Roseland Farms Ltd. v. R., 99 DTC 5704, [1999] 4 CTC 348 (FCTD), aff'd 2001 DTC 5392, 2001 FCA 167

Sharlow J.:

In 1980, the plaintiff Roseland Farms Ltd. sold farm property it had purchased in 1976 and 1977. The sale resulted in a gain of $420,630. In filing its income tax returns for 1980, the plaintiff treated the gain as capital, only 50% of which is taxable.

In 1982, Revenue Canada reassessed on the basis that the gain was taxable in full as income, thus increasing the plaintiff’s 1980 income by $310,315. At the same time the plaintiff’s income was increased by a further $12,455, the value of grain inventory at the end of 1980 that was sold in 1981.

The plaintiff appealed the reassessment to the Tax Court of Canada. A Tax Court Judge dismissed the plaintiff’s appeal for reasons rendered on December 18, 1985. [1] On February 26, 1986, the plaintiff appealed to this Court pursuant to the appeal provisions then in force.

This appeal is by trial de novo. There are two issues. One is whether the gain on the sale of the farm land is income or a capital gain. The other is the tax treatment of the value of the plaintiff’s closing 1980 grain inventory.

The trial was held on June 29, 1999, more than 13 years after this proceeding was commenced. The delay was due in part to a number of interlocutory motions rooted in the desire of the directors of the plaintiff to avoid public disclosure of certain facts relating to its shareholders. The result of those motions was that the names of the shareholders were disclosed to me but are not to be disclosed on the public record. Their names are known to the Crown. The Crown conceded and I accept that the names of the shareholders are not relevant to any of the issues to be determined in this appeal.

Sale of farm property: capital gain or income

Most of the facts are undisputed. The plaintiff was incorporated in 1976 under the Manitoba Companies Act. The share capital is a nominal $100. Two individuals are the beneficial owners of all the shares. It is not clear from the evidence whether the majority shareholder owns 80% of the shares or 60%, but nothing turns on that. Both of the shareholders are Italians who have never become residents of Canada.

The shareholders are not and have never been directors of the plaintiff. The directors of the plaintiff are Mr. MacKay, Mr. DeGraves (now Mr. Justice DeGraves) and Mr. Unruh of the law firm that incorporated the plaintiff. Mr. MacKay was the only director who gave evidence.

In April of 1976, the plaintiff purchased 634 acres of farmland for $220,000. The funds were provided by shareholder loans, of which $150,000 bore interest at the rate of 10% per year and was repayable in 1981. The remainder, $70,000, bore no interest and had no fixed term for repayment.

In June of 1977 the plaintiff purchased a further 2201 acres of farmland for $1,100,000. Again, the funds were provided by loans from the shareholders. Of the total shareholder loans, $750,000 bore interest at the rate of 10% per year and was repayable in 1983. The remainder, $350,000, bore no interest and had no fixed term for repayment.

The Crown argues in its pleadings that the property should be held not to be capital because it was financed heavily with short term debt. The method of financing the purchase of property may be important in distinguishing capital from income if, as a practical matter, the property is so burdened with debt that the owner is unlikely to recover its cost without selling it. However, that is not as important a consideration where the financing is entirely by way of shareholder loans.

In this case, the acquisition of the property was entirely funded by debt, but all of that debt is held by shareholders. Over 30% of the debt bears no interest and has no fixed repayment terms. The remainder is interest bearing debt with a term of five years, which I would not characterize as short term debt. There is no evidence of any indirect third party financing.

In these circumstances, the method of financing the purchase is a neutral factor. It does not assist in characterizing the gain on the sale of the property as either income or capital.

The plaintiff undertook some improvements to the property, including some ditching work and the demolition of a house and other buildings on the property that were not in use.

The property was used for farming throughout the period of the plaintiff’s ownership. Although the plaintiff owned no farm equipment, nothing turns on that because the plaintiff carried on its business in a manner that did not require it to acquire its own equipment. Both parcels were initially farmed by someone who leased the property. After the first year, the smaller parcel was “custom farmed,” while the larger one remained on lease.

As I understand it, custom farming involves contracting out various aspects of the farming operation, such as the tilling, the seeding, the harvesting and so on, to someone who is equipped for such operations. The Crown suggested in argument that custom farming is essentially a passive use of land and thus is more like leasing than active farming.

A corporation is an incorporeal entity. It cannot undertake farming activities except through human beings. The workers may be employees of the corporation or contractors. In a closely held farm corporation, they may even be shareholders who are not compensated directly for their work. The precise legal relationship between the plaintiff and the individuals who ac- tually performed the farming work on the plaintiffs property is not relevant to any issue in this case. For present purposes, what is important is that while the plaintiff owned the farm property, it generated revenue for the plaintiff in the form of rent and the proceeds of sale of crops.

The net income and losses of the plaintiff, as set out in the financial statements filed in its income tax returns, may be summarized as follows:

In November, 1980, all of the farm land was sold for $1,826,241. It was a condition of the sale that there be a subsisting lease providing for an annual rental of $35 per acre. It was argued for the plaintiff that its efforts to ensure that the land was profitably leased indicates that the sale was on capital account. In my view, the fact that the property produced rental income prior to the sale and at the time of sale simply shows what efforts were undertaken to ensure that the property would retain its value as farm property. That fact is equally consistent with the gain on the sale of the property being characterized as capital or income.

The circumstances of the sale were described by Mr. MacKay at the trial. He said that the majority shareholder wished to be dissociated from the minority shareholder because of some problems, perhaps fiscal problems, that the minority shareholder was having in Italy. Mr. MacKay and the others in his law firm were unable to devise a reorganization that would have met the needs of the majority shareholder and still enable the plaintiff to retain its property. It was decided that the only solution to the majority shareholder’s problem was to have the plaintiff sell its property. Presumably, the net proceeds would then be distributed in some fashion to the shareholders so that they could each go their own way.

The property was never listed for sale. There were a number of agents who maintained a continuing interest in property of this kind. After the de- cision to sell was made, an agent came to Mr. MacKay to ask if he knew of any properties for sale. Mr. MacKay told the agent he did know of some property, referring to the plaintiff’s property, but that he did not wish to list it. Shortly after that Mr. MacKay received a telephone call from someone in a law firm in Toronto, who expressed some interest in the property. That person indicated that he would send an agent out to look at the property. Ultimately an offer was presented by an agent, and the property was sold. The agent was paid a commission pursuant to the sale agreement.

The only fact in controversy relates to the plaintiff’s purchase of the property. The Crown’s pleadings state that in issuing the reassessment under appeal, Revenue Canada made the factual assumption that one of the motivating factors that induced the plaintiff to purchase the property was the possibility of reselling it at a profit at some future time. [3]

By this pleading the Crown raised the question of “secondary intention.” That is shorthand for the general proposition that if, as a matter of fact, the prospect of resale at a profit is an operating motivation for the acquisition of property, then the property must be considered to have been acquired on income account, and any gain on the sale of the property must be income. [4] That is so regardless of the use made of the property after its acquisition, or the reason for its sale.

The taxpayer has the onus of disproving a factual assumption on which a tax assessment is based: Johnston v. Minister of National Revenue, [1948] S.C.R. 486 (S.C.C.). [5] The burden of proof shifts to the Crown only if evidence is adduced that contradicts the assumption. Thus, an assessment based on a factual assumption must be upheld unless there is evidence that the assumption is not true. Counsel for the plaintiff cited several cases that suggest the contrary, but they all predate Johnston, supra. [6] Here, the onus was on the plaintiff to adduce evidence to contradict the Crown’s factual assumption that the prospect of reselling the land at a profit was an operating motivation for the purchase.

The intention of a corporation is that of the natural persons by whom it is managed and controlled: Metropolitan Motels Corp. v. Minister of National Revenue (1966), 66 D.T.C. 5208, [1966] C.T.C. 246 (Fed. T.D.); Leonard Reeves Inc. v. Minister of National Revenue (1985), 85 D.T.C. 419, [1985] 2 C.T.C. 2054 (T.C.C.). In the case of a widely held public corporation, the requisite intention may be that of a corporate officer or group of officers or directors who made the purchasing decision. The intention of a closely held corporation, however, is normally that of the shareholders.

In this case, it is abundantly clear from Mr. MacKay’s evidence that the decision to have the plaintiff purchase the farmland originated with the shareholders. The only steps Mr. MacKay and the other directors took in connection with the purchase and sale of the property were steps calculated to give effect to the shareholders’ instructions.

What then is the evidence relating to the shareholders’ motivation in having the plaintiff purchase the land? The shareholders did not testify. Mr. MacKay gave evidence that explained his understanding of their position. His evidence was honest and frank, but it was not capable of disproving the Crown’s factual assumption with respect to the shareholders’ motivation at the time of purchase.

Mr. MacKay testified that he had met with both shareholders at the outset, but only once or twice. Their main contact with his law firm was with Mr. DeGraves. In fact, Mr. MacKay learned very little about the shareholders at the time of the purchase. He guessed that they might have been in their fifties in 1976. He does not know what business, if any, they carried on in Italy. The shareholders spoke Italian but no English. Mr. MacKay speaks no Italian. Because of these language problems their conversations were conducted through Mr. Len Franco, who acted as an interpreter. Mr. Franco was also the person who introduced the two shareholders to Mr. MacKay’s law firm. He did not give evidence.

From his one or two meetings, Mr. MacKay drew some inferences, which I summarize as follows. Neither shareholder had any farming experience. The minority shareholder wished to come to Canada to learn how to farm, perhaps from the vendor of the first parcel who had agreed to lease the farm for a short period after the purchase. However, the minority shareholder did not immigrate to Canada, for reasons Mr. MacKay never learned. In fact, Mr. MacKay was unable to determine whether the minority shareholder had ever applied for the right to immigrate. In any event, the directors of the plaintiff had the task of managing the property on a day to day basis. When it became necessary to operate part of the land through a custom farming arrangement, the shareholders advanced the necessary funds and the arrangements were made by the directors.

Mr. MacKay also speculated from experience with other European clients that the shareholders of the plaintiff might have been motivated by a desire to move capital out of Italy to avoid some political uncertainties. However, he was unable to say whether this particular topic was ever discussed in the context of the shareholders of the plaintiff.

None of this evidence contradicts the Minister’s factual assumption that an operating motivation, at the time of purchase, was to resell the property at a profit. The part of Mr. MacKay’s evidence that comes closest to the critical factual issue is found at page 17 of the transcript, in direct examination:

Q. At the time of these properties being purchased did you, as a director, have any reason to believe that they were purchased other than for farming?

A. No. They were to be run by the minority shareholder.

I accept that Mr. Mackay did not know of the existence of a secondary intention on the part of the shareholders, and by extension the plaintiff. But the fact that he knew of no secondary intention cannot prove that there was no such secondary intention. It is worth recalling that Mr. MacKay had no direct knowledge of the facts relating to the shareholders and their reasons for purchasing the property. Again, it was not Mr. MacKay but Mr. DeGraves who was the main contact between the law firm and the plaintiff’s shareholders. Mr. DeGraves did not give evidence.

I have considered whether it is possible to infer from other circumstances whether any secondary intention was present. Both parcels of land acquired by the plaintiff are located between Portage la Prairie and Bran- don, Manitoba. Mr. MacKay testified [7] that he believed that the land was suitable only for farming and had no speculative value at the time of the purchase. Mr. Grace, the representative of the Crown, admitted in the examination for discovery that there was no obvious development potential for the land, and that its best use would be farming. [8] However, this testimony does not directly address the factual question: what was the motivation of the shareholders, or the plaintiff, in acquiring the property? The shareholders may well have seen the world differently than Mr. Mackay or Mr. Grace.

I conclude that there is no evidence that contradicts the Crown’s factual assumption that the prospect of the resale of the property at a profit was an operating motivation for the purchase.

At the same time, there is no evidence that this factual assumption is true. On the contrary, the answers given by Mr. Grace in the examination for discovery indicate that the Crown probably could not prove its assumption if it were called upon to do so.

However, the absence of evidence to support a factual assumption made by the Crown is irrelevant. The result of the principle established in Johnston, supra, is that the Crown may justify an assessment on whatever factual assumption it sees fit, even if the assumption is not consistent with the information the taxpayer has presented. [9] The Crown is entitled to disbelieve the taxpayer. An assessment based on a factual assumption that the Crown cannot prove will stand if the taxpayer cannot or does not adduce evidence that contradicts the assumption.

I conclude that the assessment of the gain on the sale of the property as income must stand.

Closing 1980 grain inventory

The second issue relates to the tax treatment of the sale of grain that comprised the plaintiffs closing inventory for the 1980 taxation year. The only evidence on this point is found in Mr. Grace’s answers to questions in the examination for discovery. No oral submissions were made. Both counsel rely solely on the pleadings. The pleadings on this point are unhelpful.

According to the Statement of Defence, one of the Crown’s factual assumptions was that the plaintiff, in filing its returns for the taxation years prior to 1980, computed its farming income on the accrual basis. However, Mr. Grace admitted in the examination for discovery that the plaintiff’s income before 1980 had been reported on the cash basis. [10] That method of computing farming income is permitted under subsection 28(1) of the Income Tax Act, as it read at the relevant time.

The evidence of Mr. Grace rebuts the Crown’s factual assumption on the question of the plaintiff’s accounting method for years prior to 1980. I conclude that in fact the plaintiff elected in those years to compute its income on the cash basis pursuant to subsection 28(1).

The grain that comprised the plaintiff’s 1980 closing grain inventory was the product of its farm. The sale of grain is an integral part of its farming business. The plaintiff’s farming business, such as it was, continued until the 1981 sale was complete. Thus, the plaintiff was entitled to continue to use the cash method of accounting in 1980, and was correct in excluding from its 1980 income the value of its 1980 closing inventory. The reassessment under appeal is therefore wrong in respect of that item.

I would add that even if the plaintiff’s farming business had ceased in 1980, the result would be the same. Subsection 28(3) provides that a taxpayer who computes farming income on the cash basis in a particular taxation year must do so for subsequent years unless the Minister concurs in a change of accounting method. By virtue of subsection 28(5), any amount received on income account after the cessation of the farming business must be included in income in the year of receipt.

Conclusion

The appeal is allowed in part. The reassessment will be referred back to the Minister for reassessment on the basis that the 1980 income of the plaintiff should be reduced by $12,455, the value of the closing 1980 grain inventory.

As the Crown was successful as to well over 90% of the amount in issue, costs are awarded to the Crown.

Appeal allowed in part.