Citation: 2011 TCC 294
Date: 20110608
Docket: 2010-2234(IT)I
BETWEEN:
JOHN HARE,
Appellant,
and
HER MAJESTY THE QUEEN,
Respondent.
REASONS FOR JUDGMENT
Hershfield J.
The Issue
[1] The Appellant was
reassessed in respect of his 2005 taxation year. The reassessment disallowed $24,000
of a rental loss claimed for the year. The amount disallowed reflects an
assessing position that such amount, incurred on two rental properties, was on
capital account. The Respondent relies on paragraph 18(1)(b) of the Income
Tax Act (the “Act”).
[2] Prior to the
hearing, having particularized the expenses at issue in respect of each of the
two rental properties, the parties narrowed the expenditures at issue. Expenses
relating to appliances in the amount of $1,465.25 were agreed to be on capital
account. Various miscellaneous expenses totalling $4,402.96 were agreed to be
on income account. That left $18,133.60 at issue. Such amounts consisted of
various expenses incurred on what I will call, for the moment at least,
renovations. The renovations consisted of new doors, windows, flooring, kitchen
cabinets, siding and the like, which were installed after the properties were
acquired in 2005 and prior to any tenancies being in place. Such renovations
also required some redoing of existing plumbing and electrical installations.
[3] The renovation work
undertaken on each rental property was described in some detail at the hearing
and exhibits included a number of before and after pictures. While I will
outline the renovations in these Reasons, the issue before me is not about this
new window or that new door. It is about the classification of the entirety of
the work as either the restoration of a property, which the authorities tend to
treat as maintenance and repairs incurred on income account, or the creation of
what is essentially a new property, which the authorities more clearly treat as
capital improvements. There is also an issue concerning the timing of the work
in that it was done, in both cases, immediately after acquisition of the
property, before the first tenant was secured.
Background
[4] The two properties
are co-owned. The Appellant is one of the co-owners. Another co-owner, Mark
Garrett, testified at the hearing. He acknowledged at the outset that he and
his wife started out some ten years ago in the renovation business.
[5] They then started
buying rental properties and started to seek investment partners. They
purchased approximately 57 properties and over a course of years they started a
construction company and a property management company based out of Hamilton.
[6] The Appellant was
an investor in the two properties that are the subject of this appeal. They
have been identified as the Houghton property and the Kensington property. The
Appellant’s ownership share of the Houghton property was 33.77%. His interest
in the Kensington property was 50%. It is my understanding that Mr. Garrett and
his wife owned a 50% interest in each of the properties and that they entered
into a Joint Venture Agreement with the other co-owner(s) on the basis that the
investors (the other co-owners) would put up 100% of the equity required for
the purchase of the properties. Initial pre-tenancy renovations were included
as part of the purchase price for this purpose. Thereafter, all expenses were
shared in accordance with the co-ownership interests.
[7] The investment
approach was spoken of by Mr. Garrett to be along the following lines. A
realtor would be informed of the type of property sought. The realtor would
source a property and identify possible work the property would need. Mr.
Garrett would visit the property with a series of trades who could provide on-site
estimates to determine what the renovation/repair costs would be. The investor
would then be consulted, advised of the purchase price and estimated renovation
or repair costs, and a decision would be made as to whether to proceed. If the
decision was to proceed, an offer would be made and negotiations would be
conducted by Mr. Garrett.
[8] Once an offer was
accepted, Mr. Garrett would attend to the closing, line-up the
renovations/repairs and begin advertising for and identifying tenants. They
would manage the repairs as they were being done and begin interviewing
tenants. Once a tenant moved in they would manage the property for the life of
the tenancy. When a tenant left they would attend to any needed maintenance or repairs
and seek a new tenant.
[9] With respect to the
Houghton property, Mr. Garrett provided the following information:
·
The
property was occupied at the time of the initial inspection.
·
It appeared
to be a relatively well-maintained and tidy property. It looked like all that
was needed was new paint, a cleaning and what Mr. Garrett referred to as the
standard “lipstick and rouge” approach.
·
After
taking possession in March 2005 and doing a closer inspection which was enabled
by the removal of all the occupant’s personal effects, they discovered that the
windows were in a much worse state of repair than originally anticipated. The
positioning of personal effects like a bed or a couch against a windowed wall
would make it difficult to have a close inspection of the window. The wood
tracks along which panes of glass could slide to open and close the window, had
begun to rot due to water seepage. The window sills and window frames were similarly
damaged. Repairing the windows would not be feasible as it would require
re-milling the entire frame. It was cheaper to replace the windows so that is
what was done.
·
The
replacement windows were a low grade, vinyl-clad window. Mr. Garrett referred
to it as an entry level window but admitted that it would be regarded as being
a better quality than the window that was replaced. The cost of the window
replacements was $3,027.14.
·
The
next expenditure that Mr. Garrett addressed was the new siding put on to the
exterior of the house. Mr. Garrett referred to the exterior shell of the
building as the building envelope. The existing building envelope was pebble
stucco that was approximately 80 years old. When the property was first
inspected it looked like the building envelope was in acceptable condition as
were the soffits. What was later discovered, however, was that the owner had
covered up a lot of issues. Between the time of the first inspection and taking
possession in March, previous repairs started showing signs of requiring
attention. Water from the winter melt must have gotten inside cracks, breaking
down the original repairs. There were several examples of this, specifically in
the corners and toward the basement.
·
Continuing
patchwork repairs afforded no guarantee that they would survive over the course
of the next winter season. Consequently, re-stuccoing the building needed to be
considered. Re-stuccoing required removal of all existing stucco which
likely meant dealing with any insulation problems that would be exposed and any
other issues that may be revealed by opening the exterior envelope. What was
recommended then was to strap the exterior of the building and put on vinyl
siding. The cost to re-stucco was uncertain. An estimate to remove the existing
stucco, which would have been required to re-stucco had the big unknown of dealing
with any exposed insulation. The conservative estimate to re-stucco then was $6,000
- $9,000. The cost of the new siding including soffits and gutters was $3,514.13.
·
The
next expenditure was to replace the carpet in the property and the vinyl in the
kitchen area.
·
The
plan with the carpet was to remove it and buff the hardwood floors that were
originally there. Unfortunately, the carpet had been glued to the floor and on
lifting it, the hardwood was basically destroyed. Estimates were received for a
new hardwood floor versus putting a new carpet down to replace the old carpet.
The cost of a new hardwood floor would be approximately $4,000. The cost of
carpeting would be much less. In fact, carpeting plus the new vinyl floors was
less than putting in a new hardwood floor.
·
In
the kitchen, the vinyl was beginning to peel underneath the sink as a result of
water leaking. The damage on the floor was hidden at the time of the inspection
by a rubber mat. The vinyl could not be repaired without replacing part of the
sub-floor as vinyls are now different thicknesses. As well, matching floor
materials and patterns would not have been possible. The total cost to re-vinyl
together with the carpet was $2,720. It was also pointed out that the new vinyl
was of a lower grade with a life of maybe ten years. The old vinyl had likely
lasted 30 or 40 years.
[10] With respect to the
Kensington property, Mr. Garrett provided the following information:
·
The
property was occupied at the time of the initial inspection. The individual
that was living there had been living there for 60 years and was
moving to a retirement home.
·
The
property was a little more dishevelled and there were lots of personal
effects all over the place reflecting the fact that this individual
had lived there for so long. Still, the property seemed generally well kept.
Painting and a lot of cleaning might only be required once the personal
effects were removed.
·
Before
closing, the individual selling the property passed away and further inspections
were apparently made more difficult. Still, it was discovered that a toilet
and sink had been installed in the closet of the master bedroom. They
were placed right on top of a carpet and they were leaking. It was not up
to code and would have to be removed. But for that, it was thought that
all the property would need would be painting, cleaning and a little
updating of the hardware to get it ready to have a tenant move in.
·
After
possession, a bathroom in the basement was discovered. At the time of the
inspections it was being used as a storage closet. It was poorly done
and leaking and also not up to code. The wall sink was propped up and the
faucets did not work. In any event, this bathroom had to be removed, as well.
·
Once
the plumbing work was started, the plumber by code had to remove
galvanized drain piping as well as galvanized supply tubes that were
exposed and that led to replacing piping connected through to the kitchen.
The piping was replaced with copper piping. The entire plumbing bill was
$909.50.
·
The
next expense relates to the installation of new kitchen cupboards.
o
After
taking possession, it was discovered that the stove and range top were not in
proper working order and were unsafe. Repairs were not feasible. As well, it
was discovered that the floor boards and flooring under the lower kitchen
cabinets had suffered extensive water damage. The lower cabinets were unstable.
They needed to be repaired or replaced. Removal allowed them to see if there was
any further mold or rot issues behind or underneath the cabinets as well.
o
Removal
of lower cabinets, replacing the stove at a location in relation to the sink
that was to code and addressing plumbing and electrical concerns could most
economically be done by what Mr. Garrett described as a slight reorganization
of the kitchen. The end result was, in effect, a renovated kitchen. The
refrigerator had been moved to a new location, newly configured cupboards were
installed and the sink and the new stove were relocated. Unlike the original
cabinetry which was wood, the new cabinetry was particle board. The new
counter top, like the old counter top, was a particle board with a laminate
finish.
o
The
entire cost of the kitchen renovation including placing the sub-floor under the
cabinets was $2,889.
·
The
next expenditure of $1,435.83 deals with a number of items.
o
It
covers a new exterior door to the back porch door. It was so badly scratched
and damaged on the inside that it was virtually unrepairable. A solid wood door
was used to replace a solid wood door.
o
Four
internal doors also needed to be replaced since once they were removed for
painting, it was discovered that the door casings were in such bad condition
that the doors could not be re-hung properly. Replacing the doors with casings
was the only feasible option. The original doors were solid slab hardwood
whereas the new doors were cheap particle board, hollow core, doors.
o
The
next item was repairs to the main bathroom. The bathroom had seniors’ aid
equipment installed. Removal of such hardware caused wall damage and there was water
damage around the tub as well. The wall had to be repaired and what was
referred to as the “tub surround” had to be replaced and resealed. As well, a
shelf unit was replaced; as was the sink. The old wall mounted sink needed
support under it and had to be replaced as did the faucets. The old porcelain
sink was replaced with a new vinyl sink and a vinyl countertop was installed.
·
The
last category of expenditure was electrical. As one might understand, as
issues with three bathrooms were being addressed and as a kitchen was being
renovated, old wiring that was not to code was being exposed and needed to
be brought to code. The cost was $3,638.
[11] On
cross-examination, Mr Garrett offered additional information.
[12] He looked for long
term tenants. It saved advertising costs and did not require more cleaning and
painting costs. He viewed the property as habitable when acquired. Even though
it was not being lived in when the repairs were started, there were people
living there before that. He went in to repair what was broken and, yes, it
benefited the property in the long term. He suggested that he could have moved
in tenants without doing all the work and just done the work as required. But
the market was slow – they had time to do the work. However, he did say the
work had to be done to pursue their business model. Still, he said that in reality,
tenants do not stay long suggesting that they could have been rented regardless
of that.
[13] He said the repairs
prevented deterioration. If you leave exterior cracks and water leaks, the
property will deteriorate. He said they kept properties for five to ten years
and that it was feasible that the work done had an effect over that period. He
said some of the work was required for insurance purposes.
[14] He also confirmed
certain assumptions set out in the Reply to the Notice of Appeal (the “Reply”).
The Houghton property acquired in December, 2004 for $80,000 was rented by
August and the Kensington property acquired in April, 2005 for $122,000 was
rented by November. As well, he confirmed that the repairs and renovations were
completed between taking possession and the first rentals.
Appellant’s Submissions
[15] The Appellant relies
on a strong line of cases that support his position that notwithstanding the
enduring nature of the repairs and the renovating aspects of some of them, they
have not altered the character of the properties or changed them into, or
replaced them with, something new. He places emphasis on Gold Bar
Developments Ltd. v R..
[16] In that case an
entire brick facing of an apartment building had become unsound and was replaced
using metal cladding instead of brick veneer. The analysis in that case, in
focusing on the purpose of the repair which was not to improve the capital
asset or make it different or better, found that the new facing was a
deductible outlay. That repairs are expected to and do inevitably improve a
property and may even be a “once-in-a-lifetime” incurrence, do not mean they
are not “repairs”. Further, that new advancements in building techniques give
new and better options to repair deteriorating property does not mean that
undertaking repairs utilizing those better, more modern, options will condemn a
repair to a capital expenditure. In the case at bar the options chosen were
largely cheaper options than those that would restore the properties back to
anything like their original condition or even the condition that the Appellant
believed they were in when they were acquired.
[17] It is submitted the
repairs here were piecemeal repairs dealing with issues as they were discovered
on close post-acquisition inspection. They were not part of a design to improve
the existing properties or to, in effect, replace them with something other than
what they were and when the work was complete, no new assets had come into
existence. Like Gold Bar, nothing was done more than what was required
to repair deteriorating conditions.
[18] Contrasting the
current case with one where repairs did constitute capital outlays, the
Respondent referred to Shabro Investments Ltd. v. R.. In that case the floor of a building had
to be reconstructed on top of newly sunken steel piles. A consideration that Jackett
C.J. of the Federal Court of Appeal took into account was that the work made
the building a long term usable asset – a character it did not previously have
due to a serious construction defect. It went from usable to unusable. But for
remedying the fabric of the building, replacing the floor using modern
technology that incidentally improved the building would not make the repair
capital in nature as long as the replacement is not substantially different
than what was there before. Urie J. acknowledged that all repairs involve some
degree of improvement – the question is whether the improvement brought into
existence a different capital asset. Where an integral part of the building has
changed in character, that goes beyond a replacement that simply performs the
same function of that which is replaced. The purpose in Shabro, when
examined, was not to restore a functional floor without increasing the value of
the building, it was designed to function in a different way as an integral
part of the building as a whole.
[19] The Appellant relies
as well on McLaughlin v R.. In
that case Justice Bowman (as he then was) took exception at paragraph 9 to the
Minister of National Revenue’s (the “Minister”) premise that improvements to a
habitable rental property made to obtain enhanced rents were capital in nature.
He cites the principles in Shabro and Gold Bar and reiterates
that repairs done to put a house back to its original state – not to effect a
permanent structural improvement or create something virtually new, as in a
case like Methe v. M.N.R.
- were current expenses. In Methe a total renovation was found to have
resulted into a totally new building making the expenditure on capital account.
[20] Reference is made to
Lewin v R.. In
that case a 20 year old deck with a fibreglass covering was replaced with a new
deck with a vinyl covering – a modern equivalent. Other deck changes such as
railings, lattice work and vented soffit were not significant and of nominal
cost. The replacement was known to be needed when acquired. Again, applying
authorities like Gold Bar and referring to Justice Lamarre Proulx’s
decision Bergeron v. Minister of National Revenue which allowed that income related
expenses included repairs the purpose of which was to make the part of the
property repaired suitable for normal use again, it was held the repairs were
deductible.
[21] The Appellant’s
counsel also referred me to Brunet v. R., Jacques v. R., Janota v. R. and Preiss v. R..
[22] In a written
submission, Appellant’s counsel, responded to two questions that I raised at
the hearing: what if any bearing does the overall amount of work being done,
all at once, have on the issue; and what if any bearing does the work being
done right after acquisition, to ready the properties for rental, have on the
issue.
[23] Appellant’s counsel
pointed to his authorities that largely confirmed that aside from excluding
individual capital additions, that the timing of the expenditures was not
regarded as a factor. Doing a large number of repairs at the same time or doing
them to ready a new rental property for rent were not considerations taken into
account when considering the purpose and nature of the repairs which were the
determinative factors.
[24] For example, he
cited McLaughlin where a substantial number of repairs were undertaken
on a newly acquired property. Justice Bowman (as he then was) applied the tests
and principles applied in what he referred to as the leading cases, Gold Bar
and Shabro. Those principles related to the purpose and nature of the
work as reflected in paragraph 10 of his reasons:
A substantial portion of the work that was done was, on the evidence, repairs to put the house back to
its original state -- not to effect a lasting permanent structural improvement.
Painting and wallpapering, repairs of
floors, replacement of drywall, replacing of fixtures is essentially repair. …
[25] As well, the
Appellant’s counsel pointed out that the Canada Revenue Agency (“CRA”) accepts
that multiple repairs being done together would not reclassify the nature of
repairs. In paragraph 4(d) of Interpretation
Bulletin IT-128R it states:
… where a
major repair job is done which is an accumulation of lesser jobs that would
have been classified as current expense if
each had been done at the time the need for it first arose; the fact that they were not done earlier does not
change the nature of the work when it is done, regardless of its total costs.
[26] Appellant’s counsel
acknowledges an exception to this principle where the effect of multiple repairs is
to substantially improve the repaired property to a point past its original
condition or to bring into existence an asset different from that which it replaced
as was the case in Shabro where Justice
Urie in the concurring decision for the Federal Court of Appeal stated at paragraph 21:
… All repairs involve to some degree, renewal and
replacement of parts of the subject matter of the repair and, therefore, of necessity an improvement to the repaired
structure, machine or whatever the
subject matter is.
He
then stated:
That alone, it appears from the
jurisprudence, is not sufficient to convert an expenditure for repairs to an
income producing property from an income expenditure to a capital expenditure.
The crucial question it appears was the outlay such as to bring into existence
a capital asset different from that
which it replaced?
[27] In Janota,
Justice McArthur
cited Justice Brulé in Chambers v. R.,
wherein Justice
Brulé stated:
14 It would seem that if the repairs
resulted in virtually the same old building as before the repairs were undertaken then such should be
properly expensed, but if on finishing the repairs a virtually new
building or at least quite a different building results then the repairs should
be on capital account.
15 One criteria to make such a determination
apart form the appearance inside and out of the structure and whether or not
the place had to be vacated before repairs were undertaken is the dollar amount of the repairs in relation to
the value of the asset. Here these were not extraordinarily large in relation
to the building. …
[28] In Bishop v. R. Justice François Angers
stated at paragraph
10:
The evidence
as presented at trial leads me to the conclusion that the repairs and improvements that were made to the house during
the three taxation years at issue were made to materially improve the house
beyond its original condition. In fact, the repairs made to the house
were substantial enough for one to say that, once they were completed, a
totally different house was created ...
[29] A second exception that
Appellant’s counsel referred to was where a taxpayer has acquired a property that is in very poor
condition and requires a total reconstruction or rehabilitation. In such cases the Courts have
recharacterized what would otherwise be current
expenditures into capital expenditures.
[30] In Fiore v. R. (a case relied on by
the Respondent) the
Federal Court of Appeal had to decide whether expenses totalling $326,648 incurred by the taxpayer to
renovate two buildings
were current or capital expenditures. Both buildings were bought in poor
condition and
substantially renovated after purchase. The Court stated at paragraph 5:
Where, as in the instant case, property is bought
for a price ($107,000) below its ordinary capital value at the time of the purchase ($263,380 in 1983) and the
expenses are necessary because of
the condition of the buildings and are incurred to restore them to their
ordinary value, we consider that those
expenses are capital in nature.
[31] In Marklib Investments II-A Ltd. v. R., Justice Brulé at paragraph 34
states:
This Court is unable to find the relevance of a number of cases the respondent relied
on in his argument. The respondent
relied on cases involving newly-acquired buildings in poor condition, the need of repairs to get the building operational, and payment of a
decreased purchase price because of
the building's poor condition. All of the above cases are distinguishable from the case at bar as all
involved the taxpayer acquiring or purchasing a deteriorated property.
The taxpayers knew the state and condition of the property upon acquisition. I have to wonder whether the
respondent is extracting the reasoning out of the cases and erecting it into
general principles without taking into consideration the specific facts of the cases.
…
[32] In closing, Appellant’s counsel made the following
submission:
We
submit that the evidence at trial establishes that:
·
each of the
properties in question were habitable, having been lived in prior to the purchase of them by the Appellant
and the other individuals;
·
the Appellant
would have rented the properties out if tenants were located and, as admitted by the Respondent in the Reply, the Appellant took steps to rent
out each property after their purchase;
·
Because the
properties were not rented out, repair work was undertaken on each property to fix individual
aspects of the property that needed repair or replacement, or would need repair
or replacement in subsequent years, in order to put the properties in good operating condition; and
·
The work undertaken to fix aspects
of each property did not result in a substantial improvement to either property, as often the work
involved a cheaper material or repair technique being used, than originally existed in each
property.
Respondent’s Submissions
[33] The Respondent essentially
urged me to see the repairs as having been made to ready the properties for rental.
They were not habitable as rental units of the type that the Appellant wanted
to secure would rent. The expenses were incurred to put together a rental
property that met his business plan. It was not the mere repair of an income
generating property, it was a necessary cost of assembling and readying the
capital asset that would generate the rental income.
[34] The Respondent relies
on a number of cases. The first case he referred to was Fiore. This
decision by the Federal Court of Appeal concerned expenses totalling some
$326,000 incurred to renovate two buildings intended to be used as rental
properties. At the time of acquisition they were in poor condition and the appellants
set about renovating them at once. It was held in that case that the expenses
were capital in nature and the Respondent argues that the circumstances are
similar in the present case, namely that the expenses were necessarily incurred
because the condition of the buildings when acquired required them to be
restored to their ordinary value. It was further argued that like in Fiore,
the subject appeal involved renovations that involved a significant improvement
to the asset. The improvements in Fiore which are asserted to be
comparable to those in the instant appeal were summarized in Fiore at
paragraph 6 as follows:
… Accordingly, there are now poured
concrete foundations that did not exist before. Hardwood floors replaced
plywood floors. Ceramic tile took the place of vinyl tile and linoleum. A
low-amperage, obsolete electrical system (60 amperes) was replaced by a modern
and more powerful system (125 amperes). Walls and ceilings were improved by
using gypsum plaster board to replace prefit, plaster and plywood.
[35] The Court of Appeal
found that it was not unreasonable for the trial judge to have concluded that
the property in question had become new property and that the expenses were
capital expenses.
[36] The Respondent takes
the position that the purpose of the expense was to confer a lasting benefit to
the rental operation. Reliance was placed on Leclerc v. R.. In that case, this Court found
that if the object of an expenditure was to provide a lasting advantage to the
property then it can only be classified as a capital expenditure. Reference was
made in Leclerc at paragraph 10 to the Federal Court of Appeal decision
in Canadian Reynolds Metals Co. – Société Canadienne de Métaux Reynolds Ltée
v. R.
where that court emphasized that it was the purpose of the expense, to
confer a lasting benefit, that was the focus of the question. That was the test
applied in Marklib Investments as well. In Leclerc the judge at
paragraph 12 concluded that the repairs were on capital account “… because the
repairs were not usual repairs on a property in rental condition but repairs to
make the property rentable, the purpose of which was to confer a lasting
benefit on the property.” The Respondent submits that the purpose of the
repairs in the instant appeal was, similarly, to obtain a lasting benefit.
[37] Focusing on the
enduring benefit it was argued that repairs such as eliminating water damage
and strapping the building envelope went beyond normal recurring maintenance
and repairs. These provided enduring benefits. Similarly to replace cupboards
and redesign a kitchen in the process of removing rot went beyond being normal
recurring maintenance expenses.
[38] The Respondent
argues that the renovations here were in the nature of replacing parts of the
building making it something that was essentially different in kind from what it
was before so as to constitute an improvement to the building rather than a
mere repair of it. Referring to Shabro, a case contrasted to the present
case by the Appellant, the Respondent submits that that case which found there
had been sufficient replacements and substitutions to essentially create a different
building was comparable to the one at bar.
[39] Respondent’s counsel
emphasized that his argument was based, in any event, not so much on the
overall improvement of the property but rather on the nature of each of the
repairs which if left unattended would cause serious detriment to the
buildings. A new kitchen was built because the old kitchen was rotting away.
This is not a repair, it is a replacement caused by such degree of
deterioration as to underline its enduring benefit as something new.
[40] It was argued that
the business model required such capital improvements in order to put the
properties in a rentable condition.
[41] In a written
submission, Respondent’s counsel also referred me to Brunet. In
that case, Justice Lamarre placed her emphasis on cases that found that the
crucial question was whether the outlay was such as to bring into existence a
capital asset different from that which it replaced.
[42] Respondent’s counsel
argued that the subject properties were not up and running income producing
assets when acquired and were not part of an existing rental operation. Repairs
and renovations were necessary prior to the property being available for
rental. The fact that the properties were occupied prior to purchase did not
mean that the repairs and renovations were necessary to bring the properties
into rentable condition. The expenses were incurred to bring the capital asset
into use as rental properties.
[43] The Respondent
argues that the overall number of repairs and renovations looked at as a whole
demonstrate an overall change in character of the asset. That is, an entire
renovation project differs from ordinary ongoing maintenance. The Respondent
relies on the additional authorities of Audrey B. Wager v. M.N.R. and Charney v. The Queen.
Analysis
[44] There is no doubt
that the cases in this area suggest that the fact that an enduring benefit
arises from a repair will not disqualify it from current expense treatment.
This, in itself, makes the analysis difficult since it takes the analysis away
from a traditional perspective. Replacing a roof or kitchen cupboards can be a
repair notwithstanding that they have enduring value. This departure from a
traditional analysis seems to stem from the inevitability that all repairs will
have some enduring value and from the ongoing and repetitive cycle of repairs
due to usage, time and unforeseen issues. Such realities require, or at least
have caused, a change in focus and I agree with Appellant’s counsel that the
primary focus is on the purpose and nature of the work done.
[45] I would not go so
far as to say that such focus applies universally with identifiable exceptions as
argued by Appellant’s counsel. I would say that the analysis of the purpose and
nature of the work done incorporates consideration of a number of factors each
given different weight in different circumstances. As Justice Bowman suggested
in McLaughlin, a common sense application of the various factors
provides the answer.
[46] Nonetheless, it must
be recognized that in this area at least, common sense is not particularly
“common” to all observers. Is it common sense that replacing a roof is a
current expense? I might suggest that it is not – but that would be to ignore an
abundance of authorities, including the Minister whose positions on the matter
say otherwise. Interpretation Bulletin IT-128R last revised in May, 1985 for
example provides as follows in paragraph 4(b):
(b) Maintenance or Betterment - Where an expenditure
made in respect of a property serves only to restore it to its original
condition, that fact is one indication that the expenditure is of a
current nature. This is often the
case where a floor or a roof is replaced. Where, however, the result of the expenditure is to materially improve the property
beyond its original condition, such as when a new floor or a new roof clearly is of better quality
and greater durability than the replaced one, then the expenditure is regarded as capital in nature.
Whether or not the market value of the property is increased as a result of the expenditure is
not a major factor in reaching a decision. In the event that the expenditure includes both current and capital elements and
these can be identified, an appropriate
allocation of the expenditure is necessary. Where only a minor part of the
expenditure is of a capital nature, the Department is prepared
to treat the whole as being of a current nature.
[47] I cite this to
underline that even a new roof can be a current expense. As I will note later
in these Reasons, the Minister can point to several cases to support this
position. As well, it does reflect a position that regards repairs that restore
a property to its original condition to be of greater significance in the determination
of the current versus capital issue than repairs that may result in a modest increase
in the value of the property.
[48] This might well
reflect the way many if not the majority of the authorities view repairs in
spite of the Federal Court of Appeal decision in Fiore. In Fiore the scope of the improvements
could be seen from valuation reports that revealed the property, which should
have been worth $263,000, was acquired in poor condition for $107,000 and
later, after repairs totaling a grand total of $326,000, was valued at
$437,000. In finding that the repairs ($174,000 of which were in dispute) were
capital in nature, the Court clearly rejected the argument that expenses
incurred in that case, to bring a property up to its ordinary value had it been
properly maintained, were current expenses. That rejection seems to be based on
the premise, as noted in paragraph 4 of that decision, that that cannot always
be true. In some cases, like the case in Fiore, restoration expenses, expenses
incurred to restore the property to its ordinary value, should be treated as on
capital account.
[49] This strikes me, theoretically speaking, as an
appropriate result. Capital costs of buildings are, after all, allowed a
deduction for wear and tear in the form of capital cost allowance. Allowing a full
deduction for the cost of restoring a depreciated property to the starting
point in the name of repairs suggests a liberalization of a pretty fundamental
aspect of the scheme of the Income Tax Act.
Still, it must be acknowledged that Fiore, on its facts, does
present a clear and obvious case of restoration to a new starting point in
terms of the appropriateness of capital cost allowance treatment.
[50] Seen in this way, the decision in Fiore is not at
odds with the authorities that support the Minister’s position as reflected in
IT-128R. The Bulletin speaks of restoration to a particular condition. Fiore
speaks of restoration to a value that, but for the deteriorated conditions that
made the repairs necessary, would be an ordinary value. Where value is
materially enhanced beyond that, by repairs, Fiore is authority for
finding that such repairs are capital in nature. As well, it should not be
overlooked that in Fiore the repairs included structural improvements –
a poured concrete foundation that did not exist before. This suggests a change
in the nature of the property as later found in Shabro. Based on such
additional facts, the Federal Court of Appeal in Fiore was able to rely
on the work done as having resulted in a significant improvement to the asset.
[51] Another aspect of Fiore,
reflected in other cases as well, relates to the relevance of the overall cost
of the repairs.
Where the extent of the repairs or work done require expenditures that are
quantitatively significant relative to the cost of the property to the taxpayer
seeking current expense treatment, there is less likelihood that an intention
to restore will suffice. The character of that which was acquired may
have changed. Restoration to a former character by a new owner may be a capital
project demanding a
new starting point in terms of capital cost allowance treatment where the cost and
timing of the project undertaken is reflective of an intention to do more than
a mere repair. That is, in cases like the case at bar, the issue might be
whether the repairs changed the character of the property as purchased as
opposed to whether the repairs restored the property to what it was prior to
deterioration suffered in the hands of previous owners. While the timing of the
repairs in the case at bar may be suggestive of an intention to change the
character of the property as purchased, I have not come to that conclusion in
this case. As I will note later in these Reasons, timing in this case is of
considerable relevance but not because there has been a change in the character
of what was acquired.
[52] While the timing of
and the relative cost of work done are factors to consider, I note that there
is little doubt that, generally speaking, the current treatment of repairs will
not be changed simply because a number of repairs are undertaken at the same
time.
There seems to be no suggestion in the authorities that the courts will second-guess
an owner’s decision as to the timing of repairs that may, for example, be done
at various stages of wear, during vacancies or slow rental markets or when
economies present themselves, including a decision to do multiple repairs that
may, when done together, appear to be a renovation when they might more properly
be considered to be cyclical restorative repairs undertaken with no intention
of altering the character of the property.
[53] My reference to a
“renovation” does suggest that the extent of the repairs will still be a
factor. Intuitively, that seems to align with what common sense might suggest.
Still, the authorities on the whole, perhaps recognizing the economic realities
of the ongoing and recurrent nature of general maintenance which is largely
restorative in nature, suggest that there is room for considerable latitude and
tolerance here to allow fairly significant renovations current expense
treatment provided they do not go so far as to change the character of the property
and that they were undertaken with the purpose to repair the property, in a
restorative sense.
[54] The restorative
aspect of a repair which is given current expense treatment can readily be seen
in the example already mentioned, namely, a new roof. New shingles may last 25
years but they restore a property to its original state from a functional point
of view. The shingles may be of better quality, designed to perform and even
look better, but if the purpose was primarily to repair a worn or damaged roof,
the cost will be deductible.
[55] Perhaps it should go
without saying, but the purpose test inevitably must have an objective element.
The cost of some materials, the design or even the function of work done, may
objectively suggest that mere restoration was not the primary purpose for
undertaking it. If a repair becomes an excuse to upgrade a property to appeal
to a different class of renter, that might suggest a change in the character of
the property as opposed to a consequential improvement incidentally achieved in
completing the repair in a restorative sense.
[56] Consider the new
kitchen in the Kensington property in the case at bar. Water damage caused rot
which led to a variety of required repairs which in turn led to plumbing and
electrical code issues. I am satisfied that the new cupboards and flooring were
restoration oriented. Reconfiguration of the kitchen, required in large part by
building code issues presented by the old configuration, gave rise to an
opportunity to improve aspects of the kitchen design. However, this all flowed
from the need to repair the damage. Indeed, repairs that involve work on older
properties, work required by deterioration, occupant neglect or abuse or
intervening events, may never be capable of being restored except in a modern
fashion. They are still repairs. Consequential improvements incidentally achieved
in completing repairs undertaken in a restorative sense do not change the
character of the expenditure. The focus of the work done on the new kitchen in
the Kensington property was not to upgrade to modern standards and current
residential standards. These became opportunities or requirements that could be
or had to be addressed as incidental to the restorative needs of the property. There
are no costs here that suggest that the materials, finishings or design changes
were indicative of anything but repairs. Indeed, all costs incurred are
surprisingly modest. This is most apparent perhaps in the cost of the
electrical and plumbing repairs. I am satisfied that the purpose of the work
done on each property was to repair damage. That is, it was restorative in
nature. There was no intent to change the character of the properties.
[57] Referring to costs, again
draws the analysis to consider whether there has been an enhancement of value
beyond the ordinary value that these properties might have had but for the need
for the repairs. As noted above, that was found to be determinative in Fiore.
It certainly can speak to intent from an objective perspective. While the
Respondent relies on that case, I have no evidence on the point. While there
would inevitably be some value enhancement were the problems that needed repair
detectable at the time of purchase so as to enable a reduction in price, I have
nothing to contradict Mr. Garrett’s assertions that that was not the case. They
were hidden issues reflecting more deterioration and damage than
pre-acquisition inspections revealed. If there was any enhanced value by virtue
of the repairs, that could not be seen as indicative of the repairs having crossed
over to a renovation in the sense of there having been an intent to effect a fundamental
improvement, or change, in the nature of the property. Again then, I accept
that the repairs were restorative in nature in this sense.
[58] Accordingly, I have
no concerns in the case at bar as to the restorative nature of the expenses
incurred by the Appellant even as a new owner of the properties. I have no
concerns that the character of the properties were significantly changed or that
their value was materially enhanced compared to what was paid. The only troubling
aspect of the instant appeal is that the expenses, even as acknowledged in Appellant
counsel’s written submission, were incurred in order to put the properties in good operating condition. Given
the timing of the expenditures, this suggests that although the properties were
habitable and, as asserted by Mr. Garrett, could possibly have been rented,
they were not really ready to be rented.
[59] While the emphasis of the Respondent’s argument, that
the expenses were incurred to ready the properties for rental, was on their not
being habitable, the crux of that argument does not, in my view, depend on the
correctness of that latter assertion. If the properties, on acquisition, are
not habitable, that state of affairs points to the conclusion that the rental activity
had not commenced. The expenses could not then be found to have been usual
operating costs incurred in the normal course of pursuing a rental activity.
However, habitable or not, I am not satisfied on the evidence that the properties
in this case were ready to be rented when the repairs were undertaken.
The expenses strike me as having been incurred, foreseen or not, as part of the
process of acquiring the properties.
[60] Respondent’s counsel referred me to several cases but the
one that spoke the loudest was an obiter dicta comment made by Justice
Boyle of this Court in Martinello v. Canada. At paragraph 20, Justice Boyle cites
cases that involved expenses incurred to repair a property after it was
acquired and before it was used by the taxpayer to produce income. Justice
Boyle then said:
… It is obvious that such expenses should
ordinarily form part of the capital cost of the property. The property was
being put in rentable condition for the first time.
[61] This comment strikes me as eminently true. However, the
cases he relies on, Fiore, Albayate v. The Queen,
and Nguyen v. The Queen do not themselves necessarily suggest
that the reason the taxpayers lost their appeals was only because they had just
acquired the properties and were readying them for rent for the first time. In Nguyen
for example at paragraph 15 Justice Sarchuk said:
Clearly, the expenses claimed were for a
substantial reconstruction of a portion of the building and were not repairs on
a property in rental condition, but repairs to make the property rentable, the
purpose of which was to confer a lasting benefit on the property.
[62] On the other hand, a review of the repairs done in that
case and their cost suggest that the repairs were no more substantial than the
ones I am considering in the case at bar. Further, the evidence in that case was
that the taxpayer said the property was in rentable condition before the
repairs were done if he found a willing tenant. That testimony is not
dissimilar from the testimony of Mr. Garrett who said the properties in the
case at bar were rentable before the repairs, intimating that I would be
surprised what people would rent.
[63] In Albayate, the property was in very bad
condition having been used as a “grow-op”. The repairs were found to be extensive
renovations. In reaching his conclusion that the outlays were capital in
nature, Justice Little relied on a comparison with Fiore where, as noted
above, the scope of the improvements could be seen from valuation reports that
revealed the property, which should have been worth $263,000, was acquired for
$107,000 and later after the repairs was valued at $437,000. Nothing in Fiore
or Albayate necessarily suggests that the reason expenses were
capitalized was because they were incurred after acquisition, before the first
rentals.
[64] Still, Justice Boyle’s
reasoning in Martinello is persuasive and
aligns with my views. Aside from concluding that Mr. Garrett’s testimony was
somewhat disingenuous as it related to the rentability of the properties before
the repairs, it is clear that the intentions of the co-owners of the subject
properties was, as between themselves, to treat the repairs in the same manner
as the purchase price. If that arrangement can be taken as reflecting the nature
of the expenditure it would be quite damning. That, however, is not a factor
that weighs heavily in my analysis because that aspect of the bargain stuck
between the co-owners derives from a tax planning purpose. It does not speak to
an intention to repair or renovate and as noted above I accept that the
intention here was to repair in a restorative sense. However, as stated, what does
weigh heavily is my concurrence with Justice Boyle’s general premise which, in
this case at least, accords with my earlier remarks concerning the appropriate
starting point in the calculation of capital cost allowance.
[65] It is true that a
lot more may be done in the name of repairs than lipstick and make-up touch-ups
in the course of an active rental program. It is true that repairs of the very
nature incurred in the case at bar can be done during a vacancy so as to ready
the property for the next tenant, even at a higher rent, without losing current
expense treatment. It is true that there might be a fine line between attaching
a repair cost to an acquisition where it is incurred before a first rental and
not doing so where such cost is incurred during the initial months of a first
tenancy; nonetheless, the case at bar is not concerned with those fine lines. Such
issues would have to be addressed on a case by case basis.
[66] As well, I might
suggest that readying a property for occupancy has more likelihood of being
considered on current account where the repairs were undertaken to make the
property suitable for normal use again by the same owner. Indeed, the
concept of “suitable for normal use again” was embraced as part of the
principles that Justice Lamarre Proulx formulated in Bergeron. I would,
as a matter of common sense, read-in “by the same owner” in the case of a newly
acquired property.
[67] Similarly, in Methe,
a certain amount of weight was given to the fact that the buildings in question
were always operational and that maintenance costs had to be incurred in order
to safeguard and maintain the rental income. Again, as a matter of common
sense, I would read-in “by the same owner” in the case of a newly acquired
property.
Conclusion
[68] On the facts, I find that the Respondent’s
position that the subject expenses were incurred to ready the property for
rental is correct. Given my acceptance in this case, in general at least, of the principle
stated by Justice Boyle in Martinello and
given that the repairs in this case were not just on the heels of the
acquisition of the properties and undertaken before a first rental but were expenses
incurred, foreseen or not, as part of the process of acquiring the properties, I
conclude that the cost of them must be on capital account. Accordingly, the
appeal is dismissed, without costs.
Signed
at Ottawa, Canada this 8th day of June 2011.
"J.E. Hershfield"
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