Paul D. Sipley v. Her Majesty the Queen (Informal Procedure), [1995] 2 CTC 2073

Hamlyn J.T.C.C.:-I indicated yesterday that I would be reserving the judgment. Upon review, I decided that in an oral judgment, I would be able to deal with this matter. However, in any formal reproduction I reserve the right to edit these reasons.

This is in the matter of Paul J. Sipley and The Queen and it is an appeal for the 1989, 1990, and 1991 taxation years. In computing income for the 1989, 1990, and 1991 taxation years, the appellant claimed rental losses from a property located at 30 Tomlinson Circle, Unionville, Ontario, in the amounts of $13,128.34, $13,405.98, and $13,969.20, respectively. In reassessing the appellant for the 1989, 1990, and 1991 taxation years, by concurrent notices of reassessment mailed on November 23, 1992, the Minister of National Revenue (the ’’Minister”) disallowed the deduction of the rental losses.

From the evidence, the appellant reviewed the Minister’s assumptions and agreed or amended them as follows. In 1989, 1990, and 1991, the appellant resided at 30 Tomlinson Circle, Unionville, Ontario, one-third being his principal residence. Secondly, the appellant purchased the property in October 1988 for $320,000 with a first mortgage of $240,000 and thirdly, for the years in question, the appellant rented two-thirds of the property out to other persons. Fourthly, from 1989 to 1991, the appellant reported rental income expenses and losses from the property as follows: in 1989, the income was $9,500 and the expenses after the deduction of a personal amount of 32.9 per cent were $22,628.34, with a loss of $13,128.34; in 1990, the income was $10,000, expenses after deduction of a personal amount of 33.1 per cent were $23,405.98, showing a loss of $13,405.98; and in 1991, the income was $10,500, the expenses netting out after a personal deduction of 33 per cent were $24,469.20, resulting in a loss of $13,969.20. The appellant included 100 per cent of the advertising costs because he believed 100 per cent of the advertising costs related to the rentable portion of the house.

Issues

The issues before the Court are whether the expenses in excess of the amounts allowed by the Minister were incurred by the appellant for the purpose of gaining or producing income from a business or property; whether the appellant had a reasonable expectation of profit from the property in the 1989, 1990, and 1991 taxation years; and, in the alternative, whether the disallowed expenses were reasonable in the circumstances.

Legislation and jurisprudence

In terms of the legislation and jurisprudence, I have reviewed it as follows. A reasonable expectation of profit: a taxpayer’s income for a taxation year from business or property is his profit therefrom for the year. Profit means net profit, that is revenue minus expenses incurred for the purpose of earning income. The expenses sought to be deducted must be reasonable, not artificial, not personal, must be for the purpose of producing income, and must not be prohibited by the statute. A reasonable expectation of profit is an objective test and not just a fanciful dream. The objective test includes an examination of profit and loss experience over past years, also an examination of the operational plan and the background to the implementation of the operational plan including a planned course of action. The test further includes an examination of the time spent in the activity as well as the background of the taxpayer and the education and experience of the taxpayer. The purpose of an expectation of profit determines whether income from a particular source is income from a business. The expectation of profit is central to the concept of business and is distinguished from the pursuit of a hobby. The determination of a reasonable expectation of profit is a finding of fact.

In the case of Baker v. M.N.R., [1987] 2 C.T.C. 2271, 87 D.T.C. 566, Chief Judge Couture of the Tax Court said at page 2274 (D.T.C. 568):

...a reasonable expectation of profit exists where given all the facts pertinent to a venture it could, within a realistic time (the period will vary depending on the nature of the operation), yield a profit barring abnormal circumstances. In other words, is the venture as structured and normally operated capable of generating a profit?

Significant evidence

The taxpayer is a bachelor of commerce graduate in marketing and finance. In 1982, he lived in the Ottawa area and worked for an individual whose business activities included the buying of real properties and renting the same with the purpose of generating income. Shortly thereafter, the appellant bought his first property, rented it, and had a small loss in his first year, but thereafter generated a profit. His other work experience included a short period of time with the federal government, a management training period with McDonald’s Restaurants, and then from 1984 on positions of sales representative, supervisor, and project manager with Imperial Oil. His position at Imperial Oil involves, amongst other things, business income analysis, income projections, and investment projections.

In 1988, the appellant was transferred to Toronto. At that time he decided to look for a property that could be rented out and also serve as his residence. The appellant, it is to be noted, lives alone. He found a property in Unionville, Ontario that he believed was a good rental location. He found that there were few rental facilities in the area and there were proposals for new commercial developments leading to what he believed an enhanced rental market. The property that he purchased had 2,000 square feet, four bedrooms, and two bathrooms.

He presented to the Court his economic expectations for 1988 in the form of a best-case scenario and a worst-case scenario by reviewing the factors of inflation, interest rates, rental rates, and vacancy rates in relation to his investment and he reviewed the actual results under these headings. In his presentation of his evidence to the Court, he prepared several projections. These projections in their final form were of recent vintage. However, the appellant maintained the information presented therein was from the period of time when the decisions were made or thereafter as noted on each chart. These projections are found in Exhibit A-l.

I have reviewed Exhibit A-1 in detail and I found it very useful in coming to a decision in this matter. In essence, these projections show profits would have been achieved from four to six years after 1989. In actual fact, a profit was declared in 1993 and the appellant is confident there will be profits hereafter including 1994.

For the taxation years in question, the taxpayer found that in reality inflation declined, interest rates rose, and the commercial development proceeded very slowly. These factors significantly affected the profitability of his operation. The latter-day profit has been produced by the decline of interest rates and the reduction of principal owing on the mortgage, that is by the increase in capitalization. The appellant operates his rental property in a very organized and business-like way.

Argument

Essentially the Minister’s position is that with the inception of the mortgage on the property and the high interest rates fixed thereto, as well as the amount of the mortgage, this property rental operation could not have had a reasonable expectation of profit. The Minister also questions the degree of expenditures and the reasonableness of the expenditures.

The appellant, on the other hand, states that given effect of the factors, as he had interpreted them, factors of inflation, rental rates, and vacancy rates on his projection analysis, he had a reasonable expectation of profit. Moreover, the taxpayer states that the expenditures were necessary and reasonable for the operation of his rental business and were directed towards the earning of a profit.

Analysis

I find in the evidence that the appellant is a credible witness. He was not a neophyte in a rental property business. He did his forecasts, he developed his business plan, he had both formal training and actual training to prepare him for the rental property business, and indeed had a history of profitable rental property. The losses experienced in the initial years were considered by the appellant in his pursuit of profit and were accounted for in his planning. Economic factors change. Business, as we all know, does not operate in a vacuum and this appellant adjusted to make his operation profitable by taking advantage of subsequent lower interest rates and increasing the capitalization of his operation.

To this end, I adopt the reasons of Kempo J., who in Paikin v. M.N.R.,

[1987] 1 C.T.C. 2041, 87 D.T.C. 6, at page 2047 (D.T.C. 11) said in relation to a mortgage reduction to increase the capitalization that:

Of greater significance or merit, however, is the compelling and highly persuasive reasoning and submission by counsel for the appellant that:

The Court may consider the investment of additional capital in subsequent years where the nature of the business carried on in the years in question is the same as the business carried on after the investment of additional capital and the capital investment is part of a well orchestrated plan for profit making which was followed from the outset.

I find that to be also the case here.

The appellant has not taken into account capital cost allowance, but has done so for a specific reason, so that on the eventual disposition he is not subject to recapture rules and his anticipation that at that time he would be subject to higher tax rates. He also showed the Court that if he had taken into account capital cost allowance he still was on the road to profitability.

I also conclude the expenses as claimed by the appellant in excess of the amount allowed by the Minister were incurred by the appellant for the purpose of gaining or producing income from the rental business. I also conclude that those disallowed expenses were reasonable in the circumstances, and I have concluded that from the evidence I have heard, as well as a close review of Exhibit R-2.

Therefore, I find on all the evidence before the Court that the approach of the appellant, the business involved, and the appellant’s knowledge of the business, that the expectation of profit was reasonable and would occur in a reasonable time. Lastly, as a finding of fact I conclude that the appellant occupied one- third of the property as his principal residence.

Decision

The appeal is allowed and the assessment is referred back to the Minister of National Revenue for reconsideration and reassessment on the basis that the appellant did have a reasonable expectation of profit from renting the property in the 1989, 1990, and 1991 taxation years. The disallowed expenses were incurred for the purpose of gaining or producing income from the rental business and the disallowed expenses were not unreasonable. Lastly, the appellant occupied one-third of the property as his principal personal residence.

Appeal allowed.