Robertson J.A.:
1 This is one of nine appeals stemming from a decision of the Tax Court of Canada in which it was held that the taxpayers are entitled to deduct from income their proportionate share of a $1.2 million tenant inducement payment. The Minister of National Revenue takes exception to this finding on several grounds. His principal argument is that the payment in question was made by the taxpayers to the taxpayers. According to the Minister, a payment to one's self does not give rise to any tax consequences. As will be explained, that legal proposition is an offshoot of the common law rule against contracting with one's self.
2 In the reasons that follow I conclude that the Minister's characterization of what occurred is correct. I also accept die novel proposition of tax law being advanced. As the decision below is now reported it is only necessary to recite the relevant facts: see(1995), 96 D.T.C. 1145 (T.C.C.).
3 The Dartmouth Medical Centre consisted of eighteen doctors practising as a partnership (the “Partnership”). In the early 1980's the Partnership became interested in acquiring new premises to carry on the medical practice. In 1984, all eighteen doctors entered into what they termed a “Co-Tenancy” agreement with the intention of developing a professional office building in which the Partnership would lease space. The remainder of the building was to be rented out. In fact, the so-called Co-Tenancy was an agreement respecting co-ownership of the lands to be acquired in trust by a company to be incorporated for that purpose and which company would act as “agent or bare trustee” for the Co-Tenancy. The lands were so acquired by 1577349 Holdings Limited (hereafter the “Bare Trustee”) in trust for the eighteen co-owners. Each co-owner was an equal shareholder of the corporate Bare Trustee which was to construct and operate the new building on behalf of the Co-Tenancy.
4 The Co-Tenancy agreement provided that title to the lands and “all cash flow and losses arising from the property” were to be held and received by the co-tenants (or more accurately “co-owners”) as tenants-in-common. In structuring the transaction in this fashion each of the eighteen doctors would claim, for example, his or her proportionate share of the capital cost allowance. At the same time, each doctor held an undivided interest in the lands with the other doctors, thereby preserving the right to convey his or her interest in the lands to a third party in accordance with the terms of the co-tenancy agreement.
5 On May 21, 1985 the Partnership and the Bare Trustee signed a lease agreement in which the Partnership agreed to lease the upper five floors of the new building together with part of the basement. The lease agreement also provided for the payment of a lease inducement totalling $1.2 million. The monies were raised through financing obtained by the Bare Trustee, as registered owner of the lands, and guaranteed by each member of the Partnership. Under the terms of the lease agreement rent was to be paid by the Partnership to the Bare Trustee. The Partnership, and in turn the individual partners, treated those payments as an expense. Members of the Co-Tenancy treated the rental payments as income for both accounting and tax purposes. In computating the Bare Trustee's taxable income, none of the rental income was included, nor any expenses relating thereto deducted. In short, all revenue received and expenses incurred by the Bare Trustee with respect to the building flowed through to members of the Co-Tenancy.
6 In calculating the income of each taxpayer the Partnership did not include the $1.2 million lease inducement payment as income of the Partnership, either for accounting or taxation purposes. Apparently, it was believed that the payment constituted a non-taxable capital benefit. As a result none of the eighteen doctors included in income the $66,666 received. This was a common assumption prior to the enactment of section 12(1)(x) of the Income Tax Act (see: Ikea Ltd. v. R. (1998), 222 N.R. 161 (S.C.C.). On the other hand, in computing income from property for the 1985 to 1988 taxation years, each doctor deducted his or her respective share of the rental inducement amount paid by the Bare trustee to the Partnership as a deferred leasing cost amortized over ten years. In summary, each taxpayer took a deduction with respect to the tenant inducement payment, but none included the amount received as income in any of the taxation years in question.
7 The Minister reassessed each doctor's tax liability by denying the deduction claimed in respect of their proportionate share of the tenant inducement payment made by the Bare Trustee to the Partnership and of the additional mortgage interest incurred to finance the $1.2 million payment. Twelve of the eighteen doctors appealed to the Tax Court. [Three of the twelve appeals by the Minister to this Court were allowed on consent, leaving nine taxpayers.]
8 Before the Tax Court Judge the Minister argued that: (1) the tenant inducement payment was not an expense incurred for the purpose of gaining or producing income within the meaning of paragraph 18(1)(a) of the Income Tax Act; (2) such deduction would unduly or artificially reduce the income of the taxpayers within the meaning of section 245; and (3) the payment was not “reasonable” within the meaning of section 67. In short, counsel for the Minister argued “that it is artificial and not reasonable for a landlord to pay a rental inducement amount to himself” (Reasons at 1150). The Tax Court Judge disagreed and went on to hold that the real problem stemmed from the failure of the Minister to reassess the taxpayers on the basis that the tenant inducement payment should have been included in income, in which case the entire transaction would have been a “wash” for tax purposes. In other words, the Minister assessed the “wrong side” of the transaction. With respect to the Minister's argument that the taxpayers were contracting with themselves, the Tax Court Judge held at 1150:
It is perfectly obvious in these appeals that the landlord and tenant were not at arm's length. The eighteen doctors who were landlords as co-owners in the Co-Tenancy were the same eighteen doctor/partners who were tenants in the DMC Partnership. The non-arm's length relationship could affect the reasonableness of the rental inducement amount but it does not affect the principle as to whether a landlord may pay and deduct a rental inducement amount.
9 It is apparent that the Tax Court Judge approached the issue in terms of a non-arm's length transaction as between two distinct or separate legal entities. The Minister now argues that the Tax Court judge erred in not recognizing that, as a matter of law, the eighteen doctors made a payment of $1.2 million to themselves. Furthermore, the Minister rejects the contention that he assessed the wrong side of the transaction. I am in agreement with both submissions.
10 In my respectful view, the success of this appeal hinges on whether as a matter of law, and for tax purposes, the contract of lease under which the tenant inducement payment was paid was entered into between two distinct legal entities. The Tax Court Judge presumed as much and on appeal to this Court counsel for the taxpayers submits that both the Partnership and the Co-Tenancy are separate legal entities [Respondent's Memorandum, para. 13]. With great respect, I cannot accede to this characterization of the Partnership and the Co-Tenancy. My reasons address two questions: who was the landlord and who was the tenant? I shall deal first with the contention that the Partnership was the tenant. Parenthetically, I note that neither party made any reference to the provisions of Nova Scotia's Partnership Act R.S.N.S. 1989, c. 334 and, thus, I assume that the common law principles are not affected by that legislation.
11 It is well accepted that at common law a partnership does not constitute a distinct legal person such that it is separate from its members. Indeed, it is the lack of a separate legal personality and limited liability that distinguishes a partnership from a corporation. In this regard, the Income Tax Act recognizes the lack of legal personality of a partnership by not treating “it” as a taxpayer. Admittedly, a partnership must file an annual information return setting out the income of the partnership, but it is the individual partners who are liable to pay tax on the partnership's income. For taxation purposes the partnership is treated as a “separate person resident in Canada” solely for the purpose of calculating income at the partnership level. In this way each partner's share of the income may be allocated accordingly: see paragraph 96(1)(a).
12 Accepting that a partnership does not constitute a distinct legal entity, neither at common law nor for tax purposes, then in strict legal theory the true tenants under a lease entered into by a partnership are the individual partners existing as of the date of the lease. Title to land, whether it be freehold or leasehold, cannot vest in a non-entity such as a partnership: see A.B. Oosterhoff, W.B. Rayner, Anger and Honsberger Law of Real Property, vol. 2 (Toronto: Canada Law Book, 1985) at 1256. In the present case each of the eighteen doctors in the Partnership must be deemed to have been a tenant under the lease agreement of May 21, 1985. It remains to be decided whether the same eighteen doctors were the landlords under that agreement. Before passing on to that question, it must be remembered that the legal propositions stated above are not affected by the fact that in some jurisdictions it may be possible under the rules of civil procedure to initiate an action for or against partners in the name of the partnership. Such procedural rules, however, do not affect the individual liability of partners but are intended to remove procedural hurdles imposed by the common law: see Thorne v. New Brunswick (Workmen's Compensation Board) (1962), 33 D.L.R. (2d) 167 (N.B. C.A.). I turn now to the question of who was the landlord.
13 Based on principles of agency law I take it for granted that the Bare Trustee cannot be deemed the landlord. First, it must be remembered that a bare trustee holds property in trust at the absolute disposal and for the absolute benefit of the beneficiaries, in this case the eighteen co-owners. According to the “Trust Declaration”, the Bare Trustee was to act merely as agent for the co-owners. I take it to be axiomatic that where an agent makes a contract with a third party on behalf of a disclosed principal and that principal has authorized the making of such contract the principal can sue and be sued by the third party on the contract. In other words, a direct contractual relationship is thereby created between principal and third party by the acts of the agent, who does not become a party to the relationship. This is the very purpose and rationale of agency law: see G.H.L. Fridman, Law of Agency, 7d, 1996 at 216.
14 From the above, it follows that when the Bare Trustee entered into the lease agreement with the Partnership on May 21, 1985 the Bare Trustee was acting as agent for the eighteen co-owners. The Bare Trustee was not a party to that contract. As principals, the eighteen co-owners must be deemed landlords unless the Co-Tenancy is regarded as a legal entity, separate and distinct from the eighteen doctors who were also tenants under the lease agreement. I agree with the Minister that the Co-Tenancy is not at law a distinct legal entity, nor for that matter a taxable entity. The Co-Tenancy merely evidences a contractual relationship between eighteen persons who are to share in the revenues and expenses generated by a particular rental venture. At best, it is arguable that the Co-tenancy amounted to a partnership agreement; a finding which, in any event, would not advance the taxpayers' case. Having decided to structure their transaction around the concept of a bare trustee, the taxpayers cannot now resile from the legal consequences which necessarily follow. The eighteen doctors who were members of the Partnership and Co-Tenancy were both the tenants and landlords under the agreement for lease.
15 The only question which remains is with respect to tax consequences flowing from the fact that the taxpayers paid themselves a tenant inducement. In my view it is sufficient for purposes of dealing with this appeal to rely on paragraph 18(1)(a) of the Act which prohibits a deduction from income except to the extent “it was made or incurred by the taxpayer for the purpose of gaining or producing income”. In Royal Trust Co. v. Minister of National Revenue (1956), [1957] C.T.C. 32 (Can. Ex. Ct.)the meaning of that provision was explained in the following terms (at 42):
Thus, it may be stated categorically that in a case under the Income Tax Act the first matter to be determined in deciding whether an outlay or expense is outside the prohibition of ... [paragraph 18(1)(a)] of the Act is whether it was made or incurred by the taxpayer in accordance with the ordinary principles of commercial trading or well accepted principles of business practice. If it was not, that is the end of the matter. But if it was, then the outlay or expense is properly deductible unless it falls outside the expressed exception of... [paragraph 18(1)(a)] and, therefore, within its prohibition...
16 Adopting the above analysis, the question to be addressed is whether a payment to oneself can be said to be in accordance with the ordinary principles of commercial trading or accepted principles of business practice. No evidence was lead by the taxpayers on this issue and understandably so. On the facts, what is obviously missing is the element of “bargain” that inevitably accompanies any commercial contract.
17 Putting aside the legal niceties of this appeal, one should not lose sight of the fact that what the taxpayers did in this case is no different than that outlined in the following hypothetical. Two doctors practising as a partnership in Dartmouth decide to move their practise to Halifax. To that end they find a building suitable to their needs. Faced with the decision of acquiring the lands and building through a holding corporation, or in their personal capacities, they elect to acquire the land as tenants-in-common. They are also aware that had they rented office space in Halifax from a third party they would have been offered a tenant inducement payment. Accordingly, the two partners agree to pay themselves the amount they would have received had they leased premises from a third party. Though the tenant inducement might well be considered reasonable within the meaning of section 67 of the Act, the reality is that the two partners have done no more than move a sum of money from one pocket to the other in the hope that they would reap the benefit of certain tax advantages. While the two doctors may be able to claim their proportionate share of the capital cost allowance on the building, they cannot profess to be landlord and tenant at one and the same time. Even if they did, the doctrine of merger would come into play, an issue which I need not address.
18 In support of the proposition that a payment to oneself cannot give rise to a tax deduction, the Minister could have also relied on the common law rule against contracting with one's self. As a general proposition it makes good sense, as does the proposition that one cannot sue one's self: see Simpson & Co. v. Thomson (1877), 3 App. Cas. 279 (Scotland H.L.). But as with all propositions, there are exceptions. Surely, it cannot be doubted that it is possible for a partner to lease property to a partnership without offending the notion that one cannot contract with oneself: see: Brenner v. Rose (1972), [1973] 1 W.L.R. 443 (Eng. Ch. Div.). Individuals may have more than one legal personality and thus may contract with themselves in different capacities. For instance, in my capacity as executor under a will I might enter into a contractual obligation in my capacity as a beneficiary under that testamentary instrument. Legal consequences may flow from such a contract even though on its face it might appear that I am contracting with myself: see J. M. Perillo, Corbin on Contracts, vol. 1 (St. Paul: West Publishing, 1993) at 311.
19 I can see no basis on which to hold that the eighteen co-owners were acting in a different capacity when they agreed through their agent to pay themselves a tenant inducement payment. Had the Co-Tenancy consisted of eighteen persons of which only five were members of the Partnership then arguably a different legal result might have been reached on the basis that the element of “bargain” was present. But in the present case, the fact is that the same eighteen persons who formed the Partnership were the very same persons who comprised the Co-Tenancy. Thus, I am of the opinion that the agreement to pay the tenant inducement payment of $1.2 million was of no legal consequence and that it cannot be considered an outlay or expense made for the purpose of gaining or producing income within the meaning of paragraph 18(1)(a) of the Act.
20 Hindsight reveals that the tax strategy pursued by the taxpayers was doomed to failure once the decision was made to acquire and develop the lands through an agent and bare trustee rather than the conventional “holding” corporation. The belief that each taxpayer would be permitted to deduct his or her proportionate share of the capital cost allowance together with the expectation that they could claim a deduction with respect to the tenant inducement payment without including a corresponding amount in income may well have proved irresistible. Unfortunately, there are recognized limits in effecting any tax strategy. In this case these limits are imposed by the doctrines governing recognition of legal personalities.
21 For the above reasons, the appeal must be allowed with costs here and below, the judgment of the Tax Court of Canada dated December 5, 1995, set aside and the assessment of the Minister affirmed. These reasons shall constitute the reasons for judgment in the related appeals: A-10-96, A-1 1-96, A-12-96, A-13-96, A-15-96, A-16-96, A-17-96.
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