John W. Rose v. Minister of National Revenue, [1988] 2 CTC 2246, 88 DTC 1559

Sarchuk, T.C.J.:—John W. Rose ("Rose") appeals with respect to reassessments of income tax for his 1979, 1980 and 1981 taxation years. Two issues are raised by him. In filing his income tax returns for the years in issue the appellant sought to deduct certain amounts as management fees. By way of reassessment of those taxation years the respondent disallowed their deduction in the amounts of $3,193, $3,479 and $4,548 respectively on the basis that these amounts were not shown to have been outlays or expenses incurred for the purpose of gaining or producing income within the meaning of paragraph 18(1)(a) of the Income Tax Act ("the Act") or that the said amounts were reasonable in the circumstances within the meaning of section 67 of the Act.

Furthermore, in computing his income for those taxation years, the appellant reported farming losses in the amounts of $5,000, $26,948 and $23,943 respectively. The respondent reassessed the appellant in accordance with subsection 31(1) of the Act and disallowed farming losses in excess of $5,000 in the 1980 and 1981 taxation years, being $21,948 and $18,943 respectively.

With respect to the deductibility of management fees the respondent is now prepared to consent to judgment on the basis that the appellant is entitled to deduct the amounts of $1,594, $1,802 and $4,548 in taxation years 1979, 1980 and 1981 respectively as additional amounts of management fees.

The appellant submits that with respect to the farming losses the respondent erred in assessing on the basis that the taxpayer's chief source of income in the relevant taxation years was neither farming nor a combination of farming and some other source of income. The appellant contends that by virtue of the extensive capital invested by him in his farming operation and the degree of effort and time expended by him in running his farming business, he was properly entitled to claim the losses incurred by him in that his chief source of income for those taxation years was from farming and the conduct of his professional business.

The facts relevant to this issue can be briefly summarized. The appellant is a physician. He received his medical degree from Durham University in England and came to Canada in 1953. He has been engaged in the practice of medicine for some 35 years. Although he initially lived in Toronto, in 1955 he moved to Wawa, Ontario, where he lived for ten years. Medical problems with two of his children, however, required him to return to southern Ontario and, in 1965, he moved to Cobourg, Ontario, where he joined an already existing family practice with three other doctors. Shortly thereafter he was appointed to the staff of the Cobourg District General Hospital and for a short period of time was the Chief of Staff for the hospital.

The appellant's medical practice served a town of approximately 11,000 people as well as a nearby town of 7,000 people and a rural community of approximately 25,000. In the period 1965 to 1971 the appellant's practice required his attendance at the clinic from 8 o'clock in the morning to 5 o'clock at night and an additional two to three hours two evenings per week. He was also on call two nights of each week and one weekend in four. The clinic of which he was a member began to expand in 1973 and by 1978 they had added three physicians. The call obligations were somewhat relieved at that point of time and the appellant was down to one call each evening and one weekend in five, a schedule which he follows to this day. When on call to the clinic he is responsible, after regular clinic hours, for attending to the clinic’s patients on behalf of all of the other doctors. Periodically the appellant is also on call for the town which means that he is responsible for seeing any patient who appears at the hospital and did not have a local practitioner.

Prior to 1971 the appellant and his family owned horses acquired for pleasure riding and because he had been advised that it was a very good therapy for the two children who had medical problems. These horses were stabled ouside of Cobourg. For several years prior to 1971 the appellant, together with an acquaintance, owned 300 acres of range land near Cobourg. However it became apparent that the relationship was not satisfactory and a friendly arrangement was made to separate. In 1971 the appellant acquired the farm which forms the subject matter of these appeals. Essentially the appellant, who had no experience with farming whatsoever, was motivated to purchase the farm by the fact that he felt hemmed in, living in southern Ontario, and wanted to own sufficient land to be able to wander around freely. At the time of its purchase the farm was totally run down. It consisted of an uninhabitable farmhouse; an equally dilapidated barn and a driveshed; and approximately 120 acres of land, none of which was capable of being immediately farmed. The purchase price was $33,000.

Over the course of the next several years the appellant effected numerous improvements to the farm. The first year was devoted to renovating the house which had to be completely gutted and repaired. That task was performed by a contractor hired for the purpose and was completed in time to permit the family to move onto the farm in 1972. The barn required a thorough cleaning out and substantial restoration. The driveshed required repairs. There was no fencing. The fields had lain fallow for many years and were overgrown; the pastures had gone to seed, and a great deal of work was required to bring them back into an arable condition. Substantial portions of this work was contracted out, however, most of the unskilled work such as picking rocks, removing small brush and weeds, was done by the appellant and his children who were teenagers or young adults at the time.

The appellant personally spent some three and a half hours a day as well as considerable time on weekends in performing necessary tasks around the farm. He took evening courses in small farm and squire management at several nearby community colleges. By the taxation years in question the barn was functional; horse stalls had been constructed and a tack room and wash rack had been incorporated into the building. Pens and corrals had been fenced and some 60 acres were under cultivation in hay. Forty acres of pasture were also available for the stock. By that time the appellant had accumulated approximately 20 horses and 12 cows.

The appellant's principal interest is in Quarter horses. Originally an all- purpose horse bred to work cattle, it has now developed to the point where Quarter horses are trained and shown in various disciplines, are raced, and are popular pleasure horses. Although the appellant's initial involvement was purely for recreational purposes, following the acquisition of the farm he took courses in equine studies and in 1974 started breeding Quarter horses. Concurrently he became interested in showing his horses. At that point of time the appellant admittedly did not know very much about breeding but was in the process of reading and talking to people and developing an interest in it. In 1978 the appellant succeeded in selling one of his first bred horses for $16,000 (U.S.) at one of the largest Quarter horse shows in Columbus, Ohio. This horse had performed well, having been shown by the appellant's son Alistair. It had gained a large number of “halter points" and had won a three-year-old futurity. He was understandably elated as a result of this sale, which incidentally was the first sale of a Rose bred horse, and he concluded that there was money to be made in the Quarter horse business and decided to embark on that course.

Prior to 1978 the farm, in the appellant's view, had largely been a simple operation, an exercise for his family, but following the sale he began to think that there was a good potential for something beyond that and that he should go into a commercial breeding operation. He had a stallion on his property who had been the sire of the horse that had been sold as well as other brood mares. The appellant believed there was a "good chance of doing well with the stallion” and proceeded to breed more mares in an attempt to duplicate the 1978 success. The appellant threw himself into this new activity with the same enthusiasm he had previously demonstrated towards the farm in general. He and his children took part in virtually all phases of the initial training; they began to show throughout Ontario and the United States; and the appellant became active in both the American and Ontario Quarter Horse Association, becoming president of the latter organization.

Although the appellant said that a commercial animus first arose following the sale in 1978, his income tax returns indicate that he had claimed restricted farm losses in taxation years 1976 and 1977. Whatever the actual commencement date, the evidence is that at no point of time did he ever succeed in making a profit. In those years when Rose says that he began to view his farm as a commercial operation, he chose to rely on his own skills and acquired knowledge. He did not, however, at any time seek any professional advice with respect to the economic viability of the proposed operation nor did he at that time draw up an overall business plan for the farm. Moreover, throughout this period, he was still totally engaged in the practice of medicine and, as the following schedule of his income indicates, was earning substantial income therefrom:

The column "earned income” is taken from the appellant's Exhibit A-7 and represents earned income from the partnership. The column "professional income" is found in the respondent's Exhibit R-1(7) and is the appellant’s income from the practice of medicine for tax purposes. Nothing of import hinges on the different methods of presentation.

In addition the appellant made certain other investments which were generating income, albeit limited.

A number of reasons were advanced by the appellant to account for the continued inability of the farm operation to show a profit in the taxation years in issue and in the immediately succeeding years. The first related to expenses described by the appellant as extraordinary which were incurred in the 1981 to 1985 years. According to Rose, at least until 1979, the operation was conducted principally by the family. His son Alistair did the bulk of the training, and was, with his sister Lindis, involved in showing the horses. A successful showing was, according to the appellant, an essential part of establishing the quality of his stock without which sales could not be expected to increase. At some point of time in 1979 Alistair left for Alberta where he continued to be involved in the horse business. Shortly thereafter, the appellant hired Sue Leppard as a trainer. Her arrangement required her to live on the farm, but permitted her to be employed in the same capacity by other clients with the added right to bring in outside horses to the Rose farm. Early in 1980 the appellant’s daughter Lindis left the farm. In 1981 Leppard relocated to another stable some 25 or 30 miles removed from the appellant's farm. The "extraordinary" costs incurred in those years were generally described by the appellant as the cost of boarding, training and transportation. These costs included Leppard's expenses, which after 1981 included the transportation of Rose's horses to and from her new location. Additional "extraordinary" costs were incurred in transporting several horses to Alberta and later to California to be trained by the appellant's son Alistair.

The appellant told the Court that those horses that required training that he could not give them personally were shipped to his son. The rationale was that these were expenses that would not have been incurred if the horses had been trained on the farm but, with the departure of Alistair and later Leppard, there was nobody available to train them there and such expenses were therefore justified.

The second reason advanced was that during the period 1978 to 1981 the appellant made a number of poor and ill-founded business decisions. The departure of his daughter meant the loss of a competent rider and the departure of Alistair meant the loss of a trainer and the hiring of a replacement became a necessity. However according to Rose the hiring of Leppard was an error. Although he did not recognize it initially, he ultimately concluded that during the years that Leppard was training and showing his horses they were being shown unsatisfactorily, as a result of which she was eventually dismissed. Other trainers were subsequently hired, with limited success. These problems were alleged to have been a factor in the poor financial results in those years.

The principal error in judgment made by the appellant was his failure to cull out certain brood mares in the years 1978 to 1981. He believed that the quality of his breeding stock was excellent and he refused to take any action. He said, and I quote:

I suppose I still had hopes that they would produce if they were bred to good stallions and he had produced good babies for me. For two years I went the wrong way. It was a poor decision.

A further error in judgment occurred in 1982 while Alistair was "out West", and the appellant attempted to expand his operation by investing in cutting horses. This breed of horse had become extremely popular in Western Canada and Rose concluded that it was important to become involved, particularly if his son Alistair could do the training. Rose believed that there was more money to be made in cutting horses than there was in the Quarter horse business and he therefore made what he described as a major investment in that direction. A yearling cutting horse, a brood mare, a yearling halter horse and a reining horse were purchased. Shortly thereafter the cutting horse business deteriorated and this venture came a cropper.

It should be noted that Rose had not considered this sector of the horse breeding business prior to or during the taxation years in question, and its relevance is questionable. Nonetheless it was advanced as another reason for the continuing financial failure of the farm operation.

The appellant further alleged that in several years he had substantial losses of stock. In 1980 he lost four horses including one of his better brood mares which died in foal. A gelding became lame and was put down. A show horse contracted a common equine disease and died. A foal colicked and died just after being weaned.

It was the appellant's evidence that the operation is expected to be profitable in the future because Alistair had returned to the farm and had taken on the responsibility of breeding and training the stock. Alistair is qualified to show and train any horse in any discipline. He has competed successfully in California and Alberta shows and since his return in Ontario shows as well. With the return of Alistair it will no longer be necessary to incur any “extraordinary expenses". In 1985 the operation turned the corner, and the first two years under Alistair’s guidance enable Rose to say that the stock he has on hand is second to none in Ontario. The current arrangement is that Alistair is not an employee, and is not paid any wages. His income, if any, is to be generated by way of commission on the sale of stock. The cost base of any horse sold is to be determined by calculating the cost of breeding and raising the horse as well as the cost of showing it. These costs are deducted from the sale price and Alistair's commission is to be 50 per cent of the resulting profit.

Based on the evidence adduced counsel for the appellant contended that the appellant, having determined to go into horse breeding as a business, purposely went out and prepared himself. He took courses and he became involved in various associations to the point that he became a director and executive in these organizations. He learned the horse business well enough to establish himself as a quality breeder. At all relevant times the appellant spent and continues to spend considerable time, effort and energy in developing his business. It was submitted that not too much weight should be placed on the financial failures in the years in question since these could be accounted for by certain errors of judgment made in 1978 and 1979. These errors and the problem arising from not having competent trainers during the years 1981 to 1985 have now been rectified.

Substantial amounts of capital were invested in the operation over a period of some ten years and notwithstanding the losses the appellant continues to invest capital and will continue to do so until the operation is successful. The value of the stock inventory increased from $60,000 in 1979 to some $115,750 in 1986. From all of the foregoing it was submitted that the appellant has demonstrated that farming was a substantial activity and not a casual pastime.

The issue here with respect to the 1980 and 1981 taxation years is whether the appellant's income from his horse breeding operation was a “chief source of income" within the meaning of subsection 31(1) of the Income Tax Act. The relevant portion of that subsection provides:

31. (1) Where a taxpayer's chief source of income for a taxation year is neither faming 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 leading decision on the interpretation of subsection 31(1) is Mold- owan v. The Queen, [1977] C.T.C. 310; 77 D.T.C. 5213. In that case Dickson, J. (as he then was) concluded that the Income Tax Act as a whole envisaged 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 respondent says that the appellant falls into the second class of farmers enumerated above. The appellant, for his part, maintains that he is free of the limitations of subsection 31(1) in that he looks to farming for his livelihood.

The factors to be considered in determining the chief source of income were discussed by Dickson, J. at page 314 (D.T.C. 5215-16):

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.

[Emphasis added.]

The evidence before me leads to the conclusion that Rose falls into the second class of farmer. While he is serious about his quarter horse operation and has invested a good deal of money and time, I am satisfied that at all relevant times his responsibility to the medical practice took priority over the farm. That fact is demonstrated by the difficulties he encountered when his son and daughter left the farm, leaving him at the mercy of outside trainers. I am not satisfied that the appellant made a change in his occupational direction, and although at the time of the hearing the farm operation was in its twelfth or thirteenth year, I saw no evidence which convinced me that the appellant's commitment to his medical practice had been reduced or subordinated to his commitment to his horses.

It is clear that the appellant has committed substantial capital to this endeavour. That factor, however, must be viewed in the context of the appellant's approach to his operation. Of all farming endeavours, the raising and selling of “special breed" horses is an undertaking involving extremely high risk. Breeding thoroughbred horses is one prime example, but at least the sector can be described as a large and fairly thriving industry. When one becomes involved in the more esoteric sectors, such as cutting horses, quarter horses, show horses, jumpers and so on, the risks remain high but the market becomes constrained and limited. The appellant himself said that at its peak the Ontario Quarter Horse Association had only 1,500 members, a number now reduced to some 700 or 800. His estimate was that 60 per cent of the members, at the very least, were in it "just for fun”. Given these considerations one would expect that prior to the commitment of reasonably substantial amounts of capital the appellant would have adopted a more pragmatic approach; that he would have made some projections of the capital required; that he would assess fundamental cash flow requirements; that he would consider the optimum size of his operation and its ultimate effect on profitability; and that he would consider the size of the market for his product. It is not unreasonable to expect that if such analysis was too difficult or too time-consuming then independent professional advice would have been sought to ensure a successful and profit-making operation. None of that was done.

Considering some of the other factors identified by the Supreme Court in Moldowan, supra, it is significant that for 12 consecutive years there has been an absence of profit from the appellant's operations. It was not surpris- ing that Rose asserted that in the taxation years in issue his operation, in due course, could be expected to realize its financial goals but I am not satisfied that these assertions are supported by other objective facts. It was necessary for the appellant to adduce evidence capable of satisfying the Court that the horse operation he carried on in the taxation years in issue was soundly structured and directed. However he has failed to do so. His persistence in the face of adversity may be commendable but it does little to assist the appellant. Indeed, one comment made by the appellant suggests that he recognized this fact when he stated:

I suppose some of it is stubbornness because I really think it should be able to go. I think that in the next couple of years I’m sure it will go, because I think that the expertise I have on site now is such that it’s bound to. If it doesn't it has to be folded.

On any objective view of each of the appellant's sources of income from the point of view of capacity for present or future profit, taking into account his plans, and the manner in which he has implemented those plans, it is not possible to conclude that farming was the chief source of his income in the taxation years in issue or in the foreseeable future. Accordingly the respondent's reassessment limiting the appellant’s losses pursuant to the provisions of subsection 31(1) of the Income Tax Act is supported by the facts and is correct.

Pursuant to the consents to judgment filed the appellant's appeals for the 1979, 1980 and 1981 taxation years are allowed, without costs, and the matter is referred back to the Minister of National Revenue for reconsideration and reassessment on the basis that in those years the appellant is entitled to deduct the following additional amounts as management fees:

In all other respects the reassessments are confirmed.

Appeal allowed in part.