Michel Dupont v. Minister of National Revenue, [1993] 1 CTC 2219, 93 DTC 617

Tremblay, T.C.C.J.:—This appeal was heard at Montréal, Québec on February 7, 1992.

1. Point at issue

According to the notice of appeal and the reply to the notice of appeal, the question is whether the appellant was correct in calculating his income for the 1985, 1986 and 1987 taxation years to deduct losses of $11,162 (1985), $11,827 (1986) and $7,845 (1987) resulting from the leasing of farmland held by him to the company Les Entreprises Michel Dupont Inc. (hereinafter referred to as '"the company") and also resulting from the holding of Class B preferred shares in the said company.

The respondent contended that in the years on appeal the farmland was not held in the course of a business carried on by the appellant. Further, the respondent submitted that the appellant did not lease the land with the reasonable expectation of deriving a profit therefrom. The losses were accordingly not deductible.

The appellant argued that the deductions concerned are permitted, inter alia, by section 9 of the Income Tax Act, R.S.C. 1952, c. 148 (am. S.C. 1970-71-72,

c. 63) (the "Act") and not prohibited by section 18 of that Act.

2. Burden of proof

2.01 The appellant has the burden of showing that the respondent's assessments are incorrect. This burden of proof results from several judicial decisions, including a judgment of the Supreme Court of Canada in Johnston v. M.N.R., [1948] S.C.R. 486, [1948] C.T.C. 195, 3 D.T.C. 1182.

2.02 In the instant case, the facts assumed by the respondent are described in paragraphs 15(a) to (f) and in paragraph 16 of the reply to the notice of appeal. They read as follows:

15. In reassessing the appellant's 1985, 1986 and 1987 taxation years the respondent assumed inter alia the following facts:

(a) on December 30, 1984 and January 1, 1985, the appellant transferred to" Les Entreprises Michel Dupont Inc.,” in which he is the principal shareholder, a farming business (including equipment, rolling stock, good will and inventory) which he had previously been operating personally; [admitted]

(b) in consideration of this transfer the company assumed certain of the

appellant's debts and issued him Class B preferred shares; [admitted]

(c) however, the appellant remained owner of the land on which his business

had been operated before being transferred to the company; [admitted]

(d) during 1985, 1986 and 1987 the appellant leased his land to his company and

in this connection reported the following income and expenditure:

		1985		1986		1987
Gross leasing income		$10,800		$ 7,400		$ 6,900
Expenditure:
Interest	20,887		17,635		14,131
Other costs	1,075	21,962	1,592	19,227	614	14,745
Net leasing loss		$11,162		$11,827		$ 7,845
					[admitted]

(e) for his 1985, 1986 and 1987 taxation years, the appellant did not operate any business; [admitted]

(f) during those years the appellant's land was not used in the operation of or

held in the course of a business carried on by the appellant. [denied]

16. During the 1985, 1986 and 1987 taxation years, the appellant did not lease any land with the reasonable expectation of deriving a profit therefrom. [denied]

[Translation]

3. Facts

3.01 On March 13, 1981 the appellant purchased farmland worth $48,000, $10,000 of which was the value of a building located on the said land. The purchase of this farmland was financed by a mortgage loan of $48,000, renewable annually.

3.02 On December 22, 1981 the appellant borrowed $132,000, also secured by a mortgage on farmland purchased between 1975 and 1977 for the amount of $33,500. In the early 1980s he also took out a personal loan of $20,000, bearing interest at 12 per cent, which he repaid in 1987.

3.03 Up to $80,100 of the loans of $132,000 and $20,000, namely $152,000, was used to finance the cost of purchasing farmland acquired from 1975 to 1977 and to pay the cost of installing underground drains. A sum up to $71,900 of the loans was also used to finance the appellant's farming business.

3.04 On December 30, 1984 and January 1, 1985 the appellant assigned all the equipment, rolling stock, good will and inventory and all the buildings in his farming business to the company. However, he remained owner of all the farmland purchased between 1975 and 1981. This property was assigned in consideration of the company assuming the debts of the appellant’s business and of the issuing of Class B preferred shares having a fair market value of $85 ,080.

The said shares are non-voting, return an annual non-cumulative 9 per cent dividend and are redeemable by the company in an amount equal to their paid-up capital. The appellant also holds all the company’s ordinary shares.

3.05 The appellant is recognized as a farmer. He holds a farm producer's card personally as well as one for the company.

3.06 The company's farming business is operated by the appellant and the employees he hires each season.

3.07 Since 1984 the appellant has leased the farmland purchased between 1975 and 1981 to the company. In his notice of appeal the appellant maintained that this lease was made in return for rental equal to or greater than the market rate. The leases have subsequently been annually renewed and fixed at the market rate.

3.08 Since 1985 the company has reported the following turnover on a cash accounting basis:

3.09 In the 1985, 1986 and 1987 taxation years the appellant received the following gross income for leasing the farmland:

3.10 For the same years, the appellant also claimed losses resulting from the leasing of farmland and the holding of Class B preferred shares. The appellant's income, losses and expenditure for the years concerned were as follows:

3.11 The expenditure incurred by the appellant also included the acquiring of licences and permits and promotion and advertising expenses.

The respondent argued that the licences and permits were only used to enable the appellant to keep his farmer's cards, with which he enjoyed certain privileges.

3.12 The appellant also claimed losses for years 1988 and 1989.

4. Act — Case law — Analysis

4.01 Act

The principal legislative provision with which we are concerned in the instant case is subsection 18(2) of the Income Tax Act, in its version applicable in the years at issue. Subsection 18(2) then read as follows:

18.(2) Restriction relative à certains intérêts et à certains impôts fonciers.— Nonobstant l'alinéa 20(1)(c), lors du calcul du revenu d’un contribuable tiré, pour une année d'imposition, d'une entreprise ou d’un bien, aucune déduction ne peut être effectuée relativement à toute somme payée ou payable par le contribuable dans l’année et après 1971, au titre ou en paiement intégral ou partiel

a) d'intérêts sur de l’argent emprunté et utilisé pour acquérir un fonds de terre,

ou sur une somme payable par lui relativement à un fonds de terre, ou

b) d'impôts fonciers (non compris l'impôt sur le revenu ou sur les bénéfices ni l'impôt afférent au transfert de biens) payés ou payable par lui à une province ou à une municipalité canadienne, relativement à un fonds de terre,

si, compte tenu de toutes les circonstances, y compris le prix que le contribuable a payé pour le fonds de terre par rapport au revenu brut, si revenu brut il y a, qu'il en a tiré dans cette année ou dans toute année antérieure, le fonds de terre ne peut pas raisonnablement être considéré comme ayant été, dans l’année

c) utilisé dans l'exploitation ou détenu dans le cadre d'une entreprise exploitée dans l’année par le contribuable, ou

d) (Abrogé par 1974-75-76, chap. 26, art. 7(2).)

e) détenu par le contribuable principalement en vue de tirer de ce fonds de terre un revenu pour cette année,

sauf dans la mesure où le revenu brut, si revenu brut il y a, tiré du fonds de terre dans cette année par le contribuable dépasse le total de toutes les autres sommes déduites lors du calcul du revenu qu'il a tiré du fonds de terre dans cette année.

18.(2) Limitation re certain interest and property taxes on land.—Notwithstanding paragraph 20(1)(c), in computing the taxpayer’s income for a taxation year from a business or property, no deduction shall be made in respect of any amount paid or payable by the taxpayer in the year and after 1971 as, on account or in lieu of payment of, or in satisfaction of,

(a) interest on borrowed money used to acquire land, or on an amount payable by him for land, or

(b) property taxes (not including income or profits taxes or taxes computed by reference to the transfer of property) paid or payable by him in respect of land to a province or a Canadian municipality,

if, having regard to all the circumstances, including the cost to the taxpayer of the land in relation to his gross revenue, if any, therefrom for that or any previous year, the land cannot reasonably be considered to have been, in that year,

(c) used in, or held in the course of, a business carried on in the year by the taxpayer, or

(d) (Repealed, 1974-75-76, c. 26, S. 7(2)),

(e) held primarily for the purpose of gaining or producing income of the taxpayer from the land for that year,

except to the extent that the taxpayer's gross revenue, if any, from the land for that year exceeds the aggregate of all other amounts deducted in computing his income from the land for that year.

4.02 Case Law

The parties referred the Court to the following case law:

1. Bigelow v. The Queen, [1990] 1 C.T.C. 351, 90 D.T.C. 6262 (F.C.T.D.);

2. Koritni v. M.N.R., [1984] C.T.C. 2811, 84 D.T.C. 1716 (T.C.C.); 3. Albers v. M.N.R., [1984] C.T.C. 2310, 84 D.T.C. 1260 (T.C.C.);

4. Timpson v. The Queen, [1987] C.T.C. 389, 87 D.T.C. 5266 (F.C.T.D.);

5. Blair Supply Co. v. M.N.R., [1984] C.T.C. 2560, 84 D.T.C. 1457 (T.C.C.);

6. Audet v. M.N.R., [1985] 2 C.T.C. 2237, 85 D.T.C. 557 (T.C.C.);

7. McKay v. M.N.R., [1984] C.T.C. 2805, 84 D.T.C. 1699 (T.C.C.);

8. Emerson v. The Queen, [1985] 1 C.T.C. 324, 85 D.T.C. 5236 (F.C.T.D.); [1986] 1 C.T.C. 422, 86 D.T.C. 6184 (F.C.A);

9. Bronfman Trust v. The Queen, [1987] 1 S.C.R. 32, [1987] 1 C.T.C. 117, 87 D.T.C. 5059;

10. Moldowan v. The Queen, [1978] 1 S.C.R. 480, [1977] C.T.C. 310, 77 D.T.C. 5213.

4.03 Analysis

The most important question that emerged from the oral arguments was as to the interpretation to be given to subsection 18(2) of the Act, and in particular its final paragraph. However, alternative questions were also raised by the parties. They related to:

(a) the appellant's reasonable expectation of profit from leasing his land to the company;

(b) the legal effect of the actual transfer applied to the circumstances of the instant case; and

(c) alternatively, the legitimacy of the various expenses claimed by the appellant.

In view of the nature of the dispute between the parties, primarily regarding the correct interpretation of subsection 18(2) of the Act, it seems important to this Court to briefly review the parties' arguments in the instant case.

4.03.1 Parties' Arguments

In general the parties’ arguments may be summarized essentially as follows.

4.03.1(1) Interpretation of subsection 18(2)

The respondent submitted that he was justified under subsection 18(2) of the Act to disallow the leasing losses claimed by the appellant.

He firmly maintained that that subsection does not in any case allow the complete deduction of interest. In his submission, even if the interest was incurred to produce income (paragraph 18(2)(e)), the latter would only be deductible up to the amount of the net income, which the respondent alleged is set out in the final paragraph of the said section:

18(2) except to the extent that the taxpayer's gross revenue, if any, from the land for that year exceeds the aggregate of all other amounts deducted in computing his income from the land for that year.

The respondent accordingly submitted that this final paragraph of subsection 18(2) of the Act limits the deduction of interest in fact allowed by that same section.

He argued that paragraph 53(1)(h) of the Act corroborates this interpretation, since it provides that amounts not deductible under subsection 18(2) of the Act will be added to the adjusted cost base of the farmland purchased.

4.03.1(2) The respondent accordingly submitted that when land is specifically in question, the legislature intended by means of subsection 18(2) of the Act to provide and put in place a limitation on the deduction of interest relating thereto, although the property may have been held for the purpose of producing income (paragraph 18(2)(e), 4.01).

Finally, the respondent argued that allowing a deduction in full under subsection 18(2) of the Act would deprive the latter of all meaning since the same result can be achieved under paragraph 20(1)(c) of the Act. When there is a reasonable expectation of profit, the latter provision allows deduction in full, not subject to a limitation, of the interest expense incurred.

4.03.1(3) The appellant argued that paragraph 20(1)(c) of the Act is the general interest deduction and that subsection 18(2) of the Act is legitimized by the fact that real estate is actually a special sector of the economy and warrants a broad rather than a limiting interpretation.

He accordingly submitted that subsection 18(2) of the Act limits the application of paragraph 20(1)(c) of the Act only in the case where the conditions stated in paragraph 18(2)(c) or (e) are not met, namely that:

(c) the property was used in, or held in the course of, a business carried on in the year by the taxpayer, or

(e) the property was held primarily for the purpose of gaining or producing income of the taxpayer from the land for that year.

4.03.1(4) So, according to the appellant, it should first be determined whether the particular facts of the case meet one of the aforementioned paragraphs. If they do, deduction of the interest expense incurred will then be allowed in its entirety and will thus have the same effect as paragraph 20(1)(c) of the Act.

However, if those facts in no way meet the said paragraphs (c) and (e), in that particular case the last paragraph of subsection 18(2) of the Act will apply, the appellant submitted, to effectively limit the deduction of interest expense incurred by the taxpayer.

4.03.2 Reasonable Expectation of Prof it

4.03.2(1) The respondent admitted in the oral arguments that the appellant did purchase the land for the purpose of earning income. However, he submitted that the leasing of the land and the income he derived from it did not in any way mean that the appellant had a reasonable expectation of profit in the years at issue.

4.03.2(2) The respondent submitted that the amount of the expenses incurred by the appellant was much higher than the gross income from leasing the land to Michel Dupont Inc. even if the maximum price was obtained (3.07, 3.10). This fact, he alleged, clearly rebuts the appellant's argumentas to a reasonable expectation of profit.

He further relied on the fact that there was no indication of an improvement in the situation, that is a reasonable expectation of profit, in the years subsequent to the taxation years concerned (3.12).

4.03.2(3) Counsel for the appellant submitted that his client had a reasonable expectation of profit. However, he argued that the low income and high expenses incurred by the appellant in leasing his land can be explained by the slump in the world farm market in the early 19805. He submitted that there was no way of foreseeing such a slump when the land was bought by the appellant and if that situation had not occurred, the appellant would have made greater profits.

4.03.2(4) He also added that throughout those years the appellant had the expectation that he would be able to lease his land in subsequent years for a much greater amount than what he was receiving during the said period at issue.

4.03.2(5) Counsel for the appellant based his client’s reasonable expectation of profit first on the income he would receive from the leasing of land and second on the income he could expect to receive as a shareholder in Michel Dupont Inc.

Further, he emphasized the fact that the appellant’s undisputed experience of farming should be seen in relation to the reasonable expectation of profit which he said his client had.

4.03.3 Alternatively to the appellant's preceding argument and in connection with the expenses incurred by the appellant and deducted by him, the respondent argued that the only expenses really assumed by him were those relating to various pieces of land, since he is still owner of them, unlike the farming business and movable property associated with it, which were all transferred to the company in 1984 and which are no longer owned by the appellant (3.01.3). Consequently, the respondent submitted that the transfer meant that the source of income from the said farming business no longer belongs to the appellant, and so the deductions claimed for that (preferred shares and expenses relating to the transferred property, and so on) cannot therefore be deducted, since they are now in fact borne by the company and no longer by the appellant.

He therefore argued that for the years at issue, the appellant's land could not reasonably be regarded as having been held in the course of a business carried on by the appellant.

4.03.4 Contrary to the respondent's arguments, the appellant maintained that the interest expenses incurred are fully deductible since the land was used first to acquire business property which was subsequently (in the transfer) transformed into preferred shares.

He also indicated that although from a legal standpoint the appellant and the company are in fact two separate and autonomous individuals, from a primarily economic standpoint this operation is actually an economic entity, and this is illustrated by the fact that the appellant personally leases land to the corporation which in turn probably operates the farming business.

4.04 Alternatively, the respondent argued that the appellant had not incurred the expenses claimed (advertising, permits and so on) in order to produce income from property and therefore were not deductible.

He noted that the advertising expenses incurred by the appellant are uncertain since the latter leased land to the company. He therefore had no need to advertise it. He further added that the permits held by the appellant conferred on him certain advantages in purchasing farm products and that was the only reason for having them. These permits were not held for the purpose of producing income from the property in question.

4.05 Analysis by the Court

With reference to the arguments described above, this Court considers that at this stage of the analysis it should first examine whether the facts and circumstances of the instant case enabled the appellant to expect making a profit from leasing his land.

4.05.1 As mentioned in the well-known case of Moldowan v. The Queen (4.02(10)), in order to have a "source" of income, the taxpayer must intend to make a profit or have a reasonable expectation of profit.

The reasonable expectation of profit must be objectively determined using certain criteria such as the taxpayer's experience in the field in question, as in the instant case. These different factors will of course vary depending on the nature and size of the business. Such a determination therefore cannot be made on a subjective basis. Accordingly, the fact that when the land was purchased the taxpayer "intended" to earn income from it cannot suffice to establish that there was in fact a reasonable expectation of profit.

Although the appellant probably had considerable experience in the farming business, does this fact mean that there was actually a reasonable expectation of profit? I do not think so.

4.05.2 To the argument that the collapse of the international farm market led to the situation here of losses resulting from the leasing of land, this Court replies that such an argument can have no significance in the instant case.

The appellant himself indicated in his notice of appeal that he was leasing the farmland to the company in consideration of a rent equal to or greater than the market rate (3.07). It thus appeared that he was receiving the maximum amount from this lease that he could or might have obtained on the market during that specific period. However, he made no profits during that period, any more than during subsequent years, that is 1988 and 1989 (3.12). That is not all. The evidence also showed that the expenses incurred by the appellant to lease his land were almost entirely interest expenses connected with the land purchased by him (3.10). They were thus foreseeable, since the appellant had obtained loans to purchase his land in 1981 (3.01, 3.02). He was thus aware of the interest expense the latter entailed in proportion to his leasing income.

It seems difficult in such circumstances to have a reasonable and genuine expectation of profit from leasing the land.

4.05.3 The Transfer

In 1984 and 1985 the appellant transferred his farming business, inter alia, in return for preferred shares, a transaction which in fact occurs fairly frequently. In the instant case it was part of the process of incorporating the farming business formerly operated by the appellant.

4.05.4 This transfer concluded between the appellant and the company is a legal fact which has certain consequences. It is a fundamental principle that a company is a legal entity, independent of its shareholder. Accordingly, the portion of interest on the loan allocated as the financing source for the farming business, namely $71,900 (3.01.2), which later became the company's operation, cannot properly be deducted by the appellant since the income source in fact no longer belonged to the appellant but actually to the company.

This also applies to the amount of $10,000 allocated to the building located on the farmland purchased for $48,000 (3.01). In this case too, the transfer meant that the building was no longer the appellant's responsibility but was definitely that of the company.

In transferring the farming business to the company Michel Dupont Inc., the sources of income were transferred and so the deductions claimed on their account cannot properly be granted to the individual Michel Dupont. The appellant's argument that the connection existing between Michel Dupont and the company after the transfer makes it actually one economic entity (4.03.4) cannot negate the legal consequences of such an operation.

4.05.5 Subsection 18(2) of the "Act"

At the hearing counsel for the parties each energetically defended their positions (4.03.01(1)), seeking to persuade this Court to adopt their own interpretation of subsection 18(2), and in particular its final paragraph, reading:

. . .except to the extent that the taxpayer’s gross revenue, if any, from the land for that year exceeds the aggregate of all other amounts deducted in computing his income from the land for that year.

4.05.6 The complexity, indeed the ambiguity, of certain sections of the Income Tax Act has many times been criticized. However, it is not the function of the courts to increase the confusion surrounding the implementation of some of those sections and that is why an analytical approach tending more toward the major classical principles of interpretation is to be preferred.

4.05.7 Interest was formerly regarded as capital, as explained in Bronfman Trust (4.02(9)) at page 45. Thus, the provisions relating to the deduction of interest are in fact exceptional provisions. The rules of interpretation require that they be generally given a limiting interpretation and application. As we already mentioned above (4.03.1(1) et seq.), while the appellant relied primarily on a broad interpretation of subsection 18(2) of the Act, the respondent suggested an interpretation based on the principle that the legislature never speaks in vain and that accordingly to accept the appellants interpretation would deny this principle, since it would deprive subsection 18(2) of all significance by giving it the same force as paragraph 20(1)(c) (4.03.1(2) in fine).

4.05.8 The Income Tax Act contains certain special provisions dealing with the deduction of interest costs. Subsection 18(2) of the Act is part of them.

There are also paragraph 20(1)(c) and 18(1)(a) of the Act. The first permits the deduction on certain conditions of interest borrowed to produce income from a business or property. The second excludes the deduction of an expense not incurred for the purpose of gaining income from a business or property.

The Court accordingly considers that the nature of the instant case requires the interpretation of one subsection, namely 18(2) of the Act, in light of the others, namely paragraph 18(1)(a), 20(1)(c) and 53(1)(h) of the Act. Further, the interpretation given to subsection 18(2) of the Act must give it a meaning which makes it possible to attain its fiscal purpose.

In his text entitled Interprétation des lois (1982), Pierre-André Côté comments as follows:

Modern authorities generally agree that fiscal statutes should not be construed by a strictly literal method, but rather by the normal methods that apply to all legislation. The task is to discern the legislator’s intent by studying the words in the context of their enactment. /n particular, this implies that the enactment's object must be considered.

[Translation; emphasis added.]

4.05.9 What then is the real purpose of subsection 18(2) of the Act?

The Court considers that it is intended to impose a limitation on deduction of interest relating to loans used to acquire land.

This is not only true in certain circumstances, as counsel for the appellant argued in (4.03.1(4)), but whenever an interest deduction is possible under subsection 18(2) of the Act.

Consequently, expenses of which the deduction is thus prohibited under subsection 18(2) of the Act will under paragraph 53(1)(h) of that Act be added to the adjusted cost base so that the latter will be deducted only when the property is disposed of in the future.

Section 53(1)(h) reads as follows:

53(1) In computing the adjusted cost base to a taxpayer of property at any time, there shall be added to the cost to him of the property such of the following amounts in respect of the property as are applicable:

(h) where the property is land of the taxpayer, any amount paid by him after 1971 and before that time pursuant to a legal obligation to pay

(i) interest on borrowed money used to acquire the land, or on an amount payable by him for the land, or

(ii) property taxes (not including income or profits taxes or taxes imposed by reference to the transfer of property) paid by him in respect of the property to a province or to a Canadian municipality,

to the extent that that amount was, by virtue of subsection 18(2), not deductible in computing his income from the land or from a business for any taxation year commencing before that time.

Once again, what purpose would subsection 18(2) of the Act really serve if it only restated what was already permitted under paragraph 20(1)(c) of the Act?

The former taken together with the latter requires this Court to construe the first part of subsection 18(2) of the Act (that is, up to paragraph (b)) as a general limitation on paragraph 20(1)(c) regarding interest paid to acquire land (and real estate taxes). Additionally, the Court interprets the second part (that is, from “if, having regard to. . .” up to paragraph (e)) as a mitigation of the general limitation in the first part. Finally, the Court regards the last paragraph (” . . .except to the extent”) as a limitation on the earlier mitigation.

4.06 Expenses

The facts and circumstances of the instant case appear to indicate the uncertain nature of the advertising, promotion and licensing expenses incurred by the appellant.

The appellant was well aware of the fact that his land would be leased by the company Michel Dupont Inc., and so testified himself. As such, the promotion and advertising expenses are surprising.

4.06.1 As to the costs incurred for licences and permits, the respondent argued that they were only obtained so as to retain the farm cards and to benefit from certain privileges. This Court sees nothing wrong with doing that. However, the taxpayer cannot expect to go beyond certain limits in preserving his interests.

He cannot expect to deduct expenses incurred in order to obtain permits when they were not used in order to earn leasing income.

4.06.2 Accordingly, for the foregoing reasons, the evidence submitted favours the respondent's position.

5. Conclusion

For the foregoing reasons the appeal is dismissed.

Appeal dismissed.