Spire Freezers Ltd. v. R., 98 D.T.C. 1287, [1998] 2 C.T.C. 2764

Rip T.C.J.:

1 Spire Freezers Limited, Edward Butcher, John Dobrei, Patrick Gouveia, Maroje Miloslavic and John O'Neill (sometimes referred together as the “Canadians”) appeal assessments of income tax for 1987 in which the Minister of National Revenue (“Minister”) disallowed their claims for non-capital losses and capital losses for 1987. The following appellants also appeal subsequent taxation years in which the losses carried forward from 1987 were denied:

Appellant	Taxation year
Spire Freezers Limited	1990
Patrick Gouveia	1989
John Dobrei	1988
Edward Butcher	1990

2 Counsel agreed that the appeals would be heard together on common evidence and the decision rendered in the appeal of Spire Freezers Limited would apply to all the appeals. In fact the evidence at trial was with respect to the appeal by Spire Freezers Limited.

3 In 1987 a general partnership formed under the laws of California and named the Hamilton Cove Partnership (“HCP”) was in the process of developing and constructing a 423 unit residence condominium building on Santa Catalina Island in the State of California (sometimes referred to as the “HCP Condominium” or “Hamilton Cove Development”). The partners of HCP were BCE Developments Inc. (“BDI”), a Delaware corporation, and Peninsula Cove Corporation (“Peninsula”), a California corporation. Peninsula was a wholly-owned subsidiary of BDI that, in turn, was a subsidiary of BCE Development Corporation (“BCED”), a Canadian corporation, ultimately owned by BCE Inc.

4 By the end of 1986 the costs of the HCP condominium project being developed and built by HCP far exceeded the fair market value of the project (by approximately $10 million U.S.) which would potentially produce significant losses for HCP.

5 Mr. Jeffrey Wagner, formerly a director of BDI and its Director of Taxation, testified that the process of obtaining permission to develop the HCP condominium had been a lengthy one and in order to obtain permission of the local authorities to construct the condominiums, HCP had agreed to build a low income apartment project known as the Tremont Street Apartments (“Tremont Apartments”) in Avalon on Santa Catalina Island.

6 The Tremont Apartments was owned by a California corporation known as “Tremont Street Apartments Corporation” (“TSAC”). The Tremont Apartments was a federal and state subsidized and controlled low to moderate income rental project consisting of 20 to 30 units.

7 Mr. Wagner stated that he doubted that HCP would have built the Tremont Apartments on its own, that is, other than a means of obtaining approval for the construction of the condominium project. BDI was willing to sell the Tremont Apartments if it got the right price since that building was not viewed as a strategic asset by BDI, which was generally in the business of building for resale. Neither BDI nor Peninsula was looking to make money on the Tremont Apartments project since they considered it a cost of developing the condominium project.

8 Mr. Wagner explained that the Hamilton Cove Development was referred to as a “joint venture”, a term commonly used in the United States when more than one party has an interest in a business activity. He explained that notwithstanding there was a “50-50” interest between BDI and Peninsula in HCP, since BDI owned 100 per cent of Peninsula. He considered that BDI owned 100 per cent of the partnership. He stated, therefore, that the split of the capital account was not material to him.

9 It would appear that sometime in 1987 BDI and Peninsula were entertaining the possibility of disposing of the partnership interests they held in HCP subject to the condition that the HCP Condominium project would be retained or transferred to BDI.

10 In the latter part of May 1987, Mr. Jim Millson of CMF Enterprises Ltd. (“CMF”), a company in Toronto carrying on the business of selling tax shelters, appears to have prepared a two-page proposal entitled “re: $7.1 million partnership business loss”. Mr. Butcher, Spire Freezers Limited[FN1: <p>At the time the corporate name was Trans Canada Freezers Limited.</p>] lawyer at the time, brought this proposal to the attention of the corporation's president, Patrick Gouveia. According to the proposal a partnership in the United States had a “minimum” business loss of $7 million (U.S.) and assumed that an investor would pay 20 per cent of the loss, or $1.42 million (U.S.), to acquire the loss for tax purposes. The transaction proposed by Mr. Millson was as follows:

a) an investor corporation would purchase a partnership interest for $37.42 million (U.S.);

b) a holding company would then purchase the real estate at fair market value, that is for $36 million (U.S.);

c) the partnership loss of $7 million (U.S.) would be allocated to the new partners, creating a $3.6 million (U.S.) tax savings at the highest effective tax rate; and,

d) a new partner would continue the partnership by rolling in a nominal similar asset and in effect retain a cash surplus on a transaction of $2.18 million (U.S.) until some future date when the partnership could be wound up and a capital gain triggered, resulting in $1.4 million (U.S.) of taxes.

11 Mr. Millson's proposal appears to have ignored the partnership's ownership of the shares in TSAC. He assumed the “loss is an ordinary business loss and that the partnership is a true general partnership”.

12 After reviewing Mr. Millson's proposal, Mr. Gouveia spoke to a Mr. Dan Torbiak and a Mr. Howard Henry of Touche Ross, the auditors for Spire Freezers Limited. Mr. Gouveia explained that before speaking to Mr. Torbiak he wanted to know the names of the principals of HCP and when he learned it was a Bell Canada company, he pursued the matter.

13 Mr. Gouveia testified that he arranged a meeting with Mr. Millson and several executives and significant shareholders of Spire Freezers Limited for Mr. Millson to outline his proposal. (Certain persons associated with Spire Freezers Limited wished to participate in the investment outlined in the proposal.) However, Mr. Gouveia did not want to negotiate with a middle man and asked for the name of a responsible person at BDI. Mr. Millson “reluctantly” gave him the name of a Mr. Currie.

14 “Our interest was to get the tax losses and get the transaction to work”, Mr. Gouveia explained. To accomplish this goal the partnership must continue in business; that is, the partnership must “survive the transaction”. With this in view Messrs. Gouveia and Butcher and a shareholder in Spire Freezers Limited, went to California on Friday, May 31 to meet with Mr. Currie and other representatives of the BDI group.

15 Mr. Gouveia first learned of the existence of the Tremont Apartments between “Thursday afternoon and June 2”, a Tuesday “when we were sitting in California” but, he said, “its existence was not relevant to us”.

16 Mr. Torbiak testified that the proposal by BDI was a “take it or leave it” deal. He was concerned that the partnership continue and not be dissolved. For the partnership to continue it had to have an income producing asset. At one time he considered that it may be necessary to “roll in a nominal asset to achieve this goal”. However “if you already have property why roll something in”. This property was the Tremont Apartments and therefore, Mr. Gouveia confirmed, it was desirable to structure the transaction so that the partnership, rather than TSAC, be the owner of the Tremont Apartments before the contemplated transactions commenced. Mr. Torbiak discussed this matter with Mr. Currie and ultimately a decision was made to “go for the deal”, according to Mr. Torbiak. Negotiations continued. A California lawyer was engaged by Mr. Gouveia. He also met the property manager of the Tremont Apartments.

17 The proposed transaction between Spire Freezers Limited, BDI and Peninsula was reduced to writing by way of a draft letter dated June 2, 1987. The draft letter was reviewed by the parties and their advisors and a revised letter of agreement, also dated June 2, 1987, was executed. This letter provided, among other things, for the transfer of TSAC shares from HCP to BDI.

18 Mr. Gouveia stated in June 1987 that he was not aware of the full extent of the losses associated with the condominium development and that the parties anticipated that the full purchase price on closing would be adjusted. He also testified that he did not know the price attributed by the vendors to the Tremont Apartments. He did not know how the price of the condominiums was determined by the vendors. Again, it was a “take it or leave it” deal. Mr. Torbiak also confirmed that when he reviewed the proposal and the June 2, 1987 letter he did not know what amounts were in play and that no projections of income had been prepared. A “pro forma” balance sheet of Spire Freezers Limited had been prepared as of May 1987 to take account of a sale of property in Montreal and an investment in a loss company, presumably the HCP investment. Mr. Torbiak also prepared a hypothetical analysis of the HCP transaction.

19 Mr. Gouveia is a chartered accountant. He acknowledged that it is “normal” that a transaction of this size be analyzed carefully. Notwithstanding the value of the properties involved aggregated approximately $33,000,000 Mr. Gouveia did not take the caution of analyzing the transaction because “as this deal was structured, our risk was minimal ... everything had to happen ...”.

20 Mr. Gouveia assumed the losses of HCP were non-capital losses and would be fully deductible against other income. The appellants were guaranteed a minimum tax loss of $7,000,000 (U.S.) and would not have to pay more than the $1,400,000 (U.S.) if the loss was subsequently determined to be larger.

21 The laid out cost of the transaction was to be the cash portion. The mortgage on the Tremont Apartments, which was added to the transaction later on, was to be a liability of HCP. Mr. Torbiak testified that the value of the Tremont Apartments building was very close, if not equal to, the amount for which it was leveraged. In his view, since the amount of debt was close to fair market value, “we should not have to pay anything additional for the partnership interest because in fact, we were acquiring very little or no equity in the apartment complex”.

• (a) BDI and Peninsula amended the HCP agreement to provide that it would continue regardless of the withdrawal of a partner or the admission of a new partner.

• (b) TSAC sold the Tremont Street Apartments to HCP for $2,900,000 U.S., payable as to $696,629.68 U.S. in cash and the balance by the assumption of liabilities. The cash was obtained from a loan of $696,629.68 U.S. that BDI had previously advanced to HCP for a promissory note (the “Note”).

• (c) HCP sold the shares of TSAC to BDI for $696,629.68 U.S., which BDI paid by assigning the Note to the Partnership.

• (d) Peninsula purported to sell its 50 per cent interest in HCP to Spire Freezers Ltd., and BDI purported to sell a 25 per cent interest in the Partnership to Spire Freezers Ltd. and a 25 per cent interest in HCP to Spire Group, which was acting on behalf of itself and the other Canadians, as follows:

  Mark Anbar	5.00%
  Ouzi Anbar	6.25%
  Edward Butcher	2.78%
  John Dobrei	1.67%
  Patrick Gouveia	6.25%
  Maroje Miloslavic	1.11%
  John O'Neill	1.39%
  Spire Group	.22%
  Spire Freezers (formerly Diamond Cold Storage Limited)	.33%
  Total	25.00%

  Under various agreements the Canadians purported to become partners of HCP pursuant to their acquisition of the interests in the HCP as described above. Upon the completion of this transaction, the Canadians say they were partners of HCP, which owned the Tremont Street Apartments and the Condominium Project.

• (e) The Condominium Project was then sold to BDI for $33,321,662 U.S.

• (f) The name HCP was then changed to “Tremont Street Partnership”.

23 The appellants' formal admission of facts acknowledged that their motive in entering into the transactions was to reduce their Canadian tax liability by gaining access to the losses of the HCP. They add that “[i]n the sense that the expected losses exceeded the costs incurred by the appellants, the transaction may colloquially be referred to as a ‘tax avoidance transaction' or a ‘tax loss transaction’”. The appellants also concede that a “significant portion of the price paid” by the appellants to the vendor (at least $511,962.32 (U.S.) before legal, accounting and other transaction costs) related to the underlying tax losses of HCP which the appellants hoped to offset against their income for Canadian tax purposes. The appellants were also aware that “for their objective to succeed, it was necessary that [HCP] continue in existence”. Thus, the appellants “were receptive” to having HCP acquire and continue to own and operate the Tremont Apartments. Messrs. Gouveia and Torbiak acknowledged that the entire transaction was pre-ordained and once it started, everything had to finish.

24 Mr. Gouveia testified that it was never the intention of any of the appellants that the HCP Condominium be retained: the deal dictated that it would be sold back to BDI. Also, BDI did not want to retain ownership of the Tremont Apartments building. Mr. Gouveia stated that “maybe for a fleeting moment” the Canadians considered retaining the condominium development. In his view, however, the project was “just too big for us”.

25 Respondent's counsel asked Mr. Gouveia whether it was ever contemplated that Spire Freezers Limited and the other Canadians would have the risks and benefits of ownership associated with the HCP Condominium project. He answered “no”. Under the agreement with HCP the appellants were obliged to transfer ownership of the HCP Condominium to BDI. Mr. Gouveia conceded that it was anticipated that BDI would lose beneficial ownership of the condominium for only a “moment of time”.

26 Mr. Wagner testified that as far as BDI was concerned the nature of the transaction, although structured as a sale of partnership interests and of the condominium project, was, for U.S. tax purposes, a distribution of the HCP Condominium to BDI and not a sale. As far as the Tremont Apartments was concerned, for US tax purposes the property was sold to the Canadians for $1,200,000 (U.S.). The change in title of the condominium project was merely to create the desired structure of the transaction. Since, at the end of the day, BDI retained ownership of the HCP Condominium, the economic reality of the transactions was that HCP distributed the condominium project to BDI, a former partner in HCP. For U.S. tax purposes, BDI did not recognize the transfer of the condominium to it as a purchase and sale.

27 Since all development costs of the HCP Condominium and of the Tremont Apartments had been added to the costs of the condominium inventory, according to Mr. Wagner, the result of the transaction was that BDI had made a further adjustment to its inventory.

28 Effective ownership of the condominium project was always with BDI, stated Mr. Wagner, except for the moment it was owned by the Canadians. In his view the transaction was a distribution of property to a partner because BDI never ceased to effectively own HCP Condominium project notwithstanding the transactions that took place on November 30, 1987.

29 The proportional interests of the Canadians, other than Spire Freezers Limited, to be acquired in the investment was determined by Mr. Gouveia. Their total interest was to be 25 per cent. Nobody considered the profit or potential profit from any building (i.e., the HCP Condominium or the Tremont Apartments) when deciding to enter the transactions. The interest of each of the Canadians was related to what they could afford. In an opinion letter by Touche Ross to Spire Freezers Limited and the other Canadians, Touche Ross assumed that the intention of the Canadians was to continue the HCP indefinitely for the purpose of operating the Tremont Apartments project as a revenue producing rental property after closing.

30 In examination in chief, Mr. Gouveia stated that when he entered the transactions he anticipated the Tremont Apartments would be profitable and, in fact, profits have been realized on the apartment building every year after 1988.

31 The HCP income statement for 1987 reflects sales of units in the condominium project before November 30, 1987 as well as the sale of the remainder of the HCP Condominium project to BDI on that date, with the cost of properties sold being the total costs incurred by HCP to November 30, 1987.

32 During the years 1987 to 1995 the only assets owned by the Tremont Street Partnership (formerly HCP), as it was then called, were the Tremont Apartments and related assets. According to statements of income and Partners' Capital of the purported Tremont Street Partnership for its fiscal years ending on December 31, 1989 to 1995, prepared by its U.S. auditors, income of the purported partnership and the amounts withdrawn by the purported partners were:

Year	Net Income	Amount withdrawn
1989	$ 33,224 (U.S.)	$ 50,136 (U.S.)
1990	38,506	48,528
1991	73,483	99,379
1992	66,345	119,109
1993	114,165	156,913
1994	82,521	151,520
1995	49,192	130,839

33 Income for Canadian tax purposes was:

Year	(CDN $)
1989	0
1990	0
1991	0
1992	0
1993	$72,023
1994	62,162
1995	32,954

34 The owners reduced the principal amount of the mortgage on the HCP condominium each year.

35 According to the government rent subsidy program under which the Tremont Apartments building was built, the owners of the Tremont Apartments are required monthly to deposit amounts of money in what Mr. Gouveia described as a “sinking fund” in order to ensure that money would be available for repairs and other expenses, such as insurance and property taxes. In 1990 and 1993, for example, the amounts so deposited were $72,895 (U.S.) and $50,603 (U.S.) respectively. The management of the Tremont Apartments was audited by the state agency every three months.

36 In computing the income from the purported partnership for Canadian income tax purposes for the fiscal year ending December 31, 1987, the Tremont Street Partnership claimed $10,030,887 (U.S.) ($11,412,300 CND) as a loss on the sale of the HCP Condominium and $367,107 (U.S.) ($480,836 CND) as a loss on the sale of the TSAC shares. Each of the appellants claimed to be entitled to deduct their proportionate share of those losses.

37 The respondent does not dispute the quantum of the losses or the allocation as between Spire Freezers Limited and the other Canadians, but denies that the appellants are entitled to deduct those losses for Canadian income tax purposes.

38 Two persons testified as experts at trial. Richard M. Buxbaum is an attorney at law licenced to practise before the Courts of the State of California. He is a professor of international law of the School of Law (Boalt Hall) at the University of California at Berkeley, specializing in Partnership and Corporation Law, international and European economic law and international business transaction. He testified as an expert in Partnership Law of California on behalf of the appellants. In his opinion the relationship between BDI and Peninsula was a partnership even though it may have been referred to as a “joint venture”.

39 According to Professor Buxbaum, a joint venture agreement is synonymous with a partnership “in this situation”, although a “joint venture” is not a term of art; parties are free to choose whatever name they wish to describe a situation. Professor Buxbaum was unaware if the Internal Revenue Code of the United States distinguishes between the two terms but acknowledged there are differences in California law between a partnership and a joint venture.

40 As a result of the amendment to the partnership agreement, Professor Buxbaum stated, the HCP continued to exist upon the withdrawal of BDI and Peninsula from the partnership and the admission of the appellants to the partnership. He said that the sale of the HCP Condominium project did not terminate the partnership. Furthermore, he stated that the appellants became members of the partnership when they acquired interests in the partnership.

41 Professor Buxbaum explained that under California Partnership Law partnership is “terminated”[FN2: <p>California Corporations Code section 15030. Provisions referred to in thisparagraph are those of the California Corporations Code.</p>] only upon the conclusion of two prior steps a) “dissolution”, defined as “the change in relation of the partners caused by any partner ceasing to be associated in the carrying on as distinguished from the winding up of the business” (section 15029); and b) “winding up” (following the event of dissolution), which is not itself defined by the statute but the attributes and operations of which are described in sections 15033-15040 of the Code. In other words, he explained, “dissolution” itself is not the equivalent of “termination”; rather, it is the beginning of the process leading to termination. Upon the completion of that winding up process a partnership is “terminated” (section 15030). While the definition section 15029 itself identifies only one method of dissolution, that is, a partner ceasing to be associated in the carrying on of the business, other acts, including the admission of a new partner, may also cause dissolution (section 15031).

42 However, section 15031 (7) of the California Corporations Code provides that the admission of a new partner at most may cause a “dissolution” of the partnership, which is not the equivalent of a “termination” of the partnership but only the initiation of the wounding up process. In most commercial situations, including the one at bar, the admission of a new partner does not cause a dissolution because the existence of a provision in the partnership agreement precludes that result. A partnership simply continues in formal legal terms, and not only in functional economic terms, as before. In the case at bar the erstwhile partners of HCP had amended the partnership agreement to permit the partnership to continue in the event new partners were admitted to the partnership.

43 Professor Buxbaum conceded that for purposes of his opinion, he had been advised by appellants' counsel that it was the intention of the Canadians to become partners of the partnership and that BDI and Peninsula also intended that the Canadians become partners.

44 Richard Hartnig testified for the respondent as an expert in the United States income tax law. Mr. Hartnig is a graduate in law from Duke University and has a Masters Degree in taxation from Georgetown University Law Center. From 1979 to 1983 he was a staff attorney for the Interpretative Division of the Chief Counsel Office of the U.S. Internal Revenue Service. In 1983 he held the position of assistant branch chief. During his ten years with the Internal Revenue Service he was responsible for work in the partnership, tax shelter and financial instrument areas. Since 1983 he has practised law in Atlanta, Georgia. Mr. Hartnig's evidence was with respect with United States tax law.

45 I always have reservations about accepting evidence as to how a transaction is treated for tax purposes in a foreign jurisdiction. I considered Mr. Hartnig's testimony only for the purpose of learning how the transactions were, or ought to have been reported, for United States tax purposes. How a transaction is treated in a foreign jurisdiction is of no import as to how it ought to be treated for Canadian tax purposes. However, for example, if a taxpayer treats a transaction as a disposition of property in the foreign jurisdiction and something else in Canada, I would want to know the reason. In any event, Mr. Hartnig testified that in his opinion, for U.S. tax purposes BDI treated the HCP Condominium not as an acquisition but as a distribution to it. This, he said, was inconsistent with the agreement of June 2, 1987 (and subsequent modifications), which in form was an agreement of sale but in substance was a distribution. In his view, the Canadians bought into a partnership with only one asset, the Tremont Apartments; the condominium had been previously distributed to BDI. The Canadians never had any risk of ownership and had no ability to obtain any of the benefits of ownership of, or any appreciation from, the HCP Condominium; the Canadians never had an ownership interest in the condominium. If after the sale of the partnership interest the Canadians had reneged and not sold the HCP Condominium, Mr. Hartnig wrote in his statement, BDI a) would have either a claim for specific performance or damages and b) would have demanded payment of the notes and claimed a default rate of interest if the notes were not paid.

46 I note that in Mr. Hartnig's view the ongoing HCP partnership was terminated for US tax purposes since there was a sale or exchange of 50 per cent or more of the total interest in partnership capital and profits.[FN3: <p>Section 708(b)(i) of the US Internal Revenue Code.</p>] He did not opine on whether a partnership terminated under state partnership law. He was not of the view, however, that there was any intention to deceive on the part of any person notwithstanding that for Canadian tax purposes the transfer of the HCP Condominium to BDI may constitute a sale and for U.S. tax purposes the transfer may be a distribution to a partner.

Question

47 I think it is fair, then, to conclude from the facts that the appellants' sole operating motivation in entering into the transactions with BDI and Peninsula was to acquire a tax loss. The appellants were not interested in carrying on a business in partnership in California except as an instrument in achieving their aim of acquiring the loss. Nevertheless, are the appellants entitled to deduct the purported losses of HCP?

Appellants' Argument

48 The appellants' counsel argues that by virtue of section 96 of the Income Tax Act (“Act”), the business and capital loss of the HCP partnership for its 1987 financial year are to be attributed to the appellants and treated as their business losses and capital losses for purposes of the Act.[FN4: <p>For 1987, subsection 96(1) read, in part, as follows:<blockquote><ul>(1) Where a taxpayer is a member of a partnership, his income, non-capital loss, net capital loss, restricted farm loss and farm loss, if any, for a taxation year, or his taxable income earned in Canada for a taxation year, as the case may be, shall be computed as if<li><p>(a) the partnership were a separate person resident in Canada;</p></li><li><p>(b) the taxation year of the partnership were its fiscal period;</p></li><li><ul>(c) each partnership activity (including the ownership of property) were carried on by the partnership as a separate person, and a computation were made of the amount of<li><p>(i) each taxable capital gain and allowable capital loss of the partnership from the disposition of property, and</p></li><li><p>(ii) each income and loss of the partnership from each other source or from sources in a particular place,</p></li>for each taxation year of the partnership;</ul></li><li><p>(f) the amount of the income of the partnership for a taxation year from any source or from sources in a particular place were the income of the taxpayer from that source or from sources in that particular place, as the case may be, for the taxation year of the taxpayer in which the partnership's taxation year ends, to the extent of the taxpayer's share thereof; and</p></li><li><ul>(g) the amount, if any, by which<li><p>(i) the loss of the partnership for a taxation year from any source or sources in a particular place,</p></li>exceeds<li><p>iii) in any other case, nil</p></li>were the loss of the taxpayer from that source or from sources in that particular place, as the case may be, for the taxation year of the taxpayer in which the partnership's taxation year ends, to the extent of the taxpayer's share thereof.</ul></li></ul></blockquote></p>]

49 Under section 96, income and losses are computed at the partnership level and are then attributed to the individual partners. A change in the membership of a partnership does not affect the computation of income and losses of the partnership. In particular, the fiscal year of a partnership is not terminated on such an event, nor is the partnership required to treat its accrued gains and losses as having been realized before the change of membership so that they can be attributed to former partners for income tax purposes.

50 A Canadian resident must include in his income his attributed share of the income and losses of all partnerships of which he is a member. For that purpose, the Act does not distinguish between partnerships governed by the laws of a Canadian province and those governed by the laws of a foreign jurisdiction.

51 All of the transactions in the appeals at bar, appellants' counsel said, were real and legally effective, and had real legal consequences. The contracts between the parties were intended to be binding and were binding on them in accordance with their terms. The HCP partnership continued in existence notwithstanding the events of November 30, 1987. Firstly, the law governing the partnership is the law of California. Professor Buxbaum explained that because of the terms of the partnership agreement, as amended, the HCP continued in existence notwithstanding that the “old” partners sold their partnership interests to the appellants and that HCP sold the condominium project. Secondly, the ordinary meaning of partnership as defined in most provincial statutes is, counsel stated, “the relation that subsists between persons carrying on business in common with a view to profit.” In the case at bar, counsel declared, the appellants became partners of the partnership which owned the Tremont Street Apartments. They expected to carry on that business with a view to profit and, in fact, the Tremont Apartments have had annual profits.[FN5: <p>See, for example,<em>Partnership Act</em>, R.S.O. 1990 s. 2 and<em>Continental Bank of Canada v. R.</em>(1996), [1997] 1 C.T.C. 13 (Fed. C.A.)</p>]

52 The appellants also argue that the transaction did have a reasonable expectation of profit. For a net investment of $1,208,591,000. (U.S.), their cost of obtaining the losses, the appellants have received substantial distribution of profit from the operation of the Tremont Apartments. Counsel for the appellants distinguishes this fact from those in Continental Bank.[FN6: <p>Footnote 5,<em>supra.</em></p>] He notes that in this context “profit” bears its ordinary commercial meaning, including both an excess of revenue over expenses and an increase in the value of assets: Schultz v. R. (1995), [1996] 2 C.T.C. 127 (Fed. C.A.). Counsel for the appellant submitted that there is no basis in law or common sense for the proposition that the HCP cannot be considered profitable until it recovers its loss on the sale of the condominium project. A partnership that carries on a losing business does not thereby cease to be a partnership, nor does it cease to be a partnership when it divests itself of a losing operation and retains a profitable one.

53 Professor Buxbaum was also of the view that the appellants, upon acquiring their interests in HCP and agreeing to be bound by the terms of the partnership, became partners in the HCP according to California law.

54 Spire Freezers Limited was a member of HCP holding a 75.33 per cent interest at the end of the partnership's year end and its own year end on December 31, 1987. The other appellants held their respective interests in the partnership as well at the end of 1987. Therefore, counsel concludes, Spire Freezers Limited and the other appellants were required by section 96 of the Act to include in their respective income for the year their proportional share of the income and losses of the HCP for their fiscal years all of which ended on December 31, 1987. They are the only taxpayers to whom those losses can be attributed for income tax purposes pursuant to section 96 of the Act.

Respondent's Argument

• (a) there was no reasonable expectation of profit;

• (b) the appellants were not members of a partnership which had a loss;

• (c) the condominium project was distributed to BDI; there was no sale;

• (d) there was no true loss and no allocation of loss;

• (e) the transaction was artificial and the expenses were unreasonable and not incurred to earn income; and

• (f) the transaction was a sham.

56 The nature and purpose of the transaction, says respondent's counsel, was to require tax losses. The transaction was structured for the appellants to obtain the losses. However, the transaction, as structured, fails to meet the threshold standard for being a source for tax purposes, that is, the venture, as constituted, did not have a “reasonable expectation of profit”. A loss was not only anticipated but was a necessary element of the transaction. The transaction undertaken by the appellants, therefore, cannot be said to have been incurred to earn a profit. In addition, there cannot be a source of income for tax purposes unless the activity is engaged in with “a reasonable expectation of profit”.

57 The appellants state they experienced a loss in the first moments after they became partners in the HCP. Again, this was the goal of the appellants. The respondent suggests that when the purpose of a particular taxpayer, objectively viewed, is to have an enormous loss so as to reduce its tax liability, that activity cannot have been undertaken for the purpose of gaining or producing income. It may well be that one element of the transaction, that is, the Tremont Apartments, may produce some cash flow and perhaps some profit, but the profit is not of a sufficient degree to overcome the losses integral to the transaction. Respondent's counsel submits that the potential of producing revenue in excess of expenditure in the near future has not been met. Counsel refers to Walls v. R. (1996), 96 D.T.C. 6142 (Fed. T.D.), at 6146 where Pinard J. stated that:

Given all the circumstances, it appears to me that the Partnership did not carry on business with a reasonable expectation of profit. Rather it was set up as a tax shelter, with the intention that the operation of the storage park would give rise to large initial losses in order to provide the limited partners with tax claims....

I believe the reduction of tax in this case was the sole reason for the existence of the shelter. In the case of Moloney v. The Queen (1993), 145 N.R. 258, the Federal Court of Appeal considered the case of a tax shelter arrangement and stated the following, at pages 258 and 259:

While it is trite law that a taxpayer may so arrange his business as to attract the least possible tax (see Duke of Westminster's Case, [1936] A.C. 1), it is equally clear in our view that the reduction of his own tax cannot by itself be a taxpayer's business for the purpose of the Income Tax Act. To put the matter another way, for an activity to qualify as a “business” the expenses of which are deductible under paragraph 18(1)(a) it must not only be engaged in by the taxpayer with a reasonable expectation of profit, but that profit must be anticipated to flow from the activity itself rather than exclusively from the provisions of the taxing statute.

Analysis

58 There is no doubt that the losses claimed by the appellants were incurred with respect to properties that, at their time of acquisition by the HCP, were sources of income to HCP; HCP was formed as a bone fide partnership under the laws of California. The partners of HCP at the times it was created and when it undertook construction of the condominium project and the Tremont Apartments had a reasonable expectation of profit from the investments and carried on a business with a view to profit.

59 When the appellants entered into the transaction they did so with only one purpose in mind: to get a tax loss. From the evidence it is quite clear that the thought of the transaction being profitable was never in the minds of the appellants.

60 Earlier this year I rendered judgment in the appeal of Backman v. R. (IT)G (T.C.C.). The facts in Backman were not identical to the facts in the appeals at bar but there is a similarity between them. In Backman, the appellants purported to be partners in a limited partnership rather than a general partnership, as is the case here. The taxpayers in Backman also acquired an apartment project which fell in value from its original cost. The purported partners in Backman also acquired for a modest price an exploration property, and when that was not successful, a condominium unit, also at a modest price compared to the overall investment. The latter two properties were acquired for the purpose of demonstrating that the partnership was carrying on a business after it sold the apartment project. In Backman I held that the transactions were not a sham and that they were legally effective. I do so here as well for the reasons expressed in Backman.

61 Also, as in Backman, it is my view that the transaction at bar was not artificial. In 1987, subsection 245(1) of the Act read as follows:

In computing income for the purposes of this Act, no deduction may be made in respect of a disbursement or expense made or incurred in respect of a transaction or operation that, if allowed, were unduly or artificially reduce the income.

62 In these appeals the fair market value of the Tremont Apartments had decreased. A decrease in the value of an asset is not, as far as I understand, a disbursement or expense. Therefore former subsection 245(1) has no application to the appeals at bar. Similarly section 67 of the Act also is not applicable in the circumstances; any outlay, if a reduction in value is an outlay, would have been reasonable in the circumstances since it resulted from the market's view of value.

63 I now turn to whether the appellants were indeed partners of HCP on November 30, 1987.

64 The parties agreed that subsection 96(1) of the Act requires that the income of a taxpayer who was a member of a partnership be calculated on the basis that the partnership is a person with a taxation year. Furthermore, a taxpayer who is a member of a partnership is entitled to claim his or her pro rata share of the partnership loss for the year, provided the taxpayer is a member of the partnership at its year end.[FN7: <p>I am unable to find any real or legal distinction between a partner and amember of a partnership.</p>] A partnership is a partnership and it does not make any difference for Canadian tax purposes, in my view, whether residents of Canada are partners in a partnership created under the laws of a Canadian province or a foreign jurisdiction so long as the relationship between the residents of Canada (and others) are contemplated by the partnership law of a Canadian province. In the appeals at bar, HCP was created under the laws of California and there is no evidence before me that partnership was not a partnership for Canadian tax purposes.

65 The Act does not define the term “partnership”. As I stated in Backman, the courts have looked at the partnership legislation of the partnership's province to determine whether a partnership exists: see, for example, W. v. Minister of National Revenue (1952), 52 D.T.C. 1150 (Can. Ex. Ct.), at 1153-54 and Sandhu v. R. (1980), 80 D.T.C. 6097 (Fed. T.D.), at 6103.[FN8: <p>The view of Revenue Canada is that the relevant provincial law ofpartnership is persuasive in determining whether or not a particular arrangementconstitutes a partnership. See Interpretation Bulletin IT-90: What is aPartnership? at paragraph 2.</p>]

66 While provincial law varies from province to province, a partnership possesses the same basic attributes, qualities and hallmarks in both common and civil law jurisdictions. In the common law provinces, a partnership is defined as “the relationship that subsists between persons carrying on a business in common with a view to profit”.[FN9: <p>See the<em>Partnership Acts</em>of the various provinces:, R.S.A. 1980, c. P-2, s. 1(d); R.S.B.C. 1996, c. 348, s. 2; R.S.M. 1987, c. P30, s.3; R.S.N.B. 1973, c. P-4, s. 3; R.S.N. 1990, c. P-3, s. 2(c); R.S.N.S. 1989, c. 334, s. 4; R.S.O. 1980, c. 370, s. 2; R.S.P.E.I. 1988, c. P-1; R.S.S. 1978, c. P-3, s. 3(1). See also<em>Northern Sales (1963) Ltd. v. Minister of National Revenue</em>(1973), 73 D.T.C. 5200, (Fed. T.D.), at 5204.</p>] The Canadian common law jurisdictions have essentially identical statutory provisions governing partnership, based upon the original British statute.[FN10: <p>Alison R. Manzer,<em>A Practical Guide to Partnership Law</em>, (Aurora: Canada Law Book, 1996) at 1-2.</p>]

67 In Québec, the relevant portion of article 2186 of the Civil Code provides that:

[a] contract of partnership is a contract by which the parties, in a spirit of cooperation, agree to carry on an activity, including the operation of an enterprise, to contribute thereto by combining property, knowledge or activities and to share any resulting pecuniary profits.

68 Professor Buxbaum opined as to whether, under California Partnership Law, any of the events on November 30, 1987 caused the termination of the HCP partnership and his opinion was that they did not. He addressed his mind to whether certain events may cause the termination of a partnership under California Partnership Law. He did not address his mind, nor did he cite any provisions of the California General Partnership Law, with respect to any relationship that must exist between persons who are partners. Hence, I must conclude that with respect to such matters, the partnership law of California is similar to that of the Canadian provinces.

69 Therefore, as in Canada, a partnership in California is a “relationship that subsists between persons carrying on a business in common with a view to profit”.

70 When HCP was originally formed by BDI and Peninsula there was no doubt that their relationship was to carry on business in common with a view to profit. And they did so until November 30, 1987. It is admitted by the appellants that when they entered into the transactions on November 30, 1987 they did so with a view to obtaining a loss to be applied against their income for Canadian income tax purposes. The relationship between the various appellants was not to carry on a business in common with a view to profit. Indeed, the evidence of Mr. Gouveia and Mr. Torbiak, as well as the evidence of John Dobrei and Edward Butcher in discovery, was that the Tremont Apartments was retained by the appellants on the advice of the auditors of Spire Freezers Limited so that the purported partnership would continue to have an income producing asset and thus confirm the continuity of the HCP partnership. I do not accept appellants' counsel's submission that the appellants expected to carry on a business, the ownership of the Tremont Apartments, in partnership with a view to profit. The appellants got together to obtain a tax loss; this was the single overriding motivation to their relationship.

71 The Minister had assessed the taxpayer in Continental Bank, supra, on the basis among others, that no partnership had been created. In the reasons for judgment of the Federal Court of Appeal in Continental Bank, Linden J.A. considered, among other things, the definition of a “partnership” at 6359-64:

Tax planning and the careful organization of one's business affairs must be more than an intellectual game. Schemes may be designed with great imagination, but in the end they must be real. The Income Tax Act must be complied with. A business form that is used cannot be fanciful. Hence, if a partnership is chosen for a particular business purpose, the parties must, in law, create a real partnership.... In every instance, a Court will look to the “true commercial and practical nature of a taxpayer's transactions”.[FN11: <p><em>The Queen v. Bronfman Trust</em>[87 DTC 5059].),[1987] 71 S.C.R. 32 at 52, per Dickson, C.J.</p>] Where legal reality is found to be lacking, a transaction, even though it may not be a sham, may not achieve what parties may have earnestly desired. The present case is an example of this.

The proper question [to ask] ... is ... not whether [the parties] could deny they were partners. It is, rather, whether they met the legal requirements to form a partnership. This question can be answered only by the Court, not by third parties.

Partnership is a contractual relation.[FN12: <p><em>Pooley v. Driver</em>(1876), 5 Ch. D. 458at 472, per Jessel M.R.;<em>Davis v. Davis</em>, [1894] 1 Ch. 393;<em>Collins v. Baker</em>, [1893] 1 Ch. 578.</p>] It is, in essence, an agreement between two or more persons to run a business together in order to make profit. No person can become a partner unless that person intended, or by their conduct can be seen to have intended, to do so. This is what was meant by Duff, J. when, in Robert Porter & Sons Ltd. v. J.H. Armstrong and Another, et al.[FN13: <p><em>Robert Porter &amp; Sons Ltd. v. J.H. Armstrong and Another, et al.</em>, [1926] S.C.R. 328.</p>] , he stated:

Partnership arises from contract, evidenced either by express declaration or by conduct signifying the same.[FN14: <p><em>Ibid.</em>, at 329.</p>]

The existence of partnership is therefore in every case determined by what the parties actually intended. As stated in Lindley and Banks on Partnership:

[I]n determining the existence of a partnership ... regard must be paid to the true contract and intention of the parties as appearing from the whole facts of the case.[FN15: <p>Banks,<em>Lindley and Banks on Partnership</em>, 16th ed. (1990), at 60.</p>]

As I have stated, form must give way in this analysis to substance. Parties can insist that they are not partners, and can still be found by a Court to be partners, based on an evaluation of all the evidence. This was the issue before this Court in Schultz v. Q[FN16: <p><em>Schultz v. Q.</em>, (1995) 95 DTC 5657 (F.C.A.), per Stone, J.A.</p>] , where Stone, J.A. stated:

It is trite to say that the express denial of a partnership, as in this case, does not of itself show that no partnership existed ... In the present case we can find no declaration to the effect that the appellants intended to carry on business as partners. However an intention to do so may be inferred from all of the surrounding circumstances and especially from the manner in which the parties conducted themselves in arranging their affairs and in transacting the business in question.[FN17: <p><em>Ibid.</em>, at 5663.</p>]

The converse is also true; parties can insist that they are partners and can be held not to be[FN18: <p><em>Pooley v, Driver</em>(1876), 5 Ch. D. 460;<em>Stekel v. Ellice</em>, [1973] 1 W.L.R. 191.</p>] . The substance of the relationship is the key. Form, though certainly important, is not enough. Nor is it conclusive that “the parties have used a term or language intended to indicate that the transaction is not that which in law it is.”[FN19: <p><em>Weiner v. Harris</em>, [1910] 1 K.B. 285 at 290, per Cozens-Hardy, M.R.</p>] In my view, in this case, language and form was used to make it look like the transaction “was not that which in law it is.”

What this case teaches us is that where the law requires that a person intend something, this intention must be demonstrated on the facts, or a Court will simply conclude it did not exist. Hence, if a person's sole intention in transferring a business operation into a corporate or partnership structure is to gain a tax consequence from that transfer, and that upon the happening of this tax consequence the facilitating structure is discarded or the person is removed from it, that person had in fact no intention to run the business within that structure. It follows that any intention to earn income from such business from within the structure, to adopt the Trial Judge's characterization from Hickman, can only be described as “notional.” This was put as follows in Lindley and Banks on Partnership:

Where a partnership was formed with some predominant motive other than the acquisition of profit, e.g. tax avoidance, but there is also a real, albeit ancillary, profit element, it may still be permissible to infer that the business is being carried on “with a view to profit.” However, it is apprehended that if any “partner” entered the partnership solely with a view to being credited with a tax loss (or, formerly, a capital allowance), and it was contemplated from the outset that, whilst he remained a member of the firm, no profits (in the sense of net gains) would be derived from carrying on its business, he could not be said to have the requisite “view of profit” to qualify as a partner.

In the case before me, fiscal and other elements dominated the parties intentions and compel the conclusion that they did not intend to create a genuine partnership. The parties may have created certain contractual and other obligations of a legally binding nature, but these were not sufficient to create a partnership.

To conclude, the arrangement before me is not a sham, but it did not meet the requirements of the partnership definition....

72 In the appeals at bar as well, none of the appellants intended anything other than to obtain a tax loss. The retention of the Tremont Apartments was an afterthought the appellants were advised was necessary. The quantum of the initial loss anticipated by the appellants compared with any anticipated, or real, profits from the Tremont Apartments cannot, in my view, lead to the conclusion that the relationship subsisting between the appellants was to carry on a business in common with a view to profit or with a reasonable expectation of profit.[FN20: <p><em>Walls, supra.</em></p>] Any profits from the Tremont Apartments compared to the initial loss requires an exaggerated imagination to conclude that the transactions were undertaken with a view to profit. Again, the relationship subsisting between the appellants was not that of carrying on a business in common with a view to profit; they did not associate themselves to carry on a business for profit.

73 I find the Canadians were not partners with respect to the ownership of the HCP condominium complex and the Tremont Apartments. In his opinion Professor Buxbaum noted the advice of counsel for the appellants to him that the appellants intended to become partners of HCP, and this may in fact be so. But nowhere in his opinion does Professor Buxbaum consider whether the relationship existing between the appellants was to carry on business with a view to profit. The Federal Court of Appeal has held that, in Canada, carrying on business with a view to profit is an important element in determining whether a person qualifies as a partner of a partnership. Absent this element, there is no partnership for the purposes of the Act.

74 The appellants' position was that they acquired an interest in an existing partnership and, based on the opinion of Professor Buxbaum, the partnership continued to exist with the Canadians as partners. However, as I have previously stated, there did not subsist between the Canadians a relationship of carrying on a business with a view to profit, the very essence of partnership. This relationship must exist between persons whether they create a new partnership or whether they are admitted to an existing partnership. The fact that BDI and Peninsula were partners in HCP does not assist the appellants. Words, I stated in Backman, must mean something. The legislature defines words in a statute to give a particular meaning to that word for the purpose of that statute. The definition of a word in a statute, whether of Ontario or California, means something and that “something” is what the legislator intends it to mean, and that plain meaning cannot be ignored.[FN21: <p>Any interpretation of legislation ultimately adopted by a judge must beplausible and must be one that the text of the legislation is reasonably capableof bearing. A judge should not depart from the ordinary meaning. Ruth Sullivan,ed.,<em>Dreidger on the Construction of Statutes</em>, 3d ed., Toronto and Vancouver: Butterworths; pp. 101-104, pp. 110-113. See also pp. 114-122.</p>] Thus if a partnership is defined as a certain relationship between people the Court must inquire if, in a given situation, that relationship exists. And in the appeals at bar, it does not appear to do so.

75 The appeals are dismissed with costs.