Paletta v. The Queen

Paletta v. The Queen
Court (s) Database
Tax Court of Canada Judgments
Date
2022-04-05
Neutral citation
2019 TCC 205
File numbers
2013-225(IT)G, 2013-2420(IT)G, 2013-4837(IT)G
Judges and Taxing Officers
Robert James Hogan
Subjects
Income Tax Act
Decision Content
Docket: 2013-225(IT)G
2013-2420(IT)G
BETWEEN:
ANGELO PALETTA,
Appellant,
and
HER MAJESTY THE QUEEN,
Respondent.
Appeals heard on March 11-22, 2019 at Toronto, Ontario, May 28-31, 2019 at Vancouver, British Columbia, June 3, 2019 at San Jose, California, June 5-6, 2019 at Los Angeles, California, and June 10-12, 2019 at Vancouver, British Columbia.
Before: The Honourable Justice Robert J. Hogan
Appearances:
Counsel for the Appellant:
David R. Davies
Alexander Demner
Vivian Esper
Counsel for the Respondent:
Charles M. Camirand
Nicole Levasseur
AMENDED JUDGMENT
The Appellants’ appeals are allowed in part only and the assessments are referred back to the Minister for reconsideration and reassessment in accordance with the attached Reasons for Judgment.
The parties will have until October 21, 2019 to arrive at an agreement for costs, failing which they must file written submissions on costs no later than October 21, 2019. Such submissions are not to exceed ten pages.
Signed at Ottawa, Canada, this 7th day of October 2019
“Robert J. Hogan”
Hogan J.
Docket: 2013-4837(IT)G
BETWEEN:
PALETTA INTERNATIONAL CORPORATION,
Appellant,
and
HER MAJESTY THE QUEEN,
Respondent.
Appeals heard on March 11-22, 2019 at Toronto, Ontario, May 28-31, 2019 at Vancouver, British Columbia, June 3, 2019 at San Jose, California, June 5-6, 2019 at Los Angeles, California, and June 10-12, 2019 at Vancouver, British Columbia.
Before: The Honourable Justice Robert J. Hogan
Counsel for the Appellant:
David R. Davies
Alexander Demner
Vivian Esper
Counsel for the Respondent:
Charles M. Camirand
Nicole Levasseur
AMENDED JUDGMENT
The Appellants’ appeals are allowed in part only and the assessments are referred back to the Minister for reconsideration and reassessment in accordance with the attached Reasons for Judgment.
The parties will have until October 21, 2019 to arrive at an agreement on costs, failing which they must file written submissions on costs no later than October 21, 2019. Such submissions are not to exceed ten pages.
Signed at Ottawa, Canada, this 7th day of October 2019
“Robert J. Hogan”
Hogan J.
Citation: 2019 TCC 205
Date: 20220405
Docket: 2013-225(IT)G
2013-2420(IT)G
BETWEEN:
ANGELO PALETTA,
Appellant,
and
HER MAJESTY THE QUEEN,
Respondent,
Docket: 2013-4837(IT)G
AND BETWEEN:
PALETTA INTERNATIONAL CORPORATION,
Appellant,
and
HER MAJESTY THE QUEEN,
Respondent.
THIRD FURTHER AMENDED REASONS FOR JUDGMENT
Hogan J.
I. Overview
[1] These appeals concern a complex series of transactions purportedly designed to finance investments in Hollywood film productions. The Appellants characterize these transactions as bona fide investments made as part of an overall strategy to break into the film industry in a big way. The Respondent characterizes those same transactions as nothing more than shams and/or tax shelters.
[2] The transactions are explained in more depth below. The following provides an overview of the structure, using the 2006 investment as a guide.
[3] In 2006, Paletta International invested US$8,013,895 cash in the Six Iron Productions Limited Partnership (“Six Iron Partnership”) to finance the alleged acquisition of a recently produced film entitled “Night at the Museum” (“Six Iron Film”). The film was produced for and on behalf of Twentieth Century Fox Film Corporation (“Fox”), which allegedly sold it to the Six Iron Partnership for US$128,310,000 through a complex series of transactions described below. As part of the transactions, the Six Iron Partnership signed a distribution agreement (“Distribution Agreement”) with Fox and agreed to bear an amount of US$82,000,000 for the prints and advertising expenses (“P&A expenses”) with respect to the film.
[4] Fox, or an affiliate, had the right to reacquire the film under a series of option agreements (“Option Agreements”) prior to, or within five days following the commercial release of the film. The option price was essentially the cost of the film, plus the P&A expenses allegedly incurred by the Partnership, less 3% of the P&A expenses. The options were allegedly exercisable at the option holder’s sole discretion. Fox, through its affiliate, exercised the options and reacquired the film prior to its commercial release. This series of transactions led to the dissolution of the Six Iron Partnership.
[5] The Six Iron Partnership reported a non-capital loss of US$82,763,192 for the P&A expenses, and Paletta International, as the sole limited partner, claimed the lion’s share of that amount. In total, Paletta International reported a loss of CAD$96,109,415 from the Partnership. [1] Paletta International also reported a capital gain from the disposition of its partnership units and took advantage of the 5-year capital gains reserve. It further claimed other financing charges and expenses in connection with its investment in the Partnership.
[6] A few years later, Angelo Paletta, along with other members of his family, invested in the Swilcan Bridge Productions Limited Partnership (“Swilcan Partnership”). This Partnership allegedly acquired a second picture from Fox entitled “The Day the Earth Stood Still” (“Swilcan Film”). Like the Six Iron Partnership, the Swilcan Partnership also disposed of the film prior to its commercial release and realized a significant loss from the P&A expenses. Angelo Paletta deducted his share of the loss, as well as other expenses that were allegedly incurred.
[7] The parties acknowledge that the Swilcan transactions are, in their entirety, virtually identical to the Six Iron transactions. I therefore refer almost exclusively to the Six Iron transactions in this judgment, and my reasons should be taken to extend to the Swilcan transactions as well. I will reference the Swilcan transactions to make necessary clarifications to point out any differences.
[8] The Minister of National Revenue (“Minister”) disallowed all of the losses and other expenses claimed by the Appellants in respect of their investments in the partnerships on the grounds that:
i) some of the transactions entered into by the parties were a sham;
ii) the partnership interests acquired by the Appellants were unregistered “tax shelters”;
iii) the partnerships were not validly created;
iv) the partnerships’ acquisitions of the films were ineffective; and
v) the Appellants realized business income rather than capital gains from the disposition of their partnership interests.
[9] I will consider issues (iii) to (v) only if I dispose of the first two issues in favour of the Appellants.
[10] There are two subsidiary issues, one per appeal. In the Paletta International appeal - and this is an issue unrelated to the film transactions - the Appellant, Paletta International, disputes the characterization of real estate gains realized in its 2007 taxation year. When filing its return, the Appellant, Paletta International, reported the gains on income account. It now alleges that this was done in error and that the properties were capital in nature. In the case of Mr. Paletta’s appeal, Mr. Paletta carried back part of his non-capital loss to his 2005 taxation year. The Minister’s denial of that carry-back occurred outside the normal reassessment period and is therefore statute-barred unless the Court finds that Mr. Paletta made a misrepresentation attributable to carelessness, neglect or wilful default.
[11] For the most part, the appeals were heard on common evidence.
[12] For the reasons that follow, with respect to the main issue, the appeals are dismissed. The parties agreed from the start that Fox would reacquire the films before their commercial release by exercising its option to acquire all of the partnership interests. Consequently, the Appellants and the partners knew that they would never generate income from the films. I find that the Option Agreements in each appeal were a sham.
[13] Paletta International’s appeal is allowed with respect to two of the nine real estate dispositions. I find that the Doble/Bluffs disposition and the “eco-gift” disposition were on account of capital. The disposition of the remaining properties were on income account. The appeals are dismissed in respect of these properties.
II. Facts
[14] Paletta International was created by Pasquale “Pat” Paletta, who controlled it during the years under appeal. Pat Paletta, the recently deceased patriarch of the Paletta family was widely regarded as a very successful self-made business person. Paletta International carried on several businesses during the years under appeal. These businesses included real estate and farming, as well as film and foreign exchange dealings.
[15] Pat Paletta’s son, Angelo Paletta (“Mr. Paletta”), began working in Paletta International’s real estate and other businesses in the late 1980s. He eventually took over the day-to-day operations of the company in the early 2000s.
[16] Messrs. Warren Nimchuk and Warren Fergus presented Mr. Paletta with an opportunity to allegedly acquire ownership of a major motion picture. The details of these film transactions are set out below.
[17] On a matter unrelated to the film transactions, Paletta International claims that it realized its accountants had misreported gains from the disposition of long-term real estate holdings as business income instead of capital gains. The facts relating to this aspect of the appeal are discussed in the relevant analysis section below.
A. Film Transactions
[18] The series of transactions for each film deal was complex and there were many individuals and entities involved. The following is a brief summary of the relevant individuals and entities in the Six Iron transactions:
i) Studio: Fox is a large international fully integrated film studio. It was involved in each of the film transactions. Fox purportedly had discussions with Mr. Nimchuk regarding its interest in selling its copyright to certain films after production and in the lead-up to theatrical release.
ii) Lending trust (“Fintrust”): Standard Finance Trust borrowed money from the Royal Bank of Canada (“RBC”) and lent it to Paletta International.
iii) Corporate Trustee for Fintrust (“Fintrustee”): 0774339 B.C. Ltd. was Fintrust’s trustee in the Six Iron transactions. The parties did not call Adrian Ward, an entertainment industry leader, who was the director of 0832307 B.C. Ltd. (the Fintrustee for the Swilcan transactions).
iv) Partners of the Partnerships:
General Partner: Six Iron Productions Inc. and Swilcan Bridge Productions Inc. were respectively the general partners in each of the transactions. Both of these corporations were controlled by Mr. Fergus.
Limited Partners: Paletta International was the limited partner in the Six Iron transactions. Angelo Paletta, along with his parents Pasquale and Anita and his brothers Remigio, Paul and Michael were the Limited Partners in the Swilcan transactions.
v) Option-Holding Companies: In both transactions, Fox entered into secondary option agreements with related parties, through which Fox transferred the option granted by the partners on their partnership interest. In the Six Iron transactions, the second option agreement was with Wordsmith Inc. (“Wordsmith”), [2] which was a wholly owned subsidiary of Fox. Wordsmith then assigned its interest in the film by transferring the option to its Canadian subsidiary, Faultline Productions Inc. (“Faultline”). [3]
vi) Warren Nimchuk: Mr. Nimchuk was a chartered accountant. During the relevant years for the transactions under appeal, he was a senior manager and then a partner at PricewaterhouseCoopers (“PwC”) in the field of entertainment tax. He stated in his testimony that he started working in the film industry in the mid-90s and had worked with all of the major studios on a variety of finance and tax credit facilitations in Canada and elsewhere. From his testimony, I found that Mr. Nimchuk had a great deal of knowledge about, and experience in, the film industry, particularly in the areas of film financing and film tax planning. He was involved with engineering the tax structure and setting up the partnerships. The Appellants admit that Mr. Nimchuk structured the film transactions in consultation with Mr. Fergus. Mr. Nimchuk also negotiated the contracts, including the copyright purchase price, the P&A expenses, the option price and the distribution fees, with Fox. Mr. Nimchuk himself testified that his role in these transactions was to assist the studio to sell the copyright in the films to a partnership.
vii) Warren Fergus: Mr. Fergus was a former chartered accountant. Mr. Fergus had a history in film financing. He was the director of the general partner in each of the film transactions. Mr. Fergus and Mr. Nimchuk together created and marketed to the Appellants the tax structure at issue.
viii) Isaac Tamssot: Mr. Tamssot was the director of the Fintrustee in the Six Iron transactions. During the time of these transactions, in 2006, Mr. Tamssot worked as an investment advisor at CIBC, a role that he had held since 1998. In this position, Mr. Tamssot was responsible for meeting with high-net-worth and sometimes ultra-high-net-worth individuals to provide financial planning and investment planning advice. Mr. Tamssot testified that he became involved in the Six Iron transactions through his connection with Mr. Fergus – Mr. Tamssot’s brother had gone to school with Mr. Fergus and they had remained close friends.
[19] Following the flow of funds in the transactions makes it clear that the cash flow was circular. The transactions are described in detail below. However, to summarize, the flow of funds occurred as follows:
i) Fintrust obtains a loan from RBC (“Daylight Loan”);
ii) Fintrust loans the Daylight Loan funds to the partners;
iii) The partners use the Daylight Loan funds, plus their own additional cash, to purchase the partnership units;
iv) The partnerships then direct the Daylight Loan funds to be paid to Fox as payment of both the purchase price of the copyright and the P&A expenses;
v) Fox receives part of the Appellant Paletta International’s proceeds as payments of the fee;
vi) Fox directs that the Daylight Loan funds be paid to Fintrust; and
vii) Fintrust directs that the Daylight Loan funds be repaid to RBC.
[20] Additionally, Fox allegedly paid the partnerships an advance in respect of Australian receipts; meanwhile, the Appellant Paletta International’s cash investment in the partnerships is used to pay Fox an amount equal to 3% of the P&A expenses and to pay fees to the promoters of the transactions.
[21] The essential transactions and documents for the Six Iron transactions are explained in detail below:
(1) Daylight Loan
[22] The Six Iron Fintrust borrowed US$212,000,000 from RBC under the Daylight Loan. This initial advance from RBC had a structuring fee of 0.1285%, which was payable at closing. [4]
[23] RBC complied with its own internal policies and guidelines in providing the Daylight Loan. However, in the internal RBC document, RBC’s employee made notations stating, “[a]lthough the transaction is not labelled by the tax lawyers as a ‘tax shelter’, it does present significant tax benefits to the investor”, [5] as well as the “taxing authorities will likely view this as aggressive tax planning.” [6]
[24] As security for the Daylight Loan, Fintrust provided to RBC a promissory note for the full amount of the loan. This note was later cancelled once the Daylight Loan was repaid.
[25] The Daylight Loan was repaid by Fintrust using funds it received as a loan from Fox.
(2) Loan from Fintrust to Paletta International
[26] Fintrust then loaned the US$212,000,000, which it had borrowed from RBC, to Paletta International (“Fintrust/Paletta International Loan”). On an outstanding principal amount of US$175,000,000 or more, Paletta International was required to pay 9.5% interest per annum. Once the principal dropped below US$175,000,000, the interest rate was lowered to 5% per annum.
[27] Under this loan, Paletta International was also required to pay a credit facility fee of US$2,500,000 and a foreign exchange fee of US$3,305,753, both of which were partially or fully capitalized and added to the principal borrowings and were interest-bearing. Additionally, if Paletta International wanted to have the ability to prepay the loan, it was subject to a one-time prepayment fee in the amount of US$2,650,000, which was payable within 180 days following the advance of the loan funds. This amount would also be capitalized and added to the principal of the loan and would bear interest.
[28] The interest on the loan would accrue for 10 years, at which point Paletta International was require to pay all of the accrued and unpaid interest in full.
[29] Paletta International was obligated to provide Fintrust with a “Collateral Security Agreement” along with the original unit certificates issued by the partnership as security.
(3) Partnerships
[30] The Six Iron Partnership was purportedly created to acquire, exploit and monetize the rights to the Six Iron Film. It was initially created on November 17, 2006, with Six Iron Productions Inc. as the general partner. The original limited partner was an entity the sole shareholder and director of which was Mr. Fergus. This entity was replaced by Paletta International when it invested in the Six Iron transactions. Thus, Paletta International became the sole limited partner.
[31] Pursuant to the Limited Partnership Agreement, [7] the business of the Six Iron Partnership was limited to purchasing the film, entering into a distribution agreement whereby Fox would exploit the film, promoting the film and paying the costs associated therewith, as well as lending excess funds of the Partnership to such parties as the general partner decided.
[32] To finance its investment, Paletta International used the US$212,000,000 that it had borrowed from Fintrust plus an additional US$6,121,475 of its own cash resources to subscribe for Class B units of the Six Iron Partnership. Thus, the aggregate subscription price for Paletta International’s units of the Six Iron Partnership was US$218,121,475.
[33] Paletta International’s total cash investment in the Six Iron deal was in the amount of US$8,013,895. It provided this amount to the Six Iron Partnership for the balance of the acquisition price of the partnership units and for financing fees payable by Paletta International to Fintrust.
[34] The Six Iron Partnership used the subscription proceeds to purchase the film and pay the P&A expenses. The Partnership had US$7,811,475 remaining plus the US$1,000,000 Australian advance (discussed below). The Partnership directed these funds to be used, in part, for paying Fintrust and paying Fox upon closing. The Six Iron Partnership retained the remainder of the funds to pay other partnership expenses.
[35] The Swilcan Partnership was purportedly created to acquire, exploit and monetize the rights to the Swilcan Film. Mr. Paletta was one of the limited partners and Swilcan Bridge Productions Inc. was the general partner. In similar fashion to what was done in the Six Iron Partnership, the Swilcan partners used their own cash resources and a loan from Fintrust to subscribe for the partnership units.
[36] The film transactions were materially identical for both the Six Iron Partnership and the Swilcan Partnership (together the “Partnerships”). I will mostly refer to the film and parties involved in the Six Iron transactions. Unless otherwise stated, my findings in respect of the Six Iron Partnership will apply equally to the Swilcan Partnership.
[37] Pursuant to the Limited Partnership Agreement, the general partner is entitled to a reasonable fee as compensation for the services provided and is also responsible for paying all of the operating expenses of the partnership.
(4) Kagan Media Appraisals
[38] Kagan Media Appraisals (“Kagan”) is a company that specializes in film cash flow projections. Kagan was retained to prepare cash flow projections (“Kagan Report”) for the films. According to the Appellants, a satisfactory Kagan Report was a condition of closing.
[39] According to Mr. Derek Baine, a long-time employee of Kagan, Mr. Nimchuk commissioned the Kagan Reports for both transactions. The Appellants were never in contact with Kagan.
[40] Kagan has a proprietary database of motion picture information. This database includes items such as film budgets, genres and P&A expenses.
[41] Mr. Baine testified that, at the time of the Kagan Reports, his colleague Mr. Wade Holden was responsible for extrapolating the required numbers and information from Kagan’s database. Mr. Baine would order the numbers from Mr. Holden and then spend approximately one hour preparing the Kagan Report. Mr. Baine testified that, in preparing the Kagan Report, they primarily looked at budget, talent and genre with respect to the film. Kagan would not ask to view the film in order to prepare the report.
[42] From Mr. Baine’s testimony it became clear that the Kagan Report was merely a cash flow projection of how a film could do, based on the average success of films that had comparable budgets. This report was not at all a valuation of the film or an indication of its potential success. He stated that the report was not an indication of the investor’s rate of return.
[43] In preparing a valuation, he would ascertain the cost of capital, create discounted cash flows and discounted gross profits and losses and add the terminal value for the film. Mr. Baine stated, however, that a full valuation of a film would be more elaborate.
[44] Here, the cash flow projections were not discounted. However, Mr. Baine testified that, since all of the expenses for the film had been included in the calculations, even if the amounts in the cash flow projections had been discounted, the ventures would still be profitable for the Appellants.
[45] Additionally, Mr. Baine testified that he was not provided with the investment information package or the distribution agreement as part of his preparation materials. Essentially, it appeared that the only information that he was provided with was the budget, the P&A expenses and the genre. The cast was not considered when conducting the analysis here.
(5) Purchase and Sale of Copyright
[46] On November 21, 2006, Fox transferred the copyright and all rights in the Six Iron Film to its subsidiary, TX Productions Inc. (“TXP”). [8]
[47] Also on November 21, 2006 (“Six Iron Closing Date”), [9] the Six Iron Partnership allegedly purchased the worldwide perpetual copyright from TXP. [10] The Six Iron Partnership paid US$128,310,000 for the film. It paid this amount using the subscription proceeds.
[48] Under the sale agreement, TXP provided representations and warranties that it validly owned the copyright to the film, free and clear of any encumbrances. Fox guaranteed TXP’s representations and warranties.
(6) Distribution Agreement
[49] As part of the series of transactions, the Appellants and Fox entered into a Distribution & Other Rights Acquisition Agreement (“Distribution Agreement”) on each closing date. [11] Pursuant to this agreement, the Partnerships grant Fox the rights to exploit the film on behalf of the Partnerships as the exclusive worldwide distributor for a term of 15 years. Fox is granted exclusive and unqualified discretion as to the time, manner and terms of distributing, exhibiting and exploiting the films.
[50] Fox is able to collect all royalties, fees and other revenues that the Partnerships would otherwise be entitled to collect. Pursuant to the Distribution Agreement, the Partnerships do not have the ability to make separate claims or to collect any of the copyright revenues.
[51] In the Six Iron transactions, following its acquisition of the film, Fox was obligated to spend a minimum of US$92,000,000 for “Distribution Expenses” in connection with the theatrical distribution of the film (“Fox’s P&A Commitment”). Distribution Expenses are defined in the documents as the aggregate of the “Distribution Costs” [12] , the distribution expenses for home video and on-demand reproduction materials, as well as the subdistributor distribution costs. The distribution and exploitation provision effectively transfers to the copyright owners (i.e., the Partnerships) liability for costs which are typically included in distribution expenses.
[52] Under its Distribution Agreement, the Six Iron Partnership agrees to incur US$82,000,000 in P&A expenses in the lead-up to the release of the film. The Six Iron Partnership paid this amount using the subscription proceeds. Each partnership claimed its P&A expenses in full and allocated that amount to its partners as a loss for its initial fiscal period.
[53] The Distribution Agreement also sets out the terms governing how payments from Fox are to be made to the Partnerships. Section 12 of the agreement states that Fox shall pay the Partnerships the amount of “Gross Receipts” [13] after deducting the “Distribution Fees” and the “Release Costs”. The “Distribution Fees” are defined as being various rates that Fox shall be entitled to retain as its fee for distributing the film. The “Release Costs” are defined as meaning “Distribution Expenses” [14] , except that the advertising administrative fee is to be based on 15% of costs instead of 10% of costs. Importantly, section 12 also provides that while Fox’s obligation to pay the Partnerships arises as and when any “Gross Receipts” are earned, Fox may defer the payment until May 31, 2007. Fox may also further defer payment if the Partnerships are in breach of any terms of the agreement or any other agreement entered into with Fox in respect of the film.
[54] Section 12A of the Distribution Agreement provides that the Partnerships are to earn US$1,000,000 as a non-recoupable advance for the Partnerships’ share of home video receipts from Australia. Mr. Nimchuk testified that he negotiated this fee with Fox to ensure that Australia would not be ignored with respect to distribution expenses. Mr. Fergus also testified that, since distributions occur over an extended period of time, this fee was intended to ensure that Fox would remain engaged in the worldwide distribution of the film.
(7) Option Agreements
[55] As a condition of the Six Iron transactions, Fox required the partners to grant it an option to acquire their units of the Six Iron Partnership (“Option 1”). According to Mr. Nimchuk, Fox was adamant about incorporating the option into the deal.
[56] Under the Option Agreement, [15] the price payable for the option, if the option was exercised, was US$218,093,121. Mr. Nimchuk testified that he negotiated this amount with Fox.
[57] Option 1 in the Six Iron transactions expired on the earlier of December 25, 2006 or five days after the theatrical release of the film.
[58] Under Option 1, the Partnerships were required to grant Fox a first-ranking mortgage and security interest in respect of their assets.
[59] Fox then assigned its option to acquire the partnership units. In the case of the Six Iron transactions under the “Assignment and Option Agreement [16] ” Fox assigned Option 1 to Wordsmith. In return, Wordsmith granted an irrevocable option back to Fox (“Option 2”), which allowed Fox to acquire the Six Iron Partnership’s interest in the film upon Wordsmith exercising Option 1. In consideration of Option 2, Fox was required to pay US$214,521,000 to Wordsmith. The assignment agreement provided that if Fox exercised Option 2 Wordsmith would be required to exercise Option 1. Wordsmith agreed that upon Fox assigning Option 1 to it, Wordsmith would assume all of Fox’s obligations under the Option Agreement. Wordsmith also agreed to deliver to the Partners a second-ranking security agreement containing a security interest with respect to all of its present and after-acquired property as security for its payment of the option price if it exercised Option 1. Additionally, as security for their obligations to Wordsmith (as the assignee of Fox), the partners were required to cause the Six Iron Partnership to grant to Wordsmith a second-ranking security (subject to the first-ranking security granted to Fox) providing a security interest in respect of all of the Six Iron Partnership’s present and after-acquired personal property.
[60] Wordsmith later assigned Option 1 to Faultline, which also assumed the obligations of Wordsmith. Through the delivery of a promissory note, Faultline paid Wordsmith US$2,430,000 in order to acquire Wordsmith’s rights and interests.
[61] The Appellant provided evidence and arguments in the hope of demonstrating that, at the time of closing, Fox had given no assurances or indications that it would exercise its option.
(8) Loan from Partnership to Fintrust
[62] The Partnerships and Fintrust entered into the Partnership/Fintrust Loan Agreement (“Partnership/Fintrust Loan”). [17] From their remaining subscription proceeds, the Partnerships loaned US$6,000,000 to Fintrust. The agreement indicates that this loan was made to allow Fintrust to repay the Daylight Loan from RBC. Mr. Nimchuk tried to convince the Court that the structure was created with room for excess funds, such as this $6,000,000, in order to provide resources for marketing costs after the film had been released. He alleged in this regard that the Partnerships had always intended to retain ownership of the films.
[63] The loan was advanced on the closing date and was to be repaid either on the tenth closing date anniversary or at the Partnerships’ demand. The interest rate on the loan was 9.5% per annum.
(9) Loan from Fox to Fintrust
[64] On the closing date, Fox and Fintrust entered into the Distributor/Fintrust Loan Agreement (“Fox/Fintrust Loan”). [18] As regards the Six Iron transactions under this agreement Fox agreed to provide a credit facility to Fintrust in the amount of US$206,850,000. According to the agreement, this credit facility was made available partly to allow Fintrust to repay the Daylight Loan. The 5% per annum interest rate on the loan was to be paid on each closing date anniversary for 10 years, at which point all accrued and unpaid interest was to be paid in full.
[65] An important feature of this loan is that repayment in full of the loan was to be made at the earlier of the tenth closing date anniversary or at Fox’s demand.
(10) Security Agreements
(a) Partnership/Fox Security Agreement [19]
[66] This Partnership/Distributor Security Agreement (“Partnership/Fox Security Agreement”) is between Fox as the secured party and the Six Iron Partnership. Here, the Six Iron Partnership and its general partner agreed to grant Fox a security interest in certain collateral in consideration of Fox entering into the Distribution Agreement, the Option Agreement, the Assignment and Option Agreement, and the Fox/Fintrust Loan Agreement (“Transaction Documents”).
[67] As collateral, the general partner and the Six Iron Partnership granted a fixed and floating charge to Fox over all of their present and after-acquired personal property. The collateral includes the Six Iron Partnership’s property (including all rights to the film) and all accounts receivable (including all amounts that are due or owing to the partnership). The collateral also includes all proceeds from any of the other collateral property. The general partner also provided a security interest in its interest in the Six Iron Partnership.
[68] The security granted under this agreement had to be at all times a first-ranking priority charge.
[69] Under section 8 of the agreement, Fox could collect the accounts receivable “in such manner, upon such terms and conditions and at such time or times, whether before or after default, as may seem to it advisable and without notice to Partnership”. [20] This provision also requires that all monies collected or received by the partnership from any accounts receivable be held in trust for Fox and immediately paid to Fox. Importantly, the provision also states that “all moneys collected or received by [Fox] in respect of the Accounts Receivable or other Collateral may be applied on account of such parts of the indebtedness and liability of Partnership to [Fox] as [Fox] deems best.” [21]
[70] Section 11 of the agreement lists the events constituting default which include default by the Six Iron Partnership, any of the partners, Fintrust, Wordsmith or Faultline under any of the Transaction Documents. Pursuant to a “Pledge of Copyright Transfer Documents” [22] the general partner and the Six Iron Partnership are required to attach to the pledge document two undated assignment documents and to authorize Fox to complete the documents in the event of any default under section 11 of the Partnership/Distributor Security Agreement. However, Mr. Nimchuk stated that the pledge document was put in place to effect the transfer of the copyright if Fox chose to exercise the option.
(b) Partners/Fox Security Agreement [23]
[71] The Partners/Distributor Security Agreement (“Partners/Fox Security”) is between the general and limited partners of the Six iron Partnership and Fox. Under the agreement, the partners grant Fox a security interest in each partner’s rights to and interest in the Six Iron Partnership. The “security interest” includes any interest in the partnership units, the film, the Distribution Agreement, the Transaction Agreements [24] (or any agreements referred to therein), and the income and rights accruing to each partner as a holder of the partnership units.
[72] The security interest under this agreement is in addition to, and not in substitution for, any other security interests granted to Fox. Furthermore, except for the “Permitted Encumbrances” in Schedule B of the agreement, the security interest granted under the agreement must at all times be first in priority. Unless Fox provides written consent, no additional security interest can be granted which does or could rank pari passu with any security interest created by the agreement.
[73] Section 8 states that in the event of a default under the agreement or a breach under the Option Agreement or the Assignment and Option Agreement, all distributions on account of the partnership units owned by a partner will be applied to the obligations of that partner to Fox. Additionally, any proceeds received by the partner in respect of the partnership units will be added to and form part of the collateral.
[74] Section 9.1 of the agreement enables Fox to “receive any increase in profits on the Collateral” regardless of whether default has occurred.
[75] Finally, section 10 of the agreement states that all amounts collected or received by Fox will be applied on account of the partners’ indebtedness in the manner that Fox deems best or, at the option of Fox, such amounts may be held unappropriated in a collateral account or released to the Six Iron Partnership, all without prejudice to the liability of the partners or the rights of Fox under the agreement.
(c) Other Security Agreements
[76] These complex transactions contained numerous other security agreements, some of which I will mention here.
[77] The November 21, 2006 Partner/Fintrust Security Agreement (“Partner/Fintrust Security”) [25] was provided as security for the loan from Fintrust to Paletta International. Under this agreement, Paletta International granted a security interest in its units in the Six Iron Partnership. Section 9 of this agreement is identical to section 9 of the Partners/Fox Security Agreement, except that the party benefiting from the security is Fintrust.
[78] In accordance with the Partnership/Fintrust Loan, Fintrust granted a security interest in all of its present and after-acquired personal property to the Six Iron Partnership under the Fintrust/Partnership Security Agreement (“Fintrust/Partnership Security Agreement”). [26]
(11) Escrow Agreements
[79] To accommodate the parties exercising their options sometime after the closing dates, the parties signed on the Six Iron Closing Date certain documents consequential upon the option exercises and placed those documents in escrow (“Escrowed Documents”) with Davis & Company, the law firm acting as escrow agent. The escrow terms were set out in a written document. Pursuant to this document, the Escrowed Documents were to be executed and only released from escrow in accordance with the “Conditions of Post-Closing”. [27]
(12) Exercise of Options
[80] In each of the transactions, Fox exercised its option near the release date of each film. The theatrical release date for the Six Iron Film was December 22, 2006. Prior to that, on December 18, 2006, Fox exercised Option 2 for the Six Iron transactions, [28] which forced Wordsmith to exercise Option 1. [29] On the same day, the Escrowed Documents were released from escrow. The aggregate price for Option 1 was US$218,093,121 and the price payable to Paletta International for its units under Option 1 was US$218,091,000.
[81] Wordsmith then assigned to Faultline all of its interest in the underlying copyright on the film, its interest in the related agreements, and its obligation to pay the option price to the former partners of the Six Iron Partnership.
[82] According to the Appellants, once the options were exercised, the Partnerships ceased to exist as a matter of law. The Appellants claim that time that the Partnerships realized a loss for tax purposes because of the deductibility of the P&A expenses. These losses were denied by the Minister.
(13) Defeasance Transactions
[83] As explained above, under the Fox/Fintrust Loan, Fox agreed to provide a credit facility to Fintrust in the amount of US$206,850,000.
[84] Following the exercise of Option 1 and the assignment of the obligations thereunder to Faultline, Paletta International had an amount receivable from Faultline and an amount payable to Fintrust. Both were interest-bearing.
[85] Immediately after the closing, Fintrust owed US$206,850,000 to Fox. [30] After Fox exercised Option 2, Fox owed US$214,521,000 to Faultline.
[86] Pursuant to the Assumption of Obligations Agreement, [31] Fintrust paid the outstanding amount of the Fox/Fintrust Loan (i.e.,US$206,850,000) by assuming Fox’s indebtedness to Faultline (i.e.,US$214,521,000). This is where the “defeasance” occurs. Following this defeasance, Fintrust had a greater liability than it started with.
[87] The difference between the principal amount of the Fox/Fintrust loan and the Fox/Faultline debt was US$7,671,000. The Appellants submit that this can be treated as a loss or deduction. The Appellants submit that this amount almost entirely offsets Fintrust’s income – being the loan fees, the credit facility fee and the foreign exchange fee – which amounts to US$8,455,753.
[88] The Appellants also submit that the Fintrusts did not have tax liabilities because the income they earned, in the form of loan fees or interest income, was offset by the loss realized in connection with the defeasance transaction.
III. Preliminary Issue
[89] From the outset of the trial it became clear that one of the important questions to be determined by me was whether Fox had pre-agreed to exercise its option to acquire the partnership interests such that there would be a return of the films to Fox. In short, were the options shams designed to mask the parties’ pre-agreement that the films would be reacquired by Fox prior to their commercial release?
[90] During argument, the Appellants’ counsel raised an issue as to whether the Respondent failed to properly allege sham in relation to the Option Agreements. I invited both counsel to address this point as a matter of procedural fairness because I planned to address the issue in my reasons. After the hearing, b