John T Quelch, David R Kaufmann, Winston M Foster v. Minister of National Revenue, [1984] CTC 2669, 84 DTC 1551

Taylor, TCJ:—This is an appeal heard on common evidence, at Vancouver, British Columbia on May 29, 1984 against the fact that the Minister of National Revenue had taxed the gain realized on the sale of a parcel of real estate as an income not capital account. There were some technical and mathematical differences which appeared in the appellants’ assessments, but the essence of the issue before the Court can be summarized by quoting certain extracts from the Minister’s reply to notice of appeal, as it was filed in the case of Mr Quelch:

4. In reassessing the Appellant as aforesaid, the Respondent, the Minister of National Revenue, relied upon the following assumption of fact, inter alia:

(a) the Appellant purchased his interest in the Highlander Apartments in the City of Seattle, in the State of Washington, in 1975 for $15,000.00;

(b) the Appellant disposed of the aforesaid interest in 1977 realizing a gain of $22,244.64;

(e) the Appellant purchased his interest as aforesaid with the primary or at least secondary intention, ab initio, of turning it to account by means of resale at the first reasonable opportunity.

The subject property was the Highlander Apartments, constructed in 1968 and consisting of a total of 175 modern garden-type apartments. The purchase price was $2,000,000 representing 6.16 times the gross rental roll in 1975, averaging approximately $11,500 cost per apartment unit. The building was valued at $1,700,000 and the land at $300,000. It was estimated, at purchase, that some $35,000 would be required for “cosmetic improvements”. There was on-site management. Purchase was arranged by selling proprietorship units (not to be confused with “apartment units”) representing a 10 per cent equity, each for $35,000, thereby raising $350,000; and a mortgage for the balance. Mr Kaufmann had purchased his equity by investing $35,000 himself, whereas Mr Quelch and Mr Foster had joined with a certain Mr Casilio (a business aquaintance familiar to both of them) in acquiring among them a 10 per cent equity. (The term “investment” is used throughout this judgment without attributing thereto any significance other than that which may be ultimately regarded as appropriate resulting from the decision itself).

All three appellants were Vancouver businessmen and there was little if any evidence that any of them had been seriously involved in real estate transactions prior to the one under review. Each one claimed that the capital contribution had been made as an investment since the projected 12 per cent anticipated return on investment looked very good when compared with other available interest yields. In effect each one had taken on a “‘long-term” investment. They were either unaware or unaffected by any prospects or possibilities of sale of the building in three or four years, (a situation referred to later).

Two particular documents were filed at the hearing — Exhibits A-l and R-l. Exhibit A-l is a “Commitment Letter” with certain attachments indicating it was prepared in late 1975 for circulation to prospective investors in the Highlander project. It had as one attachment a four-page description of the project together with certain financial projections. Exhibit R-l, was a “Joint Venture Agreement”, dated October 7, 1975 and although no completely signed copy was submitted there was no objection taken by either party to that situation, or to the proposition that Exhibit R-1, did represent that kind of agreement eventually reached between all the parties with investment percentages in Highlander. Both parties to this dispute agreed that Exhibit A-l was a critical and important document and both parties made considerable reference to it. Mr Casilio did not testify, but it would appear that he signed all papers necessary for the three (Casilio, Foster, Quelch) and that Mr Foster and Mr Quelch were only mildly involved or interested in the details of the project. Mr Casilio knew a certain Mr Dell, who together with a Mr White and a Mr Fraser, was one of the three prime movers in putting the project together. Each of Mr Dell, Mr White and Mr Fraser held a 10 per cent interest in the project by holding companies. Together they formed a “Management Committee” and were delegated by the others the responsibility for the management and operation of the project. There was little indication that any of Mr Kaufmann, Mr Foster or Mr Quelch knew Mr White or Mr Fraser, but Mr Dell had been a neighbour of Mr Casilio and had conducted business dealings with Mr Kaufmann. It was contended by all three appellants that to whatever degree they might have been aware of the business affairs of Mr Dell, they did not know him as a real estate trader or dealer at the time critical to their acquisition of the interests in Highlander — 1975. In fact, they believed him to be interested in investments, and property management — no more. The Court, would note that counsel for the respondent viewed some of the physical evidence presented as making the business interests of the members of the “Management Committee” rather evident. However, I do not believe that this issue can be resolved on a straight “taxation by association” principle in light of the uncontradicted testimony of the three appellants.

All three appellants indicated that they had seen and received in about 1975 the documents submitted as Exhibit A-l. Neither Mr Foster nor Mr Quelch was able to recall seeing another document, submitted as Exhibit R-l, until much more recently after the reassessments at issue had been struck. That does not strike me as strange, since both Mr Foster and Mr Quelch left the affairs dealing with Highlander up to Mr Casilio. In the case of Mr Kaufmann, he agreed he had seen and reviewed Exhibit A-l in 1975. However, he also had no recollection of Exhibit R-l in 1975 and only recalled seeing it in 1984. In financing his $35,000 unit, Mr Kaufmann put up $3,500 in cash, and borrowed $31,500 from his bank. As security for that loan, he believed he deposited a couple of mortgages he held but his interest in the Highlander would have been his prime security. It was the position of the appellants, that Exhibit R-l served no purpose in this appeal, and should be ignored. It was the proposition of the respondent however, that the Court should not ignore Exhibit R-l but take it into account, on the inference that the appellants being responsible businessmen would have, or should have, insisted on seeing that document. I do not believe Exhibit R-l can rightly be ignored in this matter. First, I suggest that to obtain the $31,500 bank financing, Mr Kaufmann must have been required to submit a formal indication of some sort regarding the use of the funds and not merely the projections from Exhibit A-l. No one has challenged that Exhibit R-1, or something very much like it was the formal documentation available to all the ultimate investors, to represent and indicate the investment they had made. Second, Mr Kaufmann does recall another document (submitted as Exhibit R-6) which is in effect an amendment to Exhibit R-1. Exhibit R-6 is dated in April of 1976, and would have required Mr Kaufmann’s signature at that date (just as did Exhibit R-l in 1975). In my view Mr Kaufmann would not have executed Exhibit R-6 without prior or at least concurrent knowledge regarding the contents of Exhibit R-l. Accordingly as I see it, at the time of acquisition of Highlander, it is a reasonable assumption for the Court to make that for his own financing and for his own protection Mr Kaufmann was familiar with the contents of Exhibit R-l. I am equally prepared to make the same assumption for Mr Casilio, and if his own partners Mr Quelch and Mr Foster were not exposed to Exhibit R-l, that is an internal affair for the three of them, not for the Court. It is clear Mr Casilio had their concurrence in acting for them.

Clauses 2 and 5 of the “Commitment Letter” (Exhibit A-l) read:

(2) My/our funds will be secured by way of Title to the property being registered jointly in the names of all the joint venture participants.

(5) Before closing I/we will execute joint venture and management agreements of the draft form which will be submitted to me for approval.

These clauses further support my opinion that Mr Kaufmann would have seen Exhibit R-l, as already described. In the “Project Description” attached to Exhibit A-l, there is a “Valuation of Investment” schedule, which portrays not only a “Current overall yield on purchase price” calculation based on rental of the units, but also an “Estimated 3 year Value” of the project, indicating that the 1975 cost of $2,000,000 should be expected to yield in three years a total “market value” amount of $2,816,000. Finally there is a calculation bringing these two together and providing an indication of total projected gain in a three- year period. When this factor is combined with a clause in the section dealing with “Organization Structure”, reading as follows:

The Managers, who have committed to invest $105,000.00 in the venture, will be fully responsible for and will control the management decisions with regard to the project including decisions about refinancing and resale. They will in return for a property management fee of 5% of gross revenues assure that proper management is provided to the property either by themselves or another professional property manager of their choice. In addition they shall receive an addition compensation for providing management of 15% of the net profits including capital gain on sale.

in my view a very clear indication of the prospects for the project emerges.

All three appellants were completely direct in their testimony, indicating that the project held out for them the prospect not only of the 12 per cent annual return on investment, but also the “potential for growth” (the capital gain). Some of the operating profit proposition in Exhibit A-l appeared very attractive even on its own. In fact, by any reasonable standards of return on investment, the prospects were almost exorbitant. All three appellants indicated they took a rather jaundiced view of these operating projections, and Mr Foster added that it was known that Seattle had a depressed real estate market in 1975 due to the recent reduction in activity at Boeing Aircraft.

It is difficult for me to conceive of many rental projects holding prospect for an average return on down payment investment of almost 25 per cent, let alone one in an acknowledged depressed market. (This comes from Exhibit A-l.) Without the additional projections related to gain on market value over the next few years, I would think these responsible businessmen would have taken an even more critical look at the proposition. They all agreed, they felt their initial investments were “safe”, and for this safety they relied on the projected increase in capital value of the apartment building. There is nothing wrong with that in my view (and we shall come to that later in a look at the relevant jurisprudence). The problem for the Minister arises, when and if such a view of future prospects is linked-in directly with evidence regarding the prospect and intention of resale, in order to realize on that increased value. The actual operating reports (filed with the tax returns) for the years after acquisition show not only a different position from a financial viewpoint but even a very substantial deficit from a cash flow viewpoint. None of the appellants, by their own admission, made any attempt to analyse or check the figures presented to them supporting the purchase, and indeed none of them ever saw the building in question, before, during, or after their equity positions. I take that as a rather clear indication that its potential from an operating viewpoint — as an investment to be precise — was of little direct interest to them, and indeed it proved to be the case. As far as capital investment made after acquisition, it was my interpretation of the testimony that all three regarded any physical changes or improvements made as largely cosmetic in nature, rather than structural and permanent.

In my view, even without the use of Exhibit R-1, the appellants would have great difficulty surmounting the obstacles arising strictly out of Exhibit A-l, to which they all admit exposure. But when the “Joint Venture Agreement” (Exhibit R-l) is added to the evidence and as I said it legitimately must be, the problem for them becomes more complex. Clause 7.01 in Exhibit R-l reads as follows:

It is the intention of the parties hereto that this Joint Venture shall have a limited life of four years from the date hereof. It is further the intention of the parties hereto that the Management Committee shall attempt to improve the Property during the term, increase the rental income and dispose of the Property at a profit to the Joint Venture prior to the termination date of this Joint Venture.

I am satisfied that Mr Kaufmann knew, and that both Mr Foster and Mr Quelch could have or should have known, that the project had its main attraction as an inventory item — to be cosmetically refurbished at minimum cost to the investors, rented to its potential, and sold as quickly, directly and profitably as possible. The projected time frame within which to accomplish that was four years. In a “depressed market’’ as the situation was termed by Mr Foster, this was probably a realistic time frame, particularly if any of the members of the Management Committee had experience in such affairs (a version of the evidence urged on the Court by the Minister). This prospect may have been tempered in their minds by the additional possibility (which soon collapsed) of some cash flow back to them in the interim period, but that was not the major motivation for the investment, if it existed at all.

It now only remains to be seen whether given all those facts, the contention that the gain is still on income account can be sustained. For this question, we must look at the signal case of Hiwako Investments Ltd v The Queen ([1978] CTC 378; 78 DTC 6281). I say Hiwako, (supra), since in my view the four other cases submitted by counsel for the appellants and the nine cases submitted by counsel for the respondent are all distinguishable in relatively direct ways, from this situation before the Court. Counsel for the respondent did not comment on the obvious comparability between Hiwako, (supra), and the instant case and the Court is therefore left to its own review of any application of the case law and the reliance of the perspective of counsel for the appellants on Hiwako, (supra).

From Hiwako, (supra), it can be assumed that mere recognition by a taxpayer “in making the purchase (of) — the prospect of inflation in land values. ... is not evidence of a purchase for resale amounting to the launching of an adventure or concern in the nature of trade” (see Hiwako, (supra), at 380 [6282]). Counsel for the appellants strongly relied upon that perspective, and properly so. I would add, however, that the footnote provided by the Court in connection with the above quotation is equally important:

While I need not express any final opinion thereon, I am not persuaded by the appellant’s argument that the acquisition of an asset ripe to produce income must be classified for present purposes as being either

(a) an acquisition for purposes of holding it as an income-producing asset, or

(b) an acquisition for re-sale in the nature of trade (even though it may involve incidental receipt of profit therefrom between acquisition and sale).

As I see it, at the moment, a keen business man might acquire such an asset motivated by a conviction that

(c) it will be a good income-producing asset as long as he keeps it, and

(d) there is a concrete probability that, with or without improvements, he may be able to re-sell it as a trader would for a profit.

In this connection, I see no difference between acquiring a profit-producing property and a capital asset for a business. Compare Anderson Logging Co v The King, [1925] SCR 45.

I would take from that note of caution by the Court, that while the circumstances described in Hiwako, (supra), essentially, acquisition of an incomeproducing property, concurrent recognition that it should increase in value — and subsequent sale — does not of itself characterize the transaction as on income account, but neither does it necessarily characterize it as on capital account. Hiwako, (supra), in my opinion does not serve in itself to put this instant transaction before the Court, beyond the parameters within which the Minister can validly strike the assessment. Therefore in order for the appellants to succeed in removing the transaction from the taxation peril into which the Minister’s assessments have propelled it, these appellants must show that there did not exist an intention of a quality and character greater than that described in Hiwako, (supra), at 383 [6285]:

In my view, an intention at the time of acquisition of an investment to sell it in the event that it does not prove profitable does not make the subsequent sale of the invest- ment the completion of an “adventure or concern in the nature of trade”. Had the alleged assumption been that there was an expectation on the part of the purchaser, at the time of purchase, that, in the event that the investment did not prove to be profitable, it could be sold at a profit, and that such expectation was one of the factors that induced him to make the purchase, such assumption, if not disproved, might (I do not say that it would) support the assessments based on “trading” if not disproved.

As I see it, the key phrase, repeated in both aspects of the above quotation is “in the event that”. While the Court in Hiwako, (supra), later on in the judgment expresses caution regarding “secondary intention”, as I read the quotation above, it would be incumbent on these appellants to show that the sale of the property was virtually a recognition of failure of their objective — if I might use the term “prime” objective. There was some attempt made during this hearing to do just that — demonstrate how various unknown and unexpected factors contributed to the decision on the part of the Management Committee to sell the project. I am not persuaded that the doubtful viability of the project from an operative perspective should have been completely unclear at the date of acquisition to these appellants. And further there was considerable evidence brought up by counsel for the respondent that to whatever degree there had been early operating difficulties (even if not anticipated) these had been largely overcome by the date of sale. I am persuaded that the program of rehabilitation, and restructuring of operations — perhaps correctly described as “cosmetic” — was an integral part of the four-year plan to prepare the project for sale and to so finalize the venture. In my view, even at the most liberal interpretation, Hiwako, (supra), does not insulate from income assessment a transaction conceived and completed according to such a program, with the prospect of profit from the venture as the major, and I would say in this instance, the only source of profit. I would add finally, I specifically use there the term “profit”, as opposed to “income”. While these appellants might have indeed received income, during the first few months they held their equity, (to the degree that they received regular cheques of something like 12 per cent per annum return on their investment) that did not arise out of any “profit” accruing out of the rental operations of the building. The profit came from the sale of the building and in relevant terms was reduced by proportionate losses from operation during tenure.

The appeals are dismissed.

Appeals dismissed.