Algonquin Enterprises Ltd. v. The Queen, 86 DTC 6233, [1986] 1 CTC 493 (FCTD), aff'd 90 DTC 6377 (FCA)

Reed, J.:—This is an appeal (trial de novo) from a decision of the Tax Review Board finding that sales of certain lands by the plaintiffs were transactions in the nature of trade and consequently the proceeds therefrom were of an income nature rather than capital gains.

These reasons apply to actions brought separately by two plaintiffs, Dartmouth Developments Ltd. (court file number T-5034-79) and Algonquin Enterprises Ltd. (court file number T-5033-79). The facts (except for details) and the issues arising therefrom are identical in both cases.

The plaintiffs during the 1960s were in the business of assembling land on the outskirts of Winnipeg, opening it up for subdivision and selling the serviced lots to builders. Between 1962 and 1968, 1098 serviced residential lots were made available by Dartmouth, in a subdivision known as Kensington Square, for either sale or lease. Of these, 869 lots were sold outright and 229 were leased. During the same period of time, Algonquin held 322 residential lots in a subdivision known as Heritage Park. Of these, 172 were sold outright and 160 were leased.

The leases provided for a 50-year term; the rent was fixed for that period and calculated at no more than 6V2 per cent per annum of the market price of the lot at the time the lease was entered into (ie: between 1962 and 1968). The leases contained an option to purchase at any time during the 50-year term at the market price of the lot when the lease was entered into. The leases were fully assignable and indeed while the original lease was with the builder (in the case of Dartmouth this was Metropolitan Construction Limited and in the case of Algonquin, Metropolitan Homes) the intention was that the leases would be assigned eventually to whoever purchased the home built on the lot, and to be assignable in turn to any subsequent purchaser or assignee thereof. This was in fact done and it is the proceeds arising out of the exercise of options to purchase during 1970 to 1973 (six in the case of Dartmouth, five in the case of Algonquin) that this case arises. The plaintiffs argue that these proceeds are of a capital nature; the defendant asserts they are income.

There is no dispute that when the land was originally acquired it was acquired for resale ie: as “inventory”, for trading purposes. There is no dispute that when the land was subdivided into serviced lots, those lots were held by the plaintiffs with the same intention and for the same purpose. It is argued, however, that the intention of the plaintiffs changed when the decision was made to lease some lots and not sell them outright. It is argued that with respect to the leased lots there was thereafter an intention that they be held as capital assets, not inventory. Indeed, when the lots were leased they were transferred on the companies’ books from inventory and carried thereafter as capitalized fixed assets.

The decision to lease a certain percentage of the lots was made in early 1962. At the time the residential housing market was soft. Lots were only purchased by the builder as the builder was ready to build on them. In fact, once a lot was sold to the builder it was only paid for, six or nine months later, after the house was built. It was paid for out of mortgage funds which the purchaser of the house obtained. In order to enable the respective builders of the two subdivisions to broaden their markets the plaintiffs agreed to lease a certain percentage of the lots rather than selling them outright. The price to the ultimate purchaser of the house was thereby reduced and individuals not otherwise eligible for CMHC mortgages became eligible.

In fact, CMHC had a significant role to play in the development of the terms of the lease. CMHC approval was necessary for the builders and the plaintiffs to achieve their objectives. Thus, negotiations were carried on with that agency for several months.

CMHC had some influence on the term of the lease since they wished to have a term which extended beyond the maximum CMHC mortgage term (40 years). They had a limiting effect on the rent which could be charged — 6 /2 per cent of the appraised value of the lot at the time the lease was entered into. If more were charged the maximum CMHC loans would not be available to the purchaser of the home built thereon. They had a determinative role in the fixing of the price at which the lot could be purchased under the option to purchase — the value of the lot at the time the lease was entered into. The plaintiffs pressed for a clause which would have allowed re-appraisal of the value of the land in terms of current market value from time to time during the life of the lease but CMHC's objective was to put the purchaser of a house built on a leasehold interest in the same position as the purchaser of a home built on a freehold interest.

The issue is whether there was a conversion of the leased lots from inventory to capital asset as that concept is used in the jurisprudence for income tax purposes. A leading decision in this respect is Edmund Peachey Limited v. The Queen, [1979] C.T.C. 51; 79 D.T.C. 5064 (F.C.A.). Mr. Justice Heald at 55 (D.T.C. 5067) described the requirements that were not present in that case as follows:

. a clear and unequivocal positive act implementing a change of intention would be necessary to change the character of the land in question from a trading asset to a Capital asset — and that on the facts here present, there was no evidence of such a positive or overt act. There was no documentary evidence to indicate that the new intention had been carried into reality, there was no dedicating of the land for another purpose. All that we have here is the expressed intention of the appellant to thenceforth hold the land as a capital asset. That is not, in my view, sufficient of itself to convert the proceeds of sale from trading proceeds to proceeds from the sale of a capital asset.

See also Pinehill Investments Ltd. v. M.N.R., [1967] Tax A.B.C. 233; 67 D.T.C. 204 (T.A.B.); Lars Kvellestad v. M.N.R., [1971] Tax A.B.C. 714; Watkins et al. v. M.N.R., [1985] 2 C.T.C. 2023; 85 D.T.C. 372 (T.C.C.).

Counsel for the plaintiffs argues that the requirements set out in Peachey have been met in the present case. It is argued that a clear and unequivocal positive act has been shown by the clear and conscious decision of the plaintiff companies to lease the lots rather than sell them outright. There is evidence that, at the time, the ground rent which would accrue to the plaintiffs was considered to be a very good return — 6V2 per cent on the appraised value of the serviced lots was 11 — 12 — 13 per cent on the cost of the lots to the plaintiffs. This was in the context of a market situation in which 6 per cent interest was normal. The return was also very secure; the lease was a first charge on the land; the rents were collected by CMHC; there were no carrying charges — taxes etc. were to be paid by the home purchaser. Counsel invites me to equate the leasehold interests held by the plaintiffs to long term government bonds.

It is argued that the implementation of the changed intention is seen in the extensive negotiations with CMHC which were carried out.

Documentary evidence of the changed intention, it is argued, is found in the leases themselves as well as the changes to the financial statements and books of the companies.

The dedication of the land to another use, it is argued, is seen in the fact that the companies “created investment portfolios” of the leased lots and managed them as investments. As I understand it, the two companies in question were created for the purpose of assembling and developing the respective subdivision lands only. Thus, in 1972 (approximately) when all the lots had been either sold or leased, the two companies, which might otherwise have been wound up, were left administering the rents which came from the leased lots. So as not to be misunderstood I emphasize that I do not understand Mr. Buchwald’s argument to be that the investment portfolios were only created in 1972. I understand his argument to be that the “portfolios" were created with the leasing of the first lots in 1962 and added thereto during the subsequent years until the leasing program was phased out in 1968.

While the Court of Appeal in the Peachey decision (supra) had difficulty finding an unequivocal act which demonstrated a changed intention, my difficulty is finding a changed intention itself. The conclusion I draw from the evidence is that the leasing scheme was merely a mechanism for postponing the date of the ultimate purchase of the land. The leases provided for reversion to the plaintiffs of the land and all buildings thereon at the end of the term of the lease, if the option to purchase had not been exercised. There is no provision for automatic renewal. The leased lots were scattered randomly throughout the subdivisions; they were not retained in one block. Whether a lot was leased or sold in the first instance was, in general, determined by the purchaser of the home (subject to the plaintiffs’ decision to lease no more than one third of the total number of the lots available).

In my view, the scheme was designed to put purchasers of a house built on a leasehold interest in the same position as purchasers of a house built on a freehold except that payment for the land component was deferred. Thus the purchaser could pay for that component when he or she had more liquidity than might be the case at the time of the initial purchase of the home. I cannot conclude that the plaintiffs ever considered the leasing of the lots to be a permanent conversion from inventory to capital asset. If there was an intention to convert, it was that the lots would be so converted for a temporary period of time only, with the certainty (apart from some few exceptions) that they would eventually, when the option to purchase was called, be reconverted to their original status.

Considerable argument in this case focussed on the effect an option-to- purchase clause has in a lease. The defendant referred to M.N.R. v. Edgeley Farms Ltd., [1969] C.T.C. 313; 69 D.T.C. 5228 (S.C.C.). In that case a taxpayer had acquired a parcel of land in the path of urban development without a settled view as to how he intended to use the land. Eventually the property (350 acres in extent) was leased to a tenant who was given the option to purchase the land in 10 acre (or more) parcels. Parts of the land were so purchased in 1962 and 1963. The Supreme Court held that when the plaintiff taxpayer first granted the lease it had thereby indicated its intention to consider the land as a trading, rather than as an investment asset. It was held that the option scheme “was the method which the company adopted in putting through its real estate transactions” and that the company was selling its lands in the course of an operation of a business for profit. See also Lehrer v. M.N.R., [1972] C.T.C. 255; 72 D.T.C. 6224 (F.C.T.D.).

The plaintiffs refer to the decision of Mr. Justice Mahoney in The Queen v. Ball Brothers Limited, [1976] C.T.C. 793; 77 D.T.C. 5004. In that case a taxpayer who never engaged in the business of trading in land or in constructing buildings for sale was prevailed upon by a prospective lessor of property to include in the lease an option for purchase. The option to purchase was subsequently exercised in circumstances unanticipated and unexpected at the time the lease was entered into. Mr. Justice Mahoney held that an option to purchase in a lease cannot be held ipso facto to render the asset covered by the lease, stock in trade rather than a capital asset. He stated that regard must be paid to the circumstances in each case. In the circumstances of the Ball case the fact that the would-be lessor required the inclusion of an option to purchase for its purposes was a significant factor, as was the fact that the plaintiffs normal business was not the buying and selling of land and the fact that initially it was not anticipated by the parties that the option would be called. Other cases which have held that options to purchase do not automatically render an asset stock in trade as opposed to a capital asset are: Les Immeubles Réal Verreault Ltée v. M.N.R., [1979] C.T.C. 2583; 79 D.T.C. 455 (T.R.B.) and Trans-World Industrial Development Inc. v. M.N.R., [1979] C.T.C. 2465; 79 D.T.C. 422 (T.R.B.).

The option clauses in this case are crucial, not because they automatically characterize the assets to which they relate as stock in trade but because when read together with the other terms of the lease and the circumstances in which they were given it is clear, in the words of the Edgeley case, they were "the method which the company adopted in putting through its real estate transactions.” The terms of the options were influenced by CMHC but they were not required by that agency in any way comparable to the fact situation in the Ball decision. It was the plaintiffs decision, in conjunc tion with the builders, to adopt a leasing scheme and it was assumed from the beginning that an option to purchase would be part of that scheme.

The defendant cites Canadian Kodak Sales Limited v. M.N.R., [1954] C.T.C. 375; 54 D.T.C. 1194 (Exch. Ct.) and The Gloucester Railway Carriage and Wagon Co. Ltd. v. C.I.R., [1925] A.C. 469; 12 T.C. 720 (C.A.) as examples of cases where a taxpayer had initially leased equipment and then sold it outright. The courts in both cases held that the sale of the equipment was part of, and not fundamentally different from, the taxpayer's normal business activity by which income was earned. Therefore the profits from the sale of the equipment was income. Californian Copper Syndicate v. Harris, 5 T.C. 159 is cited for the test, therein set out, for distinguishing a capital gain from proceeds of an income nature (at 166):

. . . the question to be determined being — Is the sum of gain that has been made a mere enhancement 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 application of this test to the facts in this case leads to the conclusion that the proceeds received from the exercise by homeowners of the options to purchase were proceeds received from the operation of a business for profit-making and not merely proceeds resulting from the enhanced value of a capital asset which has been disposed of. In so concluding, I have not ignored the fact that the plaintiffs are not actively encouraging homeowners to exercise the options in the leases. They have been passive in this regard.

One last argument should be referred to. If I understand it correctly, that argument proceeds on the basis that even if the lots were converted from inventory to capital asset when they were leased, the proceeds arising out of their sale in 1970-73 takes its character from the business activities of the plaintiffs at the time those proceeds were generated (ie: prior to the lease being entered into). The price paid under the options to purchase in 1970- 73 was that of the market price of the lot at the date the lease was entered into (assume $4,000).* [1] The plaintiffs carried the lots on their books at cost (assume $1,000). It is argued that the $3,000 profit which is not received until the option to purchase is exercised takes its character from the business activity by which it was generated prior to the lease being granted and retains that character, regardless of the classification of the asset to which it relates. The argument is made by analogy to the Exchequer Court decision in J. Bert Macdonald and Sons Ltd. v. M.N.R., [1970] C.T.C. 17; 70 D.T.C. 6032 where it was held that a taxpayer who received land from his father was not required to take it into inventory at the value which the father had paid for it several years before, but only at the market value as of the date of the transfer from his father.

The plaintiffs argue that this argument should not be allowed because it is not fairly raised by the pleadings and has taken them by surprise. In addition, it is argued that the argument is not valid because the cases cited in support deal with the conversion of an asset from capital to inventory, not vice versa. Also, the conclusions reached in the Lars Kvellestad and the Watkins decisons (supra) run counter, it is said, to the defendant's position.

I do not need to consider the merits of this argument and do not propose to do so. I make reference to it only to indicate that I think it is fairly raised by the pleading — as a result of the amended statement of defence filed on consent at trial. The argument may be novel but it does not rely on any evidence as a foundation, additional to that which is already before the Court. Thus, in my view, it is an argument which is open to the defendants to make on the basis of the pleadings and the evidence which has been adduced.

For the reasons given above, the plaintiffs’ claims must be dismissed.

Appeals dismissed.