Citation: 2008 TCC 476
Date: 20080826
Docket: 2006-2078(IT)G
BETWEEN:
DALRON CONSTRUCTION LIMITED,
Appellant,
and
HER MAJESTY THE QUEEN,
Respondent.
REASONS FOR JUDGMENT
Mogan D.J.
[1] The Appellant is an
Ontario corporation carrying on business in the City of Sudbury. The business of the
Appellant is the purchase and development of land through the construction of
residential and commercial buildings. Some of the buildings are sold to arm’s
length purchasers while other buildings are transferred to an associated
corporation to retain and lease. The Appellant’s fiscal period in each year
ends on the 28th day of February. The Appellant’s 2002 taxation year (the only
year under appeal) includes transactions occurring in the spring and summer of
2001.
[2] On or about August
30, 2001, the Appellant transferred to Prime Property Inc. (“Prime”) a parcel
of land identified as 1361 Paris Street, Sudbury, For convenience, that parcel
of land will herein be referred to as “1361 Paris”; and the adjoining land to
the north, 1347 Paris Street, will be referred to as “1347 Paris”. At all
relevant times, the Appellant owned, directly or indirectly, 80% of the issued
shares of Prime. In connection with this transfer, the Appellant and Prime
filed a joint election under subsection 85(1) of the Income Tax Act (the
“Act”) designating $494,900 as the fair market value of 1361 Paris, and $186,500 as the
agreed amount.
[3] As a result of filing
the joint election under subsection 85(1) of the Act, the Appellant
reported for income tax purposes a gain of $79,500 on the disposition of 1361 Paris. The amount of the gain
was determined by subtracting the book value of 1361 Paris ($107,000) from the agreed amount
($186,500). Canada Revenue Agency (“CRA”) has taken the position that 1361 Paris was inventory in the
hands of the Appellant in August 2001 and, therefore, was not “eligible property”
as that term is defined in the Act.
[4] By reassessment,
CRA has regarded the joint election under subsection 85(1) as invalid, and
has determined that the Appellant realized a profit of $387,900 on the transfer
of 1361 Paris to Prime. The amount of
the profit and the additional income actually assessed were computed as
follows:
|
Proceeds of disposition
|
$494,900
|
|
Book value of 1361 Paris
|
107,000
|
|
Profit on disposition
|
387,900
|
|
Gain previously reported
|
79,500
|
|
Additional income assessed
|
$308,400
|
[5] The property
described in the joint election is in fact 1347 Paris (See Exhibit 1, Tab
4) but the parties are in agreement that the description is a mistake. The
Appellant and Prime always intended to make the joint election with respect to 1361
Paris. CRA recognizes the
mistake and has reassessed on the basis that the Appellant disposed of 1361 Paris on or about August 30,
2001. In some of the documents filed as exhibits, land described as 1347 Paris should, depending on
the context, be read as 1361 Paris.
[6] Before reviewing
the evidence, it will be helpful to summarize the relevant parts of section 85
of the Act. In tax jargon, a “rollover” is a tax-free transfer of property
usually between persons not dealing at arm’s length. Subsection 85(1) permits a
rollover of “eligible property” from a taxpayer to a taxable Canadian
corporation if certain conditions are met. The words “eligible property"
are defined in subsection 85(1.1) which states in part:
85(1.1) For the purposes of
subsection 85(1), “eligible property” means
(a) a
capital property (other than real property, or an interest in or an option in
respect of real property, owned by a non-resident person);
(b) …
(f) an inventory (other than real
property, an interest in real property or an option in respect of real
property);
(g) …
[7] The Appellant
claims that in August 2001, it held 1361 Paris as capital property. CRA claims
that at all relevant times 1361 Paris was inventory in the hands of the Appellant. The basic
issue in this appeal is to determine the character of 1361 Paris in the hands of the
Appellant as at August 30, 2001. Was it capital or was it inventory?
[8] The only witness
who testified at the hearing of this appeal was Ronald Arnold, president
of the Appellant corporation. The Appellant was incorporated in 1969. Ronald Arnold
holds 51% of the issued shares. The remaining 49% of the issued shares are held
by Ronald’s three brothers: David, Frank and Phil. A second corporation, Dalron
Leasing Ltd. (“DLL)” was incorporation in 1977 and is a wholly owned subsidiary
of the Appellant. At the commencement of the hearing, counsel for both parties
entered a joint binder of documents identified as Exhibit 1, containing 52
Tabs. Any reference to a “Tab” herein will refer to a document in Exhibit 1.
Later, the Appellant entered Exhibits A-1 and A-2; and the Respondent entered
Exhibits R-1, R-2 and R-3.
[9] As stated in
paragraph 1 above, the Appellant’s business is the purchase and development of
land through the construction of residential and commercial buildings. Mr.
Arnold stated that, if it was the Appellant’s intention to retain a particular building
as a source of rental income, that building would ordinarily be transferred to
DLL. In 1987, the Appellant purchased 1361 Paris at a cost of $135,000. See Tab 10.
The agreement of purchase and sale describes the property as 1361 and 1365 Paris Street and as containing two
houses each producing rental income. Mr. Arnold stated that the property at
1361 and 1365
Paris Street covered approximately three or four acres. Paris Street is a significant street
in the heart of Sudbury running north and south and having not less than four lanes. According to
a survey of the relevant land (Exhibit A-2), the property at 1361 and 1365
Paris Street has a frontage of approximately 145 feet on the west side of Paris
Street and, although irregular in shape, has an average depth of approximately
340 feet. The property at 1361 and 1365 Paris Street described in the agreement of
purchase and sale (Tab 10) is the same property referred to in these reasons as
“1361 Paris”.
[10] Tab 50 is the
consolidated financial statements of the Appellant and its subsidiaries as at
February 28, 2001. The principal subsidiary was DLL. The consolidated balance
sheet shows assets with a book value of $53,199,969. The five assets with the
largest book value are as follows:
|
Inventory of property for sale
|
$6,589,683
|
|
Work in progress
|
8,262,588
|
|
Deferred costs
|
3,931,884
|
|
Mortgages receivable
|
3,228,779
|
|
Capital assets, net
|
28,809,475
|
[11] Mr. Arnold reviewed
the consolidated balance sheet commenting on certain assets. The inventory of
property for sale was acquired over a long period of time. Some parcels of land
had been held for 25 years. The work in progress was primarily houses under construction
for sale. The capital assets were shown at depreciated values and, according
to Note 7 to the financial statements, represented land at $10,120,000 and
buildings at $17,657,000.
[12] Tab 48 is the
financial statements of DLL as at February 28, 2001. These are the financial
statements of DLL alone, not consolidated. The balance sheet of DLL as at February
28, 2001 shows capital assets at a depreciated value of $14,481,247. According
to Note 3 to the DLL financial statements, the capital assets included land at
$6,076,000 and buildings at $7,853,000. When I compare Note 3 to the DLL
financial statements with Note 7 to the Appellant’s financial statements (Tab
48 and Tab 50 both as at February 28, 2001), I am required to reconcile the
following amounts:
|
|
Note 3
DLL
|
Note 7
Appellant
|
|
Land
|
$6,076,000
|
$10,120,000
|
|
Building
|
7,853,000
|
17,657,000
|
[13] Because DLL is
included in the Appellant’s consolidated financial statements, I conclude that
60% of the land on the Appellant’s balance sheet as capital assets is land
actually owned by DLL; and 45% of the depreciated value of buildings on the
Appellant’s balance sheet as capital assets is buildings actually owned by DLL.
On the DLL balance sheet, capital assets ($14,481,247) represents 84% of the
book value of all assets ($17,140,702) whereas, on the Appellant’s consolidated
balance sheet, capital asserts ($28,509,475) are only 54% of the book value of
all assets ($53,199,969). I therefore conclude that DLL is primarily a holding corporation
while the Appellant is primarily an operating corporation. This conclusion is
reinforced by the fact that the Appellant’s consolidated balance sheet shows
significant amounts as “inventory of property for resale” and “work in
progress”. The DLL balance sheet shows no such assets.
[14] The balance sheets
reviewed in paragraphs 10 to 13 above support Mr. Arnold’s statement that,
if a particular building was to be retained as a source of rental income, it
would ordinarily be transferred to DLL.
[15] In March 1997, at
the start of its 1998 fiscal period, the Appellant still owned 1361 Paris. The book value had
increased from $135,000 (purchase price in 1987; see Tab 10) to $186,481. Mr.
Arnold explained the increase in relation to two events. First, the two houses
which were on the property producing rental income at the time of purchase had
been demolished at some cost. And second, the Appellant was required to pay an
amount to the City of Sudbury for access to larger water and sewer lines which had been
installed along Paris Street.
[16] At the end of the
Appellant’s 1998 fiscal period (February 28, 1998), the Appellant wrote down
the value of certain lands held in inventory and applied the aggregate
write-down to its profit computation. Tab 12 is a page from the Appellant’s financial
records showing a portion of the write-downs. Tab 12 shows the writing down of
18 lots on Roselawn
Street and
Sandlewood
Court, 42 lots
on Donald
Street and
Jack Street, and 5 other lots
including 1361 Paris
written down from $186,481 (see paragraph 15 above) to $107,000. The net
write-down of 1361 Paris
is shown as $79,481. There is no doubt that, at the end of its 1998 fiscal
period, the Appellant regarded 1361 Paris as part of its inventory of land for sale.
[17] I turn now to the
circumstances in which the Appellant transferred 1361 Paris to Prime in August
2001, and jointly elected a rollover of that land under subsection 85(1) of the
Act. In the fall of 2000, the Appellant entered into discussions with
RBC Dominion Securities Inc. (“RBC-DS”) with respect to leasing 6,500 square
feet of a building to be constructed on Paris Street. Tab 21 is an Offer to
Lease dated October 2, 2002 in which RBC-DS is referred to as the Tenant and
the Appellant is referred to as the Landlord. The Offer to Lease refers to land
fronting on Paris Street as Parcel 7935 S.E.S. and Parcel 49415 S.E.S. The second parcel must be
mistakenly described because, according to the survey (Exhibit A-2) and the
oral testimony of Mr. Arnold, Parcel 49410 S.E.S. contains the land referred to
herein as 1361 Paris; the land immediately to the north is Parcel 7935 S.E.S.
owned by Prime and identified as 1347 Paris; and the land immediately to
the south is Parcel 48415 S.E.S. owned by a stranger. We are concerned only
with Parcel 49410 owned by the Appellant (1361 Paris) and the adjoining
land to the north, Parcel 7935 owned by Prime (1347 Paris).
[18] As stated in
paragraph 2 above, the Appellant owns 80% of the issued shares of Prime. The remaining
20% interest in Prime is owned by Andy Humbert, a man not related to the Arnold brothers. According to
Mr. Arnold, Andy Humbert also owned the land immediately west of 1347 Paris and 1361 Paris. Because Andy Humbert
(“AH”) owned 20% of Prime which owned 1347 Paris, he was interested in any
development which might occur at 1361 Paris. Mr. Arnold stated that AH had
always wanted to be involved with the Arnold brothers in some kind of real estate development or
investment.
[19] The land at 1347 Paris had been purchased by
Prime in 1991. It had good frontage on Paris Street, and it provided legal
access from Paris Street to AH’s land immediately west of 1347 Paris and
1361 Paris. The Appellant did not need 1347 Paris to proceed with the RBC-DS
building on 1361 Paris but, by combining 1347 Paris with 1361 Paris, the Appellant could
more easily sell or rent a second building on the same site with plenty of
parking. Because there was a real commercial advantage in combining the
properties, and because AH had always wanted to be involved with the Appellant
in a project, the Appellant decided to transfer 1361 Paris to Prime.
[20] Tab 7 is the Asset
Transfer Agreement dated August 30, 2001 between the Appellant as vendor and
Prime as purchaser. The parties agreed (i) that the fair market value of
1361 Paris was $494,900; (ii) that
the purchase price would be the fair market value; (iii) that the purchase
price would be paid as to $186,500 by a promissory note from Prime, and as to
$308,400 by the issue of 100 common shares of Prime. The parties also agreed
(in paragraph 2.6) to make a joint election under subsection 85(1) with respect
to 1361 Paris. Tab 8 is the Deed of
Land giving effect to the transfer. Tab 4 is the Joint Election under
subsection 85(1) as filed with CRA. In Tab 8 and Tab 4, 1361 Paris is
mistakenly described as 1347 Paris.
[21] Tab 9 is a
Share-for-Share Exchange between the Appellant and Prime in which the Appellant
agrees to exchange 100 common shares of Prime for 308,400 Class B shares of
Prime. The Share-for-Share Exchange was necessary to maintain the 80-20 ratio
in the equity of Prime as between the Appellant and AH.
[22] Tab 45 is the Final
Lease between RBC-DS and Prime dated February 7, 2001. The Appellant must have
assigned to Prime its right in the Offer to Lease (Tab 21). I note that Prime
is the named landlord in the Final Lease as at February 2001 even though the
transfer of 1361 Paris did not occur until August 30, 2001. The Appellant
must have informally agreed with AH by February 2001 that the two parcels (1361
Paris and 1347 Paris) would be joined to proceed with the RBC-DS building. In
the Final Lease, the RBC-DS leased space is identified as the second floor
(6,500 sq. ft.) of a two-storey office building at the Paris Street site.
[23] Tab 22 is a lease
proposal from Manulife dated May 31, 2001 addressed to Royal LePage (Sudbury) asking to lease 2,600
sq. ft. on the ground floor of a two-storey office building at 1361 Paris. The proposed landlord
is identified as DLL. Tab 24 is the lease between Manulife and DLL (undated) in
which Manulife leases 2,600 sq. ft. at 1361 Paris commencing August 31,
2001. Tab 23 is an Assignment of Lease from DLL to Prime dated August 31,
2001 assigning the Manulife lease at 1361 Paris.
[24] As stated in
paragraph 7 above, the basic issue is whether the character of the land at 1361
Paris was capital or
inventory in the Appellant’s hands as at August 30, 2001. This is a question of
fact. Having regard to all of the evidence, I have no difficulty in concluding
that 1361 Paris was inventory in the
hands of the Appellant at all relevant times. 1361 Paris was clearly inventory at February 28,
1998 when the Appellant wrote down the value of many parcels of land at the end
of its 1998 fiscal period. See paragraph 16 above.
[25] Exhibit R-3 is a binder
containing certain passages from the Examination for Discovery of Andrew Sostarich
on behalf of the Appellant, to be taken as “read in” by counsel for the
Respondent. Within Exhibit R-3 is confirmation No. 18 in which the Respondent
has asked the Appellant to confirm a particular fact, and the Appellant has
answered. I will set out confirmation No. 18 as it appears in Exhibit R-3:
18. To confirm that
the subject property as at February 28, 2001 was held in the books and records
of Dalron Construction Limited as inventory.
The lots on
hand listing of $5,946,989.38 at February 28, 2001 includes 1361 Paris Street at a book value of $107,000.00.
[26] Confirmation No. 18
proves that 1361 Paris
was valued for inventory purposes at $107,000 in February 2001. Tab 12 proves
that 1361 Paris was written down in
value to $107,000 as inventory in February 1998. Apart from the Offer to Lease
(Tab 21), there is no evidence that the Appellant, standing alone, used 1361 Paris for any commercial
purpose in the 36-month period from February 1998 to February 2001. I therefore
conclude that 1361 Paris
was inventory to the Appellant throughout that 36-month period.
[27] Exhibit R-3 contains
certain statements made by Mr. Sostarich on Discovery which clearly indicate that
the Appellant did not hold properties with long-term leases because such
commercial properties always end up in Dalron Leasing Ltd. (“DLL”). I will
quote questions 116, 117 and 141 as they appear in Exhibit R-3:
Q. Is there
examples of a deal similar to this where land is transferred to Dalron Leasing
after the building went up?
A. I could check
and try and give you one, yes.
Q. And more than
one. I’d like an idea as to how these transactions typically occur. What you
told me at the outset, so I can clarify and understand this - - Dalron Leasing
usually holds commercial leases - - properties - - properties that have a
long-term lease; is that correct?
A. That’s right. If
you look at the balance sheet of Dalron Construction versus Dalron Leasing
you’ll see no commercial property on Construction’s balance sheet. They always
wind up on leasing.
Q. Why in this instance
did the Appellant want to hold this as a commercial property as opposed to
doing what it typically did and send it to the leasing company? What was
different about this transaction?
A. Actually I don’t
think anything was different about it. And I can believe that, had Humber not
gotten involved the project would have wound up at some point in time in Dalron
Leasing Limited.
MR. DUCHARME: I think it would be our
position, counsel, that this particular property followed the model that the
witness has laid out in some detail, that Construction wasn’t going to hold it.
It was going to build and at some point Construction doesn’t hold commercial
rental properties.
The above answers on Discovery
confirm Mr. Arnold’s testimony that commercial rental properties were
ordinarily transferred to DLL. See paragraph 9 above.
[28] Although the
original Offer to Lease (Tab 21) was signed October 2, 2000 between RBC-DC and
the Appellant, all subsequent documents indicate that the Appellant would not
continue to own 1361 Paris as landlord. The final lease (Tab 45) was between
Prime and RBC-DS and was dated February 7, 2001. From that document, I infer
that Andy Humbert had been brought into the transaction well before February
2001; and that the Appellant had agreed to join 1361 Paris with 1347 Paris by transferring
1361 Paris to Prime.
[29] I cannot find any
evidence that the Appellant ever adopted an investment intent with respect to
1361 Paris. The Appellant wrote
down the book value of 1361 Paris as inventory at February 28, 1998. See paragraph 16 above.
Although the Offer to Lease between the Appellant and RBC-DS is dated October
2, 2000 (Tab 21), the Appellant continues to show 1361 Paris as part of its inventory five
months later as at February 28, 2001. See Confirmation No. 18 in Exhibit R-3.
Also, the Appellant must have assigned the Offer to Lease to Prime (proving an
intention to transfer 1361 Paris to Prime) because the final Lease (Tab 45) is dated February
7, 2001 between Prime and RBC-DS. And finally, the actual conveyance of 1361 Paris from the Appellant to Prime
on August 31, 2001 (Tab 8) is the best evidence that the Appellant never
intended to hold 1361 Paris as revenue-producing rental property.
[30] Mr. Ducharme, counsel
for the Appellant, relied on the decision of the Federal Court of Appeal in Edmund
Peachey Limited v. The Queen, 79 DTC 5064. In particular, he relied on the
following passage from the unanimous reasons of that Court:
I agree with the learned trial judge that
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. …
Mr. Ducharme argued that the Offer
to Lease (Tab 21) signed by the Appellant was such a clear and unequivocal
positive act because the Appellant was committed to put the tenant in
possession by a specific date.
[31] In my opinion, the
Offer to Lease (Tab 21) cannot be regarded as evidence of any change of intent
on the Appellant’s part because the Offer to Lease must be seen in context with
the following four unassailable facts:
(i) 1361
Paris was inventory to the
Appellant as at February 28, 1998;
(ii)
the
final lease with RBC-DS is dated February 7, 2001, and was signed by Prime;
(iii) 1361
Paris was still shown as
inventory to the Appellant as at February 28, 2001; and
(iv) 1361
Paris was conveyed by the
Appellant to Prime on August 31, 2001 (Tab 8).
[32] In addition to the
four facts listed above, Exhibit R-3 contains many extracts from the Examination
for Discovery of Andrew Sostarich who represented the Appellant. Mr. Sostarich
stated consistently that it was not the Appellant’s policy to hold rental properties;
and that such properties were usually transferred to DLL. Indeed, in Question
141, Mr. Sostarich states that if Andy Humbert had not been involved, the
building at 1361 Paris would have wound up in DLL.
[33] The appeal for the
2002 taxation year is dismissed, with costs.
Signed at Ottawa, Canada, this 26th
day of August 2008.
“M.A. Mogan”
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