The Estate of John S McEachran, Deceased v. Minister of National Revenue, [1985] 2 CTC 2474, 86 DTC 1001

Kempo, TCJ:—An appeal has been brought by the Estate of John S McEachran from a reassessment made by the Minister with respect to the taxation year of the appellant ended the 10th day of December 1979.

The late John S McEachran, QC (the “deceased”) was a founding member of and senior partner in the law firm of McEachran & Associates which carried on a general legal practice with emphasis on real estate at the City of Sarnia, Ontario (the “law firm”). The fiscal year-end of the law firm was September 30. The deceased died on the 10th of December 1979.

The issues in the appeal are essentially two-fold. The first concerns the deductibility of an amount taken by the law firm as a reserve and a further amount paid out by it as indemnification to a client with respect to a loan made by the law firm on behalf of the client to another client.

The second issue is with respect to the characterization of a payment received by the appellant's estate under a written buy-sell agreement made in 1979 between the deceased and the other partners of the law firm.

Loan Indemnification

Two unrelated loans are involved. The first one was for $45,000 of a client's money loaned to another client on the security of a mortgage (the “McCart” loan). The law firm considered this mortgage to be doubtful in 1979 and in anticipation of making good on any loss to its client, it claimed a $5,000 reserve or allowance in determining its income for its fiscal year ending September 30, 1979. The mortgage was subsequently recovered in full and the $5,000 reserve was taken into income of the law firm during its 1980 taxation year.

During the hearing it became obvious to all that the claim for the reserve is not supportable as the circumstances do not fall within the provisions of paragraph (I) of subsection 20(1) of the Income Tax Act which reads as follows:

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:

(I) a reasonable amount as a reserve for

(i) doubtful debts that have been included in computing the income of the taxpayer for that year or a previous year, and

(ii) doubtful debts arising from loans made in the ordinary course of business by a taxpayer part of whose ordinary business was the lending of money;

Subparagraph (i) thereof had not been complied with and, in any event, the ordinary business of the law firm was to earn a legal fee by reason of the legal work connected with the preparation of the real estate security in exchange for advancing the principal amount thereunder. As the lending of money was not part of the law firm’s ordinary business its claim for the reserve must fail: vide, The Queen v Pollock Sokoloff Holdings Corp. [1976] CTC 349; 76 DTC 6181 (FCA).

The second loan in this appeal is like the first one only in so far as it involved the loan of a client’s money to another client.

For some time prior to 1979 the law firm had adopted, in the course of its real estate practice, the practice of loaning client trust funds on behalf of the client to other clients in order to assist the latter in purchasing property. The amounts were for shortfalls in the range of $3,000 to $4,000 and were secured by second mortgage. In this way the firm gained legal fees for both the mortgage security and the purchase.

The real estate component of the firm's business amounted to approximately 60 per cent of its overall practice; the success of which was claimed to be attributable to this loaning practice being known and commonly done at the time in the City of Sarnia.

Because Sarnia’s population of 55,000 was perceived as being relatively small and cohesive, the partners of the firm felt that if any of these client loans had become bad it would have become rapidly known throughout the community which would have adversely affected the income of their practice. Accordingly the partners decided that the law firm would stand behind the loans. Written guarantees were not made. Rather, verbal assurances were given. The prime source of the money was from two named clients who, on the understanding of a promise of indemnification, gave a blanket authorization for the use of their money. They would not be made aware of any particular loan transaction but simply obtained yearly accounting statements. Any loan transaction of more than a couple of thousand dollars would firstly be reviewed and discussed by all of the partners, otherwise the deceased or the other senior partner, Jack George, would in consultation approve the loan.

The law firm would not charge, nor accept if volunteered, any kind of brokerage fee. It was described as that of a legal business which they were attempting to enlarge in the real estate field. It was the opinion of Mr Ship- ley, one of the partners, that this practice not only increased their income but also enabled them to hold, if not increase, their then large share of the real estate market in Sarnia.

The second loan transaction which is in issue in this appeal was different from those of the usual practice described above in that it was for a much larger amount, that is $20,000, and was without security other than a promissory note given by the borrower in favour of the lending client. The loan transaction occurred in May of 1977. It was to one Arthur Chester (the “Chester loan") who had recently purchased all of the shares of Longley & Chester Real Estate Limited which was described as the largest real estate brokerage firm in Sarnia at the time. The funds were needed partially by his corporate business and also for his own land speculation and development business.

Mr Shipley testified that in his opinion Mr Chester had subsequently expanded his businesses too rapidly and was too thinly financed because after approximately six months things were known to be going bad. However, following the making of the loan the firm had acted on a number of transactions for Mr Chester not only in the buying and selling of real estate but also with respect to his corporate matters.

Mr Shipley's evidence was supportive of the ensuing scenario which is extrapolated from paragraphs 11 to 17, inclusive of the notice of appeal:

11. During the summer of 1978, Mr Chester sold his interest in Longley and Chester Real Estate Limited to Thomas Peddigrew, Norman Carr and James Pum- ple, who changed the name of the corporation to “Peddigrew-Chester Inc”. As part of that agreement, the three new owners agreed to assume the $20,000.00 loans from the clients of the Law Firm, although such clients were not directly involved nd did not release Mr Chester from his obligations.

12. During the fall of 1978 the Law Firm attempted to arrange a new loan or obtain security from the new owners or their new corporation but were unsuccessful in such attempts.

13. In January of 1979 it became obvious to the Law Firm that the outstanding loan from the clients of the Law Firm in the amount of $20,000.00 would not be honoured as financial difficulties adversely affected Arthur Chester personally, Peddigrew-Chester Inc and Messrs Thomas Peddigrew, Norman Carr and James Pumple personally.

14. In accordance with its long standing practice of indemnifying its clients with respect to loans obtained for them by the Law Firm, the Law Firm borrowed $20,000.00 from the Bank of Nova Scotia, paid it to its clients, and obtained an assignment of the promissory note made by Arthur Chester. The Law Firm claimed a bad debt deduction of $20,758.82 which the Minister disallowed.

15. In April of 1979, Arthur Chester became bankrupt and, although the Law Firm filed a claim in the bankruptcy, the estate was negligible and there were no assets available to unsecured creditors such as the Law Firm.

16. In a subsequent taxation year, the Law Firm attempted to recover some of its loss by purchasing from Arthur Chester's Trustee in Bankruptcy the agreement which Arthur Chester had from Thomas Peddigrew, James Pumple and Norman Carr to assume the liabilities under the note from the clients of the Law Firm. Messrs Peddigrew and Pumple declared bankruptcy leaving only Mr Carr. Peddigrew-Chester Inc was insolvent.

17. Eventually the Law Firm in a subsequent year, obtained a settlement from Mr Carr in the amount of $6,500.00 which amount was reported as income of the Law Firm in such year.

I concur with the Minister’s initial position that the amount in respect of the Chester loan is not deductible as a bad debt under either paragraphs 20(1 )(l) or 20(1)(p) of the Act.

However I do agree with the appellant’s submission that it has been shown, on a balance of probabilities, that the amount in respect of the Chester loan is deductible pursuant to paragraph 18(1)(a) of the Act and that it is not otherwise prohibited by virtue of being on account of capital under paragraph 18(1)(b).

While the Chester loan has its unique characteristics with respect to its size and want of security when compared to the other loans made, this uniqueness is somewhat diminished when viewed globally and in context. It was part and parcel of the law firm’s then established practice of loaning clients’ money to clients of the firm in the context of and for the purpose of gaining or producing income from its considerable real estate practice. The other loans were made on a case by case basis. The Chester loan, on the other hand, was similar with respect to the real estate segment of the law practice but was made on a global basis with a reasonable expectation of future real estate referrals and legal fees gained.

I have no reason not accept Mr Shipley's testimony that not only had the firm given its verbal assurances to its lending clients that it would cover any losses, but further that this practice was known and commonly used in Sarnia at the time: and more importantly that the firm’s reputation in the community would have suffered adversely with a resultant loss of income if they had failed to live up to their known promises of indemnity.

Both parties to this appeal cited Frappier v The Queen, [1976] CTC 85; 76 DTC 6066 (FCTD) and The Queen v F H Jones Tobacco Sales Co Ltd, [1973] CTC 784; 73 DTC 5577 (FCTD) in support of their positions. The facts of these two cases are somewhat distinguishable from and not as strong as those in the case at bar in that they are concerned with a singular or isolated instance of a business decision sought to be characterized as on account of income or revenue instead of capital. Here the law firm was making frequent business decisions of a similar and ongoing nature closely related to the earning of an ongoing and increasing income stream or, at the very least, to its income-earning process.

Accordingly, and in these somewhat unusual circumstances, I am unable to find any reason in paragraph 18(1)(a) of the Act for the exclusion of the amount claimed in respect of the Chester loan but rather find that it was made as a matter of commercial expediency and for commercial reasons in accordance with ordinary business principles.

In my view the evidence would not support a finding that the Chester loan payment was made to preserve trust property in the firm and to avoid any possible disciplinary action by the governing body of the Law Society, real or perceived.,

The Buy-Sell Agreement

The deceased and other partners of the law firm were parties to a buy-sell agreement dated October 1, 1979 (the “Agreement”). The Agreement (Exhibit A-1) is short and concise and is reproduced hereunder. The issue is basically an interpretative one with respect to the meaning of clause 4 of the Agreement and more particularly as arising therefrom whether the receipt of the payment of six-month's income is to be characterized as or on account of income as asserted by the appellant or as on account of capital as assessed by the Minister.

THIS AGREEMENT made in sextuple this 1st day of October, 1979.

BETWEEN:

JOHN S MCEACHRAN, of the Township of Sarnia, in the County of Lambton,

hereinafter called “MCEACHRAN” OF THE FIRST PART,

and

JOHN D GEORGE, of the Township of Moore, in the County of Lambton,

hereinafter called "GEORGE” OF THE SECOND PART,

and

JOSEPH F FOREMAN, of the Township of Sarnia, in the County of Lambton,

hereinafter called "FOREMAN” OF THE THIRD PART,

and

ROBERT G MURRAY, of the Township of Plympton, in the County of Lambton,

hereinafter called "MURRAY” OF THE FOURTH PART,

and

WAYNE N SHIPLEY, of the City of Sarnia, in the County of Lambton,

hereinafter called "SHIPLEY” OF THE FIFTH PART,

and

WILLIAM E TENNYSON, of the Township of Moore, in the County of Lambton,

hereinafter called "TENNYSON” OF THE SIXTH PART.

WHEREAS the parties hereto carry on the practice of law in partnership.

AND WHEREAS the parties are desirous of entering into an agreement to govern the dispositions, if any, of each partner’s respective share in the partnership in the event of the death of each partner or the withdrawal from the partnership by each partner, it being the intention of the parties that the partnership continue upon the occurrence of the events.

NOW WITNESSETH that the parties hereto do mutually covenant and agree as follows:

1. In the event of the withdrawal of any one of the parties the remaining parties shall have the option to purchase the assets of the withdrawing party in the partnership business upon paying to the withdrawing party his share of the capital account plus interest accrued thereon to the date of withdrawal. No allowance shall be made for work in progress or goodwill in the partnership. Should the said option to continue the partnership be exercised by the remaining parties, the aforesaid purchase price shall be paid to the withdrawing party in equal monthly installments without interest for a total of 60 months after the date he withdraws. In the event that the withdrawing party dies during the said 60 month period, the aforesaid payments shall be paid to his respective estate or to anyone so directed by Will and he shall be deemed not to be included within the provisions of paragraph 3 of this agreement.

2. The withdrawing party shall also be entitled to his share of the partnership profits to the date of withdrawal in accordance with the partnership agreement. However, all monies due to any withdrawing parties shall not be payable earlier than three (3) months after the financial year end of the partnership; and payment of the share of the withdrawing party in the partnership accounts receivable shall be paid only as such accounts receivable are collected.

3. The withdrawing party shall be at liberty to retain such Wills as he brought into the firm or drew while in the firm upon the appropriate Release from the client. In the event such Wills remain with McEachran & Associates, no money shall be paid to the said partner for them. With respect to the other files in progress, those files shall be billed in the name of McEachran & Associates to the date of withdrawal and again upon the proper Release from the client and the files shall thereafter be released except as aforesaid.

4. In the event of the death of one of the parties, should the remaining parties wish to continue the partnership, it is agreed that his estate shall be entitled to all of his share of the capital account and his share in the accrued profits in accordance with the partnership agreement to the date of death. The aforesaid monies shall be paid to the deceased’s party estate in equal monthly installments without interest for a total of 60 months after the date he dies. The estate of the deceased’s party shall be entitled to payment of six (6) months income based on the calculation of six (6) months income received by the deceased party in respect of his income in that preceding fiscal year, such amount to be paid out over a period of six (6) months from the date of death of such party. All files shall continue to be the property of McEachran & Associates and no remuneration shall be paid in respect of the same except as aforesaid.

5. AND IT IS AGREED that this Agreement and everything herein contained shall enure to the benefit of and be binding upon the parties hereto, their respective heirs, executors, administrators and assigns.

AND IT IS FURTHER AGREED that wherever the singular and masculine are used throughout this Agreement, they shall be construed as if the plural or the feminine or the neuter had been used, where the context or the party or parties hereto so require, and the rest of the sentence shall be construed as if the grammatical and terminological changes thereby rendered necessary had been made.

IN WITNESS WHEREOF the parties hereto have hereunto set their hands and seals.

SIGNED, SEALED AND DELIVERED
in the presence of	“J M Howard for John S McEachran”
	John S McEachran
	“John B George”
	John B George
	“Joseph F Foreman”
	Joseph F Foreman
	“Robert G Murray”
	Robert G Murray

“Wayne N Shipley”

Wayne N Shipley

“William Tennyson”

William Tennyson”

Mr Robert Howard is a chartered accountant, had been the accounting adviser for the law firm and is a co-executor of the estate of the deceased. The Agreement reproduced above bears the signature of Mr Howard under a Power of Attorney of the deceased who was then in the hospital pending surgery.

Mr Howard testified that the deceased had participated in the partners' negotiations and meetings leading up to the making of the Agreement. Howard said he had attended some of the meetings between the deceased and his senior partner, Jack George, but that he could not recall attending any meetings of the partners as a whole. The Agreement had been drafted by the deceased.

The deceased was a founding member of the firm and Jack George was a senior partner, both of whom having been the primary contributors of capital to the firm. The September 30, 1979 year end financial statement revealed that the law firm’s capital account was then approximately $118,000 of which approximately $65,000 was that of the deceased, $46,000 was that of Jack George and the balance of roughly $7,000 was as to the remaining members. Both the deceased and Jack George had made it known to Mr Howard that they wanted to ensure the continuance of the law firm in the event of their death in order that their capital investment could be recouped.

Mr Howard's accounting firm had been asked to review previous partnership agreements that had been entered into and to render advice as to the format the buy-sell agreement might take. Goodwill had been discussed and was decided to be ignored in respect of incoming or outgoing partners. Howard was not able to enlighten the Court with respect to the Agreement which omits any specific reference to matters of goodwill or work-in- progress as to a deceased partner (clause 4) but which specifically makes reference to and denies any such allowance to be made as to a withdrawing partner (clause 1).

Mr Howard said that the deceased expressed concern for his spouse and that the estate should be as liquid as possible with a smooth running of estate affairs. Because he was also aware that his capital account was large and that immediate payment thereof could cause the law firm partnership to cease his primary intention, as expressed by Mr Howard, was two-fold: the first was to allow the ongoing partnership suffficient time to retire his capital account and the second was to arrange for cash-flow protection for his widow based on an income allocation method. With respect to the latter, Mr Howard testified:

A That they should, for a figure, come up with, if somebody died he would be entitled to an allocation of income equal to six months of the earnings of the prior year. He would be entitled to this regardless of whether he died at the beginning of the fiscal year of the law practice, the end of the fiscal year of the law practice, whether the law practice was having a good year, or whether the law practice was having a bad year. It was a rough and ready rule if you like but one that was easily understandable and allowed each party, each other partner to look at the financial statement at the end of the year and say, hey, this is what we would be faced with. I think that was, you know, but there was a scenario that was gone through between myself and John McEachran on the intent of the paragraph.

Q Did you discuss the agreement with the other members of the law firm, the partners who signed it?

A I would have, I think I would have discussed it with at least Jack George, whether or not it was discussed with — I don’t think I discussed it at a meeting of all partners, no.

Q I see.

A But I would have discussed it with Mr George.

[T 23, 11 23-29; T 24 11 3-18]

Mr Shipley, who is a member of the ongoing law partnership, testified that the deceased was always of the opinion that there was no goodwill in the law practice since client loyalties in the real estate field were very shortlived. He conceded that the six-month formula was arbitrary, but that it had the desirable element of certainty which would be an important element to a decision to continue the partnership after the death of one of the partners. He agreed that the formula would not have had anything to do with the profitability, or otherwise, of the current year's operations; it was negotiated and accepted as an arbitrary amount having the desired certainty as to quantum. Because the law partnership had previously elected not to include work-in-progress in the calculation of its income, it was expected that there would be some work-in-progress of a deceased partner which the ongoing firm would retain and share as profits. No payment was to have been made for goodwill.

Mr Shipley said that aside from the ambiguity in the Agreement, it was always understood that there were to be three payments in the event of the death of any partner — and that the numbers were then easily calculated by anyone should they wish to pay in order to continue the law firm. The three payments were to be those set out in clause 4 of the Agreement; namely the deceased’s share of the capital account, his share in the accrued profits to the date of death and the six-month income figure.

Mr Shipley agreed with counsel for the Minister that clause 4 of the Agreement required the files of the deceased to be left with the ongoing firm, that no remuneration was to be paid in respect of same except as foresaid and that the meaning of “foresaid” could be in respect of the repayment of money that had been put in by the deceased in the capital account including the after-tax profits that had been left by him in the firm.

Mr Shipley admitted that clause 4 is ambiguous, and that neither he nor his partners had interpreted it as meaning that the six-month income formula was to have any relationship to the files left behind. He said that, while the Agreement is silent in this respect, there had been discussions that the six-month payment would be for unbilled work or for work-inprogress of the firm as a whole. However he freely admitted that at the time no calculation had been made or attempted as to work-in-progress or unbilled work that might have been done by the deceased, and that clause 1 specifically denied any allowance to be paid to a withdrawing partner for work-in-progress in the partnership.

Counsel for the Minister notes that while an interpretation of the Agreement may afford the possibility of some connection between the six-month formula and the retention by the firm of the deceased’s files, the same is nebulous and further that there is an absence of an accounting foundation as to any known or ascertainable amount of work-in-progress. And in any event, that if there was any residual work-in-progress intended to be compensated, it could have been spelled out as such in the Agreement inas- much as it is in clear contradistinction to paragraph 1 with respect to a withdrawing partner.

Additionally, counsel for the Minister asserts that even if the amount could be characterized as income, the provisions of subsections 96(1.1) and 96(1.4) would not be applicable because an allocation of a share of the income or loss of the partnership had not been made. Rather the intent was that the arbitrary six-month amount would pertain irrespective of the state of the current income or loss of the ongoing partnership. That being the case subsection 96(1.4) is of no use to the appellant. The aforementioned subsections are as follows:

96 (1.1) For the purpose of subsection (1) and sections 101 and 103,

(a) where the principal activity of a partnership is carrying on a business in Canada and the members thereof have entered into an agreement to allocate a share of the income or loss of the partnership from any source or from sources in a particular place, as the case may be, to any taxpayer who at any time ceased to be a member of

(i) the partnership, or

(ii) a partnership that at any time has ceased to exist or would, but for subsection 98(1), have ceased to exist, and either

(A) the members thereof, or

(B) the members of another partnership in which, immediately after that time, any of the members referred to in clause (A) became members

have agreed to make such an allocation

or to his spouse, estate or heirs or to any person referred to in subsection (1.3), that taxpayer, his spouse, estate or heirs, or that person, as the case may be, shall be deemed to be a member of the partnership; and

(b) all amounts each of which is an amount equal to the share of the income or loss referred to in this subsection allocated to a taxpayer from a partnership in respect of a particular fiscal period of the partnership shall, notwithstanding any other provision of this Act, be included in computing his income for the taxation year in which that fiscal period of the partnership ends.

96 (1.4) For the purposes of this Act, a right to a share of the income or loss of a partnership under an agreement referred to in subsection (1.1) shall be deemed not to be capital property.

The Agreement had been drafted by the deceased whose expertise was not in matters of taxation but rather chiefly in the field of real estate. Accordingly it is without the precision that may have otherwise avoided the reassessment in issue. However the ambiguities are there and it is for this primary reason that extrinsic evidence as to intent is admissible.

I am satisfied that when the relevant provisions of the Agreement are fairly construed in light of all the surrounding circumstances which existed at the time, the amount was not a capital amount received by the appellant in respect of the disposition of a partnership interest. Rather it was, pursuant to the Agreement, an income allocation calculated on an arbitrary basis.

In coming to my decision I have taken the following matters into account which, in my view, have tipped the scales in favour of the appellant.

1 The evidence of Mr Howard and Mr Shipley is in accord as to the intent of the deceased and his partners that an amount of income was to have been paid.

2 The deceased was the founding and long-term member of the law partnership and there is no reason to discount the likelihood of the existence of a residual income entitlement which had been recognized as such and which had been negotiated and agreed upon without any resort to mathematical accuracy.

3 The choice of the arbitrary amount of income was not unreasonable nor unrealistic given all of the circumstances.

4 The word “income" is used in conjunction with the six-month formula in clause 4 of the Agreement.

5 The Agreement differentiated between and provided for a five-year interest free repayment of capital whereas the payment of income was to have been made over a six-month period of time.

6 The matter of the requirement of the files remaining with the ongoing firm is, by its wording, severable from the rest of the paragraph and could stand on its own. However, this would serve only to lessen the ambiguity and not to resolve it.

7 The payment thereof was made within a very short time and was treated consistently throughout as on account of income.

8 Had the amount been unrealistic, unreasonable or unaffordable the remaining partners had the option not to continue the partnership.

Having heard the evidence and observed the manner and demeanour of the witnesses, and taking into account the above eight factors, I am satisfied from a global perspective that on the basis of probabilities the true nature of the receipt has been shown in this case to have been that of a distribution of income calculated on an arbitrary basis and that the provisions of subsection 96(1.1) have been satisfied.

While each case must be determined in accordance with its own facts, I am of the opinion that the same result flows in the case at bar as in The Queen v Boorman, [1977] CTC 464; 77 DTC 5338 (FCTD), MNR v Wahn, [1969] CTC 61; 69 DTC 5075 (SCC) and MNR v Sedgwick, [1963] CTC 571; 63 DTC 1378 (SCC) and that these cases are supportive of the interpretative approach I have employed in arriving at my determination.

The two cases cited by the appellant, while factually different, are somewhat analogous to the matter at bar. Dacen v MNR, [1979] CTC 2868; 79 DTC 732 (TCC) and Slan v MNR, [1981] CTC 2880; 81 DTC 794 (TCC) involved a withdrawing partner's claim that he was not bound by an allocation of income agreement that had been made unilaterally by the ongoing partners and that what had really occurred was a sale of a partnership interest which is a capital transaction.

In Dacen, supra, MJ Bonner (as he then was) said at 2870 (DTC 733):

The Appellant’s first submission amounts to a suggestion that subsection 96(1.1) can have no application where the agreement referred to in paragraph (a) was not one to which the retiring partner was a party. The wording of the subsection is, to say the least, complex, but I can find nothing in it to support the restriction suggested. The body of members who, if the subsection is to apply, must have entered into an agreement to allocate cannot be regarded as necessarily including "... a taxpayer who, at any time, ceased to be a member of the partnership . . .”.

The evidence does not support the second submission. . . .There was no reference in the evidence to any events that were regarded by the parties, or could reasonably be regarded by anyone, as a sale of an interest in a partnership. In any event the appellant was entitled, while a partner, to a share of income. Even if Exhibit A-1 could be viewed as an agreement for the sale of a partnership interest, the disposition of the appellant’s right to a share of income in the course of such sale cannot, by reason of subsection 96(1.4) of the Act, be regarded as a disposition of a capital property.

Conclusion

The appeal is allowed, in part, and the matter is to be referred back to the Minister for reconsideration and reassessment on the basis that the calculation of the appellant’s income shall include the amount of $40,341.00 as income with respect to the buy-sell agreement and that there shall be deducted the appellant’s share of $20,758.82 with respect to the Chester loan. There is to be no deduction or reserve allowed with respect to the McCart loan.

The appellant will have his costs if applied for.

Appeal allowed in part.