Richcraft Homes Ltd. v. The Queen, 95 DTC 657, [1995] 2 CTC 2714 (TCC)

Rip J.T.C.C.:-The issues in these appeals from income tax assessments for the appellant Richcraft Homes Ltd. ("Richcraft”) are whether the proceeds of disposition of twelve single family residential properties were received on capital or income account in its 1988 and 1989 taxation years and whether the cost to the appellant of the installation of sanitary and storm sewers within a plan of subdivision are deductible in computing income for the appellant’s 1988 taxation year pursuant to paragraph 20(1)(ee) of the Income Tax Act, R.S.C. 1952, c. 148 (am. S.C. 1970-71-72,

c. 63) (the ’’Act”).

Capital vs. income gain

Krishan Singhal, the president of Richcraft and controlling shareholder of Richcraft, testified the appellant was incorporated in 1982 as a land developer and builder of homes and commercial buildings in the Ottawa area. The appellant buys raw land, subdivides it and directs the servicing of the land. Richcraft has been a successful business; in 1983 it sold two homes, in 1992, its best year, it sold 410 homes.

In 1988 the appellant’s commercial rental property consisted of a shopping centre, which it built around 1987, a 120,000 square foot warehouse, which it purchased in 1984, and an office building.

By the mid 1980s the appellant and its auditors realized that the company’s profits were generated solely by housing sales and discussions were held to diversify the appellant’s activities and tax plan. John Frouin, the appellant’s erstwhile auditor, recalled that the appellant was advised to build rental properties. Rental properties would generate a regular cashflow. For tax purposes, the appellant would be permitted to claim capital cost allowance on the rental property and deduct interest on money borrowed to build the homes, for example. Frouin also stated that a property with a tenant would be easier to sell than a vacant property, if the need ever arose. However the main reason for Richcraft to start building rental housing units was for diversification and cash-flow, according to Frouin. Singhal’s reasons were similar: to have a steady cash-flow and over a period of time to build equity into the units. Rental properties would provide financial stability for continuous cash-flow.

Following this advice, Richcraft decided to build 56 single family homes in a subdivision block as rental properties. The block consisted of 88 units and were located in a fast growing area of Ottawa. These homes were built of the same quality and style as the other homes in the subdivision that were for sale. The block was serviced and "ready to go". The lots were 30 feet, 40 feet and 50 feet wide. Richcraft had not built on 30 foot lots before. Singhal testified that the appellant could have sold the 56 units "easily", if it had wanted to do so.

Prior to 1988 all homes built by Richcraft were for sale, stated Singhal. The economy was buoyant in 1987-1988 and "sales were booming". Singhal recalled that at the time a customer "had to wait a year to buy a Richcraft home.... Our resources could not keep up". The appellant sold whatever it built. Richcraft did not build on speculation; it built only homes that it had pre-sold.

Construction of homes for sale had already started and it was "midway" when the appellant decided to set aside the 56 units for rent. Singhal declared he wanted good tenants and therefore the houses were rented with an option to purchase. Indeed, advertisements for rent featured the purchase option. Rents were approximately $1,000 per month, which Singhal described was "high rent at the time". According to Singhal, "statistically, people who rent, don’t buy". He minimized the significance of the option to purchase. The rent with option to buy also "gave us the opportunity to screen for good tenants". In order to discourage tenants from exercising the options, Singhal said, prices on the options were as much as 20 per cent more than the current sale prices. However prices of homes were increasing more than 20 per cent at the time and nine tenants in 1989 and four tenants in 1990 exercised their options to buy.

Three of the 56 homes were sold in 1988 to tenants without options. These tenants approached Richcraft to purchase their homes. Two of these homes were leased on October 15, 1986 and the other on November 1, 1986. One of the home leased on October 15, was "sold" on November 3, 1986 and "closed" on October 31, 1987. The other home leased in October, was "sold" on March 6, 1987, the house leased in November was "sold" on January 28, 1987. The sales of the latter two homes were "closed" in October 1987.

Richcraft gave a credit of $6,000 to tenants purchasing a home. The credit effectively reduced the rent they had paid which, Singhal stated, was high.

None of the 56 units designated for rental had been pre-sold, declared Singhal. Richcraft applied for building mortgages on the basis the homes were to be built for rental and the money so borrowed was based on the rental values of the properties. Each unit cost about $100,000, of which 75 per cent was financed.

Richcraft’s expected no immediate profit from the rental homes. Singhal anticipated the rentals would cover costs such as mortgages, maintenance and taxes so that the appellant would break even, at the latest, in three years, when a positive cash-flow would start. He said the appellant was looking at the long-term.

Richcraft’s internal property management department looked after the rental homes. Singhal testified the management department consisted of three people: a leasing officer, an assistant and a secretary. A person was also on call 24 hours a day.

In cross-examination Singhal acknowledged that once the appellant started selling homes in the subdivision it could "switch" to rentals at any time and the number of rentals could be more or less than 56. Singhal testified he anticipated Richcraft holding the 56 units for a period of three to five years. At time of trial Richcraft retained only five of the units. Singhal stated the appellant started to sell the units within the last two to three years.

Service connections

By agreement dated May 29, 1986 the appellant entered into a subdivision agreement with the Corporation of the City of Ottawa to construct and install at its own expense, sanitary and storm sewers within its property to service the subdivision on land it owned in the City in consideration of the City’s approval of the appellant’s plan of subdivision. The appellant subcontracted the construction and installation of the sanitary and storm sewers to service the subdivision. The work to service 23 homes which were completed in 1988 was performed in that year. The homes are part of the same subdivision as the 56 units discussed above. In its tax return for 1988 the appellant claimed a deduction for the cost of the installation of the sewers in the amount of $77,651.29.

Singhal estimated 60 per cent of the costs are for the storm sewers, which have larger pipes, and 40 per cent to the sanitary sewers.

Analysis

I do not share the appellant’s view that the 56 homes designated for rental, or specifically, the twelve homes in issue, were capital assets of Richcraft. There is no doubt that a taxpayer that builds homes for sale may also hold capital assets. Indeed, on the evidence at trial, the warehouse, shopping plaza and office building are capital assets. It is also possible for a taxpayer such as Richcraft to own residential units as capital assets. But this was not the case here.

Richcraft no doubt wished to rent for a limited time a number of homes built in the subdivision. The fact these homes were offered for rent do not entail a conversion to capital property any more than the sale of what is otherwise capital property becomes sale of inventory: 475588 Ontario Inc. v. The Queen, [1995] G.S.T. 9, 9-1.

Many of the 56 homes were sold with an option to purchase. Any sale to a tenant would be at a profit; this was built into the option. Singhal’s reasons for the option to purchase was to afford Richcraft an opportunity to screen tenants. I am not convinced this was the sole reason. Certainly the appellant does not come within the ratio of R. v. Ball Bros. Ltd., [1976] C.T.C. 793, 77 D.T.C. 5004 (F.C.T.D.). The appellant’s business activities were not those of Ball Brothers Ltd. Ball Brothers Ltd. had never engaged in the business of trading in land or in constructing buildings for sale. Ball Brothers Ltd. built buildings for lease. The option it gave a lessee to purchase a building was a willingness to sell under certain circumstances, not necessarily to sell at a profit. Ball Brothers Ltd. acquired the property as an investment; the possibility of its resale at a profit was not an operating motivation for the acquisition. [1]

Richcraft was also willing to sell homes to tenants who did not have an option to purchase. Three such homes were sold in 1988, one of which the appellant agreed to sell less than a month after the property was rented. The properties were sold on simple requests of the tenants to purchase them.

Richcraft did not consider that it held the 56 units as capital assets over the long run. Richcraft never dedicated the units to be held exclusively as rental properties. Richcraft did not intend to keep the properties more than five years. While it rented these units, it also retained the choice of selling them: see Algonquin Enterprises Ltd. et al. v. The Queen, [1986] 1 C.T.C. 493, 86 D.T.C. 6233 (F.C.T.D.). The units were held as rental properties only as a convenience. The properties were available for rent but at the same time were also available for sale.

In the appeals at bar, the operating motivation of the appellant was not to acquire or to build the 56 rental properties solely as an investment; at the time Richcraft allocated the 56 units to rental properties, it had in its mind, or in the mind of Singhal, the possibility of reselling them at a profit if the occasion arose in the normal course of carrying on its business of selling homes. And that is what it did.

The profits from the sales of the 12 units in 1988 and 1989 were on income account.

Paragraph 20(1 )(ee) of the Act reads as follows:

20.(1) 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:

(ee) an amount paid by the taxpayer in the year to a person (other than a person with whom he was not dealing at arm’s length) for the purpose of making a service connection to his place of business for the supply, by means of wires, pipes, or conduits, of electricity, gas, telephone service, water or sewers supplied by such person, to the extent that the amount so paid was not paid

(i) to acquire property of the taxpayer, or

(ii) as consideration for the goods or services for the supply of which the service connection was undertaken or made;

The appellant submitted that each of the housing lots to which the service connections were made is a place of business of the appellant. This submission assumes that each lot is a capital property to the appellant and is a place of business.

Appellant’s counsel argued that the appellant made a payment to the subcontractor for the purpose of making a service connection to its place of business for the supply, by means of pipe, of water or sewers supplied by the City of Ottawa and that the amount of the payment is deductible in computing its income on the authority of Curlew Ltd. v. M.N.R., [1970] 70 D.T.C. 1017, Tax A.B.C. 28

(T.A.B.).

The Queen v. Guaranteed Homes Ltd., [1978] C.T.C. 636, 78 D.T.C. 6510 (F.C.T.D.) is the leading case dealing with the deductibility of the costs of service connections pursuant to paragraph 20(1 )(ee). Respondent’s counsel submitted that Guaranteed Homes is authority for the principle that a lot in a subdivision is not the appellant’s "place of business". To Smith D.J., the words "his place of business" in paragraph 20(l)(ee), at page 643 (D.T.C. 6515) of Guaranteed Homes'.

indicate a single place which is already the taxpayer’s place of business.... [It is] not simply the place where the [taxpayer] is building a house or houses, but also the place which will be the recipient of the services which the connections to be made under the contract are intended to make available and in which the [taxpayer] will have the benefit of those services. They further mean the place in and from which control and direction of the house building work on the 77 lots will be exercised. I do not understand how they can properly be said to mean 77 places of business...comprised separately of 77 building lots…. The 77 lots...are all places in which the [taxpayer] will work at the business of house building, but neither they nor one of them is indicated by the words "his place of business" in paragraph 20(1 )(ee).

In Curlew, supra, it was suggested that water in a storm sewer could not be said to be supplied by anyone. It was on this ground that Mr. Fordham of the Tax Appeal Board allowed the Curlew appeal, although Smith D.J., suggested, at 643 (D.T.C. 6516-6517) of Guaranteed Homes, the board might conceivably have come to a different conclusion bearing in mind the onus on the taxpayer in an appeal. However, Smith D.J., agreed that the board’s decision was correct on the facts. Nonetheless, he added, the board’s decision does not affect the Crown’s argument that the language of paragraph 20(1 )(ee) of the Act requires, for the deduction to be allowed, that the person who makes the service connections to the taxpayer’s place of business, for the supply of services by means of wires, pipes or conducts, shall also be the person who supplies the service or sewers for the supply of which the service connections were made.

Smith D.J., agreed, at pages 645-46 (D.T.C. 6517), with the Crown’s alternate argument in Guaranteed Homes, supra, that paragraph 20(1 )(ee) is not intended to permit the deduction from the taxpayer’s income of money paid in a situation where the taxpayer has purchased land which he has subdivided into building lots and which he is developing as a subdivision by building houses thereon for sale. Crown’s counsel in Guaranteed Homes submitted that paragraph 20(1 )(ee) is clearly intended to grant a right of reduction to a person who has his place of business at a certain location, to which location the service connections are made, and in which location that person, as operator of the business, will be the recipient of the services that are made available by the installation of the connections. There is nothing in paragraph 20(1 )(ee) or in any other provision in the Act which suggests that the paragraph is intended to have a wider meaning; in particular that there is nothing to suggest that a developer who is building houses for sale, in respect of which houses the purchasers and not the developer will be the recipients of the services, is granted a right to deduct from his income the cost of connecting the services to the front lot line of the lots on which he is building the houses.

Smith D.J., added that what a taxpayer does in his business, with respect to the costs of making these service connections, is to add them to the cost of the land, or alternatively to the total cost of the development, in the expectation of recovering them proportionately, with a margin of profit, in the selling prices of the houses as they are sold. This being so, he asks, why should anyone conclude, in the absence of a clear indication to that effect in the legislation, that Parliament intended to grant to a developer, in such circumstances, a right to deduct from his income for the appropriate taxation year, the money paid by him to someone else for making such service connections.

Counsel for Richcraft stated that the lots in Guaranteed Homes were inventory and submitted that Guaranteed Homes would have been decided differently if the lots were capital. I need not consider this submission since I have found that none of the lots in the subdivision were capital assets of the appellant. Guaranteed Homes is binding on me and is good law.

The amounts paid by the appellant for the installation of the sanitary and storm sewers in 1988 are not deductible in computing its income for its 1988 taxation year pursuant to paragraph 20(1 )(ee) of the Act. The service connections were not made to the appellant’s place of business.

The appeals for 1988 and 1989 are dismissed with costs.

Appeals dismissed.