Leopold Langlois v. Minister of National Revenue, [1986] 1 CTC 2236, 86 DTC 1166

Tremblay, T.C.J. [TRANSLATION]:—These appeals were heard in Québec, Quebec on March 23, 1984. They were taken under advisement in June 1985 after the written pleadings had been submitted by counsel for the parties and all documents filed.

1. Point at Issue

According to the originating proceedings, the point is whether the appellant, a member along with four other persons of the Société d'Exploitation [et d'Exploration] Minière Boisbuisson Enr (SEEMBE), is correct in claiming various expenses in computing the income of the said partnership for 1973 to 1976 (legal fees, court costs, accommodation, subscription fees and interest), the whole amounting to some $168,000. Losses of some $35,000 claimed by the appellant against its other income for the years in question were disallowed by the respondent.

The appellant argued that the losses were actual and applicable, because the expenses claimed were incurred to earn income and should be allowed as deductions.

The respondent argued, first, that the expenses were of a capital nature and so not deductible, and second, that even if they were incurred to earn income, they still could not be allowed as deductions as they had been used to generate tax-exempt income for the partnership and so could not constitute losses applicable to other taxable sources of income.

2. Burden of Proof

2.01 The appellant has the burden of showing that the respondent's assessments are incorrect. This burden of proof results not from a particular section of the Income Tax Act, but from several judicial decisions, including a judgment of the Supreme Court of Canada in Johnston v. M.N.R., [1948] C.T.C. 195; 3 D.T.C. 1182.

The appellant initially disputed this burden, but ultimately admitted it.

2.02 The facts presumed by the respondent are set forth in subparagraphs

(a) to (n) of paragraph 13 of the respondent's reply to the notice of appeal. That paragraph reads as follows:

13. In assessing the appellant for the 1973 taxation year the respondent relied, inter alia, on the following presumptions of fact.

(a) The appellant was a member of a partnership to which Messrs James G.

Russell, Louis Landry, Jean-Yves Bérubé and Yvon Pelletier also belonged.

(b) In computing the partnership's income for its 1973, 1974, 1975 and 1976 taxation years, the following expenses were claimed:

1973	$ 25,007.19
1974	111,963.47
1975	54,685.48
1976	15,556.21

(c) The following expenses were disallowed as the result of an initial audit by the Department of National Revenue:

	1973	1974 1974	1975 1975	1976
Legal Fees	1,804.00	90,852.86	45,292.88	3,973.33
Court costs	1,920.65	—	1,044.00	—
Accommodation	4,635.78	4,350.09	2,387.32	—
Interest	8,096.64	2,698.78	—	—
Subscription fees	—	530.00	—	545.00
Total	16,457.07	98,431.73	48,724.20	4,518.33

(d) Certain expenses were deducted as exploration costs from the balance of eligible expenses:

	1973 1974 1974		1975	1976
Balance of
eligible exp	$8,550.12	$13,531.71	$5,961.08	$11,037.88
Exploration costs	(6,604.25)	(12,234.58)	(4,857.30)	(9,304.30)
Deductible expenses	1,945.87	1,297.16	1,109.78	1,733.58
(e) The partnership’s income was therefore computed as follows:
	1973	1974 1974	1975	1976
Income	1,307.00	5,000.00	—	—
Expenditure	(1,945.87)	(1,297.16)	(1,109.78)	(1,733.58)
Exploration costs	(1,320.85)	(3,702.84)	(3,733.28)	(4,847.49)
Net income or loss	(1,959.72)	—	(4,843.06)	(6,581.07)
Appellant’s share	(391.94)	—	(968.61)	(1,316.21)

(f) As appears from Table I, attached hereto to have effect as if stated at length, the computation of exploration costs had to be revised in light of the notices of objection, and the following amounts were added to the losses as revised:

1973	$ 30.61
1974	140.70
1975	260.11
1976	1,047.44

(g) A further expense of $500 was allowed in computing the partnership's income for the 1973 taxation year, thereby allowing the appellant a further loss of $100.

(h) The sum of $3,151.40 claimed by the partnership as interest expense was deducted in the 1975 taxation year, thereby allowing the appellant a further loss of $630.20.

(i) The amendments made to the appellant’s reported income for the assessments of May 29, 1979 were accordingly as follows:

	1973	1974	7975	7976
Exploration costs	30.61	147.70	206.11	1,047.44
Additional expenses	100.00	—	630.20	—
Total	130.61	147.70	836.31	1,047.44

(j) On December 1, 1965 the partnership sold to Forbex Ltd and Area Mines Ltd “99 unpatented mining claims located in Boisbuisson and Laportardiére Townships, county of Gaspé, province of Quebec" and all rights relating thereto.

(k) As a consequence of this sale by the partnership, Mr C Pelletier brought an action against it in connection with certain rights relating to the “claims” sold In 1965.

(l) The expenses mentioned above, which were disallowed in the various assessments, related to this action which was successfully defended by the partnership.

(m) None of the disallowed expenses was incurred in order to earn or produce income.

(n) All the disallowed expenses were of a capital nature.

3. Facts

3.01 The material facts are not in dispute. The respondent admitted allegations 1.1 to 1.6 of the appellant’s notice of appeal. They read as follows:

1. Facts

1.1 Messrs James G Russell, Louis Landry, Jean-Yves Bérubé and Yvon Pelletier on May 23, 1963 formed a partnership known as the “Société d’Exploitation and d'Exploration Minière Boisbuisson Enr" (hereinafter referred to as (’’Boisbuisson’’); as can be seen from a document filed as No A-1.

1.2 The appellant became a partner in Boisbuisson in June or July 1963, by a verbal agreement.

1.3 As a consequence of certain exploration and development activity and certain legal steps (the formation of companies, the purchase or sale of mining rights and company shares and various transactions), Boisbuisson and/or one or more of the partners individually, including the appellant, acquired certain rights to income, as can be seen from documents filed jointly as No A-2.

1.4 On September 17, 1966 Messrs Charles-Eugène Pelletier and Paul E Dumont filed an action in the Superior Court to dissolve the partnership and obtain an accounting, and in addition to the principal action, a claim in the amount of $1,500,000 for unjust enrichment against Messrs James G Russell, Louis Landry, Jean-Yves Bérubé, Yvon Pelletier and Leopold Langlois, the partners in Boisbuisson, as can be seen from documents filed as No A-3.

1.5 On February 8, 1974 Georges Pelletier J of the Quebec Superior Court dismissed the action by Messrs Charles-Eugène Pelletier and Dumont, as can be seen from a document filed as No A-4.

1.6 Mr Charles-Eugène Pelletier, one of the plaintiffs, appealed the decision of Georges Pelletier J of the Superior Court, and on December 27, 1978 Owen, Crête and Dubé JJA of the Court of Appeal dismissed Mr Charles-Eugène Pelletier’s appeal, as can be seen from a document filed as No A-5.

3.02 The respondent admitted that there was a direct connection between all the expenses mentioned in subparagraph (c) of paragraph 13 of the reply to the notice of appeal, cited above, and the action successfully defended by the appellant and his partners.

The respondent further admitted that the appellant had a 20 per cent share in SEEMBE, and that the total amounts of the said expenses had to be divided by five to determine the share applicable to him.

The legal fees amounted to $143,000, and at first sight seem rather high; but considering that at the Superior Court hearings alone there were 618 entries in the plumitif, 477 exhibits filed and 200 sittings by the Court, the amount of work done is understandable and so are the fees.

3.03 The evidence established that the action brought against the SEEMBE partners on September 17, 1966 not only sought to have the SEEMBE dissolved and an accounting made, but in addition the plaintiffs were seeking their share of the profits earned from sale of the mining claims (Superior Court judgment, Exhibit A-3).

3.04 The said 99 mining claims were sold to Forbex Ltd and Area Mines Ltd by a contract concluded on December 1, 1965 and amended on February 1, 1968 (Exhibit A-2). SEEMBE was represented in the contract by Messrs J S Russell, Louis Landry and J Y Bérubé. In clause 3 of the contract of December 1, 1965, the selling price is stated, and the terms of payment are set forth in the amendments of February 1, 1968. On signature of the contract on December 1, 1965 the purchasers paid $18,000, and were required first to make over to the sellers a number of shares in Wexford Mines Ltd., and second to pay them $500,000 from the profits if the claims were successfully exploited (trans. pages 27, 28, 29, 45 and 46).

3.05 According to the appellant (trans p 50), this sale of claims was part of the activities of the appellant and his partners. The aim of mining exploration, one of the purposes of the SEEMBE, was to discover mineral deposits and then sell the claims.

3.06 The appellant received the profits realized on sale of the claims. However, the evidence is not clear as to the years in which the amounts were paid to the appellant (testimony of the appellant, pages 56 and 57). It was also established that the appellant did not include them in income because they were exempt.

3.07 Counsel for the appellant, in paragraph 7 of his submissions, clearly stated the appellant’s evidence regarding the circumstances in which the expenses were incurred and the effect of dissolving the SEEMBE. Paragraph 7 reads as follows:

7. The evidence

Though the evidence was summary and at times imprecise, it helps us to understand (i) the context in which the expenses described in paragraph 1 of these submissions were incurred, and (ii) the effect of dissolving the SEEMBE.

7.1 It appeared from the testimony of Senator Langlois that (references are to pages of the transcript);

(i) the applicants in the action to dissolve the partnership were excluded because of strikes in which they took part (p 14);

(ii) the action to dissolve was preceded by seizures (pp 22, 57, 61 and 62). This paralyzed the partnership. On re-examination by Mr Frank Barakett, the Senator testified as follows:

You said earlier, Senator — Senator, you mentioned certain seizures which were made by the plaintiffs in the Superior Court.

A. Seizures before judgment.

Q. Could you tell the Court how that affected you, or affected the partnership’s operations?

A. It paralyzed everything.

Q. What did you do to keep things moving?

A. We tried to have the seizure set aside, were not successful, and had to borrow from the bank and give security to have the seizure released.

Q. Do you recall the amounts of those securities?

A. No, there I cannot help you.

Q. Thank you. No further questions.

(iii) The SEEMBE had sources of income and, inter alia, received royalties (see Exhibit A-2, pp 28-30). The Senator received payments relating to these royalties (p 56).

(iv) If the defence to the action to dissolve had failed this would have meant the end of the partnership, and so:

Mr Frank Barakett: Senator, in the event that the plaintiff’s action to dissolve had succeeded instead of being dismissed, what would have been the result for you and for the exploration partnership?

A. The result would have been that we lost those profits, those future profits, that future income.

Q. Would that have put an end to the operations or not?

A. Well, I said a moment ago, it would have terminated our operations, because in their action to dissolve they were also asking us to carry out an alleged contract to form a partnership in which they had made no investment; we had no money to invest ourselves — it would have been the end of everything. We were losing all the future income which we had anticipated receiving.

Q. And the current income involved in this transaction in those years, did you keep it or was it distributed differently?

A. It was distributed among the members of the Boisbuisson partnership.

Q. And if they had been admitted, or their status of partner recognized, every penny received at that time, would they have shared in this amount in the dissolution?

A. Well, of course. By they, you mean the plaintiffs?

7.2 It appeared from the testimony of the accountant Gérard Lavoie that (references are to pages of the transcript):

(i) the SEEMBE had taxable income, dividends and interest (pp 67, 68 and 72) as well as royalties (pp 69 and 70);

(ii) it also sold claims (pp 100-106);

(iii) in 1973 dividends of $45,000 were paid (p 107); in 1974 dividends of $71,250 were paid (p 111);

. . . these dividends were distributed among the partners in equal shares of 1/5 each (p 109);

(iv) when cross-examined by counsel for the MNR, the witness testified:

Q. 71,000 — so the 71,000 is not in the partnership income as such, is that right? You have 5,000, you have 5,000 income in the partnership, if you look at the profit and loss statement — you say there you have 71,000 in dividends.

A. You are putting words into my mouth .. . this is how it worked. There was partnership income which we did not include, in which we did not include dividend income and interest income, for the good reason that for such income there were letters sent to each partner telling him: this is the income on which you will have to pay tax. It is interest income, dividend income; and for that reason such income was not included in the partnership.

Q. But it was partnership income?

A. It was partnership income. Yes, yes, yes. It was simply a method of accounting, instead of showing it as income it was shown as an investment with an explanation; each partner then reported it in his personal tax return, or at least was supposed to report it.

4. Act — Case law — Analysis

4.01 Act

The principal provisions of the Income Tax Acts, cited from the old Act, RSC 1952, c 148, as amended, and new Act, SC 1970-71-72, c 63, as amended, are:

Old Act

12(1)(c)

83(1)(b) — definition of a “mining property”

83(2)

139(1 )(o) — definition of "exempt income”

New Act

18(1)(a)

18(1)(b)

18(1)(c)

35

These provisions will be cited in the analysis if necessary.

4.02 Case law

In their pleading counsel referred to the following case law and scholarly opinion:

A. Scholarly opinion

1. Droit des compagnies et droit des sociétés — Yves Lauzon and J Lucien Perron (Les Editions Themis Inc) — partnership rules, pages 1229 and 1230.

B. Case law

2. Dominion Natural Gas Co Ltd v. M.N.R., [1941] S.C.R. 19; [1940-41] C.T.C. 155.

3. W E Bannerman v. M.N.R., [1959] S.C.R. 562; [1959] C.T.C. 214.

4. Premium Iron Ores Ltd v. M.N.R., [1966] S.C.R. 685; [1966] C.T.C. 391.

5. Philip Sarin v. M.N.R., 64 D.T.C. 62 (TAB).

6. No 355 v. M.N.R., 15 Tax A.B.C. 451; 56 D.T.C. 449.

7. Harold Flagal v. M.N.R., [1970] Tax A.B.C. 364; 70 D.T.C. 1245.

8. Jager Holdings (Calgary) Ltd. v. M.N.R., [1980] C.T.C. 2345; 80 D.T.C. 1315 (T.R.B.); [1983] C.T.C. 225; 83 D.T.C. 5256 (F.C.T.D.).

A. Argument of the appellant

4.03.1 The argument of the appellant is summarized in paragraphs 8, 9, 10, 11 and 13 and the conclusion of paragraph 17 of his submission. It reads as follows:

8. A partnership is a corporate vehicle of economic activity which many consider a separate artificial personality. We refer you on this point, inter alia, to Lauzon and Perron, Droit des compagnies et droit des sociétés, pp 1229 and 1230 (see Appendix I).

9. From a tax standpoint this separate artificial personality is important (s 96 ITA). A partnership conducts its own business undertakings and must compute its income as if it were a separate person.

10. The partnership is therefore subject to the general rules regarding deductibility of expenses.

11. These rules are contained in s 18(1)(a) and (b) I.T.A. Three comments must be made on these provisions, as they have been applied with respect to legal fees:

11.1 “In the ordinary course, it is true, legal expenses are simply current expenditure and deductible as such” — Duff J in M.N.R. v. Dominion Natural Gas Company Ltd., [1940] S.C.R. 19, at 25 (see Appendix Il);

11.2 it suffices if the expense was incurred “with the object or intention that it should earn income” — Kerwin J, in Bannerman v. M.N.R., [1959] S.C.R. 562, at 564 (see Appendix III);

11.3 it was recognized that this type of expense was deductible when it was incurred “with a view to protecting the income earning capacity of the company” — Martland J in Premium Iron Ores Ltd v. M.N.R., [1966] S.C.R. 685, at 703 (see Appendix IV).

13. It was established that the SEEMBE had access (or could have had access) to taxable income: royalties, dividends, interest and so on; it was also indicated that it had sold “claims”. Its “earning capacity” must be determined not only in relation to a transaction or particular type of transaction during a given period (such as the sale of claims), but in relation to all its activity, and in particular the various revenues resulting from that activity. The SEEMBE held various rights over property and might have concluded agreements giving it access to royalties in return for those rights. Its dissolution would have prevented it from being able to make this type of agreement. Finally, it should be mentioned, since 1972 the sale of mining claims is subject to s 35 ITA, which provides for deferred taxation instead of an exemption, and only in very limited circumstances.

4.03.2 The other paragraphs refer to the case law, and primarily to Jager Holdings (Calgary) Ltd, which is now on appeal with the Federal Court of Appeal. That case fell within the dictum of Martland J. in Premium Iron Ores Ltd (see subparagraph 11.3 of the pleading cited above).

The pleading concludes as follows:

17. For all these reasons, we feel that the expenses incurred by the SEEMBE over the years, in defending the action to dissolve, are deductible expenses in computing its income for the years in question, in accordance with the three statements mentioned in subparagraphs 11.1, 11.2 and 11.3. Moreover, they were not incurred solely to earn or preserve exempt income but actually to preserve the “earning capacity” of the SEEMBE (supra, paragraph 13).

B. Argument of the respondent

4.03.3 The respondent maintained that the expenses claimed are not deductible for the following reasons:

(a) To the extent that C E Pelletier and P E Dumont were attempting to obtain a share of the profits or income realized on sale of the claims, the expenses incurred to block such a request are not deductible because the income was tax- exempt, and in addition the expenses were not incurred to earn income.

(b) To the extent that C E Pelletier and P E Dumont sought recognition for their right of ownership over the claims, as a result of the dissolution of the partnership and distribution of its assets, the appellant and his fellow partners were protecting their right to such assets and the expenses were accordingly of a capital nature. Further, in so far as they were striving to protect the very existence of the partnership, the expense is still of a capital nature.

B.1 Exempt income: expenses not deductible

4.03.4 As counsel for the respondent also provided such a clear summary of his client's position, the Court cites at length from his argument at paragraphs 8 to 13:

8. Section 83(2) of the Income Tax Act, RSC 1952, c 148 (hereinafter referred to as the “old Act”), in effect when the sale of the mining claims was made on September 1, 1965, provided:

An amount that would otherwise be included in computing the income of an individual for a taxation year shall not be included in computing his income for the year if it is the consideration for

(a) a mining property or interest therein acquired by him as a result of his efforts as a prospector either alone or with others, or

(b) shares of the capital stock of a corporation received by him in consideration for property described in paragraph (a) that he has disposed of to the corporation,

unless it is an amount received by him in the year as or on account of a rent, royalty or similar payment.

Section 83(1)(b) defined “mining property” as:

. . . a right to prospect, explore or mine for minerals or property the principal value of which depends upon its mineral content . . .

9. The evidence in the case at bar clearly establishes that the appellant and his partners were engaged in mining exploration for the purpose of finding mineral deposits and then selling the claims (supra, paragraph 4). It thus followed that the profits made by selling the claims would have been included in the appellant's computation of his income, for the appellant was not making a capital gain but earning business income. However, s 83(2) excluded from computation of the appellant's income the amount which would otherwise have been part of it.

This means that the income generated by the sale of mining claims in December 1965 constituted “exempt income'' under the definition of s 139(1)(o) of the old Act.

10. Since this income was “exempt income'', s 12(1)(c) of the old Act did not allow the deduction of amounts spent to earn or produce this type of income. The provision read as follows:

In computing income, no deduction shall be made in respect of . . .

(c) an outlay or expense to the extent that it may reasonably be regarded as having been made or incurred for the purpose of gaining or producing exempt income or in connection with property the income from which would be exempt.

Section 139(1)(o) of the old Act defined “exempt income'' as follows:

(o) “exempt income'' means property received or acquired by a person in such circumstances that it is, by reason of any provision in Part I, not included in computing his income and includes amounts that are deductible under section 28 or that would be so deductible if it were not for subsection (2) of section 28.

11. Section 18(1)(c) of the present Act is identical to s 12(1)(c) of the old Act, except that [in French] the legislator now refers to “revenu exonéré”.

“Revenu exonéré" is defined by s 248(1) in the same way as “revenu exempté” in the old Act.

As the expenses at issue in the case at bar were incurred after 1971, it is the present Act which applies. However, it should be borne in mind that the action was initiated on September 17, 1966, when the old Act was in effect (Superior Court judgment, Exhibit A-3, p 3).

Under the present Act, income from the sale of “mining property” is not as clearly exempt as under the old Act. All such matters are subject to a very special system provided in ss 35 and 59 of the Act. However, as the income was clearly exempt under the old Act and the expenses incurred can reasonably be regarded as having been incurred to produce exempt income, they are not deductible.

See, for example, Laurentian Club Inc. v. Minister of National Revenue, 83 D.T.C. 1325.

12. In any case, even if the provisions of the present Act were not sufficient to classify expenses as not deductible under s 18(1)(c), as a result of the wording of s 18(1)(a) they still would not be deductible.

There is no doubt that the income earned from the sale of the claims was exempt under s 83(2) of the old Act. That being so, the expenses at issue do not fall within s 18(1)(a) of the present Act, which requires that the expense be made or incurred “for the purpose of gaining . . . income . .. from the business”. The expenses covered by this provision are essentially incurred in the normal course of business (see MNR v Dominion Natural Gas Ltd, [1940] D.T.C. 499-133, at 499- 134, right column).

Thus, in BP Oil Ltd. v. The Queen, 80 D.T.C. 6252 (Tab A), the Federal Court of Appeal had to decide whether legal fees were deductible. BP Oil Ltd operated a service station in Beloeil and a neighbour sought an injunction to prohibit such operation. The company objected to the application but the Superior Court issued the injunction. However, even after the injunction had been issued the company continued operating the service station, and accordingly had to face charges of contempt of court.

The trial judge had held that all the legal fees were of the same nature and had been incurred for the purpose of protecting the very existence of the service Station.

13. In the case now before the Court, the income has already been earned. What is more, the income was not included in computing the appellant’s income because it was exempt under s 83(2) of the old Act. In these circumstances, it is impossible to regard such expenses as deductible either under s 18(1)(c) or under s 18(1)(a).

C. Conclusion regarding exempt income

4.03.5 One fundamental fact underlies this disputed point. The action brought in 1966, which gave rise to the expenses at issue, was intended not only to ensure that SEEMBE was dissolved, but also that there was an accounting. The latter certainly had greater significance for the plaintiffs Pelletier and Dumont. The effect of an accounting would have been, first, to give the plaintiffs Pelletier and Dumont rights in the distribution of the partners' assets to the 99 claims sold. Second, the plaintiffs would have been entitled to part of the profits made on the sale of the said claims. (See para 7.1 (iv) of the appellant's submissions, cited above, at para 3.07.) The seizure before judgment carried out by the plaintiffs Pelletier and Dumont when the court action was brought was an important precaution in this regard (para 3.07, citation 7.1 (ii)).

4.03.6 Though the evidence was not clear as to receipt of the profits made by the appellant on sale of the claims (see para 3.06), it should be noted that as the accrual accounting (As opposed to cash accounting) method was applicable to the business, the right to the selling price and so to the income had to come into being before the end of 1971. In any case, the appellant had the burden of proof.

4.03.7 The Court agrees with the arguments of the respondent that the profits resulting from the claims should be regarded as exempt income (para 4.03.4).

Moreover, the appellant regarded them as such, since he did not tax them (para 3.06).

The expenses incurred undoubtedly were incurred to protect this exempt income in addition to protecting SEEMBE against being dissolved.

Counsel for the appellant, in his conclusion, stated that the expenses ... were not incurred solely to earn or preserve exempt income but actually to preserve the “earning capacity” of the SEEMBE (para 4.03.1, in fine).

There is no evidence that a proportion can be assigned to exempt income on the one hand and to “earning capacity” on the other.

In view of the evidence presented, however, I think it is clear that what was important in the defence against the action by Messrs Pelletier and Dumont was above all the mining claims the sale of which produced the exempt income. Messrs Pelletier and Dumont were seeking their share of the sale of these mining claims, and brought their action soon after the said claims.

Having said that, should the principle be applied that once the expenses were largely incurred to earn or to preserve exempt income, this was sufficient to make the expense not deductible? This appears to me to be a reasonable conclusion.

Having arrived at this conclusion, there is no need for the Court to rule on the question of “earning capacity”.

The assessments must be upheld.

5. Conclusion

The appeals are dismissed in accordance with the attached reasons for judgment.

Appeals dismissed.