Hau v. R., [1997] 1 CTC 2113 (Informal Procedure)

Rip J.T.C.C.: — Ly Hau and Neng Hau are brothers. In November 1990 they and another brother, Sang Hau, purchased three commercial condominium units located on Silverstar Boulevard in Scarborough, Ontario (“condominium property”) for the following amounts: [1]

Unit 30: $133,860.00

Unit 31: 128,360.00

Unit 32: 146,300.00

Total: $408,520.00

Ly Hau, a sewing machine operator, carried on a business on the condominium property from November 1990 to October 1991, when he closed down the business. During the time he operated the business, called “L.A. Fashions”, he had 30 sewing machines on site. The arrangements between the brothers were that Ly would run the business and when he had income from the business he would pay rent. However all three brothers were liable for the payments of mortgage interest. The appellants used their own savings to pay the interest. Ly also borrowed money from his brothers to honour his obligations. No rent was paid during the time the appellants owned the condominium property.

In 1992 the appellants disposed of their interest in the condominium property to Sang Hau for $190,598; each appellant’s share of the sale price was $95,299. The Minister of National Revenue (“Minister”) assessed the appellants for 1992 on the basis that they each incurred a capital loss on the disposition, as follows:

Proceeds of Disposition: $ 95,299.00

Less

Adjusted Cost Base: 136,173.34

Loss on Disposition: ($40,874.31)

The appellants have appealed (Informal Procedure) the assessment for 1992. [2] In their view they each incurred a terminal loss of $40,874.34 on the disposition in accordance with subsection 20(16) of the Income Tax Act (“Act”). The appeals were heard on common evidence.

Ly closed his business because the business incurred a loss and he “could not sustain the business”. Sang Hau took over the business as well as the condominium property in 1992. Ly believes Sang “ran the business for a year or more” but was not sure. After October 1991, and before the sale, the condominium property had been rented to Sang, although no rent was ever paid.

Neng Hau continued to work at Magna Corporation as a dye- setter during the years in appeal. He testified - as did Ly - that the brothers’ intention on purchasing the condominium property was to open a family business “later on”. Neng confirmed that the rental arrangement with Ly was that the latter would operate a business, pay his share of the mortgage interest, and if he made “extra money above the mortgage”, he would pay rent. The amount of rent was not divulged at trial. Neng testified that during the time Ly operated the business, Neng paid a “big part” of the mortgage because Ly did not make money. Neng had accumulated savings from his employment at Magna Corporation during a 13 year period. He also borrowed money from a sister and brother.

Neng stated that if he had known at time of purchase he would not obtain rent from the condominium property “I wouldn’t have invested all my savings into the building...”. All three brothers, he said, wanted to open a family business.

Subsection 20(16) generally permits a taxpayer to claim a terminal loss in a taxation year when the taxpayer no longer owns depreciable property of a particular class. The term “depreciable property” of a taxpayer as of any time in a taxation year is defined in subsection 13(21) of the Act to mean:

property acquired by the taxpayer in respect of which the taxpayer has been allowed, or would, if the taxpayer owned the property at the end of the year and this Act were read without reference to subsection (26), be entitled to, a deduction under paragraph 20(1 )(a) in computing income for that year or a preceding taxation year;

Paragraph 1102(l)(c) of the Regulations to the Act state that:

classes of property...shall be deemed not to include property...that was not acquired by the taxpayer for the purpose of gaining or producing income....

Thus, the issue before me is whether the appellants acquired the condominium property for the purpose of gaining or producing income.

Respondent’s counsel argued the condominium property was acquired by the appellants to rent to persons not at arm’s length and no rent was paid. The property was not purchased for the purpose of gaining or producing income. She also submitted that when Ly Hau ceased carrying on business in October 1991, there was a change of use of the property. She added that during the time the property was rented to Sang Hau, no rent was paid. The property, in her view, was never a source of income.

Appellant’s agent submitted that two of the brothers purchased the condominium property as investors and the third brother, Ly, purchased the property for the purpose of carrying on a business. He said the appellants, in particular Neng, acquired the property to collect rent to cover the mortgage, and if there was a profit from Ly’s business additional rent would be paid. When Ly closed the business in 1991, he continued to own an interest in the property for several months. The agent argued that a putative rent was paid since the mortgage payments by Ly and, after October 1991, by Sang, were rental payments.

A property eligible for capital cost allowance and terminal loss deductions must have been acquired by the taxpayer for the purpose of gaining or producing income: Regulation 1102(l)(c). The leading case on the meaning of the phrase “for the purpose of gaining or producing income” is found in the Federal Court of Appeal case Hickman Motors Ltd. v. R., (sub nom. Hickman Motors Ltd. v. Minister of National Revenue) [1995] 2 C.T.C. 320, (sub nom. Hickman Motors v. Canada) 95 D.T.C. 5575 (F.C.A.); leave to appeal granted (May 3, 1996), Doc. 24994 (S.C.C.). [3] In that case the appellant’s subsidiary was wound up into the appellant on December 28, 1984. December 31 was the appellant’s fiscal year-end, and for the year 1984 the appellant claimed capital cost allowance on the property received from the subsidiary as a result of the wind-up. On January 2, 1985 the appellant sold most of the assets it had received from the subsidiary. The Minister denied the claim for capital cost allowance because in her view the assets were not held for the purpose of gaining or producing income. The trial judge agreed, stating that any income derived from the property was “nominal”. The Federal Court of Appeal upheld this finding and stated, at page 327 (D.T.C. 5579) that the test was the following:

In my view, the test to be applied in determining whether property has been acquired for the purpose of gaining or producing income is similar to that which was authoritatively settled by the Supreme Court of Canada for determining the analagous [sic] question as to whether a taxpayer is carrying on a business with a reasonable expectation of profit. In Moldowan v. R.* [4] Dickson, J., as he then was, speaking for the Court, said as follows:

There is a vast case literature on what reasonable expectation of profit means and it is by no means entirely consistent. In my view, whether a taxpayer has a reasonable expectation of profit is an objective determination to be made from all of the facts. The following criteria should be considered: the profit and loss experience in past years, the taxpayer’s training, the taxpayer’s intended course of action, the capability of the venture as capitalized to show a profit after charging capital cost allowance. The list is not intended to be exhaustive, [at page 5215] Several of the criteria mentioned by Dickson, J. in his non- exhaustive list argue strongly against the taxpayer’s contention; there is no evidence to support any which would point the other way.

The leading case interpreting the Moldowan test is Tonn v. R., [1996] 1 C.T.C. 205, 96 D.T.C. 6001 (F.C.A.). This case does not directly change the law on the meaning of reasonable expectation of profit as developed in the courts, but instead gives guidelines as to how the Moldowan test should be applied by the courts. The test should not be applied too strictly. Linden J.A. admonished judges substituting their business judgments for that of a taxpayer. On this subject he stated, at pages 219-26 (D.T.C. 6009), that:

… The tax system has every interest in investigating the bona fides of a taxpayer’s dealings in certain situations, but it should not discourage, or penalize, honest but erroneous business decisions. The tax system does not tax on the basis of a taxpayer’s business acumen, with deductions extended to the wise and withheld from the foolish.

Consequently, when the circumstances do not admit of any suspicion that a business loss was made for a personal or non-business motive, the test should be applied sparingly and with a latitude favouring the taxpayer, whose business judgment may have been less than competent.

Later on, at page 224 (D.T.C. 6012), Linden J.A. stated that:

The primary use of Moldowan as an objective test, therefore, is the prevention of inappropriate reductions in tax; it is not intended as a vehicle for the wholesale judicial second-guessing of business judgments. ... Errors in business judgment, unless the Act stipulates otherwise, do not prohibit one from claiming deductions for losses arising from those errors.

Linden J.A. then reviewed the case law on this subject and concluded that the cases may be classified into two broad categories: the personal benefit and hobby type cases where a taxpayer has invested money into an activity form which that taxpayer derives personal benefit, and other cases where there is no personal benefit involved and the activity cannot be classified as a hobby. He made a distinction as to how the Moldowan test should be applied to these two types of cases in the following passage from page 225 (D.T.C. 6013):

... the Moldowan test should be applied sparingly where a taxpayer’s “business judgment” is involved, where no personal element is in evidence, and where the extent of the deductions claimed are not on their face questionable. However, where circumstances suggest that a personal or other-than-business motivation existed, or where the expectation of profit was so unreasonable as to raise a suspicion, the taxpayer will be called upon to justify objectively that the operation was in fact a business. Suspicious circumstances, therefore, will more often lead to closer scrutiny than those that are in no way suspect.

Linden J.A. further stated, at page 220 (D.T.C. 6009), that the Moldowan test “is a useful tool by which the tax-inappropriateness of an activity may be reasonably inferred when other, more direct forms of evidence are lacking”.

Subsection 9(1) of the Act states that for the purposes of the Act “a taxpayer’s income for a taxation year from a business or property is the taxpayer’s profit from that business or property for the year”. Thus it cannot be said that the partnership received any income as no profit was ever made from the condominium properties. This is true whether or not the partnership received a putative rent from Ly’s business, as his agent claimed.

A case similar to the appeals at bar is Electrical Industries (Western) Ltd. v. Minister of National Revenue, [1990] 2 C.T.C. 2590, 90 D.T.C. 1842 (T.C.C.). In that case the taxpayer acquired certain assets and rented them to another corporation which was 48 per cent owned by the taxpayer. Due to the unprofitability of the lessee, however, the taxpayer decided to forego rent on the assets until the business became profitable, and no rent was ever actually received from the assets. Beaubier T.C.C.J. concluded, at page 2593 (D.T.C. 1844):

... that the appellant purchased the fixed assets for the sole purpose of gaining or producing income therefrom and for no other purpose. The appellant, in the Alberta economy of those days, had over 35 years of continuous profitable operations in the same business as the fixed assets would be used. ... It is quite credible in the practical business world that the appellant would not contract for, charge or “book” rent for the years in question in the expectation that Damont Pumps Ltd. would be turned around and that the rent shortage would be made up.

In my opinion it is difficult to distinguish Electrical Industries from the appeals at bar. Notwithstanding that Ly operated a business for only one year and at a loss, one must not lose sight of the fact that Ly and his brothers undertook the investment for Ly to operate a business, and to operate it successfully, and for them all to receive rent from the business. It was not unreasonable for them to enter into an arrangement that until the business showed some success no rent would be charged and when the business turned around rent would be paid. That there may have been a change of use in the property once Ly ceased to operate his business does not change the reason for which the appellants acquired the property. The appellants impressed me to be hard working people who wanted to own their own enterprise. Ly failed in his business aspirations but the failure does not derogate from the fact the condominium units were purchased for the bona fide purpose of gaining income, one way or another. I am not of the view, as alleged by the respondent, that because the condominium units were rented to a person not dealing at arm’s length with the appellants, it must follow the condominiums were not a source of income to the appellants. In my view the appellants’ venture falls into the second category of cases described in Tonn, 1.e., that of a genuine business investment with no personal or non-business interests involved. I have therefore applied the Mo Ido wan test sparingly to the appellants and have not second-guessed their business judgment.

The appeals for 1992 are allowed with costs, if any, to permit a terminal loss to each appellant. The appeals for the earlier years are dismissed.

Appeal allowed.