Carter v. R., 99 DTC 585, [1999] 2 CTC 2553 (TCC)

Teskey T.C.J.:

The Appellant appeals his reassessment of income tax for the year 1986.

Issue

The issue before the Court is the characterization of certain transactions done in the names of the Appellant, Linda Carter (his spouse) and 693099 Ontario Ltd. (the “Corporation”).

The questions to be determined are:

1. Were the spouse and the Corporation acting as agents for the Appellant?

or

2. Were the Appellant, his spouse and the Corporation partners?

or

3, Were the Appellant, his spouse and the Corporation acting on and for their own account?

Facts

The Appellant, with no previous experience in hedging transactions, became involved in this type of transaction in 1986.

The Appellant’s involvement in hedging transactions was as a result of an advertisement placed by Jack Maguire (“Maguire”) who operated an income tax return preparation and financial planning service, operating under the name J.K. Maguire and Associates (“Associates”).

Asa result of the advertisement, the Appellant met Maguire in November 1986 and immediately retained Associates. Maguire advised the Appellant on hedging transactions and the tax implications thereof. Associates prepared the Appellant’s and his spouse’s TI income tax returns for 1986 through 1991.

The Appellant decided that a number of stock transactions would be entered into under his name, under his spouse’s and the Corporation’s names because of the tax benefits alleged by Maguire. These stock transactions shall be referred as a “Convertible Hedge Strategy”.

To start this Convertible Hedge Strategy, the Appellant, in 1986, opened trading accounts with the brokerage firms of Nesbitt Thompson Bongard Inc. (“N.T.B.”) and Merrill Lynch Canada Inc. (“M.L.”) which were guaranteed by his spouse acting on the Appellant’s instructions.

The Appellant’s spouse had not met Maguire and did not receive any independent legal advice, she simply did what the Appellant told her to do.

At the same time, his spouse, following the Appellant’s instructions, also opened brokerage accounts with N.T.B. and M.L., which the Appellant guaranteed.

The Corporation opened accounts with N.T.B. and M.L. which accounts were guaranteed by the Appellant and his spouse.

Xerox Hedge [paragraphs 12 to 17]

The Xerox Hedge was commenced on December I, 1986. The Hedge started with both sides in the Appellant’s account and by day’s end, the account in his name was short the same number of common shares which were held long in the account in his wife’s name.

The Appellant sold short 138,600 common shares of Xerox Canada Inc. at a price of $22.125 on December 1, 1986. This generated a credit to the Appellant’s account of $3,065,139.

Also on December I, 1986, the Appellant purchased 138,600 warrants of Xerox Canada Inc. The warrants could be used to subscribe for the same number of Xerox common shares. The transaction resulted in a debit to the account of $299,376.

Also on that date, the Appellant sold the warrants for proceeds which resulted in a credit to the account of $261,954. However, also on that date, 138,600 warrants were purchased in the account under his wife’s name, which resulted in a debit of $264,726 to that account. These warrants were used to subscribe for the same number of common shares of Xerox Canada Inc., resulting in a further debit of $2,772,000. At the end of the day, the account under his spouse’s name held 138,600 common shares while the account in the Appellant’s name was short the same number of common shares.

On December 12, 1986, the Appellant bought 138,600 common shares resulting in a debit of $3,327,786. This purportedly covered the short sale of December I (described in paragraph 13 above). However, the corporation did a short sale of the identical number of common shares also on the same day resulting in a credit to that account of $3,325,014.

At the end of 1986, on Maguire’s advice, cross cheques were issued and delivered which the Appellant admitted served no purpose.

Falconbridge Hedge [paragraphs 18 to 25

The Falconbridge Hedge was conducted along the same lines as the Xerox Hedge. It was also initiated with the Appellant commencing the hedge, taking both sides of the transaction in the account under his own name. Thereafter, positions were shifted between the three related accounts.

On December 3, 1986, the Appellant deposited $40,000 into his account with N.T.B.

The Appellant, on December 4, 1986, sold short a total of 100,000 common shares of Falconbridge Ltd. This generated a credit to the Appellant’s account of $1,711,750.

The offsetting trade was the purchase of 20,000 warrants of Falconbridge Ltd. The warrants could be converted to common shares of Falconbridge at a rate of 5:1 (1.e., the 20,000 warrants were convertible into 100,000 common shares). The purchase of the warrants resulted in a debit to the account of $441,750. The Appellant also purchased Canadian treasury bills resulting in a further debit of $1,309,641.16.

On December 15, 1986, half of the Appellant’s long position (10,000 warrants) was sold and on the Appellant’s instructions, 50,000 common shares were purchased in his spouse’s account. At the end of the day, the Appellant’s short position (100,000 common shares) was offset by the warrants (10,000 warrants convertible into 50,000 shares) and the treasury bills in the account under his name, and by the 50,000 common shares in the account under his spouse’s name.

On December 22, 1986, the Appellant sold the 10,000 warrants held in his account and, on his instructions, 10,000 warrants were purchased in his spouse’s account.

The $40,000 initially deposited on December 3, 1986, was based on the differential between the opening positions. After the December 15, 1986 transactions, the Appellant drew out $19,000 of the total amount deposited.

The Hedge remained opened until 1989. There was activity on January 26, 1987, February 16, 1987 and March 9, 1987. Thereafter, until the Hedge was closed in 1989, the positions were always “common”, there was no opportunity to make any money on fluctuations in the differential. There was no expectation of profit on the fluctuation of the market. What goes up on one side goes down on the other side, dollar for dollar.

The Corporation was a shell and was utilized by the Appellant to implement Maguire’s Convertible Hedge Strategy which was its only function. The Appellant, on Maguire’s advice, directed the opening of the Corporation accounts at N.T.B. and M.L.

The Corporation never filed a tax return and its only activity was with respect to the Convertible Hedge Strategy.

Concerning the $40,000 that the Appellant deposited with N.T.B., to implement the Convertible Hedge Strategy, I conclude that these funds come from the Appellant.

In 1986, the Appellant reported a business loss in the amount of $383,013.13 arising from his participation in the Convertible Hedge Strategy. In the statement of income and expenses filed with his 1986 tax return, the “type of business” is described as “adventure in the nature of trade” and the “principal commodity” is described as “speculation”. In a statement of loss carry-forward also filed with the tax return, the Appellant reported that, of the loss claimed in that year, $61,379.41 was unused and available to be carried forward.

The Appellant claimed that the majority of the loss incurred in 1986 related to the Xerox Hedge, with a lesser amount relating to the Falconbridge Hedge, and that the remainder ($16,600 for management fees and $180 for accounting) was paid to Mr. Maguire. The management fee was calculated as a percentage of the actual tax loss and the Appellant’s spouse was never billed in any way by Maguire or Associates.

The Appellant’s calculation of his loss is based on the alleged independent existence of his spouse’s and the Corporation accounts.

The Convertible Hedge Strategy was orchestrated by Mr. Maguire. He would contact the Appellant and advise him what positions to take in which accounts. The Appellant would then contact the brokers and instruct them accordingly with respect to all accounts.

In the case of the Falconbridge Hedge and the Xerox Hedge, the Convertible Hedge Strategy was the same. A short position was taken on the common stock with a corresponding long position taken in the same common stock or in warrants which were convertible into the common stock.

A short sale is the sale of shares one does not own but has borrowed. An individual who sells short a security is speculating the market will decline and the individual can then purchase the security to “cover” the short sale (i.e., to return the borrowed stock) at a lower cost and thereby realize a gain.

In the Convertible Hedge Strategy, a short position was always offset by a corresponding long position in one of the other accounts. Thus if you lump together all the accounts, any potential gain from one position would be offset by a loss on the corresponding position.

The accounts were cross-guaranteed. Consequently, the only margin requirements which the brokers demanded were based on the net difference between the three accounts. Any credit balance in one account was offset by a debit balance in another account. Any credit balance in an account was not an actual credit balance which could be withdrawn while leaving a debit balance in another account. Due to the cross-guarantees, a substantial debit balance could be maintained in one account as long as there was an offsetting credit balance in another account. The net difference between the accounts was what the brokers based margins on and what the Appellant had at risk.

The difference in value between two positions is referred to as the “differential” or “premium”. The differential can in some circumstances vary with time. For instance, if there is a precipitous drop or a meteoric rise in the value of the common shares, the corresponding change in the value of the warrants may not be as pronounced. In such circumstances, the differential may vary; the individual can dispose of the positions and realize a loss or gain on the difference between the initial differential and the closing differential. A speculator hopes to make a profit on such fluctuations.

No losses or gains arising from the Xerox and Falconbridge Hedges were reported by his spouse or by the Corporation.

The Appellant never disposed of only one leg of a hedge. In fact, he could not do this as the margin requirements would have been overwhelming. All transactions were fully hedged. No position was closed out without the corresponding position in one of the three accounts being closed out at the same time.

Analysis

The principal purpose of these transactions by the Appellant was income splitting, i.e. to reduce the Appellant’s higher income and increase his spouse’s lower income.

The principal purpose of the Corporation was to muddy the waters in an attempt to hide the true situation.

All the transactions and all the entities (i.e. the Appellant, his spouse and the Corporation) were linked together, all transactions being conducted on the direct orders of the Appellant.

The Minister of National Revenue, when assessing the Appellant, made assumptions of fact which were reproduced in paragraph 10 of the Reply herein. The first set of facts set forth in subparagraph (a) are true and correct. It reads:

(a) The Appellant was a participant in a tax avoidance strategy marketed by the firm J.K. Maguire and Associates (“Maguire”) and referred to as a “convertible hedge strategy” (the “Convertible Hedge Strategy”).

The second subparagraph designated as (b) is also true and correct and it reads:

(b) The Appellant carried out the Convertible Hedge Strategy in his (sic) own account and/or with accounts in the name of others (the “Other Party”).

Subparagraph (C) alleges that the relationship between the Appellant and the other party was one of partnership, and subparagraph (d), in the alternative, states the relationship was as principal and agent.

Herein, the Appellant was the sole directing mind in the execution of all of the transactions, also in directing in essence the shifting of securities from one non arm’s length entity to another non arm’s length entity.

Finding that the Appellant’s spouse and the Corporation were not acting in their own right, then they were acting either as partners in partnership or as principal and agent.

Although my colleague Beaubier, T.C.C.J. in Schultz v. R. (1993), 93 D.T.C. 953 (T.C.C.); upheld on appeal, (1995), 95 D.T.C. 5657 (Fed. C.A.), found a partnership therein between Dr. Schultz and his wife, herein I find that the spouse and the Corporation were in fact the Appellant’s agents and the assets held in their brokerage accounts at all times were the Appellant’s assets.

The brokerage accounts opened in the Appellant’s spouse’s name and in the name of the Corporation were the Appellant’s accounts. The only action taken by the spouse (who had mainly been a mother and housewife), was to open the accounts that were in her name and to guarantee the other accounts. This, she did on instructions from the Appellant. After that she did nothing. The spouse did not give any evidence at the trial, from which I draw the inference that her evidence would have been detrimental in the Appellant’s position. All the transactions were at the Appellant’s instigation. He alone had met Maguire and he alone took advice from Maguire.

The Corporation was a shell with no assets or liabilities and was controlled exclusively by the Appellant. It was used as a vehicle by the Appellant in an attempt to separate the transactions. It was his agent or in essence him. All assets and liabilities were in fact the Appellant’s.

Although the Appellant seeks this Court to view only one part of the hedge and that a loss or gain is realized when a position is “shifted” from his account to a related account, I reject this premise entirely. I find that a position is disposed of only when the position is no longer held in any of these accounts.

I find that the Appellant did not have a loss in 1986, as I look at all the accounts as one account and until a position is totally disposed of, there cannot be a loss or gain.

For these reasons, the appeal is dismissed with costs to the Respondent.

Appeal dismissed.