“Now then, Pooh,” said Christopher Robin, “where’s your boat?”
“I ought to say” explained Pooh as they walked down to the shore of the island “that it isn’t just an ordinary sort of boat. Sometimes it’s a Boat and sometimes it’s more of an Accident. It all depends”.
“Depends on what?”
“On whether I am on the top of it or underneath it”
A. A. Milne, Winnie-the-Pooh
Readers who were tax practitioners in the mid-80s will well remember the luxury yacht tax shelters, which were sold in 1984, 1985 and 1986 and which were one of the most popular tax shelters of that period. Many of us had clients who invested in this tax shelter and are aware that the CRA was very upset with this tax shelter and reassessed all of the investors. Tax practitioners from that period will also remember that the promoter of the tax shelter and several of his associates were prosecuted and convicted in connection with the luxury yacht tax shelter.
Approximately thirty years later, Associate Chief Justice Eugene Rossiter of the Tax Court of Canada released his decision in Garber et al. v. The Queen on January 7, 2014. The three appeals involved investors in limited partnerships which were established in 1984, 1985 and 1986 to acquire and charter luxury yachts and the deductions claimed by the Appellants in their 1984 to 1988 taxation years. The Appellants, as limited partners, claimed losses relating to the operation of the partnerships, interest deductions on promissory notes which were used to pay for the limited partnership units and professional fees paid in the year the Appellants subscribed for partnership units. The reasons for judgment note that 600 investors were reassessed and approximately 300 investors settled with the CRA.
The hearing opened on January 11, 2012 and in total over 62 days of evidence was given by 34 witnesses and there were 23 agreed statements of fact. The decision of Associate Chief Justice Rossiter is over 150 pages long and may rank as one of the longest Tax Court decisions (we previously commented on the length of the decision by Justice Boyle in McKesson Canada Corporation v. The Queen which was released in December 2013 – for those of you who keep track of such matters, this decision is fifty percent longer that the decision in McKesson.)
In basic terms, each of the Appellants invested in a limited partnership which was created to purchase a luxury yacht from the promoter. The promoter, as general partner, was committed to providing the yachts and to market and manage a luxury yacht chartering business for each limited partnership. The projections provided to the Appellants showed significant deductible start-up costs and the Appellants also expected to benefit from the tax depreciation (capital cost allowance) on the yachts. The Appellants’ investments were heavily leveraged with financing organized by the promoter and, therefore, a taxpayer who acquired a limited partnership unit would benefit from an attractive tax deduction in excess of his or her cash investment.
Associate Chief Justice Rossiter carefully reviewed the background facts relating to the limited partnerships (almost 100 pages are devoted to recounting the evidence). He noted that the promoter of the tax shelter and several of his associates were convicted of fraud in connection with the arrangement and found that the scheme was a fraud because virtually no yachts were acquired and the money paid by investors was used to promote future partnerships and not used in a yacht chartering business.
The CRA had offered numerous reasons why the expenses claimed by the Appellants should be disallowed:
- The limited partnerships did not constitute an income source under sections 3 and 4 of the Act because there was no genuine yacht charter business. The limited partnerships were not true partnerships because no actual business was carried out in common.
- The transactions were “mere” shams.
- Limited partnerships never actually incurred expenses for the purpose of gaining or producing business or property income.
- In the alternative, under subsections 9(1) and 18(9) of the Act, certain expenses incurred were not deductible in the years claimed because services were to be rendered after the end of the taxation year.
- In respect of interest payments, the CRA alleged that the promissory notes did not constitute actual loans and that no money was lent or advanced to the investors and, therefore there was no interest deductibility.
- To the extent any yacht was acquired by the 1984 partnership, capital cost allowance was restricted by the leasing property rules in subsections 1100(15), (17) (17.2) and (17.3) of the Income Tax Regulations.
- In the alternative, if interest was deductible, it would be limited by the half year rule in subsection 1100(2) of the Income Tax Regulations.
- For partnerships marketed in 1986, the partnership losses are restricted by the “at–risk” rules introduced on February 26, 1986.
- Subsection 245(1) of the Act is applicable because the expenses and disbursements claimed by an Appellant would unduly or artificially reduce the taxpayer’s income.
- The expenses are not deductible under section 67 of the Act because they were not reasonable and were not incurred to earn income.
After his extensive review of the evidence, Associate Chief Justice Rossiter analysed the legal issues. He found that there was no source of income for purposes of the Act under section 9 because the transactions were a fraud (similar to Hammill v. Canada, a 2005 decision of the Federal Court of Appeal) and because the scheme was a fraud, there was no source of income. It was noted that it is possible to have a fraud and a business (several cases are cited in this regard); however, based on the facts, in this situation, there was no business whatsoever. Therefore, there was no source of income.
One of the arguments made by the Appellants is that the significant amount of money received from investors was spent by the promoter and this indicates that there was a business. However, the facts were clear that money was not spent on acquiring yachts or a yacht charter business. Some of the funds were spent on unrelated endeavours and most of the funds were spent by the promoter on marketing and promoting future limited partnerships.
Associate Chief Justice Rossiter also noted that the Appellants commented during the trial on the “aggressive or inappropriate behaviour by members of the CRA”. He stated that his task “is not to assess the conduct of the CRA, but rather to determine whether or not the expenses claimed in these appeals are legitimate”. He also noted that the tax shelters were a Ponzi-like scheme which were set to collapse eventually and the conduct of the CRA did not turn the Ponzi-like scheme, which was a fraud from beginning to end, into a genuine business. In effect, all the CRA did was “lift the veil” to reveal the pervasive nature of the fraud.
Associate Chief Justice Rossiter also made clear that because the investment by limited partners was heavily leveraged, there was a lack of capital and this was a significant indication that there was no business being carried on.
Accordingly, there was no genuine business and the Appellants did not have a source of income from which they could deduct expenses or losses.
Furthermore, there were no genuine partnerships. For a partnership to exist, the parties must be a) carrying on a business b) in common and c) with a view to profit. Here, there was no business carried on; merely a fraud perpetuated by the promoter. Business was not carried on “in common” despite the existence of a partnership agreement because the promoter was perpetrating a fraud even though the limited partners were ignorant of the fraud perpetrated on them. As to a “view to profit”, there was no “view to profit”; the promoter had the intention to profit at the expense of the limited partnerships and the activities were so underfunded and so limited that there was no intention to profit.
Associate Chief Justice Rossiter went on to state that if there was a business carried on, the expenses claimed were not incurred for the purpose of operating the limited partnerships’ yacht chartering business and therefore were not deductible pursuant to subsection 18(1) of the Act.
Associate Chief Justice Rossiter also reviewed the requirement under subsection 18(9) of the Act that a taxpayer match any prepaid expense for services, interest, taxes, rent, royalty or insurance to the year in which those expenses relate. Based on the facts, the deductions claimed had little relation to actual expenses incurred and therefore deductibility is precluded under this provision.
Associate Chief Justice Rossiter also stated that in respect of one yacht which the taxpayers argued had been acquired by one of the 1984 partnerships, no evidence was presented that ownership of the boat was acquired by the limited partnership and therefore capital cost allowance was not deductible pursuant to paragraph 1102(1)(c) of the Income Tax Regulations. In any event, a boat was never acquired for income gaining or earning purposes and was only used by the promoter as window dressing to perpetrate the fraud.
In respect of the interest expenses claimed, the test under sub-paragraph 20(1)(c)(ii) was not met, because there was never a legal obligation to pay interest. The taxpayers entered into promissory notes based on fraudulent misrepresentations and any contractual obligation to pay interest would have been vitiated by the fraud.
In addition, in respect of the 1986 partnerships, the “at-risk” rules applied. It had been argued by the Appellants that the partnerships were grandfathered under the legislation but the statutory test for grandfathering had not been met.
Finally, any expense would have been denied under section 67 of the Act as the expenses were not reasonable in the circumstances if one considers the entire scheme. The Appellants had offered no evidence to show that expenses were legitimate or reasonable in light of services rendered or if any services were rendered at all.
Associate Chief Justice Rossiter concluded by stating that because of the lack of a source of income, the non-existence of genuine limited partnerships, the fact that the expenses were not incurred for business purposes, as well as the alternative arguments he addressed in his decision, it was not necessary to deal with all of the CRA’s arguments (e.g. sham and section 245). Accordingly, the appeals were dismissed with costs.
Given the amounts involved, and the number of taxpayers who were awaiting these decisions, it is likely that this case will “sail” into the Federal Court of Appeal.