Dennis Hughes v. Minister of National Revenue, [1990] 1 CTC 2125, 90 DTC 1021

Mogan, T.C.J.: — The issue in this appeal is whether, in 1982 and 1983, the appellant’s chief source of income was farming or a combination of farming and some other source of income. The appellant is a medical doctor who practices his profession in Medicine Hat, Alberta. He, his wife and their two daughters live on 65 acres of land three miles south of Medicine Hat where he has operated a purebred Arabian horse farm from 1979 to 1989 when this appeal was heard. In each of the years under appeal, the farm suffered a loss which the appellant consolidated with the profit from his medical practice when computing income. The respondent relied on section 31 of the Income Tax Act and reduced to $5,000 the amount which the appellant could deduct in each year when computing income.

The appellant was raised in rural Alberta and as a youth had a close connection with livestock. At various times, he owned a pony, a sow and a mare from which he raised and sold a number of ponies, pigs and foals respectively. The appellant attended university where he studied to become a veterinary surgeon. Upon graduation, he worked for a period of time ina large animal practice in Alberta but concluded that the personal and financial rewards would be greater in medicine. Accordingly, the appellant attended medical school and graduated as a physician in 1973. At that time, the appellant and his wife borrowed money to buy their first purebred Arabian, a yearling filly.

From 1973 to 1975, the appellant was at the Foothills Hospital in Calgary training in internal medicine. In 1975, he transferred his training to the University Hospital in Edmonton. Also in 1975, the appellant and his wife purchased their second mare and they had their first foals in 1976. He was influenced in moving to Edmonton because he could continue raising his Arabian horses by keeping them on his parents' land at Ponoka, Alberta.

In June 1977, the appellant finished his training in internal medicine and moved to Medicine Hat, Alberta where he commenced his professional practice. At that time, he and his wife rented a house while they were searching for a farm. In the fall of 1977, they purchased 65 acres approximately three miles south of Medicine Hat on which they planned to establish their purebred Arabian horse breeding operation. Actually, they moved their horses onto the land in the fall of 1977 before they took up residence there in the spring of 1978.

There was no house on the land and so the appellant and his wife borrowed a mobile home from his parents; moved it to their land; and set up residence there with two infant daughters in the mobile home. Indeed, even when this appeal was heard in 1989, the appellant and his wife and the two teenaged daughters were still living in the mobile home with a modest addition because they had expended most of their capital in building a barn, improving the land and expanding their stable of horses.

There is no doubt that the appellant and his wife are dedicated to the breeding and raising of purebred Arabian horses. When they moved to their farm in 1978, they had to drill a well and have utilities (electricity and natural gas) installed. The appellant and his wife do much of the work on their farm. In 1978, they put up a fence along the irrigation ditch which crossed their property. In 1979, the appellant researched literature on barns and he did the design and site planning for a barn (86 feet x 36 feet) which was constructed on their land. The appellant constructed eight stalls for horses in the barn. He and his wife removed a number of cross fences so that their land could be more effectively worked. Most of their available cash, however, was invested in breeding stock.

The appellant embarked on a program of line breeding which, I understand, concentrates the presence of one really good stallion in the pedigrees of his horses to increase the probability of producing a higher quality of horse for the marketplace. The stallion that he has concentrated in his pedigrees is “PIETUSZOK DWA" which was bred in Russia and has produced outstanding horses that are good under saddle physically and psychologically. PIETUSZOK DWA is a syndicated stallion for which the appellant paid $20,000 in 1978 to acquire a /4o share. One of the appellant's mares foaled a colt by this stallion in 1979 which was sold in 1980 as a yearling for $25,000.

By 1982 and 1983, the years under appeal, the appellant had acquired 16 to 18 horses which were valued at year end between $280,000 and $350,000. In those years, the appellant also owned shares valued at $50,000 in two stallions. There was produced in evidence an article written by the appellant in a magazine entitled "Canadian Arabian News" extolling the virtues of “El Kasaka", one of the stallions in which the appellant owns a syndicated share. Also produced in evidence were a number of high quality coloured brochures which the appellant and his wife used to market their horses under the name "Hughes Arabians".

Notwithstanding the dedication of the appellant and his wife to the breeding and raising of purebred Arabian horses, their horse farm has lost money in every year. Set out below is a comparison of the appellant's net income from his medical practice and the results of operating his horse farm for the years 1979 to 1987.

From 1977 to June 30, 1983, the appellant carried on his medical practice in a partnership with about 25 other doctors under the name “Medical Arts Clinic’. After June 30, 1983, the appellant continued his medical practice with most of the same doctors through a joint venture under the same name. As a specialist in internal medicine, the appellant received many of his patients by reference from other doctors and, through the clinic, he had good control over his hours of work. In effect, the appellant was able to work a regular day from 8:30 a.m. to 4:30 p.m. like many other persons subject to taking his turn on call for nights and weekends.

The appellant entered in evidence a document (Exhibit A-5) which provided detail as to how he allocated his time between his medical practice and his farm operation. In summary, the appellant's time was allocated as follows:

Exhibit A-5 described certain farm business which the appellant could do in his medical office and certain farm work he could perform if he went home for lunch. He spent absolutely no time in the doctors' lounge at the hospital. Although the appellant's time allocated to farming may be somewhat overstated, there is no doubt that he has committed a significant portion of his time and energy to his farm operation.

A separate schedule (Exhibit A-6) demonstrated that in any relevant year (i) the appellant had substantially more of his capital invested in his farm than in his medical practice; and (ii) the annual cash income derived from his medical practice was, after providing for personal expenses, totally consumed in the farm operation to the extent that the appellant was left with a net cash deficit at the end of each year.

In 1982 and 1983, the appellant had deducted in computing income his farm losses of $99,899 and $105,185 respectively; and the respondent relied on subsection 31(1) of the Income Tax Act to reduce to $5,000 the amount deductible in each year.

31(1) 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 his loss, if any, for the year from all farming businesses carried on by him shall be deemed to be the aggregate of

(a) the lesser of

(i) the amount by which the aggregate of his losses for the year, determined without reference to this section and before making any deduction under section 37 or 37.1, from all farming businesses carried on by him exceeds the aggregate of his incomes for the year, so determined from all such businesses, and

(ii) $2,500 plus the lesser of

(A) /2 of the amount by which the amount determined under subparagraph (i) exceeds $2,500, and

(B) $2,500, and

(b) . . .

The respondent allowed the $5,000 deduction under subsection 31(1) of the Act on the assumption that the appellant was farming with a reasonable expectation of profit. Otherwise, the respondent would have used paragraph 18(1)(h) of the Act to disallow the deduction of all the appellant's farm losses as "personal or living expenses" applying the definition of those words in subsection 248(1).

For the reasons set out below, I have concluded that the appellant’s chief source of income for 1982 and 1983 was neither farming nor a combination of farming and some other source of income. During those two years, the appellant had only one chief source of income and that was his medical practice.

A reconciliation of the many cases decided under subsection 31(1) of the Act is a daunting challenge which, hopefully, can be by-passed as a consequence of certain recent decisions. The starting point of any case study is Moldowan v. The Queen, [1978] 1 S.C.R. 480; [1977] C.T.C. 310; 77 D.T.C. 5213 in which Dickson, J., as he then was, stated at page 314 (D.T.C. 5215):

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.

In Morrissey v. Canada, [1989] 1 C.T.C. 235; 89 D.T.C. 5080, the Federal Court of Appeal has recently considered subsection 31(1) of the Act as construed by Moldowan. Mahoney, J. delivered the reasons for the majority in Morrissey and, after quoting the learned judge in the Trial Division, Mahoney, J. stated at pages 241-42 (D.T.C. 5084):

With respect, I do not agree that Moldowan suggests disjunctive consideration of pertinent factors in quite the way the learned trial judge has dealt with them. The discussion in Moldowan begins as follows:

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.

Moldowan also says, dealing with the difference between classes 1 and 2, “while a quantum measurement of farming income is relevant, it is not alone decisive”. While the determination that farming is a chief source of income is not a pure quantum measurement, it is equally not a determination in which quantum can be ignored.

The appellant has admitted that the respondent was farming with a reasonable expectation of profit. That means he was farming as a business and is conclusive that he was not a class 3 farmer. It also implies that farming was a potential source of income and calls for an enquiry whether it was potentially a chief source of income either alone or in combination with another source. In considering s. 31(1), it seems to me that potentiality, rather than actuality, is the question in all cases since the provision applies only where there is a loss in a taxation year. That is not, of course, to say that actual profitability in other years may not be evidence of the potential for profit in years of losses.

Moldowan suggests that there may be a number of factors to be considered but we are here concerned only with three: time spent, capital committed and profitability. In defining the test as relative and not one of pure quantum measurement, Moldowan teaches that all three factors are to be weighed. It does not, with respect, merely require that farming be the taxpayer’s major preoccupation in terms of available time and capital.

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.

I quote at length from Morrissey because two subsequent decisions in the Federal Court-Trial Division accept the decision in Morrissey as clarifying the manner in which the tests from Moldowan are to be applied. In Mohl v. The Queen, [1989] 1 C.T.C. 425; 89 D.T.C. 5236, Strayer, J. stated at page 428 (D.T.C. 5238):

It now appears clear from the Supreme Court decision in Moldowan as recently interpreted by the Federal Court of Appeal in Her Majesty the Queen v. Morrissey that, 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).

And in Hoeft v. Canada, [1989] 1 C.T.C. 350; 89 D.T.C. 5144, Martin, J. also relied on the decision in Morrissey and used profitability as an important factor along with time spent and capital invested.

The appellant’s farm has never been profitable. From 1979 to 1987, the appellant accumulated farm losses of approximately $870,000. In each of those years, farm expenses plus capital cost allowance were at least two times farm revenue and, in certain years, farm expenses plus capital cost allowance were greater than three times, four times or five times farm revenue. If in 1988 the farm were to show a profit of $54,000 (an amount equal to the lowest loss in the preceding nine years), the appellant could conceivably argue that his farm had become profitable but this would still be a long way short of proving that it was or could reasonably be regarded as his chief source of income. In The Queen v. Connell, [1988] 1 C.T.C. 247; 88 D.T.C. 6166, Strayer, J. stated at page 250 (D.T.C. 6168):

While the Minister has, by applying subsection 31(1), conceded that the taxpayer’s farming is “a source of income" and this implies some expectation of ultimate profitability, this is not determinative of whether the taxpayer could have a reasonable expectation that his farm income would be his chief source of income either alone or in combination with another source of income.

On the facts it is difficult to see how he could have had a reasonable expectation of his farm income even being significant in relation to his employment income so as to constitute one of his chief sources of income.

The appellant relies on the decision of the Federal Court-Trial Division in Timpson v. The Queen, [1987] 1 C.T.C. 389; 87 D.T.C. 5266 in which a medical doctor who practiced at Collingwood, Ontario was allowed to deduct in 1977 and 1978 the losses he suffered from operating his purebred Hereford cattle farm. The learned trial judge in Timpson relied on the decision in Hadley v. The Queen, [1985] 1 C.T.C. 62; 85 D.T.C. 5058 in which a successful businessman was allowed to deduct the losses he suffered in operating a purebred Charolais cattle farm. In the Timpson and Hadley cases, the taxpayers were able to establish that farming was a “chief source of income” by proving that they had a significant amount of time spent and capital invested in their respective farm operations. In my view, the more recent decision of the Federal Court of Appeal in Morrissey, supra, indicates that “profitability” is a third factor just as important as time spent and capital committed. Mahoney, J. stated 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.

The reasons for judgment in Timpson are silent concerning the relevant financial information (revenue, expenses, profit or loss) with respect to the taxpayer's medical practice and Hereford cattle farm although such information appears in the earlier Timpson decision in this Court [1985] 2 C.T.C. 2114 at 2116-17 (85 D.T.C. 446 at 448). After the Federal Court decision in Hadley, it may have been thought that a taxpayer had to prove only capital committed and time spent in order to establish farming as a chief source of income. The following statement by Strayer, J. in Mohl, supra, shows the new importance of profitability:

It now appears clear from the Supreme Court decision in Moldowan as recently interpreted by the Federal Court of Appeal in Canada v. Morrissey, [1989] 1 C.T.C. 235; 89 D.T.C. 5080 that, 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.

The comments of the learned trial judge at page 394 (D.T.C. 5270) in Timpson concerning start-up costs would, I think, have to be modified as a result of the decision in Morrissey.

In this appeal, I have no difficulty in finding that, for 1982 and 1983, the profitability of the appellant's Arabian horse farm was "improbable"—to use the word of Mahoney, J. in Morrissey. The appellant's farm recorded consistent losses and he had to inject additional capital of $870,000 to sustain the farm operation from 1979 to 1987. Although a particular type of farming may require 10-15 years from a standing-start to earn a profit and thereby have an expectation of profit, such expectation does not mean that the losses suffered in the long start-up period become the taxpayer's chief source of income. Indeed, one’s imagination is stretched to the limit by regarding such long start-up losses as a source of income at all, leaving aside the "chief source" concept.

Expert evidence was given by Dr. George Allen, a veterinarian from Taber, Alberta who owns and operates one of the largest and most successful Arabian horse farms in North America. Dr. Allen has visited the appellant's farm on a number of occasions and he described it as “simple, effective and efficient”. In his opinion, the appellant's 65 acres would support about 42 head of horses representing 12 brood mares, 10 foals, 10 yearlings and 10 two- year olds. Thereafter, the appellant would have to sell each year a number of horses equal to his foal crop without selling only the foals.

Dr. Allen expressed the opinion that it would take 10 to 15 years to establish a breeding herd of purebred horses to make a profit in the open market. That opinion would, of course, assume a certain stability in the market for Arabian horses. In his own experience, he described how the Arabian horse business "ran wild” in the early 1980s and then suffered a “radical drop" around 1984/85. He also described how the market had changed dramatically in that it now demands horses trained under saddle that can compete in various athletic functions. According to Dr. Allen, the "end use", of an Arabian horse is to be ridden by an amateur—mainly in one of two groups age 15 to 25 or age 35 to 55. The appellant has therefore decided to develop a farm product which, unlike grain or dairy cattle, does not have an universal demand as food but sells to a relatively limited market.

Dr. Allen is, no doubt, an expert in the breeding of Arabian horses and his projection of 10-15 years to make a profit with a purebred herd from a standing start may be accurate. That projection begs the question as to whether, for income tax purposes, it is reasonable for a taxpayer to deduct start-up losses for 10-15 years before turning a profit. Can such a business, so capitalized, be regarded as the appellant's chief source of income during that 10-15 year period? In Moldowan, supra, Dickson, J. referred to the objective determination of whether a taxpayer has a reasonable expectation of profit and he cited certain criteria including "the capability of the venture as Capitalized to show a profit after charging capital cost allowance". Perhaps the words “as capitalized” in Moldowan indicate that a taxpayer who decides to farm should have enough capital to acquire his chosen product at a relatively mature stage (if it is horses, cattle, or fruit trees) or to grow his chosen product within a few crop years (if it is grain, hay or vegetables) so that he can get the product to market in some reasonable time without having to suffer and deduct start-up losses over a period of many years.

The Supreme Court of Canada stated in Moldowan that 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. The appellant’s reasonable expectation of income from his medical practice is proven, substantial and consistently positive; whereas his reasonable expectation of income from his farm is at best remote in time and possibly negative. Farming was not the centre of the appellant's work routine. Quite the opposite, his medical practice was the centre of his work routine because he attended at the clinic and hospital on a daily basis from about 8:30 a.m to 4:30 p.m; and his farming work, although greater in hours, was fitted in around his medical practice.

For 1982 and 1983, the appellant completed one of the blank spaces on the face of his income tax returns as follows:

And in the years 1984 to 1987, he responded to the same blank space by designating his occupation only as “farmer”. Such a self-serving designation does not assist the appellant when it flies in the face of common sense by ignoring the occupation (i.e. his medical practice) which provides him and his family with the necessities of life and the financial ability to operate the money-losing horse farm. The appellant would be insolvent if he were only a farmer.

Applying the above cases to the facts in this appeal, I find that the appellant has passed the tests of “time spent" and “capital committed" with respect to his Arabian horse farm. On the other hand, I find that the appellant has failed to demonstrate that there is a reasonable expectation of his farm being significantly profitable or even profitable relative to the income he has in fact earned and may expect to earn from his medical practice. When the appellant decided to farm and chose a product which required 10-15 years to develop from a standing-start before it could be taken to market in sufficient quantity to be profitable, he made it difficult for himself to prove that he had a reasonable expectation of profit during his long product development period. Market conditions 10-15 years hence are unpredictable for most farm products particularly if they are non-food products. Suppose a person had decided in the 1%0's to grow tobacco or raise mink. It is common knowledge how public opinion has affected the market for cigarettes and fur garments in recent years.

Certain farm products like wheat, eggs, milk and butter are regarded as basic foods and a government (federal or provincial) will sometime establish a marketing board to protect the farmer by providing an assured buyer and a stable price for such products. Other farm products like Arabian horses are not basic foods and may even be regarded as luxury items. It is most unlikely that there would be any government marketing board to protect the person who breeds and raises Arabian horses. When the appellant started his Arabian horse farm in 1979, he had no way of looking 10-15 years into the future and knowing how many other persons would be bringing Arabian horses into the market in the period 1989-1994.

When the appellant will have been farming 10-15 years, Arabian horses could be a glut on the market or the appellant may not be able to compete in price with those who are breeding and raising Arabian horses in greater numbers or with better blood lines. The evidence of Dr. Allen demonstrated how quickly the market for Arabian horses could swing from "running wild" in the early 1980s to a “radical drop" in 1984/85. In all the circumstances, a 10-15 year development period is too long for the appellant to prove that his Arabian horse farm had a profit potential which would make it his chief source of income during the development period either alone or in combination with some other source of income.

The appeal is therefore dismissed.

Appeal dismissed.