McKervey v. MNR, 92 DTC 1570, [1992] 2 CTC 2015 (TCC)

Bowman, T.C.C.J.:—This is an appeal from assessments of income tax for the 1981, 1983, 1984 and 1985 taxation years of the appellant, Arthur McKervey.

The pleadings raise two issues: the application of section 44 to a gain realized by the appellant in his 1981 taxation year and the appropriateness of penalties assessed against the appellant pursuant to subsections 162(1) and 163(1) as well as subsection 150(1) of the Income Tax Act, R.S.C. 1952, c. 148 (am. S.C. 1970-71-72, c. 63) (the "Act").

At trial counsel for the appellant informed the Court that in the interests of proceeding with the main issue in the case his client would pay the penalties imposed without further contestation but without any admission that there was any attempt wilfully to evade payment of tax. Accordingly, no evidence was adduced by the respondent to support the imposition of penalties.

In addition, the Minister, in assessing for certain of the years in question, did not allow the appellant a deduction for charitable donations and a deduction in respect to a contribution to a registered retirement savings plan. Evidently prior to filing the reply, the Minister was given further evidence of these payments and conceded that they were deductible.

This leaves therefore the issue relating to section 44 of the Income Tax Act. That section, in essence, permits a taxpayer to defer the recognition in income of a taxable capital gain realized on the disposition of a “former business property" where before the end of the second taxation year following the year in which the disposition of the former business property took place the taxpayer acquires a "replacement property”. For the section to apply both the former property and the replacement property must be capital properties. Subsection 44(5) of the Income Tax Act reads as follows:

For the purposes of this section, a particular capital property of a taxpayer is a replacement property for a former property of the taxpayer, if

(a) it was acquired by the taxpayer for the same or a similar use as the use to which he put the former property;

(b) where the former property was used by the taxpayer for the purpose of gaining or producing income from a business, the particular capital property was acquired for the purpose of gaining or producing income from that or a similar business; and

(c) where the taxpayer was not resident in Canada at the time he acquired the particular capital property, in addition to the requirements in paragraphs

(a) and (b), the particular capital property was taxable Canadian property.

In 1981, the appellant sold a parcel of land in the Province of Alberta ("Block 2") and realized a capital gain of $199,950. He acquired another parcel of land ("Block X")and claimed the benefit of section 44 by filing an election in prescribed form.

The Minister denied the claim on the following basis:

(a) On or about May 18, 1979, title to Block 2 was obtained in the name of Patrick McKervey, the son of the appellant, and the appellant became the beneficial owner of Block 2.

(b) On or about April 23, 1981, the appellant disposed of Block 2 to the Province of Alberta for the sum of $566,500.

(c) The taxable capital gain realized by the appellant in his 1981 taxation year upon the disposition of Block 2 was $199,950 calculated as follows:

Proceeds of Sale		$566,500
less: Cost of A.C.B.	$165,000
cost of disposition	1,600	$166,600
Capital gain as declared		$399,900
Claimed replacement cost	$600,000
Allowable replacement reserve	—
Total capital gain		399,000
Net taxable gain		$199,950

(d) An election under Section 44 was claimed on the basis of a replacement cost of the qualifying property (Block X) of $600,000.

(e) Block X was acquired by the appellant prior to his filing his 1981 tax return and was acquired on or about March 8, 1983.

(f) Neither Block 2 nor Block X were used by the appellant for the purpose of earning income from a business.

The issues may therefore be stated briefly as follows:

(a) Whether Block X was acquired before the end of 1982, the second taxation year following the year in which Block 2 was disposed of.

(b) Whether the “former business property" (Block 2) was used for the purpose of gaining or producing income from a business and whether the replacement property" (Block X) was acquired for the purpose of gaining or producing income from that or a similar business.

The first issue has to do with the rather complex method followed by Mr. McKervey to obtain title to Block X. It is not necessary that I review in detail the extensive documentary evidence that was adduced by the appellant. Counsel for the respondent stated in argument that while he was not conceding the point he was offering no argument opposing the appellant's position that he acquired Block X in 1982. Accordingly I need do no more than summarize the steps leading up to the appellant's acquisition of Block X.

On June 11,1979, the two owners of Block X, D.B.O. Investments Ltd. and Cenaltco Management and Holdings Ltd. mortgaged the property to Clarence Wagenaar and on September 24,1979 D.B.O. Investments mortgaged its 50 per cent interest by way of second mortgage to Kase Mortgage Ltd. The mortgages were subsequently transferred to Bobco Investments Ltd.

On December 18, 1981, the appellant entered into an agreement with Cenaltco Management and Holdings Ltd. which recited that Cenaltco was the owner of an undivided one half interest in Block X containing approximately 35.2 acres which it wished to dispose of to Mr. McKervey. The lands were subject to foreclosure proceedings commenced by the mortgagee, Bobco Investments Ltd. The plan was that Cenaltco would demand that Bobco assign the mortgage to the appellant upon the payment to it by the appellant of the balance outstanding on the mortgage and the appellant, as mortgagee, would take over with the foreclosure proceedings and ultimately obtain title to the property.

The plan did not go smoothly. Litigation ensued between D.B.O. Investments and Bobco in an attempt to force Bobco to transfer the mortgages to the appellant. Ultimately, however, the appellant was successful in obtaining all of the interests in Block X as mortgagee and on December 2, 1981 a final order of foreclosure was made by Master Cairns of the Court of Queen's Bench of Alberta in the foreclosure action between the appellant as plaintiff and Cenaltco and D.B.O. Investments as defendants.

The importance of this order in the appellant's claim under section 44 of the Income Tax Act warrants my setting it out in full.

UPON the application of the plaintiff; UPON reading the Order for Sale herein dated the 2nd day of June 1981

AND IT APPEARING that since the date of the Order for Sale herein no money has been paid pursuant to the terms of the said Order, that the lands were duly advertised and offered for sale on three occasions and that on the first occasion there were no tenders, on the second occasion the tender was rejected by this Honourable Court and upon the third occasion tenders were withdrawn, and upon hearing Counsel for the plaintiff;

1. IT IS HEREBY ORDERED that the defendants do stand absolutely debarred and foreclosed of and from all their estate, right, title, interest and equity of redemption of property herein, namely:

PLAN CALGARY 4506 A.H. BLOCK "X" CONTAINING 14.2 HECTARES (35.2 ACRES) MORE OR EXCEPTING THEREOUT THE ROAD WIDENING ON PLAN 4377 J.K. CONTAINING .190 HECTARES (0.47 OF AN ACRE) MORE OR LESS.

2. AND IT IS FURTHER ORDERED that the said lands be and the same are hereby vested in Arthur McKervey for all the estate, right, title, interest and equity of redemption of the defendants therein and thereto.

3. AND IT IS FURTHER ORDERED that the Registrar of the South Alberta Land Registration District do cancel the existing Certificate of Title to the lands in question and do issue a new Certificate of Title to the lands in the name of Arthur McKervey free from the Plaintiff's mortgage and all encumbrances, caveats and mortgages, but subject to the reservations and condition contained in the original grant from the Crown, or in the existing Certificate of Title, and subject only to prior encumbrances.

4. AND IT IS FURTHER ORDERED that the defendants and all subsequent encumbrancers immediately upon the service of this Order deliver up to the plaintiff, or to whom he shall appoint, possession of the said lands or such part thereof as may be in possession of the defendants.

5. AND IT IS FURTHER ORDERED that in default of possession being delivered up as aforesaid a Writ of Possession do issue without further order.

6. AND IT IS FURTHER ORDERED that the plaintiff shall have leave to speak to solicitor client costs.

Under section 506 of the Rules of the Alberta Court of Queen's Bench a party wishing to appeal such an order has 20 days from the date upon which the order was signed, entered and served.

Subsection 180.1(1) of the Alberta Land Titles Act provides as follows:

Subject to subsection (3), the Registrar shall not register a judgment, order or certificate made in any proceedings of a court that operates to cancel a certificate of title, terminate an interest in land or discharge an instrument or a caveat unless the judgment, order or certificate

(a) is consented to by all the parties to the proceedings or their solicitors,

(b) was granted ex parte and states that it does not have to be served on any person,

(c) is accompanied by a written undertaking from those persons having a right to appeal from the judgment, order or certificate, or their solicitors, that no appeal from the judgment, order or certificate will be commenced,

(d) is accompanied by a certificate of the clerk of the court that issued the judgment, order or certificate to the effect

(i) that no defence or demand of notice of proceedings has been filed in the proceedings on behalf of any defendant, or

(ii) that the time for appeal from the judgment, order or certificate has expired and that no notice of appeal has been filed,

or

(e) is accompanied by a certificate of a solicitor to the effect

(i) that an appeal to the Court of Appeal has been finally disposed of or discontinued, that the time for an appeal to the Supreme Court of Canada has expired and that no notice of appeal has been filed,

or

(ii) that the judgment, order or certificate has been appealed to the Supreme Court of Canada and that the appeal has been finally disposed of or discontinued.

In the result the certificate of title certifying that the appellant was the owner of Block X was not registered until March 9, 1983.

I have no difficulty in concluding that the appellant acquired the property not later than December 2, 1982, the date upon which the final order of foreclosure was made. The fact that section 180.1 of the Land Titles Act prohibited the registration of the final order unless it was accompanied by a certificate of no appeal was not an impediment to the appellants having both legal title and all of the incidents of ownership, including possession, use and risk: M.N.R. v. Wardean Drilling, [1969] C.T.C. 265, 23 D.T.C. 5194.

The second issue is more difficult. To substantiate his claim under section 44 for what in essence amounts to a deferral of the recognition of a capital gain the appellant must establish that the former property (Block 2) was a capital property in his hands and that it was a "former business property". "Former business property" is defined in section 248 as follows:

"former business property” of a taxpayer means a capital property that was used by him primarily for the purpose of gaining or producing income from a business, and that was real property or an interest therein of the taxpayer, but does not include,

(a) a rental property of the taxpayer,

(b) land subjacent to a rental property of the taxpayer,

(c) land contiguous to land referred to in paragraph (b) that is a parking area, driveway, yard or garden or that is otherwise necessary for the use of the rental property referred to therein, or

(d) a leasehold interest in any property described in paragraphs (a) to (c),

and, for the purposes of this definition, rental property" of a taxpayer means real property owned by the taxpayer, whether jointly with another person or otherwise, if the property was used by the taxpayer in the taxation year in respect of which the expression is being applied principally for the purpose of gaining or producing gross revenue that is rent, but, for greater certainty, does not include a property leased by the taxpayer to a lessee, in the ordinary course of the taxpayer's business of selling goods or rendering services, under an agreement by which the lessee undertakes to use the property to carry on the business of selling or promoting the sale of the taxpayer's goods or services.

He must also establish that the replacement property (Block X) was a capital property, and that it was acquired by him for the same or a similar use as the use to which he put the former property and, where the former property was used by him for the purpose of gaining or producing income from a business, that it was acquired for the purpose of gaining or producing income from the same or a similar business as that in which the former property was used. [1] It should be noted that the qualification of Block 2 as a former business property depends on the use to which it is actually put whereas the qualification of Block X depends on the purpose for which it was acquired.

Was Block 2 a capital property?

The 1981 assessment was based upon the assumption that Block 2 was a capital property. The Minister assessed a taxable capital gain arising from its disposition. Counsel for the Minister moved to amend the reply to the notice of appeal to add the following paragraph:

In the alternative the respondent states that the assessment can be supported on the following fact not assumed by the respondent

(a) Block 2 was not used by the appellant primarily for the purposes of gaining or producing income from a business.

I allowed the amendment over the objections of counsel for the appellant, although I had some difficulty in seeing how this amendment added anything to what had already been stated in paragraph (f) of the Minister’s assumptions set out above. Counsel informed me that the purpose of this amendment was to permit him to establish that, notwithstanding the Minister's treatment of the gain on the sale of Block 2 as a capital gain, it was held and disposed of as part of an adventure in the nature of trade and was therefore not capital property and was not used in the business but was in essence property held for resale. I permitted the amendment because it is my view that the interests of justice are best served if the true facts are put before the court. Cases should not be decided on the basis of erroneous admissions of fact or law. It is open to the Minister to put forward in support of an assessment facts that did not form the basis of the assessment but that are not inconsistent with the assumptions pleaded. He can also put forward facts that are inconsistent with those pleaded as assumptions but, even if no estoppel arises, in repudiating his own basis of assessment the Minister undertakes the difficult task of establishing a factual underpinning for the amount of tax assessed that is contrary to that upon which the assessment was founded. In either case the onus is upon the Minister to establish such facts. The Minister may not, of course, in advancing a new and inconsistent ground for supporting the assessment, seek to increase the amount of tax assessed.Moreover, if he seeks to raise the new grounds at trial by way of an amendment, he may not do so if it would result in a material prejudice to the appellant that is not compensable in costs.

The appellant on the date of trial was 64 years of age. He has been married for 42 years and has 15 children. He has been in business for 40 years. He described his business as that of machinery and truck dismantling. Evidently he bought trucks and other machinery which he either dismantled and sold piecemeal or used to repair other trucks, which he sold. He was also involved in some degree in selling building materials. Formerly he operated under the name of McKervey Wholesale and latterly under the name of Empire Truck Parts.

He acquired, in the name of his son Patrick, Block 2, Plan Calgary 7549 JK in May of 1979. The property, comprising about 22 acres was located about one- quarter mile north of the Glenmore Trail on the Shepherd Road.

He testified that in 1979 he had been operating his business from approximately one acre, an area that was too small to accommodate both the building materials business and the truck parts business. Accordingly the possibility of obtaining a 22 acre site was attractive to him and gave him room for expansion. The property was not zoned to permit the storage, dismantling and repair of trucks or the sale of trucks and parts. One development permit application was made in December of 1979 to the Municipal District of Rocky View for permission to use the property for storage of trailers and pipe. Why the application did not refer to the truck demolition and sale business was not explained. In 1980 the application was refused. Notwithstanding the absence of zoning the appellant put some structures on the property and made some use of it for the storage of trucks and machinery. Since the appellant was aware that such use was not in conformity with the zoning, he made some attempt to conceal this use of the property by storing the equipment over the edge of a hill so as not to attract the attention of the municipal authorities who were evidently unsympathetic to him.

In 1981, he was approached by the Government of Alberta and asked to sell Block 2. However, the Government was interested in purchasing the adjacent Block 3 which was held by the appellant's son, Mark, whereas Block 2 was registered in the name of his son Patrick. The Government was interested in purchasing both blocks and the appellant put pressure on his son Patrick to acquiesce in the sale.

In result, Blocks 2 and 3 were sold in April of 1981. The gain on Block 2 was treated by the appellant as a gain on capital account that was deferred by reason of the election under section 44 of the Act. The gain on Block 3 was declared by his son Mark as a capital gain.

Mr. McKervey testified that he was aware that up the road Block X was available. It had approximately 35 acres. He started using Block X late in 1982 but he started negotiating for the purchase only in 1981. An offer was made on November 16, 1981 but that deal did not close and from then on until the ultimate acquisition of the property in December of 1982 there commenced the complex series of mortgage transactions and court proceedings which culminated in his acquisition of Block X as described above. On October 12, 1982, he was using Block X. He had started to move equipment onto the land but he was delayed by the fact that the previous owner had a crop on it which was not taken off until September. Block X extended 500 yards wide by half a mile east and west. There was a tenant on the property, Mayfair Lumber, which occupied about 4 acres. The appellant moved some of the buildings that had previously been on Block 2 to Block X as well as some of the equipment. By 1983, he had completely vacated Block 2 and he testified that in 1983 he made a greater use of Block X than he did of Block 2. Not all of Block X was used for storage of equipment by the appellant.

The appellant was subjected to a very thorough cross-examination by counsel for the Minister and, without reviewing all of the evidence, the following points should be observed. The appellant acquired Block 2 and Block X without checking the zoning. As counsel for the Minister observed it might have been understandable that he would have purchased Block 2 without being aware of the zoning on the assumption that he would be permitted to use the property for the same purposes as the adjoining properties were used but it is more difficult to understand why he would have purchased the second property without a clear idea of what uses were permitted. Second, Mr. McKervey accepted counsel's suggestion that by 1979 land prices had started to rise and that gives some basis to the suggestion that Block 2 was acquired not as a place for the appellant's business but rather as part of an adventure in the nature of trade. In cross-examination Mr. Curley also brought out that the appellant spent $600,000 on Block 3, a remarkably high price to pay for property that was ostensibly intended to be used to store machinery. Fourth, counsel pointed out that the use for which the appellant unsuccessfully applied was that of a pipe storage facility and not a location for the storage of vehicles. Fifth, the appellant signed a consent to one Quadrelli to make application for development permits with respect to a small bus and storage business on Blocks 2 and 3. He testified that he never intended to give such consent to Quadrelli with respect to Block 2 and that Quadrelli was never a tenant of Block 2. Finally, in December of 1982, Mr. McKervey gave an option to Orizon Resources Ltd. to purchase a portion of Block X. This option was never exercised and the option price was never paid. The appellant's explanation was that he was considering going into business with the owner of Orizon Resources, a Mr. Outhwaite.

The question which I have to decide is whether, notwithstanding these apparent inconsistencies, it can be said,on a balance of probabilities, that the appellant used Block 2 in his business, that he acquired Block X for the purpose of gaining or producing income from that or a similar business and that neither block was held as part of an adventure in the nature of trade.

The determination of the issues of fact in this case was difficult but I have concluded that, on a balance of probabilities, the appellant has established the factual basis necessary to entitle him to the relief provided by section 44 of the Income Tax Act. Some of the difficulty is attributable to the appellant himself. He was a somewhat unsatisfactory and in many ways a most exasperating witness. His answers on cross-examination were rambling and in some cases unresponsive. He read into the record a lengthy and argumentative letter that he wrote to the Department of National Revenue interspersed with somewhat emotional and irrelevant rhetoric about the alleged harassment that he was suffering at the hands of the officials of the tax department. There were, as I stated above, a number of unexplained inconsistencies in his testimony. Yet on the whole I am inclined to accept in broad outline his evidence, taking into account the length of time that has elapsed since the events in question, his age, and the complexity of the transactions that culminated in his acquisition of Block X. In brief, I accept that he acquired Block 2 for the purpose of using it in the rather varied mélange of businesses that he carried on—truck dismantling, sale of trucks and truck parts, trucking and the sale of building materials.

He certainly did not use all of Block 2 all the time and I agree with Mr. Curley that a nominal or incidental use in a business is insufficient for the purposes of section 44. The use to which he put it was more than nominal. He used it to the extent that it was necessary to accommodate the overflow from the other properties from which he worked and it does not appear from the evidence that there was any time at which the property was not being used to some degree for the purpose of his business. I do not think that for property to be used” primarily in a business it is necessary that it be used to full capacity all of the time provided that a reasonable amount of use is made of it and it is dedicated to and held in readiness for that use and provided further that it is not being put to any other significant use. I draw no adverse inference from the fact that the use was not in conformity with local zoning by-laws.

Mr. Curley argued in the alternative that Mr. McKervey's acquisition of lot 2 had less to do with its use in his truck parts business than it did with his rather canny assessment of the direction in which land prices were going in the Calgary area. Mr. McKervey is an astute businessman notwithstanding his protestations to the contrary and I am sure that he was not oblivious to the increase in land prices at that time. I am not, however, satisfied that the Minister has established that his own assumption on assessing that the land was Capital property was wrong. Block 2 was sold when Mr. McKervey was offered an attractive price by the Province of Alberta. There is no evidence that he solicited the sale or that he contemplated that or any sale when he acquired Block 2. Similarly there is no evidence that Block X was acquired for resale or for any purpose other than to use in his business in the same way in which he used Block 2. The appellant still owns and uses Block X.

In determining the capital gain for a particular taxation year from the disposition of a former property, one factor in the formula set out in paragraph 44(1)(e) is the cost of the replacement property. I do not think that the entire cost to the appellant of Block X should be treated as the "cost to him . . . of his replacement property" within the meaning of clause 44(1)(e)(i)B. Approximately four of the 35 acres of Block X were occupied under a lease to Mayfair Lumber. That portion cannot be regarded as forming part of the replacement property. Accordingly the cost to the appellant of the replacement property for the purposes of clause 44(1)(e)(i)B should be reduced by that portion of the cost of Block X that is attributable to the part occupied by Mayfair Lumber. If the parties are unable to agree on a figure they should communicate with the Registrar of this Court to fix a time and place at which the issue may be argued before me and determined.

The appeals will therefore be allowed and the assessments referred back to the Minister of National Revenue for reconsideration and reassessment on the basis that the appellant is entitled to deduct the amounts claimed in the years as Charitable donations and contributions to a registered retirement savings plan as consented to by the respondent, and on the basis that the appellant is entitled to the deduction in computing the capital gain realized on the disposition of Block 2 provided by section 44 of the Income Tax Act to the extent permitted by these reasons for judgment. Since the appellant withdrew that portion of his appeals relating to the imposition of penalties, the penalties are confirmed.

The appellant is entitled to his costs.

Appeals allowed.