INCOME TAX
Partnerships
Appeals, cross‑appeals from T.C.C. decisions in cases arising from taxpayers’ resort to “convertible hedging” investment strategy—Taxpayers sought to deduct losses, expenses incurred due to strategy—M.N.R.’s reassessments disallowed number of deductions—Description of strategy necessary to understanding of issues—Common shares of publicly traded companies are “sold short” and at same time, another security carrying right to acquire same number of shares is purchased, these may be preferred shares or debentures convertible to common shares or warrant to acquire them—Selling short means sale of shares not owned but “borrowed” by arrangement with broker who permits sale of shares belonging to another (broker or customer)—Sale proceeds, net of broker’s fees, are credited to short seller’s account—Taxpayers herein paid “rental fee” to brokers plus amount (“compensatory dividends”) equal to dividends paid on shares between time borrowed, returned—Profit or loss on short sale is determined when “closed out” (when short seller replaces borrowed shares) by having broker purchase equivalent number of identical shares for lender with purchase cost (including fees) debited to short seller’s account—If cost of replacement shares less than short sale proceeds (value of shares having declined), short seller makes profit—“Hedging” is technique for mitigating risk of loss—To mitigate risk on short sale, seller may acquire security carrying right to acquire same number, kind of common shares (such as right of conversion attached to convertible share, debenture)—To extent value of convertible security includes value of common shares into which may be converted, its value increases as value of common shares increases—Holding convertible security to hedge loss on short sale is termed “convertible hedge”—Opportunity to earn income during hedge, since convertible preferred shares yield greater dividends than common shares—Also chance of profit or loss on spread between value of common shares sold short and value of warrant conferring right to acquire common shares for limited time period at specified price—Said to be potential tax benefits from strategy regardless of whether market rises or falls so it was win/win proposition—Promotion for scheme touted it as offering “countless permutations of potential tax games to be played with a hedge of this nature . . . this is a game only suitable for taxpayers with the best of professional assistance”—Taxpayers herein claimed deductions as result of coordinated transactions between spouses or daughter— M.N.R. reassessed taxpayers on basis acting in partnership or principal‑agent relationship and could not isolate transactions that created losses deducted from income—M.N.R. relied on Schultz v. Canada, [1996] 1 F.C. 423 (C.A.), wherein partnership found to exist between spouses engaged in convertible hedge strategy—In cases at bar, T.C.C. found no partnership, convertible hedging was adventure in nature of trade with spouses co‑adventurers—Each convertible hedge separate identifiable property consisting of both acquired convertible securities and short sale of common shares (the long position and short position)—Any loss on one position could not be isolated or tax deduction—Only deductible amounts were losses on premiums, expenses during hedge period—Appellants submit T.C.C. erred in finding convertible hedge was separate identifiable property, they were not partners and Schultz was distinguishable— Intervener, Canadian Bankers Association, argued T.C.C. erred in concluding convertible hedge separate identifiable property—T.C.C. relied on Income Tax Act (ITA), s. 248(1) definition of “property”, broadest of definitions, inviting non‑restrictive approach—Right implicit in convertible hedge was “right to rely on one component of the convertible hedge to satisfy the margin requirements of the other component”—Upon taxpayers’ evidence, T.C.C. concluded common view that investment was convertible hedge itself, this was consistent with finding it was property and that property was subject of adventure—T.C.C. recognized difficulty in reaching conclusion, for in introduction to reasons explained tax laws had not kept apace with financial community’s ingenuity and that Court ought not be precluded from equally innovative approach to tax law application so that “round hole of taxation principles” might “expand to accommodate square peg of financial innovation” with result economic, legal reality meshed—T.C.C. admitted having approached issues “with both an eye to the true legal nature and an eye to adaptability of tax laws to the moving target of financial innovation”—T.C.C. erred in approach to interpretation, application of Act—Role of Court to find facts, interpret law, apply law to facts—T.C.C. saw Court’s role to restrict innovative tax avoidance measures—Such approach wrong in law—Not Court’s role to act as protector of public revenue: up to Parliament to enact legislation for that purpose—Absent specific statutory bar, taxpayer entitled to arrange affairs so as to reduce tax payable—T.C.C.’s elastic approach inconsistent with Court’s role, which is not to expand taxation principles depending upon taxpayers’ innovation—Error to synthesize components of hedge into single identifiable property—Term “convertible hedging” shorthand description of individual transactions taking place at approximately same time—Each transaction concerned with certain identifiable property—That transactions involve same investor(s) in related security transactions, not justifying collapsing results of separate transactions into single property —Theory of T.C.C. based on financing of convertible hedge— T.C.C. pointed to right to rely on one component of hedge to satisfy margin requirements of other component— Necessary to understand margin arrangements referred to by T.C.C.—Since value of shares could decrease, broker requires customer to maintain margin (cash or securities) in account—In case of non‑hedged transactions, 50% of price at which convertible securities acquired or common shares sold short must be in customer’s account—But, under convertible hedge strategy, brokers waived 50% margin requirement as of view convertible security purchased, proceeds from short sale of common shares each hedged loss that might be incurred from the other—Only amount at risk was premium and that amount had to be put up, in cash—In result, minimal financing required to engage in convertible hedge strategy—Brokers’ willingness to forego usual 50% margin requirement convinced T.C.C. convertible hedge separate identifiable property—T.C.C. erred in thinking right to rely on one component of hedge to satisfy other component’s margin requirements was right that gave convertible hedge separate identifiable property status—ITA not commercial code— Application of ITA relies on general law of property— Reference to broader commercial law to give meaning to words well defined outside Act—Convertible security used to satisfy margin requirements separate identifiable property belonging to investor, whose ownership rights not altered because part of convertible hedge—Rights existing in respect of short sale independent of convertible hedge involving short sale—Strategy of minimizing risk not transforming separate properties into single property—Margin arrangements might be seen as contractual overlay on each convertible hedge component, reflecting how taxpayers, brokers dealt with their property—While ITA definition indeed broad, does not grant licence to courts to create, for income tax purposes, new type of property not recognized outside Act—Nothing in record supported T.C.C.’s view brokers’ practice of waiving usual margin requirements gave taxpayers “legally enforceable claim”—This was mere accommodation which could be cancelled at broker’s option—Under customer agreements, brokers have discretion as to margin required, could demand additional margin at any time—Furthermore, synthesizing acquisition of convertible securities with short sale of common shares constitutes re‑characterization of effect of transactions and that, says S.C.C., is permissible only if label attached by taxpayer does not properly reflect transaction’s actual legal effect—Ordinary market transactions may not be re‑characterized for tax purposes—Convertible hedge as separate identifiable property constituted new assessment basis created by T.C.C. in 2003, Minister’s limitation period for assessing having expired by 1998—Turning to issue of partnership, primary basis of reassessments, T.C.C. concluded taxpayers involved in adventures in nature of trade prior to considering whether might be in partnership, finally determined they were not—Under Partnerships Act, s. 2 no partnership unless there is business carried on in common with view to profit—Trading herein was a business—T.C.C. found, while business existed, was not being carried on as of understanding adventure in nature of trade is not carrying on business and, that being requirement for partnership, there was here no partnership—T.C.C. relied on Tara Exploration & Development Co. Ltd. v. M.N.R. (1970), 70 DTC 6370 (Ex. Ct.) in which Jackett P. concluded “with considerable hesitation” “carried on” did not go with word “adventure”— But Tara did not involve partnership and no authority for proposition adventure in nature of trade cannot be business for Partnerships Act purposes—S.C.C. has held partnership may be created for single transaction—Lindley & Banks on Partnership, 18th ed., 2002, stating “virtually any activity or venture of a commercial nature, including a ‘one off’ trading venture, will be regarded as business for this purpose” (determination of existence of partnership)—That statement of law preferred to Tara—To illustrate no business being carried on, T.C.C. pointed to lack of business cards, advertisements, telephone lines—But doubtful partnership formed for single transaction needed these—In Friesen v. Canada, [1995] 3 S.C.R. 103, Major J. noted adventure in nature of trade is not defined in ITA, is judicial creation to determine which purchase and sale transactions are of business nature, which of capital nature—This was important prior to 1972, when capital transactions were tax exempt—Wrong for T.C.C. to have adapted tax concept to separate issue of partnership— Court of view appellants were carrying on businesses in convertible hedging—Questions if, when parties begin carrying on business in common with view to profit is objective test determined by parties’ conduct—Trading activity not required—Setting up of accounts by each spouse, execution of cross‑guarantees made it possible to maintain hedges, while triggering loss in one account—T.C.C. ignored evidence of marketing of win‑win strategy, appellants’ motivation for engaging in strategy—Profits, tax deductions part of strategy, therefore part of same business—By setting up accounts, cross‑guarantees, spouses began to carry on business in common with view to profit—That spouses denied were in partnership carries no weight—Nor is absence, existence of partnership agreement decisive—To suggest spouses established independent accounts would ignore convertible hedge strategy—Nor is finding of partnership dependent on equal profit sharing—Necessary only to ascertain profit‑sharing agreement—Income splitting not requirement for partnership—Given margin requirements were minimal, cross‑guarantees were of greater significance than source of contributions to satisfy margin requirements— T.C.C. mistaken in distinguishing binding authority Schultz, similarities between it, case at bar being overwhelming—That account opening documents represented appellants not in partnership not conclusive of legal effect of conduct—Income Tax Act, R.S.C., 1985 (5th Supp.), c. 1, s. 248(1) “property”—Partnerships Act, R.S.O. 1990, c. P.5, ss. 1(1) “business”, 2.
Rezek v. Canada (A‑463‑03, A‑462‑03, A‑465‑03, A‑464‑03, A‑466‑03, 2005 FCA 227, Rothstein J.A., judgment dated 17/6/05, 46 pp.)