Stewart v. Canada, [2002] 2 S.C.R. 645,
2002 SCC 46
Brian J. Stewart Appellant
v.
Her Majesty The Queen Respondent
Indexed as: Stewart v. Canada
Neutral citation: 2002 SCC 46.
File No.: 27860.
2001: December 12; 2002: May 23.
Present: McLachlin C.J. and L’Heureux‑Dubé,
Gonthier, Iacobucci, Major, Bastarache, Binnie, Arbour and LeBel JJ.
on appeal from the federal court of appeal
Income tax – Source of income – Test to determine
whether taxpayer has business or property source of income – Whether
“reasonable expectation of profit” test appropriate test – Income Tax Act, S.C.
1970‑71‑72, c. 63, s. 9.
The appellant, an experienced real estate investor,
acquired four condominium units from which he earned rental income. The
properties were part of a syndicated real estate development, and were sold on
the basis that the purchaser would be provided with a turnkey operation, that
management would be provided, and that a rental pooling agreement would be
entered into. All units were highly leveraged with the appellant paying only
$1,000 cash for each unit. The appellant was provided with projections of rental
income and expenses in respect of each of the properties. The projections
contemplated negative cash flow and income tax deductions for a ten‑year
period. However, the actual rental experience ended up being worse than what
had been set out in the projections. For the taxation years 1990 to 1992, the
appellant claimed losses, mainly as a result of significant interest expenses
on money borrowed to acquire the units. These losses were disallowed by the
Minister of National Revenue on the basis that the taxpayer had no reasonable
expectation of profit and therefore no source of income for the purposes of
s. 9 of the Income Tax Act, and that the interest expenses were not
deductible pursuant to s. 20(1)(c)(i) of the Act. Both the Tax
Court of Canada and the Federal Court of Appeal upheld the decision.
Held: The appeal
should be allowed.
The “reasonable expectation of profit” test should not
be accepted as the test to determine whether a taxpayer’s activities constitute
a source of income for the purposes of s. 9 of the Income Tax Act.
In recent years, this test has become a broad‑based tool used by both the
Minister and courts independently of provisions of the Act to second‑guess
bona fide commercial decisions of the taxpayer and therefore runs afoul
of the principle that courts should avoid judicial rule‑making in tax
law. The test is problematic owing to its vagueness and uncertainty of
application; this results in unfair and arbitrary treatment of taxpayers.
The following two‑stage approach should be
employed to determine whether a taxpayer’s activities constitute a source of
business or property income: (i) Is the taxpayer’s activity undertaken in
pursuit of profit, or is it a personal endeavour? (ii) If it is not a personal
endeavour, is the source of the income a business or property? The first stage
of the test is only relevant when there is some personal or hobby element to
the activity. Where the nature of an activity is clearly commercial, the
taxpayer’s pursuit of profit is established. There is no need to take the
inquiry any further by analysing the taxpayer’s business decisions. However,
where the nature of a taxpayer’s venture contains elements which suggest that
it could be considered a hobby or other personal pursuit, the venture will be
considered a source of income only if it is undertaken in a sufficiently
commercial manner. In order for an activity to be classified as commercial in
nature, the taxpayer must have the subjective intention to profit and there must
be evidence of businesslike behaviour which supports that intention.
Reasonable expectation of profit is no more than a single factor, among others,
to be considered at this stage.
The deductibility of expenses, which presupposes the
existence of a source of income, should not be confused with the preliminary
source inquiry. Once it has been determined that an activity has a sufficient
degree of commerciality to be considered a source of income, the deductibility
inquiry is undertaken according to whether the expense in question falls within
the words of the relevant deduction provision(s) of the Act. To deny the
deduction of losses on the simple ground that the losses signify that no
business (or property) source exists is contrary to the words and scheme of the
Act. Whether or not a business exists is a separate question from the
deductibility of expenses. To disallow deductions based on a reasonable
expectation of profit analysis would amount to a case law stop‑loss rule
which would be contrary to established principles of interpretation which are
applicable to the Act. As well, unlike many statutory stop‑loss rules,
once deductions are disallowed under the “reasonable expectation of profit”
test, the taxpayer cannot carry forward such losses to apply to future income
in the event the activity becomes profitable.
In sum, whether a taxpayer has a source of income from
a particular activity is determined by considering whether the taxpayer intends
to carry on the activity for profit, and whether there is evidence to support
that intention. In this case, the taxpayer purchased four rental properties
which he rented to arm’s length parties in order to obtain rental income. A
property rental activity which, as here, lacks any element of personal use or
benefit to the taxpayer is clearly a commercial activity. As a result, the
appellant satisfies the test for source of income and is entitled to deduct his
rental losses. Section 20(1) (c)(i) of the Income Tax Act,
which permits the deduction of interest on borrowed money for the purpose of
earning income from a business or property, is not a tax avoidance mechanism
and, in light of the specific anti‑avoidance provisions in the Act,
courts should not be quick to embellish provisions of the Act in response to
tax avoidance concerns. In addition, since a tax motivation does not affect
the validity of transactions for tax purposes, the appellant’s hope of
realizing an eventual capital gain and expectation of deducting interest
expenses do not detract from the commercial nature of his rental operation or
its characterization as a source of income.
Cases Cited
Restricted: Moldowan
v. The Queen, [1978] 1 S.C.R. 480; referred to:
Mohammad v. Canada, [1998] 1 F.C. 165; Landry v. Ministre du
Revenu national (1994), 173 N.R. 213; Hugill v. The Queen, 95 D.T.C.
5311; Sirois v. M.N.R., 88 D.T.C. 1114; Tonn v. Canada, [1996] 2
F.C. 73; Corbett v. Canada, [1997] 1 F.C. 386; Allen v. The Queen,
99 D.T.C. 968, aff’d 2000 D.T.C. 6559 (sub nom. The Queen v. Milewski); Nichol
v. The Queen, 93 D.T.C. 1216; Bélec v. The Queen, 95 D.T.C. 121; Kaye
v. The Queen, 98 D.T.C. 1659; Dorfman v. M.N.R., [1972] C.T.C. 151; Smith
v. Anderson (1880), 15 Ch. D. 247; Terminal Dock and Warehouse Co.
v. M.N.R., [1968] 2 Ex. C.R. 78, aff’d 68 D.T.C. 5316; Erichsen v. Last
(1881), 4 T.C. 422; Hickman Motors Ltd. v. Canada, [1997] 2 S.C.R. 336; Ludco
Enterprises Ltd. v. Canada, [2001] 2 S.C.R. 1082, 2001 SCC 62; Canderel
Ltd. v. Canada, [1998] 1 S.C.R. 147; Roopchan v. The Queen, 96
D.T.C. 1338; Royal Bank of Canada v. Sparrow Electric Corp., [1997] 1
S.C.R. 411; Shell Canada Ltd. v. Canada, [1999] 3 S.C.R. 622; Engler
v. The Queen, 94 D.T.C. 6280; Neuman v. M.N.R., [1998] 1 S.C.R. 770;
Walls v. Canada, [2002] 2 S.C.R. 000, 2002 SCC 47.
Statutes and Regulations Cited
Income
Tax Act, R.S.C. 1985, c. 1 (5th Supp .),
ss. 18(1) (a), (h), 248(1) “personal or living expenses” [am.
2000, c. 12, s. 142 (sch. 2, s. 9 (r))].
Income Tax Act , S.C. 1970‑71‑72, c. 63 [now R.S.C. 1985,
c. 1 (5th Supp .)], ss. 3 (a), 9(1) , (2) , 13 , 18(1) (a), (h)
[rep. & sub. 1988, c. 55, s. 10(3)], 20(1)(c)(i), 67,
248(1) “personal or living expenses”.
Income War Tax Act, R.S.C. 1927, c. 97 [previously S.C. 1917, c. 28], ss. 2
“personal and living expenses” [ad. 1939, c. 46, s. 2], 6(f).
Authors Cited
Fien, Cy. “To Profit or Not To
Profit: A Historical Review and Critical Analysis of the ‘Reasonable
Expectation of Profit’ Test” (1995), 43 Can. Tax J. 1287.
Krishna, Vern. The
Fundamentals of Canadian Income Tax, 6th ed. Scarborough, Ont.: Carswell,
2000.
Nichols, Brian S. “Chants
and Ritual Incantations: Rethinking the Reasonable Expectation of Profit
Test”, 1996 Conference Report, Report of Proceedings of the Forty‑Eighth
Tax Conference, vol. 1. Toronto: Canadian Tax Foundation, 1997, 28:1.
Owen, John R. “The Reasonable
Expectation of Profit Test: Is There a Better Approach?” (1996), 44 Can.
Tax J. 979.
Silver, Sheldon. “Great
Expectations: Are They Reasonable?”, Corporate Management Tax Conference 1995,
Real Estate Transactions: Tax Planning for the Second Half of the 1990s.
Toronto: Canadian Tax Foundation, 1996, 6:1.
APPEAL from a judgment of the Federal Court of Appeal
(2000), 254 N.R. 326, 2000 D.T.C. 6163, [2000] 2 C.T.C. 244, [2000] F.C.J. No.
238 (QL), affirming a decision of the Tax Court of Canada, 98 D.T.C. 1600,
[1998] 3 C.T.C. 2662, [1998] T.C.J. No. 310 (QL). Appeal allowed.
Richard B. Thomas
and Lisa Wong, for the appellant.
Richard Gobeil and Donald G.
Gibson, for the respondent.
The judgment of the Court was delivered by
Iacobucci and
Bastarache JJ. –
I. Introduction
1
This appeal requires the Court to consider the appropriate use of what
has come to be known as the “reasonable expectation of profit” test. The test
originated with the following comments of Dickson J. (as he then was) in the
seminal case of Moldowan v. The Queen, [1978] 1 S.C.R. 480, at p. 485:
Although originally disputed, it is now accepted
that in order to have a “source of income” the taxpayer must have a profit or a
reasonable expectation of profit. Source of income, thus, is an equivalent
term to business ....
2
Since then, decisions have varied in the application of this test.
Although some cases have held that the reasonable expectation of profit test
should only be used at the threshold stage of distinguishing between commercial
and personal activities, others have used the test as a tool to assess the
profitability of various bona fide commercial ventures in order to
determine whether the taxpayer has a source of income, and is therefore
entitled to deduct losses relating to that source.
3
The present appeal is just such a case. The appellant, Brian Stewart,
purchased four condominium units from which he earned rental income. For the
tax years in question, the appellant incurred losses, mainly as a result of
significant interest expenses. These losses were disallowed by the Minister on
the basis that the taxpayer had no reasonable expectation of profit, and
therefore no source of income.
4
In our view, the reasonable expectation of profit analysis cannot be
maintained as an independent source test. To do so would run contrary to the
principle that courts should avoid judicial innovation and rule-making in tax
law. Although the phrase “reasonable expectation of profit” is found in the Income
Tax Act , S.C. 1970-71-72, c. 63 (the “Act”), its statutory use does not
support the broad judicial application to which the phrase has been subjected.
In addition, the reasonable expectation of profit test is imprecise, causing an
unfortunate degree of uncertainty for taxpayers. As well, the nature of the
test has encouraged a hindsight assessment of the business judgment of
taxpayers in order to deny losses incurred in bona fide, albeit
unsuccessful, commercial ventures.
5
It is undisputed that the concept of a “source of income” is fundamental
to the Canadian tax system; however, any test which assesses the existence of a
source must be firmly based on the words and scheme of the Act. As such, in
order to determine whether a particular activity constitutes a source of
income, the taxpayer must show that he or she intends to carry on that activity
in pursuit of profit and support that intention with evidence. The purpose of
this test is to distinguish between commercial and personal activities, and
where there is no personal or hobby element to a venture undertaken with a view
to a profit, the activity is commercial, and the taxpayer's pursuit of profit
is established. However, where there is a suspicion that the taxpayer's
activity is a hobby or personal endeavour rather than a business, the
taxpayer's so-called reasonable expectation of profit is a factor, among
others, which can be examined to ascertain whether the taxpayer has a commercial
intent.
6
In the present appeal, the taxpayer purchased four rental properties
which he rented to arm’s length parties in order to obtain rental income.
There was no personal element to the taxpayer’s endeavour, and its commercial
nature was never questioned. As a result, the appellant’s rental activities
constitute a source of income from which he is entitled to deduct his rental
losses. We would therefore allow the appeal.
II. Facts
7
The appellant held senior positions with the Toronto Transit Commission
in the years 1990 to 1992, the tax years relevant to this appeal. Between 1986,
and 1992, his annual income ranged from $65,000 to over $90,000. The appellant
was also an experienced real estate investor and had in the past acquired and
disposed of several rental properties.
8
In 1986, the appellant acquired the four condominium rental units that
are the subject of this appeal. The properties were part of a syndicated real
estate development promoted by the Reemark Group, and were sold on the basis
that the purchaser would be provided with a turnkey operation, that management
would be provided, and that a rental pooling agreement would be entered into.
The Reemark Group also arranged financing for the projects.
9
The first two units, the “White Oaks” units, located in London, Ontario,
were purchased for $72,990 each. These units were financed by a first mortgage
of $52,553, initially amortized over a 30-year period. Additional financing
came in the form of two promissory notes totalling $19,437. The second two
units, the “Park Woods” units, located in Surrey, British Columbia, were
purchased for $74,990 and $58,990 and were similarly financed. All units were
highly leveraged with the appellant paying only $1,000 cash for each unit. The
appellant was provided with projections of rental income and expenses in
respect of each of the properties. The projections contemplated payout of the
promissory notes over a period of years terminating in 1994. They also projected
negative cash flow and income tax deductions for a ten-year period in all
cases. However, the actual rental experience of the four units ended up being
worse than what had been set out in the projections provided by Reemark to the
appellant, owing to worse than expected rental and vacancy rates.
10
The appellant tried to reduce the amount of financing on the units. In
1991, he increased the frequency of first mortgage payments on the units from
monthly to weekly, thereby reducing the amortization period significantly. He
sold one of the Park Woods units in 1991 and used the proceeds to pay down the
debt on the other unit. By 1994, the appellant had paid off the promissory
notes on all of the units. The appellant also exited the White Oaks rental
pool arrangement in 1995 because of high vacancies and poor management and set
up his own management company. In 1996, he changed management companies for
the Park Woods unit.
11
For the taxation years 1990, 1991 and 1992, the appellant claimed
losses of $27,814, $18,673 and $12,306, respectively. The losses resulted
primarily from interest expenses on money borrowed to acquire the units. The
Minister of National Revenue reassessed the appellant, disallowing his losses
on the units for these taxation years solely on the basis that he had no
reasonable expectation of profit for the years in question.
12
The appellant argued that the fact that the purchases were almost 100
percent financed was not determinative of whether he had a reasonable expectation
of profit, and he argued that he should be able to deduct the carrying charges
for monies borrowed to finance the rental losses. The respondent argued that
the appellant had had no reasonable expectation of profit but had purchased the
properties as a tax shelter, attracted by the promises of income tax deductions
and capital gains projections promoted by the vendor Reemark. The appellant
had followed the vendor’s plan instead of following his usual investment
practices, and chose not to pay down the debt owing at times when he clearly
had money with which to do so.
13
The Tax Court of Canada found that the appellant’s rental losses were
not deductible in computing his income for income tax purposes because there
was no reasonable expectation of profit. The Federal Court of Appeal dismissed
the appeal.
III. Relevant
Statutory Provisions
14
Income Tax Act , S.C. 1970-71-72, c. 63 (now R.S.C. 1985, c. 1
(5th Supp .))
9. (1) Subject to this Part, a taxpayer’s income
for a taxation year from a business or property is his profit therefrom for the
year.
18. (1) In computing the income of a
taxpayer from a business or property no deduction shall be made in respect of
(a) an outlay or expense except to the extent that it was made
or incurred by the taxpayer for the purpose of gaining or producing income from
the business or property;
...
(h) personal or living
expenses of the taxpayer, other than travelling expenses incurred by the
taxpayer while away from home in the course of carrying on his business;
20. (1) Notwithstanding paragraphs 18(1)(a),
(b) and (h), in computing a taxpayer’s income for a taxation year
from a business or property, there may be deducted such of the following
amounts as are wholly applicable to that source or such part of the following
amounts as may reasonably be regarded as applicable thereto:
...
(c) an amount paid in the year or payable in respect of the
year (depending upon the method regularly followed by the taxpayer in computing
his income), pursuant to a legal obligation to pay interest on
(i) borrowed money used for the purpose of earning income from a
business or property...
...
or a reasonable amount in respect thereof, whichever is the lesser;
248. (1) In this Act,
...
“personal or living expenses” includes
(a) the expenses of properties maintained by any person for the
use or benefit of the taxpayer or any person connected with the taxpayer by
blood relationship, marriage or adoption, and not maintained in connection with
a business carried on for profit or with a reasonable expectation of profit
....
IV. Judgments
Below
A. Tax
Court of Canada, 98 D.T.C. 1600
15
McArthur J.T.C.C. characterized the issue as whether the appellant had
a reasonable expectation to profit from the subject rental properties such
that there existed a source of income from which he could deduct rental losses
incurred in the years under appeal. While recognizing that the comments of
Robertson J.A. in Mohammad v. Canada, [1998] 1 F.C. 165 (C.A.), in
respect to reasonable expectation of profit were obiter, McArthur
J.T.C.C. found them to be instructive and of assistance in determining the
outcome. In light of these comments, he considered the crux of the appeal to
be whether the appellant possessed the intention to pay down the principal on
the rental units, regardless of whether this actually occurred. Without an
intention to reduce the amount of the principal owing on each unit, there could
be no reasonable expectation of profit.
16
According to McArthur J.T.C.C., the effect of the Reemark plan was to
use rental losses to offset income and then to realize a gain at the end of the
day from the expected capital appreciation of the properties. Accordingly, the
Reemark plan held out no expectation of profit from rental income.
17
While noting that the appellant deviated from the Reemark plan somewhat,
McArthur J.T.C.C. found instructive the fact that the appellant had deviated
from his usual practice of paying down 25 percent of the purchase price on his
prior rental property investments in order to reduce the risk that income
expenses would exceed rental income. He also emphasized that in 1988 the
appellant chose to advance $40,000 in principal toward the purchase of a
condominium for his own use, and, in 1990, he sheltered $50,000 in an RRSP
rather than paying down more of the indebtedness. Thus, he had several
opportunities to reduce the outstanding indebtedness and chose not to.
McArthur J.T.C.C. concluded that having considered all the evidence, he was not
satisfied that the plan the appellant followed was realistic in its ability to
pay down a sufficient portion of the principal on the subject properties so as
to create a positive cash flow. As a result, he concluded that the reasonable
expectation of profit test was not satisfied, and therefore that the appellant
had no source of income from which to deduct expenses under s. 20(1) (c).
B. Federal
Court of Appeal (2000), 254 N.R. 326
18
Rothstein J.A. for the court noted that the reasonable expectation of
profit test derives from the well-known case of Moldowan, supra.
In that case, Dickson J. determined that in order to have a source of income
for purposes of the Act, the taxpayer must have a profit or a reasonable
expectation of profit. The appellant argued that the Moldowan test only
applied where there was an element of personal use, and so did not pertain to
the properties in question. Rothstein J.A. disagreed, saying, at para. 7 that
“[t]he Moldowan principle is that in order to have a source of income, the
taxpayer must have a profit or a reasonable expectation of profit.”
19
Rothstein J.A. commented that the reasonable expectation of profit test
is not an opportunity for the Minister to second-guess the business judgement
of the taxpayer, but found that this was not why the learned Tax Court judge
found that there was no reasonable expectation of profit in this case.
According to Rothstein J.A., the lower court’s finding was based on the fact
that the Reemark plan held out no expectation of profit from the rental income,
and instead offered rental losses to offset other income and eventually realize
a gain from the appreciation in value of the property. Rothstein J.A. also
accepted the Tax Court judge’s finding that the appellant did not have a
realistic plan to produce a profit. It followed that there was no source of
income, and therefore that the interest expenses claimed by the appellant were
not deductible pursuant to s. 20(1) (c).
V. Issues
20
1. Is the “reasonable expectation of profit” test set out
by the Court in Moldowan the test for determining whether the taxpayer has
a business or property source of income under the Act? If not, what is the
test?
2. Did the courts below err in
disallowing the appellant’s interest expense deductions pursuant to the
provisions of s. 20(1)(c) of the Act on the basis that there was no
source of income?
VI. Analysis
A. A.
The Test to Determine Whether the Taxpayer has a Business or Property Source
of Income Under the Act
(1) A Brief Overview of the Cases Leading up to Moldowan
21
It well accepted that the Canadian tax system adopted the concept of
“source” from the English taxation statutes, and that the Act has always
referred to income from various “sources”: see V. Krishna, The Fundamentals
of Canadian Income Tax (6th ed. 2000), at pp. 102-3. However, the term
“source” is not defined in the Act, and it has been left to courts to determine
the nature and scope of the various sources of income in the Act.
22
With respect to the phrase “reasonable expectation of profit”, this
wording first appeared in the Income War Tax Act, R.S.C. 1927, c. 97
(previously S.C. 1917, c. 28) (“IWTA”), through a 1939 amendment which
added a definition of “personal and living expenses” to the IWTA: S.C.
1939, c. 46, s. 2. That amendment defined “personal and living expenses” to
include:
. . . the expenses of properties maintained by any person for the use
or benefit of any taxpayer or any person connected with him by blood
relationship, marriage or adoption, and not maintained in connection with a
business carried on bona fide for a profit and not maintained with a
reasonable expectation of a profit;
This
definition was relevant to s. 6(f) of the IWTA which read, “[i]n
computing the amount of the profits or gains to be assessed, a deduction shall
not be allowed in respect of ... personal and living expenses”. The phrase
“reasonable expectation of profit” still appears in the virtually unaltered
definition of “personal or living expenses” (now found in s. 248(1)), which in
turn relates to s. 18(1)(h). Section 18(1)(h) disallows the
deduction of personal or living expenses from business or property income. It
can be seen, therefore, that the statutory use of the phrase “reasonable
expectation of profit” has changed little since its introduction into the IWTA.
23
Despite this fairly restrictive statutory use of the term “reasonable
expectation of profit” (to disallow deductions for expenses of properties not maintained
in connection with a business carried on with a reasonable expectation of
profit), one author notes that several cases began to expand the use of the
phrase in viewing “reasonable expectation of profit” as a general requirement
of the “source of income” concept:
The first suggestion to this effect actually
appears in the 1964 decision of J.S. Stewart v. MNR, a case
concerning the raising of dogs for use in a display advertising business, in
which the court stated (in obiter) that a business must be “carried out in good
faith with a reasonable expectation of profit.” [[1964] C.T.C. 45, at p. 51
(Ex. Ct.)] Seven years later, in 1971, the Federal Court — Trial Division in CBA
Engineering Ltd. v. MNR [71 D.T.C. 5282, at p. 5286] stated that farming could
be either a hobby or an “operation with the expectation of profit,” in which
case it would be a source. CBA Engineering Ltd. was followed in 1972 by
O. Dorfman v. MNR, another farming case, in which the Federal Court —
Trial Division stated, “In my view the words [source of income] are used in the
sense of a business, employment, or property from which a net profit might
reasonably be expected to come” [[1972] C.T.C. 151, at p. 154].
(C. Fien, “To Profit or Not to Profit: A Historical Review and Critical
Analysis of the ‘Reasonable Expectation of Profit’ Test” (1995), 43 Can. Tax
J. 1287., at p. 1298)
From this, the
author concludes at p. 1299 that “[i]t appears that CBA Engineering Ltd.,
Dorfman, and [D.A.] Holley [v. MNR, [1973] C.T.C.
539 (F.C.T.D.)] may well have been the springboard to Revenue Canada’s
adoption of a broadly based ‘reasonable expectation of profit’ test.” In any
event, these early cases were certainly germane to the decision in Moldowan.
24
In Moldowan, the taxpayer carried on a horse-racing activity.
The Minister had conceded that this activity constituted a business; the issue
before the Court was whether the taxpayer’s farming was his chief source
of income such that he could fully deduct his losses under s. 13 of the Act.
As such, the following comments of Dickson J. at pp. 485-86 relating to
“reasonable expectation of profit” were obiter:
Although originally disputed, it is now accepted
that in order to have a “source of income” the taxpayer must have a profit or a
reasonable expectation of profit. Source of income, thus, is an equivalent
term to business: Dorfman v. M.N.R. [[1972] C.T.C. 151]. See also s.
139(1) (ae) of the Income Tax Act which includes as “personal and
living expenses” and therefore not deductible for tax purposes, the expenses of
properties maintained by the taxpayer for his own use and benefit, and not
maintained in connection with a business carried on for profit or with a
reasonable expectation of profit. If the taxpayer in operating his farm is
merely indulging in a hobby, with no reasonable expectation of profit, he is
disentitled to claim any deduction at all in respect of expenses incurred.
There is a vast case literature on what reasonable expectation
of profit means and it is by no means entirely consistent. In my view, whether
a taxpayer has a reasonable expectation of profit is an objective determination
to be made from all of the facts. The following criteria should be
considered: the profit and loss experience in past years, the taxpayer’s
training, the taxpayer’s intended course of action, the capability of the
venture as capitalized to show a profit after charging capital cost allowance.
The list is not intended to be exhaustive. The factors will differ with the
nature and extent of the undertaking: The Queen v. Matthews [(1974), 74
D.T.C. 6193]. One would not expect a farmer who purchased a productive going
operation to suffer the same start-up losses as the man who begins a tree farm
on raw land.
25
Since this Court’s decision in Moldowan, the “reasonable
expectation of profit” or “REOP” test has been applied by the Minister and the
courts in a variety of situations in order to determine whether a taxpayer has
a source of income, whether business or property. However, as the above
discussion indicates, equating the phrase “reasonable expectation of profit”
with a “source” of income for the purposes of the Act is a case law expansion
of the use of that phrase in the definition of “personal or living expenses” in
the Act. As such, it is appropriate to examine the REOP test closely in order
to determine whether it should be accepted as a stand-alone source test, or
whether there is a better approach to assessing the existence of a source.
Indeed, the wide range of approaches that courts have taken to the REOP test
alone calls for clarification.
(2) Post-Moldowan REOP Cases
26
Since Moldowan, courts have differed in their acceptance of the
REOP analysis as the appropriate test for the source of income determination,
and a brief survey of some of these cases is a useful starting point for an
evaluation of the Moldowan test.
27
Although cases where the Minister has disallowed deductions or losses on
a “no reasonable expectation of profit” basis have taken a range of positions,
they can generally be categorized into two groups: those which accept the use
of the test where there is no personal element to the taxpayer’s activities,
and those which hold that the test has no application unless there is a
personal or hobby aspect to the endeavour.
28
In Landry v. Ministre du Revenu national (1994), 173 N.R. 213 at
paras. 1 and 3, the majority of the Federal Court of Appeal held that the
taxpayer who had come out of retirement to practice law at the age of 71 did
not satisfy the REOP test and thus had no source of income from which to deduct
the losses that his practice had incurred. Writing for the majority, Décary
J.A. quoted and accepted the Tax Court judge’s application of the test:
I see no reason why the reasonable expectation of profit test should
not apply to any profession, liberal or otherwise, any occupation or activity
which purports to be in the course of carrying on a business. As I see it, the
reasonable expectation of a profit is a general rule applicable to any
activity which may give rise to business income.... [Emphasis added.]
Décary J.A.
then concluded that:
It is possible for someone, with the best will in
the world, to practise an activity that takes all his or her time and that
activity may still not be a business for the purposes of the Income Tax Act ....
For the purposes of determining whether there is a source of income, only an
activity that is profitable or that is carried on with a reasonable
expectation of profit is a business.... [Emphasis added.]
29
This decision was followed in Hugill v. The Queen, 95 D.T.C. 5311
(F.C.A.), in which the taxpayer’s deductions in respect of rental properties
were disallowed. At p. 5311, the Federal Court of Appeal affirmed the Tax
Court of Canada’s determination that the taxpayer’s business plan was
unrealistic and therefore that there was no reasonable expectation of profit:
In reaching this
decision, the Tax Court judge had regard to: the constant losses suffered by
the taxpayer since 1984; the lack of improvements required if the properties
were to be rented during both the summer and winter seasons; and the fact that
the venture “has been, and continues to
be, under capitalized”. It is true that
the applicant had a “plan” which if realized might reasonably have resulted in
a profit but unfortunately it was a plan which changed from year to year as his
personal financial circumstances changed. In the circumstances, the reasoning
of Mr. Justice Décary in Landry [v.
Ministre du Revenu national (1994), 173 N.R. 213, at paras. 1 and 3] is
particularly apt: “There comes a time
in the life of any business operating at a deficit when the Minister must be
able to determine objectively ... that a reasonable expectation of profit has
turned into an impossible dream.”
30
A similar approach was taken in Sirois v. M.N.R., 88 D.T.C. 1114
(T.C.C.), where the taxpayer ran a restaurant business that suffered losses
from 1976 to 1984. The Minister disallowed the losses for the 1981 and 1982
taxation years. Couture C.J.T.C. reviewed the operations of the business,
including seating capacity and opening hours in order to determine whether a
reasonable expectation of profit existed so as to allow the taxpayer to deduct
the losses. At pp. 1115-16, he concluded that:
. . . for the 1981 taxation year, considering that the restaurant was operated
with seating for only twenty (20), four days a week, and that since 1976 the
operations had shown a loss, there was no realistic reasonable expectation of
profit in these circumstances.
For the 1982 taxation year, however, when the
situation was entirely different, I am of the opinion that the respondent ...
was not justified in presuming that there was no reasonable expectation of
profit in such circumstances.
31
Although cases such as Landry, Hugill, and Sirois evidenced
a willingness on the part of the Tax Court of Canada and the Federal Court of
Appeal to reassess the business decisions of taxpayers, in Tonn v. Canada,
[1996] 2 F.C. 73, the Federal Court of Appeal appeared to temper this approach
somewhat. In that case, the taxpayers purchased a rental property which
incurred losses. In allowing the taxpayers to deduct these losses, Linden
J.A., at paras. 26 and 28, made the following remarks with respect to the REOP
test:
But do the Act’s purposes suggest that deductions
of losses from bona fide businesses be disallowed solely because the
taxpayer made a bad judgment call? I do not think so. The tax system has
every interest in investigating the bona fides of a taxpayer’s dealings
in certain situations, but it should not discourage, or penalize, honest but
erroneous business decisions. The tax system does not tax on the basis of a
taxpayer’s business acumen, with deductions extended to the wise and withheld
from the foolish....
...
The Moldowan test, therefore is a useful
tool by which the tax- inappropriateness of an activity may be reasonably
inferred when other, more direct forms of evidence are lacking. Consequently,
when the circumstances do not admit of any suspicion that a business loss was
made for a personal or non-business motive, the test should be applied
sparingly and with a latitude favouring the taxpayer, whose business judgment
may have been less than competent.
However, to
this Linden J.A. added that it was open for courts to determine that “though
the taxpayer genuinely intended the pursuit of profit through a purely
commercial activity, the intention was unrealistic, the expectation of profit
unreasonable, and hence, the activity was not a business” (para. 36).
32
In Corbett v. Canada, [1997] 1 F.C. 386 (C.A.), Linden
J.A. applied the REOP test to a situation where the taxpayer had defaulted on
mortgage payments in respect of a rental property which was subsequently
ordered to be sold to the mortgagee. The Minister disallowed the deduction of
interest payments on the mortgage in respect of the interim period before the
mortgagee acquired the property on the basis that the taxpayer had no
reasonable expectation of profit. At para. 20, Linden J.A. upheld the
Minister’s assessment and the application of the REOP test to these facts:
In cases such as this, therefore, where it is clear that no profit
could be earned in the year or forever after because of the judicial sale
proceedings, Moldowan is applicable.... This is not a case of
second-guessing poor business decisions that do not yield profit, which was the
case in Tonn.
33
In contrast to the above cases, other decisions, particularly those of
Bowman A.C.J. of the Tax Court of Canada, have taken a different view of the
applicability REOP test. In Allen v. The Queen, 99 D.T.C. 968 (T.C.C.),
aff’d 2000 D.T.C. 6559 (F.C.A.) (sub nom. The Queen v. Milewski), Bowman
J.T.C.C. (as he then was) held at paras. 18-25 that the REOP test had no
application in a situation similar to the one at bar, where, with near 100
percent financing, the taxpayers formed a partnership which carried on a rental
business and incurred losses:
In my opinion, the respondent has misapplied the
[REOP] doctrine. We are dealing here with two individuals who have invested,
through a limited partnership, in a perfectly viable business that started
making a profit in the second year. There was no personal element involved —
neither appellant has any intention of residing in the apartments....
...
How then does the fact that the acquisition of the
limited partnership interests was financed substantially by the borrowing of
money through the Equity Notes and Second Equity Notes at what, on the
evidence, was a favourable interest rate, turn a viable and profitable business
into one that had no reasonable expectation of profit and was, therefore, not a
business and not a source of income? The investment was clearly long term and bona
fide, with the expectation that in the fullness of time the debt would be
paid down and ultimately paid off and the appellants would have a lasting
investment. The Minister’s position, as revealed in the portions of the
examination for discovery that were read in, is that once the income from the
partnership exceeded the interest charges, the non-business will become a
business and the Minister will start to tax.
...
Whatever else may be said about 99% financing of an
investment, it certainly cannot be said that its result is that the vehicle in
which the taxpayer has invested did not carry on a business. This is wrong as
a matter of logic, law and common sense. The Minister is seeking to limit the
deduction of the amount of interest which is permitted by paragraph 20(1) (c)
by intoning the ritual incantation [REOP], where it is obvious and admitted
that the partnership is carrying on a profitable business.
...
The [REOP] principle may have some application
where a person tries to write off losses from a hobby such as horseracing (Rai
v. The Queen, February 8, 1999, file number 98-925(IT)I); or from
collecting antique Coca-Cola bottles (Kaye v. The Queen, 98 DTC 1659);
or renting a portion of the basement of that person’s dwelling to a relative
and trying to write off 2/3 of the costs of the house. It operates at the
liminal stage of questioning the existence of a business. Where there is no
personal element and a genuine business exists the [REOP] doctrine has no
application.... [Emphasis added.]
Bowman
J.T.C.C. has expressed a similar view in a variety of cases: see, for example,
Nichol v. The Queen, 93 D.T.C. 1216 (T.C.C.); Bélec v. The Queen,
95 D.T.C. 121 (T.C.C.); Kaye v. The Queen, 98 D.T.C. 1659 (T.C.C.).
34
It is evident from this brief review that the REOP test has not been
interpreted and applied in a consistent manner. The cases dealing with this
concept fall along a spectrum. At one end are the decisions which consider
REOP to be the test by which the viability of the taxpayer’s business plan is
assessed, whatever the activity in question happens to be, and to determine
whether this activity deserves to be considered a “source of income”. At the
other end of the spectrum are the cases which use the REOP analysis only where
the activity in question contains a personal or hobby element, and then only as
a factor in determining whether this activity is sufficiently commercial to be
labelled a “source of income”. The only coherent message that emerges from a
survey of the cases which have followed Moldowan is that the proper role
of “reasonable expectation of profit” is in need of clarification.
(3) Problems with the REOP Test
35
Since Moldowan, there has been a fair amount of judicial and
academic criticism of the alleged misuse of the REOP test. These comments can
be generally classified into two types. First, some critics allege that there
is no statutory foundation for using “reasonable expectation of profit” as the
test to determine whether a source of income exists. Second, it is argued
that, even if Moldowan did set out a legitimate “source” test, the test
is problematic and should be rejected.
36
In Dickson J.’s obiter comments with respect to reasonable
expectation of profit, he cites Dorfman v. M.N.R., [1972] C.T.C. 151
(F.C.T.D.), as authority for the proposition that in order to have a source of
income the taxpayer must have a reasonable expectation of profit. However,
several commentators have pointed out that Dorfman stands for a slightly
different proposition. In particular, in Dorfman, the Federal Court,
Trial Division was dealing with an argument by the Minister that because the
taxpayer had not realized net farming income for the year, that farming could
not be a source of the taxpayer’s income. In rejecting that argument, Collier
J., at p. 154, stated that:
I cannot accept the interpretation put by counsel
for the Minister in this case on the words “source of income”: that there must
be net income before there can be a source. In my view the words are used in
the sense of a business, employment, or property from which a net profit might
reasonably be expected to come.
In other
words, the court was addressing the contention that the phrase “source of
income” required a net profit. In response to this particular argument, the
court held that, where an activity had a reasonable expectation of net
profit, this was enough to constitute a source of income. Put in other terms,
the fact that an activity is being carried on with a reasonable expectation of
profit is sufficient for the activity to constitute a source of income.
37
It has been pointed out that, as a matter of logic, the fact that an
activity carried on with a reasonable expectation of profit is a sufficient
requirement for a source of income (the proposition from Dorfman) does
not entail that a reasonable expectation of profit is a necessary
requirement for a source of income (the proposition from Moldowan): see
B. S. Nichols, “Chants and Ritual Incantations: Rethinking the Reasonable
Expectation of Profit Test”, 1996 Conference Report, Report of Proceedings
of the Forty-Eighth Tax Conference, vol. 1, 28:1, at pp. 28:4-28:5; S.
Silver, “Great Expectations: Are they Reasonable?”, Corporate Management Tax
Conference 1995, 6:1, at pp. 6:6-6:7. In other words, it is argued that by
taking the comments from Dorfman out of their particular context and
applying them generally, Moldowan mistakenly equated “source of income”
with “reasonable expectation of profit”.
38
Indeed, equating the term “business” with the phrase, “reasonable
expectation of profit” does not accord with the traditional common law
definition of business, which is that “anything which occupies the time and
attention and labour of a man for the purpose of profit is business” (Smith
v. Anderson (1880), 15 Ch. D. 247 (C.A.), at p. 258; Terminal Dock and
Warehouse Co. v. M.N.R., [1968] 2 Ex. C.R. 78, aff’d 68 D.T.C. 5316
(S.C.C.)). In addition, early cases dealing with the proper definition of a
business rejected looking exclusively at one factor. For example, in Erichsen
v. Last (1881), 4 T.C. 422, at p. 423, the English Court of Appeal stated:
I do not think there is any principle of law which lays down what
carrying on of trade is. There are a multitude of incidents which together
make the carrying on [of] a trade, but I know of no one distinguishing incident
which makes a practice a carrying on of trade, and another practice not a
carrying on of trade. If I may use the expression, it is a compound fact made
up of a variety of incidents.
Thus, to
equate “source of income” with “reasonable expectation of profit”, at least in
the instance of a business source, is not in line with these earlier
characterizations of “business”.
39
The view has also been taken that Dickson J. did not intend to set out a
broadly applicable source test in Moldowan, but instead that he was
simply distinguishing between mere hobbies and bona fide businesses:
see J. R. Owen, “The Reasonable Expectation of Profit Test: Is There a Better
Approach?” (1996), 44 Can. Tax J. 979, at p. 1002. This view stems from
the fact that in the same paragraph where Dickson J. equates a business with a
reasonable expectation of profit, he states “[i]f the taxpayer in operating his
farm is merely indulging in a hobby, with no reasonable expectation of profit,
he is disentitled to claim any deduction at all in respect of expenses
incurred”: Moldowan, supra, at p. 485. As well, various cases
have held that the Moldowan test is only applicable where there is some
personal element to the taxpayer’s endeavour: Hickman Motors Ltd. v. Canada,
[1997] 2 S.C.R. 336, at paras. 69 and 72; Allen, supra; Nichol,
supra; Bélec, supra.
40
In light of the definition of “business” developed in earlier cases, as
well as the dubious scope of Dickson J.’s obiter reference to
“reasonable expectation of profit” in Moldowan, which may also have been
a mistaken application of that phrase as used in Dorfman, the REOP test
should not be blindly accepted as the correct approach to the “source of
income” determination. This conclusion is strengthened by the fact that
subsequent cases have run the gamut with respect to the application of the REOP
concept.
41
It has also been argued that the limited use of the phrase, “reasonable
expectation of profit” in the Act, does not support its use as a stand-alone
source test. As mentioned above, the phrase first appeared in the Act in the
definition of “personal or living expenses”. The current version of that
definition, in s. 248(1) (R.S.C. 1985, c. 1 (5th Supp .)), reads:
“personal or living expenses” includes
(a) the expenses of properties maintained by any person for the
use or benefit of the taxpayer or any person connected with the taxpayer by
blood relationship, marriage or common-law partnership or adoption, and not
maintained in connection with a business carried on for profit or with a
reasonable expectation of profit;
The phrase
“personal or living expenses” relates to s. 18(1)(h) of the Act which
now reads:
18. (1) In computing the income of a taxpayer from a business
or property no deduction shall be made in respect of
...
(h) personal or
living expenses of the taxpayer, other than travel expenses incurred by the
taxpayer while away from home in the course of carrying on the taxpayer’s
business;
Silver, supra,
at p. 6:4, contrasts this limited statutory use of the phrase “reasonable
expectation of profit” with its broader judicial application:
In any event, while the definition of “personal or
living expenses” in subsection 248(1) is inclusive rather than exhaustive, it
is clear that the provision and paragraph 18(1)(h) have limited application.
The legislation establishes a “reasonable expectation of profit” test only in
connection with expenses incurred in the maintenance of properties and only in
connection with expenses from which the taxpayer may derive some use or
benefit.
It can be seen, therefore, from an examination of
the Act that the statutory provisions that employ a “reasonable expectation of
profit” test are specific in nature and would not appear to support a broad
application of this test by Revenue Canada and the courts.
42
Thus, the only way to accept “reasonable expectation of profit”
as the test to determine whether a taxpayer has a source of income is to adopt
an interpretive rule of law which is independent of the provisions of the Act.
As this Court observed in Ludco Enterprises Ltd. v. Canada, [2001]
2 S.C.R. 1082, 2001 SCC 62, at para. 53, “this Court has repeatedly stated that
in matters of tax law, a court should always be reluctant to engage in judicial
innovation and rule making”. Although it is true that the term “source” is
undefined in the Act, and courts must frequently determine whether a taxpayer
has the requisite source of income, there is a distinction between judicial
interpretation and judicial rule-making, and, in our respectful view, several
cases have crossed the line between use of REOP as an interpretive aid to
assess whether a source of income exists and use of REOP as a stand-alone
“source” test. The fact that the REOP test has been applied to both business
and property sources, activities with completely different natures, indicates
that the test has transcended its use as a mere interpretive tool, and has
taken on a life of its own. Indeed, in Tonn, supra, at para. 25, the Moldowan test was described as a “common law formulation respecting the purposes of
the Act” which was “ideally suited to situations where a taxpayer is
attempting to avoid tax liability by an inappropriate structuring of his or her
affairs.”
43
As stated by this Court in Canderel Ltd. v. Canada, [1998] 1
S.C.R. 147, at para. 41, “[t]he law of income tax is sufficiently complicated
without unhelpful judicial incursions into the realm of lawmaking.” In our
view, the range of uses and interpretations that courts have given to the
phrase “reasonable expectation of profit”, and the corresponding uncertainty
this has created for the taxpayer, are illustrative of the dangers inherent in
this type of judicial exercise. Moreover, even if one were to accept the use
of the REOP test as a legitimate source of income standard, there are numerous
practical difficulties which arise in its application that suggest to us that
the test is ill-suited for this purpose.
44
It has been pointed out that it is unclear what exactly the REOP test
refers to by the term “profit”. For example, it is unclear whether the
capacity for profit should be determined after taking into account depreciation
and, if so, whether capital cost allowance or accounting depreciation should be
used: see Roopchan v. The Queen, 96 D.T.C. 1338 (T.C.C.), at p. 1341.
Even if the basis for calculating profit was clear, it is still uncertain how
much expected profit would be required, in what time frame, and whether the
amount of expected profit should vary with the risk of the venture: see Fien, supra,
at pp. 1304-6. For example, a high-risk venture may incur substantial losses
which may be disallowed by virtue of a reasonable expectation of profit
analysis; however, it is highly unlikely that, where such a venture does pay
off, the Minister would abstain from an assessment on the ground that there was
no reasonable expectation of profit and therefore no business.
45
The vagueness of the REOP test encourages a retrospective application
which, as pointed out by Bowman J.T.C.C. in Nichol, supra, at p.
1219, causes uncertainty and unfairness:
[The taxpayer] made what might, in retrospect, be seen as an error in
judgment but it was a matter of business judgment and it was not one so
patently unreasonable as to entitle this Court or the Minister of National
Revenue to substitute its or his judgment for it, or penalize him for having
made a judgment call that, with the benefit of 20-20 hindsight, that Monday
morning quarterbacks always have, I or the Minister of National Revenue might
not make today....
46
In addition, the way in which a particular venture is capitalized may
have significant effects on its profitability. The extent of capitalization,
rates of interest, and level at which a venture is capitalized (for example
partner financing versus partnership financing, or corporate financing versus
shareholder financing) may have significant effects on the bottom line, and it
is difficult to see why the characterization of a commercial venture as a
source should depend on the extent or method of financing: see Fien, supra,
at pp. 1306-7.
47
To summarize, in recent years the Moldowan REOP test has become a
broad-based tool used by both the Minister and courts in any manner of
situation where the view is taken that the taxpayer does not have a reasonable
expectation of profiting from the activity in question. From this it is
inferred that the taxpayer has no source of income, and thus no basis from
which to deduct losses and expenses relating to the activity. The REOP test
has been applied independently of provisions of the Act to second-guess bona
fide commercial decisions of the taxpayer and therefore runs afoul of the
principle that courts should avoid judicial rule-making in tax law: see Ludco,
supra; Royal Bank of Canada v. Sparrow Electric Corp., [1997] 1
S.C.R. 411; Canderel, supra; Shell Canada Ltd. v. Canada,
[1999] 3 S.C.R. 622. As well, the REOP test is problematic owing to its
vagueness and uncertainty of application; this results in unfair and arbitrary
treatment of taxpayers. As a result, “reasonable expectation of profit” should
not be accepted as the test to determine whether a taxpayer’s activities
constitute a source of income.
(4) “Source of Income”: The Recommended
Approach
48
In our view, the determination of whether a taxpayer has a source of
income, must be grounded in the words and scheme of the Act.
49
The Act divides a taxpayer’s income into various sources. Under the
basic rules for computing income in s. 3, the Act states:
3. The income of a taxpayer for a taxation
year for the purposes of this Part is his income for the year determined by the
following rules:
(a) determine the aggregate of amounts each of which is the
taxpayer’s income for the year ... from a source inside or outside
Canada, including, without restricting the generality of the foregoing, his
income for the year from each office, employment, business and property;
[Emphasis added.]
With respect
to business and property sources, the basic computation rule is found in s. 9 :
9. (1) Subject to this Part, a taxpayer’s
income for a taxation year from a business or property is his profit therefrom
for the year.
(2) Subject to section 31, a taxpayer’s loss for a
taxation year from a business or property is the amount of his loss, if any,
for the taxation year from that source computed by applying the provisions of
this Act respecting computation of income from that source mutatis mutandis.
50
It is clear that in order to apply s. 9 , the taxpayer must first
determine whether he or she has a source of either business or property
income. As has been pointed out, a commercial activity which falls short of
being a business, may nevertheless be a source of property income. As well, it
is clear that some taxpayer endeavours are neither businesses, nor sources of
property income, but are mere personal activities. As such, the following
two-stage approach with respect to the source question can be employed:
(i) Is the activity of the taxpayer undertaken
in pursuit of profit, or is it a personal endeavour?
(ii) If it is not a personal endeavour, is the
source of the income a business or property?
The first
stage of the test assesses the general question of whether or not a source of
income exists; the second stage categorizes the source as either business or
property.
51
Equating “source of income” with an activity undertaken “in
pursuit of profit” accords with the traditional common law definition of
“business”, i.e., “anything which occupies the
time and attention and labour of a man for the purpose of profit”: Smith, supra, at p. 258; Terminal Dock,
supra. As well, business income is generally distinguished from property
income on the basis that a business requires an additional level of taxpayer
activity: see Krishna, supra, at p. 240. As such, it is logical
to conclude that an activity undertaken in pursuit of profit, regardless of the
level of taxpayer activity, will be either a business or property source of
income.
52
The purpose of this first stage of the test is simply to distinguish
between commercial and personal activities, and, as discussed above, it has
been pointed out that this may well have been the original intention of Dickson
J.’s reference to “reasonable expectation of profit” in Moldowan.
Viewed in this light, the criteria listed by Dickson J. are an attempt to
provide an objective list of factors for determining whether the activity in
question is of a commercial or personal nature. These factors are what Bowman
J.T.C.C. has referred to as “indicia of commerciality” or “badges of
trade”: Nichol, supra, at p. 1218. Thus, where the nature of a
taxpayer’s venture contains elements which suggest that it could be considered
a hobby or other personal pursuit, but the venture is undertaken in a
sufficiently commercial manner, the venture will be considered a source of
income for the purposes of the Act.
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: see, for example, Landry,
supra; Sirois, supra; Engler v. The Queen, 94
D.T.C. 6280 (F.C.T.D.). 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.
54
It should also be noted that the source of income assessment is not a
purely subjective inquiry. Although in order for an activity to be classified
as commercial in nature, the taxpayer must have the subjective intention to
profit, in addition, as stated in Moldowan, this determination should be
made by looking at a variety of objective factors. Thus, in expanded form, the
first stage of the above test can be restated as follows: “Does the taxpayer
intend to carry on an activity for profit and is there evidence to support that
intention?” This requires the taxpayer to establish that his or her
predominant intention is to make a profit from the activity and that the
activity has been carried out in accordance with objective standards of
businesslike behaviour.
55
The objective factors listed by Dickson J. in Moldowan, at p.
486, were: (1) the profit and loss experience in past years; (2) the
taxpayer’s training; (3) the taxpayer’s intended course of action; and (4) the
capability of the venture to show a profit. As we conclude below, it is not
necessary for the purposes of this appeal to expand on this list of factors.
As such, we decline to do so; however, we would reiterate Dickson J.’s caution
that this list is not intended to be exhaustive, and that the factors will
differ with the nature and extent of the undertaking. We would also emphasize
that although the reasonable expectation of profit is a factor to be considered
at this stage, it is not the only factor, nor is it conclusive. The overall
assessment to be made is whether or not the taxpayer is carrying on the
activity in a commercial manner. However, this assessment should not be used
to second-guess the business judgment of the taxpayer. It is the commercial
nature of the taxpayer’s activity which must be evaluated, not his or her
business acumen.
56
In addition to restricting the source test to activities which contain a
personal element, the activity which the taxpayer claims constitutes a source
of income must be distinguished from particular deductions that the taxpayer
associates with that source. An attempt by the taxpayer to deduct what is
essentially a personal expense does not influence the characterization of the
source to which that deduction relates. This analytical separation is mandated
by the structure of the Act. While, as discussed above, s. 9 is the provision
of the Act where the basic distinction is drawn between personal and commercial
activity, and then, within the commercial sphere, between business and property
sources, the characterization of deductions occurs elsewhere. In particular,
s. 18(1)(a) requires that deductions be attributed to a particular
business or property source, and s. 18(1)(h) specifically disallows the
deduction of personal or living expenses of the taxpayer:
18. (1) In computing the income of a taxpayer
from a business or property no deduction shall be made in respect of
(a) an outlay or expense except to the extent that it was made
or incurred by the taxpayer for the purpose of gaining or producing income from
the business or property;
...
(h) personal or living expenses of the taxpayer ....
57
It is clear from these provisions that the deductibility of expenses
presupposes the existence of a source of income, and thus should not be
confused with the preliminary source inquiry. If the deductibility of a
particular expense is in question, then it is not the existence of a source of
income which ought to be questioned, but the relationship between that expense
and the source to which it is purported to relate. The fact that an expense is
found to be a personal or living expense does not affect the characterization
of the source of income to which the taxpayer attempts to allocate the expense,
it simply means that the expense cannot be attributed to the source of income
in question. As well, if, in the circumstances, the expense is unreasonable in
relation to the source of income, then s. 67 of the Act provides a mechanism to
reduce or eliminate the amount of the expense. Again, however, excessive or
unreasonable expenses have no bearing on the characterization of a particular
activity as a source of income.
58
In addition to the fact that the deductibility, or otherwise, of an
expense is a separate question from the existence of the underlying source of
income, it is also true that the profitability of the activity to which the
expense relates does not affect the deductibility of the expense. In
particular, there have been a number of cases where a taxpayer’s large interest
expenses have resulted in net losses, which in turn have caused the Minister to
conclude that there is no reasonable expectation of profit, and therefore no
source of income from which the interest expenses can be deducted. However, as
stated above, reasonable expectation of profit is but one factor to consider in
determining whether an activity has a sufficient degree of commerciality to be
considered a source of income. Once that determination has been made, then the
deductibility inquiry is undertaken according to whether the expense in
question falls within the words of the relevant deduction provision(s) of the
Act. Although it is true that the phrase “personal or living expenses” in s.
18(1)(h) is defined with reference to the phrase “reasonable expectation
of profit”, as we pointed out above, this definition has a narrow scope. In
addition, it has been pointed out that the definition refers to a business
carried on “for profit or with a reasonable expectation of profit”. However,
since, to get to s. 18, it must already have been determined under s. 9 that a
business or property source exists, and since a business is defined as an
activity undertaken “in pursuit of profit”, it is hard to imagine a situation
where the phrase “business carried on for profit or with a reasonable
expectation of profit” would add any further restrictions to the activity in
question: see Owen, supra, at p. 1009.
59
The comments of Bowman J.T.C.C. in Allen, supra, at paras.
20 and 22, aptly illustrate the problems which result from intermingling the
question of the existence of a source of income with the issue of the
deductibility of expenses, in particular, interest expenses, and are worth
repeating:
How then does the fact that the acquisition of the
limited partnership interests was financed substantially by the borrowing of
money through the Equity Notes and Second Equity Notes at what, on the
evidence, was a favourable interest rate, turn a viable and profitable business
into one that had no reasonable expectation of profit and was, therefore, not a
business and not a source of income?...
...
Whatever else may be said about 99 % financing of an
investment, it certainly cannot be said that its result is that the vehicle in
which the taxpayer has invested did not carry on a business. This is wrong as
a matter of logic, law and common sense. The Minister is seeking to limit the
deduction of the amount of interest which is permitted by paragraph 20(1) (c)
by intoning the ritual incantation [REOP], where it is obvious and admitted
that the partnership is carrying on a profitable business.
Clearly the
existence of financing does not indicate that the underlying activity should
not be characterized as a source of income. On the contrary, the fact that an
activity has been financed externally is an indication that the taxpayer is
operating his or her activity in a businesslike manner. As such, the existence
of financing is an element which adds to the commerciality of a venture,
and thus operates in favour of characterizing the activity as a source
of income.
60
In summary, the issue of whether or not a taxpayer has a source of
income is to be determined by looking at the commerciality of the activity in
question. Where the activity contains no personal element and is clearly
commercial, no further inquiry is necessary. Where the activity could be
classified as a personal pursuit, then it must be determined whether or not the
activity is being carried on in a sufficiently commercial manner to constitute
a source of income. However, to deny the deduction of losses on the simple
ground that the losses signify that no business (or property) source exists is
contrary to the words and scheme of the Act. Whether or not a business exists
is a separate question from the deductibility of expenses. As suggested by
the appellant, to disallow deductions based on a reasonable expectation of
profit analysis would amount to a case law stop-loss rule which would be
contrary to established principles of interpretation, mentioned above, which
are applicable to the Act. As well, unlike many statutory stop-loss rules,
once deductions are disallowed under the REOP test, the taxpayer cannot carry
forward such losses to apply to future income in the event the activity becomes
profitable. As stated by Bowman J.T.C.C. in Bélec, supra, at p.
123: “It would be ... unacceptable to permit the Minister [to say] to the
taxpayer ‘The fact that you lost money ... proves that you did not have a
reasonable expectation of profit, but as soon as you earn some money, it proves
that you now have such an expectation.’”
B. Application
of the Source Test to the Case at Bar
61
As stated above, whether or not a taxpayer has a source of income from a
particular activity is determined by considering whether the taxpayer intends
to carry on the activity for profit, and whether there is evidence to support
that intention. As well, where an activity is clearly commercial and lacks any
personal element, there is no need to search further. Such activities are
sources of income.
62
In this case, the appellant was engaged in property rental activities.
He owned four rental condominium units from which he earned rental income. The
fact that there was no personal element to these properties was never
questioned. The units were all rented to arm’s length parties and there was no
evidence that the appellant intended to make use of any of the properties for
his personal benefit. In our view, a property rental activity which lacks any
element of personal use or benefit to the taxpayer is clearly a commercial
activity. For what purpose would the taxpayer have spent his time and money in
this activity if not for profit? As a result, the appellant satisfies the test
for source of income. Although this is sufficient to dispose of the appeal, in
our view a few additional remarks are warranted.
63
Even if the appellant had made use of one or more of the properties for
his personal benefit, the Minister would not be entitled to conclude that no
business existed without further analysis. A taxpayer in such circumstances
would have the opportunity to establish that his or her predominant intention
was to make a profit from the activity and that the activity was carried out in
accordance with objective standards of businesslike behaviour. Whether a
reasonable expectation of profit existed may be a factor that is taken into
consideration in that analysis.
64
The Minister and the courts below made much of the fact that the
appellant anticipated a capital gain from the eventual sale of the properties.
It was argued that it was this anticipated gain, and not rental profits, which
motivated the taxpayer. As well, the Minister argued that an anticipated capital
gain should not be included in assessing whether the taxpayer had a reasonable
expectation of profit. As such, it was the Minister’s submission that the
appellant should not have been allowed to deduct his interest payments
under s. 20(1) (c)(i) as amounts paid in respect of borrowed money used
to produce income from a business or property. The application of the REOP
test by the Minister was motivated by the policy concern that Canadian
taxpayers should not have to subsidize mortgage payments made in respect of
properties where the primary motivation is a long-term capital gain.
65
In response to this argument, it must be remembered that s. 20(1) (c)(i)
is not a tax avoidance mechanism, and it has been established that, in light of
the specific anti-avoidance provisions in the Act, courts should not be quick
to embellish provisions of the Act in response to tax avoidance concerns: Ludco,
supra, at para. 39; Neuman v. M.N.R., [1998] 1 S.C.R. 770, at
para. 63. In addition, in Walls v. Canada, [2002] 2 S.C.R. 000, 2002
SCC 47, the companion to this case, we point out at para. 22 that a tax
motivation does not affect the validity of transactions for tax purposes. As
such, the appellant’s hope of realizing an eventual capital gain, and expectation
of deducting interest expenses do not detract from the commercial nature of his
rental operation or its characterization as a source of income. Moreover, in Ludco,
supra, at para. 59, this Court specifically stated that s. 20(1) (c)(i)
does not require the taxpayer to earn a net profit in order for interest to be
deductible:
The plain meaning of s. 20(1) (c)(i) does not support an
interpretation of “income” as the equivalent of “profit” or “net income”.
Nowhere in the language of the provision is a quantitative test suggested. Nor
is there any support in the text of the Act for an interpretation of “income”
that involves a judicial assessment of sufficiency of income. Such an
approach would be too subjective and certainty is to be preferred in the area of
tax law. Therefore, absent a sham or window dressing or similar vitiating
circumstances, courts should not be concerned with the sufficiency of the
income expected or received. [Emphasis added.]
66
Indeed, a clear analogy can be drawn between the facts in Ludco,
and the facts in the case at bar. In Ludco, the taxpayer deducted
approximately $6 million in interest charges on borrowed money used to purchase
shares which yielded some $600,000 in dividends. On disposition of the shares
the taxpayer realized a significant capital gain. The Minister disallowed the
deduction of interest under s. 20(1) (c) on the basis that the borrowed
money was not used for the purpose of earning income from property. This Court
held at para. 54 that, in order to come within the scope of s. 20(1) (c)(i),
the taxpayer had to show that “considering all the circumstances, the taxpayer
had a reasonable expectation of income at the time the investment was made”.
The taxpayer satisfied this test, and the Court allowed the interest deduction.
67
Similarly, in this case, the taxpayer’s interest payments exceeded his
rental income for the years in question. Although the taxpayer only disposed
of one of the properties during the relevant time period, the Reemark plan held
out the prospect of an eventual capital gain on disposition. As in Ludco,
the appellant used borrowed money to engage in a bona fide investment
from which he had a reasonable expectation of income, and thus, he falls within
the scope of s. 20(1) (c)(i).
68
With respect to whether or not an anticipated capital gain should be
included in assessing whether the taxpayer has a reasonable expectation of
profit, we reiterate that the expected profitability of a venture is but one
factor to consider in assessing whether the taxpayer’s activity evidences a
sufficient level of commerciality to be considered either a business or a
property source of income. Having said this, in our view, the motivation of
capital gains accords with the ordinary business person’s understanding of
“pursuit of profit”, and may be taken into account in determining whether the
taxpayer’s activity is commercial in nature. Of course the mere acquisition of
property in anticipation of an eventual gain does not provide a source of income
for the purposes of s. 9 ; however, an anticipated gain may be a factor in
assessing the commerciality of the taxpayer’s overall course of conduct.
VII. Conclusion
69
For these reasons, we conclude that the appellant’s rental activities constituted
a source of income. As a result, we would allow the appeal with costs
throughout, set aside the judgment of the Federal Court of Appeal and refer the
assessments for the taxation years in issue back to the Minister for
reassessment on the basis that the taxpayer had a source of income from which
he was entitled to deduct losses from the rental properties in question.
Appeal allowed with costs.
Solicitors for the appellant: McMillan Binch, Toronto.
Solicitor for the respondent: The Deputy Attorney General
of Canada, Ottawa.
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