Date: 19980205
Dockets: 96-1999-IT-I; 96-2000-IT-I
BETWEEN:
MARVIN SAUNDERS, JUDITH SAUNDERS,
Appellants,
and
HER MAJESTY THE QUEEN,
Respondent,
Reasons for Judgment
Bowman, J.T.C.C.
[1] These appeals were heard together and concern assessments
for the 1991, 1992 and 1993 taxation years. The issue is the
deductibility of losses sustained by the appellants from the
rental of property.
[2] Marvin Saunders is an engineer with INCO Limited, Judith
Saunders, his wife, teaches school. Their combined annual incomes
in the years in question were over $100,000.
[3] In 1989, they purchased a condominium unit in Kingston,
Ontario as an investment. They did so with the intention of
holding it as an income producing property. If subjective
intention is relevant, as counsel for the appellant contends, I
find as a fact that it was their intention to earn income from
the property and to hold it as a long term investment. There is
no suggestion in the evidence or the pleadings that they acquired
it with a view to selling it, or that the prospect of capital
gain was a motivating factor in the acquisition.[1]
[4] Moreover, I find as a fact that there was no personal
element involved in the acquisition or use of the property.
Neither Mr. and Mrs. Saunders nor any of their relatives have
ever lived there.
[5] The property was purchased after considerable research.
Both appellants were familiar with the Kingston area, having
attended university in that city. The building in which they
purchased the condominium was, and apparently still is, regarded
as one of the most desirable in Kingston. It is situate between a
park, a golf course and the lake.
[6] Also, in March of 1989, before the transaction closed they
consulted with a tax accountant, Mr. Edward G. Skinner, F.C.A. on
the tax implications of the purchase, including the deductibility
of interest, the rate of depreciation and the advisability of
their locking into a five year mortgage.[2]
[7] The property was listed for rental at $1,300 per month and
ultimately leased for $1,250, on July 1, 1989. The property
remained rented to that tenant until November 1992.
[8] The rent gradually rose to $1,425 by November 1992. In
1993 and 1994, it was $1,400 per month. In 1995 to April 1, 1996
it was $1,300 and then $1,350 per month.
[9] These rental rates, which were received from arm’s
length tenants, represented fair market value.
[10] An important feature of this case is the fact that the
purchase price of $240,000 was 100% financed by mortgages on the
condominium in Kingston and the appellants’ home in
Naughton, Ontario. It is this aspect of the case that I find most
troubling. Nothing else makes it any different from any other
commercial venture. It was a carefully researched purchase of a
desirable rental property in a good location in Kingston. No
personal element was involved. The only thing unusual was the
100% financing, at rates which were locked in at 11.75% during
the three years in question. The rates fell in 1994 to 8.05% on
one mortgage and 7.25% on the other. They have varied since that
time between 5.5% and 9.5%. They are arm’s length
rates.
[11] By the end of 1993, the appellants had paid down $23,887
on the principal. By the end of 1997, they had paid down $83,446.
They projected that by 2004 the entire mortgage will be paid off,
on the assumption that interest rates remain at 6% or lower.
[12] Exhibit A-6 sets out the actual profits and losses up to
the end of 1994. It also sets out what they would have been,
assuming the expenses had remained the same, but that rents had
increased by 5%, 7% and 10%. On the most favourable hypothesis
there would be no profit until 1997, following which the profits
will steadily increase. Exhibit A-5 indicates that based on
actual data a profit was realized in 1997.
[13] We have, therefore, two additional factors that must be
taken into account:
(a) that in 1989 on the most favourable assumption a profit
could not be realized until 1997;
(b) that it was reasonable to expect a profit in 1997 and in
fact a profit was realized in that year. It is also reasonable to
anticipate increasing profits after 1997.
[14] We have then the following ingredients:
(1) a bona fide intention to earn income from the
holding of a rental property;
(2) no personal element;
(3) a reasonable projection of profit after eight years, and,
in fact, an actual realization of profit in 1997 and a reasonable
expectation of increased profits;
(4) a plan to pay off the mortgages by 2004, a period of 15
years from the date of acquisition;
(5) interest expense that exceeds the gross rents every year
until 1997;
(6) 100% financing.
[15] Counsel for the respondent contended that once a profit
is realized this project becomes a “source of income”
because there is a reasonable expectation of profit but in the
years when losses are sustained — and are expected to be
sustained — there is no reasonable expectation of profit
and therefore, following the obiter dictum in Moldowan
v. The Queen, 77 DTC 5213, the losses are not
deductible. The argument has a familiar ring. Obviously the
question of the deductibility of losses arises only in a year
when there is a loss. If the “reasonable expectation of
profit” doctrine is to be applied solely because of an
anticipated loss in the early years, but the profits earned in
the subsequent years are taxable, it would follow that no such
losses could ever be deducted. This is not in my view what the
“no reasonable expectation of profit” rule means. If
it is reasonable to expect profits within a reasonable period of
time — and what is reasonable is a question that must be
determined in all of the circumstances — the existence of
losses in the earlier years does not in itself lead to the
conclusion that there is no reasonable expectation of profit in
the years when the losses are sustained.
[16] Since the Moldowan case, we have a trilogy of
cases in the Federal Court of Appeal that afford considerable
guidance in this area. In Tonn et al. v. The Queen, 96 DTC
6001. Mr. Justice Linden, speaking for the court, said at
page 6008:
The Moldowan test is stricter that the business purpose
tests set out in subsection 9(1) and paragraph 18(1)(a).
As mentioned above, these tests stipulate that a taxpayer be
subjectively motivated by profit when incurring an expenditure.
The Moldowan test, however, also requires the presence of
a profit motive, but, in addition, it must be objectively
reasonable. In reality, in most situations, the objective
Moldowan test and the subjective statutory tests will not
yield many different results. A subjective intention is often
determined by what may be reasonably inferred from the
circumstances. Someone who claims a subjective intention that is
foolish may not be believed. A taxpayer’s intention to
produce profit normally has to be reasonable before a Court will
accept it.
[17] At pages 6009 and 6010 he said:
A closer look at this jurisprudence will illustrate that this
is the approach now taken in most of the cases. The cases in
which the “reasonable expectation of profit” test is
employed can be placed into two groups. One group is comprised of
the cases where the impugned activity has a strong personal
element. These are the personal benefit and hobby type cases
where a taxpayer has invested money into an activity from which
that taxpayer derives personal satisfaction or psychological
benefit. Such activities have included horse farms, Hawaii and
Florida condominium rentals, ski chalet rentals, yacht
operations, dog kennel operations, and so forth. Though these
activities may in some ways be operated as businesses, the cases
have generally found the main goal to be personal. Any desire for
profit in such contexts is no more than a “pious
wish” or “fanciful dream”. It is only a
secondary motive for having set out on the venture. What is
really going on here is that the taxpayer is seeking a tax
subsidy by deducting the cost of what, in reality, is a personal
expenditure.
[18] As stated above, I do not think there is any personal
element involved. The ownership and rental of the property is
obviously not a hobby. At page 6011 he said:
The other group of cases consists of situations where the
taxpayer’s motive for the activity lacks any element of
personal benefit, and where the activity cannot be classified as
a hobby. The activity, in these cases, seems to be operated in a
commercial fashion and not as a veiled form of personal
recreation. Usually these deductions are not challenged by the
Department, and, therefore, they do not get appealed and are not
reported very often in the law reports. The Courts still have a
role, however, in deciding whether there exist less apparent
factors which might suggest a different conclusion in cases such
as these. The Courts are less likely to disallow these expenses,
but they do so in appropriate circumstances.
[19] At page 6012 he said:
When the cases are categorized into two groups as above, one
cannot help observing that the hobby and personal benefit cases
are rarely decided in the taxpayer’s favour. In contrast,
where the activity is purely commercial, they rarely are
challenged. If they are the Courts have been reluctant to
second-guess the taxpayers, with the benefit of the doubt being
given to them. I also note that in terms of sheer numbers, the
hobby/personal-benefit cases vastly outnumber those of the
commercial activity and variety, which are quite rare, indicating
that taxpayers are challenged less often in such situations.
The primary use of Moldowan as an objective
test, therefore, is the prevention of inappropriate reductions in
tax; it is not intended as a vehicle for the wholesale judicial
second-guessing of business judgments. A note of caution must be
sounded for instances where the test is applied to commercial
operations. Errors in business judgment, unless the Act
stipulates otherwise, do not prohibit one from claiming
deductions for losses arising from those errors. This point was
stated strongly by Sheldon Silver.
[20] At page 6013 he said:
Though I do not support the use in the Nichol case of
the word “patently”, I otherwise agree that the
Moldowan test should be applied sparingly where a
taxpayer’s “business judgment” is involved,
where no personal element is in evidence, and where the extent of
the deductions claimed are not on their face questionable.
However, where circumstances suggest that a personal or
other-than-business motivation existed, or where the expectation
of profit was so unreasonable as to raise a suspicion, the
taxpayer will be called upon to justify objectively that the
operation was in fact a business. Suspicious circumstances,
therefore, will more often lead to closer scrutiny than those
that are in no way suspect.
[21] At page 6014, he referred to the fact that losses may
occur for several years until the project becomes profitable.
Here the appellants have demonstrated that the project is capable
of becoming profitable. I do not think that the eight years is in
itself unreasonable, unless one considers that the 100% financing
is itself unreasonable. I shall deal with this point when I come
to discuss Mohammad v. The Queen, 97 DTC 5503.
[22] At page 6015 he said:
The evidence clearly showed that the taxpayers engaged
themselves in a business enterprise and their expectations of
profit were not unreasonable in the circumstances. A small rental
business was launched without the aid of sophisticated market
analysis at a time when the rental market looked promising. Soon
after, as a result of unforeseen circumstances, it became
precarious. No personal benefit accrued to the taxpayers by the
rental arrangements. The property was not a vacation site. The
house was not used to give free or subsidized housing to
relatives or friends. They made an honest error in judgment and
lost money instead of earning it. It is not for the Department
(or the Court) to penalize them for this, using the reasonable
expectation of the profit test, without giving the enterprise a
reasonable length of time to prove itself capable of yielding
profits.
[23] After the decision in Tonn, the Federal Court of
Appeal decided A.G. of Canada v. Mastri et al., 97 DTC
5420. The Federal Court of Appeal stated that there was no doubt
that Tonn was correctly decided. The decision of the Tax
Court of Canada was reversed on the basis that it was an error in
law to say that just because there was no personal element
involved an unchallenged finding of fact that there was no
reasonable expectation of profit was not sufficient grounds for
disallowing the loss. The error of the Tax Court of Canada
appears to have been in the interpretation that it put on
Tonn that the absence of a personal element superseded the
finding of no reasonable expectation of profit. In fact, the
finding of the Tax Court of Canada that there was no personal
element appears to have been suspect since the taxpayers bought
the house to be used as their personal residence and in fact,
after one year, they moved into it.
[24] I have no difficulty in reconciling Tonn with
Mastri.
[25] In Mohammad it was held to be an error in law to
reduce the amount of interest deductible by an arbitrary amount
under section 67. In Mohammad there was 100% financing. At
page 5506 Robertson J.A. said:
The above analysis is to the effect that there can be no
reasonable expectation of profit so long as no significant
payments are made against the principal amount of the
indebtedness. This inevitably leads to the question of whether a
rental loss can be claimed even though no such payment(s) were
made in the taxation years under review. I say yes, but not
without qualification. The taxpayer must establish to the
satisfaction of the Tax Court that he or she had a realistic plan
to reduce the principal amount of the borrowed monies. As every
homeowner soon learns, virtually all of the monthly mortgage
payment goes toward the payment of interest during the first five
years of a twenty to twenty-five year amortized mortgage loan. It
is simply unrealistic to expect the Canadian tax system to
subsidize the acquisition of rental properties for indefinite
periods. Taxpayers intent on financing the purchase of a rental
property to the extent that there can be no profit,
notwithstanding full realization of anticipated rental revenue,
should not expect favourable tax treatment in the absence of
convincing objective evidence of their intention and financial
ability to pay down a meaningful portion of the purchase-money
indebtedness within a few years of the property’s
acquisition. If because of the level of financing a property is
unable to generate sufficient profits which can be applied
against the outstanding indebtedness then the taxpayer must look
to other sources of income in order to do so. If a
taxpayer’s other sources of income, e.g., employment
income, are insufficient to permit him or her to pay down
purchase-money obligations then the taxpayer may well have to
bear the full cost of the rental loss. Certainly, vague
expectations that an infusion of cash was expected from Aunt
Beatrice or Uncle Bernie will not satisfy the taxpayer’s
burden of proof. In practice, the taxpayer will discharge that
burden by showing that significant payments were in fact made
against the principal indebtedness in the taxation years closely
following the year of purchase.
[26] It is clear from Mohammad that 100% financing is
not in itself a justification for disallowing part of the
interest provided that the taxpayer can meet the reasonable
expectation of profit test.
[27] I find on the facts that the appellants have done so.
Obviously, if, as Mohammad has held, 100% financing is no
bar to full deductibility of interest, then it may take somewhat
longer to pay the mortgage down to the point at which a profit is
being realized. If it is arbitrary (and therefore wrong) to
reduce the amount of interest deductible because the property was
100% financed, it would be equally arbitrary to pick a number of
years (say three or five) in which the appellants must start
earning a profit.
[28] Here the appellants started earning a profit in eight
years and have a plan to pay off the mortgage within a reasonable
period of time.
[29] I find as a fact that the appellants have demonstrated
that, contrary to the four bases of disallowance set forth in the
assumptions, they had a reasonable expectation of profit, that
the expenses in connection with this rental project were laid out
for the purpose of gaining or producing income, that they were
not personal or living expenses and that they were not
unreasonable.
[30] In fact the last point, that the expenses were
unreasonable, was abandoned at trial. I might add that the facts
in this case are virtually indistinguishable from those in
Wallace v. The Queen, [1996] T.C.J. No. 583 (QL).
[31] The appeals are allowed with costs and the assessments
are referred back to the Minister of National Revenue for
reconsideration and reassessment in accordance with these
reasons.
[32] The appellants are entitled to one set of counsel
fees.
Signed at Ottawa, Canada, on this 5th day of February
1998.
"D.G.H. Bowman"
J.T.C.C.
Email this Content