Mitchell v. R., [1996] 2 CTC 2659, 97 DTC 607

Bell J.T.C.C.: — The Appellant has appealed from a reassessment of his 1990 and 1991 taxation years denying the deduction of what he had claimed as his share of the business losses of a limited partnership (“Partnership”).

ISSUE

The issue is whether the adjusted cost base of the Appellant’s interest in the Partnership includes the sum of $121,067 being the amount of Partnership debt guaranteed by the Appellant. If this amount is included, the Appellant’s “at-risk amount” under subsections 96(2.1) and 96(2.2) of the Income Tax Act (“Act”) will be greater than the business losses deducted. In these circumstances, the appeal would be allowed.

FACTS

The Partnership was formed in July 1987 to develop a residential care facility for senior citizens. In the Partnership Agreement, the term “Capital Contribution” was defined to mean the “gross amount” of cash contributed or agreed to be contributed to the capital of the Partnership by each partner, being the initial contribution described in section 3.02 less any repayments thereof.

Section 3.02 reads as follows:

Number of Units The interests of the Limited Partners in the Partnership shall be divided into 45 units. No additional Units shall be issued. Each unit shall represent a cash contribution of $29,074.00. Payment for each unit shall be as follows:

(a) $5,000.00 in cash or by certified cheque upon subscription;

(b) $10,000.00 by cash or certified cheque upon signing of this Partnership Agreement;

(c) $14,074.00 by execution of a non- interest bearing promissory note due December 1, 1987; and

(d) $121,067.00 by guarantee of partnership debt obligations including a Pro Rata guarantee of the Construction Loan, the Partnership Note and the Take Out Mortgage. An Initial Limited Partner shall make a contribution to the capital of the Partnership by the purchase of an initial unit for the sum of $1.00. The Partnership will redeem the initial unit for the sum of $1.00 following the issuance of the Unit by the Partnership and the Initial Limited Partner, as such, shall not be entitled to any other share in the net income or losses of the capital of the Partnership.

Section 3.04, respecting sale of units, states in part,

Each Unit shall represent an initial cash contribution of $29,074.00 to the capital of the Partnership.

The Partnership Note was a promissory note for $5,459,000 given by the general partner to the developer to secure payment of the price of a construction contract in respect of which the Appellant guaranteed a pro rata share, to the limit of $121,067. This was achieved by the general partner executing a guarantee in the name of the Appellant to Central Trust Company in that amount. Following default on the mortgage, Central Guarantee Trust Company (successor to Central Trust Company), by written demand dated December 4, 1989, demanded payment of the sum of $121,067 from the Appellant. On January 31, 1990 Central Guarantee Trust Company commenced an action against the Appellant for the amount of $121,067. The Appellant filed a 76 paragraph statement of defence, dated August 13, 1990, to such action.

The Appellant, in filing his income tax returns for the 1990 and 1991 taxation years, deducted business losses of the Partnership in the respective amounts of $49,265 and $21,030. By Notices of Reassessment dated July 5, 1993 the Respondent disallowed the deduction of a portion of those business losses in the amount of $47,314 for 1990 and $19,180 for 1991, upon the assumption that only $29,074 should be included in the adjusted cost base of his interest in the Partnership. [1] The Appellant has commenced this appeal claiming that the full subscription price of $150,141 is correctly included in the adjusted cost base of his interest in the Partnership and that he is entitled to deduct the disallowed business losses of $47,314 for 1990 and $19,180 for 1991.

Legislation

“Adjusted cost base” is defined in section 54 of the Act to mean, with respect to an interest in a Partnership, “the cost to the taxpayer of the property adjusted... in accordance with section 53.”

The appropriate portion of section 53 reads as follows,

(1) In computing the adjusted cost base to a taxpayer of property at any time, there shall be added to the cost to the taxpayer of the property such of the following amounts in respect of the property as are applicable:

(e) ...

(iv) where the taxpayer has ... made a contribution of capital to the partnership otherwise than by way of loan, such part of the amount of the contribution as cannot reasonably be regarded as a benefit conferred on any other member of the partnership who was related to the taxpayer.

Appellant’s submission

The Appellant submitted that a guarantor’s liability under a guarantee arises immediately upon default by the principal debtor and cited as an authority for this submission Halsbury’s Laws of England (4th Ed.) Volume 20, paragraphs 158 and 159 which read in part as follows,

The surety’s liability arises when the principal debtor has made default, but not until then. ...

Notice of the principal debtor’s default need not be given to the surety, and he his liable without being requested to pay, in the absence of a stipulation to the contrary, express or implied, or of circumstances rendering a demand upon him a legal obligation. It is not necessary for the creditor, before proceeding against the surety, to request the principal debtor to pay, or to sue him, although solvent, unless this is expressly stipulated for; ...

Counsel supported this with reference to Rowlatt on the LAW OF PRINCIPAL AND SURETY, Fourth Edition, page 108. His submission proceeded with the proposition that “cost” includes any liability incurred, whether paid or still owing. He cited Newfoundland Light & Power Co. v. R. (sub nom. Newfoundland Light and Power Co. Ltd. v. The Queen) (sub nom. Newfoundland Light & Power Co. v. Canada), [1990] 1 C.T.C. 229, 90 D.T.C. 6166 at 239 (F.C.A.) where the Court said,

Indeed, in order for an expense to be incurred during a year, the obligation to pay must be created during that year; similarly, there is no cost of property to a taxpayer as long as the obligation to pay that cost has not come into existence.

He completed his initial submission by stating that the liability of $121,067 for the Partnership debt was properly included in the “cost” of the Partnership Unit which is determined before examining the definition of “adjusted cost base” in section 54 of the Income Tax Act (“Act”).

Appellant counsel’s alternative argument was that the sum of $121,067 was added to the cost under subparagraph 53(l)(e)(iv) as a contribution of capital to the Partnership otherwise than by way of loan.

ANALYSIS AND CONCLUSION

I do not accept the Appellant’s submissions. The definition of “Capital Contribution” in the Partnership Agreement means the gross amount of cash contributed or agreed to be contributed to the capital of the Partnership. Section 3.01 of that Agreement makes it clear that the amount so contributed was $29,074. The amount of Partnership debt, namely $121,067, guaranteed by the Appellant was not part of the capital contribution.

Although counsel’s authorities provide that a surety’s liability arises when the principal debtor has made default, that proposition must, of necessity, contemplate the existence of a liability in the sense of a valid guarantee providing a clearly enforceable right against the surety to recover the amount guaranteed. In the Appellant’s case, a lengthy and complex statement of defence has been filed in response to a statement of claim demanding payment of the amount guaranteed. No amount has been paid by the Appellant under the guarantee. Further, any amount paid by the Appellant thereunder will be paid to Central Guarantee Trust Company. The Appellant, in order to succeed, must have “made a contribution of capital to the Partnership”. The Appellant has not paid the sum of $121,067 to the Partnership. The Appellant has not assumed an obligation of the Partnership in that amount. The Appellant has merely guaranteed payment of the Partnership debt to the extent of that amount. Reference is made to Rayner & Co. v. Rhodes, [1926] Lloyd’s List Law Reports, Vol. 24-25, a King’s Bench Division decision made in 1925. In that case, the defendant, in an action to determine whether he was a limited partner or a general partner, was obliged to contribute 5,000 pounds to the Partnership. He had given to the bank a running guarantee for 5,000 pounds and had deposited, as additional cover for that guarantee, securities valued at 5,500 pounds. The relevant point considered was whether the provisions of one section of the Limited Partnerships Act had been complied with, because if they were not complied with the Partnership was never a Limited Partnership. That portion of the Act read as follows,

One or more persons to be called limited partners, who shall at the time of entering into such partnership contribute thereto a sum or sums as capital or property valued at a stated amount...

The defendant contended that the guarantee coupled with the depositing of securities should be treated as the contribution of a sum as capital and further that it should be treated as a sum contributed by the defendant and paid in cash. The Court did not accept that argument and stated,

...I cannot bring myself to the conclusion that this transaction which I have referred to can be regarded as the contribution of a sum of money.

and

All that happened here was that the defendant undertook to the bank that if the bank would lend money to the firm he would in that event, if called upon, repay that money. That was merely the assumption of a future contingent liability. The deposit of the shares in no way gave the company any rights in the shares, nor were [sic] the company in a position to enforce the guarantee; and in my judgment there is nothing here which could be treated as a payment in cash or as an equivalent to a payment in cash, however much latitude one gives to these words....

What the Act contemplates is that either actual money or the equivalent of money in the form of property should be transferred to the company for their [sic] use.

Because the sum of $121,067 was not part of the Appellant’s “cost” of the Partnership interest and because that sum was not contributed to the capital of the Partnership, it cannot be included in the adjusted cost base of the Partnership interest. Subsections 96(2.1) and 96(2.2) provide that the extent to which a limited partner may deduct partnership losses is restricted to the capital risked by that partner in the partnership. This “at-risk amount” is described in subsection 96(2.2) as the adjusted cost base of the partnership interest with certain adjustments, none of which apply here. Because the sum $121,067 is not part of the Appellant’s adjusted cost base of his Partnership interest, it is not part of his “at-risk amount” and he cannot deduct losses from that Partnership in excess of his adjusted cost base of $31,424. [2]

Accordingly the appeal is dismissed with costs to the Respondent.

Appeal was dismissed.