Date: 20020221
Docket: 97-3264-IT-G
BETWEEN:
PETER M. BROWN,
Appellant,
and
HER MAJESTY THE QUEEN,
Respondent.
Directions and Reasons for
Directions
Rip, J.
[1] In the reasons for judgment in the
appeals of Peter M. Brown from income tax assessments for 1993,
1994, 1995 and 1996, dated November 15, 2001, I concluded
that the appeals would be allowed and referred the assessments
back to the Minister of National Revenue ("Minister"),
if necessary, for reconsideration and reassessment in accordance
with the reasons. I instructed counsel for the respondent to
prepare a draft judgment to implement my decision, which was to
be approved as to form by counsel for the appellant. I stated
that if counsel required directions as to settle the term of the
judgment, a conference call would be arranged. I also invited
submissions as to costs, once the judgment had been approved.
[2] Subparagraph (d) of a paragraph
(not numbered) entitled Conclusion in the reasons for judgment
states:
d) The
Partnership and ASC did not deal at arm's length. The price
the Partnership purported to pay for the computer programs was
greater than the fair market value of the computer programs. I am
not fixing a value. Having regard to my other findings, in
particular, that the appellant's at-risk amount is nil, it
may not be necessary to determine the fair market value of the
engines as of December 31, 1993. In any event, if a valuation is
necessary to determine fair market value of the engines as of
December 31, 1993 for the purposes of making reassessments, these
reasons are to serve as the basis of such valuation.
[3] Counsel have informed me that they
require directions. They also advise that it is necessary to
determine the fair market value of the engines as of December 31,
1993. The aggregate market value of the engines was to be
determined based on my Valuation Analysis at paragraphs 108 to
143, inclusive, of the reasons for judgment.
[4] Conference calls between counsel
for both parties and me were held on December 6 and 18, 2001 and
January 18, 2002.[1]
[5] During the first conference call
counsel and I discussed the general principles of the reasons to
guide Mr. Rosen in calculating the value of the Partnership
interest in the engines. Since the respondent's counsel was
to prepare the draft judgment, the respondent's valuator was
to calculate the value of the engines; his calculations would be
subject to review by the appellant. Mr. Rosen, counsel advised,
wished clarification of two points, the period of time over which
the games would have been sold and the cost of the
"extra" three games referred to in paragraph 141
of the reasons. (This is set out in Mr. Rosen's letter of
December 14, 2001.)
[6] Mr. Rosen participated in the
conference call of December 18, 2001 and subsequently calculated
the value of the Partnership's interest in the engines to be
$4,128,000.[2]
Respondent's counsel informed appellant's counsel of the
calculation and forwarded to the appellant's counsel
Mr. Rosen's "revised" schedules 1, 2, 3 and 5
of the Wise Blackman valuation report ("Wise Blackman
report"), namely revised (1) Valuation Summary, (2) Present
Value of Net Cash Flow as at December 31, 1993, (3) Discretionary
Cash Flow for three-month periods ending on June 30, September 30
and December 31 of 1994, 1995 and 1996 and March 31 of 1995 and
1996, and (5) Projected Statement of Income for the same periods
as in revised Schedule 3. By letter dated January 11, 2002
appellant's counsel advised respondent's counsel of
possible errors or omissions in Mr. Rosen's calculations.
These items were discussed during the conference call of
January 18, 2002.
[7] At the end of the conference call
of January 18, only two items were not settled.[3] One item was whether, in his
evidence, Mr. Wilkinson expressed the costs of derivatives and
sequels in Canadian or United States currency. Mr. Rosen assumed
the costs were in American funds. If the costs were in Canadian
funds, he would have to revise his calculations to increase the
valuation of the Partnership's interest in the engines to
$4,146,000.[4]
Counsel were to get in touch with Mr. Wilkinson to confirm the
currency but have so far been unsuccessful. If counsel cannot
contact Mr. Wilkinson by March 14, 2002, I must assume that the
currency is in Canadian funds and the Partnership's interest
in the property be valued at $4,146,000. The evidence was heard
here and there is no reason for me not to infer that the currency
stated at trial is local currency.
[8] The second item related to
figures underlying the calculation of the present value of the
tax shield. Appellant's counsel did not have the actual
calculations. Respondent's counsel agreed to forward the
appropriate software containing the calculations to the
appellant's counsel.
[9] Finally, on January 29, 2002, both
counsel sent letters to the Registrar of the Court with respect
to the calculation of the tax shield component of the engines
acquired by the Partnership. Respondent's counsel also wrote
on February 1, 2002 in response to the appellant counsel's
letter of three days earlier. Appellant's counsel took issue
with two assumptions inherent in Mr. Rosen's calculation of
the value of the tax shield: that he erred in assuming that the
tax shield cash flows ought to be discounted at the same rate as
that applied to the software business cash flow, and he erred in
assuming the tax shelter would be realized at two points in time,
the first half one year after the valuation date, and the second
half, two years after the valuation date.
[10] Counsel for the appellant challenged
how Mr. Rosen valued the asset. He writes that Mr. Rosen valued
"the asset in a 'vacuum', to a notional corporate
purchaser with no other source of income against which to apply
the CCA [capital cost allowance] deductions. As a result, the CCA
shelters only the income produced by the business in which the
software is employed, not other sources of income". Mr.
Michelin, the appellant's valuator, had advised counsel to
take the view "that the class of purchasers who would be
interested in an investment of this nature (namely,
high-income individuals) is sufficiently broad that it
comprises the actual market and that the asset ought to be valued
with this group in mind". The value of the tax shield should
consider high-income taxpayers, the target market of the
investment product.
[11] Therefore, in the view of the
appellant, the discount rate applied to the tax shield component
ought to be the risk-free rate of return, not the same rate as
applied to software business cash flows. The reason for this is
that the benefit to be derived from reducing the taxes payable by
Mr. Brown is virtually certain, whereas the value of the
software business cash flow is much less certain, according to
the appellant's counsel. In other words, counsel suggests
that even if the software does not generate any revenues, the
Partners would still have realized the tax shield by deducting
CCA against their other income. This approach assumes a purchaser
has income from other sources against which to apply CCA. This is
contrary to the position taken by Mr. Wise in his testimony. In
describing the discounted cash flow method, he testified:
. . . we are talking about property or an asset. A product is
an asset. Take any asset. What will that asset, by being
commercially exploited, not a business, just that asset, what
will that generate by way of revenues and cash flows if commonly
exploited?[5]
I am only interested in the value of the engines, without
regard to any potential purchaser's tax situation.
[12] Mr. Rosen discounted the tax shield
cash flows by one and two years, respectively, according to the
appellant. The discounting of the tax savings, appellant's
counsel states, ought to be tied to the time at which Mr. Brown
would have realized the savings: he would realize the benefit of
the first half of the tax shelter when he filed his 1994 tax
return on April 30, 1994 and claimed CCA on one-half of the
value of the software. Thus, the first half of the tax shelter
benefit ought to be discounted by only four months, not one year
as proposed by Mr. Rosen. As far as the second half of the tax
shield is concerned, the benefit to Mr. Brown would be realized
in four equal instalments over the course of 1994, when he makes
his quarterly instalment payments, realizing he could reduce 1994
taxes by deducting the other half of CCA. This, of course,
assumes all potential purchasers are individuals, not
corporations. Mr. Rosen's analysis assumes the value of the
second half of the tax shield would not be realized until
December 31, 1995, two years after the valuation date.
[13] I have some difficulty in considering
the appellant's representations. First, he appears to be
offering new evidence. The fact that new evidence - as
opposed to new argument - is being submitted at this late
date is enough for me to disregard it. However, the evidence I am
being asked to consider also refutes much of what is contained in
the Wise Blackman report as well as the testimony of Mr. Michelin
at trial.
[14] For example, to consider the personal
tax situation of the appellant and the other Partners, in valuing
the engines, assumes they are special purchasers. But I had been
advised earlier that this was not so. In cross-examination
Mr. Michelin stated that:
It's always this notional fair market value I'm not
talking about the sale to a partnership. My value is fair market
value. It's a notional concept. So it's any potential
purchaser or investor, be it an individual or be it a corporate
investor.[6]
[15] Mr. Michelin declared there was no
"special purchaser" of the engines.[7] He referred to page 7 of the
Wise Blackman report where the author writes that the fair market
value of the video games relates to the "intrinsic
value" thereof, "which we define as a notional value
that would prevail based upon rules of return required by
potential purchasers . . . without consideration of possible
synergistic benefits and/or strategic advantages, which might
enure in differing degrees to arm's length
purchasers".
[16] The Wise Blackman report did not
include the recognition of a special purchase premium for the
engines. Indeed, management of American Softworks Corporation
("ASC") informed Messrs Wise and Blackman that there
were no identifiable special purchasers in the marketplace for
the engines either on or after December 31, 1993.
[17] As far as the tax shield discount rate
is concerned, Mr. Michelin, in his testimony, stated he used a 20
per cent discount rate. Respondent's counsel alleges that,
based on Mr. Michelin's calculations in Exhibit R-14, he used
a discount rate of 29 per cent and 33 per cent when valuing the
engines, and Mr. Rosen used 31 per cent, mid way between 29
per cent and 33 per cent in the revised calculations. In the
appellant counsel's letter of January 29, 2002, counsel
advises that Mr. Michelin now suggests a tax shield discount rate
of 7.28 per cent.
[18] The tax aspects of the transaction to
any individual taxpayer should not influence the value of the
engines; the taxes payable by any one purchaser is not intrinsic
to the asset itself. In their original valuations, both Mr. Rosen
and Mr. Michelin used corporate tax rates to value the engines as
business assets. Payment of tax in quarterly instalments, as
required by individuals, should not influence the timing of the
tax shield benefit. Let us not forget that the value of the
engines must be the same to all potential purchasers as well as
to the vendor.
[19] In my view, to consider the tax
implications to different potential purchasers in valuing the
engines would distort value. One must, as Mr. Michelin and
Mr. Rosen agreed in their reports, fix a notional value to the
engines, not a value that depends on who the buyer is. I am
certain that if there were a special purchaser, or if the tax
advantages to the various investors were relevant in determining
value, as suggested by the appellant's counsel in
correspondence, that would have been addressed in the original
Wise Blackman report.
[20] Given my finding that the appellant
carried on a business with a reasonable expectation of
profit, respondent's counsel agreed the appellant is entitled
to deduct his share of interest paid on the Acquisition Note.[8] The parties agree
that interest paid by the appellant from revenue allocated to the
Partnership was as follows:
1993 - nil
1994 - $45,727
1995 - $39,931[9]
[21] The parties do not agree as to the
treatment of net income reported by the Partnership in 1995. The
appellant reported business income of $38,606 and claimed
interest expense of $42,255 in his 1995 income tax return. The
Minister reassessed 1995 to delete both the business income and
the interest expense.
[22] Normally, the income of a taxpayer from
a business carried on with a reasonable expectation of profit is
included in the taxpayer's income for the year. Also, any
expenses incurred in the business or for interest on money
borrowed to acquire an interest in the business is deductible in
computing the taxpayer's income.
[23] Appellant's counsel writes[10] that since the
Minister "voluntarily deleted" the appellant's
share of income from the Partnership in reassessing him for 1995,
the income ought not be included in any subsequent reassessment
made pursuant to a judgment of this Court. In his pleadings, the
appellant did not suggest that the income be restored. The
addition of the income from the Partnership to Mr. Brown's
income for 1995 would be tantamount to the Minister appealing his
own assessment, which he cannot appeal.
[24] Counsel for the appellant also argues
that the Minister and I are bound by the assessments appealed
from, unless they are validly changed. A court cannot reassess on
its own initiative by adding amounts into income that were not
subject of the assessments. The income from the Partnership was
not an amount (or issue) appealed from, counsel declares, it was
not pleaded by the parties and it is not before the Court. Thus,
he submits, I am without jurisdiction to deal with the issue.[11]
[25] Respondent's counsel argued that
the appellant raised the issue of whether or not he carried on a
business in 1993 and subsequent years and evidence was led on
this point. The respondent's pleadings also raised the issue
as the primary basis for upholding the Minister's
reassessments, including the deletion of reported business income
and interest expense in 1995. My colleague Judge Bowie discussed
the purpose of pleadings in Zelinski v. The Queen:[12]
The purpose of pleadings is to define the issues in dispute
between the parties for the purposes of production, discovery and
trial. What is required of a party pleading is to set forth a
concise statement of the material facts upon which she relies.
Material facts are those facts which, if established at the
trial, will tend to show that the party pleading is entitled to
the relief sought. Amendments to pleadings should generally be
permitted, so long as that can be done without causing prejudice
to the opposing party that cannot be compensated by an award of
costs or other terms, as the purpose of the Rules is to ensure,
so far as possible, a fair trial of the real issues in dispute
between the parties.
[26] The pleadings of both parties in these
appeals raised the issue among others, whether the taxpayer
carried on a business in partnership with a reasonable
expectation of profit during the years in appeal. The taxpayer
was successful on this issue. When a litigant raises an issue,
the litigant must realize the consequences if he or she is
successful (or not successful). When a business is held to have
been carried on, then all the consequences of the decision must
flow logically. Income from the business is to be included and
appropriate deductions in computing income allowed. In assessing
as he did for the years in appeal, and in particular, for 1995,
the Minister assessed all years in appeal on a consistent basis:
there was no business. Once the issue is decided, the normal
consequences must follow in a subsequent reassessment. However,
the amount of any reassessment for 1995 arising from the appeal
for 1995 cannot, of course, exceed the amount of the reassessment
for 1995 that is under appeal.
[27] The decision of the Supreme Court in
Continental Bank[13] does not affect the position of the Minister on
the facts of the 1995 appeal. The basis of any subsequent
assessment for 1995 by the Minister resulting from the appeal
from the 1995 reassessment is the same: whether the taxpayer
carried on a business (in partnership) with a reasonable
expectation of profit. The inclusion of income by a subsequent
reassessment for 1995 will be the result of the appellant's
success on the issue of whether a business was carried on.
[28] Mr. Brown's share of the income
from the Partnership will be included in his income for 1995. He
will also have the right to deduct the interest in computing his
net income for 1995. Respondent's counsel has advised me that
there will be a reduction in his income for 1995 from that
previously reassessed.
[29] A draft judgment shall be prepared and
approved without further delay.
[30] The parties are still to speak on the
matter of costs.
Signed at Ottawa, Canada, this 21st day of February 2002.
J.T.C.C.
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