Waldy Hugel v. Her Majesty the Queen (Informal Procedure), [1993] 2 CTC 2281

Teskey, T.C.C.J.:— The appellant elected to have his appeal against an assessment for 1989 heard pursuant to the informal procedure.

Issue

The Minister of National Revenue (the Minister"), in making his assessment, restricted the appellant’s farming loss by applying subsection 31(1) of the Income Tax Act (the "Act"). The appellant claims that he is a class 1 farmer, as defined by Dickson, J. as he then was, in Moldowan v. The Queen, [1978] 1 S.C.R. 480, [1977] C.T.C. 310, 77 D.T.C. 5213 and therefore subsection 31(1) of the Act should not be applied.

Facts

The appellant, a commerce graduate, has a full-time job with a firm of insurance brokers in Calgary as its financial manager. This is basically a nine to five, five days a week job. The year end creates a little overtime work which is insignificant.

Prior to 1989, he farmed as a breeder and racer of standardbred horses. By year end of 1988, he had suffered losses on this total operation for three straight years. He realized that, of his total loss for 1987 of $9,252, only $715 of this loss was attributable to his racing portion of the operation. The appellant claims that in 1988, even though the total operation had a loss of $7,960, the race portion had a profit of $4,050. With this knowledge, he decided to abandon his breeding operation and only be in a racing operation.

On January 1, 1989, he owned three horses, namely, a ten-year-old brood mare, called Show Baby, which his brother kept at no expense to the appellant. Show Baby had not been bred in 1988 and was not to be bred again. The other two horses were offsprings of Show Baby called Royal Occasion ("Royal") and Regal Rampage ("Regal").

Royal was a four-year-old and Regal was a three-year-old. Neither Royal nor Regal earned any money in 1989. Royal had to be put down and Regal was given away rather than being sold to a packing plant for $200.

In November of 1989, the appellant purchased two horses in Kentucky namely Sugar Kyle ("Kyle") and Timeless Almhurst ("Timeless"). Kyle, a two- year-old colt was purchased for U.S. $16,000. Timeless, a yearling filly was purchased for U.S. $2,500.

Kyle in 1990 had four starts which resulted in one win, two second places and one third place. The colt then came down with a virus and had to be pastured until June of 1989. In September, he started racing again but his times were not competitive. Kyle was kept until March of 1991 when he was sold for $600.

Timeless also started to race in 1990 and had a win and a second place when she developed a physical problem which could not be overcome and her racing career, for all intents and purposes, ended in the spring of 1990 and although she was put on lease in 1991, she was eventually sold in 1992 for $700.

The appellant claimed that his plan was to purchase two horses a year in Kentucky for $20,000 and import them to Alberta. By 1991, this operation would produce a profit of $2,000 and by 1993 a gross profit of $30,000.

The appellant gave evidence to the effect that out of 400 horses bred for racing the following results on average would occur:

100 would never reach the race track.

100 would be marginal with no profit.

100 would be slightly profitable taking into consideration winnings and sale price at end of a racing career.

Of the remaining 100, two would be exceptional and would produce huge winnings and the other 98 would double in value.

The appellant's only assets were his horses and he had no plans to invest in any other capital assets. All animals would be boarded at the tracks. His time spent in this racing enterprise did not nearly match his employment time.

Danny Dayril Garinger ("Garinger") the executive director of the Alberta Standard Breeders Association was called by the appellant to give evidence. He said that in his opinion to be successful in a standardbred racing enterprise the owner had to have:

1. adequate research.

2. contacts with successful people.

3. knowledge of the rules.

4. high credibility.

5. luck.

6. awareness of the business and understanding of the general aspects thereof (this would include sufficient capital to carry a losing enterprise from the required start-up period).

With regards to “luck” he compared the purchasing of race hoses to the hockey draft. There was a great deal of luck in the draft as well as in the selection of horses to be purchased at auctions. However, if a horse doesn't win or place, there is no income, whereas hockey attracts spectators whether the team wins or loses.

He said that in 1989, there were approximately 1,000 horses racing in Alberta for prizes totalling 10 million dollars. The average racer in Alberta earns annually as much as its cost for upkeep and that 20 per cent of the racers earns 80 per cent of the prize money.

He said in review of the breeding of both Kyle and Timeless that without seeing either horse that they appeared to have a better than average potential. This opinion is worthless and does not assist the appellant in any way.

In 1990, the appellant, even though he claims he had the funds to do so, did not purchase any more race horses and abandoned the enterprise. He claims that he started on this route because of a special relationship he had with a particular trainer. This relationship deteriorated in 1990 and was a major factor in his decision to abandon his race horse operation.

Legal principles

The premier decision is Moldowan, in which Dickson, J., as he then was, said at pages 485-86 (C.T.C. 313-14; D.T.C. 5215):

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.

He went on to say at pages 487-88 (C.T.C. 315, D.T.C. 5216):

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 Moldowan decision was dealt with at length by the Federal Court of Appeal in The Queen v. Morrissey, [1989] 1 C.T.C. 235, 89 D.T.C. 5080. Mahoney, J. said at page 242 (D.T.C. 5084):

On a proper application of the test propounded in Moldowan, when, as here, it is found that profitability is improbable notwithstanding all the time and capital the taxpayer is able and willing to devote to farming, the conclusion based on the civil burden of proof must be that farming is not a chief source of that taxpayer's income. To be income in the context of the Income Tax Act that which is received must be money or money's worth. Absent actual or potential profitability, farming cannot be a chief source of his income even though the admission that he was farming with a reasonable expectation of profit is tantamount to an admission which itself may not be borne out by the evidence, namely, that it is at least a source of income.

Strayer, J. in Mohl v. The Queen, [1989] 1 C.T.C. 425, 89 D.T.C. 5236 after citing both Moldowan and Morrissey said at page 428 (D.T.C. 5238):

. . .for a person to claim that farming is a chief source of income, he must show not only a substantial commitment to it in terms of the time he spends and the capital invested, but also must demonstrate that there is a reasonable expectation of it being significantly profitable. I use the term significantly profitable” because it appears from the Morrissey decision that the quantum of expected profit cannot be ignored and I take this to mean that one must have regard to the relative amounts expected to be earned from farming and from other sources. Unless the amount reasonably expected to be earned from farming is substantial in relation to other sources of income then farming will at best be regarded as a "sideline business” to which the restriction on losses will apply in accordance with subsection 31(1).

The Federal Court of Appeal in 1991 reviewed the Moldowan and Morrissey decisions and The Queen v. Graham, [1985] 1 C.T.C. 380, 85 D.T.C. 5256 in Roney v. M.N.R., [1991] 1 C.T.C. 280, 91 D.T.C. 5148. Desjardins, J.A. for the Court said at page 288 (D.T.C. 5155):

Start-up costs. . .cannot be considered as the basis for an alternative ground of decision. The permissible amount to be deducted depends on the class the taxpayer finds himself in.

Furthermore she stated that when Dickson, J. said in Moldowan at page 488 (C.T.C. 315, D.T.C. 5216):

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.

Desjardins, J.A., then went on to say, that Dickson, J. was referring to a class 1 taxpayer (farmer).

Analysis

With these legal principles in mind, I must determine if the appellant's race horse farming business would have, in a reasonable period of time as capitalized, produced sufficient income that it would have been the appellant's chief source of income or that his chief source of income would be a combination of farming and his regular employment income, particularly in light of Strayer, J.'s Mohl decision that the farming operation must be "significantly profitable". The appellant has failed to convince me that his business plan was a sound business adventure.

His business plan, as produced in Exhibit A-13, is not realistic. It does not take into consideration many factors such as veterinary fees which undoubtedly could be substantial. It is also based on the assumption that, in 1993 the two five-year-olds would only lose $5,000; the two four-year-olds would together earn $10,000; the two three-year-olds would together earn $25,000 and the one two-year-old would only lose $6,000, thus producing a profit of $24,000 on racing only. This does not take into consideration the sale of two horses at $18,000.

Against this, I must look at his actual history and compare it against the percentages as given by Garinger. The two horses the appellant had in January of 1989 never earned any money. The two horses purchased in Kentucky in November of 1989 were total losses both as to the winnings and the sale. The enterprise was partially based on the ability of an outside person namely, the trainer. This is not a sound business foundation.

The plan did not take into consideration luck nor the percentages as given by Garinger. Luck can be either good or bad. For every horse that does exceptionally well, there are 50 that never reach the track, 50 that race and lose money, 50 that race and break even and 49 that do better. Even if the appellant, with his knowledge, could eliminate buying horses that never race, the odds were that only one in three would make money.

The appellant has failed to convince me that his racing of standardbred horses as planned would produce in five years “significant profit". Even if I accepted his five-year plan (E.A.B.) which I specifically reject, it fails to demonstrate “ significant profit” and to fit the definition of a class 1 farmer.

There is nothing before me to suggest that the appellant's horses would do any different than average. In fact, his history would suggest a below average performance.

The adventure was speculative. Without winnings in excess of upkeep to either pay back the purchase price or to maintain a sale price, the operation would be a losing proposition. The appellant was chasing a dream, it being highly probable that he would never have turned a profit.

Based on the evidence before me and for these reasons, the appeal is dismissed.

If the Minister had disallowed all losses, I would still have dismissed the appeal. This was a highly speculative adventure with very little chance, if any, of producing a profit in the future. In 1989 he had no chance of making a profit. The losses cannot even be classified as start-up costs. Start-up losses can only be used if the enterprise, as existing, can be shown to produce, in a reasonable length of time, substantial profit. I would classify the appellant as a class 3 farmer.

Appeal dismissed.