William Everett Code v. Her Majesty the Queen, [1995] 1 CTC 2456, 95 DTC 812

Beaubier J.T.C.C.:—This matter was heard pursuant to the rules of general procedure at Calgary, Alberta on September 20, 1994. The parties filed an agreed statement of facts and the appellant testified.

The appellant deducted farm losses in 1987 and 1988. He was assessed an allowed a restricted farm loss pursuant to subsection 31(1) of the Income Tax Act, R.S.C. 1985 (5th Supp.), c. 1 (the "Act”). This was confirmed by a reassessment dated January 16, 1992 for his 1987 and 1988 taxation years. He appealed.

The introduction to subsection 31(1) of the Income Tax Act reads:

31(1) Loss from farming where chief source of income not farming .-Where a taxpayer’s chief source of income for a taxation year is neither farming nor a combination of farming and some other source of income, for the purposes of sections 3 and 111 the taxpayer’s loss, if any, for the year from all farming businesses carried on by the taxpayer shall be deemed to be the total of

(a) the lesser of...

The agreed statement of facts filed by the parties reads:

The following facts are agreed to by the parties for the purposes of determining the matters at issue in this cause:

1. The appellant carried on the business of racing and breeding thoroughbred horses ("the operation") from approximately 1978 to 1991 during which time he was also engaged in the practice of law in the province of Alberta.

2. The appellant reported his profits (losses) from the operation on his respective income tax returns as follows:

l Taxation Year Gross Revenue Expenses			Net Income	Professional/	Interest/
				Business	Dividend
			(Loss)
				Income	Income
1986	$113,765	($104,175)	$9,500	$70,104.09	$42,284
1987	$37,006	($95,434)	($58,428)	$173,877.00	$26,23
1988	$38,005	($99,939)	($61,934)	$175,493.00	$117,031
1989	$34,814	($9,814)	$25,000	$251,165.00	$16,607
1990	$17,764	($5,824)	11,940	$304,314.00	$29,663

Attached herewith as Exhibits "A", "B", "C" and "D" are the appellant’s copies of his income tax returns as filed in respect of taxation years 1986 to 1989. Attachments to the appellant’s copies of his income tax returns exhibited hereto summarize the nature of the investments in and structure of the operation.

3. Officials of the Minister of National Revenue conducted an audit of the appellant’s income tax returns for taxation years 1987 and 1988 (the "audits"). Pursuant to the audits, the Minister of National Revenue reassessed the appellant and restricted his losses pursuant to section 31 of the Income Tax Act (Canada) in respect of such years.

4. During the years in issue, the appellant expended significant funds and periods of time in the development and coordination of all aspects of the operation.

5. The appellant’s income tax liability for taxation years 1982, 1983, 1984 and 1985 was also subject to audit and reassessment by the Minister of National Revenue. On those reassessments, no changes were made to the reporting by the appellant of his income or losses from the operation.

The parties agree that either of them is free to lead evidence in the trial of this matter which is not inconsistent with this agreed statement of facts but merely supplements or elaborates upon this agreed statement of facts.

The appellant is a lawyer whose professional income is from his partnership in law. The "gross revenue", "expenses" and "net income (loss)" figures in paragraph 2 of the agreed statement of facts relate to his "business of racing and breeding of thoroughbred horses".

Paragraph 1 of the agreed statement of facts states that "the appellant carried on the business of racing and breeding thoroughbred horses ("the operation") from approximately 1978 to 1991...." Mr. Code testified that he reported losses from racing and breeding thoroughbred horses in 1982, 1983, 1984 and 1985 and the business losses he reported in those years were confirmed as filed by audit of Revenue Canada.

The audit in question for 1987 and 1988 allowed a restricted loss. Thus the Crown admits that the appellant is a class (2) farmer according to the analysis of Dickson J. in Mo Ido wan v. The Queen, [1978] 1 S.C.R. 480, [1977] C.T.C. 310, 77 D.T.C. 5213. The appellant claims that he is a class

(1) farmer. Dickson J.’s analysis at pages 487-88 (C.T.C. 315; D.T.C. 5216) reads:

In my opinion, the Income Tax Act as a whole envisages three classes of farmers:

(1) a taxpayer, for whom farming may reasonably be expected to provide the bulk of income or the centre of work routine. Such a taxpayer, who looks to farming for his livelihood, is free of the limitation of subsection 13(1) in those years in which he sustains a farming loss.

(2) the taxpayer who does not look to farming, or to farming and some subordinate source of income, for his livelihood but carried on farming as a sideline business. Such a taxpayer is entitled to the deductions spelled out in subsection 13(1) in respect of farming losses.

(3) the taxpayer who does not look to farming, or to farming and some subordinate source of income, for his livelihood and who carried on some farming activities as a hobby. The losses sustained by such a taxpayer on his non-business farming are not deductible in any amount.

The reference in subsection 13(1) to a taxpayer whose source of income is a combination of farming and some other source of income is a reference to class (1). It contemplates a man whose major preoccupation is farming, but it recognizes that such a man may have other pecuniary interests as well, such as income from investments, or income from a sideline employment or business. The section provides that these subsidiary interests will not place the taxpayer in class (2) and thereby limit the deductibility of any loss which may be suffered to $5,000. While a quantum measurement of farming income is relevant, it is not alone decisive. The test is again both relative and objective, and one may employ the criteria indicative of “chief source” to distinguish whether or not the interest is auxiliary. A man who has farmed all of his life does not become disentitled to class (1) classification simply because he comes into an inheritance. On the other hand, a man who changes occupational direction and commits his energies and capital to farming as a main expectation of income is not disentitled to deduct the full impact of start-up costs.

The evidence before the Court is that the appellant first joined a group owning thoroughbreds in the late 1970s. By 1982 this group, called "Par Four", was into fairly large investments. They bought the horses and had them boarded and trained but they did not own any facilities for the horses. Par Four was a syndicate consisting of the appellant and others.

By 1987 the appellant had purchased two horses by himself and one with another partner. The other members of Par Four wanted to buy horses and race them but the appellant also wanted to breed horses.

By this time the appellant was devoting about 30 hours a week to the study of blood and breeding lines and to the horse operation itself. He was also devoting between 30 and 40 hours a week to his law practice. In the years before developing his interest in horses, the appellant had devoted all of these hours per week solely to his law practice. Thus, by 1987 the appellant’s mode and habit of work had changed.

The appellant had suffered substantial farming losses in 1982, 1983, 1984 and 1985. However he reported net income from the horse operation in 1986. By 1987 he was also self-taught and trained in horse breeding and racing and had owned interests in a number of reasonably successful horses.

The appellant testified that his intention was and is to build up his stable so that it will show a profit and be his livelihood along with income from his RRSPs and investments when he retires from the practice of law. He is now over 60 years old so his time frame for continuous profits is in sight.

It should be noted that so far as can be determined from the evidence, the net profits shown by the horse operations have been due to inventory adjustments except, possibly, in one year. However, inventory adjustments are like capital cost allowances. They are bookkeeping entries allowed to the appellant and, in the Court’s view, the inventory adjustments are proper and they are an appropriate means to show a profit, just as capital cost allowance figures may show a loss. The Crown has not questioned the amounts of inventory adjustments.

The appellant’s evidence is clear that he expected to make a profit. The ultimate question for the Court is whether the appellant had a reasonable expectation of profit in 1987 and 1988.

In 1987 the appellant purchased all of the brood mares, weanlings and yearlings of Par Four and thereafter in 1987 and 1988 and the years following, he was both breeding and racing. This action was either a change in his occupational direction to farming or it markedly confirmed a previous change. Par Four and another group it held an interest in, purchased, raced and sold horses; it did not breed thereafter. The result of this occurrence is that the appellant had a form of start-up in 1987 in that he no longer had partners in the breeding operation which he carried on by himself. He wholly financed it and he relied solely on his own judgment and management. He had no partners to turn to for advice or support of any kind.

His personal interest in horses is separately accounted for. The 1990 figures are not in evidence. 1986 through 1989 are described as follows:

The Court notes particularly the contribution of the inventory adjustment to the bottom line for each of 1987, 1988 and 1989. Factoring that out leaves the 1987 and 1988 losses in the range of $54,000 and the 1989 loss in the range of $32,000.

For the years from 1987 to 1989, the net results of the appellant’s breeding operation, compared to his entire interest in horses (which include his breeding operation added to his interests in racing syndicates as described in the agreed statement of facts) is as follows:

Thus his total personal farming losses in these three years exceed his total farming losses from all sources.

The main sources of the appellant’s accounted positive income flow from 1986 through 1989 are the adjustments to inventory both personally and in the syndicates. In 1989 the identifiable source for this is the horse Leading Laddie in which the appellant was syndicated. Leading Laddie earned $120,443 and also booked an inventory value increase of $63,000 in 1989.

In his testimony the appellant described the time lag required by a breeding operation to choose mates, breed, gestate and raise a foal to a two year old status in order that it might enter races. The minimum period calculated was four years. This did not allow the horse time to earn money in races or to prove itself for breeding purposes in order that its progeny might fetch a good price. This time lag is of interest respecting the breeding operation acquired by the appellant in 1987. There the lag time is minimal because the appellant purchased mares, yearlings and weanlings owned by Par Four.

In Moldowan, Dickson J. referred to the start-up problem and to the chief source problem at pages 485-86 (C.T.C. 313-14, D.T.C. 5215-16), when he said:

There is a vast case literature on what reasonable expectation of profit means and it is by no means entirely consistent. In my view, whether a taxpayer has a reasonable expectation of profit is an objective determination to be made from all of the facts. The following criteria should be considered: the profit and loss experience in past years, the taxpayer’s training, the taxpayer’s intended course of action, the capability of the venture as capitalized to show a profit after charging capital cost allowance. The list is not intended to be exhaustive. The factors will differ with the nature and extent of the undertaking: The Queen v. Matthews, [1974] C.T.C. 230, 74 D.T.C. 6193. One would not expect a farmer who purchased a productive going operation to suffer the same start-up losses as the man who begins a tree farm on raw land.

Whether a source of income is a taxpayer’s "chief source” of income is both a relative and objective test. It is decidedly not a pure quantum measurement. A man who has farmed all of his life does not cease to have his chief source of income from farming because he unexpectedly wins a lottery. The distinguishing features of "chief source" are the taxpayer’s reasonable expectation of income from his various revenue sources and his ordinary mode and habit of work. These may be tested by considering, inter alia in relation to a source of income, the time spent, the capital committed, the profitability both actual and potential. A change in the taxpayer’s mode and habit of work or reasonable expectations may signify a change in the chief source, but that is a question of fact in the circumstances.

The breeding operation purchased by the appellant in 1987 was not a start-up from scratch. However it did not consist of racing horses. From the evidence, the yearlings were a year away from racing and two years away from the possibility of producing a volume of income flow.

The appellant’s own learning curve of running a breeding and racing operation by himself must also be factored into the consideration of the Court. By comparison, the Court notes that many a lawyer can produce income in a small or large partnership but cannot do it as a sole practitioner because additional skills are required.

There is a third factor which became evident as the case progressed. To be a success as a breeding operation, the business must have at least one horse that achieves success either as a racer or a breeder in the market the breeder is aiming at. This happened to the Leading Laddie syndicate in 1989. That horse is undoubtedly the result of a good purchase program, but it is also exceptional. This has a greater chance of occurring where the numbers are large enough.

In his 1982 to 1985 assessments, the Minister found the appellant to be a Class (1) farmer in his syndicate operations. It looked at profit and loss, experience, training, course of action and capital. These factors were a basis for the appellant’s personal operation which commenced in 1987. In 1986 the syndicate had a profit. The appellant’s experience as a sole operator remained to be established, but his training was acceptable. His course of action was similar. His capital investment was good.

Given the time lag already calculated, the appellant was not going to make a profit for the first two years because the breeding operation could not, given the stock acquired. The total expenses in 1987 and 1988 proved to be lower than in 1986, so the management was improved to some extent over all, which indicates that it was reasonable to anticipate that the appellant would perform well as a manager. The syndicate operation was there as a source of help in spreading the risk and Leading Laddie provided the assist in 1989.

The Court finds the appellant was entitled to a start-up period in his personally-owned breeding operation, which encompassed 1987 and 1988. That operation had a reasonable chance of success but was entitled to suffer substantial losses in 1987 and 1988 on a start-up basis. The two operations, together, had a reasonable chance of success as well, which in fact happened in 1989 with the success of Leading Laddie and its effect on the bottom line. The result of Leading Laddie’s success was, as calculated, that for 1987, 1988 and 1989 all the appellant’s losses can be attributed to the breeding operation which he acquired in 1987.

The appellant was born in 1932. In 1987 he became 55. Allowing for start-up losses for at least two years, was it reasonable to expect his farming operation to yield significant income in relation to his professional income? In 1989 his farming income was $25,000 and his professional legal income was $251,165.

In 1990 his professional legal income was $304,314. The appellant testified his law firm’s income was very high in those two years because of two very unusual files which resulted in a marked upward effect on his income. Thus it would appear that his usual professional income was somewhere below $230,000 per year and it would taper downward as he reached 65.

His average farm income in 1989 and 1990 is $18,470. This is in excess of 10 per cent of his average 1987 and 1988 professional income. In about 1987 the appellant’s professional income, subject to aberrations, would normally plateau out and then decline in the reasonably foreseeable circumstances of the law profession, particularly at that time in Calgary.

On the other hand, the appellant’s farming income would be expected to become positive and to increase once the start-up period ended. In 1987 it could have been said, correctly, that any positive farm income would be ’’significant". The appellant could reasonably expect his farm income to exceed 10 per cent of his income from the legal profession at that time, once the start-up period was passed. Therefore, the Court finds that the appellant could reasonably expect a significant farm income once the startup period had concluded.

The appeal is allowed.

The appellant is awarded his costs.

Appeal allowed with costs.