Geoffrey D.F. Skerrett v. Minister of National Revenue, [1991] 2 CTC 2787, 91 DTC 1330

Sobier, T.C.J.:—The appellant appeals the reassessment by the respondent for his 1981 taxation year whereby the respondent disallowed a deduction of $11,000 as an inventory write-down. This write-down was based on the appellant's assertion that his share of the unit of participation in question was inventory of a business.

The appellant is a lawyer specializing in tax law practising in Toronto. During the time when the events described later were taking place, he was a partner in a well-known Toronto law firm.

The appellant and two other persons known to him, each purchased an undivided interest in what has been described as a Unit of Participation, being shares in a Panamanian corporation, Norman Cay Inc.(“NCI”) and two lots of real estate on Norman's Cay, an island in the Bahamas. The lots were owned by a Bahamian corporation, San Andros (Norman's Cay) Ltd. ("SANC"), which also owned the remaining lots which were the lots to be sold to generate income.

The unit price was US $58,000. US $55,000 was attributable to the shares of NCI and US $3,000 to the two lots. In total, Canadian investors numbering up to 60 persons purchased all 30 of the units offered for sale. The proceeds of the sale of the NCI shares being US $1,650,000 in turn were used to acquire a deep discount debenture of SANC having a redemption price of US $2,610,000 which would result in an excess of US $960,000 over the amount paid for the debenture. NCI also acquired approximately 50 per cent of the shares of SANC, being both common shares and preferred shares. The remaining shares of SANC were owned by the persons who would be responsible for marketing the remaining lots owned by SANC. The shareholdings of SANC were structured so as to give the Canadian investors some degree of control if the U.S.-based sales group did not perform as anticipated.

The appellant went into great detail as to why the scheme was structured as it was. He stated that regard was had of the laws of the Bahamas as to the ownership of land and the repatriation of profits; the laws of Ontario as they dealt with the sale of securities and the various exemptions from the prospectus provisions of the Ontario Securities Act, as well as the laws of Panama as they applied to corporate and financial matters.

The selection of the unit of participation as the means of carrying out the scheme was driven by tax, corporate, financial and other reasons. But having said that, the Court must determine what in fact was the scheme notwithstanding its form or more correctly, its various forms.

According to Mr. Skerrett's evidence, this was a real estate play in the Bahamas. What people were being asked to participate in was not shares or a debenture or lots for personal use or for resale. They were being invited to participate in a scheme of sharing profits to be made by selling lots on Norman's Cay owned by the unit holders and by SANC, and sharing the proceeds of redeemed shares, dividends and the deep discount debenture. The whole matter rested upon marketing and selling lots. That, he claims, was the reality of the venture.

In order to induce participants to part with their money, the promoters attempted as best they could to make the scheme as much a self-financing one as possible. The promoters arranged for the participants to borrow the funds necessary to purchase the units and also arranged for some cash flow so that the interest on the borrowed funds could, for the most part, come from NCI through redemptions of shares and dividends. They went so far as to ensure that the participants did not use the funds for any purpose other than to pay the banks.

The appellant became involved in the venture through one of his former law partners and a client. They were heavily involved in promoting the scheme and invited the appellant to participate. They kept him informed of the progress of the venture, and in addition, he visited the site on Norman's Cay. It was through him that his two co-owners were kept up to date.

Reference was made among other things, to the offering memorandum, the promoters' share subscription form and a shareholders' agreement. In some of these documents, the participants made representations as to their investment intent, the holding period during which they could not sell their units and the negotiability of their shares.

The appellant contends that he was involved in an adventure in the nature of trade and accordingly involved in a business and that the inventory of that business was his interest in the unit of participation. The respondent contends that Mr. Skerrett invested in shares and lots which were of a capital nature.

From the evidence of the appellant and Mr. Derek Watchorn, one of the other owners of the unit of participation, the scheme was a real estate play whereby profits would be earned through selling lots on Norman's Cay. Without lot sales there would be no redemption of shares, no payment of the deep discount debenture and no other source of moneys for the participants.

No matter how the venture was structured, the appellant maintained that the reality of the situation was that this was a real estate venture which was not meant to be a long-term investment but was the purchase of lots for resale. This was the sole reason for the venture. The lots were to be sold as quickly as possible, in an orderly fashion and when it became obvious later that conditions on Norman's Cay had changed, the scheme was to sell the lots in whatever fashion would produce income or reduce losses.

While dividends were paid and shares redeemed from sales of the lots in the early years, in or about 1977 or 1978 it became apparent that lot sales were not progressing as anticipated, and the decision was made to sell en bloc at the best price possible. By 1979 at the latest, the decision was made to try to cut their losses.

At this juncture, one Joseph Lehder, a Colombian resident appeared on the scene. Mr. Lehder wanted to build larger homes than those originally planned. These homes were to be sold to wealthy individuals. Mr. Lehder was dealing with another land owner, but if the new plan to build larger homes was successful, it was felt that the value of the land owned by SANC would be enhanced. As it turned out however, Mr. Lehder was not really interested in real estate development, he was involved in drug dealing and wished to use Norman's Cay as a staging area for shipments of drugs from Colombia to the United States.

The fact that Norman's Cay had an airstrip made it attractive to Mr. Lehder. It was Mr. Skerrett's evidence that armed friends or employees of Mr. Lehder frightened off visitors to Norman's Cay. There was considerable publicity both in the press and on television describing the illegal activities taking place there, culminating in the original promoters realizing that the project was at a standstill. At this point, both the appellant and Mr. Watchorn determined that their interests in the unit were worthless.

The definition of "business" contained in subsection 248(1) of the Income Tax Act, R.S.C. 1952, c. 148 (am. S.C. 1970-71-72, c. 63) (the "Act") includes an adventure or concern in the nature of trade [1] . Having determined therefore that there was a business, he says that the subject matter of the business was the unit of participation and that the unit of participation was the inventory of the business and in accordance with the rules for valuing inventory, he is entitled to carry it at the lower of his cost or its fair market value.

In support of his submissions that the scheme was an adventure in the nature of trade, counsel for the appellant referred to M.N.R. v. Freud, [1968] C.T.C. 438; 68 D.T.C. 5279 (S.C.C.).

Also referred to was Mould v. The Queen, [1986] 1 C.T.C. 271; 86 D.T.C. 6087 (F.C.T.D.) to support the contention that a taxpayer may be engaged in an adventure in the nature of trade by acquiring shares of a real estate development company with the intention of earning a profit from the development and sale of the land owned by the company. The acquisition of the shares was merely a method of obtaining an interest in the land. The appellant claims that the acquisition of the unit of participation was the method of obtaining an interest in the land. Because the plan was complicated does not change its commercial reality.

Cull v. The Queen, [1987] 2 C.T.C. 63; 87 D.T.C. 5322 (F.C.T.D.) bears close examination, since Madame Justice Reed deals with Freud , supra, and Fraser v. M.N.R., [1964] C.T.C. 372; 64 D.T.C. 5224 (S.C.C.). In Cull, a partnership, of which the taxpayer was a member, acquired shares in a real estate development company. Because of a downturn in the economy of Sudbury, Ontario, the properties were worthless. The partnership reported a loss resulting from the partnership writing down the value of the investment, from $178,000 to $1. $100,000 of this was the original cost of the shares.

One of the questions which appeared to remain unanswered in this appeal is: How were the participants going to realize their profits. This issue was also raised in Cull, supra.

At page 67 (D.T.C. 5324-25), Reed, J. stated:

With respect to the first argument, I note that the evidence discloses that the plaintiff and his partners had not really focused on future options with respect to how a profit would be realized from the development project. The plaintiff stated that, as is usual with development schemes, they had left future possibilities open; they would have been willing to realize their profit through any number of mechanisms, that is from the sale of lots, or from the sale of blocks of land, or from the sale of shares.

This appears to be the case in this appeal.

In dealing with Fraser, supra, and Freud, supra, Madame Justice Reed went on to say at pages 67-68 (D.T.C. 5325-26):

The plaintiff argues that regardless of the prima facie rule that a purchase of shares is of an investment or capital nature (except in the case of a securities trader) the Supreme Court decisions in Fraser v. M.N.R., [1964] C.T.C. 372; 64 D.T.C. 5224 and M.N.R. v. Freud, [1968] C.T.C. 438; 68 D.T.C. 5279 are applicable. In the Fraser case the taxpayer was an experienced operator in the real estate field. He incorporated two companies; one for the purpose of constructing a shopping centre, the other for the purpose of constructing an apartment building. When the shares in the respective companies were sold (without the proposed projects being completed) the Court held that the profit arising therefrom was to be treated as income not capital since the sale of the shares was merely an alternative method the taxpayers had chosen to adopt in putting through their real estate transactions.

In M.N.R. v. Freud, [1968] C.T.C. 438; 68 D.T.C. 5279, a lawyer organized a company for the purpose of developing and promoting a special type sports car for which he thought there might be a market. He and some friends advanced money to the company for this purpose in exchange for shares. The project got into difficulty and was abandoned. The Court held that the loss was deductible from the taxpayer's income and not merely capital in nature. At page 442 (D.T.C. 5252) it was said:

It is clear that while the acquisition of shares may be an investment. . . it may also be a trading operation depending upon circumstances . . . in the Fraser case, the basic operation was the acquisition of land with a view to a profit upon resale so that it became a trading asset. The conclusion reached implies that the acquisitions of shares in companies incorporated for the purpose of holding such land was of the same nature seeing that upon selling the shares instead of the land itself, the profit was a trading profit, not a capital profit, on the realisation of an investment.

And at page 444 (D.T.C. 5283):

. . . the payments made by the respondent could not properly be considered as an investment in the circumstances in which they were made. It was purely speculation. If a profit had been obtained it would have been taxable irrespective of the method adopted for realizing it. Such being the situation, these sums must be considered as outlays for gaining income from an adventure in the nature of trade, that is a business within the meaning of the Income Tax Act, and not as outlays or losses on account of capital.

The defendant focuses on the decision in the Fraser case and argues that in the present case the shares were not merely an alternative way of dealing in land, they were not merely an alternative way of dealing with the underlying asset and therefore do not fall within that exception. Reference is made to Blok-Andersen v. M.N.R., [1972] C.T.C. 338; 72 D.T.C. 6309 (F.C.T.D.) and Weldon and Robb v. The Queen, [1980] C.T.C. 301; 80 D.T.C. 6224 (F.C.T.D.). I think the defendant's argument focuses on too narrow a view of the principle and also too narrow a view of the facts in this case. It focuses on the Fraser case (where the enterprise was profitable and a disposition of shares actually occurred) without due regard to that in Freud (where the enterprise was not successful).

In my view the Freud case is directly applicable to the present situation. The shares in the hands of the partnership were not, as the defendant claims, merely of the usual and normal investment character. They were acquired for the purpose of acquiring an interest in the lands under option and in the development project, for the purpose of making a profit therefrom, either by Simlac selling its assets or by the shareholders selling their shares. Had the partnership realized a profit from the venture, there can be no question that, on the basis of the Fraser line of cases, it would have been business income, and not a capital gain. Thus, the taxpayer should be allowed to treat the losses according to the same principle. In the Freud case, at page 441 (D.T.C. 5281), the Court stated:

. . . the principles to be applied in cases when a profit is obtained . . . must be followed when a loss is suffered. Fairness to the taxpayers requires us to be very careful to avoid allowing profits to be taxed as income but losses treated as on account of capital and therefore not deductible from income when the situation is essentially the same.

The plaintiff in Cull did not sell or dispose of his interest in the investment. Similarly, the appellant here did not dispose of his interest in the unit.

Madame Justice Reed in dealing with this question said at pages 68-69 (D.T.C. 5326):

. . . that there was documentary evidence that the distribution of dividends was considered to be a possibility; and, that there was no evidence that the partnership intended to dispose of its shares for profit quickly. With regard to this last it is noted that Simmons and Lacasse sold their shares in 1979-1980. The rhetorical question is put—why didn't the partnership sell its shares at that time too?

None of these arguments carry much weight in the circumstances of the present case. While the partnership did not (at least prior to the 1979-1980 sale of the Simmons and Lacasse shares) control the enterprise, the plaintiff was very closely involved. He was one of three members of the Board of Directors; he was actively engaged in the development project. With respect to the articles of incorporation, whatever they may say, the fact is that Simlac engaged in one activity and one only: the attempted development of the Ravina Gardens and Fay Bell properties. Dividends are always a possibility if one holds shares: this is not a significant factor in this case. With regard to the lack of evidence concerning a resale of the shares by the plaintiff: it is unlikely they would do so until the shares could be sold at a profit. For the partnership to have sold at the price Lacasse and Simmons sold theirs in 1979-80 would have been to incur a loss, particularly in view of the sums which had been expensed with respect to the payment of interest on account of bank advances.

[Emphasis added.]

The Court found that the loss sustained by the partnership with respect to the shares was from an adventure in the nature of trade.

I find no difference in the manner of holding the investment in Cull than in the case at bar. Holding shares is no way different than holding an undivided interest in a unit. The units were acquired for the purpose of acquiring an interest in the entire scheme and that is the sale of their lots, SANC's lots, the debenture, dividends and share redemption proceeds. With a changing securities and investment industry, many innovative investment vehicles have been devised. Although each must be examined separately, there should be no reason to deny favourable tax treatment to such a vehicle merely because it does not fit the established forms and methods of investment.

The venture was a speculation, no long-term income was ever anticipated. The only business was to sell the lots and share in the income. When that was completed, the enterprise would be at an end. Accordingly, I find that the appellant was engaged in an adventure in the nature of trade.

Having established that the appellant was engaged in an adventure in the nature of trade, he was engaged in a business [2] .

However, can the unit be classified as inventory of the business? The relevant provisions of the Act dealing with inventory can be found in subsection 10(1) which provides:

For the purpose of computing income from a business, the property described in an inventory shall be valued at its cost to the taxpayer or its fair market value, whichever is lower, or in such other manner as may be permitted by regulation.

See also section 1801 of the Regulations to the Act which when coupled with subsection 10(1) in the years in question, allow a taxpayer to value his inventory at the lower of his cost or at market value.

In addition the definition of inventory is set out in subsection 248(1) as follows:

"Inventory"—"inventory" means a description of property the cost or value of which is relevant in computing a taxpayer's income from a business for a taxation year;

In Bailey v. M.N.R., [1990] 1 C.T.C. 2450; 90 D.T.C. 1321 (T.C.C.), Judge Rip determined that there was an adventure in the nature of trade where farmland was held for sale and that the farmland could be described as inventory.

At page 2461 (D.T.C. 1330) he sets out:

There is no reason why the farmland cannot be described in inventory for purposes of subsection 10(1) of the Act as well. Subsection 10(1) directs a property to be valued “for the purpose of computing income from a business”. The phrase does not contemplate computing income only from carrying on a business, as suggested by counsel for the respondent. The phrases “carrying on a business” and “carried on a business” are found in several provisions of the Act: see, for example, paragraph 2(3)(b), and subsections 115(1) and 219(1). "To carry on something," stated Jackett, P. in Tara Exploration, supra, page 567 (D.T.C. 6376), "involves continuity of time or operations such as is involved in the ordinary sense of a 'business'". When this expression "carry on" is used in the Act, Parliament describes a continuity of time or operations with respect to the factual situation contemplated by the particular provision. Such continuity is not required in subsection 10(1) and its addition to that provision would add nothing to that provision’s ordinance.

Judge Rip allowed the appellant to “write down" the value of the farmland.

In Van Dongen v. Canada, [1991] 1 C.T.C. 86; 90 D.T.C. 6633 (F.C.T.D.), the taxpayer's appeal was dismissed because he was unable to establish that the properties were inventory. If he could have established this fact, the Court would have applied the principles set out in Bailey, supra.

Mr. Justice Cullen said at page 93 (D.T.C. 6638) of Van Dongen, when dealing with the reasons for judgment of Taylor, T.C.J. in Gilmour v. M.N.R., [1989] 2 C.T.C. 2454: 89 D.T.C. 658 (T.C.C.) :

An interesting aspect of this case was the Minister's position that an inventory write-down under subsection 10(1) is not available for land held as an adventure in the nature of trade. In dismissing the appeal, Taylor, T.C.J. stressed that the dismissal did not signal approval of the Minister’s position. The later Bailey case appears to have settled the issue that land held as an adventure in the nature of trade is eligible for inventory write-down.

It is not necessary to have disposed of the inventory in order to be able to "write down" its value (see Bailey, supra, page 2459 (D.T.C. 1329)). Also see Cull, supra, at page 69 (D.T.C. 5326), where the shares were not sold but “written down".

Accordingly the unit is inventory of the appellant business and he was correct in writing down its value when it became worthless.

At the opening of the hearing and in argument, both counsel referred to Waller v. M.N.R., an unreported decision of Judge Mogan of this Court. Mr. Waller was part-owner of another unit of participation in this same venture at Norman's Cay.

The following passage from Judge Mogan's reasons for judgment spells out the difference between the two appeals:

The appellant comes to Court with a higher hurdle to clear and, in my view, a surprising dearth of evidence. The absence of hard evidence in this appeal was surprising for a successful businessman. The appellant, who was on the witness stand for only a few minutes, knew almost nothing about the transaction. He had so little knowledge that I could not identify whether he was a real investor in the long term who was a bit indifferent as to the facts because he was relying so extensively on professional and more involved people like Mr. Zimmerman and Mr. Hauck, or whether he was a flamboyant speculator throwing money at the wall and engaged in crap shoot. He did not disclose enough knowledge in the witness box for me to identify him as having either character; and he certainly had to go some to show that he was a land speculator in the Bahamas.

The other two gentlemen who testified were chartered accountants and, while Mr. Hauck had been down there, he and Mr. Hagerman knew little more. They tried to prove that the island had gone down in value because it had become a drug smuggler's haven, and maybe it had. Certain newspaper articles were tendered in evidence and objected to by counsel for the Minister but, on balance, I let them in. I have read some of them and I assume that they are true. But there was no evidence of financial statements. The appellant made no attempt to describe in detail how the transaction was capitalized or how the scheme worked. He and his associates had a most casual attitude towards the arrangement. It was not until argument when counsel for the Minister actually traced the funds from the original payment by the appellant and his co-investors to their retrieval that I heard how the proposal would work if things went well. As I have said before, I was surprised that in evidence the appellant made no attempts to lay out the case of how the proposal would have worked if it had been successful. Indeed, the appellant might have been able to make some headway on discharging his onus if there had been a more adequate description of how it worked; what the promoter's expectations were; and why the expectations failed other than the allusions to a drug haven. Obviously something went wrong. On the first basis, on the onus of proof, the appellant fell far short of what he was called upon to do in order to succeed in this appeal.

The evidence of Mr. Skerrett did disclose the entire scheme. He spelled out in great detail how the project was to be structured and why. He produced a cash forecast. His evidence was corroborated by Mr. Watchorn as to what they were becoming involved in. Unlike Waller, there was ample evidence before the Court as to how and why the venture was to work.

Judge Mogan also gives the following reasons for dismissing Mr. Waller's appeal:

There is a second reason, however, for dismissing the appeal even on the relatively limited evidence I have before me. I refer to the distance in institutional terms between the appellant and where the real venture was carried on. The so-called promoters, that is the appellant, Mr. Hauck, Mr. Zimmerman, and the others, were really twice removed from the land development. The corporation which was engaging in the subdividing, development, and sale of Norman's Cay was San Andros Norman's Cay Ltd. The appellant and his co-promoters did not even own shares in that company. They owned shares in a company called Norman's Cay Inc., which in turn owned half the shares of San Andros Norman's Cay Ltd. Indeed, Norman's Cay, Inc. owned one share less than half the common shares because there were 601 common shares issued in San Andros Norman's Cay Ltd. of which 300 were owned by Norman's Cay, Inc. and 301 were owned by SABAL. So, if things had gone well and the debenture had stayed on side with its due repayment clauses, the preference shares which Norman's Cay, Inc. held in San Andros Norman's Cay Ltd. would not have been voting under the terms of the agreement and Norman's Cay Inc., would have been in a minority position with regard to the development corporation. That is where the appellant and his co-promoters come in. They are shareholders in Norman's Cay, Inc. and, in my view, on what I call an institutional basis, they are two institutions removed from the real business activity which was going on in San Andros Norman's Cay Ltd.

Since Judge Mogan did not have the evidence before him that I had, he was unable to determine in what, in fact, the investment was made. Because of the evidence of the appellant and Mr. Watchorn, I had no difficulty in making that determination.

For all the above reasons, the appeal is allowed, with costs, and the assessment is referred back to the respondent for reconsideration and reassessment on the basis that the amount of $11,000 is deductible in computing the appellant's income for the 1981 taxation year.

Appeal allowed.