Date: 20010126
Docket: 98-2063-IT-G
BETWEEN:
JOBST von HEYMANN,
Appellant,
and
HER MAJESTY THE QUEEN,
Respondent.
Reasons for Judgment
Bowie J.
[1]
These appeals are from income tax assessments for the taxation
years 1992, 1993 and 1994. The point in issue is a narrow one,
and by no means novel. The Appellant claims that in computing his
income under section 3 of the Income Tax Act (the
Act), he is entitled to deduct from his other income his
share of the losses sustained by a limited partnership in which
he held an interest, and that pursuant to paragraph
20(1)(c) the interest paid by him on the money that he
borrowed to purchase that interest may be included in computing
those losses. The Respondent's position is that he may not
deduct these amounts because his partnership interest was not in
those years "a source of income" within the meaning of
that expression as it is used in section 3 of the
Act.
[2]
The Appellant is a medical doctor with a busy practice in Port
Elgin, Ontario. During the years in question he had a substantial
income, but from it he had to provide a retirement income for
himself and his wife. He and his wife planned their investments
together, and they tried to diversify them. In the summer of 1990
the syndication of a group of condominium apartments in Waterloo,
Ontario called Northlake Trace came to their attention as a
potential investment. It consisted of a group of 10 apartment
buildings, each having three stories, containing among them a
total of 110 apartments. It was located in a good neighbourhood,
close to universities and an area of good quality single family
houses.
[3]
Mr. Martin, the principal of the Datile group of companies,
testified that Northlake Trace was recommended to him as good
quality apartment complex which was well laid out, well
landscaped, and in good physical condition. It was, however,
poorly managed, and it was not producing the rental income of
which it was capable. As such, it suited the business plan of Mr.
Martin's group of companies, and so he arranged to purchase
the buildings. Of the 110 suites making up the complex, 56 were
acquired by a limited partnership called Northlake Trace Limited
Partnership (the partnership).
[4]
The following particulars concerning the partnership, and the
Appellant's purchase of an interest in it, are agreed upon by
the parties for the purposes of these appeals.
5.
Pursuant to an Assumption and General Services Agreement (the
"Purchase Agreement"), the Partnership agreed to
acquire 85 condominium suites in Northlake Trace and interests in
related assets from Northlake Trace Investments Inc. (the
"Promoter"). In addition, pursuant to the Purchase
Agreement, the Promoter agreed to provide certain services to the
Partnership and its partners.
6.
Pursuant to an offering memorandum dated September 12, 1990 (the
"OM"), the Partnership offered units in its capital to
investors.
7.
The purchase price for a unit in the Partnership varied from
$174,000 to $291,000. The purchase price varied because under the
agreement governing the Partnership a limited partner was
entitled to have particular condominium suites in Northlake Trace
distributed to him under certain conditions.
8.
Pursuant to the OM, 28 individuals subscribed for 28 units in the
Partnership.
9.
The 28 investors (including the Appellant) paid the aggregate
amount of $5,005,308 to acquire their units in the Partnership.
In addition, the investors (including the Appellant) paid the
aggregate amount of $141,692 to the Promoter as financing
arranging fees and an interest rate buy-down payment.
10.
The investors satisfied the purchase price for their units in the
Partnership and the investor services as to $4,979,000 in cash
and as to $168,000 by the delivery of promissory notes (the
"Secured Note B") to the Promoter.
11.
On December 31, 1990, the Partnership acquired 56 condominium
units in Northlake Trace from the Promoter for an aggregate
purchase price of $3,967,704. In addition, the Partnership paid
the Promoter $518,764 as fees for establishing and financing the
Partnership, financial reporting and creating a maintenance
reserve and $518,840 as fees relating to the issue of Partnership
units.
12.
The $3,967,704 paid by the Partnership for the 56 condominium
units was allocated as follows:
land
$514,700
buildings
$3,307,404
chattels
$112,000
paving
$33,600
13.
On December 10, 1990, the Appellant subscribed for a unit in the
Partnership in accordance with the terms and conditions for such
subscription set out in the OM. As a result of his ownership of
the unit, the Appellant had the right to acquire two two-bedroom
condominium suites in Northlake Trace from the Partnership.
14.
The Appellant paid $184,000 for his unit in the Partnership and
related services. The purchase price was payable as to $178,000
in cash and the remainder by having the Appellant provide to the
Partnership a promissory note (the "Secured Note B") in
the amount of $6,000.
15.
The Secured B Note was secured by a collateral second mortgage on
the condominium suites that the Appellant had the right to
acquire. A copy of the Secured Note B is found together with the
Appellant's Subscription Agreement at Tab 8 of the Joint Book
of Documents.
16.
In order to fund the cash portion of the purchase price for his
Partnership unit, the Appellant borrowed $138,000 from Investors
Group Trust Co. Ltd. (the "Secured Loan"). The Secured
Loan bore interest at the rate of 13% compounded semi-annually
and was repayable on January 7, 1996. The Secured Loan was
secured by a collateral first mortgage on the condominium suites
in Northlake Trace that the Appellant had the right to acquire. A
copy of the Secured Loan promissory Note is found at Tab 10
of the Joint Book of Documents.
17.
In addition to the Secured Loan, the Appellant borrowed $40,000
from the Bank of Montreal (the "Equity Loan") in order
to fund the remaining cash portion of the purchase price for his
unit in the Partnership. The Equity Loan is a demand loan that
bears interest at the rate of prime plus 1½% and is
payable as to interest only for five years.
18.
The Secured Loan, the Equity Loan and the Secured Note B are
full-recourse obligations of the Appellant.
19.
The Partnership determined that it had the following losses for
income tax purpose for each of its 1992, 1993 and 1994 taxation
years and allocated the following amounts to the Appellant:
|
Taxation Year
|
Operating Loss
|
Loss Allocated to Appellant
|
|
1992
|
« $23,651 »
|
« $847 »
|
|
1993
|
« $110,395 »
|
« $3,662 »
|
|
1994
|
« $75,688 »
|
« $2,918 »
|
20.
The Appellant deducted his pro rata share of the
Partnership's loss for each fiscal period in computing his
income for the relevant Taxation Years.
21.
In each of the Taxation Years, the Appellant paid interest on the
Secured Loan, the Equity Loan and the Secured Note B and also
paid amounts relating to certain fees and carrying charges
(collectively, the "Fees") in connection with his
investment in the Partnership. The amount of the payments in
respect of interest expense and the Fees is set out in the chart
below:
|
|
Taxation Year
|
|
Deduction
|
1992
|
1993
|
1994
|
|
Interest – Secured Loan
|
$17,324
|
$17,197
|
$17,056
|
|
Interest – B Note
|
$600
|
$600
|
$600
|
|
Interest - Equity Loan
|
$3,588
|
$2,998
|
$3,290
|
|
Fees/Carrying Charges
|
$1,052
|
$1,006
|
$966
|
|
Total Deductions
|
$22,564
|
$21,801
|
$21,912
|
22.
The Appellant deducted $22,564, $23,409 and $23,478 in respect of
the foregoing expenses in computing his income for his 1992, 1993
and 1994 taxation years.
23.
The Minister of National Revenue (the "Minister")
disallowed the following amounts relating to the Partnership
investment of the Appellant in computing the income of the
Appellant for the Appellant's 1992 to 1994 taxation
years:
1992
1993
1994
Limited Partnership
Loss
$847
$3,662
$2,918
Interest and carrying
charges
$22,564 $23,409 $20,188
[5]
While they were considering this investment the von Heymanns were
shown certain projections of the financial results that could be
expected from the purchase of an interest in the partnership, if
that interest were financed to the extent of 100%, as described
in the agreed facts. They were also shown projections of the
results that would flow from a purchase on that basis, followed
by a hypothetical sale after five years, based on assumed rates
of appreciation of the underlying real estate varying from 6% per
annum to 16% per annum. The losses that the Appellant incurred,
therefore, were entirely predictable, as were his interest
payments. Dr. von Heymann's evidence as a whole satisfies me
that the potential to make a profit on resale of the unit (or the
two condominium units) when real estate values increased, and the
prospect of holding until it became an income-producing asset
both influenced his decision to buy, and in more or less equal
degrees. He did not buy with any definite intention to sell
within any specific time frame.
[6]
The basis of the Minister's assessment of the Appellant is
found in paragraph 10(b) to (h) of the Reply:
(b)
The Appellant's investment in the Partnership was completely
financed by borrowed funds;
(c)
the financial projections attached to the Offering Memorandum
show that a limited partner in the Partnership was expected to
sustain investment losses each year from 1990 to 1995;
(d)
the Appellant participated in the Partnership for the purposes of
obtaining tax advantages to generate losses to offset other
sources of income and not for the purpose of earning income
therefrom;
(e)
the Appellant did not have a reasonable expectation of profit in
respect of the Partnership investment;
(f)
the partnership investment was not a source of income of the
Appellant;
(h)[sic]the Amounts claimed by the Appellant relating to the
Partnership investment were not reasonable in the
circumstances.
The last ground was quite properly abandoned by counsel at the
trial.
[7]
At trial, counsel for the Respondent took the position that the
partnership unit could not be considered a source of income to
the Appellant because he could have had no reasonable expectation
of a profit in his hands, that is at the investor level, from
rental income, given the very large financing costs. Nor could
the unit be a source of income to arise out of a resale at an
enhanced price, because that would give rise to a capital gain
and not income. He conceded that the facts of this case so far as
they concern potential income from rent, are indistinguishable
from those in Allen v. The Queen and Milewski v. The
Queen,[1] which
at that time was under appeal to the Federal Court of Appeal. In
that case Judge Bowman of this Court rejected the Minister's
position that the partnership did not carry on a business. He
described it as being "... wrong as a matter of logic, law
and common sense". His decision has since been affirmed by
the Court of Appeal,[2] which held that the reasonable expectation of profit
test had been satisfactorily met by the taxpayers where, having
financed the purchase of their partnership interests to the
extent of 99% with borrowed funds, they were paying the interest
and principal on those loans on a 25-year amortization. In giving
the principal Reasons for Judgment, with which both the other
members of the Court agreed, Rothstein J. said this:
[6] Counsel for the Minister concedes that to meet the
reasonable expectation of profit test, an investment need not be
currently profitable. However, he does not indicate what
principle the Court should adopt to determine when the profit
must be expected to satisfy the test. He says it will depend on
the facts of each case. However, to follow this approach without
further guidelines, the Court would be left without a principled
basis to determine when profit must be expected in order to meet
the test. The determination would essentially be arbitrary. This
is unsatisfactory.
[7] If there was no indication of any principal repayment or
the annual interest expense results in losses for an indefinite
period of time, i.e., an unusually long amortization period or,
as in Stewart, there was no profit expected over the intended
holding period, there might be no reasonable expectation of
profit. However, those are not the facts here.
[8]
Here, the amortization period was 25 years. That is not an
unusual amortization period for long-term investments in real
estate. As the principal is paid down, the interest expense
decreases and, all other things being equal, profitability will
"in the fullness of time" be achieved. The Tax Court
Judge found the investment was long-term in nature. In these
circumstances, I think the reasonable expectation of profit test
was met.
[8]
Following the release of the Reasons for Judgment of the Federal
Court of Appeal in Milewski, I invited written submissions
from counsel as to its application to this case. Counsel for the
Respondent, quite understandably, did not suggest that the
Appellant had failed to meet the "fullness of time"
test established by the Federal Court of Appeal in
Milewski. Instead he advanced what I might call the
secondary argument, that the Appellant purchased the unit for
resale, and the resale would give rise to a capital gain, not
income. He relied on Stewart v. The Queen.[3] There the taxpayer
purchased real estate with the specific intention to resell at a
higher price. It was held that he did not have a source of
income, because no rental profit would be realized within the
time that he intended to hold the property, and the resale would
give rise to a capital gain, not income.
[9]
In the present case the Appellant had repaid all the principal on
the $6,000 loan, by the end of the fifth year. He had paid
$32,000 of the $40,000 loan by April 2000, and the balance of
that loan, he said, would be repaid by January 2001, which is the
end of the tenth year. The principal amount of the secured loan
was originally $138,000. By the time of the trial in April 2000,
it had been reduced to $106,000, and the Appellant had reduced
the amortization period from the original 25 years to 19 years,
because he wished to have the debt retired by the time he reached
65 years of age.
[10] Robertson
J., speaking for a unanimous Federal Court of Appeal, said in
Mohammad v. The Queen:
[4]
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.
It does not appear to me that the Appellant in this case could
satisfy that test. He made no payments on the principal during
the first five years, although his income was considerably in
excess of $200,000 per year.
[11]
Milewski is a more recent decision of the Federal Court of
Appeal, however, and its facts are indistinguishable from those
before me. In that case the Court held that the test was
satisfied, because it was reasonable to purchase real estate upon
a 25-year amortization of the purchase price. Dr. von Heymann
will have retired the purchase-money loans in this case at the
end of 19 years. I conclude, therefore, that the Appellant
satisfies the "fullness of time" test to establish a
reasonable expectation of profit.
[12] I turn
now to the Respondent's argument that in this case, as in
Stewart, the Appellant purchased the property with the
intention of reselling it at an enhanced price even before it
could become profitable, so that the purpose of the acquisition
was not to produce income, but to produce a capital gain. First,
I am doubtful that this argument is open to the Respondent on the
pleadings. For present purposes, however, I will assume that it
is. As I have already found, the Appellant was motivated in the
purchase of his interest in the partnership by both the
possibility of income in the long run and the possibility of
selling the property at a profit once the real estate market
recovered. Counsel for the Appellant argued that "there is
strong evidence to support a finding that the Appellant was
engaged in an adventure in the nature of trade in the present
case ...". I agree with that view: see Regal Heights
Ltd. v. M.N.R.[5] Any profit on resale would therefore be on income
account.
[13] The
appeals are allowed. The assessments are referred back to the
Minister of National Revenue for reconsideration and reassessment
allowing the Appellant the benefit of the losses claimed. The
Appellant is entitled to his costs.
Signed at Ottawa, Canada, this 26th day of January, 2001.
"E.A. Bowie"
J.T.C.C.
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