Tonn v. The Queen, [1996] 1 CTC 205 (FCA)

Linden J.A.: — This motion is brought pursuant to section 28 of the Federal Court Act, R.S.C. 1985, c. F-7, as amended seeking judicial review of a decision of the Tax Court of Canada. The issue raised in this motion concerns whether the Tax Court Judge erred in holding that losses incurred from a residential rental property are not deductible from other income as business expenses under the Income Tax Act, R.S.C. 1985, c.1 (5th Supp.), as amended.

The facts are not in dispute and may be briefly summarized. In August 1989, the applicant Enno Tonn purchased a vacant residential property in Scarborough for $245,000. The property contained two residential rental units. It was purchased with the stated intention to be used as a source of property income. To finance the purchase, the existing mortgage on the property of approximately $168,000 was assumed by Mr. Tonn at an interest rate of 11.25 per cent. This was supplemented by a $50,000 first mortgage on Mr. Tonn’s principal residence at an interest rate of 12.5 per cent, with the remainder borrowed interest-free from the third applicant in this application, Lester Sinanansingh.

At the time the property was acquired, Mr. Tonn anticipated obtaining rental income of $1,900 per month throughout 1990, and further anticipated that yearly revenues would increase by approximately 6 per cent in succeeding years. On the basis of income and expense projections, and intending certain repayments of the borrowed money, Mr. Tonn expected to begin earning profit from the property in 1992. He also stated “real estate is a good long-term investment”. Unfortunately, he did not receive the rental income he expected for 1989, nor in the subsequent two years Also, expenses were higher than he had forecasted. Hence, for the years in question - 1989, 1990 and 1991 — the hoped-for profits did not materialize.

Counsel for the applicants sought to introduce an affidavit by Enno Tonn to this Court containing facts not given in evidence at the hearing. This was strenuously objected to by counsel for the Crown. In response, counsel for the applicant stated that he would not rely on the new facts in the affidavit as they were not necessary for his argument. What was alleged in the challenged affidavit, which facts were not taken into account by this Court, was inter alia, that Mr. Tonn succeeded in discharging the $50,000 mortgage on his principal residence in 1991 and, to ameliorate further the unexpected, negative revenue situation, was joined in the venture by his wife, Rose Tonn. They both in turn agreed with Mr. Sinanansingh to convert his loan to a one-third equity interest in the property. This occurred in August, 1991 and led to a situation where some profit would be earned.

The applicants considered the rental operation a business and, in keeping with that assumption, deducted the losses from their other sources of income in 1989, 1990 and 1991. The Minister of National Revenue took issue with this and issued Notices of Reassessment for each of the taxpayers’ filings for the years in question, [1] disallowing the losses claimed.

The court of first instance

The applicants appealed to the Tax Court. During the examination-in- chief of Mr. Tonn, the Tax Court Judge articulated what he considered to be the issue before him. He said:

There is only one issue, sir: Why do these people feel entitled to have the other taxpayers of Canada assist them in paying for the losses that they have sustained on a rental property? That’s the only issue. The rest is just totally irrelevant.

A few moments later, the Judge restated the issue as follows:

You see, it comes down to a very simple thing and the Minister has spelled it out for you precisely. Did the Appellant have a reasonable expectation of profit from the property in the years in issue …

The Judge concluded that the applicants did not in fact have a reasonable expectation of profit from the property and decided the case in the Minister’s favour. In his reasons he stated:

The only matter in issue is whether or not the rental property and the rental alleged business, was in fact a business - that is with a reasonable expectation of profit.

In very simple terms, the question comes down to whether or not, having embarked on that which they claim to be a business, they have demonstrated that indeed it was a business and there are two ways of doing that. Either you show a profit, which probably makes it a business, or demonstrate clearly that despite losses there could have been and should have been a profit. The Income Tax Act is designed to tax profits, it isn’t designed to add the load to other people across the country ... Revenue Canada certainly does take into account losses where they are legitimate. They are not legitimate where it is clear that the losses represented expenses which cannot be shown to be for the purpose of gaining or producing income, that is a net income, not merely income.

After reviewing the taxpayers’ projected and actual revenues and expenses for the years 1989-91, he stated:

[T]here was never a point in time, when you take into account the mortgage interest alone and the taxes alone, that the expected rental revenue could produce a profit.

When you cannot show that there was a reasonable expectation of a profit, the operation is not a business for income tax purposes, and it is not entitled to deduct the losses incurred from other income, and that is what happened here.

The Tax Court Judge, thus, essentially ruled that the taxpayers did not and could not demonstrate that they had a reasonable expectation of profit in the circumstances. Therefore, for the years in question they were precluded from the outset from claiming a deduction because the projected revenues were insufficient to offset expenses. Furthermore, even if the projected revenues had materialized, the taxpayers’ books would still have shown a loss, according to the Tax Court Judge.

The argument before this Court

In challenging the Tax Court decision, counsel for the applicants, Clifford Rand, argues that the Tax Court Judge erred in his use of the reasonable expectation of profit test. First, Mr. Rand contends, where a taxpayer’s motives for an operation are strictly commercial, as in the present case, the Court should not substitute its business judgment for the taxpayer’s, unless profit expectations are “patently unreasonable”. Second, he suggests, the Court should allow the taxpayers a reasonable time to establish the profitability of the operation. The fact that an enterprise may incur losses during its initial years, the so-called start-up period, does not necessarily mean that a taxpayer lacks a reasonable expectation of profit in operating the business. Rather, counsel argues, only after the start-up period has passed, a period that varies according to the nature and circumstances of the business, may one objectively determine the prospect of profits according to the test. Third, he urges, the taxpayers encountered changes in circumstances beyond their control, such as a downturn in the real estate market and the failure of the rental revenues to climb the projected 6 per cent or so per year, which factors were not adequately considered in the reasons for judgment of the Tax Court Judge.

Counsel for the Crown, David Spiro, in a vigorous and well-reasoned argument, focussed on the taxpayers’ expense and revenue projections. Mr. Spiro argues that, on the expense side, the taxpayers failed to account in their projections for certain material expenses, making the projections unreasonably low. On the revenue side, he points out that, because the taxpayers offered no evidence explaining why they expected a 6 per cent yearly increase in revenues, this expectation was not reasonable. Therefore, Mr. Spiro contends, both the expense forecasts and the revenue projections were not those expected of reasonably prudent landlords. The approach of these taxpayers, therefore, was careless, casual and unbusinesslike. The sum total of these inaccuracies, argues Mr. Spiro, is that the applicants did not have a reasonable expectation of profit with respect to the Scarborough property and that their deductions were, consequently, properly disallowed.

RELEVANT LEGAL PRINCIPLES: BACKGROUND

This case is the latest in a procession of similar cases using the reasonable expectation of profit test to assess whether a claimed business loss is an allowable deduction from other income. The jurisprudence, though substantial, is sometimes confusing. Cases like the present involve difficult factual and legal considerations. Not the least of these difficulties is that, for circumstances like the present, no fewer than five possible tests for expense deductibility — four of a statutory and one of a common law origin — may be applied to decide the matter. A brief overview of this complicated state of affairs, it is hoped, might provide some clarification. In the analysis to follow, therefore, I will set out the legislative provisions applicable to the primary issue in this case, — business expense deductibility. This will provide the necessary backdrop against which I will then discuss the reasonable expectation of profit test on which basis this case must be decided.

The scheme adopted by the Income Tax Act taxes income according to source. Various re venue-generating activities are defined by the Act as distinct income sources, and computation rules specific to those sources are set out accordingly. Four such sources are contemplated: income from employment, business, property and capital gains income. A taxpayer’s total income for the taxation year, to paraphrase section 3 of the Act, is the sum total of the income and losses from each of these sources, each having been computed as per the rules pertaining to the source in question. The one exception to the simple addition-subtraction scheme envisaged by section 3 is that capital losses may be deducted only from capital gains. Each source is otherwise added to, or subtracted from, all the others.

Various expense deductions are provided in the applicable rules for each of the above four sources. The deduction rules for the property and business income sources are found substantially in sections 9 and 18 through 21. Four of these provisions are relevant to assessing the expenses presently before us, with each furnishing its own test for deductibility: they are subsection 9(1), paragraph 18(l)(a), paragraph 18(l)(h), and subparagraph 20(l)(c)(i).

Section 9 sets out the basic rules for computing income or loss from a business or property. Subsection 9(1) is specifically relevant, and reads:

9(1) Income. — Subject to this Part, a taxpayer’s income for a taxation year from a business or property is the taxpayer’s profit from that business or property for the year.

This subsection is the starting point in any analysis of the deductibility of business expenses, and is important for two reasons. First, it stipulates that references to business “income,” such as those contained in sections 18 and 20, are references to “profit”, which is a net concept. Second, by defining business income as profit, subsection 9(1) implicitly authorizes the deduction of legitimate expenses. In other words, profit, as a net concept, refers to the excess of revenues over expenses. Thus, profits are achieved only after expenses are deducted.

Subsection 9(1) has therefore been regarded as the provision of “first recourse” [2] in a deductibility analysis, and by its reference to “profit” has been interpreted to incorporate a business test for deductibility. The deductibility test implied by the section, as stated many years ago by Thorson

P. in Royal Trust Co. v. Minister of National Revenue, is grounded in “well accepted principles of business practice”: [3]

[T]he first approach to the question whether a particular disbursement or expense was deductible for income tax purpose was to ascertain whether its deduction was consistent with ordinary principles of commercial trading or well accepted principles of business ... practice. [4]

Among other things, well accepted principles of business suggest that only expenses incurred as relevant and working expenses of some process of income earning are deductible. Those which bear no relation to the income earning process, and those which are of a personal nature, are not. Since the pursuit of business income is founded on the intention to earn profit, subsection 9(1) incorporates as a test for deductibility the intention to make profit. This understanding of subsection 9(1) was accepted by lacobucci J. for the Supreme Court of Canada in Symes where he stated:

Adopting this approach to deductibility, it becomes immediately apparent that the well accepted principles of business practice encompassed by s. 9(1) would generally operate to prohibit the deduction of expenses which lack an income earning purpose ... [5]

It is also apparent that subsection 9(1) incorporates, in fewer words, certain of the deductibility prohibitions contained in section 18, specifically the general prohibitions contained in paragraphs 18(l)(a) and (h). This overlap is of little legal consequence, except that the latter sections provide more specifically worded forms of prohibitions than are implied in the former.

The second and third sections relevant to assessing the deductibility of the present expenses are both found in section 18. Section 18 is the first of three sections that prescribe statutory limitations on expense deductibility. Paragraph 18(1 )(a) prescribes the most general of them and reads:

18(1) General limitations. — In computing the income of a taxpayer from a business or property no deduction shall be made in respect of

(a) general limitation. — 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.

As noted above, paragraph 18(l)(a) is to be read in light of subsection 9(1). The paragraph 18(l)(a) reference to income must therefore be read as a reference to net income, or profit. Taken as such, paragraph 18(l)(a) sets out a deductibility test quite similar to that implicit in subsection 9(1). Wilson J., in Mattabi Mines Ltd. v. Ontario (Minister of National Revenue), [1988] 2 S.C.R. 175, [1988] 2 C.T.C. 294 at page 189 has called the former a “general purpose or intention test” for deductibility. [6] To be deductible according to paragraph 18(l)(a), an expense must have been incurred with the intention of producing profit. In other words, the expense must have been incurred within a business framework, bearing some relation to the income earning process. I might mention in this context that such intention, strictly speaking, is subjective; no requirement of objective reasonability is expressly imposed by the section. I will be returning to this issue below.

The next relevant provision is paragraph 18(1 )(h), which prohibits the deduction of personal or living expenses. It reads as follows:

18(1) General limitations. - In computing the income of a taxpayer from a business or property no deduction shall be made in respect of ...

(h) personal and living expenses. - 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;

Subsection 248(1) defines personal or living expenses in part as:

“personal or living expenses”. — “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 with a reasonable expectation of profit, ...

Some legislative overlap is apparent here, when one compares paragraph 18(l)(a) to paragraph 18(l)(h). Personal expenditures are impliedly excluded by the intention test of paragraph 18(1 )(a), for they are external to the pursuit of profit; this makes paragraph 18(1 )(h) somewhat redundant. Nevertheless, paragraph 18(l)(h) makes it abundantly clear that expenses incurred for personal purposes are not deductible. It differs, however, from paragraph 18(l)(a) in that its reference to “reasonable expectation of profit” contemplates an objective assessment of a business enterprise to determine whether any given expense was or was not of a personal nature. Such objectivity is not specifically mandated by either subsection 9(1) or paragraph 18( l)(a).

The final provision relevant to the present inquiry is subparagraph 20(l)(c)(i) which permits the deduction of interest expenses incurred with respect to borrowed money. It states:

20(1) Deductions permitted in computing income from business or property. — Notwithstanding paragraphs 18(l)(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) interest. - an amount paid in the year or payable in respect of the year (depending upon the method regularly followed by the taxpayer in computing the taxpayer’s 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.

As with section 18, references to income in section 20 must be read as references to profit. This noted, and also noting the reference to “purpose” in the section, subparagraph 20(l)(c)(i) sets out a business purpose test similar to the subjective intention tests in subsection 9(1) and paragraph 18(l)(a), except that the former applies only to interest expenses. In commenting on the test set out in subparagraph 20(l)(c)(i), Dickson C.J. stated in Bronfman Trust v. R. [7] that it requires a form of tracing to trigger its operation:

The statutory deduction thus requires a characterization of the use of the borrowed money as between the eligible use of earning non- exempt income from a business or property and a variety of possible non-eligible uses. The onus is on the taxpayer to trace the borrowed funds to an identifiable use which triggers the deduction. [8]

In addition to the above characterization, subparagraph 20(l)(c)(i) also requires that the purpose for which the funds are used be characterized. As Dickson C.J. wrote in Bronfman:

The interest deduction provision requires not only a characterization of the use of the borrowed funds, but also a characterization of “purpose”. Eligibility for deduction is contingent on the use of borrowed money for the purpose of earning income.” [9]

Subparagraph 20(l)(c)(i), it can be seen, sets out yet another business purpose test, albeit of a rather narrow application, but in other respects much like the tests contemplated by subsection 9(1) and paragraph 18(l)(a). In certain circumstances, and in view of the requirements set out in the Bronfman decision, any given interest expense may have to be allocated ratably between eligible and non-eligible uses to the extent reasonably practical. Such allocation is contemplated by the statutory provision and is not unusual in the case law. [10]

The Mo Ido wan test

In addition to these overlapping legislative provisions, each of which outlines a deductibility test applicable to the present circumstances, one must also consider the common law Moldowan test, which requires a “reasonable expectation of profit”. This was the test applied by the Tax Court Judge. The test was articulated by Mr. Justice Dickson in the landmark 1978 decision, Moldowan v. R.\ [11] The case concerned whether a horse farming operation was the applicant’s chief source of income under what was then subsection 13(1), now subsection 31(1), of the Income Tax Act. In the course of deciding the matter, Dickson J. stated:

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.

These words, well known to practitioners and department personnel alike, have become the first and often last resort for most cases involving the question of business expense deductibility. The words “reasonable expectation of profit” have, as such, assumed the status of a benchmark test by which questions of business expense deductibility are normally determined.

To gain a better understanding of the Moldowan test and its proper application, it might be useful to compare the test with its statutory counterparts. As an initial observation, the phrase “reasonable expectation of profit” is not unknown to the Income Tax Act. It is, in fact, found in numerous sections of the Act and is mainly used as a test for discriminating between certain acceptable and unacceptable transactions within the meaning of the sections in which it is found. More significantly, however, the phrase is found in paragraph 18( l)(h) through the incorporation of the subsection 248(1) definition of “personal or living expenses”, as explained above.

Some commentators and a handful of cases on the matter suggest that the reasonable expectation of profit test, as set out in Moldowan, had its genesis in paragraph 18(l)(h) and was merely intended as a restatement of the personal expense prohibition of that paragraph. Its proper scope, they suggest, should be no greater than that contemplated by paragraph 18(l)(h). One expression of this view, for instance, was stated by R.B. Thomas and T.E. McDonnell as follows:

The expression [reasonable expectation of profit] is found in the Income Tax Act in the extended definition of personal or living expenses, which includes the phrase “the expenses of properties ...not maintained in connection with a business carried on with a reasonable expectation of profit”. Over time, however, “reasonable expectation of profit appears to have gained an independence from the extended definition of personal and living expenses and acquired a life of its own. [13]

Similarly, disapproving of the apparent growing independence of the test, Bowman J.T.C.C. stated:

The losses were disallowed on the basis that the expenses were personal and living expenses and that there was, to use the words that are regularly intoned as a sort of ritual incantation, “no reasonable expectation of profit”. There is no basis in this case for the “no reasonable expectation of profit” concept, if indeed it exists at all as an independent fiscal principle. It has been plucked out of the context of Mr. Justice Dickson’s dictum in Moldowan ... and comes originally from the definition of personal and living expenses in section 248 of the Income Tax Act.' [14]

In support of this view of the origin of the test, one might note that Dickson J., in the Moldowan decision specifically referred to the personal expense definition immediately after the paragraph from which his words quoted above were taken. Also of importance is that one of the primary questions in the Moldowan case concerned whether the farming operation in question was a real business or whether the expenditures were personal. The prominence of this issue in the case, and the parallel wording used by the test and paragraph 18(1 )(h) might well suggest to some that the reasonable expectation of profit test was intended to differentiate between personal and business expenses and nothing more.

I do not, however, find this reading of the Moldowan decision wholly convincing. In that decision, the test propounded by Dickson J. was used to disallow the deduction of personal expenses. Section 31 cases often involve situations where a farm is operated more as a hobby than a business, and where the initial question, often determinative, concerns whether the expenditures in question are personal. However, Dickson J. did not cite the reasonable expectation of profit test solely to deal with this issue. And, on further examination, it becomes apparent that he did not intend that such “hobby” scenarios be the sole fact pattern to which the test might apply. He also intended to put to rest the notion that to have a source of income under then subsection 13(1) (now 31(1)) one must have a net income from the source. It is here that the test imported broader connotations. In this regard he referred to Dorfman v. Minister of National Revenue, [1972] C.T.C. 151, 72 D.T.C. 6131 (F.C.T.D.). which states the following on “source of income”:

Meaning of ‘source of income’

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. [15]

This quote, by its mention of the Act’s income sources, suggests that Dickson J. intended the reasonable expectation of profit test, which was similar to that set out specifically in paragraph 18(1)(h), as a general limitation on deductibility, precisely as he stated the test. The wording of the test was wisely made to harmonize with the statutory provision, thus avoiding potential conflict in the meaning of different phrases. Its application was not restricted to farming cases under section 31, to personal expenditure cases under paragraph 18(1 )(h), or even to business expense cases under the business category of income source. This view of the Moldowan test respects the general tone of Dickson J.’s reference to the concept of “source of income”, and also accords with the use made of the test in much of the case law. I am satisfied, therefore, that the scope originally contemplated for the Moldowan test by Dickson J. was broader than that suggested by paragraph 18(l)(h); that this section is not properly viewed as a statutory source for the Moldowan test; and that the section by itself does not, therefore, dictate a more restrictive reading of Moldowan.

However, I do not intend by this analysis of Moldowan to discount the concerns felt by the authors in their statements above about the expanding use of the test. It is necessary to be clear about the purpose of the test, both as it is derived from the original Moldowan decision and from its comparison to relevant statutory tests. The Moldowan test is stricter than the business purpose tests set out in subsection 9(1) and paragraph 18(l)(a). As mentioned above, these tests stipulate that a taxpayer be subjectively motivated by profit when incurring an expenditure. The Moldowan test, however, also requires the presence of a profit motive, but, in addition, it must be objectively reasonable. In reality, in most situations, the objective Moldowan test and the subjective statutory tests will not yield many different results. A subjective intention is often determined by what may be reasonably inferred from the circumstances. Someone who claims a subjective intention that is foolish may not be believed. A taxpayer’s intention to produce profit normally has to be reasonable before a Court will accept it. There is some difference of meaning and interrelationship between subjective and objective, however. Iacobucci J. attested to this in Symes where he stated the following concerning business intention within paragraph 18(1)(a):

As in other areas of law where purpose or intention behind actions is to be ascertained, it must not be supposed that in responding to this question, courts will by guided only by a taxpayer’s statements, ex post facto or otherwise, as to the subjective purpose of a particular expenditure. Courts will, instead, look for objective manifestations of purpose, and purpose is ultimately a question of fact to be decided with due regard for all of the circumstances. [16]

Summarizing the above analysis, the Moldowan test, though similarly worded, does not derive from any of the deductibility provisions in sections 9, 18, and 20. The test is much like the business intention tests of subsection 9(1) and paragraph 18(l)(a), but it contemplates stricter application because of its objective nature. To be sure, the objective aspect of the Moldowan test is the most significant feature distinguishing it from the general deductibility tests in the Act. This feature of the test has been criticized because objective reasonability may be used unfairly to police the business decisions of taxpayers from a position of hindsight. [17] One author has stated his criticism in these words:

[R]ather than simply using the test to determine whether the taxpayer had a business or a source of income, Revenue Canada is using the test to review, with the benefit of hindsight, the business judgments of taxpayers. It is disappointing to find that Revenue Canada is interested in pursuing this kind of subjective business-evaluation approach, but it is even more distressing to find considerable acceptance of this approach by the courts. In a number of cases, the courts have simply adopted Revenue Canada’s view to the effect that Revenue Canada and, ultimately, the courts should examine the viability of every business enterprise in order to determine whether the taxpayer is entitled to deduct expenses that have been incurred. Of course, this examination always occurs years after the commencement of the business and then the determination is ultimately based, in large measure, on the application of hindsight. There seems to be little justification, in the Act or elsewhere, for the adoption of such an approach by the courts. As stated earlier, the Moldowan decision does not mandate such an approach .., [18]

Looked at another way, the Moldowan test may be seen as originating in the principles and purposes of the Act, and viewed as an early harbinger of the modern approach to taxation statutes. This approach was firmly embedded in the jurisprudence in Stubart Investments Ltd. v. R., [1984] 1 S.C.R. 536, [1984] C.T.C. 294, 84 D.T.C. 6305 and has since been variously termed the “teleological approach” by Gonthier J. in Quebec (Communauté Urbaine) v. Corp. Notre-Dame de Bon-Secours, [1994] 3 S.C.R. 3 (sub. nom. Notre-Dame de Bon-Secours (Corp.) v. Quebec (Communauté Urbaine)) [1995] 1 C.T.C. 241, (sub. nom. Corp. Notre- Dame de Bon-Secours v. Québec (Communauté Urbaine)) 95 D.T.C. 5017 at 17 (C.T.C. 250, D.T.C. 5022) and the “words-in-total-context approach” by MacGuigan J. in Lor-Wes Contracting Ltd. v. Minister of National Revenue) [19] But by whatever name is used, this approach requires an interpretation of the Act in harmony with its fundamental purposes. Such purposive analysis has inevitably involved the Courts in a more rigorous scrutiny of taxpayer activities for transactions contrary to the purposes of the Act. Chief Justice Dickson put the matter as follows in the Bronfman case:

Assessment of taxpayers’ transactions with an eye to commercial and economic realities ... may help to avoid the inequity of tax liability being dependent upon the taxpayer’s sophistication at manipulating a sequence of events to achieve a patina of compliance with the apparent prerequisites for a tax deduction. [20]

Whatever the particular circumstances, transactions contrary to the purposes of the Act are generally those where the underlying aim is inappropriate tax avoidance. The attempt to deduct the costs of what are essentially hobby or personal expenses as a business expense is one good example. As common sense might suggest, the Act’s fundamental purposes are not easily construed as contemplating such tax avoidance. It is, I believe, in this spirit that Dickson J. penned the Mo Ido wan test.

I have dwelt upon the issue of the origin of the “reasonable expectation of profit” test because a proper understanding of it is necessary to the resolution of this application. As a common law formulation respecting the purposes of the Act, the Moldowan test is ideally suited to situations where a taxpayer is attempting to avoid tax liability by an inappropriate structuring of his or her affairs. One such situation is the attempted deduction of an expense incurred to gain a tax refund. [21] Another is an attempt by a taxpayer to deduct personal housing expenses under the guise of a freelance typing business operated by his wife. [22] These cases are merely instances where an inappropriate use of the Act is attempted, and where the Moldowan test has rightly denied deductibility on the basis that the Act’s purposes would otherwise be violated.

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. Rather, the Act taxes on the basis of the economic situation of the taxpayer — as it is in fact, and not as it should be, subject to what is said below.

It seems to me that for most cases where the department desires to challenge the reasonableness of a taxpayer’s transactions, they need simply refer to section 67. This section provides that an expense may be deducted only to the extent that it is reasonable in the circumstances. They need not resort to the more heavy-handed Moldowan test. In fact, in many cases, resorting to section 67 may well be more appropriate. This point has been made more than a few times by Bowman J.T.C.C. In Cipollone v. R., (sub. nom. Cipollone v. Canada) [1995] 1 C.T.C. 2598, [1994] E.T.C. 405 for example, the taxpayer attempted to deduct a variety of large expenditures as part of her “humour therapy” business. Despite the unusual nature of the business, Bowman J.T.C.C. found the business to be bona fide and thus not a candidate for the application of Mo Ido wan. He added:

The reason her losses were as great as they were was not because the business had no reasonable expectation of profit or because she was not expending money for the purpose of gaining or producing income from a business. I find as a fact that she was spending money in order to earn a profit and that her expectation of earning a profit was reasonable, if she had chosen to claim reasonable expenses. The problem lies not in the absence of a reasonable expectation of profit — businesses of this sort can be quite lucrative - but rather in the attempt to deduct unreasonable expenses. [23]

Bowman J.T.C.C.’s approach to the problem in the case above seems very sensible and might be considered in future cases such as this one.

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.

THE CASE LAW

A closer look at this jurisprudence will illustrate that this is the approach now taken in most of the cases. The cases in which the “reasonable expectation of profit” test is employed can be placed into two groups. One group is comprised of the cases where the impugned activity has a strong personal element. These are the personal benefit and hobby type cases where a taxpayer has invested money into an activity from which that taxpayer derives personal satisfaction or psychological benefit. Such activities have included horse farms, [24] Hawaii and Florida condominium rentals, [25] ski chalet rentals, [26] yacht operations, [27] dog kennel operations, [28] and so forth. Though these activities may in some ways be operated as businesses, the cases have generally found the main goal to be personal. Any desire for profit in such contexts is no more than a “pious wish” or “fanciful dream”. [29] It is only a secondary motive for having set out on the venture. What is really going on here is that the taxpayer is seeking a tax subsidy by deducting the cost of what, in reality, is a personal expenditure.

One such hobby case is McKay v. Minister of National Revenue (1993), 93 D.T.C. 1046 where Brulé J.T.C.C., in deciding that an underwater diving instruction and photography operation did not comprise a business, stated:

Although the Appellant’s course of action demonstrated a dedication to the scuba diving field, this is not sufficient to take it beyond the character of a mere hobby. In my view, on the basis of all the evidence, the Appellant has failed to establish that he did possess a reasonable expectation of making a profit from an underwater diving instruction and photography business for the years under

review. [30] 0

review.

It is not that the impugned activities in these cases are in themselves any more or less prone to being run like a business. Rather, it is the simple fact of how they are run which is decisive: though the taxpayer might well desire to profit from the activity, the profit motivation is not the main reason for the activity. Rather, the element of personal enjoyment is the dominant, motivating force.

In another hobby case, Escudero v. Minister of National Revenue, [1981] C.T.C. 2340, 81 D.T.C. 301, the applicant deducted losses arising from a dog-breeding operation. Though the operation was run ostensibly as a business, the taxpayer had an obvious personal interest in dogs, which was evidenced, among other things, by the fact that the appellant had purchased a mobile home for attending dog shows. In deciding that the deductions were correctly disallowed, Chairperson Cardin stated:

Although the appellant’s breeding kennel may be operated in a businesslike manner, it lacks, in my opinion, the one essential ingredient to make it a business and that is a reasonable expectation of profit. On the basis of the evidence and particularly the financial statements for the years 1975 to 1980 inclusive, I do not believe the appellant can, in the foreseeable future, reasonably expect to realize the profit from the operation of his breeding kennel. For whatever reason the appellant may have engaged in the breeding of pure stock St. Bernard dogs, it was not, in my opinion, for the purpose of realizing a profit from the breeding operations. [31]

A further case illustrating the personal benefit element is Huot v. Minister of National Revenue, [1990] 2 C.T.C. 2364, 90 D.T.C. 1818. In this case, the taxpayer acquired certain properties from his parents and in turn rented one of them to his parents for a rental value far below the market rate. The applicant then attempted to deduct losses arising from this arrangement. The Tax Court Judge properly found that the applicant did not entertain a reasonable expectation of profit and dismissed the appeal.

Lastly, in Maloney v. Minister of National Revenue, [1989] 1 C.T.C. 2402, 89 D.T.C. 314, a taxpayer rented a house she had purchased from her mother back to her for a low rent and attempted to deduct the losses incurred. In deciding that a motive of personal benefit predominated in these circumstances, the Tax Court Judge stated:

I do not doubt in any way the good faith of the Appellant. She presented her own appeal with sincerity and conviction. I find, however, that the plan for the mother to be self-supporting and thereby pay a reasonable rent which would permit the Appellant to derive income from the property is a plan that was not well thought out. The subjective, good faith, commercial hopes and dreams of an individual taxpayer do not confer upon his or her enterprise a reasonable expectation of profit if that enterprise does not meet the objective criteria of a prudent business in similar circumstances.^^ [32]

The other group of cases consists of situations where the taxpayer’s motive for the activity lacks any element of personal benefit, and where the activity cannot be classified as a hobby. The activity, in these cases, seems to be operated in a commercial fashion and not as a veiled form of personal recreation. Usually these deductions are not challenged by the Department, and, therefore, they do not get appealed and are not reported very often in the law reports. The Courts still have a role, however, in deciding whether there exist less apparent factors which might suggest a different conclusion in cases such as these. The Courts are less likely to disallow these expenses, but they do so in appropriate circumstances.

Thus, in Baker v. Minister of National Revenue, supra, Couture C.J.T.C. found that the taxpayer conducted himself in a business-like manner and that it would not be appropriate to disallow the deductions he claimed:

In the present appeal, it appears to me that the Appellant conducted himself like a normal average investor, an investor who was not sophisticated because of lack of professional training, but who nonetheless had a working knowledge of the basic rules of the investment process. He knew the area where the property was located. He had received assurances from the real estate agent that there would not be any problem renting the property throughout the year and furthermore the agent had indicated the rent that could be obtained. ... The fact that the rental projections did not materialize, which was the main and only cause of the failure of the venture certainly cannot be imputed to the Appellant. It was simply part of the risk related to the venture.^ [33]

In a contrasting case, the taxpayer attempted to deduct rental losses on a property. While recognizing that it is inappropriate for the Minister or the Court to substitute its business judgment for that of taxpayer, Bowman J.T.C.C. found that the operation did not meet the Mo Ido wan criteria:

Nonetheless, there must be sufficient of the indicia of commerciality to justify the conclusion that there is a real commercial enterprise being conducted. I do not find that the arrangements made by the appellant contain those indicia. The 100 per cent financing, the payment of a 25 per cent commission to Port Charlotte Homebuilders and the substantial expenses and consequent loss in comparison to the gross revenues and the overall cost of the property are among the factors that I find inconsistent with a genuine commercial operation.

This conclusion does not of course justify the automatic disallowance of losses in the early years of a genuine viable rental operation. There should be a reasonable period in which to permit the enterprise to become self-supporting. In the years under appeal, I do not think it had reached the stage where it can be called either a business or a viable rental operation. [34]

Other cases utilize the Moldowan case in what appear to be regular commercial type situations exist. The facts, of course, are always of importance in sorting out which cases will be placed on the other side of the line. Hence, where a commercial enterprise is operated at a loss in order to generate tax refunds or other such tax consequences, the Court will likely find that the enterprise is not a business under the Moldowan test. [35] In other situations, the Court may decide 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. This was the situation before this Court in Landry v. R., (sub. nom. Landry v. Canada) [1995] 2 C.T.C. 3, 94 D.T.C. 6624 (F.C.A.). In deciding that a lawyer’s expectation to earn a profit from a rejuvenated legal practice, recommenced in his seventies, was not objectively reasonable, Décary J. stated:

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.... There comes a time in the life of any business operating at a deficit when the Minister must be able to determine objectively, after giving someone a head start for a number of years, as the case may be, that a reasonable expectation of profit has turned into an impossible dream. [36]

I might note for the record that the factual circumstances in Landry were not entirely free from suspicion. One significant source for the losses claimed in the case was part of the cost of the personal residence of the taxpayer from which the practice was run at least part of the time.

In another case, Engler v. R., (sub. nom. Engler v. Canada) [1994] 2 C.T.C. 64, 94 D.T.C. 6280 (F.C.T.D.), per Joyal J. a taxpayer attempted to deduct losses from a small business he formed to buy and sell various gift items such as brass ware, watches, rings and household gadgets. The profits intended from this business were to supplement the taxpayer’s employment income. Though no personal element was apparent in how the taxpayer ran the business, and though the type of business suggested a bona fide commercial operation, the losses arising from it were held to be non- deduct- ible because the venture lacked a reasonable expectation of profit. Even though the operation could not otherwise be impugned, the rather large losses claimed were too suspicious to be overlooked, thus suggesting that a non-commercial intention lay at their source. In deciding the matter, Joyal J. stated:

On the evidence, it might be said that the plaintiff originally brought the whole controversy upon himself by claiming expenses which could not by any stretch of the imagination be justified. In the face of this obvious disproportion between the resulting losses and the volume of business generated, or the capital committed, or the time and energy devoted to it, it was an easy slide from a determination of the unreasonableness of the expenses to an assumption that the venture, in any event, did not have a reasonable expectation of profit? [37]

I also find the following words from earlier in the judgment instructive:

It is only when the taxpayer has other sources of income against which any such losses are claimed that Revenue Canada’s antennae start sending out signals which might become a source of concern to the taxpayer. Depending on the circumstances in each case, Revenue Canada will assume that the taxpayer is engaged in a business which objectively has no reasonable expectation of profit. The inference will be drawn that the taxpayer is merely engaged in a sport, hobby or some other self-satisfying endeavour, and if his losses are charged to his other sources of income, he is effectively reducing his tax exposure. [38]

The difficulty the taxpayer could not overcome was the inference, derived from the unreasonable nature of the expenses, that the business was in fact not operated for business reasons.

When the cases are categorized into two groups as above, one cannot help observing that the hobby and personal benefit cases are rarely decided in the taxpayer’s favour. In contrast, where the activity is purely commercial, they rarely are challenged. If they are the Courts have been reluctant to second-guess the taxpayers, with the benefit of the doubt being given to them. I also note that in terms of sheer numbers, the hobby/personal- benefit cases vastly outnumber those of the commercial activity and variety, which are quite rare, indicating that taxpayers are challenged less often in such situations.

The primary use of Mo Ido wan as an objective test, therefore, is the prevention of inappropriate reductions in tax; it is not intended as a vehicle for the wholesale judicial second-guessing of business judgments. A note of caution must be sounded for instances where the test is applied to commercial operations. Errors in business judgment, unless the Act stipulates otherwise, do not prohibit one from claiming deductions for losses arising from those errors. This point was stated strongly by Sheldon Silver:

It is submitted that it should not be the role of Revenue Canada to determine what businesses taxpayers should attempt to pursue. In fact, governments in Canada have often stated that new businesses and risk-taking should be encouraged and have, from time to time, enacted legislation to encourage such activity. Canadian chartered banks have recently been seriously criticised by the press and government officials for not providing adequate lending facilities to small and new businesses. Clearly, Revenue Canada’s attempt to penalize taxpayers who are unsuccessful after taking these risks is inconsistent with the government’s promotion of private entrepreneurs. [39]

This criticism was echoed by Bowman J.T.C.C. in Bélec v. R., where he stated:

It must be noted that these losses were incurred solely in a business context. There was no personal element, either in his purchase nor in his use of the building. The appellant is an experienced businessman. He took his decision in good faith on his best judgment and on the facts available to him at the time. It is not up to the Minister (or this Court) to substitute his business acumen for that of the taxpayer, with the benefit of hindsight. The question to be asked is not, “Knowing what I know now, would I have embarked upon this enterprise?” The answer is no doubt “No”, because the question only comes up when there are losses. [40]

And finally, the same caution was reiterated in Nichol v. R., supra:

[Mr. Nichol] 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. We were, after all, not there in 1986. [41]

Though I do not support the use in the Nichol case of the word “patently”, I otherwise agree that the Moldowan test should be applied sparingly where a taxpayer’s “business judgment” is involved, where no personal element is in evidence, and where the extent of the deductions claimed are not on their face questionable. However, where circumstances suggest that a personal or other-than-business motivation existed, or where the expectation of profit was so unreasonable as to raise a suspicion, the taxpayer will be called upon to justify objectively that the operation was in fact a business. Suspicious circumstances, therefore, will more often lead to closer scrutiny than those that are in no way suspect.

Analysis

I am now ready to decide this case. A variety of factors have been proposed over the years by which objective reasonability might be demonstrated in given circumstances. In the original Moldowan decision, these factors were enumerated as follows:

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 capital cost allowance. The list is not intended to be exhaustive. [42]

Another listing of the factors to be assessed was set out in Sipley v. R.:

The objective test includes an examination of profit and loss experience over past years, also an examination of the operational plan and the background to the implementation of the operational plan including a planned course of action. The test further includes an examination of the time spent in the activity as well as the background of the taxpayer and the education and experience of the taxpayer. [43]

Finally, Landry v. R. suggests the following items to consider:

Apart from the tests set out by Mr. Justice Dickson, the tests that have been applied in the case law to date in order to determine whether there was a reasonable expectation of profit include the following: the time required to make an activity of this nature profitable, the presence of the necessary ingredients for profits ultimately to be earned, the profit and loss situation for the years subsequent to the years in issue, the number of consecutive years during which losses were incurred, the increase in expenses and decrease in expenses in the course of the relevant periods, the persistence of the factors causing the losses, the absence of planning, and the failure to adjust. Moreover. it is apparent from these decisions that the taxpayer’s good faith and reputation, the quality of the results obtained and the time and energy devoted are not in themselves sufficient to turn the activity carried on into a business. [44]

These quotations suggest that the list of relevant factors is growing and that it may continue to grow. What this indicates is that a detailed look at the business in the context of its operations is what is required, and that reasonableness is to be assessed on the basis of all the relevant factors, both the already listed ones and any new ones that may be helpful.

As should be readily apparent, the most important factor in this case is the nature of the operation from which the deductions were claimed.

This operation was purely commercial. It was a real estate venture, and did not involve an element of personal satisfaction for those operating it. By personal satisfaction, of course, I mean that the rental operation had neither a hobby nor a personal benefit element about it. The taxpayers purchased the property as a form of business investment. It was not a residence for them. It was not a future retirement home in some balmy southern climate. Neither was it a residence for children or other relations. It was a residential property purchased for commercial purposes. There was nothing suspicious about it.

Of similar importance is the scale of the operation, the people involved and the context. The property in question was a residential house. It was purchased at a time when real estate held the prospect of profitable returns. The taxpayers are not, and never presumed to be, sophisticated real-estate investors. No elaborate market or economic analyses were undertaken by them. No complicated marketing study was performed. The taxpayers, like many others before them, simply decided to purchase a house for the purpose of gaining income, and as a long-term investment. To this end they compared in general terms the money they expected to spend with the revenues they thought they might earn, and took a chance. They were optimistic, perhaps too optimistic. Nevertheless, the absence of a more professional form of investment analysis does not necessarily suggest that the taxpayers unreasonably expected profits to flow from the enterprise.

The taxpayers erred and did not make money, as they had hoped. They had a plan, albeit, a rudimentary one, which they tried to follow. They may have based their expectations on misguided assumptions. One such assumption, and one on which Crown counsel focussed with some emphasis, was that rents would increase by an average of about 6 per cent per year. In his argument on this point, Mr. Spiro suggested that, because the taxpayers offered no explanation as to why they projected this increase, the expectation cannot be seen as reasonable. I note, however, that at the time the house was originally purchased, rental increases allowed by regulation averaged a consistent 6 per cent. [45] It was, therefore, not an unreasonable assumption to think that this trend would continue. Unfortunately for them, the real estate market went sour. Moreover, in 1990, the newly elected provincial government announced a moratorium on rent increases and, furthermore, that retroactive statutory guidelines would soon be enacted to restrict rent increases. Such legislation came as promised and increases were restricted to less than 5 per cent. [46] In many instances this legislation imposed rent decreases on rental units, or froze rental prices for an unspecified term. Suffice it to say that rental prices during those years became very unpredictable and generally went into decline. Whether the slump was a product of the new rent legislation, of the onset of a deep recession, or other market forces, it affected the taxpayers’ plans nega- tively.

Another factor to consider is the “time required to make an activity ... profitable”. The three taxation years in question were the initial years of the operation of the venture. The jurisprudence has long accepted that during the start-up phase of a business, courts will be lenient in applying the Moldowan test. The leniency is only fitting, for start-up is a time when uncertainty is necessarily great, and when businesses generally sustain the heaviest losses. Due to these reasons, several years may pass before one can tell whether a business will be profitable. The Courts have recognized this by allowing what is in effect a grace period for emerging operations. Encouraging the creation of new businesses makes both good economic and tax sense, which is why the Act contains many provisions to help the founding of new enterprises. The basis for allowing leeway in the start-up phase of an operation was succinctly stated by Bowman J.T.C.C. in Bélec v. R.:

Many businesses are risky or require considerable expenditure at the outset. Some succeed, some fail. It would be manifestly unfair for the Minister to be able to participate in the profits of those that succeed and to disallow the expenses of those that do not succeed on the assumption that the Minister, with his business hindsight, should be able to consider that the entrepreneur did not have a reasonable expectation of profit. It would be equally unacceptable to permit the Minister to disallow the deduction for losses at the beginning of a business’s activities on the assumption that there was no reasonable expectation of profit, and then, after the business succeeded, to demand part of the profit as taxes by saying to the taxpayer “The fact that you lost money when you began the business 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 . [47]

These considerations apply equally to a rental operation. The purchase of a residential unit for rental purposes requires a heavy capital outlay. The purchaser is not necessarily expected to cover these outlays with cash, nor is it necessary to demonstrate profitability right away. As the debt is paid off, the cost of interest reduces and the profit or chance thereof increases. The taxpayers were not given enough time to prove the viability of the operation.

In light of all these considerations, I cannot conclude that the property was purchased for any motive except to make profit. What reason, if not commercial, could the applicants have had for the purchase of this property? In this respect I agree with what was stated by Bowman T.C.C.J in Eleuteri v. R., supra:

Where we have a property whose purpose is the production of rent from arm’s length tenants, and there is no element of personal use or enjoyment involved, the question must be asked “If the purpose of the expenditures is not to earn income, what then is its purpose?” [48]

Furthermore, the taxpayers were reassessed on the initial years of the operation, during which time measures were taken to counteract the unexpected negative revenue situation which the venture presented. I notice that Mr. Tonn’s intention to pay down the amount owing on the property was an intention he developed before the venture began accumulating losses.

A further matter worthy of mention is that real estate, like shares, may be purchased not only to create an income stream but with an eye to an eventual capital gain. Mr. Tonn testified that “real estate is a good long term investment”. One reason why real estate and securities alike present good investment possibilities is that they offer the possibility both of earning income and of obtaining capital gains in the future. Purchasers usually intend to profit from both the income and the longer- term capital aspects, and, if they do, they pay tax on both sources of profit. This matter was the subject of a comment by Martland J. in Irrigation Industries Ltd. v. Minister of National Revenue, [1962] S.C.R. 346, [1962] C.T.C. 215, 62 D.T.C. 1131 (S.C.C.) where, speaking of the purchase of securities, he stated:

It is difficult to conceive of any case, in which securities are purchased, in which the purchaser does not have at least some intention of disposing them if their value appreciates to the point where their sale appears to be financially desirable. [49]

Disposition

My disposition of this case is therefore as follows. The Tax Court Judge erred in principle as well as in his application of the reasonable expectation of profit test, as it is now understood. He did not consider all of the factors he should have considered, nor did he assess the context fully. The evidence clearly showed that the taxpayers engaged themselves in a business enterprise and their expectations of profit were not unreasonable in the circumstances. A small rental business was launched without the aid of sophisticated market analysis at a time when the rental market looked promising. Soon after, as a result of unforeseen circumstances, it became precarious. No personal benefit accrued to the taxpayers by the rental arrangements. The property was not a vacation site. The house was not used to give free or subsidized housing to relatives or friends. They made an honest error in judgment and lost money instead of earning it. It is not for the Department (or the Court) to penalize them for this, using the reasonable expectation of the profit test, without giving the enterprise a reasonable length of time to prove itself capable of yielding profits.

These three applications are allowed, the decisions of the Tax Court Judge are set aside and the cases are remitted to the Tax Court to be sent back to the Minister to be dealt with in accordance with these Reasons. The costs of this application and the hearing in the Tax Court are to be paid to the applicants.

Applications allowed.