shopping centre in Orinda, California, U.S.A. The property will be referred to henceforth as the "California property". (The defendant refers to it as the "partnership" property).

Inder Chabra prepared and submitted joint property returns for the 1976 and 1977 taxation years to the Internal Revenue Service (IRS). The plaintiff was allocated $10,140 U.S. as income for the 1976 tax year and $53,322 U.S. as income for the 1977 tax year. According to the plaintiff, these figures were unsubstantiated amounts. The plaintiff did not include these amounts in income when he submitted his Canadian tax returns.

In 1977, $200,000 U.S. was negotiated in respect of a lease cancellation. The plaintiff was entitled to one-half of the proceeds ($100,000) but only received $16,000 U.S. The plaintiff also indicated that he was having difficulties obtaining the funds owing as well as having difficulty securing books and records from Inder Chabra regarding the California property.

The California property was sold in 1978 on an instalment sale. According to the Minister the proceeds of disposition in respect of the property amounted to $691,273.

In calculating his income for the 1978 tax year, the plaintiff,

(1) reported net rental income of $405 from the California property;

(2) reported a taxable capital gain of $19,000 (after claiming a reserve of $191,878) from the sale of the California property;

(3) claimed a capital cost allowance of $18,278 U.S. (the $18,278 represented capital cost allowance at the "partnership" level).

In calculating his income for the 1979 tax year the plaintiff reported interest income of $2,860. According to the defendant, the plaintiff failed to report additional mortgage income of $45,669.29. The plaintiff also failed to report the amount of the 1978 reserve as income or to take a further reserve. The plaintiff deducted travel expenses to California in the amount of $4,995.

The plaintiff was greatly concerned about Inder Chabra's activities. He indicated that he feared that he had been cheated. Therefore the plaintiff contacted the IRS and requested an audit of the returns filed by Inder Chabra. The plaintiff also contacted the Department of National Revenue

(DNR) in a letter dated September 31, 1980 regarding his concerns. He provided DNR with information relating to the joint enterprise and the tax returns filed by Inder Chabra.

The plaintiff was reassessed on the basis of the information he provided to DNR and to the IRS.

Assessments

In assessing the plaintiff for the 1976 and 1977 tax years, the Minister included $9,979 and $55,937 respectively as net rental income from the California property.

In assessing the plaintiff for the 1978 tax year, the minister:

(1) disallowed the capital cost allowance of $18,278 resulting in an increased rental income of $10,181.25;

(2) included $47,275.59 as income,

(3) reduced the taxable capital gain to $14,201.23,

(4) allowed a reserve of $143,432.36 in determining the taxable capital gain.

In assessing the plaintiff for the 1979 tax year, the minister:

(1) included $45,669.29 as mortgage interest income,

(2) included a taxable capital gain of $595.58 (1978 reserve of $143,432.26 less 1979 reserve of $142,241.20 resulting in a capital gain of $1,191.16),

(3) disallowed travelling expenses of $4,995.

Notices of reassessment were dated October 23, 1981 and included a penalty under subsection 163(2) of the Income Tax Act.

The plaintiff filed notices of objection dated November 18, 1981. The notice in respect of the 1978 tax year was confirmed but the 1976,1977 and 1979 assessments were reassessed to delete the penalty.

Plaintiffs Position

The plaintiff feels that he has been cheated by Inder Chabra (which information he submitted to the proper authorities) and that in trying to uncover the fraud and to obtain information to support his fears, has been unfairly reassessed based on untrue, unsubstantiated figures. The plaintiff believes the figures to be false and does not understand how the Minister could reassess him on figures he contends are not accurate.

The plaintiff maintains that in 1977 he only received $16,000 U.S. from the $100,000 due from the proceeds of a lease cancellation. When the plaintiff did not receive the amount owing he went to California to "pursue the matter". According to the plaintiff the travelling expenses were incurred in respect of the business of his property and to protect his investment.

Upon a review of the returns filed by Inder Chabra, the plaintiff discovered a deficiency of $9,267 in the capital account contributed by the plaintiff to the property. The plaintiff claimed this amount as a casualty loss against income allocated to him on the 1976 joint tax return (U.S. return).

The plaintiff also indicated that in 1979 he lost $45,054 deposited in a bank account with the Mercantile Bank and Trust Company Limited, Freeport, Bahamas. He claimed this loss against income allocated to him for the 1977 tax year (on his joint U.S. return).

According to the plaintiff, personal tax was calculated and paid to the IRS on the remainder of the income allocated to him on the joint returns.

The plaintiff contacted the IRS and DNR regarding the activities and operation of Inder Chabra, and requested an audit on the returns filed by Inder Chabra. The plaintiff submitted additional information to the IRS (letters dated April 4, 1981 and May 8, 1981). The plaintiff states that the IRS advised him to resubmit his 1977 return and claim the $84,000 (balance of his share of the proceeds owing on the lease cancellation) as a revised casualty loss. The plaintiff also carried forward the losses and applied them against his U.S. income received after the 1977 tax year.

The plaintiff maintains that the losses were claimed against U.S. source income per U.S. rules, not against his Canadian source income and therefore he should not be subject to Canadian income tax rules.

Regarding the 1976 tax year, the plaintiff is arguing that there was no actual cash in 1976 and therefore he did not report any rental income. Further, any income to be reported would have been offset by the casualty losses he claimed. The plaintiff only received $16,000 U.S. as proceeds from the lease cancellation and this was included as a “gain” in the 1978 tax year.

With respect to the plaintiff's 1978 reassessment, the plaintiff filed his original returns and provided the DNR with copies of his U.S. calculations, which included the loss/gain on the sale. The calculation referred to the recaptured depreciation as "gain" not "income" as per U.S. tax rules. This was acceptable to DNR at that time. The plaintiff feels that the Minister should not be allowed to arbitrarily reverse the U.S. position. (Of course Revenue Canada has that right in law.)

The plaintiff also argues that Canadian income tax rules do not apply to U.S. investments.

With respect to the 1979 reassessment, the plaintiff maintains that the Minister disregarded the "outgoing" expenses incurred by the plaintiff in the discharge of his obligations relating to the sale of the California property; further, that the travelling expenses claimed related to the pursuit of the business of his property and was necessary for the protection of his investment from fraud.

Defendant's Position

The defendant maintains that the plaintiff is subject to the provisions of the Income Tax Act and that the provisions of the Canada-U.S. 1942 Tax Convention do not affect the assessments made in respect of the plaintiff. The defendant relies upon the following information:

(1) the plaintiff was involved in a partnership and the plaintiff and a partner purchased a shopping centre in California in 1974; the shopping centre, referred to as the partnership property by the Minister, was sold in 1975;

(2) the rental income, the additional taxable capital gain, the mortgage interest, the capital cost allowance included in the calculation of the plaintiff's income was derived from information provided by the plaintiff including information provided by the plaintiff to the IRS (more on this later);

(3) the capital gain from the disposition of the California property was allocated in the following manner:

(4) the recapture of capital cost at the "partnership level” was calculated in the following manner:

The defendant maintains that the plaintiff's share of income from the California property in 1976,1977,1978 is to be included in the calculation of the plaintiff's income.

The defendant indicates that capital cost allowance cannot be claimed in the year of disposition (1978) and therefore the capital cost allowance claimed in 1978 was properly disallowed by the Minister.

The defendant also notes that the plaintiff did not establish any bad debts for the 1976, 1977, 1978 and 1979 tax years.

Further, the defendant contends that the travel costs claimed by the plaintiff were not incurred for the purpose of earning or producing income from a business but were of a capital nature and therefore not deductible.

Issues

A number of questions have been raised by the plaintiff in this appeal, namely:

1. the plaintiff's liability to pay Canadian income tax in respect of income derived by him from activities carried on in the United States;

2. the applicability of the Canada-U.S. 1942 Tax Convention;

3. the appropriateness of the reassessments made by the Minister based on information the plaintiff contends is unsubstantiated and perhaps false;

4. tax implications stemming from the disposition of property;

5. bad debts established for income tax purposes;

6. deductibility of travelling expenses.

Relevant Legislation

Sections 2, 3, 38, 39, 40, subsection 9(1), paragraphs 20(1)(a), 20(1)(p), 18(1)(a) and 18(1)(b) of the Income Tax Act, S.C. 1970-71-72, c. 63, as amended.

Plaintiff's Liability to Pay Canadian Income Tax

Subsection 2(1) of the Act provides that an income tax shall be paid upon the taxable income for each taxation year of every person resident in Canada. Therefore, the criteria for levying a tax is residency in Canada. Section 3 of the Act outlines a set of rules for calculating a taxpayer's income from various sources for a taxation year. Section 3 makes specific reference to income for the year from a source inside or outside Canada. Therefore, persons resident in Canada are subject to Canadian income tax, regardless of the country in which the income is earned. As the plaintiff is and was at all material times resident in Canada, he would fall under the provisions of sections 2 and 3 of the Act and would be subject to Canadian tax in respect of his U.S. income. The plaintiff argued that the U.S. partnership was already taxed under U.S. laws and that the U.S. partnership was "resident" in the U.S.

Assessments - Burden of Proof

The onus is on the taxpayer to prove that the Minister's assumptions and assessments are wrong: Johnston v. M.N.R., [1948] S.C.R. 486; [1948] C.T.C. 195. Therefore, the onus is on the plaintiff to refute the authenticity and accuracy of the information he provided to officials of DNR and upon which he was reassessed.

The plaintiff, in his statement of claim, makes reference to Revenue Canada “arbitrarily reversing its position and breaching a previously implied contract and understanding”. As stated earlier, under subsection 152(4) of the Act, the Minister is empowered to reassess at any time within four years as the circumstances require. As Collier, J. indicated in I can da Ltd. v. M.N.R., [1972] C.T.C. 163; 72 D.T.C. 6148, regardless of the possible inequities, the meaning of subsection 46(4) (now subsection 152(4)) is clear and therefore the Minister was entitled to reassess the taxpayer. In the Icanda case (supra) a Canadian company carried on business in both Canada and the U.S. In 1965 the company claimed and was granted a foreign tax credit in respect of the amount of U.S. tax paid. In 1967, the company suffered a loss, a part of which it carried back to offset its 1965 income (allowed under U.S. law). The company received a refund of the 1965 U.S. tax it paid. In 1970 the Minister reassessed the company for 1965 to disallow the foreign tax credit previously granted.

Bad Debts

The defendant argued that the plaintiff did not establish any bad debts for the 1976, 1977, 1978 and 1979 taxation years. Paragraph 20(1)(p) of the Act provides:

20. (1) Notwithstanding paragraphs 18(1)(a), (b) and (h), in computing a taxpayer’s income for a taxation year from a business or property there may be deducted such of the following amounts as are wholly applicable to that source or such part of the following amounts as may reasonably be regarded as applicable thereto:

(p) the aggregate of debts owing to the taxpayer

(i) that are established by him to have become bad debts in the year, and

(ii) that have (except in the case of debts arising from loans made in the ordinary course of business by a taxpayer part of whose ordinary course of business by a taxpayer part of whose ordinary business was the lending of money) been included in computing his income for the year or a previous year;

Paragraph 20(1)(p) allows a deduction for losses incurred through the uncollectability of accounts or loans receivable which arose in the ordinary conduct of a taxpayer's business and have been established by the taxpayer to have become bad debts in the year.

In Associated Investors of Canada Ltd. v. M.N.R., [1967] C.T.C. 138; 67 D.T.C. 5096, Jackett, P. held that paragraph 20(1)(p) neither literally nor implicitly prohibited a deduction for bad debts and that bad debts other than those specifically permitted by that paragraph were equally deductible if incurred on sound business and accounting principles, within the framework of the taxpayer's business.

I was and am unclear as to why the defendant is arguing this section of the Act. The section revolves around the question of whether a loan was made by the taxpayer who, in the Minister’s opinion was not in the money-lending business, or whether the debt became bad in the taxation year for which a deduction was claimed. However, the plaintiff made no claim for "bad debts" nor were there any “loans” in the widest sense of the word from the plaintiff to his "partner". If the plaintiff were to claim losses, they would be deducted as business losses.

Further, it should be noted that section 50 of the Act may apply to a situation where a taxpayer who has disposed of property has debts in respect of the proceeds. Section 50 of the Act deems the taxpayer to have disposed of his/her right to receive proceeds (where such proceeds become uncollectible) and allows the taxpayer to claim the resulting loss as a capital loss. Based on the facts at hand, I doubt the plaintiff could apply the provisions of section 50 of the Act.

Deductions

Paragraph 18(1)(a) provides that in computing the income of a taxpayer from a business or property no deduction shall be made in respect of an outlay or expense except to the extent that it was made or incurred by the taxpayer for the purpose of gaining or producing income from the business or property. Therefore, it would seem that reasonable travelling expenses, if incurred for business purposes or for the purpose of gain or producing income, could be deductible under this paragraph. The determination of "business purposes" is a question of fact to be viewed in light of all the circumstances of the case.

The onus is on the taxpayer to show that expenses were incurred for the purpose of earning income: Wellington Hotel Holdings Limited v. M.N.R., [1973] C.T.C. 473; 73 D.T.C. 5391. However, the defendant has raised paragraph 18(1)(b) of the Act which provides that no deduction shall be made in respect of an outlay, loss or replacement of capital, a payment on account of capital or an allowance in respect of depreciation, obsolescence or depletion except as expressly permitted by this part. The interrelationship between paragraphs 18(1)(a) and 18(1)(b) is described in British Columbia Electric Railway v. M.N.R., [1958] C.T.C. 21 at 31 ; 58 D.T.C. 1022 at 1028:

Once it is determined that a particular expenditure is one made for the purpose of gaining or producing income, in order to compute income tax liability it must be next determined whether such disbursement is an income expense or a capital outlay.

The distinction between a capital outlay and an income expense is not easy to define. A test, often quoted, to ascertain whether an item of expense is capital or not is: did it bring into being an asset of a permanent and enduring advantage or was it a once-and-for-all expenditure? If it brought into being an asset of a permanent and enduring advantage the expense would be attributable to capital, not revenue. (Viscount Cave's statement in Atherton v. British Insulated Cables Ltd., 10 T.C. 155).

However, in Algoma Central Railway v. M.N.R., [1967] C.T.C. 130; 67 D.T.C. 5091, Jackett, P. held that the Minister of National Revenue was wrong to skip to the final prospective step of the program and point to an advantage for the enduring benefit of the business. The Minister only looked at the expenditure itself and failed to find that the outlay produced an advantage. The Supreme Court of Canada approved Jackett, P's judgment and held that each question of this sort is to be decided on the basis of a "commonsense appreciation of its own particular facts”.

There is a distinction to be made between an expenditure which brings into existence an asset of enduring benefit to the trade, and an expenditure which preserves or protects an existing asset of the business. Expenses

incurred in the preservation of a capital asset were held to be deductible in B.W. Noble Ltd. v. Mitchell, 11 T.C. 372 at 421 :

The object [of the expenditure] . . . was that of preserving the status and reputation of the company which the directors felt might be imperilled . . . to avoid that and to preserve the status and dividend-earning power of the company seems to me a purpose which is well within the ordinary purposes of the trade.

The House of Lords took a similar view in Morgan v. Tate & Lyle Ltd., [1955] A.C. 21; 35 T.C. 406. Expenses of a campaign to oppose nationalization of the sugar industry were held to be deductible because the object of the expenditure was to preserve the assets of the company from seizure.

In my view the plaintiff is entitled to use this line of argument to support his claim for deduction of travel expenses, and they are therefore allowed.

Conclusions

This was not one of Revenue Canada's finest hours. The plaintiff's evidence that he had been the victim of embezzlement and theft is clear and uncontradicted and in fact had the support of the Internal Revenue Service of the United States of America. The conduct of the nephew-partner Inder Chabra was reprehensible, to say nothing of the complicity of his partnernephew's wife. Also, most questionable was the conduct of the CPA Herman Carmazzi. In my view, the acceptance by the IRS of the points made by the plaintiff provides solid backing to the plaintiff's evidence. There had been no attempt by the plaintiff to hide anything and all dealings with the IRS were made known to the Department of National Revenue when income tax returns were filed and certainly, as late as 1978, all had been accepted by the Department of National Revenue.

Initially, the plaintiff had filed his returns with the IRS on a provisional basis pointing out that he was clearly concerned about the authenticity of the financial statements and his inability to get any information from his nephew-partner or from the CPA. He never at any time saw any books, nor has he to this very day.

When the plaintiff was unable to secure copies of the books or get a proper accounting from the CPA he requested that the IRS do an audit on the company's books and advised that he was prepared to provide any information and/or data required or requested by the IRS. Eventually, all of the returns filed by the plaintiff with the IRS in the United States were accepted, which in my view substantiates the fact that the financial statements were suspect not only to the plaintiff but to the IRS as well. The plaintiff was unable, however, to determine whether the IRS had conducted an audit. If they had conducted an audit, certainly they were not giving any information to him which seems surprising bearing in mind that he had asked that the audit be done and he was prepared to give evidence and he was after all a partner in the enterprise. One would glean, however, that an audit was done because the new returns filed by the plaintiff with the IRS were accepted and refunds paid.

Therefore, faced with the inability of securing any information from his nephew-partner, and very little information, and suspect information at that, from the CPA, and receiving no confirmation that an audit had ever been done by the IRS, the plaintiff turned to the Department of National Revenue for assistance. He provided the Department with such material as he was able to secure, described the history of his business dealings with his nephew-partner Inder Chabra, and made the point that the statements were unreliable. He wanted the Department of National Revenue to use its power and authority under the Canada-U.S. 1942 Tax Convention, to secure information from the IRS as to whether or not an audit had been done and if done the results of that audit. He also wanted them to contact the CPA, Mr. Carmazzi, and to secure such other information as might be available to them.

The Department of National Revenue did not contact the Internal Revenue Service, nor did they make any attempt to contact the CPA, nor, for that matter, did they make any attempt to contact the nephew-partner and/or his wife. The only action taken by the Department of National Revenue was to contact the Bank of Contra Costa to secure mortgage information on the purchase and sale, particularly mortgage data.

The IRS accepted that the statements were incorrect as alleged by the plaintiff all along and could not be substantiated, and therefore accepted all of the figures provided by the plaintiff throughout the period of the purchase and eventual sale of the American business, and confirmed the tax returns submitted to the IRS by the plaintiff.

In my view the plaintiff taxpayer was treated shabbily by the Department of National Revenue. He came to them for assistance and they gave none. He pointed out to them that the financial statements were suspect (and even a cursory examination proved that) and yet, arbitrarily, without doing any checking of any kind save and except the letter to the bank, they proceeded to reassess this taxpayer on the basis of the material that he had brought to them when seeking help. I was appalled to hear the tax auditor say, in defence of his failure to contact the CPA, that because the statements were prepared by a CPA they had credibility and needed no further examination.

The plaintiff states, and I quote: "The said reassessments are erroneous, wrongful and arbitrary both in their nature and content." I agree. The taxpayer himself brought in such information as he was able to secure declaring it to be unsubstantiated, asking for help with the IRS in the United States. DNR used this information to reassess the plaintiff.

Are there flaws which make the financial statements suspect? I will use the evidence of the plaintiff which is uncontradicted and credible.

1. These reassessments, issued in the year 1981, are based entirely on the contentious and false information, information prepared by Inder Chabra in the United States and filed unilaterally there by him without my knowledge, consent and concurrence whatsoever.

2. The said information and the related accounts have never been substantiated and have been repeatedly disowned and disavowed by me.

3. Despite repeated questioning I have failed to obtain any books or other necessary data required for their verification and substantiation.

4. On filing my personal U.S returns in the United States for the years 1974 through 1977, in view of this lack of substantiation and in view of Inder's conduct, I had notified the Internal Revenue Service of my dis- affirmation of the said property accounts prepared and filed by Inder, requesting an audit and investigation of the books of the property.

5. I considered it necessary to inform Revenue Canada, and accordingly, in a letter dated September 21st, 1980, Exhibit 23, vol. 1, expressed my apprehensions about the many dealings of a fraudulent nature conducted by Inder Chabra.

6. Revenue Canada responded when someone called from the District Taxation Office in Halifax, Nova Scotia stating he wanted to come and see me in connection with my letter. I agreed to do so. In the course of my expressing my apprehensions I placed before Mr. Bruce all the contentious accounts and related schedules prepared and filed with the Internal Revenue Service by Inder Chabra, in order to assert their falsehood and my disaffirmance and disassociation with them.

7. I informed Mr. Bruce that I was afraid that funds had been embezzled and that I had taken up the matter with the IRS also and in view of their inadequate response I would like Mr. Bruce to have Revenue Canada intercede with the IRS on my behalf and have the books of the property opened.

8. Mr. Bruce then asked me for copies of some schedules which I agreed to let him have hoping that he will help me in seeking a redress as a taxpayer in Canada.

9. Mr. Bruce called me on the phone one day in April 1981 and stated that after discussion in his office he had decided to reassess me for all of the years in question, i.e. 1976 to 1979 inclusive.

10. He (Mr. Bruce) had relied totally on the unsubstantiated information supplied to him by me and contained in the accounts prepared by Inder Chabra though disavowed by me. He also had disregarded my request to follow up the matter with the Internal Revenue Service in the United States. He had used those accounts as the sole basis of his computations despite the disagreement expressed by me and the repeated assertions made by me of having been defrauded of my share of proceeds in the years 1976 and 1977 and despite the fact of my continuing request to the IRS for investigations.

11. In order, therefore, to discredit the information on which Revenue Canada had relied in the preparation of their computations and the aforementioned reassessments and in order to reassert the losses that had been sustained by me and to focus attention on the extent of the funds embezzled I prepared a long and laborious document and submitted it to the District Taxation Office in Halifax prior to the issuance of the said reassessments.

12. In order to pursue my claims I sent all relevant evidence to Philadelphia under cover of my letter of April 4, 1981. . . . Following this, evidence of additional discrepancies discovered in connection with a distortion of the capital account was also sent to IRS.

13. Philadelphia asked me to file fresh forms 1065 as per their handwritten letter of October 2, 1981. Revenue Canada, on the other hand, not only failed to acknowledge my letter of August 24, 1981, but in complete disregard of my claims proceeded to issue the said reassessments on October 23, 1981 without making any inquiries into my complaints as admitted by Mr. Bruce in the course of his discovery held on May 16, 1984. (see the Discovery transcript of Questions and Answers nos. 104 to 160).

And finally, Dr. Chhabra makes this point: "I wish to repeat here that neither prior to nor after the issuance of the reassessments has Revenue Canada ever ascertained the truth of my claims, made any inquiries with any person or any agency connected with those accounts or tried to coordinate the information submitted by me to them with the one filed with the Internal Revenue Service in the United States despite my requests made to them to do so or to invoke the provisions of the Canada-U.S. Tax Treaty, articles of which provide for an exchange of mutual information.”

It is really unnecessary to include in these reasons all of the discrepancies cited by Dr. Chhabra, the plaintiff, and they were numerous, but I do intend to point out a few to show the kind of clear indication that the financial statements should never have been relied on by the Department of National Revenue unless and until they had taken some action either through contacting the IRS to secure the books to substantiate the statements or to contact the CPA who after all prepared the statements and to determine what basis he had for preparing the statements that he did.

In my view the following examples will suffice to show the unreliability of the financial statements relied upon by the Department of National Revenue.

1. Maintenance/Repairs to the property: By reference to specific numbered cheques the plaintiff was able to show that for the year 1977 repairs in respect of the property totalled approximately $39,000, however, the Statement of Income and Expenditure (Exhibit 31, Vol. 1, item 15, form 4831) for the year 1977 revealed that only $5,579 was applied towards maintenance of the property. (The lame response was to the effect that using those figures would increase the plaintiff's taxable income. The plaintiff was not trying to lower the taxes he should pay but endeavouring to show the unreliability of the statements).

2. Insurance: The Statement of Income and Expenditure (Ex. 21, Vol. 1, item 15, form 4831) indicated that in 1977, $12,992 was applied towards insurance. Inder Chabra had informed the plaintiff that the insurance rates in respect of the property had increased from $3,000 to $12,000. However, according to the terms of the Insurance policy, (Exhibit 21, Vol. 1, appendix 1) the policy covered four properties, the property owned by the plaintiff and his partner, Inder Chabra, as well as three other properties owned by Inder Chabra and his wife. Therefore insurance premiums for the partnership property and the three additional properties were paid out of the common property fund/account. Apparently, this was also done for the year 1978. (Once again if the figures cited by the plaintiff are correct, his taxable income might increase but he risked that to show Revenue Canada what it refused to acknowledge — that the statements were suspect.)

3. Unaccounted-for withdrawals:

(a) Cheque #2015 in the amount of $5,000 was drawn by Inder Chabra (in his own name) from the property account for the purchase of equipment. However, this withdrawal did not appear anywhere on the balance sheet. (Thus, according to the plaintiff, a "non-property" item was taken from the property fund.)

(b) Exhibit 21, volume 1 appendix F, Ex. E1, was a cheque in the amount of $28,000 which was withdrawn by Inder Chabra's wife in her own name. This should not have been possible as Inder Chabra's wife's name did not appear on the property account opened in 1974.

(c) The worksheets revealed that the sum of $70,000 was transferred into a savings account but no further information regarding this transfer was included in the worksheets.

It is quite clear that Inder Chabra effectively removed the plaintiff's signing authority/control by opening a new account at the same bank with he and his wife as signing authorities. Money from the settlement with one tenant, $200,000, and money from the sale of the business all went through this new account and cheques to pay for "repairs(?)" and insurance were drawn on this new account.

There is no evidence that the CPA even saw any books, invoices or receipts nor was he asked by Revenue Canada if he had.

Did the IRS conduct an audit? Revenue Canada had a duty to find out and to get the results.

But, of great surprise to me at least, from the information they got from the banks, they charged all the interest revenue to the plaintiff and allowed no expense for dollars paid out. At trial counsel for the defendant stated that it would be allowed. One wonders if this action would have been taken if the plaintiff had meekly succumbed to the reassessments.

(A word here about Mr. Erlichman, counsel for the defendant. Counsel and the Court are always placed in a difficult position when a party does not retain counsel. We are all aware of the conclusion reached by Dumoulin, J. in Graham v. M.N.R., [1959] C.T.C. 514 at 515; 59 D.T.C. 1271 at 1272):

It should be noted, from the start, that we have here one of those few, and usually unfortunate instances, wherein a party appealing on his own behalf, in the dual capacity of counsel and witness, does meagre justice to each.

Mr. Erlichman, faced with an unrepresented applicant was most courteous and most helpful to the plaintiff. A rather large number of documents were catalogued and bound to assist the plaintiff (to say nothing of the Court), and throughout the time the plaintiff gave his "testimony" Mr. Erlichman graciously did not object even though the plaintiff actually gave both evidence and argument. It was a thoroughly commendable attitude, with Mr. Erlichman being most respectful throughout.

Although the plaintiff was compelling and credible, had he retained counsel, a full and thorough cross-examination of the defendant's witness would have been helpful.

Canada-U.S. 1942 Tax Convention

As stated earlier, persons resident in Canada are subject to Canadian income tax on their world income (sections 2(1) and 3 of the Income Tax Act). However, it is possible that a taxpayer who is a Canadian resident may be liable to pay taxes in two or more jurisdictions in respect of the same income or capital. Canada has negotiated a number of bilateral tax treaties to avoid this possible double taxation. "Tax conventions are negotiated primarily to remedy a subject's tax position by the avoidance of double taxation rather than make it more burdensome": Saunders v. M.N.R., 11 Tax A.B.C. 399 at 402; 54 D.T.C. 524 at 526 quoted with approval by Walsh, J. in C.P. Ltd. v. The Queen, [1976] C.T.C. 221 at 245; 76 D.T.C. 6120 at 6134.

The Canada-U.S. 1942 Tax Convention is the tax convention relevant to the case at hand. The Canada-U.S. 1942 Tax Convention was adopted, approved and incorporated into the domestic tax laws of Canada by the Canada United States of America Convention Act, 1943, 7 George VI, c. 21. Therefore, a taxpayer can invoke the provisions of the Canadian treaty in domestic courts. The plaintiff was perfectly correct to argue and use the provisions of the convention when he appeared before me.

Section 3 of the Canada-United States of America Convention Act, specifically provides that should there be any inconsistency between any part of the treaty and the operation of any other law of Canada, the treaty will prevail. Accordingly, provisions of a tax treaty can supersede domestic tax laws. As Walsh, J. noted in C.P. Limited v. The Queen, (supra) at 245 (D.T.C. 6134),

The parties are in agreement that the terms of a treaty will override an Act . . .

Interpretation of Tax Treaties/Conventions

As the Canada-U.S. 1942 Tax Convention is an international agreement, its provisions are to be interpreted according to the rules of international law and not according to the more strict rules of statutory interpretation relating to tax legislation. Addy, J. states in Gladden Estate v. The Queen, [1985] 1 C.T.C. 163 at 166; 85 D.T.C. 5188 at 5191:

Contrary to an ordinary taxing statute a tax treaty or convention must be given a liberal interpretation with a view to implementing the true intentions of the parties. A literal or legalistic interpretation must be avoided when the basic object of the treaty might be defeated or frustrated in so far as the particular item under consideration is concerned.

Relevant Provisions of the Canada-U.S. 1942 Tax Convention relating to the tax treatment of Canadians investing in U.S. real property

1. Article XI — reduces the U.S. withholding tax on rental income from 30% to 15%;

2. Article XIIIA — allows a Canadian resident or corporation to elect to be taxed on his U.S. real property income on a net basis as if he/she/it were engaged in trade or business within the U.S. through a permanent establishment;

3. Article VIII — exempts Canadians from any U.S. tax on capital gain derived from the disposition of U.S. real property provided they do not maintain a permanent establishment in the U.S.

The plaintiff made an election pursuant to Article XIIIA, section 1 of which reads:

Article XIIIA

1. A resident or corporation organized under the laws of Canada deriving from sources within the United States of America rentals from real property may elect for any taxable year to be subject to the tax imposed by the United States of America on a net basis as if such resident or corporation were engaged in trade or business within the United States of America through a permanent establishment therin during such taxable year.

In order to invoke this Article, the taxpayer is required to: (1) be a Canadian resident, or corporation organized under the laws of Canada; (2) derive from sources within the United States of America; and (3) rental income from real property. Once these requirements are fulfilled the taxpayer is effectively given the option of electing, in any taxation year on a year-to-year basis, to be subject to the tax imposed by the United States of America on a net basis, as if he were engaged in a trade or business within the United States through a permanent establishment during that taxation year. Therefore, the Article basically "deems" the Canadian resident for the year the election is made to be subject to U.S. taxes, on a net basis, in respect of rental income, and by implication, to calculate taxes according to U.S. income tax rules.

Such an interpretation of the Article is consistent with the view that tax conventions are to be interpreted liberally.

It should also be noted that the Internal Revenue Code (IRC) also permits a non-resident alien or a foreign corporation to make a net basis rental election which in effect allows deductions from gross income in computing income which is subject to tax (IRC 871(a), 822(d)). This election applies to all real property owned in the U.S. and is a permanent election, unless permission is granted by the IRS to revoke the election. With an election under the IRC, any gain or recapture on the disposition of property will also be subject to U.S. tax (Boidman, New Canada U.S. Treaty Effective Dates and Transnational Issue 1984 Can. Tax T. vol. 32, p. 705). Thus, the interpretation given to Article XIIIA would not conflict with the provisions of the IRC.

It is clear, therefore, that the plaintiff fulfilled one requirement of the Article (he is a Canadian resident who derived from sources within the U.S. rentals from real property) and was entitled to make an election under Article XIIIA. Indeed, the IRS accepted the election and agreed with the plaintiff's calculation of his U.S. tax payable. Further, any gain or recapture on the disposition of rental property should be subject to U.S. tax since the plaintiff, by making the election, is considered to be carrying on a trade or business in the U.S. Therefore, any gain on disposition is treated as income effectively connected with that trade or business.

The plaintiff calculated his capital gain, included his rental income and the amount of U.S. tax payable on his Canadian income tax return for the 1978 taxation year. He did not fail to include these items in his Canadian income tax returns, he merely calculated the relevant items pursuant to U.S. tax rules (the calculations were accepted by the IRS) in accordance with an election under Article XIIIA of the tax convention.

Moreover, by requiring that rental income and capital gain be calculated in accordance with Canadian tax rules, the MNR is in effect indicating that the provisions of the Income Tax Act should prevail over the Canada-U.S. 1942 Tax Convention. This conflicts with the established notion that the provisions of a tax treaty should prevail and that the treaty should be interpreted liberally.

At this point it is appropriate to refer to the quote from Saunders and C.P. Limited (supra) that:

Tax conventions are negotiated primarily to remedy a subject's tax position by the avoidance of double taxation . . .

Decision

The plaintiff has succeeded in showing that the statements relied upon by the Minister were at the very least questionable and most definitely unreliable. Moreover, the fact that the IRS did not dispute any of the figures in the amended tax returns filed by the plaintiff is indicative that the IRS accepted that the financial statements were not correct and could not be substantiated. This in itself is a good basis from which to refute the Minister's assessments.

Walsh J.'s comments in C.P. Limited v. The Queen, (supra) at page 246 (D.T.C. 6135) may be of some relevance even though the comments related to the interpretation of the Canada-U.S. Tax Convention. Walsh, J. noted that the Federal Court has the

right to interpret the Canada-U.S. Tax Convention and Protocol itself and is in no way bound by the interpretation given to it by the U.S. Treasury. The result would be unfortunate if it were interpreted differently in the two countries when this would lead to double taxation. Unless, therefore, it can be concluded that the interpretation given in the United States was manifestly erroneous it is not desirable to reach a different conclusion and I find no compelling reason for doing so.

The same type of reasoning can be applied to this case. The IRS accepted the plaintiff's figures and calculations relating to U.S. property along with an election under the Tax Convention. The Department of National Revenue, in using unsubstantiated figures and imposing calculations in respect of U.S. property pursuant to Canadian Income Tax rules, had in effect increased taxes payable on the same property in another jurisdiction. I do not think the IRS’ conclusions regarding the figures used by the plaintiff could be considered manifestly erroneous, given the facts outlined by the plaintiff in his submission.

Accordingly, the 1983 tax assessments of the plaintiff’s income for the taxation years 1976, 1977, 1978 and 1979, based as they are on erroneous, unsubstantiated financial statements, will be set aside. The plaintiff is entitled to make his election under the Canada-United States of America 1942 Tax Convention. The matter is referred back to Revenue Canada to enable them to accept the returns as filed by the plaintiff or to reassess him if substantiated financial statements based upon the books, invoices, expenses and receipts of the property in question are secured. The plaintiff is entitled to his costs of this action.

Appeal allowed.