Penner & Co Western LTD v. Minister of National Revenue, [1984] CTC 2017, 84 DTC 1006

Goetz, TCJ:—This is an appeal by Penner & Co Western Ltd (“the Company’’) with respect to its 1977 taxation year. There are two issues to be determined: (1) whether the proceeds of the sale of an apartment block known as South Park Apartments was on account of income or capital; (2) whether certain expenditures made by the appellant to its real estate agents related to the sale of the apartments or whether they were capital expenditures.

Edgar Penner, President of the Company which was incorporated in 1961, had been a farmer and a contractor since 1959. His brother, Leslie Penner, held the same amount of shares as he did, namely each had a 50 per cent interest in the Company. Edgar was a construction contractor whereas his brother operated a lumberyard business for the Company. Apparently, most of the construction work involved dealing with the Governments of Manitoba and Saskatchewan in bidding for and the construction of schools, senior citizens’ homes, and power line brush clearing for hydro. Edgar Penner did the estimating and visited the sites. Farmland, divided into approximately 50 titles, was held in the name of the Company and in the names of Edgar and Leslie Penner and their wives. They were approached by real estate agents by the name of Friesen and Bayne to purchase some of their farm property which the Company refused. It was on the suggestion of Friesen that the Company engage in Government subsidized programs under CMHC Assisted Rental Program. The real estate agents conducted the negotiations in Manitoba as well as in Saskatchewan, which resulted in the Company constructing three two-storey apartments, slab on grade. These were located at St-Pierre and Minnedosa, Manitoba and Moosomin, Saskatchewan. They were retained as assets of the Company.

Edgar Penner stated that he had carefully checked out Friesen’s qualifications and ascertained that Friesen had the best expertise in dealing with the construction, rental and sale of apartment blocks in the City of Winnipeg. It was on the suggestion of Friesen and Bayne that the Company purchased South Park Apartments in Winnipeg in October 1976 for the sum of $1,960,000. Edgar Penner made a thorough examination of South Park Apartments which consisted of four separate buildings, known as “three-storey walk-ups’’, composed of 168 units. Edgar Penner considered that the cost of construction per suite was considerably less than what it cost his company to construct a comparable building. Friesen acted for the owners of South Park Apartments and gave the appellant a handwritten statement of expenses and revenues showing a cash flow per month of $29,020. Leslie Penner examined this and extended the cash flow to the sum of $57,020. It was upon Friesen’s document that the appellant relied in making the purchase and the appellant sought no further information such as monthly revenues and expenses of South Park Apartments from the vendor until after the purchase.

Mr Penner states that they took approximately $100,000 out of the working capital of the Company on account of the purchase price and the remaining $60,000 came as a personal loan from Friesen and Bayne which was to be paid out of the cash flow. The balance of the purchase price was covered by two mortgages. The ledger sheet of the Company showed advances from Riverland Developments Ltd, a company owned by Bayne, and from Norman Friesen, in the amount of $58,511.50. The first entries on the ledger sheet commenced on September 30, 1976, and these accounts were set up as notes payable and were paid out in September 1977. On October 4, 1976, the Company gave a demand note to Riverland Developments Ltd in the amount of $38,438 at one per cent above prime rate. On March 4, 1977, the Company gave a further promissory note to Norman Friesen in the amount of $12,800. This note was given on the insistence of Friesen. A statement of cash receipts and disbursements re South Park Apartments was filed showing that from the period October 1 to November 30, 1976, there was an operating loss of $25,044. Apparently, between December 1, 1976 and April 30, 1977, the operating loss was reduced to $6,165. The difference arose because Edgar Penner admitted they had overlooked a five per cent management fee and outstanding taxes in excess of $40,000. At the time of purchase the appellant knew that there were rent controls which had been proclaimed as law on May 15, 1976. It was the Penners’ fond hope that the rent freeze would be lifted, but they could give no real sound basis for this hope.

Leslie Penner also gave evidence confirming that which had been sworn to by his brother Edgar Penner. The witnesses on behalf of the appellant stated that it was their firm intention that the purchase of South Park Apartments be a lasting investment for the families of Edgar and Leslie Penner.

The statement of cash receipts and disbursements shows the figure of $71,377 which Penner suggested must have included back taxes.

Leslie Penner said that they trusted Friesen and Bayne completely and that they “studied” Friesen and Bayne’s handwritten projection of cash flow.

South Apartments was sold on June 1, 1977, for $2,180,000.

The appellant says that it was forced into a position of having to sell in such a short period of time after purchase for several reasons, the first of which was that Friesen and Bayne were pressing for repayment of their loans, even though a condition of the loan was that they would only be repaid out of the cash flow over and above expenses. The second reason was that near the end of November 1976, their deficit was over $20,000 which amount had to be taken out of the Company’s working capital. The appellant states that their bond company, on ascertaining the withdrawal of working capital, was perturbed and told Mr Penner that the building was a liability rather than an asset and, consequently, suggested that they would have to cut down the size of their performance bonds on their many construction contracts. In its 1977 taxation year, the appellant deducted the sum of $42,164 paid to Friesen and Bayne as a business expense, but in its notice of appeal contends that this was an error and it should have been an expense on account of the disposition of South Park Apartments. The respondent disallowed this as an expense and treated it as a capital expenditure except for the sum of $10,000 and allowed the appellant to deduct $10,000 for payment to Allan Bayne for negotiations relating to site investigations of properties for building commercial developments.

The appellant used the services of Friesen and Bayne to examine the site of a bankrupt peat moss plant which had been financed by the Manitoba Government. Messrs Penner felt that in their experience in clearing land involving bogs and peat moss, this might be an appropriate investment. They ascertained that the plant had gone bankrupt because of inexperienced staff and what was required was the construction of a building on that site to be used in the drying and bagging of excavated peat moss. The Company had never been involved in the peat moss business. The other matter involved in the payments to Friesen and Bayne was for negotiations and inquiries with respect to sites for low cost housing. Friesen and Bayne did deal with the Government engineers and contacted trailer companies.

In December 1976, after the first two months of operation of the apartment building, the Company sent a very detailed and explicit inquiry with respect to small items of expense and lack of revenue to John A Flanders Limited, which company had been retained as manager of the apartment block on the recommendation of Friesen.

Findings

The appellant argued that the ledger sheet relating to notes payable belies a trading intention. In my view, it has the opposite effect because the condition of the loans from the real estate agents was that the loans would only be repaid out of revenue that exceeded expenditures each month. Counsel further argued that the Penners relied upon the expertise of Friesen and I am at a loss to understand why they paid Friesen and Bayne any moneys at all, other than duly earned commissions. The Company had an abundance of experience in dealing with Government contracts involving the construction of post offices and public buildings, schools, etc. When the Penners found out that they had been misled by Friesen and Bayne, I cannot understand why they continued to deal with them. Counsel further argued that the $42,164 is properly deductible pursuant to the provisions of paragraph 20(l)(dd) of the Income Tax Act, SC 1970-71-72, c 63, as amended, which reads as follows:

20. (1) Notwithstanding paragraphs 18(l)(a), (b) and (h), in computing a taxpayer’s income for a taxation year from a business or property, there may be deducted such of the following amounts as are wholly applicable to that source or such part of the following amounts as may reasonably be regarded as applicable thereto:

(dd) an amount paid by the taxpayer in the year for investigating the suitability of a site for a building or other structure planned by the taxpayer for use in connection with a business carried on by him;

The Company was never ever engaged in the business of the peat moss plant nor in the operation of a mobile home park and it clearly does not come within the purview of paragraph 20(l)(dd). It was Friesen and Bayne whose common knowledge of the market brought a prospective purchaser to the Company resulting in the sale in June 1977.

The appellant made a point that it never advertised the apartments for sale, but acknowledged that Friesen was the most experienced realtor in apartment blocks in the City of Winnipeg. Advertising would obviously be unnecessary. The urgency for sale escapes me because the Company carried on construction business through to 1981 and from their financial statements filed with the 1977 income tax return, it is apparent that in 1976 the Company had retained earnings of $571,660 and in 1977 it had retained earnings in the amount of $755,147. Net earnings in 1976 were $98,023 and in 1977, $183,487. The Company certainly was not in any financial straits and I do not accept Edgar Penner’s evidence with respect to the bond company as being very material to the need to sell the apartments because the size of the performance bonds was reduced. The appellant had considerable expertise in the construction business and in financing same. Its careful analysis of the income picture from the apartments for October- November 1976, as expressed to Flanders and Company, clearly indicates to me that they were indeed careful and knowledgeable in financial matters. The Penners’ casual acceptance of a handwritten sheet of expenses and revenue to produce the cash flow presented to them by Friesen, and the fact that they did not check same with regard to the cost of the purchase, leave me very doubtful as to the appellant’s avowed intention to acquire the apartments as a lasting investment.

It was quite obvious that Friesen, with his connections in the City of Winnipeg, could dispose of the property quite readily. As a matter of fact, it is my view that Friesen had this in mind from the outset of his dealings with the Company and possibly assured the Penners that if they ran into any problems, he would easily dispose of the property. Further, the appellant was aware of the rent freeze that existed at the time of the purchase and the deficit in the cash flow as opposed to Friesen and Bayne’s projections should have made them (the Penners) quite leary of dealing further with these agents. Nevertheless, the continued to do business with them. The appellant’s argument with respect to its declared intention to acquire the property as a lasting investment must be weighed against all facts prior to and after the purchase. See Joseph Friedman v MNR, [1978] CTC 2611; 78 DTC 1020, where Lucien Cardin, QC, at 2614-2615 and 1022-1023 respectively, says as follows:

In cases where the Board is to decide whether profits realized from the acquisition and disposition of properties are income or capital gain, the facts are the determining factor. The appellant’s declared intention of purchasing the properties as an investment in rental properties must, of course, be considered by the Board. However, the appellant’s course of conduct over a period of time substantiated by the facts will or will not corroborate the appellant’s declared intentions. In establishing these facts, the reasons given by the appellant for the acquisition and the disposition of the properties must be reasonable and credible. I have found and indeed noted that the appellant’s credibility left much to be desired.

See also Luigi Borrelli and Frank Borrelli v MNR, [1982] CTC 2383; 82 DTC 1374.

Having regard to the experience of the Penner brothers in financial matters, I find it incomprehensible why there is no explanation of their failure to check out the financial statements of the operations of the apartment building in the years preceding purchase by them in 1976. I therefore find that the sale on June 1, 1977 was on income account rather than on capital account.

Dealing further with the sum of $42,164 paid to Friesen and Bayne as part of the cost of disposition of South Park Apartments, as I stated earlier, the respondent has allowed the appellant to deduct $10,000 on account of this amount relating it to services rendered by the real estate agents.

The peat moss plant and the mobile home park were clearly not part of the appellant’s business and the feasibility studies relating thereto are capital expenditures. See Queen and Metcalfe Carpark Limited v MNR, [1973] CTC 810; 74 DTC 6007. At 820 and 6013 respectively, Sweet, DJ states:

So far as the circumstances of this case are concerned amounts paid for the following purposes wouild be among those which, in my opinion, would not be incurred in investigatory proceedings within the meaning of the legislation and, accordingly, would not be deductible in computing income:

3. To attempt to obtain approval of the proposed development from municipal, regulatory and other officials, committees and authorities.

4. For the preparation of plans, specifications, briefs and other material in connection with, associated with or incidental to the above-mentioned activities.

5. For the attendance of representatives of the appellant at meetings with prospective tenants, and municipal, regulatory and other officials, committees and authorities in connection with, associated with or incidental to the above purposes.

7. For the services of public relations counsel in the attempt to create a receptive climate for the proposed project.

I therefore dismiss the appeal on the above grounds.

Appeal dismissed.