Date: 19990316
Docket: 96-3792-IT-G
BETWEEN:
CARL CARDELLA,
Appellant,
and
HER MAJESTY THE QUEEN,
Respondent.
Reasons for judgment
Bonner, J.T.C.C.
[1] This is an appeal from assessments under the Income Tax
Act ("Act") for the Appellant's 1989,
1990 and 1991 taxation years.
[2] The Appellant is a physician practising in Metropolitan
Toronto. He earns income from the practice of that profession and
from teaching.
[3] At issue is the deductibility in computing the
Appellant's income of expenses incurred in connection with
two limited partnership units held by him, namely, one unit of
Gerrard Associates Limited Partnership ("GA") and one
unit of Collegeway Associates Limited Partnership
("CA").
[4] GA was formed in December 1986 with a view to acquiring a
rental real estate project at 86 Gerrard Street East, Toronto,
Ontario. The project comprised 57 dwelling units together with
parking spaces. The acquisition was financed in part by the sale
to investors of limited partnership interests. In December 1988
the Appellant and other investors subscribed for units in GA.
[5] Before investing in GA the Appellant reviewed financial
projections which had been prepared by the promoters of GA. The
projections showed that, for at least ten years, the limited
partners would suffer losses after the deduction from income at
the partnership level of payments on promissory notes which they
were required to assume in partial payment of the purchase price
of their partnership interests. The balance of the purchase price
was $1,920 which was paid by the Appellant in cash.
[6] The projections calculated proceeds which would be
received by each limited partner if the underlying partnership
property were to be sold after a ten-year period. They
rested on various assumptions regarding annual compound rates of
appreciation in value of the partnership real estate and on
assumptions regarding net expenses to be incurred during the
ten-year period.
[7] The Appellant testified at the hearing of the appeal. His
testimony made it clear that he invested in the partnership in
the hope of realizing a gain on the sale by the partnership of
its real estate. He did not intend to sell his partnership
interest.
[8] The financial arrangements pertaining to the purchase of
the Appellant's interest featured a guarantee by one of the
promoting corporations of payment to GA of any cash flow
deficiency from the Gerrard property. Such deficiency was defined
to be the amount by which payments under the main purchase price
note (designated as the A note) exceeded the difference between
gross revenues and operating expenses. Payments under the
guarantee were to be added to the principal outstanding under two
other purchase price promissory notes (designated as B and C).
The Appellant and other investors were required under the
arrangements to make aggregate payments for each year up to but
not exceeding 42 percent of their losses for tax purposes for the
year. Such losses included the carrying costs of the A, B and C
notes, the arranging fee, the guarantee fee and the
investor's pro rata share of the losses of the
partnership from rental operations.
[9] At the time that GA was marketed to the Appellant and the
others, it was projected that the partnership would suffer losses
for tax purposes over a ten-year period averaging $393,053
per unit.
[10] In computing income for the 1989, 1990 and 1991 taxation
years, the Appellant deducted the following amounts in respect of
his investment in GA:
Year Interest Arranging Fee Guarantee Fee
1989 $35,336 $1,707 $1,319
1990 $39,567 $1,707 $1,164
1991 $34,431 $1,707 $1,164
[11] There can be no doubt that the economic return which the
Appellant hoped to realize from his investment in GA was his
share of the amount by which the gain on the disposition by the
partnership of the Gerrard property exceeded his share of the
accumulated year-to-year losses of the partnership
plus acquisition and carrying costs related to his partnership
interest. The projections of the investors' proceeds of
disposition after ten years assumed that the gain on disposition
would be on capital account.
[12] The business of GA was stated in the Limited Partnership
Agreement to be:
4.1 The business of the Limited Partnership is to carry on the
business of participating in the real estate rental business in
Ontario through the ownership of the project with a view to
profit and to engage in any and all activities related or
coincidental to the ownership of the Project subject to the
limitations set out in any contract related or coincidental
thereto.
It will be observed that nothing is said about trading in
rental real estate projects.
[13] The term of GA was stated by the Limited Partnership
Agreement to be:
3.1 The term of the Limited Partnership shall commence on the
31st day of December, 1986 and shall continue until the 31st day
of December, 2018, unless earlier terminated by the provision of
article XIV. All provisions of the Agreement relative to
dissolution, winding up and termination shall be cumulative, that
is, the exercise or use of the provisions of this Agreement shall
not preclude the exercise or use of any other provision.
The Limited Partnership Agreement does not contain provisions
which seem to be designed to facilitate the sale by the
partnership of the Gerrard property before December 31, 2018.
[14] CA was formed on December 31, 1986 with a view to
acquiring a rental real estate project at 2079 Collegeway,
Mississauga, Ontario. The project consisted of 105 dwelling
units. The acquisition of the project was financed in part by the
sale to investors of limited partnership interests. According to
the Offering Memorandum the objective of the partnership was to
provide the limited partners with an opportunity to earn income
from the project, realize capital appreciation and defer payment
of income tax by utilizing the provisions of the Act
permitting tax deferral.
[15] In December 1987, 105 limited partnership units of CA
were sold to investors at a price of $171,000 each. On
subscription each investor was required:
a) to contribute $105,000 per unit by means of financing
arranged for the investor ("Note A")
b) to make a cash payment of $10,925;
c) to execute promissory notes (Notes "B" and
"C" in the principal amounts, respectively of $35,000
and $31,000 –totalling $66,000) less the cash payment of
$10,925.
Each investor pledged his unit in CA as security for the A
note. The B and C notes were in favor of the promoters of CA and
were also secured by a pledge of the investor's unit.
[16] Before investing in CA the Appellant glanced at the
Offering Memorandum. At the hearing of the appeal he produced a
projection of overall cash returns from his partnership unit
based on disposition of the project by the partnership after ten
years. That projection showed that the break even point for the
limited partners, after taking into account losses from rental
operations, interest on the notes, and a gain from the sale of
the partnership property, would occur if the partnership property
were to increase in value at an annual compound rate of
approximately 9 percent. The Appellant testified that this
projection was prepared recently but that it represented what was
presented to the investors at the outset. An explanatory note to
the projection stated "the income tax effects on a sale at
that consideration are then taken into account on the basis that
the proceeds and net profit would be subject to full income tax
on the assumption of either a primary or secondary intention to
derive at least a significant part of the economic reward through
a sale of the project". It will be observed that the view
expressed in this recently prepared document on a point very much
in issue in this appeal is at odds with the Offering
Memorandum.
[17] The projections made it clear that each limited
partner's cumulative deductions for tax purposes over the
ten-year period would amount to $187,006 being the amount
by which deductions for costs incurred by the partners
individually exceeded pro rata income from the
partnership.
[18] One of the agreements governing the purchase of the
interests of the limited partners of CA provided that any cash
deficiencies arising because revenues from the rental operation
did not cover operating costs of the partnership plus the
interest costs of the limited partners were to be paid by one of
the promoters. The amount of any cash deficiency so paid was to
be added to the principal outstanding on the B and C notes. The
Appellant and other limited partners were required to make annual
payments on the A notes up to but not exceeding 43 percent of the
following amounts:
a) the amount by which the actual interest expense in respect
of the aggregate outstanding balance of the amount originally
owing to Counsel Trust Company an evidenced by each limited
partner's Secured Note was less than the aggregate projected
interest expense therefor, as calculated in the Schedule to
"Promissory Note "B"; and
b) the amount by which the actual interest expense in respect
of the aggregate outstanding balance of the amount originally
owing to Collway was less than the aggregate projected interest
expense therefor, in the year
The Offering Memorandum states the position succinctly as
follows "... the annual investment (capital contributions to
the partnership and financing payments) are funded through
tax-sheltered cash flow and income tax savings"
[19] In computing his income for the 1989, 1990 and 1991
taxation years, the Appellant deducted the following amounts in
respect of his investment in CA:
Year Interest
1989 $21,534
1990 $23,235
1991 $21,295
[20] The CA Partnership Agreement states that the term of the
partnership shall continue until December 31, 2099 unless sooner
dissolved or terminated. The Partnership Agreement does not
contain terms which appear to have been designed to facilitate
the sale of the real property by the partnership before the year
2099 in the course of some sort of adventure in the nature of
trade. The Agreement further provides:
2.03 Business
The business of the Partnership is to invest in, acquire,
hold, maintain, operate, improve, and otherwise use the
Properties for profit and to engage in any and all activities
related or incidental hereto (collectively the
"Business") but does not include the sale of the
Property. The Partnership shall not undertake any action
unrelated to those purposes without the prior consent of the
partners given by Ordinary Resolution. (emphasis added)
[21] In making the assessments under appeal the Minister of
National Revenue ("Minister") disallowed the deductions
referred to in paragraphs 10 and 19 hereof. The Respondent
pleaded that on assessment the Minister found or assumed
that:
a) the Appellant had no reasonable expectation of profit from
his participation in GA or from his interest in CA;
b) the Appellant participated in GA and CA for the purpose of
obtaining the tax advantages which he understood would be
associated with them and not for the purpose of gaining or
producing income;
c) the only cash flowing to the Appellant and the other
limited partners of GA and CA was generated by income tax refunds
which resulted from the claiming of preplanned losses.[1]
The Respondent also pleaded that no partnership was created in
the case of either GA or CA but the Minister did allow the
deduction of losses at the partnership level in all three years.
To the extent that the question whether the relationships among
the groups of persons which made up GA and CA constituted
partnerships the onus is on the Respondent.
[22] Counsel for the Respondent commenced his argument by
asserting that neither GA nor CA constituted a partnership
because there did not exist in either case an intention to carry
on business in common with a view to profit. He also argued that
even if the two organizations did constitute partnerships the
Appellant's interest in them did not constitute a source of
income within the meaning of section 3 of the Act. In this
regard counsel relied on the test established by the decision of
the Supreme Court of Canada in
Moldowan v. The Queen, 77 DTC 5213 at page
5215 which holds that:
... in order to have a "source of income" the
taxpayer must have a profit or a reasonable expectation of
profit. Source of income, thus, is an equivalent term to
business:...
Counsel argued that because neither CA nor GA offered the
limited partners any prospect of profit, at least prior to the
sale of the partnership undertaking, there could be no business
giving rise to the losses.
[23] The theory of the Appellant was that where a transaction
has been structured to generate income in the form of profit from
sale rather than from rental operations, there is no legal basis
for dissecting the rental operation from the intended resale and
excluding the anticipated gains on resale from the profits which
might reasonably be expected to be earned. Counsel for the
Appellant argued that the acquisition by GA and CA of their
respective properties constituted adventures or concerns in the
nature of trade. He asserted that there exists no requirement
that expenses incurred in connection with such adventures be
deferred and added to the cost of the property which is the
subject of the adventure. He pointed out as well in answer to the
Respondent's arguments with regard to reasonable expectation
of profit that where, as here, the activity has no personal
element the reasonable expectation of profit doctrine is to be
applied sparingly and with latitude favoring the taxpayer.
[24] In my view it cannot be said that either GA or CA
embarked on an adventure in the nature of trade made up of the
acquisition, rental for a period and resale of their respective
rental properties. The classic statement of the test for deciding
whether a profit is of a capital nature or is business income was
laid down in Californian Copper Syndicate v. Harris,
[1904] 5 T.C. 159, at page 165 as follows:
It is quite a well settled principle in dealing with questions
of assessment of Income Tax, that where the owner of an ordinary
investment chooses to realise it, and obtains a greater price for
it than he originally acquired it at, the enhanced price is not
profit in the sense of ... the Income Tax Act.... But it
is equally well established that enhanced values obtained from
realisation or conversion of securities may be so assessable,
where what is done is not merely a realisation or change of
investment, but an act done in what is truly the carrying on, or
carrying out, of a business. The simplest case is that of a
person or association of persons buying and selling lands or
securities speculatively, in order to make a gain, dealing in
such investments as a business, and thereby seeking to make
profits....
The argument of counsel for the Appellant rested heavily on
the theory that the partnerships intended or sought to make
profits on the resale of their respective projects. It is
therefore helpful to recall the words of Noël, J. in
Racine, Demers and Nolin v. M.N.R., 65 DTC 5098 at page
5103:
To give to a transaction which involves the acquisition of
capital the double character of also being at the same time an
adventure in the nature of trade, the purchaser must have in his
mind, at the moment of the purchase, the possibility of reselling
as an operating motivation for acquisition; that is to say that
he must have had in mind that upon a certain type of
circumstances arising he had hopes of being able to resell it at
a profit instead of using the thing purchased for purposes of
capital. Generally speaking, a decision that such a motivation
exists will have to be based on inferences flowing from
circumstances surrounding the transaction rather than on direct
evidence of what the purchaser had in mind.
[25] It seems that the potential for gain on resale of the
projects after ten years was used by the promoters as a lure to
attract investors. However it is not the intention of the limited
partners which is relevant for they, at least singly, were not in
a position to manage the affairs of either partnership. Rather it
is the intention of the two general partners which counts.
[26] The evidence, far from suggesting that either general
partner intended to resell its rental project instead of using it
as a source of rental income, supports a conclusion that the
general partners intended to hold and rent the projects for a
very substantial period of time. The direct evidence of intention
to be found in the description of the business in the partnership
agreements and the terms of the two partnerships also as stated
in the agreements are of very considerable importance. As well it
will be noted that the partnerships have in fact from the outset
to the present time held the projects and have derived rental
income there from. There was no evidence adduced to suggest that
any attempt has been made by either partnership to even test the
market for resale. Finally I note that no one having knowledge of
the intentions of the general partners was called to testify with
regard to the notion that the partnerships bought the properties
with a view to earning profit on a resale at the first favourable
opportunity.
[27] It follows that the Appellant cannot look to gains which
may be realized on future sales by the partnerships of their
properties as potential income to be taken into account in
deciding whether he had a reasonable expectation of profit from
his investments in GA and CA. When such gains are excluded from
the equation the Appellant's interests in the two
partnerships cannot be regarded as sources of income. In
Canada v. Mastri et al., 97 DTC 5420, Robertson, J.A. made
the following remarks at page 5423 with regard to the reasonable
expectation of profit test laid down by the Supreme Court of
Canada in Moldowan, supra:
First, it was decided in Moldawan that in order to have
a source of income a taxpayer must have a reasonable expectation
of profit. Second, "whether a taxpayer has a reasonable
expectation of profit is an objective determination to be made
from all of the facts" (supra at 485-86). If as a
matter of fact a taxpayer is found not to have a reasonable
expectation of profit then there is no source of income and,
therefore, no basis upon which the taxpayer is able to calculate
a rental loss....
In Mohammad v. The Queen, 97 DTC 5503, Robertson, J.A.
made the following remarks at pages 5505-06 with regard to cases
such as the present where a taxpayer has made an investment which
must inevitably yield losses:
Frequently, taxpayers acquire a residential property for
rental purposes by financing the entire purchase price.
Typically, the taxpayer is engaged in unrelated full-time
employment. Too frequently, the amount of yearly interest payable
on the loan greatly exceeds the rental income that might
reasonably have been earned. This is true irrespective of any
unanticipated downturn in the rental market or the occurrence of
other events impacting negatively on the profitability of the
rental venture, e.g., maintenance and non-capital repairs. In
many cases, the interest component is so large that a rental loss
arises even before other permissible rental expenses are factored
into the profit and loss statement. The facts are such that one
does not have to possess the experience of a real estate market
analyst to grasp the reality that a profit cannot be realized
until such time as the interest expense is reduced by paying down
the principal amount of the indebtedness. Bluntly stated,
these are cases where the taxpayer is unable, prima facie,
to satisfy the reasonable expectation doctrine.... (emphasis
added)
[28] For the foregoing reasons I have concluded that the
Minister was justified in assessing as he did. The appeals will
be dismissed with costs.
Signed at Ottawa, Canada this 16th day of March, 1999
"Michael J. Bonner"
J.T.C.C.
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