The Queen v. Gorjup, 87 DTC 5348, [1987] 2 CTC 129 (FCTD)

The Associate Chief Justice: —This action by way of appeal from a judgment of the Tax Court of Canada dated May 29, 1985, allowing the defendant's appeal in respect of his 1979 and 1980 taxation years, came on for hearing at London, Ontario on May 5, 1987. At issue is the taxpayer's eligibility to deduct from his taxable income "restricted farm losses" under section 31 of the Income Tax Act. The section reads as follows:

31.(1) Loss from farming where chief source of income not farming.— 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) $2,500 plus the lesser of

(A) /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 or 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.

(2) Determination by Minister. — For the purpose of this section, the Minister may determine that 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.

This section has undergone considerable analysis (and criticism) by the Courts in recent years. The most authoritative interpretation remains that of the Supreme Court of Canada in Moldowan v. The Queen, [1977] C.T.C. 310; 77 D.T.C. 5213. In that case Mr. Justice Dickson (as he then was) held that the Income Tax Act, and section 31 in particular, envisages three classes of farmers:

(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.

(2) The taxpayer who does not look to farming, or to farming and some subordinate source of income, for his livelihood but carried 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 but carried 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.

(4) The taxpayer who does not look to farming, or to farming and some subordinate source of income, for his livelihood and who carried 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.

Most cases which have been decided under this section have dealt with farmers who are attempting to bring themselves within class No. 1 in order to deduct the full amount of their farming losses. In this case, the taxpayer claims membership of class No. 2 and eligibility to deduct only "restricted farm losses", up to a maximum of $5,000 per year.

The issue in this appeal is whether Mr. Gorjup is eligible as a member of Dickson, J.'s second class for the years 1979 to 1980. Counsel for the Crown has submitted in a closely-reasoned argument, that he is not. Her argument turns on the word "business" in the description of the second category. The Moldowan decision provides a test for whether a farming endeavour can be considered a "business", or "source of income”:

Although originally disputed, it is now accepted that in order to have a "source of income” the taxpayer must have a profit or a reasonable expectation of profit. Source of income, thus, is an equivalent term to business: Dorfman v. M.N.R., [1971] C.T.C. 151; 72 D.T.C. 6131. See also paragraph 139(1)(ae) [now subsection 148(1)] of the Income Tax Act which includes as “personal and living expenses" and therefore not deductible for tax purposes, the expenses of properties maintained by the taxpayer for his own use and benefit, and not maintained in connection with a business carried on for profit or with a reasonable expectation of profit. If the taxpayer in operating his farm is merely indulging in a hobby, with no reasonable expectation of profit, he is disentitled to claim any deduction at all in respect of expenses incurred.

There is a vast case literature on what reasonable expectation of profit means and it is by no means entirely consistent. In my view, whether a taxpayer has a reasonable expectation of profit is an objective determination to be made from all of the facts. The following criteria should be considered: the profit and loss experience in past years, the taxpayer's training, the taxpayer's intended course of action, the capability of the venture as capitalized to show a profit after charging capital cost allowance. The list is not intended to be exhaustive. The factors will differ with the nature and extent of the undertaking: The Queen v. Matthews, [1974] C.T.C. 230; 74 D.T.C. 6193. 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.

Following this test, the plaintiff submits that the defendant is ineligible to deduct any farm losses. The losses were not incurred in connection with a business of any kind, even a sideline business, as there was no reasonable expectation of profit. In particular, the plaintiff argues that the defendant could not reasonably have expected a profit because:

(i) the operation had consistent annual losses for a long period of time;

(ii) the operation was not sufficiently capitalized to carry on a business on the years under appeal;

(iii) there was no systematic operation with a realistic potential for earning profit and there was no risk management plan;

(iv) the appellant farmed in his spare time.

The basis of the Crown's case is the possibility that a taxpayer may acquire a farm and deliberately keep it undercapitalized so as to generate losses. If the farm income does not cover the cost of the mortgage, the result is that the taxpayer will be able to write off up to $5,000 of his mortgage interest, a deduction that is not available to other taxpayers. This line of reasoning was set out by Reed, J. in Gordon v. The Queen, [1986] 2 C.T.C. 280 at 287; 86 D.T.C. 6426 at 6431:

In response to may [sic] request, counsel for the defendant provided me with the following sources as giving some indication of the history and purpose behind the restricted loss provision: Bert James v. M.N.R., [1973] C.T.C. 457 at 465-70; 73 D.T.C. 5333 at 5338-42; the Report of the Royal Commission on Taxation, Vol. 4 (1966) (Carter Commission Report) with respect to “hobby farming” at pages 446-48 of that report; Report of the Royal Commission on Taxation of Profits and Income, Final Report (Cmnd. 9474, 1955) (Radcliffe Commission Report) at pages 148-50. What emerges from those sources is a concern that taxpayers (especially those who enjoy a substantial income from other sources) may be prepared to carry on a farming business with a certain degree of indifference towards the losses incurred. This indifference arises out of, for example, the fact that the farm losses may be carried at the marginal rate of tax on other income; the recreational and personal life style provided by the farm environment is attractive; farm land often carries with it potential for future land development; an asset is often created out of what would otherwise be a highly taxed income. It seems to me a significant factor, whether one be talking about the hobby farmer or the part-time farmer, is a consideration of whether or not the business is being carried on on a commercial basis with a determination to make the business profitable as soon as possible.

What lies behind the “reasonable expectation of profit” test, then, is the risk of permitting the farming taxpayer to deduct from other income losses incurred without a genuine intent, or realistic possibility of making a profit. It comes as no surprise then, that attempts to resolve these disputes have drawn the Courts beyond the balance sheets and into the hearts and minds of the taxpayer. In terms of a contribution to clarity or consistency, the exercise has not been very successful. Even the criteria set out by Dickson, J. in Moldowan were specifically subject to at least two qualifications:

. . .The list is not intended to be exhaustive. The factors will vary with the nature and extent of the undertaking . . . (page 314; D.T.C. 5215).

As an example of the possible variation, Mr. Justice Dickson cites this Court's decision in The Queen v. Matthews, [1974] C.T.C. 230; 74 D.T.C. 6193, in which an investment manager who was also a tree farmer was found to be entitled to deduct his full farming losses. In addressing the question of whether the tree farm was truly a “business”, Mr. Justice Mahoney dealt separately with the authenticity of taxpayers' expectation of profit and its reasonableness:

Leaving aside for the moment, the reasonableness of the Defendant's expectation of profit, I am satisfied that the Defendant was carrying on the "tree farming" operations on both properties during 1969 as a business and not merely pursuing a hobby or avocation in a businesslike way. The mere fact that a person enjoys a business activity, as the Defendant undoubtedly enjoys his forestry, or incidentally derives pleasure from a personal activity on a business property, as the Defendant no doubt does when he walks or rides about the North Gwillimbury property, does not per se alter the "business" nature of either the property or the activity. On the basis of the evidence before me, I cannot find that the Defendant's "tree farm" operation on either property was a mere sham or device. I think it most unlikely that he would be engaged in "tree farming" if it were not for his abiding interest in forestry but I am convinced that he is bona fide engaged in it as a business, in the ordinary sense of that word, with the intention that it be profitable.

[Reasonable expectation of profit]

There is a valid question as to the capacity for profit in circumstances where the capital investment in the land is most unlikely to be recovered out of those profits over a reasonable period of time. Without defining "tree farming” as “farming”, this is by no means a unique situation. It is notorious that profits from many agricultural businesses are, by most standards, inadequate when related to the value of the land devoted to the business. The cost of land to someone wishing to get into the business cannot, in many instances, be justified by the projected return. On the other hand the improbability of recovering the cost of the land and the inadequacy of the return on its value is not entirely unrealistic in the commercial sense. With good husbandry, farm land is not a wasting asset. In the case of a "tree farm", it is as able to yield a new "crop" in a matter of several decades as, in the case of a conventional farm, the land is able to yield an annual crop.

Accepting, as I do, the proposition that "tree farming” is capable of being a business, I cannot agree with the Plaintiff's argument that these essential characteristics of the business, when it is carried on in a small way, somehow alter its nature so that it is no longer a business. It is important to note that in section 139(1)(ae)(i) the word "reasonable" modifies "expectation" not "profit" and that the term “reasonable expectation of profit" is not synonymous with “expectation of reasonable profit”.

Each case where the realization of profit is so postponed will have to be examined on its own merits to ascertain that the profit is not merely notional and that the expectation of profit is indeed reasonable.

It is apparent from the Matthews decision that the genuineness of the taxpayer's expectation of profit is as important as its reasonableness, although the two are to be determined separately. It would also appear that the test for a reasonable expectation of profit for an agricultural business will be of a lower standard in general than for other businesses. Most importantly, that standard will vary significantly between particular agricultural operations. As pointed out in Moldowan, there will be a great difference between the reasonable expectation of profit in the first years of a brand new tree farm and in those of an on-going, productive farm of a more conventional nature. Presumably, somewhere in between will be the expectations which are reasonable with respect to the start-up of a small scale cattle operation like the one owned by the defendant in this case.

Turning to an examination of Mr. Gorjup's farm, then, we must begin with some background information. Mr. Gorjup was born and spent his early childhood in Yugoslavia, where he lived on his grandparents' farm. He immigrated to Canada with his parents at the age of nine and lived in Toronto. During high school he worked in the city for a furnace business and also on tobacco and hay farms. He graduated from Ryerson Polytechnical Institute in 1970 with qualifications as a mechanical technologist and returned in the evenings thereafter to take courses in business administration. Beginning in 1974 he took night courses toward his Bachelor of Technology degree. During the years in question and until 1985 Mr. Gorjup has consistently had full-time employment related to his training. His hours have usually been flexible and he has enjoyed a two or three week vacation every year. In August 1985 he became unemployed.

In 1965 Mr. Gorjup met his wife Madeline whose father owned a 200-acre mixed farm in Caledon. Mr. Gorjup began visiting there regularly and helping with the farming. In 1966 he married Madeline and they continued helping his father-in-law on weekends while living and working in Toronto. This went on until 1974 when his father-in-law began to feel his health failing and decided he would like to sell half his farm. The goal was to have a down payment to build a retirement home on the remaining half. He approached Mr. Gorjup and the following deal was agreed upon: Mr. Gorjup would buy 100 acres of the farm, including the house, barn and other structures, for $92,500. His father-in-law would build a new house on the other half and they would collaborate in farming the whole 200 acres. Mr. Gorjup's father- in-law would use the barn for his cattle and Mr. Gorjup would use his father- in-law's equipment to harvest his crop. They would help one another with the culivation and harvesting.

Mr. Gorjup sold his house in the city and put all the money towards a down payment for the farm. He made the purchase in 1974, taking possession immediately. There was a lot of work to do as the farm had been very run-down when his father-in-law bought it in 1965 and had not yet been restored to its full productive capacity. The buildings required renovation and of the 100 acres, only 50 had been worked by Mr. Gorjup's father-in law. Mr. Gorjup's intent was to start a cattle farm, so in 1974 he purchased cattle right away. From the beginning both he and his wife put a great many hours of labour into the farm — it is owned by both of them in partnership. They also have four children who have grown up and worked on the farm.

Mr. Gorjup took steps to inform himself about farming. One of his coworkers owned a farm and he had extensive discussions with him. In addition, he attended seminars, open houses and field trips given by Guelph University on the subject of animal husbandry. He was already familiar with much of the equipmnt that is used on a farm as it formed a large part of the products manufactured by the companies he worked for. He also formed a connection with the Ontario Hydro farming adviser and started following livestock markets. He read extensively in farm publications, following market trends and prices.

The arrangement with his father-in-law worked well for two years. In 1975 Mr. Gorjup sold cattle and replaced them, selling again in 1976. However, in that year two things happened to put an end to the co-operative cattle operation: his father-in-law had a severe stroke and the market for beef plunged. The result was that Mr. Gorjup's father-in-law was forced to retire altogether from farming, selling off his operation and equipment. Without the use of equipment, Mr. Gorjup could no longer run his cattle farming operation on the partly-developed land and his herd had to be sold.

Despite these set-backs, Mr. Gorjup's goal continued to be to establish a viable beef operation. In 1977, the only way he could see to accomplish that goal was to develop the productivity of his land until he could feed his cattle self-sufficiently. To do that he needed his own equipment, and to buy equipment he needed capital. He consequently decided to put his acreage into cash crops, using outside or "custom" labourers and equipment to harvest it.

There was another option in 1977. Instead of going out of cattle, he could have purchased half-grown steers from Western Canada and “finished” them for market. There were several problems with this idea. First, he would have had to purchase a whole truckload of cattle, approximately 60 head, and sell off those he could not accommodate, and he did not have sufficient capital. Second, he had had bad experiences in the past with cattle arriving from the West with a variety of diseases and generating large veterinary bills. He decided that it would be better in the long run to reach a position where he could breed his own herd, control the circumstances and ensure freedom from disease. In addition, he considered the low prices for beef in 1977 and the new types of crops which were coming out and decided that a cash crop operation would be more profitable even with his limited resources.

Unfortunately, despite his calculations, the cash crop operation was not a financial success. The development of a good hay field takes five years and many of Mr. Gorjup's fields had not been ploughed in 10 to 15 years. In addition, he had bad luck with both the custom workers and the weather. The two combined to result in the loss of much of his crop in the years 1977 and 1978. Consequently, Mr. Gorjup felt it necessary to invest in his own equipment in 1978 and 1979, which he was able to service himself. By 1980 he had about 25 acres of what had been pasture land under cultivation. By 1983 50 acres had been seeded. Nevertheless, crop failures, flooding and low commodity prices combined to keep his income low and his expenses high over these years.

Because of an infusion of capital in 1984 he was able to recommence his cattle operation with the purchase of 12 head of breeding stock. Mr. Gorjup is now a member of the Cattleman's Association. Following the advice of the government agricultural representatives, he has joined a five-year cattle management program whereby the results of his cow-calf operation will be monitored. Mr. Gorjup expected to have about 22 mature animals by the end of 1985 and a herd of 40 to 50 over the next three years. He is working his own acreage as well as some rented fields for a total of 65 acres and can feed his animals from his own hay production. Throughout the period described Mr. Gorjup has spent a minimum of 20 to 30 hours per week working on the farm. He and his family have lived there full time. The work fills all his holidays and spare time. Any deficit created by the farm is financed almost solely out of the defendant's employment income.

The following is a summary of Mr. Gorjup's financial position for the years 1975 to 1986:

Before I attempt any resolution of these issues, certain general comments seem appropriate. First, the Minister's task was to determine the possibility of profit on the basis of experience up to 1979 and 1980. It is not an easy chore when I have the benefit of the experience over a much longer period of time. It was obviously a good deal more difficult for the Minister in this case. I can't help but wonder why Parliament would not have come to the assistance of the Minister with some legislative scheme whereunder eligibility for this limited loss would be available only to farms under a certain gross income or under a certain percentage of the taxpayer's total income and perhaps only for a fixed number of years. Parliament's failure to do so, of course, leads me to the conclusion that the section in its present form is intended to benefit precisely the person in Mr. Gorjup's position provided the farm is a business with some hope of profit and he does all in his power to realize it. In the assessment of those questions, factors like commitment (where the family moves onto the property and everyone lends a hand) can be every bit as important as the figures on the balance sheet. It also follows that since Parliament created section 31 to come to this taxpayer's aid, it ought not be turned on and off like a tap. Some of the market conditions and changes experienced by Mr. Gorjup caused bankruptcies in quite a number of professional farming operations. That is a factor that weighs heavily in my mind in attempting to determine what is reasonable for his reaction in terms of effort, time, and money.

I am convinced that when the taxpayer bought this farm, he and his father- in-law had established a co-operative operation with an expectation of profit which was entirely reasonable. In 1974 the size of the farm, its purchase price and the existence of this co-operative plan would clearly have qualified him for the restricted farm loss deduction. In specific terms, had Mr. Gorjup and his father-in-law been permitted to continue under their arrangement, it can be assumed that his herd would have expanded steadily, if not dramatically. For several seasons, at least, there would have been a reasonable expectation of profit. I also find that since 1984, when the taxpayer bought the first of his new cattle herd, there is no question that the farm had a reasonable chance of turning a profit. Indeed, the Minister must be assumed to share my opinion as he has allowed a farm loss deduction for all of the years up to 1979 and after 1980.

What, then, was the state of affairs of this farm after 1976 and before 1984? The Crown maintains that no business existed there in the true sense of the word. Counsel urges me to find that all of the work done up to 1984 was merely preliminary, consisting of preparing the land to support a cattle farm. She has brought forward several cases which hold that farmers are not entitled to deduct "start-up" losses which are incurred not while operating a business, but in preparing a property for use as a farm at some time in the future. (See Craddock et al. v. M.N.R., [1986] 1 C.T.C. 2006; 86 D.T.C. 1014 (T.C.C.); Dreger, Kadatz et al v. M.N.R., [1985] 1 C.T.C. 2131; 85 D.T.C. 142 (T.C.C.); Karpish v. M.N.R., [1986] 2 C.T.C. 2347; 86 D.T.C. 1782 (T.C.C.) and Lorenz v. M.N.R., [1984] C.T.C. 2110; 84 D.T.C. 1118 (T.C.C.)).

The other side of the argument is that this farm was clearly a business in 1974 and 1984. The defendant argues with some force that his actions now verify what was always his intention during the years in question: to overcome the difficulties caused by the events of 1976 and to re-establish his cattle farm. The intervening years should be looked upon as a reaction to unexpected circumstances — a lull in an operating business. He should not lose his section 31 eligibility because of circumstances beyond his control — it should not be liable to be turned on and off like a tap.

Did the taxpayer act reasonably in this case? We have seen that two choices presented themselves to him in 1976. The one that he did not choose was to buy up a herd, unseen, from Western Canada. Crown counsel contended that as a result his operation was undercapitalized during the years in question. I accept that, but I also find that that option was thoroughly explored by the taxpayer and that he had a number of valid reasons for not pursuing it. Having rejected that plan, his remaining alternatives were severely limited. Unlike other businessmen, a farmer cannot simply change his location or line of products as the market shifts. He is restricted to dealing in what the land can produce, and his choices in that regard are determined by the available capital. Here, Mr. Gorjup began the process of producing hay — a cash crop for which there was a market, and a necessary component of his ultimate goal — a self-sufficient cow-calf operation. The cash-crop operation was not financially successful but it did ultimately help him to achieve his other goal of establishing productive hay fields. The move to cash crops was part of a systematic plan to make this farm profitable. As such, it was a reasonable decision.

Does the fact that his farm was not profitable during these years of "reaction" mean he was not conducting a business? The authorities indicate it does not. To repeat, most of the case-law in this area deals with claims by farmers to deduct their full farming losses — i.e., to be included in Mr. Justice Dickson's first class from the Moldowan case. In order to do so, they must establish that farming, or a combination of farming and another busi- ness, is their “chief source of income" — a considerably higher test than “reasonable expectation of profit". l note however, that people in situations similar to the present case have satisfied that higher test. In Gray v. The Queen, [1986] 2 C.T.C. 382; 86 D.T.C. 6504, Madame Justice Reed considered the case of a horse farmer who had been forced by market conditions to switch to cattle. A drought further decreased the number of livestock he could keep. He was fully employed at another business. His farm income was a fraction of his expenses for the years in question. Counsel for the Minister raised many of the same argument that were made before me. Reed, J. held:

It is a cumulative assessment of all the relevant factors which must be made. Applying this approach to the present facts my conclusion is that farming was a chief source of income for the plaintiff from 1978 forward and that he is entitled to deduct full farm losses therefor. The taxpayer was spending about equal amounts of time on the farm and on the service station (at least up until 1981) but, he was putting in 12 to 16 hour days. He committed a great deal of his available capital to the establishment of the farm. Certainly more was committed to the farm than to any other endeavour. There is no reason to doubt the farm's potential profitability. The farm is not yet actually profitable but that can be explained, as I have noted above, by reference to a number of factors beyond the plaintiff's control. The plaintiff and his wife obviously have the experience and training to operate the type of farm business they are embarked upon. Indeed the contribution his wife makes to the operation of the farm, as disclosed in the evidence, is truly impressive. No one has doubted the commitment of the plaintiff and his wife to farming or to their preference for a farm lifestyle. Their actions, for example, in changing to raising cattle when the market for horses turned sour are completely consistent with this expressed intention. In addition the evidence discloses that had the plaintiff wished to sell a portion of his land for development in 1979 and make a quick profit therefrom, he could have done so. He did not make this choice. The plaintiff and his wife are not operating the farm as a mere incidental or sideline business. Nor do I think they were doing so in 1978.

She based this finding in part on the Federal Court of Appeal decision in The Queen v. Graham, [1985] 1 C.T.C. 380; 85 D.T.C. 5256, which she summarized as follows:

. . .In the Graham case the taxpayer worked full time for Ontario Hydro. At the same time, he began the establishment of a pig farming operation. During the whole period of time under dispute the taxpayer continued to work at Ontario Hydro. The Trial Division found that the taxpayer's farming operation was, nevertheless, a chief source of income. Factors relevant in coming to this decision were the taxpayer's expressed intention to eventually make farming his only full- time occupation; the fact that he worked long hours and was in every sense working at two full-time jobs; the fact that he was committing all his employment earnings to establishing the farm, instead of borrowing for this purpose. The Federal Court of Appeal upheld that decision.

I do not find anything in this case which prevents me from reaching the same conclusion. Even if the losses experienced during the years in question could be considered "start-up costs", there is authority that 10 or even 15 years may not be excessive for an operation to experience such costs, providing the operation is basically sound. In Timpson v. The Queen, [1987] 1 C.T.C. 389; 87 D.T.C. 5266, a recent decision of Mr. Justice Cullen, a doctor who started a purebred cattle farm from scratch in 1975, was allowed to deduct his full farm losses in 1977 and 1978 on an operation that had yet to see a profit. The Judge's reasoning was as follows:

I am satisfied on the evidence here that the plaintiff had a "reasonable expectation of profit”. Most assuredly this profit did not arise as soon as the plaintiff predicted but the market, the high interest rates and the time required to gain credibility all conspired to delay what he had every right to expect — a profit.

Both counsel asked me to consider expanding on the meaning of start-up costs. Here again I believe it depends almost exclusively on the factual situation in place. Here, for example, everyone, experts and laymen alike, concede that it takes much more time, effort, capital, and dedication to be successful in a purebred cattle operation. For that very reason start-up costs must be allowed over an extended period of time, even to 15 years mentioned by one of the witnesses. Another operation, not depending upon purebred cattle and establishing credibility should no doubt be limited in the amount allowed as start-up costs.

Given the defendant's situation here, I do not find that ten years is an unreasonable length of time to experience start-up costs. The plaintiff's commitment of his time, labour and resources as well as the fact that he developed and followed an operational plan in these years ail point to the fact that he was carrying on a business from which he reasonably expected to make a profit.

For the reasons given, this appeal is dismissed. The defendant shall recover his costs.

Appeal dismissed.