Makoi Holdings Ltd, Abe D Epp, Gerald W Watkins, Peter Epp, Jr v. Minister of National Revenue, [1985] 2 CTC 2023, 85 DTC 372

Sarchuk, TCJ:—The appellant Makoi Holdings Ltd (Holdings) appeals from an assessment of income tax for the 1979 taxation year; Peter Epp appeals from assessments of income tax for his 1978 and 1979 taxation years and Abe Epp and Gerald Watkins (Watkins) appeal with respect to their 1977, 1978 and 1979 taxation years. All appeals were heard together. The common issue is whether the Minister was correct in treating the disposition of a total of 21 houses as income transactions. The appellants for their part contend that they should be accorded a capital treatment on the disposal of the said houses since they were capital property within the meaning of section 54 subparagraph (b)(ii) of the Income Tax Act.

In addition to the foregoing common issue Abe Epp and Watkins appealed from the Minister's reassessments on the basis that the Minister was wrong in disallowing the deduction by these appellants in each of the three taxation years of certain expenses ("rental losses") paid by them in respect of land under the provisions of subsection 18(2) of the Act. At the commencement of the hearing counsel for Abe Epp and Watkins advised the Court that they were abandoning their appeals with respect to this issue.

The appellants have had a long and profitable relationship. Peter Epp Jr and Abe Epp are brothers. Their father was a builder, primarily of residential houses, as a result of which both have been involved in the construction industry for most of their lives. Watkins first became associated with the other appellants when he was engaged as bookkeeper for Makoi Construction Ltd (Construction). The relationship continued and eventually he became the accountant and financial adviser for the corporate appellant, Holdings.

There are, in addition to Holdings, three other corporations whose histories and relationships to the appellants are relevant. Since considerable reference was made to the involvement of the appellants and of the related corporations in various real estate ventures it is appropriate to set out a brief synopsis of these activities.

MAKOI CONSTRUCTION LTD

In 1959, Peter Epp Jr and Watkins incorporated Construction which carried on the business of a commercial contractor. Peter Epp was responsible for design, construction and marketing while Watkins was the accountant, the financial adviser and the manager of the rental properties and other investments. Although its principal activity was commercial building, over the years Construction acquired certain properties for its own account.

In 1962 it purchased land and built an apartment complex consisting of 100 units. Fifty-two units were retained by Construction and are owned and operated to this day as rental units. In 1971 a 22-unit apartment was built on Palacewood Drive in Calgary. This building is still owned and is operated as a rental property by Construction. In the same year Construction became involved in the development of a recreational resort in British Columbia, which it operated until its sale in 1979.

In 1973 Construction ceased building and since then its only activity has been the management of its investments and rental properties.

MAKOI HOLDINGS LTD (The Corporate Appellant)

Holdings was incorporated in 1964 as a home builder and land developer. Initially, the appellants Peter and Abe Epp, their father and Abe Epp's father-in-law, Lome Pilling, were shareholders. By 1973, Messrs Pilling and Epp Sr had sold their respective interests in Holdings to Peter and Abe Epp. Holdings' activities in real estate were extensive. From 1964 to 1977 Holdings constructed and sold residential houses in various developments in Calgary. The number of sales varied from year to year ranging from 26 to 93 (Ex A-6). In 1965 a strip shopping centre was built by Construction for Holdings in Calgary. This shopping centre was sold in 1967.

In 1971 Holdings developed a small townhouse project in Mount Royal, Calgary. Ownership of the project was transferred to Peter Epp Sr in 1973, as part payment for relinquishing his interest in Holdings. That same year Holdings purchased a residential house as a rental property. This house, one of the properties in issue, was sold in 1979.

In 1973 Holdings transferred 15 houses from its inventory to its rental investment account. (It should be noted that concurrently ten houses were sold to the other appellants.) The houses once transferred were operated as rental properties by Holdings until their disposition in 1979. These dispositions are the subject matter of Holdings’ appeal.

Holdings is currently not active.

MAKOI DEVELOPMENTS LTD

This company is wholly owned by Peter Epp Jr. It was incorporated in 1975 as a residential house-builder, a business it carries on to this date.

CARRIAGE HOLDINGS LTD (Carriage)

Carriage was incorporated by Abe Epp and Watkins in 1975 to carry on the business of land development and house building.

In 1977 it was the builder as well as a 50 per cent owner of a 66-unit townhouse rental complex on Spruce Grove Lane in Calgary. Watkins supervises the management of this property for Carriage.

In 1980 Carriage constructed eight rental units (four duplexes) which are currently owned and operated by it. That same year Carriage leased six acres of land from Albert Epp and Watkins for the purpose of developing a 177-unit townhouse rental complex on Bow Trail in Calgary. The development of this project was frustrated and the complex, partially completed, was disposed of at a profit in 1981.

GERALD W WATKINS

In 1968, the appellant acquired 35 per cent of a 24-unit apartment rental complex in Calgary (Cedarcrest Apts) in partnership with Peter Epp. The complex was built by Makoi Construction. At all times the apartments have been and continue to be managed by Watkins.

In 1970 he purchased a 18.75 per cent interest in an office building in Medicine Hat. Watkins and his partners still own the building which has, since its acquisition, consistently provided a high rate of return to him. In 1974, he acquired a similar interest in what was formerly the Greyhound Bus Depot in Medicine Hat. The premises were renovated and have been commercially leased since that date.

When Holdings disposed of its inventory in 1973 Watkins acquired two of the houses. Both houses were rented. In 1978 one of the houses was listed with a real estate agent and in 1979 was sold at a profit. This is the property at issue in his appeal. The other is still owned by Watkins as a rental property.

In 1975 he incorporated Carriage with Abe Epp. That same year he and Abe Epp, as equal partners, purchased three acres on Bow Trail in Calgary with the intention of building a 175-apartment complex. As a result of a suggestion made by planners employed by the City of Calgary, Watkins and Abe Epp purchased an additional three acres to consolidate the property. The land was then remortgaged in an amount sufficient to enable both Watkins and Abe Epp to recover their initial investments. When they received approval to build from the City of Calgary, financing was arranged with Mutual Life and construction began in the latter part of 1980. After the partnership had expended approximately $700,000 the lender withdrew its support. As a result the property had to be sold. It was emphasized by Watkins that an earlier offer to purchase, made in 1978, which would have afforded the partners a $2,000,000 profit, had been rejected because the partnership preferred to be involved in the completion of the apartment complex and its management as a rental project.

In 1978 Watkins and Abe Epp acquired a 50 per cent interest in one of the Oakridge condominium units, a project built and developed by Carriage. It has been managed as a rental property by Watkins since that time.

In 1981, Watkins purchased a residential house from Carriage. He arranged his own financing to complete the purchase. It remains a rental property.

PETER EPP

In 1959, he was a principal in the incorporation of Makoi Construction Ltd a commercial contractor. In 1964, together with his brother Abe Epp, he incorporated Makoi Holdings Ltd a residential house builder.

In 1968, he acquired 65 per cent of a 24-unit apartment rental complex in Calgary (Cedarcrest Apts) in partnership with Watkins. The apartments have been and continue to be managed by Watkins.

In 1973 and 1974 Peter Epp purchased the four houses which are the subject matter of his appeals from Holdings. The houses were listed for sale in 1978 and disposed of at a profit during 1978 and 1979. In 1975 he incorporated Makoi Developments Ltd a house building company. This company is currently active.

ABE EPP

Abe Epp and his brother Peter Epp incorporated Makoi Holdings Ltd, a residential house builder in 1964. In 1973 and 1974 they acquired four houses from Holdings which were held as rental properties until 1978 at which time they were listed for sale and, in due course, were disposed of at a profit. They are the subject matter of Abe Epp’s appeal.

When Holdings became inactive in 1975 Abe Epp and Watkins incorporated Carriage Holdings Ltd which has carried on business as a builder since that time. That same year he and Watkins became involved in the Bow Trail project in Calgary. In 1979 together with Watkins he acquired a 50 per cent interest in the Oakridge condominium.* [1]

The final relevant activity occurred in 1980 when he built a house on what he described was a "one-of-a-kind lot” with the specific purpose of ultimately giving it to his son. In the interim the house was rented, however after three years it was determined to be unprofitable as a result of which it was sold.

It is clear from the foregoing history that each of the appellants has been extensively involved in real estate for 25 years or longer. These activities included commercial construction, residential house construction, the planning and construction of apartment and condominium complexes as well as the rental and management of similar properties. All of the appellants have demonstrated a remarkable degree of astuteness in terms of financing the various projects they became involved in. For these reasons it is necessary to scrutinize their evidence with care. Indeed it is their background and expertise in the construction business which formed the basis for the respondent's reassessments.

Counsel for the respondent argued that as businessmen deeply involved in the construction and selling of properties, their expertise, particularly as it related to financing enabled the appellants to acquire these houses with a built-in profit. It was submitted that they were aware of the fact that the residential house market was good and would in due course get better and, bearing in mind the small risk incurred, the appellants chose to rent these houses in the interim with the intention of reselling at an appropriate point of time at a profit.

Not surprisingly all three individual appellants denied the existence of any intention other than the retention of the house in their respective investment portfolios as rental units. It is clear, and it was not denied by any of the individual appellants, that as experienced businessmen they were aware of the possibility of resale. Abe Epp said that nonetheless his primary objective was to add to his investment portfolio. He denied that there was any intention to acquire the house at little or no risk to himself and to simply wait out the market and sell at a profit. When it was suggested to Peter Epp that the small risk involved made it easy for him to hold the houses for subsequent resale at a profit he responded by saying that all of the appellants had used the “mortgaging out" technique to finance their respective apartment block projects and that this was in his view an appropriate investment technique. Proof of that could be found in their individual and collective refusal to entertain offers to purchase the apartment units although such sales would have produced huge profits. Peter Epp pointed to the fact that with respect to the apartments arrangements could have been made to refinance the mortgages thereby enabling the owners to take out the extra funds so obtained to pursue other business interests. They did not do so since their approach was conservative and they intended to and did retain the apartments as investments.

All of the individual appellants testified. Watkins, a chartered accountant, began his relationship with the appellants in 1959 when he was engaged as a part-time bookkeeper for Construction. Since 1964 he has maintained all corporate records, has provided accounting and financial advice to all of the parties and as a result has an extensive knowledge of all of their affairs. In 1972, he accepted full-time employment with Holdings. It was his recollection that shortly thereafter in the course of various discussions with the brothers Epp, he urged them to direct their attention and activities to apartment projects rather than to the building of residential houses.

In 1973, at Watkins’ urging, Holdings decided to discontinue residential construction and to hold some of the houses remaining in its inventory as an investment. At the same time the individual appellants were afforded the opportunity to buy some of these houses for their personal investment portfolios. With respect to this decision Peter Epp stated that he and the other appellants accepted Watkins' suggestion that the criteria and philosophy utilized by them with respect to their apartment projects be applied to the acquisition of the houses from Holdings. Watkins’ recommendations were based on the fact that the construction and sale of residential houses produced profits ranging from $500 to $1,000 per unit. His personal analysis satisfied him that rentals would produce approximately the same net revenue and that, in his words, “investment and rental was a better move for holdings".

With respect to Holdings’ future, the evidence taken as a whole irresistibly leads to the conclusion that as early as 1973 the shareholders, Abe and Peter Epp, had decided that Holdings’ activities in building and selling houses should be brought to an end. This view is confirmed by the fact that concurrent with the “demise" of Holdings, Peter Epp Jr incorporated Developments as a residential house builder, while Abe Epp and Watkins incorporated Carriage for essentially the same purpose.

Referring specifically to the dispositions in issue, in 1973 Holdings transferred 15 houses from its work in process account to its fixed asset account. The transfer was made on the basis of the direct cost of the houses and no consideration was given by Holdings at that time to their fair market value. The ten houses sold by Holdings to Peter Epp, Abe Epp and Watkins were transferred on the same basis. It should be noted that as a result thereof the respondent subsequently reassessed all of the parties to reflect these transfers as having taken place at fair market value. No objection to these reassessments was taken by the appellants.

With respect to the houses purchased by the individual appellants the mortgage financing which had been put in place by Holdings and which they assumed was in each case equal to or greater than the purchase price. It was conceded by the appellants that the opportunity to acquire the properties with little or no capital outlay was an attractive proposition. The appellants' purchases of the houses were accounted for by way of book entries in the corporate accounts. Any short-fall or mortgage excess was debited or credited, as required, to the respective shareholders account. However, they maintained that the opportunity to complete the purchases in this manner arose out of some rather unusual circumstances. The practice of mortgaging out was common in apartment construction but it had not been utilized in single family developments prior to 1973. Holdings was experiencing a very stable period in terms of its costs and the lenders had a substantial degree of confidence in it. Holdings had overcome certain difficulties it had with hold-backs as a result of which it was able to arrange financing for its residential construction whereby the mortgage funds it received were equal to or greater than the cost of the project. It was not disputed that the prices paid by the appellants for these houses, which in each case approximated the mortgage funds advanced, constituted no more than 85 per cent of the then fair market value of the said properties.

It is apparent that the individual appellants acquired an equity in their respective acquisitions strictly by way of mortgage financing. No personal guarantees were required from the individual appellants by the mortgage company. It was conceded that there was a built-in profit of seven per cent to eight per cent available immediately upon acquisition and that from the point of view of an investment there was very little risk.

A further (and important) factor in the decision to acquire the houses for rental purposes was the agreement by Watkins to take responsibility for their management.

Although the houses were readily rented, primarily by way of six-month and one-year leases, during the course of the next few years Watkins saw a number of problems develop. The tenants appeared to show little or no concern for the properties. There was constant damage to the houses. As a result of tenant neglect the lawns required resodding and all trees and shrubs had to be replaced by 1977. There were ongoing problems in collecting rent and all too frequently when tenants left the damage deposit was inadequate to cover the actual cost of repairs. Watkins stated that there was a substantial difference between managing rental properties consisting of individual houses and managing an apartment complex which, in the normal course, had an on-site manager. He concluded that these houses caused more aggravation than was justified by the revenues received and indicated to the other appellants that he no longer wished to continue managing them. It was his strongly held opinion that these properties were no longer appropriate for their investment portfolios. Peter and Abe Epp accepted Watkins’ conclusion that the rental of these houses had not worked out as they had anticipated and acted on his recommendation to dispose of them. If additional impetus was needed Developments, incorporated by Peter Epp in 1975 to carry on the business of house construction, was building in the same district. Several of Developments' salesmen had been asked pointed questions as to whether Developments intended to construct rental units. When Peter Epp reviewed the situation it was apparent that buyers could identify the rental units by their state of disrepair. Concern was expressed that this would have a negative effect on sales. This was another consideration in the decision to sell the rental houses.

Appellants who are in the construction business face a difficult task in establishing that gains from dispositions such as those in issue should not be regarded as a profit of their businesses. If such an appellant contends that he acquired rental property as an investment he must do so by way of clear and compelling evidence of that investment intention. In these cases the credibility of the appellant plays an extremely critical role.

It was not surprising that each of the appellants made a strong declaration of an investment intention. In fact it would be surprising if they had not done so since they have a decided interest in the outcome of these appeals. Keeping this self-interest and possible bias in mind I considered their evidence carefully and indeed with some initial skepticism. In addition to observing their demeanour while testifying I considered their power of recollection and narration. They were responsive and forthright, making no effort to exaggerate or in any way to embellish their testimony. They were not discredited by other evidence nor was their testimony impeached in cross-examination. Without exception the appellants impressed me favourably.

In addition their evidence was consistent with other proven facts. For example, an analysis of their personal investments in real estate discloses a deliberate course of conduct designed to establish a lasting portfolio of investments consisting principally of rental properties. There was no evidence of any personal trading activities.

I am satisfied that the Minister’s assumption that the appellants Abe Epp, Peter Epp and Watkins acquired the nine houses in issue from Holdings in 1973 with the intention to turn the properties to account and to sell them at a profit when the market for houses in the southwest quadrant of Calgary improved has been rebutted.

There is no doubt that the appellants were aware in 1973 of the possibility of resale at some future point in time and that there was a distinct probability of capital appreciation. The mere fact that these rental houses would appreciate in value and that at some future time circumstances could warrant their disposition is not a sufficient basis for finding that the appellants acquired the houses for speculative purposes. (Hiwako Investments Limited v The Queen, [1978] CTC 378; 78 DTC 6281)

I was particularly impressed by the evidence of Watkins. With respect to his personal involvement in real estate his entire history has been of holding real estate assets as investments. I see no basis upon which I can disregard his evidence that unanticipated difficulties were encountered with tenants and that the properties created constant aggravation and necessitated ongoing and expensive repairs. These factors put into question the value of the houses as ongoing investment properties. His concerns were real and not imagined. I am satisfied that the houses in issue would not have been put on the market in 1978 were it not for Watkins’ reassessment of the properties and his conclusion that they had become a relatively unmanageable investment and as such were no longer inappropriate for their portfolios.

With respect to the appellant Holdings the situation is somewhat different. From its incorporation in 1964 it was in the business of building residential houses for resale, with an occasional venture into strip shopping centres and apartment renovations. At no time did Holdings construct any buildings for investment purposes for its own account. At all times prior to 1973 land and buildings were held as trading assets. In that year the appellant Holdings decided to terminate its building and construction activities and it alleges that concurrent with the winding down of its building operations it decided to and did transfer some of its inventory of houses to its investment account with the express intention of maintaining them as a revenue producing investment.

To establish that the character of the properties in question was changed from a trading asset to a capital asset it is incumbent upon the appellant Holdings to adduce evidence of a clear and unequivocal positive act implementing that change: Edmund Peachy Limited v The Queen, [1979] CTC 51 at 56; 79 DTC 5064 at 5067. The expressed intention of the appellant to convert the land from a trading to a capital asset is not by itself sufficient.

ls there evidence of a positive or overt act capable of supporting this appellant’s position? In my view there is. The evidence disclosed that a clear and conscious decision was made in 1973 to remove 15 houses from inventory and to retain them for investment purposes. This is corroborated by Exhibit A-6, an appendix to Holdings’ return for that taxation year which discloses with respect to these houses, that the appellant claimed the appropriate capital cost allowance. The Epps and Watkins stated that Holdings intended to cease constructing houses and it is a fact that it did so. It is significant that the houses in issue were not listed for sale at that time (1973/1974) as they might have been. Another factor is the refusal of the appellant to even consider listing the houses prior to 1978. Evidence was adduced from a real estate broker who approached the principals of Holdings with a view to securing listings for these houses in 1974. She was advised that neither Holdings nor the Epp brothers wished to put these properties on the market. Although she approached them regularly over the following years it was not until 1978 when Watkins made his reassessment of their worth as investments that the houses were listed for sale.

The Court is satisfied that the appellant Holdings intended to and did permanently convert these houses from inventory to capital property. This was not intended to be a temporary situation and, were it not for Watkins’ advice and in a sense ultimatum, it would not have been terminated. There is no evidence to support the Minister’s assumption that Holdings had not altered its original intention of making a profit from the sale of these houses.

For the foregoing reasons the appeal of Makoi Holdings Ltd with respect to its 1979 taxation year and the appeals of Peter Epp with respect to his 1978 and 1979 taxation years will be allowed and the assessments will be referred back to the respondent for reassessment on the basis that the gains arising from the disposition of the properties in issue were not income from a business but were capital gains.

With respect to Abe Epp and Gerald Watkins their appeals with respect to the 1977 and 1978 taxation years are dismissed. Their appeals from reassessments for the 1979 taxation year are allowed and their respective assessments will be referred back to the respondent for reassessment on the basis that the gains arising out of the sale of the properties in issue were not income from a business but were capital gains. In all other respects the assessments of Abe Epp and Gerald Watkins with respect to their 1979 taxation years are confirmed.

In view of the fact that all appeals were heard on common evidence only one set of costs will be allowed.

Appeals allowed in part.