Fred Hochachka, James R McClelland v. Minister of National Revenue, [1984] CTC 2773, 84 DTC 1673

Taylor, TCJ:—These are appeals heard on common evidence in Edmonton, Alberta on July 11 and 12, 1984 against income tax assessments for the years 1976 and 1977 in which the Minister of National Revenue treated the appellants’ portions of the gain realized on the sale of an apartment building as on income rather than capital account. An overview of the situation may be seen in the Minister’s reply to notice of Appeal to Mr Hochachka:

— In January of 1975 the Appellant acquired a 7.5% undivided interest in a 78-suite apartment building known as Westview Manor, (“the property”), in the City of Edmonton, and more particularly described as

lots 1 to 10, inclusive in block 6, City of Edmonton subdivision plan 4821. H W excepting thereout all that portion taken for road, as shown on Road Plan 3037 R S (W /

— The total purchase price of the property was $880,000.00. The Appellant became one of the registered owners of the property on February 27, 1975.

— The property was rented from March 1, 1975 to August 1, 1976 and sold for a price of $1,425,000.00 on August 13, 1976.

The appellant contended:

My intention when I purchased my interest in the Westview Manor was to use it to derive rental income; —

The major difference between the two appeals was that Mr McClelland’s proportion was 2/2 per cent instead of 7/2 per cent.

At the outset of the hearing, counsel for the appellants made it clear that the onus undertaken was to overturn the basic assumption of the Minister “one of the appellant’s major motivating factors was the possibility of resale at a profit at a future time”.

Mr Hochachka and then Mr McClelland testified that they were both practising lawyers in Edmonton. In the case of Mr Hochachka he had invested some $24,000 for his share, on the advice of one Mr Grotski, another law partner, which $24,000 had accumulated out of an earlier (1973) investment of $20,000 in a 15 per cent interest return second mortgage on the same building — again as one of the investors with the advice of Mr Grotski, whom he recognized as a businessman with a substantial knowledge and experience in real-estate matters, although he was unaware of the details or the precise nature of these. He himself (Hochachka) recited a limited but varied involvement in some real estate transactions. The building was rented (he thought fully) at the time of acquisition, but later he became aware of some physical deficiencies and management shortcomings. The imposition of rent controls late in the year of 1975 had not improved the chances to increase income return from the building. He had difficulty explaining for what reason one would “trade” a 15 per cent fixed return investment in a mortgage for an unknown rental income return — one in fact that produced an operating loss. He understood from Mr Grotski that rental income would develop and that over the years a good cash flow would result. He agreed there had been operating losses during the period the building was held. Essentially he had nothing to do with the venture, other than to agree to put up his money in a form of “in trust” arrangement with Mr Grotski. To the best of his knowledge Mr Grotski took about a 25 per cent investment proportion in the acquisition himself. He knew few, if any, of the many other investors, but understood they were represented by another individual, a Mr Kuefler, whom he did not know in any business way. He contended his only reason was to obtain an interest in a long-term investment, and derive therefrom rental income. He did recognize that the prospect of the property increasing in value over the years did exist — but he had never considered the prospect of resale at a profit, at the time of acquisition. The offer eventually accepted by Mr Grotski on behalf of the group was so large and exceptional it simply could not be turned down. He was unaware of any intention or desire by Mr Grotski and Mr Kuefler to “condomi- niumize” the building, although there was certain physical evidence submitted that such an intention was held by these other two gentlemen. Mr Hockachka’s testimony could be summed up by saying that irrespective of the intention or plans of any other investors, he intended only to use his 7.5 per cent interest in the property for the purpose of producing rental income.

Mr McClelland’s testimony was not dissimilar to that of Mr Hochachka except that he had borrowed some $8,000 from Mr Grotski, at 15 per cent interest in order to make his investment. He had no prior record of real-estate trading, and contended along with Mr Hochachka, that his only interest in the investment was to earn rental income. Like Mr Hochachka he had made little if any investigation or examination of the project before, during or after the acquisition, relying solely on Mr Grotski. He was unable to produce any physical evi- dence — in fact agreed there was none — that he had “acquired a 2.5 per cent undivided interest” or that he had “become one of the registered owners” (reply to notice of appeal, (supra),), other than the obvious fact that he had received his gain on the sale. He recognized the difficulty inherent in taking on an obligation to pay 15 per cent interest on a loan of $8,000, without any real knowledge of the source of income from the corresponding interest in the building. He agreed the building had shown an operating loss.

I note at this juncture that Mr Grotski testified later in the proceedings, but I wish to deal first with the testimony of the two appellants by itself.

In summary between them they apparently owned only a 10 per cent interest in the property. On acquisition of their respective interests, each one claims to have had little or no knowledge of the income-earning prospects of the venture; there is no tangible evidence of any ownership of the 10 per cent interest at all — their interests were held “in trust” by a third party, Mr Grotski, who owned about a 25 per cent interest himself, and apparently controlled through the same “in trust” arrangement other individual “percentages” of the same deal. There is some evidence that Mr Grotski was familiar with and involved in the real estate field, but at this hearing he is not an appellant. Further there is a fourth party, Mr Kuefler, who apparently owned or controlled 30 or 35 per cent of the venture. Neither is Mr Kuefler an appellant in this matter, but apparently he also was familiar with the real-estate field. Finally, there is an agreement submitted (Exhibit A-2) between Mr Grotski and Mr Kuefler which indicates a clear desire to condominiumize and sell the building by way of individual units. Neither appellant recalls having seen or heard of the agreement before acquisition, or discussions which would relate it to the acquisition. At the same time, there is evidence that at least Mr Hochachka was exposed to the agreement before acquisition (his signature is on it as a witness), although he does not recall reading it at all. It is clear at least that Mr Grotski made no attempt to conceal the “condominium” prospect from Mr Hochachka.

From that evidence and testimony alone, the proof of “intention” to sell is limited, almost non-existent, and vigorously denied by both appellants, and the effort of counsel for the appellants was directed at noting for the Court’s attention the very minimal association which might be made between that evidence and the Minister’s main assertion, (supra). At the same time, the evidence that the investments were made (Hochachka 7/2 per cent, McClelland 21/2 per cent) for the purposes of earning “rental income” is equally non-existent, although vigorously asserted and espoused by both appellants in testimony. There is some evidence that for the appellants to make such a capital investment under the circumstances (“holding in trust” almost total lack of knowledge of the project, lack of rental experience, etc) would indicate little real prospect of net rental income available to them, — in the case of Mr Hochachka to replace the 15 per cent return on a second mortgage from which his capital to invest in the building was obtained; and in the case of Mr McClelland to pay for interest or repayment costs (if required by Mr Grotski) for a loan from Mr Grotski with which to acquire his share of the project. Counsel for the appellants essentially contended that since there is little if any direct evidence of an intention to resell at a profit at the time of acquisition, the appellants had met the thrust of the Minister’s assumption in the reply to notice of appeal, and the appeals should be allowed. The Minister’s counsel made a valiant and complicated effort to sustain a position that on that part of the evidence alone there were grounds for dismissal, since there was not sufficient evidence to allow the appeal.

As I see it, two fundamental questions must be asked, in determining this appeal. First, is it indeed sufficient for the appellants to present no evidence in support of their own basic appeal proposition (that the acquisition was for the purpose of earning rental income), but simply to state that their intention was such; or in order to overturn the Minister’s assumption that there was an intention to resell, are they required to prove their “rental income” proposition? And second, a taxpayer — out of self-imposed innocence of the real nature of a project, enter into that project by way of capital contributed, and then claim immunity from any adverse tax results which might flow therefrom?

In this case, in answer to the first query, I would think it appropriate to virtually ignore all the other testimony and evidence presented at the hearing by the appellants, and concentrate on the simple statements made by the appellants

— in effect “no, at acquisition, I had no intention or thought whatsoever of selling for a profit, I intended that my capital invested should be on a long-term income-earning basis”. In the circumstances of this appeal, what would be the decision, if that is all the appellants had simply said and added no more? Certainly I believe it fair comment that even under the most arduous cross- examination, counsel for the Minister was unable to damage that statement to any substantial degree, certainly not enough that I would feel comfortable in implying that I disbelieved the appellants, in effect. Therefore, as I see it, at that juncture, (the completion of the appellants’ testimony) the ball should rest in the Minister’s court, to support his basic assumption, if indeed that kind of intention can be attributed directly to the appellants. That was not done, and the assessment could crumble, since there is no serious evidence to contradict the sworn statements of the appellants. For the Court to require them to prove the alternative — that their own acquisitions were for income-earning purposes, would be onerous indeed.

We then turn to the second query. Leaving aside the purity of purpose which underlies the logic in the above response to the first question, we now find the same two appellants, devoid of curiosity, interest or concern about the viability of the project into which they are being invited, and content to accept the general assurances of a certain Mr Grotski as to, not only the security of their funds and the viability of the project, but also by inference that he holds the same pure purpose of rental income production — with no thought of gain on resale — that they say they espoused. In addition they were neither offered, nor requested confirmation or verification of their alleged percentage interests in the project, and indeed left to Mr Grotski the entire operation. That is — there was no physical evidence of any kind to tie these appellants into this building transaction at the date of acquisition of the property. I do not accept their assertions that under the circumstances of this matter, they had enforceable rights of some kind, certainly none that exceeded moral or personal recognition from Mr Grotski on any aspect of the conduct of the affairs of the building — including its sale. I respect and understand their claims of confidence in, and regard for Mr Grotski, but as I see it, not having explored this situation, nor independently dealt with this factor, before, during or after the transaction involved, they must accept the intention of Mr Grotski — whether known to them or not, and the results of his conduct of their affairs become their own, for purposes of a determination of tax impact. On other occasions, I have expressed grave concern about any possible misuse or abuse of the so-called “taxation by association concept” or even the “secondary-intention concept”. But this matter is one situation in which these points cannot be ignored. We then turn to Mr Grotski’s testimony.

Mr Grotski, to his credit did not even attempt to assert that he was unaware of the potential for eventual gain from real-estate transactions, in ways other than gain from the straight rental income production route. He appeared to me keenly cognizant and prepared to take advantage of the ever present prospect of a sale under propitious circumstances in any venture. In a critique of “mortgage interest’* as a route for gain, he was explicit in his view that when factors such as “inflation” and “income tax’* were taken into account — on a Straight interest from investment basis — even at an excellent rate of 15 per cent, the investor would likely still be a loser. He characterized his own investment in the original interest bearing second mortgage, which to some degree gave rise to this real estate transaction, as an unusual, and short-term placement of funds. Clearly he preferred “real estate” to “mortgages”, and his arguments were rather persuasive. However, for this Court, there are two problems with that analysis and conclusion, as it can be related to this issue for these appellants. First, Mr Hochachka insisted that he had put his original $20,000 into the second mortgage (noted above) for the specific purpose of gaining the very good 15 per cent return, and that he did so on the advice of Mr Grotski. I can only conclude, Mr Hochachka at least, regarded it as a good investment. And second, indeed most devastatingly, both these appellants vigorously attempted to persuade the Court that the investment in the rea-estate purchase, (again on Mr Grotski’s advice, and under his control) for them was made for the purpose of gaining or producing income from the rental-income source. I would suggest that with Mr Grotski’s stated and acknowledged rejection of “mortgage interest” as a prime route for gain, he would never have attempted to persuade his colleagues, to invest nor would he so invest himself, in a project designed to provide solely rental income, since rental income, at its base, is essentially no better, possibly worse, than mortgage interest for income tax treatment, and certainly any real net rental revenue (cash flow) would be equally subject to the alleged ravages of inflation expressed by Mr Grotski. No, Mr Grotski, must see a real prospect for more than rental income before he invests in real estate, and I say that with respect for his business acumen, not in any sense critical of it. Mr Grotski agreed without hesitation that his business and financial record showed transactions of real estate on income account — his view however, was that the results of this particular transaction under review should be held to be on capital account. While he did so with reference to his own interest (and gain) in the venture, I suppose, he was primarily asserting this position at the hearing in support of his colleagues, Mr Hochachka and Mr McClelland. Mr Grotski’s tax position is not before this Court, and therefore I specifically point out that the results of a detailed hearing on Mr Grotski’s situation could conceivably produce a different result. But, for purposes of the appeal of Mr Hochachka and Mr McClelland, I an content that Mr Grotski’s perception of the prospects of this venture could be summed up (virtually his own words) as follows:

(1) Increase the rental occupancy ratio.

(2) Repair and renovate to the degree required for short term (cosmetic and urgent) operation.

(3) Restructure the debt load, to withdraw capital funds.

(4) Increase the rental charges.

(5) Implement the plan to condominiumize.

(6) Expect the value of the building to increase, and anticipate purchaser interest.

(7) React appropriately, either by holding the building for rental purposes (an unlikely result — supra)), or by selling profitably.

With regard to Exhibit A-2 noted earlier (the agreement between Mr Grotski and Mr Kuefler) it was his view that condominiumization should be the goal of every apartment-building owner, whether or not he ever intended to sell off the individual units. It certainly raised dramatically the potential for a higher return on sale — whether that sale was on an individual-unit basis, or as a block. In this particular situation, he contended he had no intention of selling the share of the units he controlled (at the time of acquisition) but Mr Kuefler might have had such an intention, and he was acceding to Mr Kuefler’s requirement that such an obligation (condominiumization) should be formalized allowing, according to Mr Grotski, Mr Kuefler to take and sell if he (Kuefler) so chose, his roughly one-third of the units. I do not accept that as a viable explanation of Mr Grotski’s position in this matter. I understand he was prepared for condominiumization, but I am also of the view that he was quite prepared to accept, in real terms, and at any time, the benefits that could come from condominiumization. Whether condominiumized or not (and the efforts to do so did not come to fruition during ownership by these appellants) Mr Grotski’s interest in the venture was founded far more on his awareness of the flexibility, perhaps multiplicity, at least duality for return on investment out of real estate than out of other forms of capital contribution.

In order for these appellants to be absolved, it would be necessary for Mr Grotski to exhibit, beyond any reasonable question, that the rental revenue route was the only one he considered and he did not come close to doing that.

Before finalization, I would note with appreciation the case law referred to by counsel for the Minister in support of the proposition that “taxation by associations” had application in this case. I would also note the major case upon which counsel for the appellants relied Hiwako Investments Limited v The Queen, [1978] CTC 378; 78 DTC 6281, but in my view it is easily distinguishable from this situation, and further comments with regard to Hiwako, (supra), are to be found in Sam Grossman v MNR, [1979] CTC 2132; 79 DTC 141. There are certain comments in the recent case of Quelch v MNR, (not yet published) which might also have value in any review of this decision.

The appeals are dismissed.

Appeals dismissed.