Lake Superior Investments Ltd. v. Minister of National Revenue, [1993] 2 CTC 2173

Sobier, T.C.C.J. (orally):—The Court is now prepared to give reasons for judgment in Lake Superior Investments Ltd. versus the Minister of National Revenue, 90-74(IT).

The appellant appeals from the assessments by the respondent for its 1984, 1985, 1986 and 1987 taxation years whereby the respondent disallowed in part the appellant's claim for a small business deduction under the Income Tax Act, R.S.C. 1952, c. 148 (am. S.C. 1970-71-72, c. 63) (the"Act"). It is the respondent's position that a portion of the appellant's income was Canadian investment income and not income from an active business. The appellant had three major sources of income in the years in question; income from the sale of building lots, income from rental property and income from investments. It is the characterization of the rental income and the investment income that is at issue. The appellant, of course, maintains that the rental income and the income from investments are active business income, whereas the respondent asserts that they are Canadian investment income.

The facts may be stated briefly as follows. The appellant was incorporated by Mr. Ben Bregman, father of Mr. Paul Bregman, presently an officer and director of the appellant and a witness who gave evidence on its behalf. Mr. Ben Bregman wished to develop a strip plaza on the Great Northern Road in Sault Ste. Marie, Ontario. To this end in 1965 he acquired a first parcel of land fronting on Great Northern Road and also fronting on Blake Street to the rear of Great Northern Road. The two parcels of land were separated by a lane owned by the City of Sault Ste. Marie. After many years and a great deal of effort, the zoning of the property was changed to permit a shopping plaza to be built. The plaza was known as the Golden Mile Plaza. Although built, the plaza remained vacant for two years and then it received its first tenants who occupied 6'/2 of the 12 units of the plaza.

There were also a series of short-term tenants and a pizza restaurant. So that by 1978 and through to 1983 the plaza was three-quarters leased. It became apparent from the start that parking at Golden Mile Plaza was a problem and considerable time and effort went into rectifying this problem. Evidence was led about the purchase of a parcel of property 500 feet away from the Plaza and of a land swap of the neighbour located between the plaza and the parking lot 500 feet away. Evidence was also given concerning the purchase of additional land behind the plaza, of closing the lane and of severe opposition from nearby residents. Further rezoning was required and was finally obtained.

While the original tenants were what may be described as local businesses, it was felt that a so-called national tenant would assist in creating traffic and would bring tenants to the plaza. The appellant believed that he had such a tenant in a Mother's Pizza Restaurant which occupied one-half of the units and opened for business in the spring of 1985.

Because the appellant did not wish to go to the expense of financing Mother's tenant improvements, Mother's was required to do so itself. However, because of that the lease with Mother's was structured in such a way that the rent for the first several years was low and thereafter was more in keeping with market rent. Mother's experienced difficulty in 1986 and in 1988 the appellant was forced to use the remedy of distress in order to recover the rent due to it.

In spite of all of the adversity in the years in question, the plaza was profitable even after all expenses were paid, and not just those related to the plaza; that is, the financial statements show the gross rental income from the plaza exceeded the expenses of the appellant from all activities. Without taking into consideration income from the sale of lots and investment income, there was a profit in each year after taking all expenses including capital cost allowance.

It is the appellant's contention that from the beginning it was its intention to assemble the land, build the plaza, lease it out and sell. The witness, Mr. Paul Bregman, stated that it was his intention and that of his father before him to sell the plaza. Although the evidence of intention is admissible, the question of what weight should be given to it must be asked and I will deal with this matter later.

It was Mr. Bregman's evidence that if the plaza was sold at a profit, he would report this profit as income and not as a capital gain. However, during the years under appeal the appellant claimed capital cost allowance on the plaza, an indication that it considered the plaza to be as a capital asset and not as inventory for sale. During this period the economy of Sault Ste. Marie was terribly depressed. The city's major employer, Algoma Steel, was experiencing great financial difficulty and was laying off a great number of employees. This, of course, has a ripple effect throughout the entire economy of the city. This would naturally lead to the depression of real estate prices in the city.

In addition, after the Golden Mile Plaza was built on Great Northern Road, other strip plazas were built there to the extent that according to the witness Mr. Ray Smith, the area was overmalled". The appellant maintains that while it was his intention to sell, he would not sell at a distress price. Mr. Bregman's price was about $1 million to $1.2 million. This price was based upon having 8000 square feet rented at $15 per square foot, using a factor of ten. However, he was prepared to negotiate.

Mr. Smith stated that after removing the Arcade as a tenant and then fully renting the plaza he believed that the market value might be in the neighbourhood of $800,000. Mr. Bregman's evidence was that the only offer he received was for about $450,000. Having these facts before me, I must now turn to the law.

In order to be successful, the appellant must establish his entitlement to the small business deduction afforded by section 125 of the Act. Subsection 125(7) contains the definition of "active business" which is used in subsection 125(1) in allowing the deduction from the income of an active business.

However, paragraph 125(7)(a) goes on to say:

. . . "active business carried on by a corporation" means any business carried on by the corporation other than a specified investment business . . . .

Paragraph 125(7)(e) sets out the definition of "specified investment business” and states, with some editing on my part, in part as follows:

. .. specified investment business” carried on by a corporation in a taxation year means a business . . . the principal purpose of which is to derive income from property (including interest, dividends, rents or royalties), unless . . . .

and there follows some exceptions not applicable to this case. The text writers give us some insight as to why there was a change in dealing with active business income and investment income, and how this came about. David Phillip Jones in 1982 Canadian Tax Journal 30 said at page 5:

In a series of cases, however, the courts effectively eliminated the idea of passive business and held that virtually any business constituted an active business. The purpose of the “specified investment income” amendment, therefore, was to make certain that income from the business of renting property did not generally constitute active business income, but rather was assimilated to investment income, thereby effectively reversing the jurisprudence on this point.

and at page 17 he states:

Income from a specified investment business is specifically excluded from the definition of “active business income" to which the small business deduction under section 125 applies and is specifically included in the definition of "income from property" by subsection 129(4.1), which in turn is contained within the definition of “ Canadian investment income" under subsection 129(4) to which the refundable dividend tax system applies.

Subsection 129(4) contains the definition of Canadian investment income” and envisages two types of income: (a) income from capital gains, and, (b) income from property. While subsection 129(4.1) includes in the computation of income from Canadian investments income from a specified investment business, it excludes income earned from property that was incidental to or pertaining to an active business.

As stated above, a specified investment business is a business the principal purpose of which is to earn income from property, including rents and interest. From the definitions and analysis provided above, it appears to me that the correct way of analyzing income would be to follow the outline I am now setting out:

1. Determine if income is from business or property. If from business, then it will be, more than likely, from active business;

2. If it is income from a business, establish if it is a specified investment business. If it is, then determine whether the property used to earn the income falls into one of the exceptions listed in subsection 129(4.1). If the property i& not of the type listed, the income is deemed to be Canadian investment income;

3. If it is income from property, ensure that all property is a source in Canada, and, if so, it is Canadian investment income within the meaning of subsection 129(4) ;

4. Finally, establish whether the property is incidental or pertaining to an active business. If it is, subsection 129(4.1) determines it to be active business income.

To be successful on this appeal, the appellant must demolish the assumptions made by the Minister. If the income in question is not active business income, then the appellant must bring into play the exception in paragraph 129(4.1)(b). This exception enables income from property to be classified as active business income if the property is incidental to or pertaining to an active business.

It must therefore be determined whether the rental and investment income was income earned from property incidental to or pertaining to an active business. The theory of the appellant is that the leasing operation of the Golden Mile Plaza was a preliminary step to the eventual sale of the plaza and therefore an active business.

The enactment of subsection 129(4.1) limited the type of property used for the purpose of earning income from active business. If it is such income, that is specified investment income, which on its face in this case it is, then the appellant must show that it pertained to or was incidental to active business. As far as the rental income is concerned, I cannot find that the evidence is strong enough to demolish the respondent's presumption. The appellant looked like and acted like a landlord whose operations were receiving income from leasing of real property. I do not find that the appellant was primarily motivated to sell the plaza. Its actions were just as consistent with those of a landlord trying to make a plaza attractive to prospective tenants for rental purposes.

There was very little evidence to show that there was a primary intent to sell. There was a study commissioned after the plaza was fully tenanted, but no active steps were taken to sell. There were steps taken to lease for the stated reason to sell. However, I will deal with the stated reasons and motivations later.

On balance the appellant has not discharged the onus upon him that the activities were incidental to or pertaining to an active business with respect to the plaza. As stated by Noël, J. in Racine, Demers & Nolan v. M.N.R., [1965] C.T.C. 150, 65 D.T.C. 5098, a decision of the Exchequer Court of Canada, at page 159 (D.T.C. 5103):

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.

The surrounding circumstances, especially the continued claim for capital cost allowance indicates that the appellant was gaining income from property and not the active business of developing for sale.

As to the investment income; were the short-term investments in securities and mortgages also incidental to or pertaining to an active business? The appellant claimed that the money was being conserved in order to enter into active business in the future, such as the proposed venture into a strip mall on Bank Street in Ottawa.

In order to establish the “incidental to or pertaining to" exception, the appellant must establish some financial relationship between the active business and the property. Without going through all of the authorities, I believe that the matter was best summed up by Associate Chief Judge Christie of this Court in Atlas Industries Ltd. v. M.N.R., [1986] 2 C.T.C. 2392, 86 D.T.C. 1756 and as approved by the Federal Court, Trial Division in McCutcheon Farms Ltd. v. The Queen, [1991] 1 C.T.C. 50, 91 D.T.C. 5047. In Atlas Industries, Associate Chief Judge Christie said at page 2404 (D.T.C. 1764):

Giving the words “ incident to or pertains to an active business” their grammatical and ordinary sense, and bearing in mind their context, there must I think be a financial relationship of dependence of some substance between the property and the active business before the exclusion in paragraph 129(4.1)(b) comes into play. The operation of the business ought to have some reliance on the property in the sense that recourse is had to it regularly or from time to time or that it exists as a back-up asset to be called on in support of those operations when the need arises. This I regard to be the basic approach to paragraph 129(4.1)(b). Whether incomeproducing property has crossed the dividing line into the paragraph will depend on the facts of each case.

In no sense were the investments needed or required by the business. Their removal from the business would not put the business at risk. They simply were surplus to the requirements of the appellant. All funds needed for the plaza or for the sale of the lot business came from current earnings.

For these reasons, the appeals are dismissed.

Appeal dismissed.