Canada

Tax Court applies sham doctrine to disallow partnership losses

TAX ALERT  | 

In Paletta v. The Queen, the taxpayers’ attempt to break into the Hollywood movie business was a flop.

In this case, the Tax Court of Canada (TCC) held that the taxpayers’ contractual arrangement was nothing more than an attempt to claim tax losses and so the TCC confirmed the Canada Revenue Agency’s (CRA) decision to disallow US$96 million in partnership losses. The TCC’s basis for its decision was that option agreements – which were key elements of the transactions under appeal – were a sham.

The TCC also considered the government’s alternative argument should the sham doctrine not apply. In that regard, the TCC held that, if the option agreements were not a sham, the TCC would have dismissed the appeal on the basis that the property the appellants purchased was an unregistered tax shelter.

This tax alert focuses on the TCC’s sham analysis, as this was the primary basis for dismissing the appeal.

Relevant facts

One of the appellants was Paletta International Inc. (Paletta International), a corporation that operated several businesses including real estate and farming businesses. In 2006, Paletta International borrowed US$212 million from the Royal Bank of Canada (RBC) and invested the borrowed funds, along with US$8 million of its own funds, into a limited partnership (LP). Paletta International was the sole limited partner of the LP. The LP used US$128 million of the capital investment it received from Paletta International to purchase a worldwide perpetual copyright for the movie ‘Night at the Museum’ (the Film) from Twentieth Century Fox Film Corporation (Fox). The Film had not yet been released in theatres.

The LP then used US$82 million of the capital investment it received from Paletta International to pay for the print and advertising expenses related to the Film. As a result, the LP reported non-capital losses of US$82 million from the print and advertising expenses, the majority of which were allocated to the limited partner, Paletta International. As part of these transactions, the parties agreed that Fox would have the option to reacquire the Film at essentially the cost of the Film plus 97 percent of the print and advertising expenses incurred by the LP (the Option Agreement). Fox exercised its option to reacquire the Film shortly before the Film was set to be released in theatres.

Angelo Paletta (Mr. Paletta), the other appellant, completed identical transactions with RBC and Fox for a second movie, ‘The Day the Earth Stood Still’, and similarly claimed non-capital losses in respect of the second movie. Due to the identical nature of the transactions, the TCC focused its analysis on the transactions related to the Film and applied the decision to both series of transactions.

The sham doctrine

The TCC set out the relevant jurisprudence and principles related to the sham doctrine. In particular, sham documents are ones that “give to third parties or to the court the appearance of creating between the parties’ legal rights and obligations different than the actual legal rights and obligations”. Furthermore, The TCC cited that for tax, “the Court will arrive at a finding of sham when the evidence shows that the parties misrepresented their arrangements in a bid to achieve a tax benefit that would be denied if the nature of their arrangements was properly disclosed”.

The government’s position was that the transactions were a sham because Fox “never truly transferred” the Film to the LP. Simply put, the government argued that the LP never owned the copyright to the Film, had no right to earn income from the Film and did not incur expenses for the purpose of earning income.

The TCC’s analysis regarding sham

To determine whether the transactions constituted a sham, the TCC first looked to the conduct of the appellants. Testifying on behalf of the appellants, Mr. Paletta stated that he entered into these transactions to earn revenue from the distribution of the Film. He stated that, although he was aware of the Option Agreement, he hoped Fox would not exercise its option. Mr. Paletta testified that he had estimated the likelihood of Fox exercising its option was 50 percent and he was confident that if Fox did not exercise the option, the appellants could earn a substantial return from the distribution of the Film.

No one from Fox testified as to why Fox entered into these transactions. Based on the evidence, the TCC determined that Fox’s purpose for entering into the transactions was to save three percent on the print and advertising costs that it was going to incur related to the Film. In other words, the TCC held that Fox did not have any intention to sell the Film and that Fox’s benefit from taking part in these transactions was to offset some of its expenses related to the Film.

Finally, the TCC believed that the transaction documents would have resulted in unintended consequences for the parties if Fox did not exercise the options. For example, the distribution agreement (pursuant to which Fox retained distribution rights to the Film) provided that Fox would pay a percentage of the profits from the distribution of the Film to the LP for 15 years. However, the security agreements permitted Fox to hold payments owing to the LP in its collateral account until the expiry of the distribution agreement. In other words, Fox, in its sole discretion, could withhold all payments to the LP for 15 years. When the TCC raised this issue to Mr. Paletta, he stated that he would not have entered into the agreements if he had known that Fox could withhold the profit payments for 15 years.

TCC’s conclusion on sham doctrine

The TCC held that the Option Agreement was a sham because, based on the circumstantial evidence, the LP never intended to earn income from the Film due to the TCC’s finding that the parties agreed that Fox was going to reacquire the Film before it was released in theatres. Therefore, the TCC concluded that the LP (and, by extension, the appellants) did not incur the print and advertising expenses for the purpose of earning income. Instead, the appellants entered into the transactions “solely to avail themselves of the tax savings that the promoters led them to believe they could expect and that they felt secure in the knowledge that Fox had agreed to reacquire the films prior to their commercial release”.

In summary, the TCC held that the Option Agreement was a sham because (1) the appellants entered into the transactions to obtain the partnership losses, (2) the appellants expected that Fox would exercise its option to reacquire the Film and (3) Fox had agreed in advance to exercise its option. Interestingly, the TCC’s basis for finding that a sham existed was different than the government’s basis for alleging sham. As set out above, the government’s position was that, notwithstanding the transactions and agreements, Fox did not relinquish the Film and the LP never acquired the Film. The TCC did not find that the LP’s acquisition of the Film was a sham that was designed to misrepresent the parties’ agreement. Instead, the TCC held that the Option Agreement was a sham because it was not, in fact, an option, but a pre-arranged agreement pursuant to which Fox would reacquire the Film. Furthermore, only one element of the Option Agreement was a sham: the purported option element. The TCC therefore treated the Option Agreement as a “reacquisition agreement”.

Will Paletta cause the CRA to increase the use of sham as an assessing basis?

It will be interesting to see if the CRA uses Paletta as a precedent to reassess taxpayers under sham more frequently. Based on the TCC’s application of the sham doctrine in Paletta, the CRA may look to apply the sham doctrine to specific elements of agreements between taxpayers rather than simply applying it to whole transactions. The appellants have appealed the TCC’s decision to the Federal Court of Appeal, so some clarity on the sham doctrine may be obtained in the near future.

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