Armstrong v. The Queen, 85 DTC 5396, [1985] 2 CTC 179 (FCTD)

Rouleau, J:—Both cases were tried on common evidence and were the subject of identical argument. File T-957-84 was the matter argued and any decision rendered is applicable to file T-956-84.

The issue is to determine whether the purchase of a yearling thoroughbred horse named “Stone Manor”, and the sale, some three years after purchase, was a Capital disposition or “an adventure in the nature of trade”.

The essential facts are as follows:

The plaintiff, a resident of the Town of Stouffville in the Regional Municipality of York, during most of his lifetime has been primarily involved in residential construction and land development. In 1978, accompanied by a thoroughbred horse trainer, he attended yearling sales at an auction in Lexington, Kentucky, at which time he purchased a yearling called “Stone Manor” for $28,000 US. Stone Manor began its racing career in 1979 and won purses totalling $41,858 and realized a net profit after expenses of $26,852. During the 1980 racing season, it earned $230,708 in purses; yielding after expenses $98,877.25. In 1981, prior to the end of its racing career, it earned $5,507.50; after deducting expenses there was an operating loss for the year of $19,354.33. In late 1981, because of a crippling injury that could have resulted in the horse being destroyed, it was retired from racing and sold for $270,000 to a New York State purchaser who intended to use Stone Manor for stud purposes. This value was arrived at because of its success as a race horse.

In computing his income for the 1981 taxation year, the plaintiff included as a taxable capital gain one-half of the sum realized by him from the sale of Stone Manor after taking into account the adjusted cost base. In October 1983, the Minister of National Revenue reassessed increasing the liability to tax for the period by $72,912.16. In reassessing the Minister treated Stone Manor as though the horse had been purchased and sold by the plaintiff in the ordinary course of a business and described the plaintiff's proceeds of disposition of Stone Manor as “re-classified as business income”. It is with this reassessment that the plaintiff takes issue.

The plaintiff Gerald Armstrong was born on a farm in the Montreal area and remained there until approximately 18 years of age; moved to Toronto, began working with construction firms, and became adept at house building. In 1956 he constructed his first house in the Metropolitan Toronto area. He subsequently became a volume home builder, constructing some 1,000 units a year in Toronto, Ajax, Oshawa and surrounding areas. He was the chief executive officer, principal shareholder and driving force behind some three or four home and land development corporations. Between 1975 and 1979 the plaintiff's companies had gross annual sales of between $20,000,000 and $40,000,000. In the fall of 1980 they went into receivership; this he attributes to the recession. Since September, 1982 he has been the president of Victoria Wood Development Corporation which is also in house building and land development.

Having previously acquired a farm property in the Brechin, Ontario area, his interest in riding, developed during his youth, led him toward the purchase of quarter horses. Starting in 1960 and continuing over the next 15 years, through two of his corporations, he purchased and sold approximately 100 quarter horses. His two children enjoyed riding and developed a keen interest in showing horses. The majority of the quarter horses, purchased in the United States, were trained by himself, his children or employees; they were taken to shows and raced competitively with other owners of quarter horses, never for gain, only for ribbons and other similar prizes. During the years that the plaintiff was buying and selling quarter horses, there was no pari-mutuel wagering in Canada on this type of racing. It should also be noted that he also raised some beef cattle and corn. An ancillary advantage to having horses and cattle on vacant land intended for development, was lower municipal assessment. The farms would be used for this purpose until they became apt for sale or development. Though the farm operations were essentialy run by the plaintiff’s son from 1980 on, counsel for the defendant tried to show that the plaintiff was intimately involved in running this business. The proof of his alleged involvement is the continued practice by the plaintiff of signing important farm documents.

The plaintiff was originally interested in riding and showing horses; his wife, on the other hand, found her enjoyment in thoroughbred racing. In the early 1970s, through his corporations, he began acquiring thoroughbreds, mostly in claiming races at Ontario tracks. They were of the cheaper variety and ran for claiming prices between $3,000 and $20,000. Testimony indicates that he would have claimed and sold from 15 to 20 horses during this period.

At the time he purchased Stone Manor, it was approximately 18 months old. The horse, as is the custom in thoroughbred racing, turned two years old on the 1st of January 1979 and, in the spring of that year, commenced training. After realizing that he had an exceptionally fast horse, the plaintiff moved the animal from a public stable to a better trainer who could realize the potential of this animal. The horse ran three times in Canada in 1979 and once in the United States; in September of that year the horse was put to pasture and rested for the winter. In early 1980 the horse was taken to Florida for training and brought back to Ontario where his career as a three-year-old began in the spring of 1980; as a three-year-old he won important stake races in Ontario, Michigan and Ohio. In the late summer or eary fall of 1980, the horse ran in Toronto and was not as successful. The plaintiff was advised by his trainer that the horse was developing a bowed tendon; he was advised “to go easy with it” and rest it through the fall and winter of 1980 and the spring of 1981. They attempted to bring the horse back to the races in 1981 but, after a second poor showing, he was advised by the trainer that the horse was not fit and if he ran it any further it would end up with bowed tendons, quite a common injury of racing thoroughbreds. In the fall of 1981 a group from New York State were interested in acquiring the horse for breeding purposes. Because of his success they offered and paid the sum of $270,000. The plaintiff testified that he did not keep the horse because he did not have facilities for breeding, that he was in horse racing for the fun of racing horses, not to raise them since his farm was not equipped for a breeding operation, that this was a hobby and that he happened to get lucky with Stone Manor.

In the spring of 1981 he attended the offices of an accounting firm to have his 1980 taxation return prepared and filed. In one of the schedules attached to his declaration, Exhibit 1, there is a handwritten, crudely drafted statement indicating at the top “Race horse activities, farming income 1980 for George Armstrong”. At the very top there are the words “Inventory — 1 horse Stone Manor; cost: $28,000 U.S.”. It then describes the purses won which amounted to $230,708.15, expenses incurred $131,830.90, showing a net from the operation of $98,872.25. This last amount was reported as income. In his tax return for the taxation year 1981, Schedule 2 indicated the disposition of Stone Manor and declared a capital gain.

Both Mr Armstrong’s accountant and the plaintiff testified on the issue of the use of the word “inventory”. In cross-examination as well as in exami- nation-in-chief they advised the Court that the word “inventory" was used for lack of a better expression.

The position of the plaintiff is that the sale of Stone Manor was a sale of a capital property producing proceeds of disposition which are only taxable as Capital gains and not as income. He relies inter alia on sections 3, 38, 39(1)(a), 40(1)(a), 54(b) and 248(1) of the Income Tax Act. It is contended that there was never any intention (“primary" or “secondary") to enter into the business of trading in horses for profit.

The defendant on the other hand argues that the sale of Stone Manor resulted in a profit from a business or an adventure in the nature of trade which is fully taxable as income. The defendant relies, inter alia, on sections 3,9, and 248(1) of the Act. The phrase “adventure in the nature of trade" is drawn from the extended definition of “business" found in subsection 248(1). While admitting that Stone Manor was acquired to be kept and raced, the main contention of the defendant is that the plaintiff had a speculative intention of selling Stone Manor for a profit. This secondary intention is said to impart to the sale the characteristics of an adventure in the nature of trade making the proceeds fully taxable as income.

Though downplayed by the defendant in argument, considerable attention at trial was devoted to the implications of the description of the horse as “inventory" in the plaintiff's 1981 tax return. It is alleged by the defendant that this provides an indication that the plaintiff was engaged in the business of buying and selling racehorses with the result that the excess of the price over costs should be regarded as profit from that business and taxed as income. I do not draw such an inference. The definition of “inventory" in subsection 248(1) is too broad to be of any great help and only defines the term for the purposes of the Act and not for the interpretation of the intent of a taxpayer. It is well established that a taxpayer can neither increase nor decrease his tax liability by the intentional or erroneous use of magic words in his accounts. The words used may be indicative of the nature of a transaction. However, in the final analysis the task for this Court is to decide on the actual nature of the transaction and the substance of the matter on the basis of all the facts and circumstances. See Sanders v MNR (1954), 10 Tax ABC 280 at 283; 54 DTC 203 (TAB); Sterling Trust v CIR (1925), 12 TC 868 (Eng CA) per Pollock, MR at 882 and per Aitkin, LJ at 888; and Glenboig Union Fireclay v CIR (1930), 12 TC 427 (Ct of Sess) per Lord President Clyde at 450. On the basis of the evidence it is my view that in substance Stone Manor was not an item of inventory in the sense of a property held in the ordinary course of business for resale.

This brings me to the more general question of secondary intention. The defendant urges me to infer, from the description of Stone Manor as “inventory", from the plaintiff's connection with corporations trading in horses and from the speculative or high-risk nature of the purchase of race horses, that the plaintiff had, from the outset, a secondary intention of turning his horse to profit. I think the evidence and the law lead to the opposite conclusion, and it is on this basis that I must decide. As Lord Justice Clerk so aptly said in deciding whether the gain from the sale of certain shares amounted to a profit from a business taxable as income or was merely a (then) untaxable capital gain in the case of Californian Copper Syndicate v Harris (1904), 5 TC 159 (Ct of Sess) at 166:

What is the line which separates the two classes of cases may be difficult to define, and each case must be considered according to its facts; the question to be determined being — Is the sum of gain that has been made a mere enhance- ment of value by realising a security, or is it a gain made in an operation of business in carrying out a scheme for profit-making?

The case of Racine v MNR, [1965] CTC 150; 65 DTC 5098 (Ex Ct) is useful for its treatment of the notion of a secondary intention to sell a property (in that case a business) for profit which converts a transaction or series of transactions into an adventure in the nature of trade. At DTC 5103 of the unofficial translation (see CTC 159 (DTC 5111) in the original French text) Noël, J said:

In examining this question whether the appellants had, at the time of the purchase, what has sometimes been called a “secondary intention” of reselling the commercial enterprise if circumstances made that desirable, it is important to consider what this idea involves. It is not, in fact, sufficient to find merely that if a purchaser had stopped to think at the moment of the purchase, he would be obliged to admit that if at the conclusion of the purchase an attractive offer were made to him he would resell it, for every person buying a house for his family, a painting for his house, machinery for his business or a building for his factory would be obliged to admit, if this person were honest and if the transaction were not based exclusively on a sentimental attachment, that if he were offered a sufficiently high price a moment after the purchase, he would resell. Thus, it appears that the fact alone that a person buying a property with the aim of using it as capital could be induced to resell it if a sufficiently high price were offered to him, is not sufficient to change an acquisition of capital into an adventure in the nature of trade. In fact, this is not what must be understood by a “secondary intention” if one wants to utilize this term.

To give to a transaction which involves the acquisition of capital the double character of also being at the same time an adventure in the nature of trade, the purchaser must have in his mind, at the moment of the purchase, the possibility of reselling as an operating motivation for the acquisition; that is to say that he must have had in mind that upon a certain type of circumstances arising he had hopes of being able to resell it at a profit instead of using the thing purchased for purposes of capital.

Generally speaking, a decision that such a motivation exists will have to be based on inferences flowing from circumstances surrounding the transaction rather than on direct evidence of what the purchaser had in mind.

See also: Bead Realties v MNR, [1971] CTC 774; 71 DTC 5453 (FCTD) per Walsh, J; Hiwako Investments v The Queen, [1978] CTC 378; 78 DTC 6281 (FCA); and Simmons v CIR, [1980], 2 All ER 798 (HL) per Lord Wilberforce especially at bottom of page 802. A common thread running through these cases is that circumstances which force the sale of a property or make such a sale attractive (in this case the horse's injury combined with its winning record making it valuable for stud) do not have the effect of retroactively converting a property held to produce income and as a capital property into something of a trading nature.

Upon evaluation of all of the evidence and circumstances I am not prepared to find that, at the moment of purchase of Stone Manor, the possibility of resale for profit was an operating motivation of the plaintiff's acquisition. I am satisfied that there was no secondary intention in buying Stone Manor to sell him for a profit rather than keep him for racing. The evidence is to the contrary. He was carefully chosen as a good racehorse, he was trained and in fact raced. A good income derived from the purses won. The sale was motivated by an unfortunate and unforeseeable leg injury which brought his racing career to an abrupt end. It has not been demonstrated to my satisfaction that the plaintiff's connection with corporations trading in horses (mostly quarter horses) coloured his personal acquisition of a racing thoroughbred so as to make the notion of secondary intention applicable in this case. A taxpayer's connection with real estate buying and selling operations has not led to the conclusion in other cases that the gain from the sale of property must be viewed as income: Racine v MNR, supra, in translation at DTC 5104 and in the original French text at 161 (DTC 5113); and, Bead Realties v MNR, supra, at 776 (DTC 5454). This is surely all the more so when, as in the case at bar, the property sold was bought for the purposes of pursuing a hobby.

It is certainly true that an isolated transaction may be characterized as “an adventure in the nature of trade" so that any resulting profit is taxable as income: MNR v Taylor, [1956] CTC 189 at 211; 56 DTC 1125 at 1138 (Ex Ct). However, in the case at bar there is no evidence whatsoever that the plaintiff intended the purchase of Stone Manor to be a business venture. He had no breeding operation on any of his farms and there was not even any evidence of breeding of quarter horses by the corporations which had bought and sold such horses. If anything his conduct was characteristic of someone who had a hobby. I am not convinced that signing documents related to the farm operations in general made the running and eventual sale of Stone Manor into a business venture for the plaintiff. He enjoyed riding, showing and racing horses. There is no evidence before me that any profit was ever before made through this hobby which would indicate a secondary intention of selling the horse for profit. The plaintiff was a land developer and house builder. His corporations were conducting $20 to $40 million of business per year when he bought Stone Manor. Even after his building corporations went into receivership he did not turn his energies to the horse-breeding business despite Stone Manor's value as demonstrated by its eventual sale for $270,000. Instead, in 1982, he returned to the land development and house building business and became president of the Victoria Wood Development Corporation.

The key element of the defendant's argument seemed to be that because the purchase of horses for racing is highly speculative, with little assurance of winnings, Stone Manor must have been bought with a view to eventual sale and not as an income-producing asset. This is said to make the present case different from other cases where a secondary intention is not found. I must say I cannot really follow or endorse this line of argument. On such logic every person who purchases property to pursue a hobby is, for income-tax purposes, in the business of buying and selling that type of property. It is true there was no assurance of success. However, there are many other highly speculative purchases one can make, for example of paintings, without such a characteristic being determinative of the intention of the buyer. It seems to me that the defendant's theory amounts to saying that the plaintiff bought something which he could not expect to produce income, but which he at the same time expected to sell for a considerable profit. This theory makes no sense in the present context. In the case of a race horse, increased value at the time of sale can only come from its income-producing capacity and potential or a record of winnings which makes it valuable for breeding. Thus, absence of expectation of income will also exclude expectation of a high resale value. This is perhaps different from cases of land purchase where the land may have almost no incomeproducing capacity but can still be expected to fetch a handsome price upon resale. Statements about the effects of a purchase being speculative in nature on the characterization of the gain from the eventual sale which are found in Regal Heights v MNR, [1960] CTC 384 at 389; 60 DTC 1270 at 1272- 73 (SCC) appear to support the defendant. On the other hand the later decision of the Supreme Court in Irrigation Industries v MNR, [1962] CTC 215; 62 DTC 1131 suggests at 218-19 (DTC 1132-3) that a high level of risk does not mean that the disposition of a property can never be considered a Capital transaction.

In conclusion I would like to briefly return to the question of secondary intention. The notion of secondary intention is nowhere enshrined in the Income Tax Act. As the Chief Justice of the Federal Court stated in Hiwako Investments v The Queen, supra, at 384 (DTC 6285) the term “secondary intention :

. . . does no more than refer to a practical approach for determining certain questions that arise in connection with “trading cases” but there is no principle of law that is represented by this tag. The three principal, if not the only, sources of income are businesses, property and offices or employments (section 3). Except in very exceptional cases, a gain on the purchase and re-sale of property must have as its source a “business” within the meaning of that term as extended by section 139 [now section 248(1)].

The purchase and eventual sale of Stone Manor was neither a business nor an adventure in the nature of trade.

An ahistorical and entirely positivist approach to the use of cases decided before the 1971 tax reform may create the risk of arbitrary distortions in the interpretation and application of the Income Tax Act. One cannot ignore the fact that cases like MNR v Taylor, supra; Regal Heights v MNR, supra; G W Golden Construction v MNR, [1967] CTC 111; 67 DTC 5080 (SCC); Pierce Investment v MNR (FCTD); Kensington Land Development v The Queen, [1979] CTC 367; 79 DTC 5283 (FCA); and, Watts Estate v The Queen, [1984] CTC 653; 84 DTC 6564 (FCTD), all cited by the defendant, were decided in respect of taxation years when failure by the courts to find that the amount in dispute was income would have freed the taxpayer from all tax liability. Such was not the case after 1971, at least until the 1985 federal budget. Capital gains were taxable and Parliament, in its wisdom, set the tax rate at one-half of that on income. In this historical and statutory context, the notion of secondary intention should be used cautiously so as not to artificially characterize receipts which are properly capital gain as income. For all of these reasons the appeal is allowed and the plaintiff will be entitled to his costs.

Appeal allowed.