R. v. Donnelly, 97 DTC 5499, [1998] 1 CTC 23 (FCA)

Robertson J.A.:

Though it has been twenty years since Moldowan v. R. (1977), [1978] 1 S.C.R. 480 (S.C.C.) was decided, we continue to hear appeals involving taxpayers who earn their income in the city and lose it in the country. In this appeal, the respondent taxpayer, a medical practitioner, sought to deduct from his professional income the full amount of farming losses incurred in the 1986, 1987 and 1988 taxation years. According to Moldowan, the taxpayer must satisfy two tests in order to succeed. First, he must establish that the farming operation gave rise to a “reasonable expectation of profit” and, second, that his “chief source of income” is farming (the so-called “full- time” farmer). If the taxpayer is unable to satisfy the first test no losses are deductible (the so-called “hobby” farmer). If he satisfies the first test but not the second then a restricted farm loss of $5,000 (now $8,500) is imposed under section 31 of the Income Tax Act (the so-called “part-time” farmer).

In the present appeal the Minister of National Revenue conceded that the farming operation gave rise to a reasonable expectation of profit. That concession was made with full knowledge that the taxpayer’s farming endeavour had not generated a profit in twenty one years (1972-1992). With respect to the Minister’s contention that farming was not the taxpayer’s chief source of income, the Tax Court of Canada disagreed, holding that the taxpayer could reasonably have looked to his farming business to provide the “bulk” of his income. The Minister now argues that the court below was in error in making that determination. I agree. In my respectful view, the Tax Court Judge failed to appreciate the distinction between the test to be applied when determining whether farming is a taxpayer’s chief source of income and that which is applicable when assessing whether a taxpayer has a reasonable expectation of profit. When the issue is placed in this perspective it is not difficult to understand why the Minister was willing to concede the latter point. As is explained below, the legal test for establishing farming as a chief source of income is, on an evidential level, a more onerous one.

At all material times, the taxpayer was a practising urologist who between 1959 and 1970 conducted a sole practice. In 1970 he joined a partnership which enabled him to reduce his hours of work considerably. The partnership enabled the taxpayer to concentrate his practice into a 24-hour work week and provided him with an annual vacation leave of between twelve and seventeen weeks. During the weeks he was practising medicine the taxpayer would spend an additional 40 hours a week on his farming operation. During vacation periods the taxpayer would spend up to 16 hours a day pursuing that venture. In short, the taxpayer “lived, ate and breathed horses” (Appeal Book, Appendix 1, at 116).

Commencing in 1972 the taxpayer became involved in the thoroughbred industry. By 1975 the taxpayer determined that standardbred horses were a more “reliable investment”, and together with James Rankin and a third party, he turned his attention to this aspect of the horse-farming industry. By 1980 the taxpayer and his partners were buying, breeding and racing standardbred horses. Their intention was to race some horses and use the prize winnings to offset expenses. Profits would be derived from the breeding side but because of start-up losses the taxpayer did not anticipate a profit until at least 1983 or 1984. During this period the taxpayer experienced two setbacks. In 1983 Mr. Rankin was killed in an accident at which time the taxpayer revised his estimate for profitability to 1985 or 1986. Then in 1985 the North American market for both standardbred and thoroughbred horses collapsed resulting in a substantial drop in horse prices. The collapse was triggered by changes to American tax laws which made the treatment of horse syndications (tax shelters) less attractive to investors. This in turn created a glut in the horse market and a severe drop in horse prices.

The evidence accepted by the Tax Court Judge was that after 1984 the taxpayer had liquidated all of his investments (RRSP’s and an apartment building) and employed the proceeds in the horse-farming business. From 1972 to 1992 inclusive, the taxpayer’s breeding and racing activities produced losses approaching $2 million dollars. It is common ground that the yearly losses could not have been sustained without the taxpayer drawing upon his professional income. For the 1986, 1987 and 1988 taxation years the taxpayer’s net professional income versus net farming losses was as follows:

Despite the losses sustained by the taxpayer in each of the years spanning two decades, the Minister assessed him on the basis of there being a reasonable expectation of profit. The principle issue before the Tax Court was whether the taxpayer was entitled to deduct the full amount of the loss in each of the years or restricted to the $5000 amount imposed under sec- tion 31 of the Act. The principal findings of the Tax Court Judge are as follows.

From 1983 and throughout the taxation years in question the standard- bred horse breeding business “engaged the majority of [the taxpayer’s] time and virtually all of his money.” The Tax Court Judge observed that the “unimpugned” expert evidence of Dr. McCarthy, a veterinarian, friend and business partner of the taxpayer, was that “start up losses” with respect to the breeding side of the business can persist for up to ten years. Following these findings the Tax Court Judge began his formal analysis by stating at page 15 of the oral reasons: “It remains to be determined if [the taxpayer] was in business.” Following that assertion the Tax Court Judge concluded that in 1980 there was a “change in direction” from the taxpayer’s medical practice to the horse-farming business. The fact that the taxpayer had committed all of his capital to that business reinforced that conclusion. Further on the Tax Court Judge concluded that the practice of medicine had become a sideline to the “standardbred breeding business”. Finally, he determined that but for the setbacks endured by the taxpayer his horse-breeding operation would have provided the “bulk” of his income for the three taxation years in question. I turn now to the relevant principles of law.

A determination as to whether farming is a taxpayer’s chief source of income requires a favourable comparison of that occupational endeavour with the taxpayer’s other income source in terms of capital committed, time spent and profitability, actual or potential. The test is both a relative and objective one. It is not a pure quantum measurement. All three factors must be weighed with no one factor being decisive. Yet there can be no doubt that the profitability factor poses the greatest obstacle to taxpayers seeking to persuade the courts that farming is their chief source of income. This is so because the evidential burden is on taxpayers to establish that the net income that could reasonably be expected to be earned from farming is substantial in relation to their other income source: invariably, employment or professional income. Were the law otherwise there would be no basis on which the Tax Court could make a comparison between the relative amounts expected to be earned from farming and the other income source, as required by section 31 of the Act. The extent to which the evidential burden regarding the profitability factor or test differs from the one governing the reasonable expectation of profit requirement is a matter which I will address more fully below.

In summary, the cumulative factors of capital committed, time spent and profitability will determine whether farming will be regarded as a “sideline business” to which the restricted farm loss provisions apply. These guiding principles flow from the following decisions: Mo Ido wan (supra), Timpson v. Minister of National Revenue (1993), 93 D.T.C. 5281 (Fed. C.A.), Poirier (Trustee of) v. Canada, (1992), 92 D.T.C. 6335 (Fed. C.A.), Connell v. Minister of National Revenue (1992), 92 D.T.C. 6134 (Fed. C.A.), Roney v. Minister of National Revenue (1991), 91 D.T.C. 5148 (Fed. C.A.), Morrissey v. R. (1988), 89 D.T.C. 5080 (Fed. C.A.), Gordon v. R. (1986), 86 D.T.C. 6426 (Fed. T.D.), Mott v. R. (1988), 88 D.T.C. 6359 (Fed. T.D.) and Mohl v. R. (1989), 89 D.T.C. 5236 (Fed. T.D.).

There is no question in this case that the taxpayer committed significant capital investment to the horse-farming activity. As noted earlier his losses were approaching the $2 million mark. This factor is in his favour. It is the two remaining elements of time spent and profitability which are more problematic for the taxpayer.

With respect to time spent, I am not persuaded that the taxpayer changed occupational direction in 1980 such that medicine became a sideline to his farming endeavour. I reach that conclusion for three reasons. Firstly, the taxpayer’s shift in focus from thoroughbred to standardbred horses in 1980 represents a business decision, not a change in occupational direction. From the time he purchased his first horse in 1972, the taxpayer’s farming activities focused on the purchase and breeding of horses. Secondly, the evidence indicates that the taxpayer entered into his current medical partnership arrangement in 1970. While he may have endeavoured to reduce his workload or take more vacation time, the record does not indicate any appreciable change in the taxpayer’s medical practice. During the three years in question, the taxpayer continued to see approximately 74 patients a week at his clinic [Appeal Book, Appendix 1, at 197]. In 1988, he performed 612 surgeries [supra at 196]. As of 1993, the taxpayer was still taking on approximately 18 new patients per week [supra at 201]. There is no indication he was phasing out the medical practice. This leads inexorably to my third point: the taxpayer acknowledged that he required his medical income to live off and fund the purchase of new horses and other aspects of the horse operations [supra at 216]. Under these circumstances, it is difficult to see how he can be described as having changed his occupational direction. It cannot be denied that the time devoted to horse-farming was significant, but this quantitative factor alone does not accurately reflect the reality that the taxpayer was financially dependent upon his medical practice and primary income-earning Occupation.

Any doubt as to whether the taxpayer’s chief source of income is farming is resolved once consideration is given to the element of profitability. There is a difference between the type of evidence the taxpayer must adduce concerning profitability under section 31 of the Act, as opposed to that relevant to the reasonable expectation of profit test. In the latter case the taxpayer need only show that there is or was an expectation of profit, be it $1 or $1 million. It is well recognized in tax law that a “reasonable expectation of profit” is not synonymous with an “expectation of reasonable profits”. With respect to the section 31 profitability factor, however, quantum is relevant because it provides a basis on which to compare potential farm income with that actually received by the taxpayer from the competing occupation. In other words, we are looking for evidence to support a finding of reasonable expectation of “substantial” profits from farming.

In the present case, it was incumbent on the taxpayer to establish what he might have reasonably earned but for the two setbacks which gave rise to the loss: namely the death of Mr. Rankin and the decline in horse prices. I say this because the Tax Court Judge concluded that but for these setbacks the taxpayer would have earned the bulk of his income from farming in the three taxation years in question. While there is no doubt that the loss of Mr. Rankin, and the changes in American tax law had a negative and unexpected impact on the business, no evidence was presented to show what profit the taxpayer might have earned had these events not occurred and whether the amount would have been considered substantial when compared to his professional income. It was not enough for the taxpayer to claim that he might have earned a profit. He should have provided sufficient evidence to enable the Tax Court Judge to estimate quantitatively what that profit might have been.

In my respectful view, neither the taxpayer nor the Tax Court Judge pursued the issue in the manner outlined above. Rather they continued to address the matter solely in terms of whether there was a business, that is to say whether there was a reasonable expectation of profit. Given the Minister’s concession on this point, the Tax Court Judge’s analysis, commencing at page 15 of his reasons, is misdirected. This misdirection manifests itself at pages 16 and 17 of the reasons for judgment:

Both the Crown and the Appellant consider that the Appellant can expect a profit. Given the concrete evidence of the quality of foals listed for sale, the Court finds that even in 1986, 1987 and 1988 the Appellant had a reasonable expectation of profit which has been (in hindsight) negatively impacted by the unexpectedly long-term effects of the changes in the United States Internal Revenue Code and the current continuing recession. It was, in 1986, 1987 and 1988, reasonable to expect that his horse-breeding business would provide the bulk of his income, even compared to his medical income. In 1986, 1987 and 1988 he could reasonably expect to look to his horse-breeding operation alone for his income, especially in those years when the full impact of the tax changes and the current recession had not taken effect. It was possible to anticipate that racing would cover current expenses and that a good breeding programme would provide substantial profit.

The Tax Court Judge did not engage in an analysis of what profit might have been earned by the taxpayer in each of the three taxation years in question. No doubt this gap was occasioned in part by the taxpayer’s failure to adduce the necessary evidence as reflected in the testimony of Dr. McCarthy. His evidence was directed at whether the horse-farming operation gave rise to a reasonable expectation of profit. He admitted that he had never reviewed the taxpayer’s books nor compared the business’ revenue and expenses [see Appeal Book, Appendix 1 at 20 and 79-80]. He could offer no opinion on the potential profitability of the horse-farming business.

In oral argument, counsel for the taxpayer sought to persuade us of the profitability of the farming operations by reference to the evidence from the examination for discovery of Rosemarie Weber, the Revenue Canada Assessment Officer who handled this file. Portions of the transcript from the examination were read in at trial [see Appeal Book, Appendix I at 221- 227]. Ms. Weber stated that in her opinion, the horse-farming activity had a reasonable expectation of profit, based on the quality of horses purchased by the taxpayer and his knowledge of horses generally. That evidence, however, supports only the concession that there was a reasonable expectation of profit [see Appeal Book, Appendix 1 at 221-227]. Once again, there is a failure to appreciate the onus that was on the taxpayer to satisfy the judge below that he would have or could have reasonably earned a profit of “X” dollars but for the unforeseen setbacks. This the taxpayer did not do and it is improbable that he could have met the evidential burden. I say this because the documentary evidence reveals that in those taxation years where the taxpayer was about to earn a profit, he would simply purchase a horse or two with the result that the farming operation incurred a loss.

The taxpayer admitted that he did not predetermine from year to year the amount he would spend in the purchase of new horses. His records indicate that any money earned from the horse business, as well as additional income transferred from the medical practice, was used to purchase new horses. Arguably, his actions do not indicate any desire to earn income from the horse-farming business during the taxation years in question. Rather, it would seem that his consistent reinvestment in new stock pointed to a de- sire to improve his stables, perhaps with the hope that he could retire in the future and live off the horse-farming income at that time.

Finally, the taxpayer relies on Graham v. R. (1985), 85 D.T.C. 5256 (Fed. C.A.). To my knowledge, this is the only case where a taxpayer has succeeded before the Court of Appeal in arguing that his farming business provided his chief source of income, despite employment in another area. In my opinion, there are two ways to distinguish Graham. First it can be argued that the Court applied an outmoded test which was further redefined in subsequent jurisprudence: see Morrisey v. R., supra. In Graham the Court applied a two stage analysis. Was there a reasonable expectation of profit and, if so, what was the taxpayer’s “ordinary mode and habit of work”? At page 5263 the Court concluded that, “in the very unusual circumstances of this case”, the taxpayer’s employment did not preclude the trial judge from finding that the main preoccupation of the taxpayer was farming. The second method of distinguishing Graham is the classical one — on the facts.

In Graham, the majority of the Court allowed a taxpayer to deduct full farm losses despite the fact that he held full-time employment with Ontario Hydro. The taxpayer, who was raised on a farm, arranged a flexible shift schedule around his hog-farming operation and took his holidays, days without pay and shift trades to accommodate planting and harvesting time. He also made arrangement with his employer to leave work in the case of an emergency at the farm. The taxpayer worked eight hours a day at his employment and a further eleven hours a day on the farm. Both the taxpayer’s wife and sixteen year old son performed the necessary tasks during his absences from the farm. Finally, the taxpayer was able to obtain needed financing from the Ontario Farm Loan Board which did not lend money to part-time farmers: see Graham v. R. (1983), 83 D.T.C. 5399 (Fed. T.D.), at 5403. Against this background the majority viewed the principal issue in terms of whether a person could have employment in two full-time occupations at the same time. The dissenting judge (Marceau J.A.) viewed the issue in terms of a taxpayer who held a full-time job, was “seriously” involved in farming but who could not expect to generate “significant” profits from the latter enterprise.

In the end, Graham stands or falls on its unique facts. But there is at least one lesson that can be derived from the case. It seems to me that Grahamcomes closer to a case in which an otherwise full-time farmer is forced to seek additional income in the city to offset losses incurred in the country. The second generation farmer who is unable to adequately support a family may well turn to other employment to offset persistent annual losses. These are the types of cases which never make it to the courts. Presumably, the Minister of National Revenue has made a policy decision to concede the reasonable expectation of profit requirement in situations where a taxpayer’s family has always looked to farming as a means of providing for their livelihood, albeit with limited financial success. The same policy considerations allow for greater weight to be placed on the capital and time factors under section 31 of the Act, while less weight is given to profitability. I have yet to see a case where the Minister denies such a taxpayer the right to deduct full farming losses because of a competing income source. Perhaps this is because it is unlikely a hog farmer such as Mr. Graham would pursue the activity as a hobby.

As is well known, section 31 of the Act is aimed at preventing “gentlemen” farmers who enjoy substantial income from claiming full farming losses: see Morrisey v. R., supra at 5081-82. More often then not it is invoked in circumstances where farmers are prepared to carry on with a blatant indifference toward the losses being incurred. The practical and legal reality is that these farmers are hobby farmers but the Minister allows them the limited deduction under section 31 of the Act. Such cases almost always involve horse-farmers who are engaged in purchasing or breeding horses for racing. In truth, there is rarely even a reasonable expectation of profit in such endeavours much less the makings of a chief source of income.

It may well be that in tax law a distinction is to be drawn between the country person who goes to the city and the city person who goes to the country. In future, those insisting on obtaining tax relief in circumstances approaching those under consideration should do so through legislative channels and not through the Tax Court of Canada. The judicial system can no longer afford to encourage taxpayers or their counsel to pursue such litigation in the expectation that hope will triumph over experience.

To summarize, a determination as to whether farming is the chief source of income is dependent upon the cumulative effect of three key factors: capital committed, time spent and profitability. In my respectful opinion, the Tax Court Judge erred in his assessment of the evidence (inferences drawn from accepted facts) presented both in terms of the taxpayer’s occupational direction and the potential profitability of the horse-farming business. Having regard to the fact that no one factor is decisive and to the primary findings of fact made by the Tax Court Judge, I conclude that the taxpayer’s chief source of income for the years in question came from his medical practice. The horse-farming activity was merely a sideline business. Accordingly, I would allow the appeal with costs here, and in the court below, set aside the judgment of the Tax Court Judge and affirm the Minister’s reassessments for the taxation years in question.

Appeal allowed.