O'Dea v. The Queen

O'Dea v. The Queen
Court (s) Database
Tax Court of Canada Judgments
Date
2008-06-17
Neutral citation
2009 TCC 295
File numbers
2004-1225(IT)G
Judges and Taxing Officers
Diane Campbell
Subjects
Income Tax Act
Decision Content
Docket: 2004-1225(IT)G
BETWEEN:
FRANCIS O’DEA,
Appellant,
and
HER MAJESTY THE QUEEN,
Respondent.
____________________________________________________________________
Appeals heard on common evidence with the appeals of
Sean O’Dea (2004-1226(IT)G), John Rankin (2004-1227(IT)G), and
Geoffrey Bailey (2004-474(IT)G) on June 17, 18 and 19, 2008
at Toronto, Ontario
Before: The Honourable Justice Diane Campbell
Appearances:
Counsel for the Appellant:
Louise R. Summerhill and
Chris Dunn
Counsel for the Respondent:
Marie-Thérèse Boris and
Brent E. Cuddy
____________________________________________________________________
JUDGMENT
The appeals from the assessments made under the Income Tax Act for the 1992, 1993, 1994, 1995 and 1996 taxation years are allowed and the assessments are referred back to the Minister of National Revenue for reconsideration and reassessment in accordance with the attached Reasons for Judgment.
If the parties cannot settle the issue of costs within 60 days of the date of the within Reasons, they may contact the Court to obtain dates for the filing of written submissions.
Signed at Vancouver, British Columbia, this 1st day of June 2009.
"Diane Campbell"
Campbell J.
Docket: 2004-1226(IT)G
BETWEEN:
SEAN O’DEA,
Appellant,
and
HER MAJESTY THE QUEEN,
Respondent.
____________________________________________________________________
Appeals heard on common evidence with the appeals of
Francis O’Dea (2004-1225(IT)G), John Rankin (2004-1227(IT)G), and
Geoffrey Bailey (2004-474(IT)G) on June 17, 18 and 19, 2008
at Toronto, Ontario
Before: The Honourable Justice Diane Campbell
Appearances:
Counsel for the Appellant:
Louise R. Summerhill and
Chris Dunn
Counsel for the Respondent:
Marie-Thérèse Boris and
Brent E. Cuddy
____________________________________________________________________
JUDGMENT
The appeals from the assessments made under the Income Tax Act for the 1992, 1993, 1994, 1995 and 1996 taxation years are allowed and the assessments are referred back to the Minister of National Revenue for reconsideration and reassessment in accordance with the attached Reasons for Judgment.
If the parties cannot settle the issue of costs within 60 days of the date of the within Reasons, they may contact the Court to obtain dates for the filing of written submissions.
Signed at Vancouver, British Columbia, this 1st day of June 2009.
"Diane Campbell"
Campbell J.
Docket: 2004-1227(IT)G
BETWEEN:
JOHN RANKIN,
Appellant,
and
HER MAJESTY THE QUEEN,
Respondent.
____________________________________________________________________
Appeals heard on common evidence with the appeals of
Francis O’Dea (2004-1225(IT)G), Sean O’Dea (2004-1226(IT)G), and
Geoffrey Bailey (2004-474(IT)G) on June 17, 18 and 19, 2008
at Toronto, Ontario
Before: The Honourable Justice Diane Campbell
Appearances:
Counsel for the Appellant:
Louise R. Summerhill and
Chris Dunn
Counsel for the Respondent:
Marie-Thérèse Boris and
Brent E. Cuddy
____________________________________________________________________
JUDGMENT
The appeals from the assessments made under the Income Tax Act for the 1994, 1995 and 1996 taxation years are allowed and the assessments are referred back to the Minister of National Revenue for reconsideration and reassessment in accordance with the attached Reasons for Judgment.
If the parties cannot settle the issue of costs within 60 days of the date of the within Reasons, they may contact the Court to obtain dates for the filing of written submissions.
Signed at Vancouver, British Columbia, this 1st day of June 2009.
"Diane Campbell"
Campbell J.
Docket: 2004-474(IT)G
BETWEEN:
GEOFFREY BAILEY,
Appellant,
and
HER MAJESTY THE QUEEN,
Respondent.
____________________________________________________________________
Appeals heard on common evidence with the appeals of
Francis O’Dea (2004-1225(IT)G), Sean O’Dea (2004-1226(IT)G), and
John Rankin (2004-1227(IT)G) on June 17, 18 and 19, 2008
at Toronto, Ontario
Before: The Honourable Justice Diane Campbell
Appearances:
Counsel for the Appellant:
Louise R. Summerhill and
Chris Dunn
Counsel for the Respondent:
Marie-Thérèse Boris and
Brent E. Cuddy
____________________________________________________________________
JUDGMENT
The appeals from the assessments made under the Income Tax Act for the 1994, 1995 and 1996 taxation years are allowed and the assessments are referred back to the Minister of National Revenue for reconsideration and reassessment in accordance with the attached Reasons for Judgment.
If the parties cannot settle the issue of costs within 60 days of the date of the within Reasons, they may contact the Court to obtain dates for the filing of written submissions.
Signed at Vancouver, British Columbia, this 1st day of June 2009.
"Diane Campbell"
Campbell J.
Citation: 2009 TCC 295
Date: 20090601
Dockets: 2004-1225(IT)G,
2004-1226(IT)G,
2004-1227(IT)G,
2004-474(IT)G.
BETWEEN:
FRANCIS O’DEA,
SEAN O’DEA,
JOHN RANKIN,
GEOFFREY BAILEY,
Appellants,
and
HER MAJESTY THE QUEEN,
Respondent.
REASONS FOR JUDGMENT
Campbell J.
Introduction:
[1] These appeals concern the disallowance of losses by the Minister of National Revenue (the “Minister”) in respect to the 1992 to 1996 taxation years for Francis O’Dea and Sean O’Dea and in respect to the 1994 to 1996 taxation years for Geoffrey Bailey and John Rankin. In addition to the disallowance of the losses, the Minister imposed gross negligence penalties with respect to Francis O’Dea and Sean O’Dea.
[2] All of the Appellants in these appeals were limited partners in the Proshred Florida/Georgia Limited Partnership (the “Partnership”). Geoffrey Bailey also purchased units in the Kilrush Limited Partnership (the “KP Partnership”), which was a limited partner in the Partnership. The Appellants are representative of a total group of 17 limited partners who purchased limited partnership units in the Partnership and/or the KP Partnership. Both the Partnership and the KP Partnership were established by the O’Deas and were registered as limited partnerships on August 29, 1988 and May 1, 1994, respectively. Both the Partnership and the KP Partnership were registered tax shelters under the Income Tax Act (the “Act”).
[3] In respect to the relevant taxation years, the Minister determined that the Appellants were not entitled to deduct the losses from the Partnership and/or KP Partnership. These losses were denied on the primary basis that the long-term promissory notes, being one of the vehicles which all of the investors utilized to pay for their purchase of partnership units, were limited recourse amounts within subsection 143.2(1) of the Act because the interest on these notes was not paid by the Appellants or was not paid within 60 days of each taxation year‑end as required under subsection 143.2(7). This had the effect of reducing each investors’ cost of their units, thereby reducing the at-risk amount for each investor under subsection 96(2.2) of the Act and correspondingly reducing, by the same amount, the Appellants’ entitlement to deduct their respective losses under subsection 96(2.1) of the Act. In addition, the Minister’s assessments were based on a determination that the Partnership was not a valid partnership and that certain expenses were unsupported and lacked credibility.
[4] I heard evidence from three of the Appellants, Francis O’Dea, Sean O’Dea and Geoffrey Bailey, as well as Glenn Fraser, a chartered accountant with Fraser, Cellucci & Associates (now Taligent Group Inc.), that provided accounting services to the entire group of companies involved in these appeals. The Respondent relied on the testimony of the auditor, Gino Casciano.
Facts:
[5] The Appellants, Francis and Sean O’Dea, are brothers who together created the Proshred mobile document shredding business in the mid-1980’s. Proshred Holdings Limited (“PHL”) was incorporated in Ontario on March 19, 1987 and operated the Proshred business through franchises in both Canada and the United States (“U.S.”) during the relevant years under appeal.
[6] As part of the franchising aspect of the business, PHL operated a centralized service bureau (the “Service Bureau”) that provided certain administrative services and functions to its franchisees in Canada and the U.S. The Service Bureau was maintained through a call centre located in Canada which took orders, maintained client accounts, including collections and remittances and provided accounting services for the franchisees in both countries. In return for these services, each of the franchisees paid a licensing fee based on the franchisee’s gross revenue (the “Licensing Fees”). To facilitate the U.S. operations, PHL operated in that country through Proshred Inc. (“PI”), a wholly owned U.S. subsidiary, which held all of the licensing rights to operate the Service Bureau for the franchisees in the U.S.
[7] Francis O’Dea was the Chairman of PHL and President of PI; Sean O’Dea was the President of PHL. They have extensive business backgrounds dating back to the mid-1970’s and both have been involved with other companies, including the establishment of the widely known Second Cup business. They initially expanded the Proshred business through limited partnerships, which were profitable for investors, before pursuing expansion through franchising operations. Sean O’Dea was primarily responsible for developing the franchises.
[8] Although PI held the licensing rights to operate the Service Bureau in the U.S., it did not carry on any operational activities (Master Licence Agreement, dated March 28, 1990, Joint Book of Documents, Tab 7). According to Francis O’Dea, PI was “just a shell” (Transcript, page 34).
(A) Expansion of the Proshred Business:
[9] After consulting with various professional advisors in 1994, PHL decided to expand into the U.S. market using the structure of a limited partnership. On April 29, 1994, PI sold its licensing rights to operate the Service Bureau for the territories of Florida and Georgia (“F/G Licensing Rights”) to another U.S. corporation, PC Holdings Inc. (“PC Holdings”). Peter Charlton, a Chartered Accountant and CPA, was the sole shareholder of PC Holdings. He also acted as a consultant for PHL in Canada and was intimately involved with the accounting and financial strategies of PHL. The Original Purchase Contract dated April 29, 1994 between PI, PHL and PC Holdings for the F/G Licensing Rights listed a sale price of $3.4 million with payment from PC Holdings to PI to be made by way of a promissory note.
[10] According to Francis O’Dea, PC Holdings acquired the F/G Licensing Rights because Peter Charlton recognized the potential of the Proshred business in the U.S. However, later in his testimony, Mr. O’Dea stated that the intention in selling the F/G Licensing Rights to PC Holdings was “… to create this partnership in order to expand the Proshred Florida/Georgia territories and this was the mechanism for doing that.” (Transcript, page 32)
[11] Shortly after, on May 2, 1994, PC Holdings sold the F/G Licensing Rights to Proshred General Partner Inc. (“Proshred GP”), a company incorporated under the laws of Ontario as a wholly owned subsidiary of PHL. Proshred GP was the only general partner of the Partnership and held a 0.1% interest in the Partnership. Proshred GP purchased the F/G Licensing Rights on behalf of the Partnership and issued a promissory note in the amount of $3.6 million to PC Holdings for payment of the F/G Licensing Rights.
[12] Also on May 2, 1994, Proshred GP entered into the following additional agreements with PHL on behalf of the Partnership:
1. the Service Bureau Management Contract, under which PHL agreed to manage the service bureau for the Florida and Georgia franchises on behalf of the Partnership;
2. the Cash Flow Deficiency Agreement (“CDA”), under which PHL agreed to supplement any cash flow deficiency to enable the Partnership to pay operating expenses and make distributions to its limited partners;
3. the Startup Services Agreement (“SSA”), under which PHL would be responsible for the initial setting up and development of the franchise territories in Florida and Georgia; and
4. the Franchise Completion Agreement (“FCA”), under which PHL would be responsible for completing the development of the franchise territories in Florida and Georgia.
[13] Throughout this period PHL continued to operate the Service Bureau for all of the franchises in both Canada and the U.S., including those in Florida and Georgia, even though PI held the licensing rights to operate the Service Bureau in the U.S. This continued despite the fact that the F/G Licensing Rights were later acquired by PC Holdings, and then by Proshred GP, which purchased the F/G Licensing Rights on behalf of the Partnership.
(B) Purchase of the Partnership Units:
[14] In the fall of 1994, a total of 4,950 units of the Partnership (the “Units”) were offered pursuant to an Offering Memorandum dated September 26, 1994, which was amended and reissued on December 7, 1994. The purchase price was $1,000.00 per Unit, payable in three components: a cash payment of $120 per Unit, a short-term promissory note of $152.73 per Unit, payable with 9% interest on January 2, 1995 (the “ST Note”) and a long-term promissory note of $727.27 per Unit, payable on December 31, 2019, with interest due and payable annually at the rate equal to “prime plus one” (the “LT Note”). The principal amount of all of the LT Notes totalled $3.6 million. This purchase price structure was determined after seeking the advice of various legal and accounting professionals.
[15] While the typical investor purchased Units by a cash component, an ST Note and an LT Note, the O’Deas each paid for their Units by an LT Note and a mid-term note payable on August 30, 1999, with interest due and payable annually at the rate equal to “prime plus one” (“MT Note”). The MT Notes represented the value, that the O’Deas would have paid by the cash component and the ST Note, had they purchased their Units according to the price structure prescribed under the Offering Memorandum. In their testimony, they could not recall why they used MT Notes instead of the cash component and ST Note.
[16] The Appellants acquired their respective number of Units as follows:
Appellants
Subscription Date
Units
Total Cost
Cash
ST Note or MT Note
LP Note
(or LT Note)
Francis
December 29, 1994
900
$900,000
-
$246,069
$654,543
Sean
December 29, 1994
300
$300,000
-
$82,023
$218,181
Bailey
December 21, 1994
97
$97,000
$11,640
$14,815
$70,545
Rankin
December 22, 1994
150
$150,000
$18,000
$22,909
$109,091
Note: Amounts for O’Deas do not equal the “totals” - these were the amounts found on the notes at tabs 21 and 22 of the Joint Book of Documents.
Note: The Partnership’s documents referred to the LT Note as the LP Note.
[17] Not all of the Partnership’s 4,950 Units were acquired by individual investors. The KP Partnership acquired the outstanding 2,559 units on December 30, 1994. As payment, the KP Partnership issued a short-term promissory note with an annual interest rate of 9% but no fixed terms of repayment (“KP ST Note”), and a long-term promissory note (“KP LT Note”), under the same terms as the LT Notes of the other limited partners. It did not pay a cash component. The KP ST Note and KP LT Note were not submitted into evidence.
[18] The ownership of a unit in the KP Partnership entitled the owner on a pro rata basis to an undivided proportionate interest in the rights, benefits, profits and losses of a Unit in the Partnership. The only assets of the KP Partnership, during the years under appeal, were the Units it held in the Partnership.
[19] On April 24, 1995, Mr. Bailey acquired 97 units in the KP Partnership at the price of $1,000.00 per unit, by a payment consisting of a cash component, a short‑term note payable on January 1, 1996 and a long-term note payable on December 31, 2019.
[20] Approximately $1.35 million in cash would have been raised as a result of the offering, if all of the Units had been fully subscribed with a subscription price that included the cash component. However, there were 3,849 units for which no cash was received because both the O’Deas and the KP Partnership did not pay this cash component. As a result $1.05 million of the anticipated $1.35 million potential cash component was not raised. Despite the Appellants’ contention that the purpose of the Partnership was to finance the U.S. expansion, aside from the MT Notes of the O’Deas and the ST Notes from Mr. Bailey and Mr. Rankin, the Partnership received no principal amounts on any of the Notes.
(C) ST Notes, MT Notes, LT Notes and the Payment of Interest:
[21] In respect of the purchase of their Units, Mr. Bailey and Mr. Rankin paid the cash component to the Partnership. They also paid the ST Notes, with interest, to the Partnership on January 2, 1995.
[22] Both O’Deas testified that their MT Notes were paid in full with interest as required on or before August 30, 1999. However, they did not make interest payments on these notes during the relevant taxation years.
[23] The Appellants relied heavily on the evidence of Glenn Fraser with respect to their contention that the requisite interest payments were in fact made by the limited partners in respect to the KP ST Note, the KP LT Note and the LT Notes during the relevant years.
[24] Although Mr. Fraser was not involved with the structuring of the Partnership or the KP Partnership, his firm, Fraser Celluci, was hired by PHL to do the bookkeeping and accounting for the entire Proshred group of companies. Under the firm’s engagement, they were responsible for preparing the annual working paper files for the taxation years beginning in 1995 and for filing the annual Partnership Information Returns with CRA for both the Partnership and KP Partnership. The firm did not prepare the financial statements.
[25] According to Mr. Fraser, interest on the KP ST Note was paid every year by cheque and therefore the Partnership had received payment by cheque from the KP Partnership in satisfaction of the KP ST Note. Subsequent statements indicate that the Partnership recognized the interest income accordingly. However a review of the Partnership’s bank account statements confirmed that those statements did not disclose any deposits during the relevant years. In fact the Partnership’s account had been inactive since December 31, 1995. He suggested that the cheques “… might have been deposited in the Proshred Holdings’ bank account” (Transcript, page 265).
[26] With respect to the payment of interest on the LT Notes, including the KP LT Note, article 4.04(a) of the Restated Limited Partnership (Schedule “A” of the Offering Memorandum, Tab 5, Joint Book of Documents) provided:
(a) A distribution shall be made in each Fiscal Year to the Limited Partners in an amount equal to interest due on the L.P. Note in respect of that Fiscal Year, to be paid on or before December 31st of that Fiscal Year. At the direction of the Limited Partner that distribution may be paid directly to the holder of the L.P. Note in satisfaction of the Limited Partner’s obligations to pay interest thereon;
[27] According to the Appellants, distributions were made according to article 4.04(a). Although article 4.03 stated that distributions should be made from the gross revenues of the Partnership, the distributions were made by way of drawings from each limited partner’s capital account. The amounts made in distributions in each taxation year are consistent with the continuity schedule from 1994 to 1997 of the Equity, ACB and at-risk amounts for each limited partner.
[28] According to the Appellants, interest on the LT Notes was paid by the limited partners via journal entries in each of the relevant taxation years (Tab 2, Exhibit A-2). Mr. Fraser stated that the entries were prepared within sixty days of the subsequent year‑end, since the working papers for the financial statements were submitted to the accounting firm within forty‑five to sixty days of the subsequent year.
[29] The Appellants stated that the Partnership had later assigned the LT Notes to PC Holdings in satisfaction of the $3.6 million promissory note that it owed to PC Holdings in respect to the F/G Licensing Rights. However, the limited partners did not sign a direction or authorization permitting the Proshred GP or the Partnership to pay the LT Notes directly or to pay the interest owing or to permit the KP Partnership to pay the LT Notes directly to any other third party. It is true, however, that the form of the LT Notes contained the following provision: “funds from the long term note would be paid over to a third party for services that are owing and performed on behalf of the Partnership”. Other than this, there was no evidence that the Partnership had assigned any of the LT Notes.
[30] Mr. Fraser dealt with Mr. Charlton and followed his direction and guidance in the course of his work for the Proshred companies. Although Mr. Fraser was not familiar with any of the relevant Agreements, he stated that he would have taken direction from Mr. Charlton in making the required journal entries. In respect to journal entries he stated:
… part of the journal entries would have been prepared by us and part of the journal entries would have bee [sic] provided to us.
…
By one of the professional firms.
(Transcript, page 219)
[31] On March 31, 1997 Mr. Fraser wrote a memorandum to Mike Kecskemeti, another employee with his firm, which stated that the interest in respect to the LT Notes was deemed to be paid on January 1, 1996 for the 1995 year‑end. (Exhibit A-1, Tab 55)
[32] Mr. Fraser testified that his phrasing “interest was deemed to be paid” meant that “it was to be paid”. (Transcript pages 252-254)
[33] With respect to the journal entries documented at Exhibit A-2, Tab 2, Mr. Fraser admitted the following:
(1) that he printed them from the computer system at his office one week prior to the hearing;
(2) that he did not recall who actually prepared the entries;
(3) that there was nothing in the documents to indicate when the entries were made;
(4) that the entries were “not proper” because, although they reference a year, they contain no exact date (Transcript, page 276); and
(5) that, although there was a list of journal entries that could support a general ledger, they were not the original journal entries that were part of the books and records of the Partnership (Transcript, page 279).
[34] At the time of the audit, Mr. Casciano was not provided with any evidence that interest on the LT Notes had been paid. He expected to see journal entries reflecting the interest amounts on the LT Notes, which were allegedly later assigned to PC Holdings, as well as entries relating to the non-resident withholding tax. Although he was not provided the journal entries, contained at Tab 2, Exhibit A-2, during the audit, he stated that the reassessments would have remained unchanged because the journal entries at Tab 2 were not dated and there were no purported entries for 1994 and 1995. Similarly, even if the working papers at Tab 1, Exhibit A-2, had been provided during the audit, the reassessments would also remain unchanged because they were “… just produced for the purpose of preparing the financial statements, but it certainly doesn't demonstrate that any books and records were kept”. (Transcript, page 363).
(D) The Partnership’s business, expenses and corresponding losses:
[35] Unlike the Canadian operation, the Florida/Georgia operation was not successful and the Partnership was unable to meet its U.S. projections. The Partnership never made sufficient revenue to cover the amount of debt it owed to PHL as a result of the fees it incurred under the various Agreements (management fees owing to PHL, $3.6 million loan payable to PC Holdings and the payments to PHL under the SSA and the FCA).
[36] Sean O’Dea was involved with the preparation of the financial projections, (Exhibit R-2), disclosed in the Offering Memorandum, which was used to promote the initial sale of the Units in the Partnership to potential investors. He confirmed that the Proforma Statement was prepared prior to the formation of the Partnership. According to the forecasts in the Proforma Statement, the Partnership would have received $521,136.00 in service bureau fees in 1996. The sole revenue source for the Partnership was from these service bureau fees. In determining the projected service bureau fees, Sean O’Dea considered the anticipated sales in Florida and Georgia. The projections contained in the Offering Memorandum anticipated that total gross shredding sales for Florida and Georgia in 1996 alone would total approximately $3.8 million. In comparison, after eight years of operations, the total gross shredding sales for all of Canada totalled only $4.3 million. Sean O’Dea admitted that his projected revenue level for Florida and Georgia, after only two years, exceeded the level achieved in Canada after a full nine years of operations. However, he pointed out that PHL had begun franchising the business in Canada during the latter years and that after only three years of operations, PHL was making approximately $2 million annually in gross shredding sales. The projections in both the Proforma Statement and the Offering Memorandum were consistent.
[37] Sean O’Dea testified that he reviewed the Offering Memorandum including the tax disclosure section at page XIII of the Offering Memorandum, which was prepared by the accounting advisors, Mintz & Partners. At page iii of the Offering Memorandum (Tab 5, Joint Book of Documents) it stated:
Ownership of Partnership Units is intended to provide Limited Partners with the opportunity to receive cash distributions from the Partnership which will be applied to pay down the L.P. Notes, may provide a cash return, and in the meanwhile provide sufficient cash to cover income tax at the top marginal rate on any income allocated from the Partnership less any interest paid on the L.P. Notes and to provide certain allowable income tax deductions which will shelter other income. See “Tax Consequences”
Francis O’Dea testified that he understood this to mean that “… the service bureau revenue will be recorded in the books of the partnership and that distributions from that revenue stream will be paid out to the partners” (Transcript, page 56). However, the Partnership failed to earn enough revenue to make the annual interest distributions to its limited partners.
[38] The Partnership incurred significant losses in its operations for the years ending on December 31, 1994, 1995 and 1996. These losses were then allocated to its limited partners, including the KP Partnership, during those years. The KP Partnership then re-allocated those losses to its own limited partners on a pro rata basis.
[39] The Partnership’s Statement of Loss, for the year ended December 31, 1994, shows “start-up fees” of $950,000.00 which were deducted by the Partnership as an expense for services rendered by PHL under the SSA. The Partnership’s Statement of Operations, for the years ended December 31, 1995 and 1996, shows that franchise completion fees in the amounts of $1.3 million and $500,000.00 were deducted as an expense for the cost of developing the franchises in Florida and Georgia and allegedly incurred by PHL under the FCA.
The relevant parts of Clauses 2 and 3 of the SSA read as follows:
2. PHL estimates that the foregoing costs and expenses to be incurred by it up to December 31st, 1994 in the provision of the items listed in paragraph 1 hereof and of such other services related to the startup of the business in the Territory will be approximately $950,000. PHL undertakes to provide to the Limited Partnership a statement of such expenses showing the various classes of expenditure with reasonable particularity as soon as may conveniently be done after the calendar year-end.
3. The Limited Partnership undertakes … to reimburse PHL for the said startup costs and expenses out of the proceeds of the sale of limited partnership units …
Similarly, the relevant parts of Clauses 2 and 3 of the FCA read as follows:
2. PHL estimates that the foregoing completion costs and expenses to be incurred by it on behalf of the Partnership in the two year period from January 1st, 1995 to December 31st, 1996 in the provision of the completion services indicated in paragraph 1 hereof and of such other services related to the completion of the development of the business of the Partnership in the Territory will be approximately $1,800,000. PHL undertakes to provide to the Limited Partnership a statement of such expenses showing the various classes of expenditure with reasonable particularity as soon as may conveniently be done after the 1996 calendar year-end.
3. The Limited Partnership undertakes to reimburse PHL for the said completion costs and expenses without interest out of funds received from the Service Bureau business …
[40] Pursuant to the SSA, the Partnership would reimburse PHL the amount of $950,000.00, which was the approximate cost related to setting up the various franchise territories. Similarly, the FCA required the Partnership to reimburse PHL for expenses incurred in 1995 and 1996 in further development of these territories, for which the fee was set at $1.8 million. With respect to these payments, Francis O’Dea testified that it was “… the cost that we thought it would be and that would be reimbursed” (Transcript, page 81). If the costs incurred by PHL, in meeting its obligations pursuant to the SSA and FCA, exceeded the amounts of $950,000.00 and $1.8 million respectively, Francis O’Dea testified that PHL would be responsible for those additional costs and would not pass those costs on to the Partnership.
[41] Although the agreements stated that PHL would provide the Partnership with a statement of the actual costs and expenses that were incurred, Francis O’Dea admitted that, to his knowledge, it was never done. However, the Appellants contend that the various documents provided under Tab 69 of the Joint Book of Documents contain all of the required invoices and receipts related to the costs and expenses that PHL incurred under the SSA and FCA.
[42] Mr. Casciano concluded that the expenses deducted by the Partnership, purportedly relating to expenses under the SSA and FCA, for the years ending 1994, 1995 and 1996, lacked credibility and that the legitimate expenses would have been “Significantly reduced. Virtually nil.” (Transcript, page 378). He also determined that the documents at Exhibit R-5, which provided a statement of expenses totalling $3,275,000.00 incurred by PHL on behalf of the Partnership between 1993 and 1996, contained a margin of $740,221.00 that was clearly not an expense but which was added to enable the statement to equal the $3,275,000.00 figure. He also had concerns that the 1993 expenses were being reimbursed by the Partnership to PHL in 1994.
[43] When the audit commenced in June 1999, Mr. Casciano wrote to the Partnership requesting various documentation. No accounting records or a general ledger were provided in response to this request. Intermittently during the audit, he did receive some handwritten and undated adjusting and closing entries and reconciliations for a PHL inter-company account and some, but not all, of the Partnership’s bank statements. Mr. Casciano concluded that this information did not demonstrate proof of proper record keeping and consequently, he was unable to verify the reporting revenues, expenses and the Limited Partners’ losses from the information provided to him during the audit.
[44] With respect to the documents at Tab 1, Exhibit A-2, Mr. Casciano stated that up until a week before the hearing, he had never seen the documents at pages 2, 3, 4, 5, 6, 12, 13, 16, 17, 19 and 20. With respect to the documents at pages 1, 8, 18, 21 and 22, he had seen similar documents but not the exact documents as those produced in Exhibit A-2. With respect to the documents at pages 9, 10, 11, 14 and 15, he saw those during the course of the audit.
[45] Similarly, Mr. Fraser’s evidence respecting whether or not the Partnership maintained independent books and records or a general ledger was inconsistent. During the hearing, Mr. Fraser first said that the Partnership maintained its general ledger and that its books and records were kept at the offices of PHL. However, he later admitted that he did not recall whether the Partnership had independent books and records and also admitted that the Partnership did not have an independent accounting system.
[46] Francis O’Dea admitted that the Appellants were unable to produce bank statements for the Partnership, other than the bank statement covering December 29, 1995 to December 31, 1996 (Tab 52, Joint Book of Documents). He also admitted that the PHL bank account had been inactive since at least December 1995.
(E) Francis and Sean O’Dea and Geoffrey Bailey:
[47] Francis O’Dea was instrumental in planning the Partnership’s expansion and actively promoting the sale of Partnership’s Units to potential investors. Although Mr. O’Dea testified that he was more concerned with expansion of the business and not the tax consequences, he did admit that he “presumably” knew that a limited partner could only deduct the full losses if the ST Note was paid. Francis O’Dea claimed full deductions for losses notwithstanding that he had not paid any cash component or subscribed to or paid on a ST Note in the relevant taxation years. He admitted that, as of December 31, 1996, he owed the Partnership $245,454.00, representing the subscription price of his MT Note (Transcript, page 93). (Note: In contrast, Tab 21 lists the Principal amount on the MT Note as $246,069.00.) However, on re-examination he stated that it was only shortly prior to the hearing that he became aware of the possibility of problems with respect to the MT Note and the deductibility of losses.
[48] The LT Notes required that interest be paid at a rate equal to “prime plus one”, “calculated half yearly not in advance and payable annually on December 31st in each year.” (Tab 21, Joint Book of Documents). Francis O’Dea testified that he was aware that interest on the LT Notes must be paid within 60 days of year‑end as per the Offering Memorandum and the tax shelter rules contained in the Act. He testified that he gave direction to Mr. Fraser to ensure that this interest was paid and he believed that interest on these notes was paid by the limited partners through journal entries. Sean O’Dea’s evidence was essentially the same in respect to the interest payments on the LT Note. In particular he knew that if interest was not paid on a loan, the amount of loss deductible by a limited partner would also be limited.
[49] Mr. Bailey, a physician in Newfoundland, was a limited partner of the Partnership, as well as a limited partner of the KP Partnership. He viewed his participation as a long-term investment which he hoped would be profitable. Before purchasing units he read the Offering Memorandum for each of the Partnerships. His subscription price for his units was in accordance with the purchase price structure under the Offering Memorandum. With respect to the payments on the LT Note, he had this to say:
A. I understood the payments were to flow from the earnings from the service bureau and make interest payments to cover the long-term note and any principal payments that -- if there was adequate income at that point, to make principal payments in the early part of the investment and then as the investment proceeded, payments on the principal as well over the course of the long-term note which was to be concluded in 2019, I believe.
(Transcript, page 180)
[50] With respect to interest on the LT Note owed to the Partnership, he stated:
I haven't paid interest on the long-term note. It was -- on my understanding it was to be paid through income generated by the Limited Partnership and in the absence of that amount of money there was another deficiency agreement between Proshred Holdings to provide loans to cover the interest payments in short-term intervals until there was sufficient cashflow through the Partnership to pay that.
(Transcript, page 185)
With respect to the taxation years in issue, Mr. Bailey received certain documents from the Partnership for the purpose of filing his tax returns that led him to believe that interest was duly paid on his LT Note.
(F) The Reassessments:
[51] The Minister reassessed Francis O’Dea, Sean O’Dea, Mr. Bailey and Mr. Rankin in July of 2000 (the “Reassessments”). The Reassessments disallowed all of the partnership losses that each of the Appellants claimed for the taxation years of 1994, 1995 and 1996. The Minister also disallowed any partnership losses that the O’Deas sought to carry back to 1992 and 1993. The Reassessments were primarily based on the application of the limited recourse rules under section 143.2 of the Act, which reduced each of the Appellant’s at‑risk amounts under subsection 96(2.2) and their entitlement to the partnership losses under subsection 96(2.1) of the Act. The Minister also determined that the Partnership was not a valid partnership and, further, that the Partnership should not be entitled to claim expenses that it allegedly incurred under the SSA and FCA. In addition, penalties under subsection 163(2) of the Act were imposed on the O’Deas.
The Issues:
[52] 1. Does subsection 143.2(7) of the Act apply to the MT Notes, the LT Notes, the KP ST Note and the KP LT Note to deem them limited recourse amounts so that the Minister would be permitted to reopen the statute-barred years pursuant to subsection 143.2(15)?
2. If the Appellants are entitled to deduct the losses, are Francis and Sean O’Dea entitled to carry back their partnership losses to the 1992 and 1993 taxation years?
3. If the Notes are not limited recourse amounts under section 143.2:
(a) Is the Minister statute-barred from reassessing the Appellants in regard to the respective Notes?
(b) Is the Minister statute-barred from reassessing the Appellants on any other basis?
4. Aside from the determination of whether the Notes are limited recourse amounts under section 143.2, are the Appellants entitled to deduct their respective partnership losses based on the following:
(a) Was the Partnership a sham and/or a valid partnership for the purposes of section 96 of the Act?
(b) Is the Partnership entitled to deduct all of the expenses that it alleges it incurred during the relevant taxation years such that the Appellants would be entitled to deduct their respective losses in this regard?
5. Are Francis and Sean O’Dea liable for gross negligence penalties as assessed by the Minister under subsection 163(2) of the Act?
The Position of the Appellant and the Respondent on the Main Issues:
1. The Statute-barred Issue:
[53] The Minister issued the Reassessments, in respect of the 1994 to 1996 taxation years (and for the O’Deas, also the 1992 and 1993 taxation years), during July 2000. Therefore, the Appellants argue that the Reassessments were issued after the statutory limitation period under subsection 152(4) of the Act.
[54] The Respondent’s position is that the Minister is entitled to open otherwise statute‑barred years pursuant to subsection 143.2(15) of the Act to enable the Minister to assess to give effect to section 143.2. The Respondent’s position is that none of the taxation years are statute‑barred to the extent that the Appellants’ entitlement to partnership losses are reduced by the deemed limited recourse amounts under subsection 143.2(7). The Respondent submits that the MT Notes, the LT Notes, the KP ST Note and the KP LT Note are deemed t