Citation: 2006TCC230
Date: 20060413
Docket: 2002-4035(IT)G
BETWEEN:
R. DAREN BAXTER,
Appellant,
and
HER MAJESTY THE QUEEN,
Respondent.
REASONS FOR JUDGMENT
Bell, J.
ISSUES
[1] The issues are:
1. Whether the Appellant was, in the taxation years in question, carrying on the business of using the license acquired from TCL TRAFALGAR B.V. ("TCL") to trade futures contracts with TRAFALGAR TRADING LIMITED ("TT") and, alternatively, whether the Appellant acquired the license for the purpose of earning income from property.
2. Whether the Appellant, in acquiring that license, was dealing at arm's length with TCL.
3. Whether the Appellant acquired a "tax shelter" as defined in section 237.1 of the Income Tax Act ("Act").[1]
4. What was the fair market value of the license when acquired?
5. Whether the Appellant's entitlement to capital cost allowance is limited by the provisions of section 67 of the Act.
6. Whether the promissory note represented a contingent liability.
FACTS
[2] The Appellant testified that he was a lawyer practicing business and tax law and that, in April, 2004, he was appointed as Vice Chairman of the Nova Scotia Securities Commission. He also said that he was recently elected as a member of the Bar Council.
[3] He said that this case arose as a result of a capital cost allowance claim made by him in respect of the purchase of a license to use software.[2] He stated that it analyzes historical trends of trading and predicts future trends and issues orders for suggestions for purchase and sales. He testified that he purchased the ten year license from TCL for the sum of $50,000.[3] Subsequent evidence established that he made a down payment of $4,375 and provided three post-dated cheques for $4,375 each, such cheques being cashed over the following nine months. He then, on December 31, 1998 made and delivered to TCL a promissory note for $32,500 due on December 31, 2008, and bearing interest payable monthly, at the rate of 5 per cent per annum. The note is not subject to the terms of the Agency Agreement, and none of the terms of the note contemplate that a licensee would enter into an agency agreement. Further, section 11.4 of the License Agreement provides that it constitutes the entire agreement between the parties pertaining to the purchase and sale of a license.
[4] The Appellant said that he entered into an Agency Agreement with TT under which he provided the software, that the agent contributed $10,000 capital and that the agent was responsible to use the license to initiate trades. The Appellant, as a licensee under the License Agreement, had the option of entering into an agency agreement with TT. He understood that that was an option provided to licensees under a License Agreement and that the licensees were not under any obligation to enter into an Agency Agreement. No evidence was provided to support the position that licensees were under such an obligation. The Respondent's own witness, Allan Peters ("Peters")[4], stated that it was his understanding that licensees were not required to enter into an Agency Agreement.
The Agency Agreement includes the following provisions:
(a) TT is the exclusive agent of the Appellant to engage in trading of S & P 500 Contracts using the license;
(b) the term of the Agency Agreement is ten years;
(c) the Appellant provides a copy of the Software to TT;
(d) TT provides $10,000 of initial trading capital;
(e) a trading report fee of US$0.50 is paid to the trading capital account for each trading report generated by the Software, up to a maximum of US$7,500 per year (the "Trading Report Fee");
(f) an agency fee of US$0.25 is paid to TT for each trading report generated by the Software, up to a maximum of US$3,750 per year (the "Agency Fee");
(g) Trading profits net of brokerage fees, Trading Report Fees, and Agency Fees (the "Net Trading Profits") are allocated on a monthly basis between the trading capital and TT on the following basis:
(i) until such time as the balance of the trading capital account is equal to the Principal Amount, 70% of the Net Trading Profits are contributed to the trading capital account, and 30% are paid to TT;
(ii) once the balance of the trading capital account is greater than the Principal Amount, 30% of the Net Trading Profits are contributed to the trading capital account, and 70% are paid to TT; and
(iii) notwithstanding (i) and (ii) above, to the extent that the balance of the trading capital account is less that the previous highest balance of such account at the end of a month, 100%of the Net Trading Profits are contributed to the trading capital account.
(h) TT agrees to pay to TCL from the trading capital account an amount equal to the accrued but unpaid interest on the Note on behalf of the Appellant;
(i) upon the expiration of the Agency Agreement, the trading capital will be allocated as follows:
(i) the $10,000 of initial trading capital is returned to TT; and
(ii) the balance is paid to the Licensee;
(j) TT covenants that the Average Annual Return (as defined in section 1.1 of the Agency Agreement to mean "the average of the annual Gross Trading profits achieved from the date of the execution of [the Agency Agreement] net of Brokerage Fees, expressed as a percentage of the License Fee") will be no less than eight per cent; and
(k) TCL agrees that the Principal Amount shall be reduced pro rata to the extent that TT breaches the covenant described above (the "Revenue Guarantee").
Accrued interest on the note has in fact been paid to TCL from the trading capital account on behalf of the Appellant.
[5] The Appellant said that he first heard about the software license potential from a client sometime in December, 1998. That client, Burton Langille ("Langille"), forwarded material to the Appellant after he had received a telephone call from the Appellant respecting same. The Appellant said that he had a long history of discussing business opportunities with Langille and that he had a lot of faith in him. He said he had received from Langille a summary of the performance of the license for a particular month.
A copy of that document, introduced in evidence contained the following description:
The following Table shows the day to day performance of a $10,000 License in Walk-Forward trading. "Walk-Forward trading" is the period from when simulation ended (May 1998) and real-time trading which will begin in November 1998. The daily returns of the S & P 500 and the TSE 300 have been included for comparison purposes. The Graph shows the cumulative return for the month.
The Appellant said:
I thought this was a rather interesting opportunity. ... I liked the concept that it would be - - this program removed ... human emotion and it was based upon statistical analysis. I also liked the concept that what the program did was it started the day in cash and it would work so that there were trades conducted throughout the day but at the end of the day, end in cash, so that was very interesting to me. And, of course, looking at the potential return looked very good, which is outlined under the heading "Potential Return" in the materials behind Tab 1.
He said that Langille had seen simulated trading results for about a year or so before actual performance and that he was very impressed with the consistency of returns. He also said that he relied upon Langille because he trusted him very much and that he, the Appellant, being a lawyer, did not know much about investing and found the demands of his law practice, serving his clients and maintaining and administering the office, quite demanding. He described Langille as "quite a capable individual" who spent a lot of time analyzing the market and trading.
[6] The Appellant stated that he had not seen the valuation of the software prepared by emc partners or the opinion of American Appraisal Canada, Inc. prior to purchasing the license. He said, however, that Langille had informed him that there were two appraisals that "more than supported the asking price of the software". He said that he had spoken to his business partner about this investment and had asked some colleagues "around town" whether they had known of the Trafalgar Group and whether it was a real company and whether it was reputable. He stated that that was confirmed to him by a number of those persons. He testified that he did not understand the workings of the software and that what he was interested in was the results and what the software could do, namely being able to predict market trends. He said that he knew he was buying software and that it was a Class 12 asset[5] and that he could claim capital cost allowance over a two year period. He also said that affected his decision.
[7] The Appellant testified that neither he nor anyone related to him had any relationship with TCL and that his purchase of the software license was "purely a commercial relationship". He said that at the time of purchase he did not know who Ed Furtak ("Furtak") was.[6] He said that he had never met Furtak until May 30[7] when he had lunch with him. He stated that he had never served Furtak in a professional capacity, that he had no friends or social acquaintances "at Trafalgar" and had never spoken to Wayne Gillis ("Gillis")[8] before making his investment and had never met or spoken to Allan Peters ("Peters").[9]
[8] The Appellant said that there were no negotiations respecting the purchase price of $50,000. He made the following statement:
The offer to acquire the license was presented to me at a fixed price. I suppose I had an option as to what - - how many licences I wanted to purchase but the price was fixed. It was a take-it-or-leave-it offer as I had understood it based upon the documentation.
[9] Respecting what happened after purchasing the license the Appellant said:
Under the arrangement with the contracts, once the contracts were accepted and I submitted - - you know, submitted the appropriate documentation and my cheques, trading would begin within about 30 days. This was in the arrangement with the Agency Agreement and the agent being Trafalgar Trading Limited, and Trafalgar Trading Limited then, I understand, had set up a bank account, contributed a total of ten thousand dollars into the bank account in accordance with the Agency Agreement and engaged a broker who is referenced in the Agency Agreement. And in addition to that, TCL Trafalgar B.V., the licensor of the software, in accordance with my instructions, forwarded the software directly to Trafalgar Trading. Trafalgar Trading then used that software to initiate the trades to - - to initiate trade instructions.
He then said that he understood that TT had received the software and began trading in "probably February of 1999". He said that he received a report, generally, on a monthly basis on the previous month's trading. He stated the minimum amount of license available to purchase was $50,000 and that is what he purchased. He then described the payment of brokerage fees and the net trading profit or loss and referred to the various formulas in the Agency Agreement. He said that the license was for a ten year period and that the agency arrangement was for a corresponding period. He stated that at the end of ten years the capital balance would be determined, the amount contributed by TT would be repaid and the balance would be his. He then read section 8.3 of the Agency Agreement. It stated:
Trafalgar Trading covenants that on expiration of the term of this agreement the average annual return generated by the Trafalgar Index Program with the trading capital shall be no less than eight per cent (8.0%).
He said he viewed the 8% of $50,000 as being guaranteed. He then read section 8.4 of the agreement as follows:
TCL Trafalgar hereby agrees that, notwithstanding the provisions of the License Agreement and the promissory note, the licensee's obligation to fulfil the terms of the promissory note and of section 3.1(e) of the License Agreement, it shall be limited, pro rata, to the extent that Trafalgar Trading fulfils the terms of Section 8.3 of this agreement.
The Appellant also said he understood that to mean that TT would generate the 8% profit and was so confident of that that, if it did not do so, the Appellant's obligation to fulfil the terms of the promissory note "would be alleviated pro rata" in accordance with what the performance might have been.
[10] On cross-examination, the Appellant said that he did not know whether Langille had had any experience in the trading of futures contracts on the Chicago Mercantile Exchange and that he had personally had no experience whatsoever with that, never having traded futures before.
He said, in response to a question, namely:
Do you know what a CTA is?
that he did not.
Respondent's counsel told him that CTA meant commodities trading advisor. The Appellant said that he did not "run" the proposal through a CTA. He stated that he deducted $2,500 in 1998 and the remainder of $47,500 in 1999. He said that he had not consulted with anyone knowledgeable in the futures industry about fees. He said that Langille had told him that:
the history of the simulated trading supported ... that the numbers were consistently phenomenal, to use his term.
He stated again, in cross-examination, that in accordance with the Agency Agreement, TT contributed $10,000 to a trading account and that was the starting point of the amount that has been traded. In answer to Respondent's counsel's questions, he said he did not attempt to negotiate the due date, being December 31, 2008 and did not attempt to negotiate the principal sum of $32,500. The following exchange took place:
Q. So, you didn't attempt in any way to negotiate that?
A. No. I saw it as a take-it-or-leave-it arrangement.
Respondent's counsel followed this with questions as to whether the Appellant would negotiate the price of a car or a mortgage. Counsel continued that line of questioning by asking the Appellant whether he tried to negotiate the interest rate on the note, the answer being in the negative.
[11] The Appellant stated again that TT was his agent, engaging a broker to follow the instructions provided by the software. He also said that his agent set up an account for trading and further that he did not disclose his name to the Chicago Mercantile Exchange but did not know whether his agent had done so.
[12] When asked if he was operating a business the Appellant replied in the affirmative. The following took place:
Q. And what is the business? Could you describe it for me?
A. Well, the business really is set out in the Agency Agreement. I own this software license and I've contributed through my arrangement with the agent to trade at my behalf. The agent has contributed the capital, and so that capital is going to be - - my agent's capital is going to be traded over a 10 year period. At the end of the 10 years we'll determine how much profit was generated through the contribution of my agent's capital and my license and then we divide that profit accordingly. And usually the agent gets paid all along, but at the end of the 10 years that's when I determine what exactly my profit is.
Q. Okay. Are you saying that you're still in this business, then?
A. Yes, I am.
Q. Okay. And you'll agree with me as being on the Nova Scotia Securities Commission as part of your ongoing duty to disclose that you've described this business to the Nova Scotia Securities Commission as such?
A. I don't know if I described the business because I'm not initiating trades. The conflict of interest rules are based upon information that I may have or be perceived to have as a member of the Securities Commission. If I can use that to my personal advantage to, you know, initiate directly, you know, orders to buy and sell, that could present a perceived conflict of interest and that should be overseen. In this particular case I have no idea of the usual securities that are being purchased and sold. That's being done by a third party. ... I'm not initiating any trades so I'm not advising on or initiating and I have nothing to report.
[13] The Appellant then testified that he had inquired of Langille as to whether a tax shelter identification number had been obtained and was advised that it had not been so obtained. He said, in response to counsel's query, that he saw no tax shelter risk. He then testified that he had seen various legal opinions from the Fraser Milner law firm, having seen same in December 1988.
[14] A long series of questions by Respondent's counsel followed. They dealt with performance of the investment after the acquisition of the software license. The Appellant then clarified that he had paid $17,500 down for the license, partially in post-dated cheques which were cashed, the payment being to TCL and that TT put $10,000 dollars into the capital account that traded on his behalf.
[15] Appellant's counsel then entered as exhibits a number of "read-ins" from examination for discovery of the Respondent's nominee, Douglas Bruce ("Bruce").
He referred to the essential evidence including the admission by the auditor that in reassessing Baxter, the Canada Customs and Revenue Agency ("Revenue") did not assume that the Appellant had received any statements or representations and that he had no facts, information or knowledge to the effect that there were representations. Appellant's counsel advised the Court that the Attorney General, following that admission, amended the Reply to remove the allegation that there had been representations to the Appellant.
[16] Appellant's counsel then said:
They had that in their initial pleading and then they deleted it in their Amended Reply, and we are now, of course, agreed that there were no statements or representations made to Mr. Baxter, and that's the import of the tax shelter evidence.
[17] Appellant's counsel said that the Attorney General had alleged that the assessor had assumed there were no bona fide arrangements to repay the promissory note. When counsel suggested to the nominee that he did not really assume that, the nominee's response was:
I can't disagree with you.
Counsel then said that the result of this was the Attorney General amending his pleading to remove that allegation.
[18] Counsel asked Bruce at the examination for discovery:
Have you, in the course of preparing for this examination for discovery, found anything in the Reply that you take issue with in any way, that you think is inaccurate, incomplete?
Bruce responded:
In terms of the Reply, the only thing I could suggest that I had some difficulty with or I have some difficulty with is the suggestion of non-arm's length.
When Bruce referred to the Reply stating that the parties involved in the investment were not dealing at arm's length, Appellant's counsel asked what his difficulty was with that and he responded:
I can't really say that I, at the time of assessment, that I was thinking in those terms.
When the question was put to Bruce on discovery:
So you're telling me that when the assessment was raised that the assumption was not, in fact, made.
the answer was:
Not - - no - - yes, I think I could - - that's what I'm saying, yes.
Appellant's counsel then said that the Attorney General deleted that allegation and pleaded it separately in the Amended Reply to the Notice of Appeal thereby assuming the onus of proof.
[19] With respect to whether the promissory note was a contingent liability, Appellant's counsel, still referring to the read-ins, said:
Basically he says - - basically what I was trying to say to him was:
What facts did you have to get to the conclusion that this was a contingent liability?
Appellant's counsel stated that his essential answer was:
All I did -- all it was was an exercise of interpreting the documents.
Counsel then said that the reason that he put that in is because if there was any suggestion by the Respondent that the facts support contingent liability he, Counsel, would ask what those facts were. He then said:
The auditor didn't find any facts, so the Attorney General will have to prove any facts that he considers necessary to that allegation, although, at the end of the day ... I don't think the Crown and I are going to have much of a dispute that really the contingent liability issue turns upon reading the contracts.
[20] Appellant's counsel then turned to the portion of the read-ins dealing with the argument of reasonableness. He said:
The import of the evidence ... is about what the - - this is another one of those allegations where the Attorney General asserted in the original Reply that when the Minister raised the assessment he concluded that the fair market value of the license was nominal. This evidence Mr. Bruce establishes that ain't so, and that is what led to the Attorney General again deleting that as an assumption, pleading it separately and saying "Okay, the auditor didn't assume that but we're alleging it and we are going to prove it." So this is another one of the assumptions that was deleted.
[21] With respect to another portion of the read-ins Appellant's counsel said:
The point I was making is that the Attorney General said that the auditor assumed that all of these transactions involved a down payment and a promissory note and the auditor admits in the following passages that that's not so, that he was aware that there were other transactions involving this license which were done fully with cash with no note. And so I said to him, "Why was the word 'apparently' used?" He said "I don't know". And then I said "And you're aware there were cash sales done without notes", and he said "Yes."
I then asked counsel whether that referred to sales to other persons and counsel replied in the affirmative.
[22] Respondent's first witness was Laurel Lee Uberoi. She was an auditor with the tax avoidance section of Revenue. Nothing in her evidence assists in the resolution of the matters herein.
[23] Respondent's counsel then produced Peters as a witness. He, an independent investment salesman, testified that he was a freelance independent salesman selling investments and that he had met Furtak and Gillis, being representatives of the Trafalgar Group. He said that upon the purchase of a license there was a requirement to enter into an agency agreement. He said that he had sold licenses to three individuals, being four sales of $50,000 each. He described what the license sought to achieve and said that he had explained the tax consequences that accompanied the purchase of a license and stated:
I explained that the entire investment of fifty thousand ($50,000.00) probably would qualify as a Class 12 asset, which meant that it was eligible for a 50% straight -- or 100% straight-line write off ... over a two year period of time.
Peters also said that the profits or losses would not be distributed until after the end of the ten year period, that interest on the note was to come out of trading profits, that an administration fee would come out of profits, that brokerage fees would come out of profits and that the $32,500 note was to be repaid out of profits. Peters also said that if the note was not paid off out of profits, the maker of the note would not have to write a cheque to make up the difference. He said that he "would have shown them" legal opinions obtained from Trafalgar. He said they were in depth analyses of the whole concept and whether or not it was a tax shelter, whether the whole investment qualified as a Class 12 asset and whether it was, therefore, eligible for the write off. He then said that the opinions were all to the effect that "yes, this was fine." The following exchange took place:
Q. Now, did you explain to your clients when you were selling them the Trafalgar Index Program Investment that they'd be running a business?
A. Yes. It was explained that it was a business but it was also explained that the business would be managed by Trafalgar.
Q. What did you explain to your clients on how to file their taxes?
A. They were told to file a separate schedule on their tax return to report this business and to claim the capital cost allowance.
Q. And you explained that to them?
A. Yes.
Peters said that he probably had provided copies of valuations on the value of the investment to investors. He said that they were not of much interest to the client because the main two focuses were the income tax savings and the potential for the investment to generate a lot of profit from "intra-day trading". When Peters was asked if he felt that there was any room for discussion of the terms in the agreements, he replied that there was no flexibility. He said:
It was presented as "This is the deal. Do you want it or do you not want it?"
He stated that the tax aspect of the investment was explained in a presentation to potential investors.
[24] On cross-examination Peters read a portion of a note that he had sent to many of his clients, namely:
The Belmont Financial Group Incorporated makes no statement or representation to you with respect to the income tax consequences of investing in the program.
He then said that he was not telling them what the tax consequences were and that they were always told to obtain their own tax opinions from their own tax advisors.
[25] Appellant's counsel presented a legal opinion from the law firm of Fraser Milner to Peters. That opinion stated:
None of the documents will contain any statement, representation or warranty concerning the tax consequences of the software for a taxpayer.
Peters said he didn't think the documents were given without any representation by Trafalgar as to the tax consequences.
This exchange followed:
Q. Well, perhaps you can explain to me why you would have thought that there were representations, although you told me you agreed with the opinions.
A. Well, I think representations were made in some of the documents, perhaps not this document.
Q. Which document were there representations in, Sir?
A. Oh, I don't remember now.
Q. You don't remember, okay. And then you see the next paragraph says:
"Each Purchaser will be given the option but not the obligation to enter into an Agency Trading Agreement."
Do you see that?
A. Um - hmm.
Q. So you understood from the ... opinions you had read, that the decision to enter into an agency was, in fact, a choice. Isn't that correct?
A. I guess it says that they were given the option, and then it goes on to say that it was - - "It is anticipated that all reasonable purchasers will exercise this option."
Q. Yes. And isn't that, in fact, how the transaction was structured with the clients, you were advising that they were given - - the option was given, but it was anticipated that they would enter, isn't that fair?
A. Perhaps it is. It's so long ago I don't remember, but I do remember that nobody wanted to exercise that option.
Q. Yeah, I think that's - - I understand what you're saying, you remember that nobody wanted to exercise the option but nobody was told that they absolutely had to sign the Agency Agreement, were they, Sir? You didn't tell them that, did you?
A. Probably not.
[26] After being presented with a number of slides upon which Peters confirmed the contents of sales promotional materials, Peters said that he relied on past performance as a basis to advise clients and that he had no reason to disbelieve any of the numbers in the promotional materials and that he thought that the investment by his clients would be a good investment. Peters agreed with Appellant's counsel's suggestion that the first step was that the licensee would acquire a license to the trading programs, that the second step would be that the licensee would appoint Trafalgar as agent to trade S & P 500 contracts using capital contributed by Trafalgar, and then that the profits derived from the trading would be divided between the licensee and Trafalgar.
[27] He testified that it was on the basis of that understanding that he had said earlier that there was a business but that it was being managed by Trafalgar. He then replied affirmatively to counsel's question to the effect that clients went into this investment knowing full well that there was potential for a huge upside but that there was also risk. He then replied affirmatively to the following question:
Q. Now, I am putting to you as my - - in concluding this part of the examination, that the essence of your advice to your clients based on all of this information was that this is a very good commercial investment with favourable tax consequences, isn't that a fair summary?
The Crown also produced Jeffery Raymond Dahn ("Dahn") as a witness. He is a professor of physics at Dalhousie University. He had a financial advisor at the relevant time called Medric Cousineau ("Cousineau"). He testified that he bought a Trafalgar Index Program license from Cousineau for $17,500 cash and a promissory note. He understood the investment to be for a ten year period. After that period he said that any profits that accrued in the trading capital account would be used to pay off the promissory note and that the remainder would be transferred to him.
[28] After lengthy discussion about Appellant's counsel's objection to the question asked by Respondent's counsel, namely:
And what did he explain to you?
Appellant's counsel withdrew his objection. The objection, based upon the answer to that question being hearsay, was withdrawn after the Court's statement that it would need time to consider the law respecting the objection, Appellant's counsel having said that he did not want an adjournment for the ruling. He then said:
All I'm saying is that I don't want my withdrawal of the objection to be an admission that I consider this to be relevant.
Dahn said that he was advised by Cousineau that he would be buying a Class 12 asset and that the $50,000 could be deducted over two years.[10]
The trading was, to my understanding, being done by the people in Bermuda, the Trafalgar Group.
He also said that he had completed and signed a License Agreement such as that of the Appellant which was shown to him. He said that he had been subpoenaed to testify and that he had not filed a Notice of Objection respecting the reassessment disallowing his capital cost allowance claims.
[29] The Crown's next witness, David Frederick Prescott ("Prescott") is a Certified General Accountant. He testified that he was contacted by Cousineau, asking him to look at the Trafalgar investment for some of his clients. He then met with Gillis of the Trafalgar organization. Prescottalso stated that he was not prepared to prepare income tax returns for clients who purchased this investment.
[30] Another witness produced by the Respondent was Judy Elizabeth Harnett ("Harnett"). Harnett is an auditor with Revenue Canada, having been a tax avoidance auditor in the Tax Avoidance section for about seven years. She said that she had seen approximately 50 different taxpayers with an investment like that of the Appellant.
[31] The Respondent's final witness before the presentation of expert witnesses was Frederik H. Myatt ("Myatt") who appeared by videoconference. He stated that at a social occasion someone mentioned the Trafalgar Investment Program. He then telephoned Gillis and, ultimately, bought the program license. He identified the License Agreement he had signed. He said that he had made four payments of $4,375 each and gave a promissory note for $32,500 and that the investment was for a ten year period. He testified that he had not had any experience in the futures trading market. He said that he met Gillis and understood that he was the first Vice President of Trafalgar. Myatt said that he thought the income was guaranteed "at an 8 per cent earnings per year". He said that that would have paid the note off within the ten year term and that if:
the investment did not operate up to the 8 per cent, then the balance of the promissory note at the end of the ten year term would be written off.
He said he understood that he would not be held responsible for any of the promissory note over and above the original investment. He further said that he understood he could write the $50,000 off over a two year period.
ANALYSIS AND CONCLUSIONS
This portion of the Reasons includes more evidence, it being appropriate in the context of determining the issues, to set out pertinent facts relating to a given issue under the analysis of that issue.
First Issue
[32] The first issue is whether the Appellant was, in the taxation years in question, carrying on the business of using the license acquired from TCL to trade futures contracts with TT; alternatively, whether the Appellant acquired the license for the purpose of earning income from properties.
[33] The Amended Reply ("Reply") stated that the Respondent:
denies that an agency relationship was ever created between the Appellant and Trafalgar Trading Limited.
However, one of the assumptions of fact contained in that Reply, upon which "the Minister relied", reads as follows:
Trafalgar Trading was the exclusive agent of the licensee for the term of the agreement to engage in the trading of capital S & P 500 Contracts using the License & Software.
Respondent's counsel made no mention of this assumption in embarking upon his submission as to why no agency relationship existed.
Paragraph 2 of the Agency Agreement provides that:
The parties hereto agree that Trafalgar Trading shall be the exclusive agent of the licensee for the term of this agreement to engage in the trading of S & P 500 Contracts using the License.
[34] The Appellant caused the delivery to TT of the copy of the Trafalgar Index Program ("TIP"), the use of which had been granted by TCL to it. The Appellant's uncontroverted evidence described his understanding that TT had set up a bank account, contributed $10,000 into that account in accordance with the Agency Agreement, and engaged a broker. The Appellant also testified that he received a report, generally, on a monthly basis on the previous month's trading. He described the payment of brokerage fees and the net trading profit or loss and referred to the value formulas in the Agency Agreement. He was also clear in his evidence that at the end of the ten year agency period the capital balance would be determined, the amount contributed by TT repaid to it and that the balance would be his.
[35] The Appellant also covenanted with TT that it would not be held responsible for any claim resulting from realized losses or unrealized profits arising from the inability to execute trades in accordance with the Trading Reports.[11] Quite simply, the Appellant provided his license for use by TT on his behalf while TT provided $10,000 trading capital in the trading activity. It cannot be denied that the trading activities were conducted by TT. It cannot be denied that those trading activities constituted a business as defined in the Act.
The pertinent part of that reads:
Business includes a profession, calling, trade, manufacture or undertaking of any kind whatever and ... an adventure or concern in the nature of trade ...
The law is clear that whenever an agent carries on business on behalf of a principal, the principal is deemed to be carrying on that business. It is beyond comprehension that a person would pay $50,000 for a license, enter into an express agency agreement with someone to exploit the use of that license, simply to have that agent carry on business on his own behalf, a premise advanced by the Minister for the Court's serious consideration. The Minister's written submission, in that regard, reads as follows:
It is submitted that Trafalgar was trading in their own name and assuming all risk with no recourse to the investor for any losses or liability. As such, the Respondent submits there is no real agency relationship between the Appellant and Trafalgar and the agreements entered into by the Appellant bear this out.
The Appellant's description of his motivation for entering into the license purchase arrangement clearly contemplated the use of the license for profit making for him.
[36] Respondent's counsel referred to Denison Mines Ltd. v. M.N.R.,[1971] F.C. 295 (F.C.T.D.), affirmed [1972] F.C. 1324 (F.C.A.). He described Justice Cattanach's reference to Smith, Stone and Knight, Ltd. v. Birmingham Corporation, [1939] 4 A11 E.R. 116 [K.B.D.] which posed six questions "as helpful indicia in determining who is really carrying on business". While those questions may have been useful in the fact situation in that case, they have no relevance here. The question in Denison was whether a subsidiary corporation formed by the Appellant was an agent carrying on business on behalf of the Appellant. The Court concluded that:
Here the very reason for the incorporation of CON-ELL was predicated on the legal advice that the appellant would be in breach of the condition of the trust deed if it conducted the housing operation on its own account. It is a principle of agency that a person cannot do by an agent what he cannot do himself. [12]
The Respondent also stated:
Simply put, there is no risk to the Appellant whatsoever.
It is patently clear that the Appellant risked losing his total investment.
[37] I have concluded, for the purposes of carrying on the business of using the license, that the Appellant had engaged in a legal relationship with TT constituting the creation of an agency whereby TT was his agent for the exploitation of the license acquired. If this was not a business, clearly the license is property, the purpose of acquiring same entitling him to a claim for capital cost allowance. Paragraph 20(1)(a) reads:
Notwithstanding paragraph 18(1)(a), (g) 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 applicable thereto:
(a) such part of the capital cost to the taxpayer of property, or such amount in respect of the capital cost to the taxpayer of property, if any, as is allowed by regulation.
(emphasis added)
I am very surprised that this was an issue, the answer being so clear.
Second Issue
[38] The second issue is whether the Appellant, in acquiring that license, was dealing at arm's length with Trafalgar.
[39] The Respondent's Reply to the Notice of Appeal contained the following assumption of fact upon which "the Minister relied" namely:
The parties involved in the Investment were not dealing with each other at arm's length.
This assumption was deleted in the Amended Reply, one of the pleaded facts therein being:
The parties involved in the Investment were not dealing with each other at arm's length
Accordingly, the Respondent had the burden of proof on this issue. In Her Majesty the Queen v. Cecilia Dianne Taylor, 84 DTC 6234 (F.C.T.D.) Cattanach J. said:
There is no impediment to the Minister basing an assessment on facts or assumptions other than those upon which the assessment was based and so alleging but in that event the onus is upon the Minister to establish those allegations (see Tobias v. Queen, [78 DTC 6028], [1978] C.T.C. 113).
[40] The Respondent did not dispute the Appellant's position that the Appellant was not "related" to any of the Trafalgar Group of companies within the meaning of subsection 251(2). Therefore, paragraph 251(1)(a) does not apply to deem them not to deal at arm's length. The question remains whether, under paragraph 251(1)(b) they did not deal with each other at arm's length as a matter of fact. The Appellant testified that he had never owned, and to the best of his knowledge no one related to him, had ever owned any capital stock in any of the Trafalgar Group of companies. He said that he had "purely a commercial relationship" with Trafalgar. He testified that he did not, at the time he purchased the license, know who Furtak was. Indeed, he only met Furtak on May 30 in the year following his acquisition of the license. He said that he had never served Furtak in a professional capacity. He said also that he had not met Gillis or spoken to him at anytime before buying the license. He made the same statement relating to Peters.
[41] The Appellant testified that there were no negotiations respecting the $50,000 price for the license. He said that the offer to acquire the license was presented to him at a fixed price. He added that he supposed he had an option as to how many licenses he wanted to purchase but the price was fixed and
it was a take-it-or-leave-it offer as I had understood it based upon the documentation
He also said that $50,000 was the minimum amount of license available to purchase.
[42] A number of cases support the proposition that normally in a commercial relationship where each party is looking out for his, her, or its separate interest, even though each party expects to benefit from dealing with the other, the parties are considered to be dealing at arm's length as a matter of fact. In McCoy v. The Queen, 2003 DTC 660, this Court said, at paragraph 66:
I do not think that in every case the mere fact that a relationship of principal and agent exists between two persons means that they are not dealing at arm's length within the meaning of the Income Tax Act. Nor do I think that if one retains the services someone to perform a particular task and pays that person a fee for performing the service, it necessarily follows in every case and non-arm's length relationship is created. For example, a solicitor who represents a client in a transaction may well be that person's agent yet I should not have thought that it automatically followed that there was a non-arm's-length relationship between them.
The learned Justice in paragraph 69 said:
Trafalgar and the partnership were in my view dealing at arm's length. There was no control exercised by either party over the other. There was no common mind. The statement that the parties did not have opposing interests but "acted in concert" is either incorrect or does not lead to the conclusion that the parties were not at arm's length.
[43] In Peter Cundil & Associates v. The Queen, 91 DTC 5543 (F.C.A.), the Court referred to an interpretation bulletin stating that the parties are not at arm's length if:
(1) there is the existence of a common mind that dictates the terms of the bargain on both sides of the transaction.
(2) the parties to the transaction are acting in concert and without separate interest
(3) there is defacto control.
I will discuss this briefly near the end of this issue analysis.
In Lenester Sales Ltd. and Sushi Sales Ltd v. The Queen, 2003 DTC 997, aff'd 2004 DTC 6461 (F.C.A.), this Court said:
I am also of the view that the franchisees and GTS were at arm's length. They had separate interests and there was certainly no single or controlling mind. Nor can it be said that they "acted in conflict" in a way that deprives the relationship of its arm's length nature. To say that everytime two independent business persons in pursuit of there own business interests work together to achieve a mutual beneficial commercial objective means that they are "acting in concert" and are, therefore, not at arm's length would mean that no business relationships would ever be at arm's length.
[44] I do not accept Respondent's counsel's submission respecting the application of Swiss Bank Corp v. M.N.R., 71 DTC 5235 (Ex. Ct.) aff'd 72 DTC 6470 (S.C.C.), counsel having said:
As in the case at hand, where one side dictates the terms of the contract and the other acquiesces because they are indifferent as to what the terms are or what the specifics are (i.e. in this case - the sale price), the parties cannot be said to be dealing at arm's length as they may not have distinct economic interests.
Not only is there no evidence to support the statement that the Appellant was indifferent but the evidence indicates clearly that he was concerned about his ability to recover his capital and to meet the obligatory interest payments.
[45] Respondent's counsel also said:
... in this situation a lack of competing interests exists. In fact, it provides further support for the position that one party (i.e. the Vendor in this case) dictated the terms of sale and the other party (i.e. the Appellant investor) acquiesced and accepted those terms because he was indifferent about the specifics of those terms.
I state again that there is absolutely no evidence leading to that potential conclusion. Respondent's counsel sought, during cross-examination of the Appellant, to compare the purchase of the software license to the purchase of a car or the negotiation of a mortgage. This ignores the evidence of Respondent's own witnesses to the effect that a number of units were sold at the same price, namely $50,000, no mention having been made by them of negotiation or an attempt at negotiation of the price of the license acquisition.
[46] Respondent's counsel continued with this type of submission saying:
... the parties to these agreements have a common interest, both wishing to maximize the "sale price" of the investment.
Trafalgar's interest in maximizing the sale price is obvious as Vendors normally seek to maximize their returns on a sale. In this case, the Appellant's interest in maximizing the sale price originates from the fact the "sale price" determines the amount of the tax refund generated by the investment. The higher the "sale price" the greater the refund.
It is apparent that this argument lacks substance.
[47] The context in which the Respondent's submissions were born is described by the following portion of Respondent's written submission:
Under these circumstances, the sale price of the TIP investment is not driven by competing interests. Instead, an agreeable "sale price" for the property can be reached that meets the needs of both parties without ever nearing fair market value or a reasonable amount. In fact, in order to make the investment attractive to potential investors there is an incentive for the vendor to inflate the purchase price in order to maximize the Appellant's reductions. For the vendor, who is in a tax-haven country, the amount of income generated is not subject to any significant amount of tax, further emphasizing the lack of competing interests involved in this transaction.
Furthermore, the transactions involved in this case lack the usual market considerations which would normally ensure a fair market value is reached. Here, where the parties are not driven by competing interests, they can both achieve their goal by transacting at an inflated purchase price. The relationship that exists in this case does not provide the assurance that the sale price will reflect the fair market value, a specific goal that is emphasized by the Supreme Court in the case of Swiss Bank, supra.
Counsel's attempt to analogize the case at bar with Swiss Bank can be dismissed with ease by reference to the facts set out in the head-note of the report of the judgment of the Exchequer Court, as set out by one editor:
The non-resident Appellants, having been assessed just 15% non-resident tax under Section 106(1)(b)(iii) in respect of interest paid to them, now claimed exemption under Clause (A) of that subparagraph on the ground that the interest was paid to a party dealing at arm's length with the Canadian payer. The latter, City Park, was a Canadian corporation utilizing funds raised by public subscription in Switzerland for the acquisition of real estate investments in Canada. The Appellants were the trustees of the fund so raised, representing some 2000 certificate holders. City Park's shares were owned by a Swiss corporation which was the manager of the fund, such shares being in the custody of the two Appellants, each of which owned of 40% of the shares in the Swiss corporation.
[48] Further, Respondent's counsel sought to characterize the transaction as having a "non-commercial nature" and suggested that the parties did not act in their separate commercial interests. Counsel referred to the Appellant not having made enquiries about the background, history or reputation of Furtak, the historical performance of Trafalgar's previous investment packages and existing appraisals with respect to the TIP investment. He went on to refer to the Appellant not having conducted any research on the futures industry, stating that the Appellant did not treat this investment like his other investments which were handled by a broker, that "he did not even consult a broker with respect to this investment" and that he relied solely on Langille. Respondent's written submission then describes what the Appellant did subsequent to making the investment, namely that he:
(a) made no inquiries about updates to the TIP software, despite the fact that he knew updates were contemplated in the agreements;
(b) never verified nor truly understood the monthly reporting statements provided by Trafalgar and simply accepted them as presented;
(c) never verified or inquired about any of the results of his investment;
(d) never inquired of Trafalgar when the investment returns went bad;
(e) first contacted someone from Trafalgar in May, 2005 which was admittedly for the purpose of preparing for this appeal; and
(f) prior to this appeal never contacted or inquired of anyone from Trafalgar with respect to his investment.
This has nothing to do with whether the parties were at arm's length at the time the Appellant bought the license.
[49] The brief proceeds with this:
When you consider, among other things, the nature (i.e. the uniqueness) and magnitude (i.e. an investment of $50,000) of this investment, all of the aforementioned facts clearly indicate a lack of due diligence on the part of the Appellant in making this investment. This is not expected behavior (sic) of a reasonable investor and is certainly indicative of a non-commercial transaction.
This ignores and/or distorts the evidence.
[50] Appellant's counsel then tried to analogize the present case to that of Brown v. R., 2001 DTC 1094 (T.C.C.), aff'd 2003 DTC 5298 (F.C.A.). Counsel said:
Similarly, in the case of Brown, Justice Rip found that parties at arm's length would not have agreed to the debt instrument given the terms of the instrument in that case (i.e. the maturity date, the lack of security and the lack of assignability of the debt). These were all factors that lead to the conclusion that the parties were not dealing at arm's length.
Counsel failed, however, to describe the facts of the Brown case to the Court when making this submission. In finding a non-arm's length relationship in Brown this Court
found that American Softworks Corporation ("ASC"), CEG Corporation (which was essentially controlled by ASC in addition to being the managing partner of the CEG Partnership), the CEG Corporation Management (including a Mr. Williams who became the sole director of CEG Corporation), the CEG Partnership and, therefore, the Partners, were not dealing with each other at arm's length. The complex fact situation included a number of transactions and the non-acceptance of some of the evidence presented. There is no authority whatever in Brown for a conclusion of a non-arm's length relationship in this case.
[51] On the basis of the foregoing, I have concluded, regarding the Cundil decision, supra, that there being no common mind dictating the terms of the bargain on both sides of the transaction, the parties were not acting in concert. The element of de facto control mentioned in that case is irrelevant here. The fact that the parties considered that they had entered into a mutually beneficial relationship when, at the same time, they were pursuing their own individual interests and were free, without either of them being controlled by the other, to enter or not enter into that relationship means they were dealing with each other at arm's length as a matter of fact.
[52] I have no hesitation in concluding that the Appellant, in acquiring the license, was dealing at arm's length with TCL. I am also very surprised that this was an issue in this case.
Third Issue
The third issue is whether the Appellant acquired a "tax shelter" as defined in section 237.1.
[53] The definition of "tax shelter" is:
"tax shelter" means any property (including, for greater certainty, any right to income) in respect of which it can reasonably be considered, having regard to statements or representations made or proposed to be made in connection with the property, that, if a person were to acquire an interest in the property, at the end of a particular taxation year that ends within 4 years after the day on which the interest in acquired,
(a) the total of all amounts each of which is
(i) an amount, or a loss in the case of a partnership interest, represented to be deductible in computing income in respect of the interest in the property (including, where the property is a right to income, an amount or loss in respect of that right that is represented to be deductible) and expected to be incurred by or allocated to the person for the particular year or any preceding taxation year, or
(ii) an other amount represented to be deductible in computing income or taxable income in respect of the interest in the property and expected to be incurred by or allocated to the person for the particular year or any preceding taxation year, other than any amount included in computing a loss described in subparagraph (i),
would equal or exceed
(b) the amount, if any, by which
(i) the cost to the person of the interest in the property at the end of the particular year, determined without reference to section 143.2,
(ii) the total of all amounts each of which is the amount of any prescribed benefit that is expected to be received or enjoyed, directly or indirectly, in respect of the interest in the property by the person or another person with whom the person does not deal at arm's length,
but does not include property that is a flow-through share or a prescribed property.
[54] The Appellant's position is that the license was not a "tax shelter" and does not, therefore, fall within the ambit of section 237.1 of the Act with the result that:
(a) the License did not need to be registered as a tax shelter;
(b) the Appellant's CCA deductions were not prohibited by subsection 237.1(6) of the Act;
(c) the License was not a "tax shelter investment" as defined in subsection 143.2(1) of the Act; and
(d) regardless of the existence of a "limited-recourse amount" or of an "at-risk amount", as defined in subsections 143.2(1), (2) and (7) of the Act, the Appellant's capital cost was not to be reduced by reason of subsection 143.2(6) of the Act, and his right to claim CCA was not reduced by subsections 1100(20.1) and (20.2) of the Regulations.
[55] Appellant's counsel submitted that the "property" included in the opening words of the definition of "tax shelter", namely:
"tax shelter" means any property ...
is the license purchased by the Appellant. He referred to section A. 11 n) and z) of the Respondent's Amended Reply which read as follows:
n) The Appellant invested in ... an arrangement involving the direct sale of software licenses to the investor (the "Investment").
z) The Investment was a "tax shelter" as defined in subsection 237.1 (1) of the Act
Appellant's written brief said that:
Any other interpretation would render the provisions of subsection 143.2 (6), read with paragraph (a) of the definition of "tax shelter investment" in subsection 143.2 (1) of the Act incapable of application.
Subsection 143.2 (1) defines "tax shelter investment" to mean:
a property that is a tax shelter for the purpose of subsection 237.1(1)
The pertinent portion of subsection 143.2 (6) reads:
Notwithstanding any other provision of this Act, the amount of any expenditure that is, or is the cost or capital cost of, a taxpayer's tax shelter investment, and the amount of any expenditure of a taxpayer an interest in which is a tax shelter investment, shall be reduced
by a formula amount.
Counsel said that if the property was the software or the original license, subsection 143.2 (6) could not apply because neither the software nor the original license belonged to the Appellant and there was no cost or capital cost to him for either of them. Counsel said, in oral submissions, that if the tax shelter was the Appellant's license then it would be property:
... in respect of which it can reasonably be considered, having regard to statements or representations made or proposed to be made in connection with the property ...
that the representations would have to be in connection with that license, not someone else's license. He then said that in those circumstances "that's the end of it".
[56] With respect to the Respondent's position that the software was a tax shelter, Appellant's counsel stated that that is not the Appellant's property. The first recital in the License Agreement reads:
WHEREAS TCL Trafalgar holds a license to grant non-exclusive, limited-use licenses to use the Trafalgar Index Program (as hereinafter defined).
That Agreement also provides that:
"Trafalgar Index Program" means the set of application software programs used to trade S & P 500 Contracts licensed to TCL Trafalgar.
and
"License" means a non-exclusive, limited-use, license to use the Trafalgar Index Program.
TCL does not own the software. It is, itself, a licensee, in effect sublicensing to the Appellant. Referring to subsection 143.2 (6) counsel said:
If the tax shelter investment is the software, the taxpayer has no cost or capital cost and the provision is absurd, which I submit is a pretty good indication of an intent that the tax shelter must be property owned by the taxpayer and not merely property in which the taxpayer has acquired some kind of interest.
He added that the Appellant's money was spent entirely for the license:
and that's the only property in respect of which he can have a capital cost. He can't have a capital cost in respect of the software so if the software is the tax shelter investment, 143.2 (6) does not make any sense.
Counsel has not expanded his submission with analysis of the words from subsection 143.2 (6) namely:
and the amount of any expenditure of a taxpayer an interest in which is a tax shelter investment
That phrase, as do the words preceding it, charitably stated, suffers from lack of legislative precision. Counsel may have considered same and found it unnecessary to discuss. If he did not consider it, the reason may well be because it is considerably inconsiderable.
[57] Appellant's written submission also contained the following:
If the license itself must be the tax shelter, it follows that representation to other persons would not relate to that property and would not be relevant to the application of the definition to the license. In any event, it is submitted that it would be an absurd result if representations made to third parties (with whom the Appellant was not in contact and of whom he may not have known, and being representations of which he was not aware) could make his license an interest in a tax shelter and thereby impose on him all the adverse tax consequences referred to in the Reply
[58] The question arises as to what is meant by the words contained in the definition of "tax shelter":
in respect of which it can reasonably be considered, having regard to statements or representations made or proposed to be made in connection with the property
Appellant's counsel said they must be made to the Appellant. Respondent's counsel said there was no necessity for that and that they could have been made to other investors and still have been made within the ambit or purview of the "tax shelter" definition.
Respondent's counsel, at the hearing, said with respect to "statements and representations" that:
They were not made to the Appellant. They were made to the others.
While the fundamental reason for my conclusion as to whether the Appellant, by purchasing a license, acquired a tax shelter, is set out below, I will comment upon the question posed. My view is that, in interpreting the definition, I must have:
regard to statements or representations made or proposed to be made in connection with the "property"
referred to in the definition.[13] That is required to assist me to conclude whether it can reasonably be considered that a person has acquired a "tax shelter". The Respondent admits that no statements or representations were made to the Appellant. Going a step further, there is certainly no evidence that any amount was represented to the Appellant "to be deductible" as set forth in paragraph (a) of the definition of "tax shelter".
Black's Law Dictionary, 6th edition, defines a "representation" as a "statement of fact made to induce another to enter into a contract". The word "statement" is defined in The Oxford English Dictionary, Volume X, in part as "something that is stated". As pointed out by Appellant's counsel in oral submissions:
While the word "representations" is coupled in the opening part of the definition with "statements", it's not repeated when you get to (a) (i) and (a) (ii) ... for example in (a) (i):
an amount, or a loss in the case of a partnership interest, represented to be deductible ...
not represented or stated to be deductible, but just represented.
The following then took place:
Mr. Harris
So our position is that reference to "statements" in the earlier part of the definition is gratuitous because it has no operating effect. You don't get any operating effect until you get down to the formula which only talks about what is represented, not what is proposed to be represented, but only what is represented.
Justice Bell
By "gratuitous" you mean useless.
Mr. Harris
Yes, it has no function in the definition.
Justice Bell
Yes.
Mr. Harris
And the same with "proposed to be made".
Justice Bell
Because they are not repeated or followed up in any way in the legislation.
Mr. Harris
Exactly. The key thing is "do we have a representation?"
[59] The Respondent's written submission states that:
Any consideration of "property" for the purposes of subsection 237.1 (1) in this case[14] must also include the TIP Software as it is the underlying asset referred to in each license ... It can be seen that by entering into a license arrangement, the Appellant has simply acquired "an interest in the property", namely, the Software in question.
Respondent's counsel seeks to use this as a foundation for his written submission that:
... it is clear from the wording in subsection 237.1(1) that the "property" can meet the definition of a "tax shelter" regardless of whether there are any sales or buyers and simply on the basis of "statements or representations made or proposed to be made".
In the case at bar, statements and representations by Trafalgar to potential investors did not identify any specific licenses or properties, thus it makes no sense to argue that it is only statements and representations regarding the Appellant that are at issue in this appeal. ... it is submitted that statements or representations as contemplated in 237.1(1) were made to various people in connection with sales or proposed sales of TIP Licenses ... Furthermore, there is no requirement that statements or representations actually be made to the Appellant. Statements or representations were made with respect to the property in question through others and thus the definition of "tax shelter" under the Act has been met. In other words, it is actually irrelevant whether statements were made to the Appellant.
[60] Tax legislation can and does have effects which may seem harsh but that harshness must be the result of legislative precision. I cannot interpret the lack of words requiring the statements or representations to be made to a taxpayer as having the result of unfairly sweeping the taxpayer into consequences which may have been justifiably unforeseen. In a self-assessing system how can one expect a taxpayer bona fide investing in what appears to be a totally legitimate investment, to be prejudiced by something he doesn't know and can't know, and yet being required to file a tax return as if that taxpayer did know?
The Respondent's brief went on to say that it was abundantly clear that the Appellant knew from the legal opinions, promotional materials and the documents that he had signed that his $50,000 investment would be written off over two years as a class 12 capital cost allowance asset and that there would be no profits or losses reported for ten years. On this basis, Respondent's counsel said that the investment was a "tax shelter".
[61] I now come to the fundamental reason for my conclusion as to whether the Appellant, by purchasing a license, acquired a tax shelter. I have determined that the question of whether a tax shelter exists can be resolved simply by the application of the provisions of paragraph (a) to the facts. I rearrange the words in that subparagraph for the purpose of demonstrating clearly and simply what they mean in the context of this case. Paragraph (a) can be reshaped as:
(a) the total of all amounts each of which is
(i) an amount ... represented to be deductible and expected to be incurred by ... the person.
or
(ii) a loss in the case of a partnership interest, represented to be deductible ... and expected to be ... allocated to the person ...
(emphasis added)
[62] Under (a)(i) the amount represented to be deductible and expected to be incurred must surely be represented to be deductible to the person expected to incur same. Similarly, under (ii) the loss in the case of a partnership interest must surely be represented to be deductible to the person to whom the loss is expected to be allocated. The claim for capital cost allowance made by the Appellant is not "an amount" that can "be incurred by" anyone. Similarly, the claim for capital cost allowance made by the Appellant is not "a loss in the case of a partnership interest" that can be "allocated to" anyone.
[63] It is clear that the words "and expected to be incurred by" refer only to "an amount". In McKee v. Her Majesty the Queen, 77 DTC 5345 (FCTD) the question was whether capital cost allowance claimed unduly or artificially reduced the Plaintiff's income. More specifically, the issue was whether section 137(1) applied. It 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, would unduly or artificially reduce the income.
The Court referred to the following passage in Louis J. Harris v. M.N.R., 66 DTC 5189, a decision of the Supreme Court of Canada, containing the following passage at 5198:
If, contrary to the views I have expressed, we had accepted the Appellant's submission that the transaction embodied in the lease was one to which Section 18 applied and that on the true construction of the lease and the terms of that section the Appellant was prima facie entitled to make the deduction of the capital cost allowance of $30,425.80 claimed by him, I would have had no hesitation in holding that it was a deduction in respect of an expense incurred in respect of a transaction that if allowed would artificially reduce the income of the Appellant and that consequently its allowance was forbidden by the terms of Section 137(1). The words in the subsection "a disbursement or expense made or incurred" are, in my opinion, apt to include a claim for depreciation or capital cost allowance, and if the lease were construed as above suggested the arrangement embodied in it would furnish an example of the very sort of "transaction or operation" at which Section 137(1) is aimed.
The learned Justice, in McKee, supra, then said:
the case was decided on other grounds and the statement is, of course, obiter dicta and therefore not strictly binding upon him. In view of its authorship however and of the fact that judgment was concurred in by the remainder of the members of the Court who were sitting at that time, that particular interpretation of Section 137(1) caused me some concern. The question, in my view, must be squarely faced in the case at bar.
I have searched several dictionaries including The Shorter Oxford English Dictionary, Third Edition revised, Britannica World Language Dictionary, Funk & Wagnalls New Standard Dictionary of the English Language, The Random House Dictionary of the English Language, The Living Webster Dictionary and Thorndike Barnhard (American Dictionary). It seems abundantly clear that the common ordinary meaning of the word "expense" pertains to a payment, an outlay of money and expenditure or that which has created a liability or which might have necessitated the transfer of some asset in payment therefor. It can also mean the cost of a thing or whatever must be given up or surrendered for it. The word "disbursement" is even more indicative of an immediate outlay or payment and signifies an expenditure. Nowhere could I find that these words are even remotely used to indicate something in the nature of an allowance. On the contrary, the sole affinity between the word "allowance" and these two words occurs when the latter is used as a set-off against or to pay for, compensate for, or counter-balance an expense or disbursement. Far from being in any way a synonym of either of these two words it constitutes, if anything, an antonym.
He referred to the evidence of an expert accountant possessing considerable academic and professional qualifications and considerable practical experience in accounting. That expert referred to a number of authorities and stated that it was abundantly clear that in accounting the distinction is clearly maintained between an "allowance" and an expense or "disbursement". He then said:
I must therefore conclude that not only in their common ordinary meaning, but also in the technical language of accountancy, and more important, everywhere else in the Act itself wherever the words are employed, they are never used nor are they intended to be used as being synonymous to the word "allowance" but that, on the contrary, they are often directly used to indicate an expenditure which one may or may not be permitted to compensate for by an allowance according to the particular provisions of the Act.
In section 137(1) itself, the words "capital cost allowance" themselves describe an allowance to compensate for the cost or expense. Surely, this allowance itself cannot be the cost, expense or expenditure for which it is intended to provide some tax relief.[15]
In view of the above and also in view of the general principle that wherever ambiguity exists, although I can really find no ambiguity here, a taxing statute must be interpreted against the taxing authority, I can find no reason why the words "a disbursement or expense made or incurred" can be taken to include an allowance which a taxpayer is permitted to claim under the Regulations to compensate for the cost or capital expenditure made in acquiring an asset.
[64] I entirely agree with that analysis. Accordingly, under subparagraph a(i) of the definition, even if an amount was represented to be deductible, no amount was deductible, capital cost allowance not having been "an amount" that can be "incurred".
[65] Although there is no partnership loss involved in this case, I refer to subparagraph (a) (ii) to buttress the logic of my reshaping paragraph (a). It is clear that the words "allocated to" refer only to "a loss in the case of a partnership interest". The word "allocate" is used in the partnership provisions of the Act. Paragraph 96(1.1)(a), reads as follows:
(a) where the principal activity of a partnership is carrying on business in Canada and its members have entered into an agreement to allocate a share of the income or loss of the partnership ...
... have agreed to make such an allocation
(emphasis added)
Also paragraph 96(1.1)(b), relating to partnerships, uses the word "allocated" as follows:
(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 the taxpayer's income for the taxation year in which that fiscal period of the partnership ends.
(emphasis added)
[66] I conclude that:
(a) The license purchased by the Appellant is the "property" in the opening words of the definition of "tax shelter", namely:
"tax shelter" means any property ...
(b) No amount was represented to be deductible and expected to be "incurred" by the Appellant within the meaning of paragraph (a) of the definition of "tax shelter".
(c) Although I do not need to decide whether the word "statements" has any meaning in the definition of "tax shelter", and it appears not to have, it certainly has no function in the determination of any amount under paragraph (a) of the definition. The words "proposed to be made" are simply too vague to add any comprehension to the task of determining the existence of a "tax shelter".
[67] As no amount is determinable under paragraph (a) of the definition of "tax shelter" in the case of the Appellant, the Appellant did not have and does not have a "tax shelter".
Fourth Issue
[68] The fourth issue is to determine the fair market value of the license when acquired.
[69] The pertinent portion of section 69 reads as follows:
(1) Except as expressly otherwise provided in this Act,
(a) where a taxpayer has acquired anything from a person with whom the taxpayer was not dealing at arm's length at an amount in excess of the fair market value thereof at the time the taxpayer so acquired it, the taxpayer shall be deemed to have acquired it at that fair market value.
Having determined that the Appellant was at arm's length with TCL from whom he acquired the license, Section 69 of the Act has no application. Accordingly, the fair market value is the amount paid by the Appellant for the license, namely $50,000. However, almost five days was devoted to adducing evidence from four expert witnesses and one ordinary witness, a commodities trader, respecting the value of the license. I have decided, therefore, to present the essence of that evidence and my views thereon.
[70] The onus was on the Respondent to establish value. Respondent's first witness, Howard Rosen ("Rosen"),[16] was qualified as an expert to evaluate the license purchased by and the promissory note made by the Appellant and to comment on the valuation reports prepared by emc partners dated October 8, 1998 and American Appraisal Canada dated November 20, 1998. In his written report Rosen says:
1. You have requested our opinion as to the fair market value of Mr. Baxter's purchase of a non-exclusive, limited use license (the "License") to use the Trafalgar Index Program ("TIP") or the ("Program") as at December 31, 1998 ("the Valuation Date") ...
5. For the purposes of our opinions, fair market value is defined as the highest price obtainable in an open and unrestricted market between informed and prudent parties acting at arm's length and under no compulsion to act, as expressed in terms of money or monies worth. ...
8. Based on the scope of our review, the explanations provided to us, and subject to the assumptions, qualifications, and restrictions noted herein, in our opinion the fair market value of the $50,000 note ... License acquired by Mr. Baxter is of nominal value as at the Valuation Date ...
10. In our determination of the fair market value of the License we have taken into consideration the structure of the transaction and the available tax shield resulting from the deductibility of the License Fee from Mr. Baxter's taxable income. We have assumed for the purposes of this calculation, that the License Fee is a class 12 asset as described in the Income Tax Act ... Our analysis concludes that since we have determined that the fair market value of the License is of nominal value the associated tax shield is also of nominal value ....
12. In the event that the Court deems the License in and of itself to have some value which is separate and distinct from the value arising from its tax shield, it is our opinion that the value so determined should be apportioned as between the License and the Agency Agreement. In our opinion the License and the Agency Agreement are two distinct agreements, whereby, the License Agreement allowed Mr. Baxter the ability to use the License to trade S & P index futures and the Agency Agreement was the vehicle through which the License was implemented. Given the nature of the investment package presented to each investor, the agreements operate in concert so that anyone of the agreements would have no value on a stand alone basis. Therefore, the basis of any value should be given equal weighting between the two Agreements. The License Agreement, could have been used on its own without the Agency Agreement in the case of a purchaser who possessed the expertise to deduct the trading on his own. Viewed in this context though our conclusion as to value would also result in a nominal value. Mr. Pardo opines the TIP trading system is unlikely to produce sustainable and substantial real time trading profits, thus having no value to the License holder in itself.[17]
Other parts of Rosen's evidence are commented upon in the Report and testimony of Stephen R. Cole ("Cole") and by Appellant's Counsel in his submissions.
[71] Cole, a Chartered Business Valuator, presented by Appellant's counsel, was qualified as an expert Canadian Business Valuator to offer evidence with respect to the TIP. The letter accompanying his Report to Appellant's counsel said:
You have requested our comments and opinions concerning the report prepared by LECG dated May 10, 2005, entitled "Determination of the Fair Market Value of a License of the Trafalgar Index Program
He agreed with the definition of "fair market value" set out by Rosen. His report reads, in part, as follows:
· The LECG Conclusions are based on several essential assumptions which assumptions are factually incorrect. As a result, the LECG conclusions are wrong and not supportable.
· In particular, we disagree with LECG's conclusion as to the fair market value of a TIP License as being of nominal value. The fair market value of a TIP License is in the range of $10,000 at the Valuation Date ...
· We disagree with LECG's conclusion that fair market value when the Licensee also enters into the Agency Agreement should be apportioned equally between the License Agreement and Agency Agreement. In our opinion:
The fair market value of a TIP License without the Agency Agreement is at least $10,000 ...
· The LECG report rightly considers the benefit of deductibility of the TIP License for income tax purposes. Whatever the fair market value of a TIP License is, the tax benefits arising from the deductibility will enhance value otherwise determined. Assuming deductibility of the License within a short while of purchase, there is an incremental benefit in value otherwise determined of approximately 40%. For example, in the LECG report they calculate the benefit to be approximately $23,000 on a $50,000 license, i.e., approximately 40%.
Cole's report then states that the tax benefit of deductibility has not been taken into account. It said that this permits him to simplify the critique of the LECG report, to simplify the explanation of the fair market value of a TIP License, to present a conservative range of value leaving a cushion in its calculations, and to demonstrate that the value of $10,000 is not contingent on tax deductibility. Cole also says that:
We understand that LECG did not review its assumptions and factual understanding with Furtak or any of his senior personnel or related trading parties, and further, that Pardo did not make such inquiries.
The report then says:
Having regard to the standards of the Canadian Institute of Chartered Business Valuators, the scope of work undertaken by LECG is not a sufficient foundation upon which to base an unqualified opinion. As a result, the LECG conclusions are much less credible than alleged and should be read subject to a qualification as a result of the limited scope of their work.
We note the following shortcomings in the scope of the LECG work:
- Failure to discuss and inquire with knowledgeable personnel at Trafalgar;
- Failure to qualify the LECG report on account of the above;
- Failure to qualify the LECG report on account of the failure of Mr. Pardo to make requisite inquiries; and
- Failure to consider relevant hindsight information.
[72] Cole's report also states that with the use of historical trading data as a substitute for the investment performance of the TIP License, and the application of the terms of the Agency Agreement, a licensee could expect to earn an internal rate of return before tax in the range of 10% to 29%. It stated further that this return, as at the Valuation Date, was in the range of a licensee's reasonable return expectation and:
implies that the fair market value of a TIP License together with the Agency Agreement is in the range of $10,000.
The report also says:
At the Valuation Date, reasonable return expectations of a licensee, assuming they did not enter into the Agency Agreement; and implied minimum fair market value for a TIP License
- Using the Back-tested trading return information and deducting reasonable trading and execution expenses, a Licensee could expect to generate an internal rate of return before tax in the range of 49% to 122%. At the Valuation Date, this return exceeds a Licensee's reasonable return thresholds. This implies that the fair market value of a TIP License without the associated Agency Agreement is at least $10,000.
We have independently computed the above referred to amounts because there are no such computations in the LECG Report and they are integral to assessing both the fair market value of the TIP License and the Promissory Note at the Valuation Date.
Cole's report continues:
At the Valuation Date, available comparable product to a TIP License - We understand that alternative trading systems were available to investors. We considered the cost of acquiring the TIP License without entering into the Agency Agreement against the cost of the alternative systems referred to in the Pardo Report. At the Valuation Date, we understand that while it may have been possible to assemble alternative trading systems comparable to TIP License, it would not have been simple or straightforward. The comparisons at the Valuation Date offer no reason to believe market value was not in the range of $10,000.
The LECG conclusions make no reference to comparable product. They aught to have considered this. We assume they rely, in part, on the analysis in the Pardo Report. The Pardo Report does reference allegedly comparable product. However, the Pardo Report analysis is at best not definitive or conclusive and may be misleading.
Nothing raised in the Pardo Report in respect of comparable product cause (sic) us to change our opinion.
[73] The report refers us to its Appendix D. The key points in this Appendix are:
- allegedly comparable product is much narrower in scope than a TIP License. A TIP License "comprises multiple trading modules". In order for a prospective licensee to obtain comparable diversification, they would have needed to purchase several of the allegedly comparable products. Seven of these would have had to have been purchased, bringing the aggregate cost much closer to that of a TIP License.
- Not only would separate software modules need to be purchased but, in order to have the benefit of the risk management features in the TIP equity management program, overlay software would have to be developed to coordinate the operation of the separate module. The cost of developing such an overlay program may be material. We have not sat to estimate it.
- These costs do not appear to be addressed in the Pardo Report. The affect of rightly considering them is to now or eliminate the cost differential alleged between the TIP License and truly comparable product and operation thereof.
- Even if separate software modules were acquired together with an overlay mechanism, if a trading systems management company was not retained then, in a lieu of a facility, like the Agency Agreement, the Purchaser of the software would have to acquire the live "feeds" of data from the S & P 500 and software to coordinate same and would have to execute the trades. Cost of software is in the range of approximately $2,000 and the cost of the feeds as much as $250 per month. We understand it is possible Tradestation can provide both the software and the fees for approximately $100 per month. The cost at the Valuation Date would likely have been as much or more. The aggregate of these costs do not appear to be addressed in the Pardo Report. The effect of rightly considering them is to narrow or eliminate the cost differential alleged between the TIP License and truly comparable product and operation thereof;
- When comparing the allegedly comparable product to a TIP License with the attendant Agency Agreement the overwhelming difference, apart from software differences, is that the purchaser of the allegedly comparable product would have had to arrange for both execution facilities and provide their own capital. In the case of TIP, a facility was provided by Trafalgar as part of the Agency Agreement. The effect of rightly considering the actual and opportunity cost narrows or eliminates the cost-differential alleged between the TIP License and truly comparable product and operation thereof.
[74] Returning from Appendix D to the Report, we read:
With the benefit of hindsight, actual Trading Returns - For two years after the Valuation Date the actual Trading Returns generated by the TIP Trading Software matched those in the Back-test period and for four years after the Valuation Date trading returns exceeded the returns of the S & P 500. Performance since that time has eroded those gains but the opportunity remains for substantial profit before the end of the term;
Actual returns in a short term following the Valuation Date support a substantial value for the License at the Valuation Date. Subsequent actual returns offer no reason to believe fair market value was not in the range of $10,000 at the Valuation Date.
The LECG Report should have addressed this hindsight information but it did not.
For more detail see Appendix G;
[75] Appendix G states that the fair market value of a license, at the Valuation Date, is based on information available at that time without the benefit of hindsight. It then says that subsequent events and available information support the conclusion that the license had a fair market value in the range of $10,000. It says that hindsight information is of value in assessing the reasonableness of assumptions made as at the Valuation Date. It states:
Where the hindsight information is confirmatory of the conclusions and assumptions as at the Valuation Date, then that enhances the credibility and reliability of those conclusions.
The report also states that the hindsight information is only relevant when the information is gleaned from relevant subsequent times which are generally only those shortly after the Valuation Date. It then says that in this matter a term of one to two years following the Valuation Date is relevant for hindsight information. The report states that it is highly supportive of the conclusions and assumptions as at the Valuation Date, and that it is not appropriate to look at hindsight information beyond that time. It states also that there is a span of approximately six years subsequent to the Valuation Date, that being too long a period from which to infer value back to that date. Nonetheless, it also states that, having considered the performance of a TIP License from Valuation Date to the report date, there is nothing in the information which would cause Cole to revise his conclusion. Appendix G then says:
A review of the top 20 CTA ordinary performance in 2000 as prepared by Barclay Managed Futures Report that shows that Trafalgar Group (Index)(TIP) was placed tenth on the list at that date. We note from page 8 of the Pardo Report that as at December 31, 1998 there were 1009 CTAs registered with the CFTC. This would indicate that for that period TIP was in the top 1% of CTA returns.
In cross-examination, Rosen had said that hindsight was not admissible generally. He added that, where admissible, the exception to the rule for valuators is that if it is used to test an assumption that existed at the Valuation Date and is reasonably proximate to that date, it has limited use. Cole's report continued as follows:
With the benefit of hindsight, subsequent Trafalgar product sales for cash support the $10,000 fair market value range - Actual sales of TIP Licenses and successor licenses demonstrate the fair market value of the TIP License. 109 Licensees have made purchases to date for approximately 11 million.
Further, the report says that:
The TIP License, together with the Agency Agreement allowed an investor to enter the managed futures market without substantial capital and without having to locate and retain a CTA, Trafalgar was providing access to this type of product that was otherwise not generally available.
An analogy to this is that of an index fund (or exchange traded fund that tracks a particular index) which allows an investor to buy an economic interest in the shares of each company that makes up that index without having to make a cash outlay to buy the shares of each underlying company.
[76] Appellant's counsel accentuated and added to the foregoing by stating that the Cole Report incorporated information from several sources not canvassed by Rosen, including key management personnel of Trafalgar. Counsel continued by stating that Rosen failed to consider important information regarding the actual trading results using the software and subsequent sales of licenses for cash.
[77] He also submitted that an "open and unrestricted market" in determining fair market value would countenance neither the identity of the purchaser nor the source of funds. This is in basic disagreement with Rosen's analysis. Counsel then said that:
In contrast, Mr. Cole testified that there is only one fair market value of an asset, regardless of the identity of the purchaser.
With respect to the source of funds to acquire an asset, Cole testified as follows:
Justice Bell, the source of funds is an utter irrelevance. By definition the fair market value of a license is to be determined in an open market with the array of prospective purchasers who will pay cash, and when you buy a stock the vendor in the market doesn't ask whether your grandmother gave you the money, whether it is coming from your RRSP, your pension or your hard earned dollars. It is irrelevant. That's the beauty of the definition. It is independent of the source of funds.
[78] Appellant's counsel made the point, that even accepting Rosen's view, which he did not, it did not account for the fact that the Appellant paid the same amount for the license as licensees who paid TCL entirely in cash. He added that Rosen testified that he was unaware of any such cash sales at the time that he prepared his report although Bruce had testified as to the existence of such sales in testimony that is included in the Rosen report's scope of review. He added that Rosen also testified that he would have considered cash sales relevant in his analysis, provided the transactions occurred at arm's length.
[79] Counsel also, making reference to the transcript, stated that Rosen valued the license on the basis that a purchaser could only deploy a license by entering into an Agency Agreement with TT. He continued by saying that Rosen further admitted that he did not investigate other potential uses of a license. Counsel then submitted that this information leads to the conclusion that Rosen did not value other uses of the license to determine whether there were any higher or better uses than trading under an Agency Agreement. He also referred to Rosen's evidence respecting the apportionment of value between the license and the Agency Agreement, namely:
Based on the information that was available to me, I was unable to quantify an apportionment based on economic parameters so I arbitrarily chose 50-50 but it's open to any apportionment, in my opinion.
[80] Appellant's Counsel's analogy of a lobster trap is helpful. He said that the purchase of a lobster trap without knowing how to use it was like the purchase of a license. The engagement by the purchaser of someone to use the lobster trap is analogous to the engagement of an agent to use the license. He submitted that the lobster trap, just as the license, earned value on its own. He said that it was the asset, not the business, that must be valued.
[81] Appellant's submission refers to a letter from Deloitte & Touche replicating the simulated trading performed by Trafalgar and confirming that trading in accordance with the software would have generated an annual trading profit of 16.5%. Pardo concluded that, depending on the extent to which leverage was employed in trading, the expected annual return would be either 4.73% (assuming 20% margin to equity) or 8.52% (assuming 40% margin to equity). In contrast, Charles Ray LeBeau ("LeBeau"), qualified as an expert witness for the Appellant as an expert on the building and testing of computerized trading systems and the operation of the futures market, concluded that the figures arrived at by Deloitte & Touche were accurate. LeBeau's written report says:
The Deloitte & Touche Back-testing model prepared in 1998 and subsequently verified by my work supports an expected trading profit of 16.5% which is precisely in the range characterized by Mr. Pardo as "one of the best". At the Valuation Date, a prospective licensee might therefore reasonably have had return expectations that were very strong and certainly not sub-standard.
The difference, according to Appellant's counsel, between Pardo's conclusions and those of LeBeau is explained by the assumptions that each employed in recreating the trading simulation. Specifically, respecting "slippage" and commission, he quoted the Pardo Report defining "slippage" as follows:
Slippage is the transaction expense charged by the trading floor. It is an estimate of the difference between the price you wanted and the price you've got. Slippage is a significant cost to trading. The degree of slippage depends on the type of order placed, the size of the order, and the liquidity of the market.
Accordingly, Appellant's counsel submitted that the less the amount of slippage and commission fees, the higher the amount of trading profit that can be generated from a trading system. Pardo used an assumed figure of $100 per buy and sell transaction for the purposes of calculating the expected returns. LeBeau used the same $50 figure for slippage and commission that was used by Deloitte & Touche. He explained in his testimony that he was satisfied that the figure was reasonable since many of the trades that would be executed using a software were "counter-trend" in nature, meaning that they would be selling when the price of the security was rising and vice versa. This not only reduces the amount of slippage on a trade, but may actually produce "positive slippage", whereby the delay in executing a trade results in a better price. Counsel then said the amount of slippage was reduced since the majority of the software modules use "limit orders" which prevent a trade from taking place on unfavourable terms by setting a limit on the price that a party would accept in order to transact. This was also stated by LeBeau. Cullis[18] testified that he had performed thousands of trades using the software and that the actual amount of slippage and commission was "in the range of $60 to $65".
[82] Appellant's counsel submitted that the results obtained by Pardo in conducting his simulation were affected by the allocation of capital among the seven trading programs comprising the software ("weighting"). Counsel said that incorrect weighting could result in an overstatement or understatement of profits as well as an overstatement or understatement of the risk associated with trading using the software. Pardo testified that he assumed that each of the seven trading programs were weighted equally. However, Cullis testified that the weighting employed by Deloitte & Touche, and the weighting actually used by the software was not equal as to each program. The asset allocation ratio used by LeBeau verified the Deloitte & Touche results.
[83] Counsel stated that Pardo also failed to use the Equity Management Module. It is a component of the software that monitored each of the seven trading programs and essentially turned off any program that was not performing as planned on a particular day. Cullis explained that, as a result of this failure, Pardo overstated the risk of trading using the software. In contrast, LeBeau used the Equity Management Module in verifying the Deloitte & Touche results.
[84] Appellant's counsel said that Rosen was misinformed in that his conclusion was predicated on the "bet the house" theory, whereby he assumed that as a consequence of the leverage rates that he expected would be deployed under an Agency Agreement, all of the trading capital was at risk at all times. In this regard, Rosen, in his report said:
Assuming the Initial Trading Capital is traded, an unexpected market fluctuation, either positive or negative, of approximately 5.4% (i.e. $10,000 - $184,447), or a series of lesser fluctuations, would be sufficient to completely deplete his Trading Capital of $10,000 and end further trading. Since the Agreements indicate that any net returns allocated to trading capital during the term are also reinvested to acquire additional futures, it follows that Mr. Baxter's trading capital always be at risk and therefore a 5.4% unexpected market fluctuation or a series of market fluctuations at anytime during the term of the license would be sufficient to deplete the current balance of trading capital and end further trading.
[85] Counsel submitted that Rosen used the wrong amount of leverage in his calculations, having failed to consider the unique features of the software, namely:
(a) the high degree of independence between the trading programs,
(b) stop loss mechanisms in the software that prevent the seven programs from resulting in a position that could lead to a substantial loss, and
(c) the fact that all positions are closed at the end of the day.
He continued by saying that the conditions that would need to be present in order for the Trading Capital to be depleted are so remote as to be "inconceivable", a word used by LeBeau. Counsel added that:
In order for Mr. Rosen's analysis to be correct, all seven trading programs would not only have to be trading on the same day (which happens approximately 2.5% of the time)[19] but they would all have to be simultaneously holding the same position, since if one trading program was holding a short position while the others were holding long positions, not all of the capital would be at risk. In addition, all trading would need to halt on the market before scheduled closing, so that the self-regulating mechanisms embedded in the software which precludes such a loss from occurring would not be able to close out the trading position. Such conditions would result in exposure to overnight market fluctuations, which fluctuations would need to be of sufficient magnitude to eliminate the trading capital.[20]
[86] In order to obtain a copy of the software's source code, Rosen enlisted the help of a third party, Ivanoff ("Ivanoff"), to decompile the software. Neither Rosen nor anyone from his valuation team had met Ivanoff nor did they know his country of residence or anything about him. Ivanoff, discovered "on line" through the internet, resided in an European time zone and was entrusted, by e-mail, with the task of determining the software source code for a fee of $300. Appellant's counsel stated that the manner in which the source code was acquired casts doubt on the extent to which the Court can be assured that the copy of the source code examined by Pardo was even the same program as the software. Neither Rosen nor Pardo contacted, or attempted to contact Furtak or any other representative of the Trafalgar Group of companies. Counsel then said:
Accordingly, the Rosen - the Pardo opinion does not benefit from the additional information that Trafalgar could provide. Moreover, this fact should have been, but was not, disclosed in the Rosen Report.
[87] Appellant's counsel also stated that Rosen reviewed the examination for discovery of Bruce wherein he testified he was aware that sales of licenses to use the software had been made for cash consideration. He then referred to Rosen's testimony that in spite of such review, he, Rosen, did not realize that cash sales of licenses had transpired.
[88] Counsel also said that:
Although both Mr. Pardo and the Minister possessed copies of the Deloitte & Touche letter confirming the results of simulated trading, Mr. Rosen did not know of its existence until after he had completed his report.
[89] In response, Respondent's counsel's written submission opened with the statement that:
The Appellant called no evidence in chief with respect to the fair market value of the license and adduced no evidence at trial that supports the position that the fair market value was the full $50,000.
This statement ignores the fact that the Appellant had no onus with respect to the fair market value of the license, the necessity of adducing evidence to establish same having fallen upon the Respondent.
[90] Respondent's counsel also fell into the error of discussing the balance in the investment accounts of the Respondent's witnesses, Dahn and Myatt, in 2005. This has absolutely nothing to do with the valuation of the Appellant's license on the day it was purchased. Also, the statement that the evidence shows that 90% of the capital has been lost in just over six years fails to take into account evidence from the Respondent's own witness, Peters. As above set forth above, he said that interest on the note, an administration fee and brokerage fees would come out of profits. That also has no relevance to the value of the license when purchased. Further, it fails to take into account any evidence from the Appellant's witnesses.
[91] It is very difficult to comprehend and, therefore, respond to Counsel's submission that:
While it is suggested by the Appellant's rebuttal expert, Mr. Cole, that the license should be valued in isolation (i.e. ignoring the existence and operation of the Agency Agreement) this completely ignores the facts of this case as they exist. What the Crown's experts valued is what the Appellant actually purchased. Any theoretical valuation that makes other assumptions is ignoring reality and common sense.
[92] I simply refer to Cole's evidence in response to this Submission.
[93] The first eight days of the hearing were devoted to the adduction of evidence and, some two months later, to the hearing of submissions over a two day period. Respondent's written brief did not adequately address the evidence presented by Appellant's witnesses, namely, the Appellant, LeBeau, Cullis and Cole.
[94] Pardo, operating in the Chicago area, did not, even after much urging by the Court, speak in terms comprehensible to someone outside his trade. I was repeatedly asking him to explain what his phrases meant and what he meant. Although he seemed almost disdainful at times, I am of the view that it was not intentional but rather that his conduct has been cultured by the level at which he operates, namely the highly monied investor world. His testimony was very difficult to comprehend.
[95] Rosen would not compromise his view that the license could not be valued alone and that the income tax effect of its purchase and the source of an investor's funds were essential to consider in the determination of value.
[96] I found Cole to be articulate, succinct and clear in the presentation of his pithy hypotheses. His written report and his oral evidence were very persuasive. He stated in his report that:
This report must be read in its entirety. Selecting portions of the analysis without considering all factors and analysis together could create a misleading view of the methodologies and approaches underlying our conclusions. The preparation for conclusion on value is a complex process and components of value cannot be viewed in isolation.
[97] Analysis of experts' reports is extremely difficult, particularly where they involve the valuation of a complex matter such as software. It is open to a Court to accept an expert report in full. It is also open to a Court, in a valuation case, to determine an amount somewhere between the opposing experts' determinations. Justifying such a finding is a mammoth, if not impossible, task. After all, an expert is someone who knows more about the subject matter than the judge knows. In this case I am persuaded by the demeanour, substance, presentation and modest certainty of Cole. Accordingly I accept his determination of the value of the Appellant's license, namely an amount equal to his purchase price of $50,000.
Fifth Issue
[98] The fifth issue is whether the Appellant's entitlement to capital cost allowance is limited by the provisions of section 67. That section reads as follows:
In computing income, no deduction shall be made in respect of an outlay or expense in respect of any amount that is otherwise deductible under this Act, except to the extent that the outlay or expense was reasonable in the circumstances.
Since I have determined that the value of the license is what the Appellant paid for it, namely $50,000, no question can arise under section 67.
Sixth Issue
[99] The sixth issue is whether the promissory note represented a contingent liability.
The Appellant's position is that his obligation under the note was not a contingent liability. The Respondent submits that the $32,500 promissory note made by the Appellant is a contingent liability and as such this amount should be excluded from the capital cost of the license.
[100] Under section 8.3 of the Agency Agreement, TT covenanted that the trading of the License would achieve an average annual return of not less than 8%. Appellant's counsel, referring to The Queen v. Gelber, 83 DTC 5385 (F.C.A.), said that such covenant would not, in itself, justify a reduction in what otherwise would be the capital cost to the Appellant. The Court said, in its penultimate paragraph:
In my opinion, the fact that a purchaser of property provides, as a condition of the purchase, for a leaseback under which he is assured of a revenue that will cover the amount of his investment and some return on it does not make the purchase price any less the true capital cost of the property.
Under section 8.4 of the Agency Agreement TCL agreed:
that notwithstanding the provisions of the License Agreement and the Promissory Note, the Licensee's obligation to fulfill the terms of the Promissory Note and of section 3.1(e) of the License Agreement shall be limited, pro rata to the extent that TT fulfills the terms of section 8.3 ...
Appellant's counsel stated that the note itself declares that it
is subject to the terms and conditions of
the License Agreement but does not state that it is subject to the terms and conditions of the Agency Agreement which contains the aforementioned guarantee of TCL. Counsel also said that the obligation under the note arose before the Agency Agreement could take effect. The first recital of the Agency Agreement states that
WHEREAS the Licensee has been granted by TCL ... a non-exclusive, limited-use license to use the Trafalgar Index Program ...
(emphasis added)
Counsel, therefore, says that the note could not be subject to any condition found in the Agency Agreement.
[101] Counsel also stated that since the issue is the capital cost of the license, that question should be determined as of the time when the license was acquired. He then said that the note, when issued in partial payment for the license, was absolute and not subject to any of the provisions of the Agency Agreement and that that fact alone is sufficient to conclude that the obligation under the note was not a contingent liability. He stated that that was apparent in Wawang Forest Products Limited v. The Queen, 2001 DTC 5212 (F.C.A.). At paragraph 16 the Court referred to the test in Winter v. I.R.C., [1963] A.C. 235 (H.L.) at page 262 as follows:
I should define a contingency as an event which may or may not occur and a contingent liability as a liability which depends for its existence upon an event which may or may not happen.
The Federal Court of Appeal in Wawang, at paragraphs 15 and 16 said:
... with respect to the uncertainty as to payment, a taxpayer may incur an obligation at a time when it is in financial difficulty, with the result that there is a significant risk of non-payment. But that uncertainty cannot mean that the obligation was never incurred. Similarly, an obligation to pay a certain amount does not become a contingent obligation merely because events may occur that result in a reduction in the quantum of the liability
... Nor does a legal obligation to pay an amount become contingent merely because payment may be postponed in certain events or no date is stipulated for payment ... the correct question to ask, in determining whether a legal obligation is contingent at a particular ... time, is whether the legal obligation has come into existence at that time, or whether no obligation will come into existence until the occurrence of an event that may not occur.
[102] Counsel then stated that whether a liability is contingent at a given time depends on whether, at that time, a legal obligation exists or whether a legal obligation will only come into existence at some later time upon the occurrence of an event or events that is or are not certain to occur. He added that if a condition must be fulfilled before a debt becomes a legal obligation, the debt is a contingent liability. If the debt is subject to a "condition subsequent" in that a legal obligation exists but could be nullified, in whole or in part, by subsequent events other than payment of the debt, it is not a contingent liability. He then submitted that the promissory note represents a present obligation that might terminate, in whole or in part, as a result of a future event, namely the failure of the trading activity to generate the assured 8% return.
[103] Appellant's counsel then referred to Hill v. The Queen, 2002 DTC 1749 (T.C.C.) pointing out, with reference to page 1759, that the existence of a contingency must be determined at the time when the debt was incurred.
[104] In Fédération des Caisses Populaires Desjardins de Montréal et de l'Est du Québec v. The Queen, 2002 DTC 7413 (F.C.A.), the issue was whether the taxpayer could deduct an estimated amount of employer contributions toward employees' vacation pay that it accrued at the end the year in question based on amounts that had been earned by its employees up to that time. The taxpayer's obligation existed from the time when the services in question were performed even though the amounts in question would not be paid until the employees chose to take their vacation. The possibility of an employee not taking a vacation was a condition subsequent. Counsel stated that neither that possibility nor the fact that the amount of the accrued obligation had to be estimated made that obligation a contingent liability.
[105] In McLarty v. The Queen, 2005 DTC 217 (T.C.C.), presently under appeal, the promissory note was expressly stated to be subject to terms that provided for its payment from cash flow generated by the venture in which the taxpayer invested and, if necessary, by the sale of the venture's assets with any remaining deficiency forgiven. The Court concluded in paragraph 46:
... the Note is not a contingent liability simply because we do not know how much or at what time the promissory note will be paid.
Appellant's counsel said, with reference to the promissory note and the interest obligation thereon, that it would be hard to conceive that an obligation on which monthly interest immediately commences to be payable is not a current obligation.
[106] There are a number of cases cited by the Appellant in which obligations were determined to be contingent liabilities.[21] The decisions in these cases are understandable, all based on facts different from those before this Court.
[107] In summary, Appellant's counsel stated that the debt represented by the note was an enforceable obligation bearing current interest from the time the note was made, regardless of any assurances of a rate of return from the trading operation. He added:
If the actual return proved to be less than the assured rate and as a result TCL did not seek payment of some or all of the balance of the Note, this was a condition subsequent and did not affect the fact that the Note was an enforceable obligation. Consequently, no part of the debt represented by the Note was a contingent liability, and its amount should not be excluded for that reason from the capital cost of the License to the Appellant.
[108] Respondent's counsel, in written submission said:
Clearly, in the case at bar, when the Appellant entered into the arrangement in 1998, the extent of his legal obligation under the promissory note was dependant upon the performance of the investment over time.
Without having been specific on that point, it is clear that the Respondent did not treat the promissory note as a "stand alone" document because of the reference to the "arrangement". Most of the cases referred to by Respondent's counsel were referred to by Appellant's counsel and are foot-noted herein.
[109] Regardless of whatever time may have passed between the execution of the License Agreement and the promissory note, and the execution of the Agency Agreement, there is no evidence to establish that the promissory note had not been made prior to the entering into of the Agency Agreement. In this regard, in The Queen v. John R. Singleton, 2001 DTC 5533, the Supreme Court of Canada, described a number of steps taken by Singleton, including the borrowing of money to refinance his capital account in a law partnership and the ultimate purchase of a house. The Court said, in paragraphs 32 to 34:
Giving effect to the legal relationships in this case, it is clear that the respondent used the borrowed funds to refinance his capital account.
This characterization of the use of funds is not altered by the fact that the respondent used the money he withdrew from the firm to purchase a house. Nor is it altered by the fact that the transactions occurred on the same day.
In my respectful opinion, it is an error to treat this as one simultaneous transaction. In order to give effect to the legal relationships, the transactions must be reviewed independently.
[110] I have concluded that the answer to the question posed in this issue must be resolved in favour of the Appellant. The promissory note did not represent a contingent liability.
[111] The Promissory Note, a copy of which was put into evidence, was made on December 31, 1998, in the principal sum of $32,500. Both Rosen and Cole valued the promissory note. The LECG Report (Rosen) states:
... it is our opinion that the fair market value of the Promissory Note as at the Valuation Date is of nominal value.
Cole's report refers to
the acquisition of five TIP Licenses by R. Daren Baxter from Trafalgar B.V. on the Valuation Date ... and the associated promissory note ("Promissory Note").
The report states that:
The fair market value of a TIP License is in the range of $10,000 at the Valuation Date
It stated then that:
The fair market value of a Promissory Note is in the range of $4,000 to $6,000 at the Valuation Date.
Obviously, the valuation refers to each of the 5 licenses purchased by the Appellant even though there was one License Agreement under which the total purchase price of $50,000 was payable.
[112] The valuation of the note or notes not having been a question posed to the Court in any of the 6 issues referred by the parties, I make no finding here on that matter. It may be settled by the parties or by a reference to this Court which can, if necessary, be made.
[113] The appeal will be allowed, all issues having been determined in favour of the Appellant.
[114] I shall not deal with costs in the judgment herein. I will be available for a telephone conference respecting same. This can be arranged by counsel.
Signed at Ottawa, Canada, this 13th day of April, 2006.
"R.D. Bell"
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