Morley v. The Queen

Morley v. The Queen
Court (s) Database
Tax Court of Canada Judgments
Date
2004-04-13
Neutral citation
2004 TCC 280
File numbers
2000-3716(IT)G
Judges and Taxing Officers
Pierre Archambault
Subjects
Income Tax Act
Decision Content
Citation: 2004TCC280
Date: 20040413
Docket: 2000-3716(IT)G
BETWEEN:
DAVID MORLEY,
Appellant,
and
HER MAJESTY THE QUEEN,
Respondent.
REASONS FOR JUDGMENT
Archambault, J.
As a retired senior partner from Coopers Lybrand said to me this morning, parts of the private sector have brought this on themselves by being both greedy and dumb. Unfortunately, we have been caught up in the process.[1]
[1] This statement, written by Mr. David Morley himself, sets the tone for the events that led to these appeals. On December 8, 1993, Mr. Morley became a limited partner of the Agensys (Canada) Limited Partnership (Partnership), formerly known as the Continental Limited Partnership. On December 31, 1993, the Partnership allocated to him a loss of $217,282, mostly attributable to capital cost allowance (CCA) claimed in respect of a software (Software) acquired by the Partnership for a disclosed price of $12,150,000. A portion of the $217,282 loss, namely $36,028, was claimed as a carried over non-capital loss in computing Mr. Morley's taxable income for the 1990 taxation year.
[2] By Notice of Reassessment dated November 21, 1997, the Minister of National Revenue (Minister, Revenue Canada or CCRA) disallowed Mr. Morley's share of the Partnership losses for its 1993 fiscal period. He also disallowed the deduction of the $36,028 non-capital loss for the 1990 taxation year. Finally, he assessed penalties aggregating $50,495.35 pursuant to 163(2) of the Income Tax Act (Act), R.S.C. 1985, c.1 (5th Supp.).
[3] A reading of the Reply to the Amended Notice of Appeal identifies the following 14 issues raised by these appeals:
1. Did the Partnership constitute a valid partnership?
2. Did the Partnership carry on any business for the purpose of earning a profit from the exploitation of the Software and did it have a reasonable expectation of profit, or was it formed for the sole purpose of creating tax refunds for investors by claiming CCA relating to the Software?
3. Did Mr. Morley participate in the Partnership for the purpose of gaining or producing income and did he have a reasonable expectation of profit?
4. Was the Software acquired for the purpose of gaining or producing income as required by paragraph 1102(1)(c) of the Income Tax Regulations (Regulations)? If not, it would not constitute depreciable property.
5. Did the Software constitute property described in paragraph (o) of Class 12 of Schedule II of the Regulations, or did it constitute a "systems software" within the meaning of section 1104 of the Regulations or property described in Class 14 of Schedule II of the Regulations?
6. Was the Software "available for use" in 1993 within the meaning of subsections 13(26) and (27) of the Act? If not, no CCA could be claimed by the Partnership in 1993.
7. When was the Software acquired: in December 1992, as claimed by Mr. Morley, or in 1993, as claimed by the respondent? If it was in 1993, the claim for CCA would be subject to the so-called "half-year rule" under subsection 1100(2) of the Regulations.
8. What was the cost of the Software to the Partnership? Was it limited to the cash payment of $960,000 or was it equal to the amount of the promissory note (Acquisition Note) for $12,150,000 issued when the Software was acquired? The respondent claims that neither the Partnership nor the vendor of the Software, Agensys Corporation (Agensys T & C), an entity incorporated under the laws of the Turks and Caicos Islands, ever intended to create a legal liability under the Acquisition Note. Furthermore, the respondent claims that Agensys T & C never intended to collect on the Acquisition Note.
9. Did Mr. Morley, the Partnership and Agensys T & C deal with each other at arm's length or not, and what was the Software's fair market value (FMV)?
10. Was the amount claimed on account of CCA prohibited by section 67 of the Act as not reasonable in the circumstances?
11. Was Mr. Morley subject to the so-called "at-risk rules" under subsection 96(2.1) of the Act, so as to reduce his share of the Partnership loss to $35,025, the amount he actually disbursed for the acquisition of his Partnership units?
12. Was Mr. Morley entitled to deduct the $36,028 non-capital loss in computing his 1990 taxable income?
13. Did Mr. Morley knowingly, or in circumstances amounting to gross negligence, make a false statement in his tax return, such that the penalty provided for in paragraph 163(2) of the Act is applicable?
14. Did the Minister in the course of his audit obtain any information or documentation in violation of Mr. Morley's Charter rights, and if so, what is the remedy?
[4] Either at the outset of the hearing or in the course thereof, both parties made admissions that resulted in the elimination of some of these issues. First, the respondent admitted that the Software was neither a systems software nor Class 14 property. The respondent also abandoned the claim that penalties should be assessed against Mr. Morley pursuant to subsection 163(2) of the Act. As for Mr. Morley, he conceded, for the purpose of these appeals, that the Software was acquired by the Partnership in December 1993, although, he claimed, there was evidence supporting a finding that it was so acquired in December 1992. As a result, the Partnership was subject in 1993 to the half-year rule.
I Factual Background[2]
[5] The hearing of these appeals lasted 14 long days[3] over a three-week period. Hundreds of exhibits were filed, representing several thousand pages.[4] I do not intend to review all the relevant facts in this summary. I will deal with the more crucial ones in the body of my analysis. However, it is useful to provide at this point a general overview of the facts and a description of the main actors in this saga.
[6] Mr. Morley is a tall, charming person who, after graduating from the University of British Columbia in 1958,[5] had a distinguished career in the Public Service of Canada. This was recognized in a personal letter of March 1978 from then Prime Minister Trudeau when Mr. Morley resigned temporarily from the Public Service. Following a few business endeavours in the private sector, including acquiring an interest in and becoming president of a software design company (Omnitech Graphics Systems), he returned to the Federal Public Service. It appears that he retired for good from the Public Service sometime in 1993, when he decided to start his own consulting firm.
[7] In September 1993, he was introduced to the Partnership by a securities broker, Mr. Mark Farmer. He received at that time a copy of a confidential offering memorandum relating to the Partnership units, a copy of the Software acquisition agreement and a copy of the source codes escrow agreement.[6] In carrying out a considerable and unusual amount of due diligence, he obtained a copy of an appraisal report (1993 Pritchard Evaluation or Report) dated June 28, 1993, prepared by Mr. Bob Pritchard, together with an undated 49-page document entitled "The Future of Information Management" describing among other things the Software, its benefits and its competitive position on the market. Included with this latter document were testimonials[7] from users as well as from a professor who, the document claims, conducted an "independent Product Evaluation of AGENSYS" (that is, the Software). Mr. Morley also consulted two software consultants in Ottawa to obtain their opinion on the Software. He even had, together with these consultants, a telephone conference call with the creator of the Software, Mr. Howard Kale, who was living in Black Canyon City, Arizona.
[8] On the basis of different marketing materials relating to the Software, Mr. Howard Johnson of Campbell Valuation Partners Limited, the valuation expert who testified at the request of the respondent, provided the following description of the Software and its benefits at pages 7 to 12 of his report (Johnson Evaluation or Report) dated May 23, 2003:
General description
The Software was described as an information management system and language for designing, creating, enhancing and documenting applications software. Developers could use the Software to create applications to manage information. Administrators could use the Software to provide security and management control of the environment. For users the Software provided an easy way to manipulate and manage their information.
The Software enabled professional application design and implementation without a prerequisite mastery of computer science. The Software created a user environment and logical instruction set, similar to Lotus 1-2-3 in the spreadsheet environment, where the developer instructed the computer what to do without having to program how to do it. Therefore, the Software enabled the programmer to concentrate on the logical processes required to do the application and not on all of the intense, detailed programming instructions required for the computer to do its tasks. The Software differed from Lotus 1-2-3 in that the Software addressed the much larger world of information and database management and applications development.
The Software included the following functions:
· programming language- the Software was afourth generation programming language, which allowed the user to write instructions (program) in a form of human language, rather than in computer code;
· application developer- which contained all the elements needed to create fully tested, functional programs and applications, from design through documentation;
· program editor- which was used to enter and edit the Software source code. It was a fully-prompted, interactive tool that eliminated many types of programming errors before they occurred;
· imaging package[8]- which allowed electronic capture, storage, retrieval, display, transmission and printing of exact replicas of document pages, the basis for a 'paperless' office information system;
· programming support and debugging package- which allowed the programmer to test the program being edited, running the program exactly as written and identifying errors to correct before they happened, thereby avoiding costly, time-consuming problems;
· compiler and linker package- which translated high-level language statements into a condensed form of symbols that could be executed;
· screen manager- which allowed the user to easily change the format of the screen used in a particular program;
· database manager- which allowed the error-free manipulation of database files, allowing the user to enter, organize, sort, and retrieve information, and which allowed programmers to create databases, files and record layouts;
· query language- which allowed the end-user to get information out of a database file without knowing any codes or key words, or having a pre-written program to get it. The Software asked the user a series of simple questions about the information wanted, and automatically instructed the computer to find and organize the information, and bring it to the screen or printer;
· utilities package- which allowed the user to easily maintain files. For systems managers and advanced users, the Support Utilities provided methods for exploring the more technical areas of the system, which would otherwise be inaccessible;
· disaster recovery package- which allowed the user to reconstruct damaged files;
· documentation package- which provided the tools to automatically produce manuals for all applications, for users, managers or developers;
· security system- which gave management the ability to control user access to the application programs and databases; and
· multiple language translation capability- which had the capability of automatically producing documentation in up to ninety-nine different languages.
Benefits of the Software
The benefits of the Software in contrast to other products available around the Valuation Date were purported to include the following:
· the main strength of the Software was its ability to handle very complex information management applications beyond the capabilities of other automated tools. The Software automatically understood basic commands to input, display, print, and process information, and it has a file system that allowed it to effectively access all required information;
· simplicity - users did not have to know a lot about computers, or understand how they worked, to use the Software effectively. The Software assumed the responsibility for instructing the computer what to do and when a command should be executed. The Software, therefore, eliminated the problem of having to be an expert in computer science;
· structured sentences - when the Software was instructed to execute a command, it was done using a structured sentence with a verb, adverb, object, and adjectives. As result of the users' familiarity with English language sentence construction, this resulted in a very fast learning curve for programmers, who could become an expert in less than three months. This, together with the automatic error correction feature, made it easier to verify that the Software applications are correct and bug free. The use of structured sentences was the fundamental breakthrough and the paradigm shift offered by the Software;
· productivity, responsiveness and reduced costs - the Software helped to speed up application development and to reduce costs by applying the concepts of reduce, reuse and recycle towards software development. That is, the Software had reusable components in its architecture, which reduced the programming required to develop an application by up to 80% relative to traditional languages and tools. The Software tools also reduced the time and cost required to develop applications by eliminating most programming errors when they were entered and by finding the remaining errors with continuous testing. By supporting the re-engineering of legacy systems, the Software made it possible to recycle existing data and processes when moving to client/server architectures;
· automatic documentation- the Software provided the tools to automatically produce manuals for all applications, for users, managers or developers, which was a major benefit not available with most other products;
· quality - the Software provided the tools and methodology required to test and validate the designs for business processes, user interfaces and application software. The Software allowed users and analysts to develop applications, which evolved gracefully to meet the changing requirements of users. The Software increased the quality and reliability of application software by assembling it from proven, reusable software components;
· portability - the Software separated data and logic specifications from each other and from the operating environment. This feature provided platform independence for applications developed and executed with the Software. The Software tools generated software that could be run on many types of computers, networks, operating systems and user interfaces. Furthermore, the communication and messaging services provided by the Software allowed applications on different platforms to exchange data;
· interoperability- the Software provided an infrastructure that developed software that conformed to international and industry open system standards. Open system standards were designed to make it easier for applications to communicate with each other; and
· scalability - an application developed using the Software was scalable since the Software was both portable and interoperable.
[Emphasis added and, unless otherwise indicated, footnotes omitted.]
[9] To understand this description and avoid some of the confusion that was prevalent during the hearing, one has to distinguish between two key elements or features of the Software: "application development" and "application usage". First of all, an application (application or business application), in the computer world, is a software whose ultimate purpose is the automation of business or human activity; examples are the well-known Microsoft Word (for word processing) and Microsoft Excel (for spreadsheet computations). What is meant by an "application development" feature is a tool or production kit that allows an application developer (i.e. the software creator) to "create" an application. In other words, it is a software that creates another software. The "application usage" feature is the tool that allows a user to use the application created by the development application. In other words, it is the end-user business application. Often, software companies that create information management systems license their product in either of two ways, one being as a version with the application usage only, also called a runtime version. This can be described as a light version of the information management system, because it only allows the user to perform the basic functions of the application and thereby enjoy its use. It excludes most of the advanced functions that allow and facilitate the creation of applications.
[10] Here, the Software offers both features: "application development" (Development Version or AGP) and "application usage" (Runtime Version or AGS). Given that the Software is described as "Agensys Development System", it is not surprising that the above-quoted technical and marketing description emphasizes its development features. What the Partnership bought was first and foremost the AGP feature of the Software, that is what it intended to sell initially to its Canadian customers. It could not sell the Runtime Version (AGS) alone because one needed first to create an application with the AGP before that application could be used with the AGS. From these explanations, it can be readily understood that the AGP is the most valuable feature of the Software. It is with this feature that one can make money either by licensing it or by using it to create business applications for resale.
[11] Mr. Larry Gamble was the promoter of the Partnership, its initial limited partner and the sole shareholder of 616927 Ontario Inc. (GP), which was the general partner of the Partnership. After graduating with a teaching degree, he became a teacher in 1970. After four years, he decided to reorient his professional life by moving into the field of real estate and securities. He joined A.E. LePage's securities division. He left that firm in 1988 to start his own real estate and securities firm, which he sold in 1990. Mr. Gamble hired a former colleague, Mr. Nicholas Barisheff, to manage the Partnership with him. Mr. Barisheff graduated with a business degree from Ryerson and started working in 1969. After five years as a consultant, he joined A.E. LePage in 1974 as a securities salesman. He left the firm in 1981. From 1981 to 1992, he was a consultant in a variety of securities and real estate transactions.
[12] It was Mr. Barisheff who, allegedly in the spring of 1992, introduced Mr. Gamble to Mr. Kale, who was looking for US$500,000 to fund a software venture. The latter was described to Mr. Gamble as the creator of a software known as "Kammand Software" (Kammand). According to Mr. Gamble, the Partnership acquired a revised version of Kammand known as the "Agensys Software".[9] It was the rights to this software that were purchased by the Partnership, according to Mr. Gamble, on December 20, 1992. Those rights were limited to the use and the marketing of the Software in Canada. A copy of the purchase agreement (1992 Acquisition Agreement) was filed at Tab 40 and Tab 55, subtab 6. This agreement was amended and restated as of June 30, 1993. Pursuant to the restated agreement (1993 Acquisition Agreement), the Partnership acquired from Agensys T & C certain exclusive intellectual rights associated with the Software for a stated purchase price of $12,150,000 paid by the issuance of the Acquisition Note. The Partnership was obliged to pay Agensys T & C for the purchase an additional consideration equal to 10% of its annual gross revenues after cumulative sales in Canada had exceeded $120 million.
[13] Pursuant to the 1993 Acquisition Agreement, the Partnership acquired more specifically the rights to:
- use, exploit, modify, develop, change, improve and maintain the Software,
- market the Software and provide related services in Canada, and
- copy or reproduce the Software and related manuals in Canada.
The source codes provided[10] to the Partnership were for execution on the following three operating system platforms:[11]
- MS-DOS version 3.3 + (Microsoft 'C' Compiler V. 6.0, and Borland 'C' Compiler V. 6.0);
- Unix - SCO SV R-3.2; and
- Sun OS.
Under the 1993 Acquisition Agreement, Agensys T & C agreed to:
- provide training (to no more than two of the Partnership's software engineers) and technical consultation (up to two person-months per year) to designated representatives of the Partnership,
- engage in promotional activities (at up to six trade shows or retail outlets during a two-year period) for a fee of a $500 per day (plus travel expenses),
- provide to the Partnership all Basic Enhancements[12] and Maintenance Modifications[13] that it developed,
- within a reasonable period of "written request therefore [sic] by the Partnership", develop the Support Software[14] (Support Software) and transfer the Canadian copyright therein to the Partnership "at no charge to the Partnership but in consideration of a commercially reasonable royalty or like fee",
- provide to the Partnership on commercially reasonable terms "Enhancements"[15] required in order for the Software to remain competitive in the marketplace,
- launch within a year a national marketing and promotional campaign for the Software in the United States and provide the Partnership with copies of user testimonials.
[14] The purchase price (the lump sum portion) described in the 1992 Acquisition Agreement was payable by the delivery by the Partnership of the Acquisition Note in the amount of $12,150,000. The note did not bear any interest until December 20, 1993, and then bore simple interest at prime (at the Royal Bank of Canada) plus 0.5% commencing on December 21, 1993. The interest was to accrue until December 20, 2002, at which time the accrued and unpaid interest was to be capitalized and to form part of the unpaid principal. Thereafter, interest on the unpaid principal was to be calculated and payable on a quarterly basis starting on March 20, 2003. The principal amount was to be repayable as follows: $960,000 in cash (representing 7.9% of the purchase price) on or before December 20, 1993, and thereafter by quarterly instalments commencing March 20, 1994. Payments prior to December 20, 2002, however, were to be limited to 50% of the net distributable cash of the Partnership. In respect of the quarterly payments starting on and continuing after March 20, 2003, they were to be made whether there was any distributable cash or not, and the Partnership had to pay in full by December 20, 2012, the principal and interest owing.
[15] On October 19, 1993, Mr. Morley subscribed for 15 Partnership units for a total purchase price of $232,500 ($15,500 per unit), payable $35,025 in cash and, as to the balance of $197,475, by way of a note (Subscription Note). The terms of the Subscription Notes issued by the limited partners (Limited Partners) regarding the calculation and the payment of interest and regarding the payment of principal are identical to those of the Acquisition Note issued by the Partnership except for one major difference: the interest rate is prime plus 1%, and not 0.5%.[16]
[16] Mr. Gamble was not only the promoter of the Partnership, the sole shareholder of the GP and the initial limited partner, he was also an important[17] Limited Partner. He acquired 63 units for a total cost of $950,000, for which he disbursed only $143,113. As for Mr. Barisheff, he stated that his financial situation did not allow him to become a partner in the Partnership. Following the closing, on December 8, 1993, of the Partnership's private placement, Agensys T & C received as payment in full of the Acquisition Note issued for the Software $960,000 in cash[18] together with Subscription Notes issued by the Limited Partners aggregating $11,190,000. The Limited Partners' units were also pledged as security.
[17] Mr. Gamble also promoted 11 other partnerships (11 Partnerships) formed to acquire the rights to market the Software in other countries, such as Australia and New Zealand, the United Kingdom, France and Italy. These partnerships distributed their units in Canada through confidential offering memoranda from 1993 to 1996. The units of the Partnership and the 11 Partnerships (together hereinafter referred to as the 12 Partnerships)[19] were marketed as tax shelters by Mr. Gamble. Accordingly, the Partnership's lawyer obtained from the Minister a tax shelter number pursuant to section 237.1 of the Act. Mr. Morley acknowledged during his testimony that there were significant tax advantages to becoming a limited partner of the Partnership.[20] Mr. Morley claimed a business loss of $217,282, although his actual disbursement was only $35,025 in 1993, which represents just 15% of the total cost of his Partnership units. For Limited Partners who could claim the full amount of the Partnership losses at the 50% marginal tax rate, this represented an almost immediate return of 310%.[21] For Mr. Morley, the actual return would have been marginally lower, given that he had to carry back to 1990 a portion of his losses. Obviously, the "tax profit" (the difference between the tax savings and the cash disbursement) would be reduced if the Limited Partners were required to pay their Subscription Notes and to pay tax on their pro rata share of the Partnership income. However, the Partnership never - that is, from 1993 to February 28, 1997, when it was dissolved - made any sale of the Software and never received any gross revenues from the exploitation of the Software. Mr. Morley (as in all likelihood all the other Limited Partners) has never been required to make any payment on his Subscription Note, either on the principal or in respect of any interest owing thereon; nor is it expected that he will ever have to.[22]
[18] On December 31, 1993, the Partnership entered into an exclusive marketing agreement (Marketing Agreement) for a period of 10 years (renewable for two additional five-year periods) with Compucor Marketing Inc. (Marketing), whose name was eventually changed to Agensys Marketing Inc., to promote and market the Software to prospective end-users.[23] According to the Partnership's 1994 financial statements, the Agensys Partnerships entered into a similar agreement.[24] Mr. Gamble indicated that Mr. Barisheff and he each held 50% of Marketing's shares. However, this is in contradiction with the above-mentioned financial statements, which indicate that Mr. Gamble owned indirectly 100% of Marketing.[25]
[19] Pursuant to article 8.1 of the Marketing Agreement, Marketing was entitled to retain, in exchange for its services, 50% of all gross sales (whether made by Marketing or not) of the Software. Under article 6.1 of that agreement, Marketing was also authorized to offer to end-users ancillary services in support of the Software, including assistance with installation, technical training and a telephone hotline. Marketing was entitled to retain 90% of the fees paid for those services. Finally, pursuant to article 8.2, the Partnership was required to reimburse such out-of-pocket expenses incurred by Marketing in the performance of its duties "as the Partnership may in its sole discretion consider advisable". In any event, the Partnership was to advance up to $500,000 to Marketing for the establishment of training and support services and facilities, as well as provide and advance against initial reimbursable marketing and promotional expenses. [26]
[20] Mr. Morley's role was not limited to that of a passive limited partner. He also joined the "management group"[27] that looked after the affairs of the Partnership. Starting early[28] in 1994, he became involved in the marketing of the Software. Although he stated during his testimony that he worked on an "unpaid basis" from March 1994 to July 1994, it is apparent from the correspondence filed in evidence that Mr. Morley was hoping to earn commission income on sales of the Software and a percentage of the service fees for providing custom application software to the federal government and other potential clients of the 12 Partnerships. However, in August 1994, Mr. Morley decided it would be more advantageous for him to charge the management group a management fee of $5,000 per month ($60,000 per year). As will become apparent below, he must have realized early on that sales were going to be very difficult to achieve and that it would take much more time than anticipated before he could earn his commission income. Given that no sale was ever made, that proved to be the right move for him, and even more so when his management fee was increased to $7,500 per month for the second year ($90,000 per year). On April 20, 1997, this arrangement was modified in favour of a fee of $75 per hour.[29]
[21] The witnesses heard at the hearing did not give a good description of the interrelationship of the 12 Partnerships, of the role of Agensys T & C and Agensys U.S., or of the Software's attributes over the years. Some light is shed thereon by an undated memorandum (February 8, 1995, Batton Memo) (found in Tab 60) from Mr. John Batton, president of Agensys U.S., to Mr. Gamble. The most likely date of the memorandum is February 8, 1995, which corresponds to the date printed on it by the fax machine. It refers to attached undated documents, such as Agensys T & C's "Operational Plan" and "Development Plan", which two documents were received by Agensys U.S. in May 1994.[30]
[22] The first two pages of the "Operational Plan" are enlightening:
Agensys Corporation
Operational Plan
Agensys Corporation[31] has the Domestic and International Rights to the Agensys Development System. It has contracted with:
Domestic (USA)
Agensys Inc.,[32] a Texas Corporation has the right[33] to sell and distribute the Agensys Development System.[34] Agensys Inc. is charged with creating the following marketplaces for the Agensys Development System:
Value Added Reseller Marketplace - Agensys Inc. is charged with getting VAR's to utilize the Agensys Development System as their base technology and developing applications for distribution into the Retail and Corporate marketplace.
Application Marketplace - Agensys Inc. is charged with creating applications with the Agensys Development System that can be resold into the Retail and Corporate Marketplace.
Agensys Inc. is charged with entering into joint ventures that will create applications with the Agensys Development System to be resold into the Corporate and Retail Marketplace.
Agensys Inc. is charged with creating a demand for the Agensys Development System in the Corporate Information Management Arena. This effort will be centered around offering solutions developed by a consulting staff with the Agensys Development System being the core technology for this staff.
These rights and charter are non-exclusive. The payment for these rights is a % Gross royalty on the Agensys Development System Licenses to be paid on a quarterly basis to Agensys Corporation. The royalty stream is assignable to a Limited Partnership.[35] Upon notification Agensys Inc. will re-direct its royalty stream to the assignee.[36]
International
A series of Limited Partnerships will be established to purchase the software for discrete countries, the following are the countries and their respective percentage to the whole:
Country
Price[37]
%
Canada*
$ 12,150,000
5.2%
Aust/NZ*
7,300,000
3.26%
France*
16,900,000
7.56%
Italy
11,500,000
5.03%
United Kingdom
18,000,000
7.87%
Germany
22,000,000
9.62%
South Africa
2,500,000
1.09%
Mexico
4,000,000
1.75%
Austria
3,700,000
1.62%
Switzerland
3,700,000
1.62%
Spain/Port
8,000,000
3.5%
Holl/Lux/Bel
9,000,000
3.94%
Nor/Swe/Den
9,900,000
4.33%
Chi/HK/Mai/Sing/
Phil/Thai/Ind
5,000,000
2.19%
USA
95,000,000
41.55%
* These countries have Limited Partnerships that are active as of the beginning of 1994.
The Revision of the Agensys Development System that is being purchased by these Limited Partnerships is the 1993 MS-DOS and SCO-UNIX platforms.
Payment for the country rights comes in two forms:
A payment at the time the limited partnership actually purchases the rights.
The payment of a loan agreement that comes out of a royalty agreement on the sales of the Agensys Development System.
[Emphasis added.]
[23] In internal memoranda of the Internal Revenue Service (IRS) written in the fall of 1995, Agensys U.S. is described as a corporation based in Dallas, Texas, and "owned and operated" by John Batton.[38] "Mr. Kale, "it is stated", is not related to this company." He only provided his services. Moreover, Mr. Kale had informed the IRS that he was not an "investor, shareholder, or officer/employee" of Agensys U.S. and Agensys T & C; nor was he related to Agensys T & C. Mr. Batton for his part had stated that he had "not dealt with anyone [at Agensys T & C] except the lawyer". He acknowledged that "Mr. Howard Kale occasionally acted as a technical conduit between" Agensys T & C and Agensys U.S. In their testimony, Messrs. Gamble, Barisheff and Morley stated that they did not have any kind of interest in Agensys T & C and were not related to that corporation. They did not know to whom it belonged, but they thought it belonged to Mr. Kale or his family. In draft minutes of the Partnership's management meeting held on February 28, 1995 (at which meeting Mr. Kale is not listed as being in attendance), we find this statement: "After a discussion between Howard Kale and Larry Gamble, Howard advised that he is in sole control of Agensys Corp. in the Turks & Caicos" (Tab 177).
[24] In January and July 1997, all the assets of the 12 Partnerships were transferred to Agensys International. Mr. Gamble indicated that this had been his plan all along, namely, first, to finance the acquisition of the Software through limited partnerships and, eventually to have the assets of the partnerships transferred to a new corporation, whose shares would be listed on a stock exchange. For reasons that will be discussed below, Agensys International ceased its operations at the end of August 1998 and, like the Partnership, it never made any sale of the Software and never received any gross revenues from the exploitation of the Software. Altogether, the 12 Partnerships raised $69 million which, net of the amount of the Subscription Notes, represented $13 million. Of the $13 million, $6 million were paid to Agensys T & C for the different territorial rights with respect to the Software and $4.6 million were used in the operations of the 12 Partnerships and of Agensys International from 1993 to 1997.[39]
[25] On July 22, 1994, the Minister wrote to Mr. Gamble to inform him that the Partnership and four of the 11 Partnerships would be audited. This audit was carried out by the tax avoidance section. On July 31, 1996, this section informed the Partnership that, in the Minister's view, the Software had no value and that the Partnership was not carrying on any business. The Minister would therefore be reassessing the Limited Partners, disallowing their share of the Partnership's losses. Most of the partners were reassessed in November 1996.[40] Mr. Morley was an exception, he was only reassessed on November 21, 1997.
[26] On September 19, 1996, the Revenue Canada Special Investigations Unit (SI) (responsible for penal (criminal) investigations) was notified by the tax avoidance section that Mr. Gamble, assisted by some individuals (including Mr. Morley), was running a major scam and that fraudulent deductions were being claimed. On August 8, 1997, Mr. Gamble was notified by the Assistant Director, Verification & Enforcement Division, that the Partnership's file had been referred to SI. The letter stated: "In order to ensure that your rights are protected, I have been advised to refer your matter over to the Chief of Special Investigations". On October 7, 1997, an SI investigator filed a detailed Information to Obtain a Search Warrant (Form 1, section 487 of the Criminal Code) (SI Information Statement) with a judge of the Ontario Court. Agensys International's attempt to have this warrant quashed for deliberate deception was unsuccessful,[41] but in the end, none of the persons involved in the affairs of the Partnership were charged with tax evasion pursuant to section 239 of the Act.
II Analysis
(A) Onus of Proof
[27] Before the specific issues raised by these appeals are dealt with, it should be stated that it is Mr. Morley who has the burden of demolishing the facts assumed by the Minister in issuing his assessments. Counsel for Mr. Morley gave the following description of the rules on onus in his written closing arguments which I reproduce here in part:
The Hickman case is also very important because of what it says about onus of proof. At page 5376, Justice L'Heureux-Dubé says as follows:
It is trite law that in taxation the standard of proof is the civil balance of probabilities: Dobieco v. M.N.R. [1966] S.C.R. 95, and that within balance of probabilities, there can be varying degrees of proof required in order to discharge the onus, depending on the subject matter: Continental Insurance v. Dalton Cartage, [1982] 1 S.C.R. 164; Pallan et al. v. M.N.R., 90 DTC 1102 (T.C.C.) at p. 1106. The Minister, in making assessments, proceeds on assumptions (Bayridge Estates v. M.N.R., 59 DTC 1098 (Ex. Ct.), at p. 1101) and the initial onus is on the taxpayer to "demolish" the Minister's assumptions in the assessment (Johnston v. M.N.R. [1948] S.C.R. 486 [sic, actually 496]; Kennedy v. M.N.R., 73 DTC 5359 (F.C.A.), at p. 5361). The initial burden is only to "demolish" the exact assumptions made by the Minister but no more: First Fund Genesis v. The Queen, 90 DTC 6337 (F.C.T.D.), at p. 6340.
This initial onus of "demolishing" the Minister's exact assumptions is met where the appellant makes out at least a prima facie case: Kamin v. M.N.R., 93 DTC 62 (T.C.C.); Goodwin (sic. Goodwyn) v. M.N.R., 82 DTC 1679 (T.R.B.). ... The law is settled that unchallenged and uncontradicted evidence "demolishes" the Minister's assumptions: see for example MacIsaac v. M.N.R., 74 DTC 6380 (F.C.A.) at p. 6381; Zink v. M.N.R., 87 DTC 652 (T.C.C.).
... Where the Minister's assumptions have been "demolished" by the appellant, "the onus shifts to the Minister to rebut the prima facie case" made out by the appellant and to prove the assumptions: Maglib (sic. Magilb) Development Corp. Ltd. v. The Queen, 87 DTC 5012 (F.C.T.D.) at p. 5018. ...
Where the burden has shifted to the Minister, and the Minister adduces no evidence whatsoever, the taxpayer is entitled to succeed: see for example MacIsaac, supra, where the Federal Court of Appeal set aside the judgment of the Trial Division, on the grounds that (at pp. 6381-2) the "evidence was not challenged or contradicted and no objection of any kind was taken thereto." See also Waxstein v. M.N.R., 80 DTC 1348 (T.R.B.); Roselawn Investments Limited v. M.N.R., 80 DTC 1271 (T.R.B.).
It is submitted that the following principles are clearly set out by Justice L'Heureux-Dubé in dealing with the question of onus:
1. In making reassessments, the Minister proceeds by assumptions and the initial onus is on the taxpayer to demolish these assumptions.
2. An Appellant has met its onus to demolish the assumptions of fact made by the Minister if the Appellant makes out a prima facie case.
3. Unchallenged and uncontradicted evidence demolishes the Minister's assumptions.
4. If the Appellant makes a prima facie case and demolishes the Minister's assumptions, the onus shifts to the Respondent to rebut the prima facie case.
5. Where the onus shifts to the Minister and the Minister adduces no evidence, the Appellant is entitled to succeed.
In other words, the Appellant does not have an absolute burden of proof the way the Crown would in a criminal case. Rather, the Appellant can demolish the assumptions on which the reassessment is based, simply by making a prima facie case. Once the Appellant does this, the onus shifts to the Minister and if the Minister adduces no evidence, the Appellant is entitled to succeed.
Justice L'Heureux-Dubé goes on to say at page 5377:
As Rip, T.C.J. stated in Gelber v. M.N.R., 91 DTC 1030 at p. 1033 '[the Minister] is not the arbiter of what is right or wrong in tax law'. As Brulé, T.C.J. stated in Kamin, supra, at p. 64: the Minister should be able to rebut such [prima facie] evidence and bring forth some foundation for his assumptions.
The Minister does not have a carte blanche in terms of setting out any assumption which suits his convenience. On being challenged by evidence in chief, he must be expected to present something more concrete than a simple assumption. [42]
[28] I agree in general with this description. However, I would add the following two comments. First, the prima facie evidence that has to be adduced by the taxpayer must be credible. Second, where the Minister adduces some evidence, it is for the judge to make an overall assessment of the weight of the evidence introduced by both sides and to come to a conclusion, on a balance of probabilities, as to whether a case has been made by the taxpayer. Mr. Morley's counsel stated at the hearing that he agreed with both of these comments.
(B) Was the Partnership formed for the purpose of exploiting the Software for a profit? Did it carry on a business in 1993?
[29] Of the 14 issues identified above, only eleven remain. The first four can all be dealt with together because they relate to the same basic issue : whether the Partnership was carrying on a business with a reasonable expectation of profit during the 1993 taxation year. Given that the main raison d'être of the Partnership was to acquire the Software, this issue comes down to determining whether the Partnership was formed for the purpose of exploiting the Software for a profit or whether its sole purpose was to create tax refunds for its Limited Partners by claiming CCA with respect to the Software. The answer to these questions will resolve, in my view, all four issues.
[30] In subparagraph 21(h) of its Reply to the Amended Notice of Appeal, the respondent stated that the Minister relied on the following assumption relating to this particular issue in issuing his assessment:
21(h) the alleged Partnership was formed by Larry Gamble for the sole purpose of creating tax refunds for investors from claiming capital cost allowance.
[31] In his written argument, counsel for the respondent takes a slightly different approach. He focuses mainly on the 1993 taxation year and states that no business was being carried on in that particular year. Here is his position:
A. NO PARTNERSHIP IN 1993
3. A partnership is two or more persons carrying on business in common with a view to profit. There is no longer any doubt that one must satisfy the three essential ingredients of (a) business; (b) carried on in common; and (c) view to profit in order to demonstrate that a partnership exists.
Backman v. Canada, [2001] 1 SCR 367 [Tab 20]
4. The Respondent would submit that no partnership existed in 1993 on the basis that the partners had no view to profit from sales in relation to the software. This is borne out by the fact that (i) a thorough examination of the software was not conducted prior to purchase, (ii) at least until 1994 Agensys Canada had no technical staff, (iii) the software was evidently not "delivered" or examined until December, 1993; (iv) all of Agensys Canada's energy, at least until 1994, was devoted to the promotion and sales of limited partnership units, not software applications.
5. Indeed, the Respondent would submit that if any "business" existed in 1993 it was promoted as a tax savings vehicle to limited partners, with little if any concern about the capacity of Agensys Canada to capitalize on the use of the software purchased, and that there could be no expectation that Agensys Canada could profit from the use of the software until the software was examined in December 1993. The Respondent would further submit that the Appellant has failed to demonstrate an expectation of profit which is exemplified by the fact that no revenues were generated whatsoever, nor were any efforts made to maintain the software as state-of-the-art in order to facilitate such sales.
6. The Supreme Court of Canada has indicated that "to ascertain the existence of a partnership the courts must inquire into whether the objective, documentary evidence and the surrounding facts, including what the parties actually did, are consistent with the subjective intention to carry on business in common with a view to profit".
Backman, supra, paragraph 25
7. As such, the Court must look at the totality of the circumstances and avoid a mechanical application of a checklist or test with more precisely defined parameters. The Court must be pragmatic in their approach to the three essential ingredients of partnership. Whether a partnership exists depends on an analysis and weighing of the relevant factors in the context of all the surrounding circumstances.
Backman, supra, paragraph 26
8. That the partnership documents and other documents indicate an intention to form a partnership is not sufficient to satisfy the requirements for a partnership. Fundamental criteria of partnership must still be met.
Backman, supra, paragraph 27
9. In summary, the Respondent would submit that there was no view to profit by Agensys Canada in 1993, nor any business carried on in 1993. The activity that took place related to the sale of the partnership units. The partnership was not in a financial position to begin a marketing effort until 1994. In the result, there was no partnership, at least not in 1993.
[32] Mr. Morley's position is that "there can be little doubt that the activities carried on by the taxpayer were of a commercial nature and the reasonable expectation of profit doctrine could not possibly have any application" (page 21 of his counsel's written argument). In support of this position, his counsel relied on the pronouncements of the Supreme Court of Canada in Stewart v. The Queen, 2002 CarswellNat 1070, 2002 SCC 46, 2002 CarswellNat 1071, 212 D.L.R. (4th) 577, 2002 DTC 6969, par. 53:
We emphasize that this "pursuit of profit" source test will only require analysis in situations where there is some personal or hobby element to the activity in question. With respect, in our view, courts have erred in the past in applying the REOP test to activities such as law practices and restaurants where there exists no such personal element. . . . Where the nature of an activity is clearly commercial, there is no need to analyze the taxpayer's business decisions. Such endeavours necessarily involve the pursuit of profit. As such, a source of income by definition exists, and there is no need to take the inquiry any further.
[Emphasis added by counsel.]
[33] Counsel also added (at page 26 of his written argument) that it "is clear that the position of the Supreme Court of Canada today is that even if a taxpayer is clearly motivated by tax motivations, such tax motivations do not affect the validity of transactions for tax purposes unless the transaction constitutes a sham." In support, he cited The Queen v. Walls, 2002 CarswellNat 1072, 2002 SCC 47, 212 D.L.R. (4th) 606, 2002 DTC 6960, par. 22:
Although the respondents in this case were clearly motivated by tax considerations when they purchased their interests in the Partnership, this does not detract from the commercial nature of the storage park operation or its characterization as a source of income for the purposes of s. 9 of the Act. It is a well-established proposition that a tax motivation does not affect the validity of transactions for tax purposes: Backman v. Canada, [2001 DTC 5149] [2001] 1 S.C.R. 367, 2001 SCC 10, at para. 22; Shell Canada Ltd. v. Canada [99 DTC 5669] [1999] 3 S.C.R. 622; Canada v. Antosko [94 DTC 6314], [1994] 2 S.C.R. 312; Stubart Investments Ltd. v. The Queen [84 DTC 6305], [1984] 1 S.C.R. 536, at p. 540. In addition, we reiterate the caution stated in Stewart at para. 65 that, given the specific anti-avoidance provisions in the Act, courts should not be quick to embellish its provisions in response to tax avoidance concerns: see also Ludco Enterprises Ltd. v. Canada [2001 DTC 5505], [2001] 2 R.C.S. 1082, 2001 SCC 62, at para. 39; Neuman v. M.N.R. [98 DTC 6297], [1998] 1 S.C.R. 770, at para. 63.
[Emphasis added by counsel.]
[34] Although it is very troubling that the Partnership never made any sales, it is my view, on a balance of probabilities, that the evidence introduced by both parties at the hearing supports the position of Mr. Morley that a partnership was validly in existence on June 30, 1993, and that it did carry on a business in 1993. First, there was a partnership agreement executed in writing on June 30, 1993, between two persons: Mr. Gamble, as the initial limited partner, and the GP, as the general partner. Their intent, as indicated in article 2.2 of that agreement, was to carry on the business of "reproducing, marketing and distributing the [Software] and other computer software within Canada and to provide ancillary, support development, management and related services, all with a view to making a profit from such business". Obviously, this, in and of it