March 06, 2012

Peter Brown (Appellant) v. Her Majesty the Queen (Respondent)

2003 DTC 5298
Federal Court of Appeal
Date: April 24, 2003

Court File Nos. A-208-02 and A-311-02

Deductions — Partnership losses — At risk rules — Taxpayer a general partner of a general partnership that acquired certain software programs from American Softworks Corporation (“ASC”) for US$8,170,000 — Whether the partnership at arm’s length with ASC — Whether US$8,170,000 the fair market value of the software — Whether taxpayer entitled to deduct his share of the partnership’s business losses, including capital cost allowance (“CCA”) based on the US$8,170,000 figure — Whether taxpayer a deemed limited partner under subsection 96(2.4) of the Act and subject to the at risk rules — Income Tax Act, R.S.C. 1985 (5th Supp.), c. 1, as amended, ss. 69(1)(a), 96(1)(a), 96(2), 96(2.1), 96(2.2)(d), 96(2.4)(b) and 251(1)(c).

Facts: The taxpayer was a general partner of a general partnership (“the CEG Partnership”) that acquired certain software programs from American Softworks Corporation (“ASC”) on December 31, 1993 for US$8,170,000. The purchase price was paid partly in cash and partly by promissory note (“the Acquisition Note”). The partners, including the taxpayer, paid for their units in the CEG Partnership by way of a cash payment of US$4,000 (payable over six months) and by assuming a proportionate share of the Acquisition Note. By an amending agreement made as of December 31, 1995, any general partner could require the managing partner to redeem all of the partner’s units on December 31, 2003 for US$8,000 per unit. In addition, any partner who exercised a retraction right would be entitled, on December 31, 2003, to a proportionate share of ASC common stock that had been issued to the CEG Partnership, provided that the stock was listed on a stock exchange at December 31, 2003. In another amending agreement also made as of December 31, 1995, ASC agreed with the CEG Partnership to provide financial assistance to the Partnership, which might be necessary to enable it to meet its obligations in respect of the retraction right. In computing his income for 1993 and 1994, the taxpayer deducted business losses, including CCA, based on the acquisition cost of the software programs and expenses incurred by the CEG Partnership after taking into account revenue. In 1996, the taxpayer had a loss carryforward arising from his partnership losses. The Minister disallowed all the deductions claimed by the taxpayer. In allowing the taxpayer’s appeal in part, the Tax Court of Canada concluded that: (a) no arm’s length relationship existed between ASC and the CEG Partnership, so that (under paragraph 69(1)(a) of the Act) the taxpayer was deemed to have acquired his proportionate share of the software programs from ASC at the fair market value, which was C$4,128,000, and not at the acquisition cost of US$8,170,000; (b) as a deemed limited partner under subsection 96(2.4) of the Act, the taxpayer’s only amount at risk was the US$4,000 per unit cash component of the purchase price of the units; (c) the amount of the assumed Acquisition Note of US$6,000 per unit was not at risk; (d) the taxpayer was entitled to take into account, in calculating his income or loss from the CEG Partnership, CCA based on the fair market value figure of C$4,128,000; (e) the taxpayer was entitled to deduct interest expenses in 1994 and 1995 in respect of interest paid to ASC on that portion of the Acquisition Note assumed by him; and (f) costs should be awarded to the Minister, excluding those in respect of two expert witnesses. The taxpayer appealed to the Federal Court of Appeal, and the Minister cross-appealed.

Held: The taxpayer’s appeal was dismissed, and the Minister’s cross-appeal was allowed in part. The Arm’s Length Issue: The parties agreed that the relevant time for determination of the arm’s length question was December 31, 1993. At the hearing, the taxpayer also conceded that, as of October 1, 1993, ASC and the CEG Partnership were not dealing with each other at arm’s length. Any matter relevant to the computation of partnership loss, including the effect of any acquisition or disposition of property, must be determined as if the partnership is a separate person (see paragraph 96(1)(a) of the Act). Where the acquisition of property is relevant, the question is whether the vendor and the partnership were dealing with each other at arm’s length. Despite the taxpayer’s view, the question is not whether an individual who decided to become a member of the partnership that was acquiring the property made his decision to enter the partnership independently. In this case, the taxpayer entered the CEG Partnership after it was already a party to a non-arm’s length transaction with ASC. Accordingly, it was inappropriate to disturb the Tax Court judge’s conclusion that the taxpayer and ASC did not deal at arm’s length. Valuation: The Tax Court judge conducted a thorough analysis of valuation of the software programs. He accepted the discounted cash flow method of valuation and made some adjustments to the assumptions made by the expert witnesses. The taxpayer did not show any palpable or overriding error on the Tax Court judge’s part in respect of the valuation issue. The taxpayer agreed that if the Court should not accede to his position on the arm’s length and valuation issues, his appeal would have to be dismissed. The At Risk Issue: In the Minister’s view, the entire amount of the taxpayer’s contribution to the CEG Partnership, i.e., US$10,000 per unit, was not at risk. This was because: (i) one amending agreement provided for the retraction of the taxpayer’s partnership units for US$8,000 per unit; and (ii) the other amending agreement provided that the partners would receive stock of ASC when issued, which the Minister said was worth US$2,000 per unit. The Minister’s conclusion was that because the entire amount of US$10,000 per unit contributed by the taxpayer to the CEG Partnership was not at risk, he should not be entitled to any deduction in respect of the CEG Partnership’s losses. Under both the 1993 and 1994 versions of paragraph 96(2.4)(b) of the Act, if a taxpayer becomes entitled to obtain any benefit from the partnership within the three years after he/she seeks to deduct partnership losses, such taxpayer will be deemed to be a limited partner. The two amending agreements in the present case came into effect within the three-year period after the taxpayer sought to deduct his partnership losses for December 31, 1993 and December 31, 1994. Hence, the taxpayer was a deemed limited partner to whom the at risk rules applied. As for the quantum that was at risk, the value of the retraction right, i.e., US$8,000 reduced the at-risk portion of each partner’s US$10,000 contribution per unit to US$2,000 per unit. There was, however, no satisfactory evidence as to the value of the ASC shares, although the Minister had alleged that these were worth US$2,000 per unit. The taxpayer’s at risk amount, therefore, was US$2,000 per unit. The Interest Issue: The Minister did not cross-appeal with respect to the taxpayer’s 1995 taxation year. Only the interest deductible for 1994 was in issue, and the Minister made no substantive submissions on this issue. The Tax Court judge’s findings, therefore, had to remain undisturbed. Costs: The taxpayer alleged that he had been substantially successful in the Tax Court, so that he should have been awarded costs. The Minister alleged that the Tax Court judge should not have denied him the expert witness costs. The net result of the proceedings, however, was much more favourable to the Minister. There was no basis for interfering with the costs award made by the Tax Court judge. Conclusion: In the end, the Minister was ordered to reassess, but only to reduce the taxpayer’s at risk amount to US$2,000 per unit.