Norman G Hall, Stirling C Lane v. Minister of National Revenue, [1983] CTC 2003, 83 DTC 8

D E Taylor:—These appeals, heard on July 8, 1982 in Charlottetown, Prince Edward Island, are against income tax assessments for the years 1978 and 1979 in the case of Mr Hall, and for the years 1978, 1979 and 1980 in the case of Mr Lane. The sole matter at issue is the deductibility of amounts claimed by the appellants as losses from farming under the provisions of section 31 of the Income Tax Act. It should be noted for the record that Mr Hall had originally claimed the amounts in question as “business” losses, but he accepted at the commencement of the hearing that the only deductibility claim which was open to him was under the restricted provisions of section 31 applied solely to “farming”. It was explained to the appellants that the concession by Mr Hall did not alleviate the basic requirement for demonstrating that the operation — even though farming — was still a business.

The respondent relied, inter alia, on sections 3, 4, 9(2), 18(1 )(a), 18(1 )(h), 31(1) and 248(1) of the Income Tax Act, S.C. 1970-71-72, c 63, as amended, in his assessment of the appellants.

Without commenting on that concession of Mr Hall, the Board does note that the interrelationships of “business”, “restricted farm loss” and “chief source of income” were reviewed at some length in James R Leslie v MNR, [1982] CTC 2233; 82 DTC 1216. The essence of Leslie (supra) is that while the deductibility of “start-up costs” should be taken seriously when the claim is related to the “restricted farm loss” provisions of section 31 of the Act, the same rationale is questionable when the claim is for the “full farm loss”. The decision in Leslie (supra) concludes on 2244 and 1226 respectively:

The dichotomy inherent in this situation is striking and noted by the Board — a reasonable expectation of income may provide the basis for deduction as “start-up costs” of the full loss resulting from any other business; whereas for farming, the “start-up costs” must have resulted from the operation as the main expectation of income. It is not evident to me that in this matter the secondary argument of the appellant based on “start-up costs” for farming which this taxpayer is entitled to deduct as operating “losses” are founded in the appropriate classification into which he falls, as outlined in Moldowan (supra) — Class (2), restricted to $5,000 per annum.

A cursory review of a recent judgment of the Federal court subsequent to Leslie (supra) — Helen Kasper v The Queen, [1982] CTC 178; 82 DTC 6148

— might lead to a re-examination of that statement but in Kasper (supra), the learned judge dealt only with the years 1977 and 1978, years in which, as he said (at 182 and 6150 respectively):

I am satisfied that the Plaintiff was totally absorbed in the operation of the horse breeding farm by 1978, and that during the years from 1974 to 1978, she was systematically transferring her attention from the previous business to the farm.

(And at 182 and 6151 respectively):

“Finally, the Plaintiff gradually increased her commitment of time and money until both were so substantial as to leave no doubt in my mind that during 1977 and 1978, she had changed her mode and habit of work to the management of her horse breeding farm from her previous active participation in the operation of Motor Express Terminals Limited.

The point at issue in Kasper (supra) did not relate to the years 1974 through 1976 when it could be said that the taxpayer’s substantial losses were “start-up costs”. In addition, I would note that the other income of the appellant in Kasper (supra) during the taxation years in question (1977 and 1978) may have been largely, if not totally, from investment as opposed to any contrasting business venture. Certainly the judgment in Kasper (supra) is significant and will be of great assistance in further clarification of the appropriate application of section 31 of the Act.

A preview of the issue was provided in the notices of appeal and the relevant replies to notices of appeal and using Mr Lane’s situation, it can be seen: For the Appellant:

Mr Lane is a successful businessman who, together with other partners of N-R Stable, decided to invest in the harness racing business. To this end he invested in several horses commencing in 1978 with the following objectives in mind:

1. To obtain horse racing winnings;

2. To realize profit on sale of successful race horses;

3. Possible breeding of successful race horses.

Since 1978 Mr Lane has spent time and monies in pursuit of these objectives. He attends monthly meetings of the partners. Quarterly income statements are prepared and reviewed. Insurance is maintained on the horses. Mr Lane has sold his share of unsuccessful horses that he felt did not have good potential for profit. He is actively involved in the decision making process in a businesslike manner. Successful horses in the stable race in Montreal where purses are larger.

With regard to the loss incurred in 1980 it should be noted:

1. As allowed by the Income Tax Act the cost of horses may be expensed in the year of purchase;

2. The exclusion, in year end inventory, of a value for the horses that would reflect their fair market value at the year end. The inclusion of such an amount would indicate a slight overall profit position for the two years, 4 months ended December 31, 1980 (see attached schedule of Horse Racing Losses).

It should also be noted that the horse racing industry is both risky and subject to great variance in income for various reasons peculiar to the industry, such as:

(a) sickness and injury

(b) training time

(c) inherent quality of the horses (as determined by selective breeding).

Mr Lane has conducted his horse racing activities in a businesslike way, with the expectation of profit.

For the foregoing reasons it is felt that the tax losses incurred should be allowed as a deduction under Section 31(1) of the Income Tax Act and that Revenue Canada Taxation should vacate its reassessment.

Schedule of Horse Racing Losses

1978-1980
Loss — 1978	$	509
1979		3,996
1980		5,923
Total losses	10,428

Value of horses at December 31, 1980

Enersave	1/8 of $30,000		3,750
Island Brandy	3/10 of $16,500		4,950
Northern Clutch	2/10 of $ 2,000		400
Amber Jeff	3/10 of $	500	150
Prudentia	1/5 of$ 6,600		1,300
Gotta Winner	1/5 of $ 1,900		400
		10,950
Net position to December 31, 1980		$	522

For the Respondent:

— In 1978 the appellant and eight other persons entered into a partnership called N-R Stable for the maintaining of horses for racing;

— The number of horses owned each year by N-R Stable were as follows:

1978 — 1

1979 — 4

1980 — 8

— N-R Stable rents a property at Harrington, PEI consisting of 1 barn and 22 acres of land, used as pasturage and to house those horses which are not racing or training;

— N-R Stable keeps those horses which are racing or training at the Charlottetown Driving Park;

— N-R owns approximately $2,500 worth or equipment;

— The appellant does not devote very much time or attention to the daily maintenance of the horses;

— N-R Stable employs a person to look after the feeding of the horses and the cleaning of the barn at Harrington and they also employ a trainer for the horses at the racetrack;

— N-R Stable reported gross income, expenses and net loss from maintaining horses for racing of which the Appellant claimed his share of such losses in the following amounts:

Farm Loss Claimed

by Appellant

	Gross Income	Expenses	Net Loss	Under Section 31
1978	Nil	$ 4,581.91	$ 4,581.91	$ 509.10
1979	$ 1,772.00	20,576.34	18,804.34	3,248.00
1980	27,838.69	45,785.67	17,946.98	3,712.00

— The appellant and N-R Stable had no reasonable expectation of earning a profit from the maintaining of horses for racing;

— The activity of maintaining horses for racing was not farming, but a hobby of the appellant and the expenses incurred by him were personal or living expenses.

Evidence

A detailed account of the history and functions of N-R Stable was read into the record by Mr Hall. The following list of exhibits and documents referenced therein provides an indication of the scope of that presentation:

A. Letter of Appeal and Notices of Objection to Assessment

B. List of Partners

C. By-Laws — Original Sept 13th, 1978

— Revised Jan 19th, 1981

D. USTA Registration

E. Bank Records — Letter from Bank

— Account Agreement

— Hypothecation of Collaterals

— Loan Authorizations 1979-81

— Application for Credit

— Signing Authorities

7— Demand Loan Ledger

F. Tabulation of Personal Time Spent

G. Copies of Minutes — Regular Meeting

H. Copies of Minutes — Annual Meeting

I. Copies of Charge Accounts

J. Financial Plan — Proposal

— Tabulation

K. Statements — Annual

L. Statements — Current Position

M. Letter of Evaluation of Enersave

N. Letter of Review

O. Brief on Industry

P. Pedigrees and Breeding Attestation

Two paragraphs from the Notice of Appeal of Mr hall summarized the significant contents in the presentation:

The Department is ignoring the basic investment/return cycle inherent in the purchase of yearling racehorses. Most racehorses do not race until three years old and from the time of purchase as yearlings (one year old) until they race there is a long and expensive process of training over a 16 to 24 month period.

The N-R Stable’s primary purpose is the investment in well bred, extensively staked yearlings which have potential for significant earnings in Sires Stakes and will ultimately be marketable once their potential has been developed and sufficiently proven to establish their value.

Dr Tom Ling, a medical doctor with a deep interest and connection with the horse racing industry in the area, also testified on behalf of the appellants. Essentially, Dr Ling stated that based upon the efforts of groups such as N-R Stable, the industry had a potentially good future and could be very positive in terms of the economy of the Island. Mr James Frederick McCann, an official with Revenue Canada, outlined the reason that the claims had been disallowed. Mr McCann had some experience in the farming business on the Island, and some exposure to the raising and racing of horses. The operations as established and conducted under the conditions existing for the industry on the Island simply would not be profitable according to Mr McCann.

The witness for the Minister also provided the Board with a schedule of the N-R Stable assets — particularly the horses — which differed markedly from the valuations attributed to them by the appellants. In general, the “realization” of the assets of the Stable even as at December 31, 1981, would not have produced any net gain to the appellants and very probably a substantial net loss.

During the questioning of the witnesses, some of the points noted by the Minister in the reply to notices of appeal (supra) were cleared up, but these did not have a determinative bearing on the fundamental issue — the demonstration of a “reasonable expectation of profit”.

Argument

Mr Hall concluded his presentation of the appeal in the following terms:

Low returns did exist, but that didn’t have any bearing on the high potentials that were there as well, provided some of these problem areas could be resolved. . . . so we felt that that investment in the share in the Charlottetown Driving Track gave us that assurance, and as a consequence, had a direct bearing on our business operation.

Much of the evidence that we’ve discussed here, relates more to a current situation than it does at the time of the years under appeal. We have presented evidence though, that I believe asserts that the N-R Stable was initiated as a business, that being the business of buying, training, racing, selling and ultimately, breeding of race horses. That, under the Act of the business of farming, we have always treated as such in terms of our accounting. Our accounting has always been done on a cash basis, as is required for all farming income.

I might make reference to The Queen v Matthews, 74 DTC 6193, to which the Court held that, and I quote, “It takes time to grow trees”. Now in this particular instance, we were talking about a tree farmer with a long term plan with a postponement of profit in the early years. And the Court additionally held, and I quote:

“each case, where the realization of profit is postponed, will have to be examined on its own merits”.

In the case of Johnson v The Minister of National Revenue, 78 DTC 1109, the Board held, and I quote:

“No profit shown in the early years, is not a basis for presumption of no expectation of profit”.

The lack of profit in the early years has to be viewed in terms of our long term plan. Now no plans are perfect. They are forecasts, and obviously, in our forecasting, we have made some errors, but . . . particularly with regard to our expectations of the aged horses. But in looking at our investments in the yearlings, to this point, we believe that we have met, and perhaps even exceeded our expectations in terms of the profitability of that investment opportunity.

The case for the Minister was summarized:

However, it is the position of the Minister, in this case, that although the start-up costs argument is sometimes a valid one, in this particular case, that argument does not stand. The reason for that position by the Minister, of course, is due to the question of reasonable expectation of profit, and we are talking about reasonable expectation of profit in the years 1978 and 1979 and 1980 . . . whether N-R Stable had such a reasonable expectation of profit.

In the decision of Warden v The Minister of National Revenue, 81 DTC 322, at page 329, it states:

“However, the principle of substantiating the ‘losses’ as start-up costs . . . remains the same for any business. The onus remains for a taxpayer to prove the reality and viability of profit even in the long term. When the taxpayer claims expenses, which are in excess of income, then he must assume the difficult task of showing that these excess expenses were rational and reasonable . . . those which a normally wise and prudent man, intending to improve ... not reduce his financial position would incur, under the circumstances.”

And it would be the position of the Minister, in relation to that quotation, that a reasonable and prudent person understanding the situation here in the Maritimes and in Prince Edward Island in particular, during this period of time that's under review, would not have had a reasonable expectation of profit ... would not have incurred these types of expenses.

Most of the material (presented by Mr Hall) is forecasts. Where the figures come from is not really sure, as we’ve found out from his testimony — bank records, by-laws, United States Trotting Association Registration, lists of partners, copies of Minutes of Annual Meetings and regular Meetings, all very interesting reading, but it does not go to showing whether there is a reasonable expectation of profit. I do however feel that within this documentation that has been presented here, that there is some documentation that does tell the tale as to what really was going on, and of course that document is in Tab “O” of Exhibit A-1 — the Brief on the (Harness Racing) Industry. . . . Paragraph 5 of the first page:

“The harness racing industry, however, is fraught with problems which combine to present considerable disincentives to the prospective investor. These problems are such that although our stable operation was in our minds, a successful one, it is unlikely that it will grow, or indeed continue unless steps are taken to remove the very real disincentives we have encountered in the first two years of our operation.”

Now, I believe Mr Hall indicated that this was prepared in 1980.

With respect to tab “J” of Exhibit A-1, the so-called investment plan for purchase and disposal of assets, it says that

“the long-term plan of N-R Stable shall be to invest, the purchase, training, racing, breeding, and sale of standard bred horses”.

Well, we’ve heard a lot about purchasing. We’ve heard a lot about training. We’ve heard a lot about racing. And breeding, we’ve heard about, but we’ve never really seen any evidence that that’s the activity that N-R Stable is actually carrying on.

As Mr McCann stated during his investigation, his audit of N-R Stable and Mr Hall, there might have been the possibility of breeding, but it certainly was not a definite type of activity within the meaning required for a reasonable expectation of profit.

Findings

As is evident by the time lapse since I heard these appeals, I have reviewed the situation and the material many times and very carefully. The conviction of the appellants that there was the potential for a viable horse breeding, raising, racing and selling industry on the Island comes through clearly. That they dedicated considerable effort and finances to the enterprise cannot be doubted and that they function in a businesslike way with records, bank accounts, meetings etc has been demonstrated. That they had a personal and subjective love for and interest in horses is also clear in my view. All this comes down to the problem that no matter how firm their conviction or evident their devotion, they had embarked on a program in an industry that must be among the most speculative and high risk in the country.

Prospects — and possible actual accounts — of specific and existing instances of individual successes undoubtedly buoyed up their spirits and maintained their interests, and for their persistence they deserve credit. At the same time, the obstacles in their path — known to them at the outset — must have been serious, and those which shortly became evident must have added to their concerns. The Minister says in effect, that it would have been impossible for the appellants not to have been aware of these difficulties (and I agree with the Minister), but the Minister continues that entering into the venture in the face of these difficulties eliminated the prospect of profit.

I am very impressed with the grasp of the situation presented by Mr McCann in his testimony and, by any standard his assessment of the situation, including asset value is far more objective and rational than that presented by the appellants. I am completely convinced that realization of the assets of the stable, even now, would result in heavy losses for the participants. Therefore, what do we have — an obviously difficult, almost insurmountable set of problems at the outset of the venture; a three-year record of no profit, and indeed increasing losses; and an asset realization situation which would only add to that bleak picture. For the appellants to have made a profit during the three years in question in these appeals would have been a feat of almost miraculous proportions — but it cannot be said that it was totally impossible. Nevertheless, within that framework of the issue the Minister had ample room for the reassessments in question. Contrasted to that bleak scenario however, and in favour of the appellants, there are a few salient factors — first, they did increase their inventory of horses from one in 1978 to eight in 1980; second, they succeeded in dramatically changing the ownership and operation of the Charlottetown Driving Park for purposes of racing their horses; third, they did conduct their affairs not merely on a mutually acceptable, informal basis, but on a regimented and formal basis; fourth, they have presented and continue to present briefs and submissions to all levels of government outlining the problems faced by the industry and suggesting changes; and finally we have the testimony of Dr Ling, an interested observer but nevertheless a knowledgeable witness, who stated that the prospect for expansion and stabilization of the horse racing industry on the Island has been materially improved.

The matter of alleged “start-up costs” has been a contentious one in income tax appeals and I have not been easily persuaded that losses resulting from less than judicious business ventures should be written off simply by adopting the appellation “start-up costs”. Nevertheless, in the circumstances of this case, I am of the view that the characteristics of the venture come much closer to filling that description than the only other option left to the Board, merely a “hobby” engaged in as a pastime with the almost certain knowledge that there would be costs involved and a minimum of return (if any) to ever be expected. I am reinforced in this view by the judgment of the Federal Court in The Queen v James R Zavitz, [1981] CTC 17; 81 DTC 5007, which upheld an earlier favourable decision of the Board reported at [1978] CTC 3021; 78 DTC 1730, I would also note the case of D A MacEachern v MNR, [1977] CTC 2139; 77 DTC 94, wherein the Board dismissed the claim of the appellant that his deep-sea diving for sunken treasure was only a hobby. Quotations from that case, to be found at 2141 and 96 respectfully, are helpful:

In response to appellant’s argument that the endeavour was a hobby, the Board points out that hobby though it may have been, it was clearly a hobby with a potential for profit, and under favourable circumstances, substantial profit. At the minimum this would tend to distinguish it from a hobby and endow it with characteristics somewhat akin to a business endeavour.

The Board is aware that the undertaking probably necessitated high risks of personal safety; that the investment of time and dollars was part of an individual commitment; and that the possibility of success may have appeared slight.

It would appear to me that a “high-risk” venture is liable to attract income tax if successful, providing the evidence demonstrates its businesslike qualities. Conversely, in the circumstances of this case, the businesslike approach which was adopted, together with the modest sucess (although not profit) the appellants achieved, should entitle them to the restricted benefits permitted for “farming”. As I have noted on several previous occasions, the unusual provisions of section 31 of the Act permit deductions which reflect the particular attention to and concern of the legislators for the efforts of those taxpayers engaged in farming enterprises. Those provisions are clearly subject to misinterpretation and abuse, and the case law is replete with decisons and judgments dismissing apeals related to it. But the same provisions must not be interpreted so narrowly as to totally eliminate, rather than to simply restrict their application. In the instant case, the claim of the appellants to “start-up costs” to the extent permitted under section 31 of the Act is justified during the years under review. That does not, of course, warrant “carte-blanche" for similar continued and uninterrupted deductions in the future, each taxation year requiring its own justification.

Decision

The appeals are allowed in order to permit the appellants to deduct losses incurred up to the limits imposed under section 31 of the Act. The entire matter is referred back to the respondent for reconsideration and reassessment in a manner not inconsistent with the above reasons for decision.

Appeals allowed.