Kenneth G. H. Watson v. Minister of National Revenue, [1986] 2 CTC 2009, 86 DTC 1468

Sarchuk, T.C.J.:—This is an appeal from assessments by the Minister of National Revenue of the appellant’s income tax for his 1980 and 1981 taxation years. By these assessments and by his pleadings the respondent conceded that the appellant’s farming activities constituted a business. At issue is the respondent's reduction of the farm losses claimed by the appellant to $5,000 on the basis that the appellant's chief source of income was neither farming nor a combination of farming and some other source of income within the meaning of subsection 31(1) of the Income Tax Act.

It is the respondent's position that the appellant is not entitled to deduct full farming losses because he is a 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.

The circumstances which led to the appellant’s entry into the business of farming are relevant. Kenneth Watson (Watson) is a teacher by profession and has been the Science Department Head of a Hamilton secondary school since 1969. He can reasonably be described as a person with an in- quisitive nature and a keen interest in all matters scientific. Since graduating from McMaster University in 1961 he has taken a number of university courses in subjects as diverse as human anatomy, astronomy, biology, agriculture and values education.

In the 1970s he concluded that he was half-way through his teaching career and in all likelihood had reached his maximum level in that field. This led him to look for an alternative career and eventually he chose farming. Although he had absolutely no farming background he felt he was ideally suited for this occupation because he had a strong theoretical background and was vigorous and enterprising. He considered his knowledge of science to be invaluable and believed that his continuing quest for additional knowledge made him adept in the learning process. Teaching and other related activities provided him with experience in searching out community resources and working with people. He told the Court that he remedied his agricultural deficiencies by marrying a farmer's daughter and by having extensive discussions with her family. He also discussed farming with a close friend who was in the business.

Armed with the results of his reading and other research and full of unbridled enthusiasm the appellant set out to find the appropriate farm, visiting some 65 sites before eventually selecting one. He told the Court he was looking for a property that provided good soil, good topography and good drainage; with ready access to markets and a reasonable storage facility for machinery.

The farm which was purchased in the fall of 1980 was comprised of 48 acres, a portion of which had been dedicated to the production of ornamental (Christmas) trees. These formed no real part of the appellant’s plans and were to be sold as they reached the appropriate size. A barn on the site appeared to provide an adequate storage capacity. Watson was satisfied that the farm met his criteria although some improvement to the drainage was required. As a result he decided to immediately take advantage of a subsidy available to farmers to defray the cost of installing a drainage system. This enabled him to obtain a loan from the Province of Ontario at an eight per cent interest rate for two-thirds of the estimated cost of the system.

The purchase price of the farm itself was $55,000. In addition the appellant expended $30,000 on the new drainage system. The net result was that the capital outlay required at the outset of his farming venture was $85,000 all of which was borrowed, $30,000 by way of a mortgage on his residence, $20,000 by way of the aforesaid loan from the provincial government and $35,000 by way of a mortgage on the security of the farm. In addition to these loans the appellant sold some shares, netting $3,000 to $4,000, an amount roughly equivalent to the cost of the machinery and equipment acquired for the farm.

When he began his search for a farm no specific crop had been chosen. Watson said that he was not wedded to one product but wanted to find the right farm upon which he could grow a long-term marketable product. He did say that he was leaning towards nut farming as one major possibility, his investigations having convinced him that nut trees could be grown successfully in commercial orchards. In this context it seems appropriate to quote Watson from a letter written by him in February 1981 (Ex. A-6):

My ultimate goal is to produce a plantation growing nut trees by the year 1995. . . . From Vineland I've obtained 240 chestnut seeds for Layeroka edible chestnuts. This cross of .. . varieties looks to be successful in coping with the blight which destroyed the chestnut forest so widespread in Ontario in pioneer times. From Fleming I've received the data which indicates that chestnut trees on their farm (research property) at Vineland start to bear in about 7 years and by 15 years are producing about 1 bushel or 65 lbs. per tree. This represents a wholesale value in current market of about $50 per tree per year if the seed was sold as food. A value of 5 times this as nursery stock might be possible but this value depends on the extent of the development by other growers. It seems prudent to be conservative. Chestnut trees can be planted at 25' centres (about 70/acre) (bu)t after 25-40 years alternate trees would (ha)ve to be removed. At 70 per acre this would produce at about $3500 (gross) per acre at present values. From 15 years onward this would be the maximum anticipated return. Planting at 50 foot (cen)tres (the mature distance) or 17 trees per acre would produce a minimum return of 17 x 50 = $850. This configuration, intercropping with filberts would be expected to boost overall returns. I plan to plant about 20 acres in chestnuts.

His original plan was to dedicate 20 acres to chestnuts, planting 17 trees per acre. Walnuts were to be planted on 15 acres, centred so as to permit intercropping. No clear plan appears to have been formulated at that time with respect to what cash crops might be inter-cropped and/or grown on the remaining acreage.

Although the new drainage system appeared to work well Watson noted that there was some flooding in the low areas which could not be corrected by pumping. This suggested to him that permanent tree plantings would have to be restricted to the 35 acres not affected by this problem.

By 1982 he had settled on a planting ratio of 35 trees per acre as contrasted to the initial projection of 17. In March of that year he wrote (Ex. A-7):

The retail price (as food) for this type of chestnut imported from Europe was noted as being up to $1.99 per pound over the winter. A wholesale price of $1.00 is reasonable to assume under these conditions. Scaling these values to commercial levels of the order I expect leads to the following projection:

20 acres @ 35 trees/acre	= 700 trees
Gross return (based on an average of	$50/tree
50 lb./tree over the period of 10 to
14 years and a $1/lb. wholesale value).
Total gross value of crop each year	= 700 x $50
(between 10 and 14 years)	$35,000

The Court notes that at the time this report was written nothing had been planted in the orchard. As Watson explained:

The 240 nuts provided by Vineland in 1980 were planted in 1981 and a 65% germination was obtained. . . . This translates into about 160 trees. A further 240 seeds are presently in hand and hopefully will generate a further 150 trees. Arrangements have been made ... to obtain an additional but unspecified number of seeds in the spring of 1982. This leads to the expectation that, by the fall of 1982, about 350 chestnut trees will be ready to set out in the spring of 1983. These trees will occupy 10 acres. [Emphasis added.] Based on the earlier calculations, this should have grown to a bearing orchard or plantation by 1993 producing a gross income of about $17,000 to $18,000. This would be augmented by further plantings over the years 1983 and following until the desired 20 acres was planted.

No prediction was made by Watson as to when he expected the full 20 acres to be in production. 1997 is mentioned in one report but the context in which this date is used is unclear.

With respect to his plan to grow 15 acres of Carpathian walnuts Watson stated:

. .. while it would be progressing in parallel . . . the productive phase of these trees is expected to lag behind that of the chestnuts .. .

He had earlier noted that walnut trees were not expected to bear until they reached 20 years" growth or more.

He also wrote:

All these nuts grow well in the area of Dunnville and the climatic data .. . supports the idea that these trees will survive. I also anticipate an increase in relative value of these nut crops as the end of the century approaches and people express their individuality in conservative society through gourmet dietary adventures.

These and other similar comments are the extent of the evidence adduced as to the feasibility of growing nuts commercially in Ontario.

While the long-term plans were being implemented it was necessary for Watson to produce some cash flow from other sources. In 1981 he contracted to grow cucumbers for a pickle manufacturer and planted pumpkins to test that market. The cucumbers provided some revenue that year and the next, however in 1983 the contracts were cancelled. Pumpkins proved to be a reasonable cash crop and by the end of 1984 the appellant had planted 15 acres. He tested sweet corn in 1984, and soya beans and buckwheat in 1983. These efforts produced some gross revenue in the taxations years in question and the subsequent two years. A schedule prepared by Watson disclosed the following (Ex. A-5):

In 1981 approximately one-third of the gross farm income was made up of the government rebates and subsidies. The farming operation was discontinued in 1985 and the farm was sold that spring.

According to Watson it was his intention "to exploit the ability of the land to grow cash crops to the limits of its capacity consistent with good long-term management of the soil resource.” In March 1982 he outlined his cash crop alternatives for the next ten years in the following manner:

Cash crop productivity on the available 35 acres or so is estimated below.

Wheat	Average yield of approx. 40 bu/acre	Gross return @ $3.75/
	(OMAF Public #61)	bu	$150/acre or
		$5250 total
	Practised experts in good years have
		@ $3.75/bu		$262.50/
	obtained 70 bu/acre
		acre or $9200 total
Clover Seed	Estimated yield 300-400 Ib./acre
		@ $.50 to $.70/lb.
(possible	(based on comment from R.Thom of
		$5250 to $9800
rotation crop)	Oseco Ltd., Brantford)
Soya Beans	Estimated $300 to $400/acre	$10,500 to $14,000 max.
(possible
rotation crop)
Corn	Not presently being considered because about the same as soya
	herbicides used for weed control kill	beans.
	nut trees in the same field. Need for
	high fertilizer costs makes this less
	attractive than soya beans at present.

He went on to say:

Adding this all together the immediate expectation is for the gross returns on cash crops like wheat, clover or soya beans to run from $5000 to a maximum of $14,000 (likely averaging at $8000/year over the rotation) and the vegetable crop to run up to $3000/year.

During this same ten-year period Watson projected that his expenses would vary from $17,000 to $20,000 a year while gross income over that same period of time would average at approximately $11,000 per year. He concluded:

The plane (sic) conclusion is that it will be about 10 years before this farm turns a profit but by that time, and from then on, the income will excalate (sic). The $18,000 nut crop will allow that profitability to be realized when it is added to the cash crop value which will be harvested between the tree rows. The break even point may arrive before 1993 depending upon the down turn in interest rates or the relative increase in the value of food crops but the latest it is projected to be is 1993.

The appellant’s projections leave a great deal to be desired. All too often they were based on generalizations. Every projection of future profitability was predicated on the nut plantation producing full crops of commercial quality nuts by 1993. In my view Watson's conclusions as to future profits are highly speculative. An example can be found in his initial cash crop projections which were based on the availability of 35 acres over a period of ten years. Clearly if the tree planting program proceeded as scheduled within three or four years Watson would have much less than 35 acres available for cash crops, except to the extent that it might be possible and practical to inter-crop. Furthermore once the 35 acres were fully dedicated to nuts the remaining 12 or 13 acres were those which the appellant described as having questionable drainage. It is not clear whether the possibility of reduced crops or crop losses due to excessive moisture in wet years was considered in his projections.

With respect to inter-cropping, as I understood the appellant, because nut trees take a long time to reach the productive stage it was his intention to plant interim crops to provide him with cash flow. Once all of the walnut and chestnut seedlings were planted other cash crops were to be grown on a rotational basis in between the immature nut trees. When asked what he planned to grow as an inter-crop Watson stated “orchard grasses for seed, spices, tomatoes, squash and pumpkin". He knew of no commercial operation using this method, and readily conceded that the viability, in an agricultural sense, of such inter-cropping was purely hypothetical and to his knowledge had never been tested. He had no idea what effect such intercropping might have on the quality of the cash crop, or on the nut plantation. He had no comment as to how the soil would be affected, or whether additional soil nutrients or fertilizers might be called for. What might occur in these unique and untested growing circumstances with matters such as pest and rodent control, a concern in the ordinary course, is unknown.

Counsel for the appellant submitted that in determining whether a source of income qualifies as the appellant’s “chief source", the Court must give consideration to the appellant’s reasonable expectation of income from the various revenue sources and to the appellant’s ordinary mode and habit of work. In assessing this the Court may inter alia examine the time spent; the capital committed; the profitability, both actual and potential and any change in the appellant’s ordinary mode and habit of work. The test, counsel argued, is directed towards the determination of whether or not Watson might reasonably expect his farming operations “to provide the bulk of income" and whether or not farming constituted the “centre of his work routine".

It is not disputed that the appellant was engrossed in his project. He devoted much of his time to farm activities and to what counsel described as his professional development as a farmer. Watson carried on extensive cor- respondence with a number of individuals and organizations on agricultural matters. He kept a detailed diary. While I have reservations about the practicality of some of his investigations, such as his correspondence with Agriculture Canada relative to the production of cannabis sativa for its fiber (hemp), there is no doubt that he spent a great deal of time planning and thinking.

On the other hand, the time he allocated to the farm was not allowed to put his teaching career in jeopardy. He lived in Hamilton, where he was employed. He maintained the same high level of teaching proficiency and indeed from 1979 to 1982 appears to have continued his pursuit of a master's degree in biology at McMaster University. Most of the time devoted to the farm activities took place during the summer months when school was in recess. At all other times he was a weekend farmer albeit a hard working and energetic one.

With respect to the appellant’s plans it was argued that he worked exhaustively to develop a scientific crop rotation system which was adapted to both his immediate and long-term needs. To do so it was necessary to coordinate his cash crop production with the long start-up time required before the walnut and chestnut trees were productive.

I am not satisfied that a scientific crop rotation system existed or that his long-term plans for inter-cropping were viable. It was Watson's expressed view that such was the case, however there is not a tittle of independent evidence before the Court to support his hypothesis. I am not suggesting that expert evidence is a requirement but the fact remains that Watson Is not such an expert and indeed is a latecomer to farming with no practical experience to guide him. As a result his assertions as to the validity of his hypothesis must be scrutinised with great care.

Watson invested most of his available capital in the start-up of the farming operation. With the exception of some $3,000 obtained through the sale of his stock portfolio all of this capital was borrowed, a circumstance which had the effect of placing the operation under a substantial debt load at its very inception. All of the mortgages were for a one-year term leaving the appellant vulnerable to unpredictable interest rates and further putting into question the validity of his financial projections. Furthermore, it is conceded that Watson only managed to sustain the venture by the commitment of all of the available income he derived from teaching without which it would have collapsed sooner than it did. Another aspect of Watson's financial planning was the intended generation of tax refunds as a source of capital. Watson had counted on full farm losses, and the resulting tax refunds, to provide the financing necessary to sustain the operation. He said the “‘tax refund became my bank’’. When his income tax returns were reassessed he “‘could not carry any more debt load” and his inability to do so precluded the construction of storage facilities as a result of which he lost a portion of a crop through spoilage.

In choosing to support his farm operation by income derived from his permanent employment (and from the tax refunds) as opposed to obtaining further capital by incurring additional debt Watson exercised a financial mechanism which, as counsel contended, has been recognized by the courts, (see: The Queen v. Paul E. Graham, [1983] C.T.C. 370; 83 D.T.C. 5399 (F.C.T.D.) and, [1985] 1 C.T.C. 380; 85 D.T.C. 5256 (F.C.A.); Leo Bastien and Donna Bastien v. M.N.R., [1985] 1 C.T.C. 2317; 85 D.T.C. 262). However one may view this practice, it puts into serious question the capability of the appellant’s venture as capitalized to show a profit and more pertinently to show a profit which coupled with some subordinate source of income could be looked to by the taxpayer for his livelihood.

With respect to the appellant’s profit and loss experience in past years and the foreseeable profitability of his venture I am constrained to say that the evidence does not enable me to share his optimism. In the course of his evidence he stated that the 1982 gross income would have been higher had it not been for some unanticipated crop losses. In my view crop losses and reduced production occurring as a result of weather, plant disease, pests and even such matters as inadequate storage are, given the nature of the farming industry, predictable. No allowance appears to have been made for such factors in any of the financial projections presented to the Court by the appellant.

All of the foregoing factors have been considered and weighed. Without doubt there was an intellectual commitment to farming. That factor favours the appellant. However considering all of the appellant's income-earning activities, the time spent, both productively and otherwise, and carefully taking into account his plans in a practical and businesslike manner I can only conclude that Watson is not a taxpayer who in the taxation years in question or in the foreseeable future could look to farming or to farming and some subordinate source of income for his livelihood.

The appeals are accordingly dismissed.

Appeals dismissed.