Citation: 2008TCC355
Date: 20080612
Docket: 2006-1296(IT)G
BETWEEN:
EMPIRE PAVING LIMITED,
Appellant,
and
HER MAJESTY THE QUEEN,
Respondent.
REASONS FOR JUDGMENT
Woods J.
[1] At issue in this
case is whether the appellant, Empire Paving Limited, was correct in reporting
a net loss from trades of publicly-traded shares as a business loss.
[2] A business loss
in the amount of $714,093 was deducted by the appellant in computing its income
for the taxation year ended January 31, 2003. The Minister of National Revenue determined
the loss to be a capital loss and reassessed to disallow the deduction
claimed.
[3] The general
background is succinctly set out in the following paragraphs from the notice of
appeal. Many of these facts are not in dispute.
3. The
Appellant is a corporation, incorporated in 1981 under the laws of the Province of Ontario,
with a head office located at 50 Highmeadow Place, Weston Ontario
M9L 2Z5.
4. At
all material times the Appellant carried on a paving, excavating, landscaping
and construction business.
5. The
sole shareholder of the Appellant is Anthony Petrozza (“Petrozza”). He was born
in 1952 in Italy, and immigrated to Canada at the age of 17 years old.
6. Petrozza
both supervises projects of the Appellant and runs the administration of the
office.
7. From
1995 to 2003 Petrozza used excess cash in the Appellant to buy and sell stock
on its behalf.
8. Petrozza
made decisions on which securities to buy and sell by gaining expertise from
observing others. He followed the market by watching business programs on TV.
He would spend several hours every night watching these programs while he
worked on activities in the paving business. He also watched them during the
day from a TV that he had in his office. He studied the methodology and track
record of analysts on these programs for several months before commencing to
buy and sell himself. He read the Financial Post every day. He read articles
written by knowledgeable people and analysts. He did not seek the advice of
brokers.
9. As
well as observing analysts and their track record, Petrozza observed trends in
the stock market. For example, a stock would gain $8 or $10 in a day and then
lose $5 the next. But in a short time it would go up again by another $10. This
ratcheting process was particularly true in the technology sector at that time.
Petrozza realized that he could buy a stock, sell after a short time for a
profit, wait for the price to decline, buy again and then sell at a new high.
He began to invest using this strategy.
10. Petrozza
financed Empire’s stock market purchases and sales with a combination of
accumulated cash in Empire and leverage. He bought mutual funds and other long
term investments with cash accumulated in Empire. These investments were used
to secure a margin account. The borrowed funds were used to buy the stocks. The
funds were borrowed from the custodian, CIBC Wood Gundy. The interest
rate was in the range of 1 ½% to 2% above prime. The custodian would lend a
significant portion of the fair market value of the entire portfolio.
11. Petrozza,
as the guiding mind of Empire, caused Empire to adopt a pattern of borrowing,
on average, 70% of the combined value of the long term investments and the
stocks. The margin account was valued every day. The borrowed funds could
remain outstanding so long as the value of the portfolio was stable. If the
value of the portfolio went below a certain value as determined by stringent
rules of the custodian, a margin call would be made. This margin call would
have to be covered with a cheque or a sale of the portfolio.
12. Petrozza
understood that the stocks in which Empire invested were subject to constant
fluctuation. So long as the market ratcheted up, he could continue to buy and
sell without margin calls and could borrow more. Unfortunately the bubble in
the stock market burst. Empire began getting margin calls. At first Petrozza
arranged for them to be covered with cheques because he believed the stocks
would rebound. However they did not. He then caused Empire to sell the long
term investments, believing the stocks would rebound. They did not. As a
result, the holding period for each stock increased while Petrozza waited for
the expected rebound. Eventually when he could wait no longer for a rebound,
Petrozza was obligated to have Empire sell the stocks in its taxation year
ended January 31, 2003 for losses in order to eliminate the margin account.
13. Empire
filed its tax return for the taxation year ended January 31, 2003 and deducted
the losses on the mutual funds and other long term investment stocks as capital
losses and carried back some of the losses to prior years. The losses on the
other stocks were treated as non-capital losses from a business and fully
deducted.
Analysis
[4] Recently, in 1338664
Ontario Limited v. The Queen, 2008 TCC 350, I had occasion to consider a similar
fact situation but one in which the taxpayer had trading gains and sought to
have them categorized as on capital account. In that decision, the applicable
legal principle was described as follows.
[4] It is the position of the respondent that the appellant’s
net gains derived from securities’ transactions are income from a business, and
are required to be included in computing income under section 3 of the Income
Tax Act.
[5] In general terms, the test for
determining whether securities’ transactions constitute a business is whether
the taxpayer is engaged in a scheme for profit‑making or whether there is
merely an enhancement of value: Irrigation Industries Ltd. v. M.N.R.,
62 DTC 1131 (SCC); Hawa v. The Queen, 2006 TCC 612, 2007 DTC 28.
[6] To the same effect, in Salt v.
Chamberlain, 53 TC 143 the English Chancery Division suggested that for
share transactions to constitute a trade, “something” must be provided by the
trade to earn the income. At page 152:
[…]
The matter is usefully summarised in the speeches of Lord Wilberforce and
Lord Simon of Glaisdale in Ransom v. Higgs 50 TC 1, at pages
88 and 95. Lord Wilberforce says this, at page 88:
“
‘Trade’ cannot be precisely defined, but certain characteristics can be
identified which trade normally has. Equally some indicia can be found
which prevent a profit from being regarded as the profit of a trade. Sometimes
the question whether an activity is to be found to be a trade becomes a matter
of degree, of frequency, of organisation, even of intention, and in such cases
it is for the fact-finding body to decide on the evidence whether a line is
passed.”
He goes on to
say:
“Trade
involves, normally, the exchange of goods or of services for reward – not of
all services, since some qualify as a profession or employment or vocation, but
there must be something which the trade offers to provide by way of
business. […]
[Emphasis
added; footnotes omitted]
[7] It is a matter of degree as to whether share trading
activity has crossed the line from passive investing to being a business. The
difficulty often lies in determining where the line should be drawn.
[8] Counsel for the appellant, citing Canadian, United Kingdom
and United States’ jurisprudence, suggests that securities’ transactions
are generally presumed to be on capital account. This may be the law in the
United Kingdom and the United States, but the matter has not yet been settled
in Canada (Robertson v. The Queen, 98 DTC 6227 (FCA), at note 18). I
would also note that the application of such a presumption in Canada could have
very harsh consequences for a taxpayer, depending on the circumstances, because
the tax relief for capital losses under the Income Tax Act is quite
limited.
[9] The application of some sort of presumption, though, can be
helpful in promoting certainty where the legislation does not provide much
guidance. In circumstances such as these, I think it is useful to bear in mind
the principle which is often described as “the tie goes to the taxpayer.” This
catchy phrase implies that the principle only applies where the facts are
extremely close to the line, but Estey J.’s famous pronouncement from Johns‑Manville
Canada Inc. v. The Queen, 85 DTC 5373 (SCC) suggests a wider
application. His comment reads as follows, at page 5384:
[…]
Such a determination is, furthermore, consistent with another basic concept in
tax law that where the taxing statute is not explicit, reasonable uncertainty
or factual ambiguity resulting from lack of explicitness in the statute should
be resolved in favour of the taxpayer.
[5] In the present case, the respondent submits that the
trading activity was similar to that of a passive investor and that it was not
a business. According to the reply, the
Minister assumed that the appellant had only 75 trades between 1996 and
2003, the average hold period was 275 days, and the investments were generally
in blue-chip stocks.
[6] Although these assumptions are accurate, they are quite misleading.
The appellant’s stock market activity was
considerably more active than these assumptions suggest.
[7] I would describe Mr.
Petrozza, the sole shareholder of Empire Paving Limited, as having
been an avid amateur stock market enthusiast, with a considerable appetite for
risk. I have used the past tense because Mr. Petrozza (and the appellant)
abandoned the stock market after terrible losses were incurred. It appears that
the appellant put at risk approximately $1,000,000 of its own funds, and most
of the money, if not all, was lost.
[8] The Minister assumed that the appellant had only 75 trades from 1996 to 2003. However, this
totally ignores the fact that the trading activity was not actively pursued
throughout the eight year period. It was only active for about four or five
years, because there was a two year hiatus during which Mr. Petrozza
liquidated the portfolio to use the funds for other purposes, and there was another
period of inactivity prior to the final liquidation of the portfolio.
Accordingly, the total number of trades over an eight year period that was
assumed by the Minister does not adequately reflect the frequency of the trading.
[9] Another problem
with the assumptions is that the average hold period assumed, 275 days,
misrepresents the appellant’s trading strategy. When the trading activity was
being actively pursued, the hold periods were significantly shorter. For
example, the average hold period for securities purchased in the 2000 taxation
year was 72 days. It was only when the value of the securities plummeted
did Mr. Petrozza choose to hold the securities for a much longer period.
In effect he was simply hanging on for the ride, hoping for an upswing in the
market which did not occur.
[10] A further problem with the Minister’s assumptions is
the description of the shares as
blue-chip. In general the securities, which had a significant weighting in the
technology sector, appear to be much more volatile than what the term “blue‑chip”
usually signifies.
[11] In my view, Mr. Petrozza was not a passive investor. His strategy was to be an active
trader, with an aggressive approach using a significant amount of leverage and purchasing
volatile shares for relatively short periods. The fact that the strategy failed
miserably with the downturn in the technology sector does not change its
essential character. It is the appellant’s intention at the time of acquisition
of the securities that is the most relevant.
[12] The question that
remains is whether the activity has crossed over the line to a business. Has
the appellant contributed something of a business-like nature to the trade?
[13] From the perspective of persons who are experts in the stock market, the methodology employed
by Mr. Petrozza was likely far from being sophisticated. This should not be the
test, however. The question is whether Mr. Petrozza intended to employ a
business-like approach, not whether the approach was sound.
[14] In my view, the
appellant did employ a business-like approach to the trading activity. The
strategy was to be aggressive, with considerable amounts at risk, and it
required constant attention.
[15] Unless there are
other factors that tip the scale in favour of capital treatment, I would have
thought that this was a case where the appellant’s trading activity could properly
be considered a business, within the approach suggested in Johns‑Manville.
[16] As for other
relevant factors, I would note that the appellant had mutual funds which were
reported on capital account for all years, including the taxation year at
issue.
[17] This fact is not
helpful to the appellant’s position, but it is not necessarily fatal. It is
possible for a taxpayer to carry on two distinct activities, one investment and
one trading, and I think the facts here are consistent with this.
[18] According to Mr.
Petrozza’s testimony, he generally selected securities on his own without his
broker’s advice, but the broker recommended that some mutual funds be
purchased. Mr. Petrozza testified that he thought the broker wanted him to
hold some conservative investments as a protection for the margin account.
[19] The trading
summary that was entered into evidence supports this testimony, or at least it
suggests that the mutual funds were not part of Mr. Petrozza’s general
trading strategy. The mutual funds were purchased in a lump sum using the
appellant’s own funds, and the margin account increased significantly after
that.
[20] If a taxpayer has
two well-defined trading strategies, there is no reason why one part of the
portfolio cannot be held on capital account and the other on income account. I
am prepared to accept that this is appropriate here.
[21] I have also taken
into account the fact that the appellant did not obtain a tax benefit from the
way it reported the mutual funds, as they had suffered losses as well.
[22] I should also
briefly mention that the appellant also reported shares of Trimark corporation
as on capital account. I do not know why these shares were treated the same way
as the mutual funds and I do not recall any reference to this at the hearing.
The Trimark shares were an extremely small holding and I conclude that they do
not affect the analysis one way or the other.
[23] Finally, I wish
to comment about an inconsistency in how these transactions were reported in
the appellant’s income tax returns. The 2003 taxation year was the first year
in which the appellant reported any share transactions on income account. Prior
to that, they were all reported on capital account.
[24] Courts have
naturally been unsympathetic if taxpayers report securities’ gains and losses on
an inconsistent basis when it is their advantage to do so. The circumstances
here are not in that category, however, because the appellant suffered losses in
most years.
[25] In circumstances where
a taxpayer has not benefited from reporting prior transactions on capital
account, I see no reason why a fresh approach cannot be taken in a later year.
[26] For all these
reasons, I conclude that the reporting of the securities’ transactions by the
appellant for the 2003 taxation year is appropriate.
[27] The appeal will
be allowed, with costs.
Signed at Ottawa,
Canada this 12th day of June 2008.
“J. Woods”
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