Magnowski v. The Queen, docket 98-828-IT-G

Date: 20000531

Dockets: 98-828-IT-G; 98-960-IT-I

BETWEEN:

TED MAGNOWSKI and RENEE MAGNOWSKI,

Appellants,

and

HER MAJESTY THE QUEEN,

Respondent.

Reasons for Judgment

Margeson, J.T.C.C.

[1] It was agreed at the outset that these two matters would be heard on common evidence and that the evidence given in one would be considered in the other, where applicable.

[2] By Notices of Reassessment dated September 23, 1996, the Minister reassessed the Appellants for the 1993, 1994 and 1995 taxation years and disallowed the deduction of certain business expenses claimed in those years, relating to direct costs associated with the construction of a house.

[3] By further Notices of Reassessment dated January 20, 1998, the Minister reassessed the Appellants for the 1993 and 1994 taxation years and allowed the deduction of certain business expenses claimed in those years, relating to indirect costs, primarily for office, vehicle and entertainment.

[4] The Appellants filed an appeal against the disallowance by the Minister in the years 1993 and 1994 of certain business expenses claimed in those years, relating to direct costs associated with the construction of a house located at 14286 29A Avenue, Surrey, B.C. which was built during the 1993 and 1994 taxation years and remained unsold as of 1995.

Evidence

[5] Mr. Stanley Nisbet was an accountant. He identified Exhibit A-1, introduced into evidence by consent, which was a letter forwarded to the Appellant Ted Magnowski by John Morecraft, of the Verification and Compliance Division of Revenue Canada, Customs, Excise and Taxation. In essence, this letter indicated to the Appellants on February 22, 1996 that they were going to proceed with an audit for the 1993 and 1994 taxation years and indicated what documentation he would have to review to support the business activities of the Appellants for the years in question.

[6] This witness further identified Exhibit A-2, also admitted by consent, which was in essence a copy of the auditor’s findings for the 1992, 1993 and 1994 taxation years. This document was dated April 9, 1996.

[7] The witness went through it and indicated that documentation was missing from it and that there were other items listed in it which were incorrect. He was told that the year 1992 was included because some of the receipts for 1993 were actually for 1992 and this witness had no problem with that. The witness said that Mr. Morecraft told him that the amount of the commission on the sale of 17085 102^nd Avenue, Surrey, B.C. was in there somewhere. He was told that the expenses for “the second home” could not be used because this home was inventory. He was told that this was not because it was in the Income Tax Act (the "Act") but it was on the basis of Generally Accepted Accounting Principles, (hereinafter referred to as “GAAP”). It was a grey area.

[8] The witness said that there were expenses with which he and Mr. Morecraft disagreed. With respect to the claim for the permit from the District of Surrey for $171.00 Mr. Morecraft had listed it under supplies. However, it was a building permit. Exhibit A-3 was a receipt from Revenue Canada to T. Magnowski and it was signed by Mr. Morecraft. This was accepted into evidence subject to proof by Mr. Magnowski.

[9] Exhibit A-4 was accepted, subject to the same restrictions. It was a receipt to Ted Magnowski from Mr. Morecraft for bank statements for the years 1994 and 1993. It also contained a list of the tool inventory as of June 1992.

[10] Exhibit A-5 was admitted, subject to proof by Ted Magnowski. This was a letter from Revenue Canada addressed to Ted Magnowski and dated July 24, 1996. This contained certain changes with respect to proposed adjustments.

[11] Exhibit A-6, a Notice of Reassessment dated September 23, 1996, was also entered by consent.

[12] The witness said that he discussed the Notice of Reassessment, Exhibit A-6, with Revenue Canada. He telephoned the Tax Centre in Surrey. Later on he received a telephone call from Mr. Morecraft saying that there was nothing more to be sent. He gave no other reasons except that the house was inventory. He reiterated that it was a grey area and related to GAAP and that it was not in the Income Tax Act.

[13] Exhibit A-7 was a statement of adjustments which was admitted by consent. It related to the property at 17085 – 102^nd Avenue, Surrey, B.C. and showed a balance due to the vendor upon completion of $357,360.00. He said that the real estate commission was not allowed initially.

[14] The bank statements were admitted as Exhibit A-8 subject to proof. These statements showed some amounts which were initially disallowed. One of the items for interest was disallowed and then allowed by the appeals officer.

[15] Exhibit A-9 was a series of cheques drawn on the Canadian Imperial Bank of Commerce from the Appellants’ account. This was admitted subject to proof. Some of the cheques were missing.

[16] Exhibit A-10 was admitted subject to proof and weight. This contained receipts made out to Allstar Custom Homes.

[17] Exhibit A-11 was a copy of a T1 Adjustment Request Form by Ted Magnowski for the year 1993. In it Mr. Magnowski indicated that the property was no longer inventory and an adjustment could be made either three years back or seven years forward. He said that they received nothing else in writing but this was accepted orally. That was the main stumbling block. If not for that, the matter might have been concluded. Then they were told that they could only take it back and not forward. They were advised recently that it was going forward.

[18] Exhibit A-12 was admitted subject to the same restrictions. This was a letter from the Canadian Imperial Bank of Commerce to Mr. Magnowski and his wife regarding a Demand Construction Loan. The administration fee was $50.00 and the processing fee was $650.00, these were allowed. The interest on the Demand Construction Loan was not allowed but Revenue Canada should have known that it was interest.

[19] Exhibit A-13 was prepared by this witness. It was an interim expense statement from January 1, 1993 to December 31, 1993 and a profit and loss statement. This witness said that the bank charges and interest were clearly stated on it as well as the insurance. The auditor should have seen it. The auditor never asked him about them.

[20] Exhibit A-14 was a statement of revenue and expense for the period January 1, 1994 to December 31, 1994. It was prepared by this witness. All expenses for that year were included. This was not questioned. Sometimes the auditor was very responsive and sometimes he was not. He would not budge on the inventory/expense items.

[21] He was uncooperative with respect to the differences in opinion regarding the expenses. He would not allow a claim for capital cost allowance or the tools item but he said that they probably would be allowed on appeal.

[22] With respect to vehicle expenses, there were also problems. The auditor said that he would give 75% across the board. The Appellants wanted 100% for Mr. Ted Magnowski’s car and a smaller percentage for his wife’s car. The auditor would not allow capital cost allowance for the wife’s car but he did allow the expenses. The auditor directed them to go to appeals where they would probably get more. Mr. Ing was the appeals officer.

[23] At the appeal’s level some expenses were allowed. They went through the audit with Mr. Ing. He allowed a considerable amount of expenses which were earlier disallowed as inventory.

[24] The witness’ position was that the materials were inventory but not the wages. The Appellants maintained the position that the money paid for wages was already taxed in the workers hands and the Appellants should be allowed to deduct it.

[25] There was an argument with respect to PST, property tax and transfer tax. The appeals officer said that the Appellants could file a T1 Adjustment Request Form which they did but they received no response to it.

[26] In cross-examination the witness said that Accura Financial Management was operated by him. He provided accounting services. He did not have a degree in accounting. He had a bachelor of commerce but no accounting degree. He had no accounting designation. He confirmed that the year 1992 was not under appeal. He confirmed that the commission amount of $12,519.00 was missed at first but then recognized. With respect to the item for $171.00 to the District of Surrey he said that it was something like a building permit, he was not sure. The property at 14286 29A Avenue, Surrey, B.C. was sold in 1997. The amount of $171.00 might relate to the second house.

[27] He confirmed that the interest and bank charges set out in Exhibit A-8 were allowed on the appeal subject to the property being sold. He had two meetings with the field officer and four meetings with the auditor. One of the meetings was at Revenue Canada and three were at his office. They discussed the same things on the telephone but they received no working papers from Revenue Canada.

[28] They paid approximately $30,000.00 of expenses to Mike McManamna. He confirmed that the amounts of $15,096.00 and $542.00 to Mike McManamna, a subcontractor, were not missed items but were listed under subcontract items. The amount of $5,000.00 for November 12, 1993 listed at page 5 was accounted for. Further, the amount of $3,900.00 paid to Anchor on November 12, 1993, was under the subcontracting column. These amounts together with a further $7,314.00 were amounts that the appeals officer was prepared to allow and these added up to more than the Appellant was claiming that the Minister missed.

[29] Exhibits A-13 and A-14 were introduced by consent being the profit and loss statements for 1993 and 1994. Exhibit A-13 set out the current assets as of December 31, 1993 as $27,972.11. The inventory was listed at 0. He admitted that the house was not listed as inventory. It was suggested that it should have been listed as work in progress and he said that it could have been. He referred to Exhibit A-14 for the year 1994 which showed administration expenses of $166,293.97 and a total revenue of $16.87. He admitted that the home did not appear as an asset anywhere in the financial statement.

[30] With respect to capital cost allowance and tools he said that they were told later that there were no receipts so that they should estimate the value of these owned prior to the commencement of business.

[31] It was suggested to him that the wages item was a subcontract item. He said that he did not know that the amount was for wages and not subcontracts.

[32] It was suggested to him that prior to filing the T1 Adjustment Request Form they were told that income and expenses had to be claimed in the year of sale and then taken back or forward if there was a loss. He did not respond.

[33] Ted Magnowski testified that they were told that all of the items in dispute were inventory for the years 1993 and 1994. He addressed the disallowed items as set out in Exhibit A-2 for the year 1993 and indicated what they were for. He did likewise with respect to the year 1994. He said that the figure of $144,892.85 included PST and this should be deducted. His position was that all of the expenses he referred to should be allowed in the years in question and in addition he should be able to claim the labour costs paid to Mr. McManamna. These items were not allowed as expenses by the auditor. They should have been. They were not inventory costs. The interest charges on the demand loan for 1993 of $2,300.00 and for 1994 of $11,263.00 were called additional inventory and they should have been business expenses.

[34] In cross-examination, he said that he had operated Allstar Custom Homes since 1992 and that it was on a 50-50 basis with his wife. The office for their business was in their home. The auditor had all of his ledgers and other documents including bank statements, contracts, cancelled cheques, receipts and invoices. These were returned to his accountant. The items that he had referred to in his direct examination were in dispute as well as the subcontract amounts. Further, the interest amounts for 1993 and 1994 should be expenses in those years. The hydro was used to service the site. The auditor had the insurance policies. Some of the insurance was for tools left on the property and some was for liability insurance.

[35] Counsel for the Respondent called Barry Fong who was a designated appeals officer. Exhibit R-1 was admitted by consent as a book of documents of the Respondent. This witness had been with Revenue Canada for 15 years and he was familiar with this file. He received the material and the documents. Tab 1 contained the T1 General for 1993 which was reconstructed. This was originally filed by e-mail. Tab 2 contained a T1 General for 1994 and Tab 3 was a Notice of Reassessment for 1993. This was the same as the original. Tab 4 was a reconstructed Notice of Reassessment for 1994. Tab 5 was a reconstructed Notice of Reassessment for 1993. Tab 6 was a reconstructed Notice of Reassessment for 1994. Tab 7 was a Notice of Objection for 1993 and 1994. Tab 8 was a letter to the Appellant from Mr. Morecraft, the auditor, requesting the normal documentation. Tab 11 was a standard questionnaire. Tab 14 was an agreement of Purchase and Sale for the second house. This tab also contained the revenue-expense statements for the Appellants, the profit and loss statements and showed total revenue for the year 1993 of $348,075.77.

[36] The documents did compare with the tax returns which claimed one half of the income but they did not compare with the loss claimed on the return. The balance sheet does not include any inventory whereas the Appellants had two houses and the remaining one should have been on the inventory list. The income statement for 1994 claiming one half of the amount of the loss does not compare with the Appellants’ tax return. There was a considerable discrepancy.

[37] The witness said that Mr. Morecraft adjusted for current expenses and inventory costs. He adjusted for those relating to the building of the house (inventory) and those related to general expenses. Tab 13 contained the working papers. No personal items were included.

[38] With respect to the year 1994 he said that the amount of $140,046.03 was added to previously allowed expenses and these are to be claimed at the time the property is sold. Tab 12 showed a Schedule of Adjustments for the first and second proposals.

[39] Tab 15 is a T1 Adjustment Request Form for 1993 and 1994. These relate back to the original filings. The second Adjustment Request Form was put on hold until after the appeal.

[40] The Appellants were given the summary of what the auditor allowed and disallowed. These were the working papers. They were a complete summary of all expenses dealt with. The Appellants submitted a green highlighted summary but had no accompanying documents to suggest why the expenses claimed were current and not inventory. There was never any concession by the taxpayers that they were only going to contest the highlighted items.

[41] In cross-examination he said that he had never seen a request for further explanation. He was never asked for a specific reference to the Act. The appeals officer had three meetings with the taxpayers’ agent.

[42] At the end of the evidence the Appellants indicated that they were contesting only the items questioned in their testimony.

[43] Both parties agreed that they would submit written arguments.

Argument on behalf of the Appellants

[44] The Appellants initially submitted separate identical written arguments. In the initial argument, the Appellants pointed out that they believed that Revenue Canada had been erroneous and inconsistent in their assessment and had omitted key items in their audit dated April 9, 1996. The Appellants also believed that because they had not received what they considered to be satisfactory verbal communication from the Respondent that they were forced to go to Court to have this matter mediated.

[45] The Appellants took the position that they were asking for nothing more than what Revenue Canada referred to as “reasonable expenses incurred to earn business income,” as described in their “Business and Professional Income” tax guide.

[46] With respect to the disputed items, the Appellants took the position that they were operating costs of running a business and were not inventory and supplies. They should be deducted in the year that they are incurred and not claimed as part of the inventory when the property is sold. It was their position that the items questioned at the time of the trial and as shown in Exhibit A-2 should have been allowed as expenses and should not have been allocated to inventory to be claimed at the time the property is sold.

[47] As indicated in the written argument on behalf of the Appellants they were seeking: (a) defined business expenses, (b) the business expenses to be deducted in the year they were incurred, and (c) the “carry back to previous years” that was suggested in the appeal by Revenue Canada as per the “Business and Professional Income” tax guide.

[48] In a further written argument on behalf of the Appellants, following the filing of the written argument by the Respondent, the Appellants concluded that they had complied, substantiated and provided all records, receipts and documents necessary to show their position. Further, they said that after the decision is made they would like to adjust all tax years since the audit and bring them up-to-date.

[49] In essence, they asked that the appeals be allowed, with costs.

[50] The Appellants presented a final rebuttal in writing, dated May 5, 2000 as follows:

Your Honour,

In February 1999, when we first appeared in your court to determine a trial date, it was on your suggestion that the Respondent and I get together and try to work out our discrepancies. After waiting almost 6 months, I contacted Ms. Truscott and in early September, we discussed the issues. The Respondent was well aware that the entire audit was not in dispute, just some key expenses. When it was obvious to me that there was not going to be a fair assessment of the issues, I felt I had no choice but to proceed to the next step.

The Respondent states I did not maintain proper books and records or accounting documents to support my position, yet in ‘The Respondents Book of Documents’ are the audits by Revenue Canada, that state the amounts used were taken directly from invoices provided by me, as entered monthly by my accountant, Mr. Stan Nisbet.

The Respondent cites Qualico Developments Ltd. v. The Queen (No.1)-84 DTC 6119 (FCA) where as a developer is deducting landscaping costs. Although I am not a limited company developer, nor am I claiming for landscaping costs, I fail to see what this case has to do with deducting legal fees, or bank interest, or waste management costs. I, in turn, would cite M.Attale v. The Minister of National Revenue 85 DTC, that states...

“that the mortgage interest paid by the taxpayer on borrowed money used for the purpose of earning income and therefore deductible.” Same should be said for interest payment on a demand builder’s loan. Another example, Santel Communications Groups Inc. v. M.N.R. 93 DTC Court File No. 90-3167(IT) The Appellant...“submitted proper supporting documentation concerning the expenses pertaining to professional services and travel and such documentation was not disputed by the Minister. These expenses, along with the interest expense in issue, were therefore deductible by the taxpayer for the taxation years in issue.” In the accordion folder given to the auditor was the proper documentation stating the interest paid on the financing from a builder’s loan from CIBC.

The expenses in dispute are just expenses necessary to operate a business. They are listed in the “Statement of Professional Activities” form #T2032E, as well as in the “Statement of Business Activities” form #T2124E as deductible expenses. These forms and the guidelines are handed out by Revenue Canada for small businesses. As per their own guidelines, you can deduct for legal fees related to financing, insurance fees, application and processing fees, telephone and utilities expenses, property taxes expenses, professional, legal and accounting fees, equipment rentals, wages paid to casual labour, etc.

The Respondent states, “...that the major issue in these appeals is mainly a question of timing.” I feel it is more an issue of interpretation. The Respondent states that the wording of subsection 18(3.1) is very broad...” this language is sufficiently broad to include interest costs on money borrowed to acquire an develop land.” Where the Respondent sees inventory costs and the “undefinable” (as per the Tax Act) ‘soft costs’, I see interest costs, property taxes, legal fees, all expenses deductible as per Revenue Canada’s Business and Professional Income guide.

I, Sir, consider myself an honest taxpayer, willing to work hard to get ahead. I am also a man of principles and feel that when those principles are challenged or compromised, I must stand up for them. This has been a long, costly and frustrating process. I believe that I have successfully substantiated my appeal, and therefore costs should be awarded to the Appellant. I appreciate your time and await your decision.

Sincerely,

Ted Magnowski

May 5, 2000

[51] The Appellants also included a copy of Form T2124 E (99), a copy of Form T2032 E (99) and a copy of the Declaration of Taxpayer Rights provided by Revenue Canada.

Argument on behalf of the Respondent

[52] In written argument counsel for the Respondent said that the years under appeal are 1993, 1994 and 1995. Any expenses relating to the year 1992 are not under appeal before the Court.

[53] Assumptions of fact - The Appellants, through Allstar Custom Homes, built a house on a property located at 14286 29A Avenue, Surrey, B.C. which as of late 1995 remained unsold. This house was built in 1993 and 1994 and the Appellants claimed current expenses of $382,451.07 in 1993 and $140,046.03 in 1994 but these were actually capital expenses. The house was held in inventory by Allstar Custom Homes and therefore the costs associated with its construction could be claimed only when the property was sold.

[54] Counsel further argued that the Appellants did not maintain proper books and records, including general ledgers, and that no working papers or other supporting accounting documents were provided to the Minister or to the Court. There was also a variance between the costs supported by invoices, those recorded on the financial statements of Allstar Custom Homes and amounts reported on the T1 income tax returns filed by the Appellants for the taxation years in question.

[55] Onus of Proof - Counsel submitted that the onus of proof was on the Appellants on a balance of probabilities. The auditor had invoices and receipts available during his review and drafted his working papers based on those materials. The Appellants relied on these working papers at trial. The Appellants have not met their onus to rebut the assumptions of fact relied upon by the Minister and set out in the Reply to Notice of Appeal; these assumptions were relied upon in making the assessments. These assumptions are presumed to be true.

[56] Evidence at trial - At trial the evidence consisted primarily of the oral testimony of Ted Magnowski and his accountant, Stan Nisbet. Renee Magnowski did not testify. It was agreed by the parties that the evidence would also apply to her appeal. No books and records were tendered as exhibits for the Appellants nor were any invoices or receipts produced by the Appellants.

[57] Class of expenses - The vast majority of the expenses in dispute for these appeals fall into the following classes, according to counsel for the Respondent: business licences, building permits, provincial sales tax, municipal property taxes, property transfer tax, property insurance, liability insurance, tool insurance, bank interest on “business demand loan”, legal fees for property transfer, engineering consulting fees, subcontract (“wages”), casual labour, utilities (hydro) for heat, light, telephone, equipment rentals, tool rentals, container rental, office supplies (stationary), building plans (home), code books and amendments, landfill (garbage/recycling), waste management (portable toilets), miscellaneous services (carpet; courier delivery).

[58] Counsel took the position that all of the expenses can be categorized in general terms as either direct costs of construction or indirect costs of construction.

[59] Direct Costs – GAAP – “inventory” - Counsel took the position that whether a particular cost incurred by a developer may be deducted as a current expense or must be added to the cost of inventory, must be decided by reference to generally accepted accounting principles unless there is a specific provision to the contrary in the Act.

[60] Development and servicing costs are generally added to the cost of the land inventory. This would normally be the result for tax purposes as well. Such costs are properly included in the cost of land for inventory purposes because this accords with both generally accepted accounting principles and commercial reporting practices, and is designed to achieve a reasonable and proper matching of costs with revenue.

[61] The Respondent maintained that the taxpayer must defer to future periods, the deduction of all costs that can be related to those periods, in accordance with generally accepted accounting principles. The decision in The Queen v. Metropolitan Properties Co. Limited, 85 DTC 5128 (F.C.T.D.) supports this position.

[62] In that case, the taxpayer agreed to install municipal services and improvements at no direct cost to the municipality. The taxpayer was required to add these expenses to the cost of land inventory for accounting purposes, while for tax purposes the taxpayer deducted the costs as current expenses. However, in that case the Court held that certain costs incurred by a developer in respect of the provision of municipal services and improvements on subdivision land to be dedicated to a municipality were required to be added to the costs of the developer’s remaining inventory. This decision requires conformity between generally accepted accounting principles and reporting for tax purposes, in the absence of a specific provision in the Act that justifies a departure from GAAP.

[63] The question in any given case is whether a particular development charge is specifically related to developing land inventory or could reasonably be regarded as an administrative or overhead cost, incurred as a running expense of the taxpayer’s business as a whole.

[64] Certain costs associated with the development of real estate may be deductible as current expenses under the general provisions in the Act. Overhead, administrative and operating costs could generally be deductible, pursuant to subsection 9(1) of the Act as expenses in the year incurred, provided that they meet the tests for deductibility under paragraphs 18(1)(a) and 18(1)(b). In other words, outlays or expenses, other than payments on account of capital, made or incurred for the purpose of gaining or producing income from a business or property are generally deductible as current expenses.

[65] However, it is appropriate to add these costs to inventory if the property being developed constitutes inventory to the developer and if the expenditures can reasonably be identified with individual lots, condominium units or specific subdivisions or development projects.

[66] Counsel submitted that in the present case the building of the house was the only business activity carried out by the partnership at the time in question, and that all the expenses claimed by the Appellants can reasonably be attributed to its construction. This would include payments made to subcontractors for materials or labour.

[67] Notwithstanding the general limitations on deductibility of expenses which are contained in paragraphs 18(1)(a) and 18(1)(b) of the Act, a developer may be able to deduct certain expenses specifically allowed by subsection 20(1). The entitlement to deduct such expenses under subsection 20(1) presupposes that the taxpayer holds the real estate for the purpose of gaining or producing income therefrom or from a business.

[68] In the land development context, paragraphs 20(1)(aa), (cc), and (dd) are examples of specific provisions in the Act which may sometimes authorize a departure from generally accepted accounting principles in computing a developer’s income for tax purposes. However, many of the deductions specifically allowed by subsection 20(1) are not available to a land developer if the costs were incurred on income account and relate to the development of the developer’s land inventory.

[69] In Qualico Developments Ltd. v. The Queen (No. 1), 84 DTC 6119 (F.C.A.), a real estate developer was not permitted to claim a deduction under paragraph 20(1)(aa) of the Act in respect of the costs of landscaping grounds around houses which constituted inventory to the developer. The Court held that the opening words of subsection 20(1) do not override section 10 relating to inventories. Therefore, the developer must include landscaping costs in the cost of inventory pursuant to section 10 and is not entitled to a deduction until the year in which the inventory is sold rather than taking the deduction in the year in which the costs were paid.

[70] Indirect costs – “Soft Costs” – capital outlays. Subsection 18(3.1) of the Act prohibits the deduction of so-called “soft costs” that may reasonably be regarded as costs incurred during the period of the construction, renovation or alteration of the building and that relate indirectly to the building or to the ownership of land. For this purpose, land includes the land on which the building is situated and any adjoining land necessary for the use or intended use of the building as a parking area, driveway, yard, garden, or any other similar use.

[71] The “soft cost” restriction is intended to prevent taxpayers from using construction costs to create a loss which would shelter income from other sources. The rules also appear to assume that “soft costs” represent a disguised portion of the cost of land and buildings.

[72] The Act does not define the term “soft costs”. This is a generic term that has been used to describe the various outlays incurred in connection with the construction of a building or the ownership of land during the construction period but they are not directly related to the acquisition of the land or to the construction of the building.

[73] There are a variety of construction period “soft costs” that are subject to the limitation in subsection 18(3.1) of the Act. An example of “soft costs” include the following: interest costs, landscaping costs, expenses of representation, site investigation costs, utility service connection costs, municipal fees (e.g. lot levies), legal and accounting fees, architectural and engineering fees, insurance charges, guarantee, standby and mortgage commitment fees, structure inspection fees, building permit costs, cost of plans and drawings, property taxes, sewer, water and hydro charges and clean-up costs.

[74] In certain circumstances, the “soft costs” described above may constitute capital outlays and are, therefore, non-deductible in any event. Paragraph 18(1)(b) of the Act would then operate to prohibit a current deduction in respect of capital outlays and there would be no need to resort to subsection 18(3.1).

[75] Subsection 18(2) of the Act deals with situations where interest is paid on a debt relating to the acquisition of land, when the land is not used in the business, but is held for resale or development. Where the restriction in subsection 18(2) applies, the carrying charges and property taxes on vacant land which are disallowed by that provision are required to be added to the cost of the developer’s land inventory under subsection 10(1.1).

[76] In considering the restrictions on “soft costs” and their mandatory capitalization, it is important to understand the parameters of the “construction period” referred to in the legislative provisions.

[77] The Act does not specify when the construction period begins. It may be inferred from subsection 18(3.5) to (3.7) that the period commences upon the installation of the footings or other base support. The Minister considers the site development to begin with the installation of services, roadways, and so on. Where serviced lots are acquired, site development is considered to begin at the earliest date the taxpayer starts to install further services to the lots or the day it starts to pour footings. [ref. Interpretation Bulletin IT-153R2].

[78] According to subsection 18(3.3) of the Act, the period of construction ends at the earlier of when actual construction, renovation or alteration is completed and the day when all, or substantially all of the building is used for the purposes for which it was constructed, renovated or altered. The Minister interprets the phrase “all or substantially all” to mean at least 90% completion.

[79] Subsection 18(3.1) of the Act expressly prohibits the deduction (during the construction period) of many "soft costs" that would otherwise be deductible in computing income for the purposes of the Act by virtue of subsection 20(1). For example, representation expenses, site investigation expenses and utility connection expenses cannot be deducted during the construction period even though paragraphs 20(1)(cc), 20(1)(dd) and 20(1)(ee) would otherwise permit the deduction of those items. If possible, such costs should be incurred by the taxpayer before the commencement of construction or after its completion in order to avoid the capitalization rule in subsection 18(3.1).

[80] Expenses that are caught by paragraph 18(3.1)(a) and that are directly incurred by the taxpayer in performing the construction, renovation or alteration must be included in computing the cost or capital cost of the building. Essentially, this postpones the deductibility of construction period costs to the post-construction period. This mandatory capitalization rule applies regardless of whether the building constitutes capital property or inventory to the taxpayer.

[81] Interest is a significant “soft cost” in borrowing money. The wording of subsection 18(3.1) of the Act is very broad and restricts the deductibility of outlays or expenses that may reasonably be regarded as a cost relating to the construction, renovation or alteration of the building or relating to the ownership of the land. This language is sufficiently broad to include interest costs on money borrowed to acquire and develop the land.

[82] Paragraph 18(3.2)(a) expands the scope of subsection 18(3.1) to include certain interest costs which might not otherwise be specifically identified with the construction, renovation or alteration of a particular building or the ownership of land during the construction period. By reason of paragraph 18(3.2)(a), interest paid or payable by a taxpayer on borrowed money that can reasonably be considered to have been used by the taxpayer in respect of the construction, renovation or alteration of the building or the ownership of the land is also potentially subject to mandatory capitalization under subsection 18(3.1).

[83] Counsel submitted that paragraph 18(3.2)(a) would also apply where a taxpayer uses available cash to fund the construction of a building and borrows money to finance its general business operations.

[84] Conclusion – In conclusion, counsel submitted that the subcontract payments of $31,000.00 and $7,314.00 were paid to Mike McManamna/Anchor Contracting. These were not “wages” as contended by the Appellants, as they have admitted that the workers were not their employees. The usual rules concerning GAAP and inventory will apply. Only the recipient of the subcontract payments can deduct them as current expenses, if it then pays wages to its employees from such payments.

[85] Interest on borrowed money – The amounts of $11,263.00 and $2,300.00 were claimed by the Appellants. The terms of the alleged “business demand loan” were not established by the Appellants as no documents were provided to demonstrate the purpose of the loan. The Minister has assumed that these amounts were capital and this was not seriously challenged by the Appellants’ evidence at trial.

[86] The major issue in these appeals is mainly a question of timing. Any of the expenses claimed which are not personal in nature are properly deductible. The question is: how and when may they be deducted? Current expenses have already been allowed by the Minister for the 1993 and 1994 taxation years for items such as vehicle, office, travel, etc. Capital cost allowance has also been allowed for depreciation on tools, auto, etc.

[87] Costs relating directly to the construction of the house are recognized by the Minister as legitimate expenses, but nevertheless form part of the inventory costs under section 10 and are used to calculate the cost base in the year of disposition, that being the 1997 taxation year. Costs relating indirectly to the construction of the house are “soft costs” subject to mandatory capitalization during the construction period. The result is to recognize income and expenses upon disposition of the property and then to carry forward or carry back any remaining loss which may be available, under section 111 of the Act.

[88] Costs – it was submitted that the Appellants cannot be substantially successful in these appeals and therefore costs should be awarded to the Respondent.

[89] Counsel requested that the appeals be dismissed, with costs to the Respondent.

Analysis and Decision

[90] The Court agrees with the submission of counsel for the Respondent, which is not seriously contested by the Appellants, that the main issue in this case is not whether the expenditures made by the Appellants may be deducted but it is a question of when the expenses may be deducted. As counsel for the Respondent pointed out in the written argument, since the original assessment in this matter, the Minister has allowed some of the expenditures as current expenses for the 1993 and 1994 taxation years for items such as vehicle, office, travel, etc. Further, capital cost allowance has already been allowed for depreciation on tools, auto, etc.

[91] There are a number of major items at issue which the Court has no problem in concluding were not current expenses of the Appellants. The amounts of $31,000.00 and $7,314.00 which were paid to Mike McManamna/Anchor Contracting, were not wages of the Appellants and the evidence given in Court established beyond any doubt that the workers were not their employees. The wages that were incurred were the wages of the subcontractors and if they are to be deducted as current expenses they must be deducted by their employer. Therefore, the appeals with respect to these items are dismissed and the Minister’s assessments are confirmed.

[92] The Appellants claimed bank charges/interest in the year 1993 in the amount of $2,299.88 and the amount of $11,263.13 in the year 1994.

[93] The Court has to agree with the argument of counsel for the Respondent that very little evidence was produced by the Appellants with respect to these items. Mr. Nisbet merely indicated that the interest claimed was not allowed on the demand loan and that the auditor should have known that it was interest. Further, he said that the bank charges and interest were clearly stated and that the auditor should have seen it. He said that the auditor never asked him about it but again he gave no further evidence about these items.

[94] In cross-examination he said that the interest and bank charges as shown in Exhibit A-8 were allowed, subject to the property being sold.

[95] In the evidence of the Appellant Ted Magnowski, these items were not discussed in his direct testimony and in his cross-examination he merely said that these amounts should be claimed as expenses.

[96] It is the duty of the Appellants to establish on a balance of probabilities the nature of the expense being claimed and where questioned, to give sufficient evidence to the Court to demonstrate the purpose of the loan. No documentation was produced before the Court that even touched upon these amounts. Consequently the presumption of the Minister that these were capital in nature has not been satisfactorily rebutted.

[97] With respect to the other disputed items, they were addressed in the evidence of Ted Magnowski and to a lesser extent by some of the evidence of Mr. Nisbet. The explanation by the Appellant Ted Magnowski as to what these items represented was helpful to the Court and perhaps offered a bit more illumination to the Court than that which might have been presented before the auditor and the appeals officer.

[98] In essence, all of these items relate specifically to the development of the land in question and the building of the residence upon it. There was no evidence which convinced the Court that these items “could reasonably be regarded as administrative or overhead costs,” incurred as a running expense of the taxpayer’s business as a whole, as referred to by counsel for the Respondent in her written argument. Further, the Respondent submitted “that in the present case the building of the house was the only business activity carried out by the partnership at the time in question, and that all of the expenses claimed by the Appellants can reasonably be attributed to the construction”. This would include payments made to the subcontractors for materials or labour.

[99] This argument is well taken and there was no evidence given in Court which would have the effect of seriously countering this proposition.

[100] The case of Metropolitan Properties Co. Limited, supra, is applicable to the facts in the case at bar. In that case the taxpayer was in the business of land development and had agreed with the municipality to install municipal services at no direct cost to the city. The Court considered that the payment to be, in effect, a prepayment of city taxes. The taxpayer reported the payment for financial statement purposes, as development costs or as an addition to the cost of its land inventory. This was in accordance with GAAP. However, in preparing its income tax returns, the taxpayer deducted development costs as current expenses of his business. The Minister disallowed the deduction of the costs as current expenses and added them to the cost of land inventory.

[101] These are not the specific costs involved in the case at bar but the decision of the Federal Court in that regard is applicable. The Court found that GAAP should normally be applied for taxation purposes. It is only where it is justified or required by the legislation or if contrary to commonly accepted business or commercial practices that GAAP need not be followed.

[102] In the case at bar counsel for the Respondent argued that GAAP should be followed and there is no evidence to suggest otherwise. Further, no attempt was made to show that there were any specific provisions of the Act which would justify a different treatment, nor was there any evidence given to suggest that such treatment would be contrary to commonly accepted business or commercial practices and that the GAAP should not be followed.

[103] There were no serious arguments that for accounting purposes, the costs should not be added to the cost of land inventory and yet for tax purposes the taxpayer should deduct the costs as current expenses.

[104] It was not seriously contended by the Appellants that the property being developed was not inventory to the developer or that the expenditures could not be reasonably identified with the individual lot which was being developed. The Appellants did not direct their attention to any particular section of the Act which would be of assistance to them. However, counsel for the Respondent has dealt with this substantially in her written memorandum and has considered the appropriate provisions including paragraphs 18(1)(a) and 18(1)(b).

[105] The Court concludes that the outlays or expenses in issue in this case were not incurred for the purpose of gaining or producing income from a business or property which would allow them to be deductible as current expenses.

[106] Counsel for the Respondent, when referring to the provisions of subsection 20(1) pointed out, “that subsection presupposes that the taxpayer holds the real estate for the purpose of gaining or producing income therefrom or from a business.” There is no evidence in the present case which would allow the Court to conclude that the real estate was held for such a purpose. Likewise, the exempting provisions in paragraphs 20(1)(a), (cc) and (dd) do not offer any relief to the Appellants on the facts in the case at bar.

[107] As indicated, the Court has concluded that the property in question should have been included in inventory of the Appellants during the years in question and consequently the landscaping costs can only be deducted when the property is sold. Qualico Developments Limited, supra, is applicable. In that case the Court held that the landscaping costs were not deductible under subsection 20(1)(aa) claimed by the taxpayer because this provision could not purport to override the provisions of section 10 relating to inventories.

[108] Counsel for the Respondent also referred to the provisions of subsection 18(3.1) of the Act in arguing that the type of deduction sought in the case at bar as “soft costs” are intended to be prohibited by these provisions.

[109] Further, subsection 18(3.1) of the Act says:

Notwithstanding any other provision of this Act, in computing a taxpayer’s income for a taxation year,

(a) no deduction shall be made in respect of any outlay or expense made or incurred by the taxpayer (other than an amount deductible by reason of paragraph 20(1)(a), (aa) or (qq) or subsection 20(29) that may reasonably be regarded as a cost attributable to the period of the construction, renovation or alteration of a building by or on behalf of the taxpayer...

Certainly many of the costs sought to be deducted as current expenses fall under that category.

[110] Again, as counsel pointed out in her written memorandum, under certain circumstances the "soft costs" referred to above may be considered to be capital outlays and would not be deductible in any event. Paragraph 18(1)(b) would prohibit such deductions even without resorting to subsection 18(3.1).

[111] The Court is satisfied that subsection 18(2) is applicable in the case at bar because it is satisfied that the land in question was held for resale or development. Therefore, the carrying charges and property taxes must be added to the cost of inventory under subsection 10(1.1).

[112] With respect to all of these items which can be considered to be “soft costs”, the Court is satisfied that these were incurred during the “construction period”. The Court is satisfied that the provisions of paragraph 18(2)(a) is sufficiently broad to include the interest costs which are claimed in the case at bar, particularly where there was no more specific evidence produced by the Appellants to suggest otherwise.

[113] In the end result, the Court is satisfied that the Appellants have failed to meet the burden of proof of establishing that the Minister’s assessments were incorrect. The Court is satisfied that all of the disallowed expenses incurred by the Appellants during the years in question were the type of expenses which should be added to the cost of inventory and deducted when the property is sold, providing that they are not personal in nature or are prohibited from being claimed by some other provision.

[114] The appeals are dismissed and the assessments are confirmed.

[115] The Respondent will have its costs, to be taxed, in regard to Ted Magnowski, file number 98-828(IT)G.

Signed at Ottawa, Canada, this 1^st day of June 2000

"T.E. Margeson"

J.T.C.C.