R & W Such Holdings Ltd. v. The Queen, 96 DTC 6455, [1996] 3 CTC 221 (FCTD)

Heald D.J.: — This is an action commenced by Statement of Claim filed October 7, 1983, wherein the Plaintiff appeals the reassessments under the Income Tax Act [1] (the “Act”) in respect of the 1977-1980 taxation years. The Minister of National Revenue, Taxation (the “Minister”) reassessed the Plaintiff for the said taxation years on the basis that the Plaintiff’s chief source of income was neither farming nor a combination of farming and some other source of income. Therefore its losses for each relevant taxation year were deemed to be $5,000 per year, in accordance with subsection 31(1) of the Act. The Plaintiff served Notices of Objection, dated August 20, 1982, on the Minister with respect to the reassessments. By Notice of Confirmation, dated July 12, 1983, the Minister confirmed its reassessments on the basis aforesaid.

I. BACKGROUND

The Plaintiff is a corporation with a registered office in Calgary, Alberta, incorporated pursuant to the laws of Alberta. Originally the issued shares of the Plaintiff were owned equally by Wolfgang Such and his father, Rudolph Such. However, following a corporate freeze in 1978, the family’s holding company, RW-LB Holdings Ltd., acquired all the issued shares of the Plaintiff.

Two witnesses testified at the trial on behalf of the Plaintiff: Robert Such, the current President of the Plaintiff and son of Wolfgang Such; and Lydia Such, the wife of Wolfgang Such. I found both witnesses to be credible and I accept their testimony. (With all due respect, for ease of reference I shall refer to the various individuals by their first names.) The Plaintiff introduced as evidence two psychological reports concerning Wolfgang, prepared for a pending dependant adult action, to explain why Wolfgang did not testify at the trial. The Defendant did not adduce any viva voce evidence.

i. History of the Plaintiff

In the 1950’s, Wolfgang and Rudolph, in partnership, established a construction and rental business in Calgary, Alberta. In 1971, the Plaintiff was incorporated and all of the business assets owned by Wolfgang and Rudolph were transferred to the Plaintiff corporation. The shares were originally owned equally by Wolfgang and Rudolph.

The business assets at the time of incorporation included 29 duplexes and one 12-unit apartment building. These buildings had been built by Wolfgang and Rudolph, in addition to several other buildings that they had constructed and then sold. Robert testified that for every four or five sales, Wolfgang would keep one building as a rental property. The final building constructed was the 12-unit apartment building, in 1971.

In December of 1973, the Plaintiff acquired approximately two quartersections of land near Bowden, Alberta, a one hour drive north of Calgary. The land was purchased with the object of establishing a big-game farm thereon. After a portion of the property was fenced in, the Plaintiff began acquiring animals which animals were located at the fenced-in portion of the property. I will discuss the details of the farm operation in due course.

In 1978, RW-LB Holdings Ltd. was incorporated as part of a corporate freeze. This holding company acquired all of the issued shares of the Plaintiff. The shares of RW-LB Holdings Ltd. were issued to Wolfgang, Rudolph, Lydia, Robert, and Barbara Patychuk (Wolfgang and Lydia’s daughter). The corporate freeze was designed to allow a tax- free rollover step in the estate planning of both Wolfgang and Rudolph. Following the freeze, Wolfgang ran the businesses, including the Plaintiff corporation, as if they were his sole proprietorships.

In 1991, Robert commenced a shareholders’ oppression action against Wolfgang. This was precipitated by the manner in which Wolfgang was operating the family businesses and the break-down of relations between Wolfgang and the rest of the family. Lydia and Barbara were subsequently added as plaintiffs. On December 2, 1992, a court-appointed receiver/manager, Mr. Harvie Hall, took over the affairs of the family’s companies, including the Plaintiff. Robert worked with Hall to put the farm operation on a proper footing. By a judgment dated December 23, 1993, the Alberta Court of Queen’s Bench ordered that Wolfgang be removed as a director of RW-LB Holdings Ltd. and that Robert, Lydia and Barbara be appointed as directors. On January 1, 1994, the receiver/manager was removed and Robert took control of the Plaintiff.

ii. History of the Plaintiff’s Farm Operation

As noted supra, the Plaintiff acquired the land for the farming operation in December of 1973. The cost of the property was approximately $20,000. The land was devoid of buildings, was not fenced, and was mostly bush with the exception of a small cleared area. In the spring of 1974, the Plaintiff started fencing the land. According to Robert, it is a substantial 7-foot fence. Wolfgang, with assistance from Rudolph and hired help, constructed the fence himself.

Initially, Wolfgang thought the farm operation would follow a European model of game ranches that raised stock for consumption and trophy purposes. Later, the Plaintiff discovered a market in antler sales. Various methods were used to obtain game. The Plaintiff acquired its first six elk under a rule that allowed zoos to acquire six of a native species that was in surplus in the wild. The Plaintiff was permitted to retain moose and big-horn sheep that entered the property and were then captured by closing the gate. Buffalo were purchased by the Plaintiff. The Plaintiff also acquired animals from zoos that sold off their surplus.

Since the Plaintiff’s operation was the first of its kind in Alberta, the acquisition of inventory presented a problem. Other then acquiring stock by the methods noted above, Robert testified that the Plaintiff essentially had to breed the animals to increase the stock. During the early years of the farm operation, Robert was only a child. He testified that the family spent summer vacations driving across North America so Wolfgang could inquire at zoos and farms about animals for the farm.

The farm operation owned the following animals at various times since its inception: prong horn antelope, black tail deer, sika deer, fallow deer, mule deer, white tail deer, elk, moose, mountain goats, and big horn sheep. [2] Ultimately, the Plaintiff focussed on elk. Robert testified that elk seemed to thrive most easily on the Plaintiff’s farm and were perfectly attuned to its climate. Furthermore, it was not economical to raise some of the other animals, such as moose. Robert testified that he currently tries to keep approximately a herd of 200 elk on the farm at a maximum. Typically the farm produces 50 to 60 calves in the fall. During the year the Plaintiff buys, sells and trades the stock. Accordingly, the inventory fluctuates throughout the year.

Robert testified that the Plaintiffs herd was unique because the Plaintiff was essentially a pioneer in the industry in Alberta. As a pioneer, the Plaintiff was able to acquire some of the better animals and develop a genetically-superior herd to other such herds in North America.

The Plaintiff earned income from the farm operation by shipping some stock to the U.S. for trophies; by the purchase and sale of stock; and by selling elk antlers and other by-products from the animals. With respect to antler sales, this necessitated cutting the antlers off the animals once a year. If this were done, the antlers would then grow back on their own. The Plaintiff corporation became aware of this potential market in 1976. However it was not until 1979 that it had developed a non-fatal method of removing the antlers. Finally, in 1980 the Plaintiff was able to remove the antlers from the entire herd. The market for antlers is primarily Asian and for pharmaceutical use.

In terms of licensing, the Plaintiff had licences periodically since the farm operation commenced. The Plaintiff eventually ran into difficulties with the government of Alberta, and in 1988 a few of the animals were seized and the government refused to issue transport notices. These problems, coupled with the deteriorating relations between Wolfgang and the rest of the family, ultimately resulted in the receiver/manager being appointed in 1992.

As noted supra, Robert assumed control of the Plaintiff corporation on January 1, 1994, and is the current President. His sister, Barbara, is the Secretary. Robert and Barbara are both Directors of the Plaintiff. Robert testified that, on average, he allocates about half of his time to the farm operation and half to the building rental business, except in the summer months when he devotes all of his time to the farm operation. His tasks include feeding the animals, maintaining proper records, and conducting the sale of the animals. He is the sole operator of the farm, only hiring people in the summertime to assist him in such necessary activities as the building and repairing of fences, for example.

Lydia testified that in the period 1977-1980, the taxation years here in issue, Wolfgang drove out to the farm nearly every day and usually remained there all day. Perhaps in the winter he spent a little less time at the farm. When Rudolph was alive, he also went to the farm frequently.

In terms of the capital committed to the farm operation, Robert testified that it was not an operation that could be built up simply by injecting capital, but rather it had to be built up over time. I understand the witness to have meant that it took as much time as money to establish the herd and to enter the market. Once the land was purchased and a fence erected, the farm operation did not require other significant capital expenditures except for the purchase of inventory.

Hi. History of the Plaintiff’s Building Rental Operation

As discussed supra, the Plaintiff at the material times owned 29 duplexes and one 12-unit apartment building. It acquired these buildings by a roll-over at incorporation in 1971. No additional buildings were constructed by the Plaintiff. Accordingly, the building rental operation, since the incorporation of the Plaintiff, only involved the maintenance and upkeep of the rental properties in addition to the actual renting of the buildings. Lydia testified that she did the renting and ensured that maintenance people were engaged when necessary. She further testified that Wolfgang also assisted and gave instructions to the maintenance people. Wolfgang did very little of the actual maintenance himself.

Presently, Lydia answers the phone and does approximately one fourth of the renting. Barbara assists in signing cheques and in preparing the financial statements. Robert coordinates all the maintenance and does the remainder of the renting.

iv. Income and Revenue of the Plaintiff

The Plaintiff provided the Court with an exhibit illustrating the expenses, net income/loss, inventory expended, and adjusted net income of the farm operation for the years 1974 through 1995. In addition, the Plaintiff provided the expenses and net income/loss of the building rental operation for the same period. Robert testified that the financial-statement summary was prepared by him based on financial statements of the Plaintiff that were unaudited and prepared for tax purposes. I have used the numbers shown on the Plaintiffs Exhibit P- 19 to produce the chart below, which shows the adjusted net income of the farm operation and the net income of the building rental operation, as these are the figures that are relevant to these proceedings.

11. ISSUE

Do the restrictions of subsection 31( 1 ) apply to the Plaintiff for the 1977-1980 taxation years?

III. ANALYSIS

The issue in this case is whether or not the restrictions of subsection 31(1) of the Act apply to the Plaintiff for the 1977-1980 taxation years. Subsection 31(1) of the Act reads as follows:

31. (1) Where a taxpayer’s chief source of income for a taxation year is neither farming nor a combination of farming and some other source of income, for the purposes of sections 3 and 111 his loss, if any, for the year from all farming businesses carried on by him shall be deemed to be the aggregate of

(a) the lesser of

(i) the amount by which the aggregate of his losses for the year, determined without reference to this section and before making any deduction under section 37 or 37.1, from all farming businesses carried on by him exceeds the aggregate of his incomes for the year, so determined from all such businesses, and

(ii) $2,5000 plus the lesser of

(A) 1/2 of the amount by which the amount determined under subparagraph (i) exceeds $2,500, and

(B) $2,500, and

(b) the amount, if any, by which

(i) the amount that would be determined under subparagraph (a)(i) if it were read as though the words “and before making any deduction under section 37 and 37.1” were deleted,

exceeds

(ii) the amount determined under subparagraph (a)(i); and for the purposes of this Act the amount, if any, by which the amount determined under subparagraph (a)(i) exceeds the amount determined under subparagraph (a)(ii) is the taxpayer’s “restricted farm loss” for the year. [3]

The starting point in determining this issue is the Supreme Court of Canada decision in Moldowan v. 7?. [4] Justice Dickson described three classes of farmers, for the purpose of section 31 of the Act, as follows:

(1) a taxpayer, for whom farming may reasonably be expected to provide the bulk of income or the centre of work routine. Such a taxpayer, who looks to farming for his livelihood, is free of the limitation of subsection 13(1) in those years in which he sustains a farming loss. [5]

(2) the taxpayer who does not look to farming, or to farming and some subordinate source of income, for his livelihood but carries on farming as a sideline business. Such a taxpayer is entitled to the deductions spelled out in subsection 13(1) in respect of farming losses.

(3) the taxpayer who does not look to farming, or to farming and some subordinate source of income, for his livelihood and who carries on some farming activities as a hobby. The losses sustained by such a taxpayer on his non-business farming are not deductible in any amount. [6]

[Emphasis added. I

The Plaintiff submits that at all relevant times it fell within Class 1 and was therefore free of the restrictions of subsection 31(1). The Defendant submits that the Plaintiff, during the material taxation years, carried on the farm operation as a sideline business, and therefore fell within Class 2 and was restricted to the $5000 farming loss dictated by subsection 31(1). The parties agree that the Plaintiff did not fall within Class 3 during the 1977-1980 taxation years.

In order to decide whether the Plaintiff was a Class 1 or a Class 2 farmer, it must be determined whether the Plaintiff’s chief source of income for the 1977-1980 taxation years was farming or a combination of farming and some other source of income. If this question is answered in the affirmative, then the Plaintiff was not restricted by subsection 31(1) of the Act to a $5000 farm loss. Conversely, if the answer to this question is in the negative, then the Plaintiff was so restricted.

In Moldowan, supra, the Court held that in order for the farm operation to be a “source of income” the taxpayer must have a profit or a reasonable expectation of profit. [7] Since the Defendant concedes that the farm operation was not a mere hobby, it necessarily follows that the farm operation had a reasonable expectation of profit.

Additionally, the evidence supports a finding that during the relevant taxation years there was a reasonable expectation of profit from the farm operation. It is well established law that in making this determination, the Court may consider evidence relating to the farm operation in subsequent taxation years. [8] The Plaintiff’s evidence detailed above in Table I illustrates that as early as 1981, the first year subsequent to the taxation years at issue, the farm operation yielded a positive adjusted net income. It has since continued to maintain a positive adjusted net income, with the exception of four other taxation years. Accordingly, I am satisfied that the farm operation was a source of income to the Plaintiff during the material taxation years.

What must be determined is whether or not, during the 1977-1980 taxation years, the farm operation was the Plaintiff’s chief source of income, either alone or in combination with another source of income. The Supreme Court of Canada in Moldowan, supra, stated the following in respect of this issue:

Whether a source of income is a taxpayer’s “chief source” of income is both a relative and objective test. It is decidedly not a pure quantum measurement. A man who has farmed all of his life does not cease to have his chief source income from farming because he unexpectedly wins a lottery. The distinguishing features of “chief source” are the taxpayer’s reasonable expectation of income from his various revenue sources and his ordinary mode and habit of work. These may be tested by considering, inter alia, in relation to a source of income, the time spent, the capital committed, the profitability both actual and potential. A change in the taxpayer’s mode and habit of work or reasonable expectations may signify a change in the chief source, but that is question of fact in the circumstances. [9]

It is therefore apparent that determining whether the farm operation was the chief source of income involves an inquiry going beyond a pure quantum measurement of the taxpayer’s various sources of income. The following factors must be taken into consideration: (1) time spent; (2) capital committed; and (3) potential and actual profitability. The same analysis is to be undertaken in cases involving a corporate taxpayer as is undertaken in cases concerning an individual taxpayer? [10]

In order for the restrictions of subsection 31(1) not to apply, the farm operation must be the Plaintiff’s chief source of income either alone or in combination with another source of income. It is well established law that there need not be a connection by way of a physical relationship or integration between the farming and the other source of income, in order for the two sources to be “in combination” for the purposes of subsection 31(1).!! [11]

However, it is also clear that “in combination” does not simply mean the addition of two sources of income. What “in combination” does mean is described by Justice Dickson in Mo Ido wan, supra as follows at page 488 (C.T.C. 315):

The reference in subsection 13(1) [now 31(1)] to a taxpayer whose source of income is a combination of farming and some other source of income is a reference to class (1). It contemplates a man whose major preoccupation is farming. But it recognize [sic] that such a man may have other pecuniary interests as well, such as income from investments, or income from a sideline employment or business. The section provides that these subsidiary interests will not place the taxpayer in class (2) and thereby limit the deductibility of any loss which may be suffered to $5,000. While a quantum measurement of farming income is relevant, it is not alone decisive. The test is again both relative and objective, and one may employ the criteria indicative of “chief source” to distinguish whether or not the interest is auxiliary. A man who has farmed all of his life does not become disentitled to class (1) classification simply because he comes into an inheritance. On the other hand, a man who changes occupational direction and commits his energies and capital to farming as a main expectation of income is not disentitled to deduct the full impact of start-up costs. [13]

[Emphasis added.]

The Plaintiff has two sources of income: the farm operation and the building rental operation. In order for the farm operation to be the Plaintiff’s chief source of income in combination with the building rental operation, it would have to be established that the farm operation was the Plaintiff’s major preoccupation and that the building rental operation was a sideline business. Pursuant to Moldowan, supra, this requires a relative and objective comparison between the two operations of the following three criteria: time spent, capital committed and potential and actual profitability. [14] In performing this exercise, the Federal Court of Appeal decision in Morrissey v. R. [15] must be borne in mind, wherein the Court held that it is the cumulative impact of the various factors that governs, not any one factor taken disjunctively. [16]

Time Spent

The Plaintiff in this case is a corporation. During the first taxation year in issue, 1977, there were only two shareholders: Wolfgang and Rudolph. During the subsequent taxation years all the issued shares were held by RW-LB Holdings Ltd., whose shares were owned by Wolfgang, Rudolph, Lydia, Robert and Barbara. In 1979, Rudolph passed away. There is no evidence that the Plaintiff corporation had any long-term permanent employees during the relevant years, although there is evidence that temporary hired help was used with respect to the farm operation in the summer and for maintenance of the rental properties. Accordingly, in the circumstances of this case, it seems most practical to consider the time spent by Wolfgang on the two operations during the material time.

As was noted above, Lydia testified that during the 1977-1980 period, Wolfgang drove out to the farm nearly every day and would spend his entire day at the farm. Robert testified that Wolfgang essentially fenced the land himself, with some assistance from Rudolph and hired help. In addition, Wolfgang spent considerable time contacting zoos and other farms with respect to purchasing more inventory.

The building rental operation involved the renting and maintenance of the properties. Lydia testified that she did the renting and ensured the properties were maintained. However, Wolfgang did assist her and gave instructions to the maintenance people.

The Plaintiff asserts, in the Statement of Claim, that during the material years, Wolfgang and Rudolph (while he as alive) devoted approximately 75% of their working hours to the creation and development of the farm operation. In view of the evidence discussed above, I accept this as a legitimate approximation. Accordingly, the time spent between the two operations clearly favours the farm operation.

Capital Committed

With respect to the farm operation, the only capital committed was that required to purchase the land, erect the fence, and acquire some of the stock. Much of the stock was acquired without the expenditure of capital by either the capture of wild game or through breeding. The building rental operation involved a significant commitment of capital, as the Plaintiff owned 30 rental properties.

Therefore, on a relative basis, the capital committed clearly favours the building rental operation. However, on an objective basis, the nature of the two operations must be considered. The farming operation was the first of its kind in Alberta. It was not a typical farm operation either. For example, the Plaintiff could not simply purchase a herd of elk. Rather, it took time and effort to select the right male and female animals from which to produce, via breeding, a worthy herd. Conversely, a building rental operation depends on the commitment of capital to acquire the rental properties. I also note that during the relevant taxation years, the Plaintiff did not commit any further capital to the building rental operation, in that it did not acquire any additional rental properties. Nonetheless, during the relevant taxation years the Plaintiff certainly had more capital committed to the building rental operation then it did to the farm operation.

Potential and Actual Profitability

The actual profitability of the two operations is displayed in Table I. The farm operation suffered losses averaging $46,000, while the building rental operation procured profits averaging $92,000. I note that this analysis will always be conducted in circumstances where the farm operation has suffered a loss, or else the issue of subsection 31(1) would not have arisen, since it only pertains to farm losses. I also note that it was during the relevant taxation years that the Plaintiff was developing a non- fatal method for removing the antlers from the animals, which later proved to be a viable source of income. This is an illustration of the atypical challenges faced by the Plaintiff due to it undertaking a novel farm operation.

With respect to the potential profitability, Table I illustrates that as early as 1981, the farm operation began to show a positive adjusted net income, albeit substantially less than that earned by the building rental operation the same year. However, by 1985, the adjusted net income of the farm operation far exceeded the net income of the building rental operation. In fact, every year from 1985 onwards, in which the farm operation showed a positive adjusted net income, it exceeded that of the building rental operation. In short, a mere 12 years from the inception of the farm operation it began to produce, in a quantitative manner, an adjusted net income far exceeding that of the building rental operation.

Taking into consideration the difficulties faced by the Plaintiff in view of it being a pioneer in this industry in Alberta, and the difficulties that arose as a result of the breakdown of relations between Wolfgang and the government and Wolfgang and his family, the Plaintiffs farm operation actually fared quite well. Ultimately, the farm operation developed a significant potential for profit. Accordingly, I conclude that a relative and objective comparison of the two operations, when related to the criteria of actual and potential profitability, favours the farm operation.

In addition to the comparison of the farm and building rental operations in terms of the above three criteria, I would like to make some further observations. In my view, the losses suffered by the farm operation from 1974 through 1980 are reasonably expected start-up losses because of the nature of the operation and its uniqueness at the time of inception. The Supreme Court of Canada recognized the potential for start-up losses, wherein Justice Dickson stated the following, at page 486 (C.T.C. 314):

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. [17]

And at page 488:

[A] man who changes occupational direction and commits his energies and capital to farming as a main expectation of income is not disentitled to deduct the full impact of start- up costs. [18]

In the case at bar, Wolfgang, the driving force behind the Plaintiff during the relevant taxation years, did indeed change occupational directions in 1974. Up until 1971, Wolfgang, in partnership with Rudolph, earned an income by constructing buildings and selling approximately four out of every five built for a profit. The remainder were retained as rental properties. Wolfgang thus devoted considerable time to the construction and rental business. However, Wolfgang ceased constructing buildings in 1971, the year of the Plaintiff’s incorporation. Shortly thereafter, in 1973, the farm operation was conceived when the Plaintiff purchased the farm land. Then in 1974, the Plaintiff erected a fence and began acquiring stock.

It is my view that these circumstances illustrate the evolution of Wolfgang’s occupational direction. Clearly, by 1974 he had switched gears from construction to farming. Due to the inherent connection between the activities of Wolfgang and the activities of the Plaintiff, during the relevant taxation years, I am satisfied that the Plaintiff’s major preoccupation was the farm operation. The relevant taxation years fell within the start-up period to be expected with such a venture. The building rental operation, at all material times, had become a sideline business.

Accordingly, for the 1977-80 taxation years, the farm operation in combination with the building rental operation was the Plaintiff’s chief source of income, and, therefore, subsection 31(1) does not apply to the Plaintiff. In view of this finding, I do not have to decide whether or not the farm operation alone constituted the Plaintiff’s chief source of income for the relevant taxation years.

IV. CONCLUSION

I have taken into consideration all of the evidence adduced at trial, as well as the able submissions of both counsel. For the aforesaid reasons, the appeal is allowed and the reassessments for the taxation years 1977-80, inclusive, are hereby referred back to the Minister for reconsideration and reassessment in accordance with these reasons.

Costs are payable to the Plaintiff.

Appeal allowed.