Toews v. R., [1996] 2 CTC 2279 (Informal Procedure)

O’Connor J.T.C.C.: — This appeal was heard in Regina, Saskatchewan on January 18, 1996 pursuant to the Informal Procedure of this Court.

Testimony was given by the Appellant, a Regina lawyer and former Chief Justice of the Provincial Court of Saskatchewan from 1982 to 1987 and also by Peter Epp, an investor in certain real estate projects. As well numerous exhibits were filed.

The only issue in this appeal is whether an amount of $12,500 U.S. ($14,342.50 CDN) claimed as a deduction by the Appellant in the 1990 taxation year was truly deductible as a business loss under the Income Tax Act (“Act”). The basic facts are contained in the following extracts from the Notice of Appeal which were admitted by the Respondent in the Reply:

2. The Appellant, Mr. Peter Epp, and later Mr. David Zawislak and Mr. Eugene Kitchen, were shareholders of McCannel Developments Ltd. (“MDL”), the general partner of McCannel Properties Limited Partnership [“MPLP”], which as established for the purpose of developing a condominium project in Regina.

3. In mid-1990, it was estimated that $6.5 million would be required to complete the condominium project. Mr. Epp discussed this with Sempre Corporation (“Sempre”) of San Antonio, Texas. It was suggested by Sempre that MDL look for an additional project as raising $6.5 million would be uneconomical. The Landmark Inn in Regina was in receivership at the time and was available for purchase. Sempre offered to assist MDL in obtaining financing in the amount of $16 million U.S.

4. On August 23, 1990, the share structure of MDL was altered so that the four shareholders would each hold 50 Class “A” shares...

5. An engagement agreement was entered into with Sempre, and a non- refundable fee of $50,000 U.S. was forwarded by the shareholders to Sempre. Each shareholder, including the Appellant, provided $12,500.00 U.S. ($14,342.50 CDN). The funds were forwarded between August 23, 1990 and October 3, 1990.

The agreement referred to in paragraph 5 above was executed August 22, 1990 between Sempre and an entity described simply as “McCannel Properties” represented by Mr. Epp. Its principal provisions are as follows:

1.0 Client hereby engages Sempre to assist Client in its financing of the Project through a securities offering that will either be (i) registered for public sale or (ii) sold privately pursuant to an exemption from registration with the Securities and Exchange Commission and the applicable state securities administrators and/or other source(s) of financing if determined to be in the best interest of Client.

1.1 The purpose of this engagement contract (the “Agreement”) is to formalize the relationship between McCannel Properties and its affiliates (the “Client”) and Sempre Corporation (“Sempre”) regarding the collection and complication [sic] of certain information, data and documents in connection with the proposed private placement pursuant to an exemption from registration with the Securities and Exchange Commission and the applicable state securities administrators for the McCannel Properties Project (the “Project”).

2.0 SCOPE OF ENGAGEMENT

2.1 Sempre will assist the Client with the following:

2.1.1 Comprehensive review of the Project, including recommendations to the Client of alternative means for obtaining the Client’s desired objectives;

2.1.2 Collection and compilation of certain information, data and documents relating to the Project and the offering of the securities;

2.1.3 Preparation of a due diligence disclosure document with respect to the Project and the Issuer of the securities to be offered;

2.1.4 Assistance with the administrative and clerical tasks required for the preparation of a private placement memorandum, or similar disclosure documents required to comply with the applicable manner of offering and sale of the securities in connection with financing the Project;

2.1.5 Coordination with the professionals employed by Client in connection with Client’s Project, including, but not limited to, financial consultants, bankers, venture capitalists, qualified accredited institutions, accountants, and attorneys, and such third parties as may be involved in the securities aspect of the Project, including the National Association of Securities Dealers, Inc. (“NASD”), and officials of any state and/or federal agencies that may exercise regulatory control over the securities laws aspect of Client’s activities relating to the Project;

2.1.6 Sempre will, on a best efforts basis only, and on your behalf negotiate with NASD member firms and/or accredited institutional investors relating to the placement of, or participation in, the private placement....

4.1 You agree to pay to us a fixed non-refundable fee (exclusive of the successful efforts fee hereinafter set forth) in the following amounts for the services above described, with said fee paid in separate and independent phases

as follows:

4.1.1 Phase I $20,000 upon the execution of this Agreement. This Phase I fee is payment for the services described in paragraphs 2.1.1, 2.1.2 and 2.1.3 above along with delivery to you of the materials and matters defined therein.

4.1.2 Phase II $20,000 upon our mutual election to proceed with the Project and upon your approval and verification of the Due Diligence Disclosure Document(s) prepared in Phase I. Upon receipt of the Phase II fee, Sempre will proceed with the matters and services described in paragraph 2.1.4 and 2.1.5 above.

4.1.3 Phase III $10,000 upon Clients approval of the documents prepared in Phase II. Upon receipt of the Phase III fee, Sempre will proceed with the services described in paragraph 2.1.6 above....

4.2 The aforementioned non-refundable fee of $50,000 shall be applied to fees which are incurred for services of Sempre personnel to be performed in accordance with this Agreement.

4.5 Client and Sempre agree that the services to be rendered by Sempre will make a significant contribution to the success of the Project. Therefore, upon successful funding of the Project, Sempre will be paid a successful efforts fee, exclusive of the aforementioned non-refundable Phase I, II and II fee payments, in the amount of $320,000 from the proceeds of the sale of the securities described in this Agreement.

The fees contemplated in paragraphs 4.1.1 to 4.1.3 were paid on the dates provided. Payments were made using the trust account of the Appellant’s law firm. The Appellant in total paid $12,500 U.S. as did Mr. Epp. The other shareholders, Zawislak and Kitchen apparently made the payments by means of monies deposited in said trust account by corporations owned by them.

The Appellant testified that the arrangement with Sempre was that if the financing was obtained and the two projects went ahead, the Appellant and the other three shareholders of McCannel Developments Ltd. (“MDL”) together would be entitled to management fees totalling $200,000. In 1991 it became apparent that Sempre was either fraudulent or incompetent. The financing was not obtained, the deal fell through and the Appellant was out $12,500 U.S.

The document evidencing the $200,000 fee is a “Summary of Offering” forming part of a draft “Private Placement Memorandum” prepared by Sempre and dated November 1, 1990. It was filed as Exhibit A-11 and its relevant pages were filed separately as Exhibit A-14. Page 2 indicates that the General Partner was to receive certain fees and other compensation. Pages 5 and 7 summarize the proposed disposition of the $16,000,000 U.S. and contain references to management fees of $100,000 for the Landmark Inn and $100,000 for the McCannel Properties development - i.e. the condominium project. Under the heading “Conflicts of Interest”, pages 41 and 42, the following is stated:

In performing its duties and fulfilling its obligations under the Limited Partnership Agreement, and fulfilling its fiduciary responsibilities to other Partners, the General Partner will be subject to conflicts between its best interests and the best interests of the Partnership and other Partners. In addition, certain other persons associated with the Offering may have conflicts of interest in connection with the Offering. Set forth below is a brief description of certain possible conflicts of interest.

7. Compensation and Fees to General Partner.

Partnership transactions involving the purchase, sale and management of the Property will result in the realization by the General Partner and its affiliates of commissions, fees, compensation and income. The General Partner has absolute discretion with respect to such transactions. The agreements and arrangements, including those relating to compensation, between the Partnership and the General Partner and its affiliates have not been negotiated at arm’s length. Conflicts of interest between the General Partner and its affiliates on the one hand and the Partnership and/or the Limited Partners on the other may arise with respect to, among other things, a timing of the dissolution of the Partnership or of a sale or other disposition of the Property.

All agreements and arrangements, including those regarding compensation, between the Partnership and the General Partner have been determined by the General Partner and are not the result of arm’s length negotiations. It is the opinion of the General Partner that such determinations are based upon common industry practice and have been made in general consideration of fairness. Certain fees to be paid to the General Partner will be received irrespective of the profitability of the Partnership.

Submissions of the appellant

Appellant’s counsel submits that the activities carried on by the Appellant and Mr. Epp constituted a business operation and the expected management fees themselves totalling $200,000, if paid, would have been income earned as a result of a business operation. In his written brief of law Appellant’s counsel submitted further as follows:

20. It is respectfully submitted on behalf of the Appellant that the amount paid to Sempre was a direct expense incurred for the purpose of gaining or producing income from a business and the loss thereof is deductible as a business loss.

21. Business is defined in section 248(1) of the Income Tax Act as:

“business” includes a profession, calling, trade, manufacture or undertaking of any kind whatever and, except for the purposes of paragraph 18(2)(c), section 54.2, subsection 95(1) and paragraph 110.6(14)(f), an adventure or concern in the nature of trade but does not include an office or employment;

22. In Firestone v. R. (sub nom. Firestone v. The Queen), [1987] 2 C.T.C. 1, [1987] 2 D.T.C. 1, MacGuigan, J. of the Federal Court of Appeal adopted the careful analysis of the trial judge, who suggested, in part, that:

In order for an expense to be deductible in computing a taxpayer’s income, two preconditions must be met. The expense must have been made or incurred for the purpose of gaining or producing income from the business or property of the taxpayer within the ambit of paragraph 18(1 )(a) of the Income Tax Act. Once it is found that a particular expenditure is one made for the purpose of gaining or producing income then it still must be determined whether or not such expenditure is a payment on account of capital within the prohibition of paragraph 18(1 )(b):....

23. The prohibition in paragraph 18(1 )(b) of the Income Tax Act is:

capital outlay or loss - an outlay, loss or replacement of capital, a payment on account of capital or an allowance in respect of depreciation, obsolescence or depletion except as expressly permitted by this Part;

Was there a Business?

Undertaking / Adventure or Concern in the Nature of Trade

25. In this appeal, the business of ETKZ [the four shareholders of MDL] consisted of a single transaction. ETKZ provided management services to assist Sempre in preparing a private placement memorandum and obtain the financing necessary to complete the condominium project and acquire the Landmark Inn. For their services in helping obtain the financing, they would receive revenues of $200,000 U.S. as management fees from the proceeds of the financing.

26. It is respectfully submitted that the provision of management services is an “undertaking” or “adventure or concern in the nature of trade” as defined in section 248(1) of the Income Tax Act.

Commencement of the Business

39. IT-364 ... suggests the criteria to be considered in the determination of when business commenced:

1. Generally speaking, it is the Department’s view that a business commences whenever some significant activity is undertaken that is a regular part of the income-earning process in that type of business or is an essential preliminary to normal operation.

[Emphasis added.]

2. In order that there be a finding that a business has commenced, it is necessary that there be a fairly specific concept of the type of activity to be carried on and a sufficient organizational structure assembled to undertake at least the essential preliminaries. This requirement is applicable whether the projected business is intended to be a continuing one or is to be a single transaction in the form of an adventure in the nature of trade.

[Emphasis added. ]

3. A business would be viewed as being merely contemplated for the future if no serious or reasonably continuous efforts are being made to begin normal business operations.

40. The first of the expenditures occurred on August 23, 1990. It is respectfully submitted that, although the exact date of commencement may not be determined, the business of ETKZ commenced prior to that first payment on August 23, 1990.

41. There were existing businesses operating that required financing. With respect to the condominium project, the MPLP and MDL were in existence and operating. With respect to the Landmark Inn, the business had operated for numerous years and was, at the time, being operated by a receiver. Although these businesses are separate businesses from ETKZ, it was their establishment and continued operation that gave rise to the business opportunity undertaken by ETKZ.

42. Evidence of the activities undertaken by ETKZ that indicate that significant activity was undertaken that was a regular part of the income-earning process in that type of business or were essential preliminaries to normal operation is as follows:

1. Letter dated August 20, 1990 from Sempre to Peter Epp indicating the following steps had been taken:

— structuring conference on August 9, 1990 to Sempre Executive Committee;

— pre-engagement due diligence investigation;

— expression of interest from institutional investors;

— pre-engagement transaction review.

2. Execution of the engagement Contract dated August 20, 1990 and executed by Peter Epp on August 22, 1990.

3. Shareholdings in MDL altered [so] that Epp, Toews, Kitchen and Zawislak were the shareholders with 50 Class “A” shares each.

4. Letter from Sempre to Peter Epp dated August 27, 1990 enclosing questionnaires, disclosure checklist and instruction sheet and completion of “QUESTIONNAIRE FOR PARTNERS, OFFICERS, DIRECTORS, PRINCIPAL STOCKHOLDERS AND OTHERS INVOLVED IN ANY OFFERING” by Mr. Toews, both handwritten draft and typed copy, during August, 1990.

Income or Capital

49. The Minister alleges that the payment was made by the Appellant on behalf of MDL. This is rejected by the Appellant. The payment was made to Sempre by the Appellant through the Appellant’s law firm. The engagement agreement was between Sempre and McCannel Properties (not MDL). The transaction does not appear on the financial statements of MDL for the time period in question; that is, there is no expense on the income statement nor liability or equity on the balance sheet and no entry in the statement of changes in financial position....

CONCLUSION

53. In the present case, the Appellant was involved in an undertaking or an adventure or concern in the nature of trade. The business had commenced operation. The Appellant was very active in the operation of the business. He was not acquiring a structure for earning profit, but rather, the structure was already in place. The funds paid by the Appellant to Sempre were expenses incurred for the purpose of producing income.

54. It is submitted that the payments to Sempre were made by Mr. Toews as an individual and not in his capacity as a shareholder of MDL as assumed by the Minister. ETKZ provided management services associated with obtaining the financing for a new limited partnership, and in return, expected to earn a share management fees in the amount of $200,000.00. It is further submitted that ETKZ commenced business prior to the payment of monies to Sempre and that the payments made to Sempre were in the nature of expenditures incurred to earn revenues, and not in the nature of capital. It is also submitted that the expenditures were reasonable in the circumstances. As a result, the it is respectfully submitted that the loss claimed by Mr. Toews in 1990 was properly claimed as a business loss.

Submissions of Respondent

The Respondent’s principal submissions are contained in Respondent’s counsel’s written submission of January 26, 1996 and read:

2. There is a preponderance of evidence that the payment made to Sempre Corporation (“Sempre”) was made on behalf of McCannel Developments Ltd., (“M.D.L.”), the general partner of the partnership. By letter dated August 20th, 1990 (Exhibit A-3), Sempre suggested that a new corporation be formed to act as the corporate general partner in order to meet requirements of American legislation. That letter said, in part, the following: “As Corporate General Partner, the company would be responsible for the day to day management of the project... In addition, it would also be responsible for the management and the day to day operations of the Landmark Hotel.” (emphasis added). There is no reference in this letter or in any other correspondence or documentation that management of the project or the hotel is to be carried out by any party other than M.D.L.

6. ... Exhibit A-3 clearly states that the general partner was to be responsible for the management of the project and the hotel. Exhibit A-14, page 5 thereof, makes reference to two management fees of $100,000 each to be paid out of the $16,000,000 capital contribution by the limited partners. There is also reference on that page to an “initial partnership administration fee” of $160,000 to be paid to M.D.L. Page 7 of A-14 makes further reference to these sums. An “initial partnership administration fee” is not a management fee and the Court should not conclude that M.D.L. was to manage the project for no remuneration.

7. The Respondent submits that there is evidence in A-14 to remuneration to be paid to M.D.L. Pages 45-46 thereof deal with fees and compensation to be paid to M.D.L. and makes specific reference to a management contract for a period of three years and to compensation to be paid to M.D.L. It states that these fees for the years 1991, 1992 and 1993 are “to be determined”. Respondent submits that exhibits A-3 and A-14, when read together, ought to lead the Court to the conclusion that the management fees were to be paid to M.D.L. At the very least, these documents, together with the absence of any mention in these or any other documents of a partnership or a joint venture, ought to be sufficient to demonstrate that the appellant has not discharged the onus which rests upon him.

8. Page 41 of exhibit A-14 is entitled “Conflicts of Interest.” In the preamble thereto, it is stated: “In addition, certain other persons associated with the Offering may have conflicts of interest in connection with the Offering. Set forth below is a brief description of certain possible conflicts of interest.” There follows a number of such possible conflicts, including “8. Compensation and Fees to Principals of General Partner.” Respondent submits that if the $200,000 in management fees was intended to be paid to Messrs. Epp, Toews, Zawislak and Kitchen in their personal capacities or as partners or joint venturers, it would have been mandatory for this to be disclosed in exhibit A-14.

9. At page 42 of exhibit A-14, also under the heading “Conflicts of Interest”, is the following:

7. Compensation and Fees to the General Partner

Partnership transactions involving the purchase, sale and management of the Property will result in the realization by the General Partner and its affiliates of commissions, fees, compensation and income.

[Emphasis added.]

Respondent submits that this constitutes clear evidence that the management fees were to be paid to M.D.L. and not to the individuals

11. Respondent further submits, and this was confirmed by the appellant in testimony, that in all of the material which was placed before the Court there was not a single reference to the fact that the management fee was to be paid to the individual shareholders of M.D.L. rather than to the corporation itself. As such, it was incumbent on the Appellant to call or to make available for cross examination all witnesses who had material evidence to proffer on this crucial point. While Mr. Epp was called in support of the Appellant’s case, Messrs. Zawislak and Kitchen were not present and no explanation was put forwarded their absence. No evidence was called nor was any information presented from Sempre and no explanation was put forward by the Appellant for this fact. Respondent submits that a failure by a party to call material evidence or to present any satisfactory explanation for its absence should be the subject of an adverse inference by this Court.

Sopinka et al.: The Law of Evidence in

Canada, 1992, page 875.

12. As the onus throughout was on the Appellant to demonstrate that this was not a capital investment, Respondent respectfully submits that the Appellant has not demonstrated that the funds were not advanced on behalf of M.D.L. As such, Respondent submits that the advances should be treated as capital expenditures, specifically loans to the corporation. [Anderson v. Minister of National Revenue, [1992] 2 C.T.C. 243, 92 D.T.C. 1778 at page 2116 (D.T.C. 1781); Freud v. Minister of National Revenue, [1969] S.C.R. 75, [1968] C.T.C. 438, 68 D.T.C. 5279 at page 78 (C.T.C. 440; D.T.C. 5282).]

13. However, should the Court decide that these funds were advanced by the appellant in his personal capacity, Respondent submits that it still has the character of being an investment of capital. Both Mr. Toews and Mr. Epp testified that the $50,000 paid to Sempre was an investment designed to generate a stream of income of $200,000. Mr. Toews further stated that the investment was not speculative. As such, Respondent submits that this admission in and off itself is decisive of the issue before the Court....

15. Respondent further submits that there is a third ground upon which this Honourable Court can conclude that this was a capital investment, specifically that there was no “business” in existence when the investment was made.…

Analysis and decision

At the outset I accept unreservedly the credibility of the Appellant. Mr. Epp’s testimony was not always clear but did support the Appellant’s contention that the four shareholders, not MDL were to earn the fees.

With respect to the payments made by the Appellant totalling $12,500 U.S. it is clear from Exhibits A-7 and A-8 that these payments were in fact made by the Appellant through his law office. It is also clear from the corporate records of MDL that there are no entries therein indicating or suggesting that the payments were considered as being made on behalf of MDL. The document (Exhibits A-11 and A-14) referring to the $200,000 expected management fees indicates on page 2 that the fees were to be paid to the general partner, MDL. I am satisfied however that the initial arrangement with Sempre was sufficiently broad to permit these fees to be paid directly to the shareholders including the Appellant. I receive some comfort in this conclusion in that the original agreement signed August 22, 1990 defines the “Client” (MDL) as including an affiliate. The word “affiliate” is not defined in that original agreement but in Schedules A to Exhibits A-10 and A-l 1 (drafts of “the Private Placement Memorandum”). “Affiliate” is defined as including, inter alia, controlling shareholders and even officers and directors. Moreover paragraph 7 of “Conflicts of Interest” in Exhibit A-11 refers to affiliates and states “The General Partner has complete discretion with respect to such transactions” - i.e. fees to be paid, etc.

For the foregoing reasons I have concluded that the $12,500 U.S. paid by the Appellant to Sempre was paid by the Appellant personally and not on behalf of MDL.

Further, for the reasons set forth in the Appellant’s submissions, I am of the opinion that a business had commenced prior to August 23, 1990 and that the $12,500 U.S. was paid for the purpose of generating income, principally to earn the anticipated management fees. The Respondent’s counsel’s written submissions have convinced me that this was certainly a marginal case but on balance I believe the foregoing conclusion is correct. Consequently, in my opinion, the $12,500 U.S. ($14,342.50 CDN) was a deductible expense to the Appellant and not a capital outlay.

Therefore the appeal is allowed with costs.

Appeal allowed.