Sardinha v. R., [1997] 2 CTC 2049

Taylor T.CJ.:

This is an appeal heard in Toronto, Ontario, on October 8, 1996 against assessments under the Income Tax Act (the “Act”) in which the Respondent disallowed claims for rental losses in the amounts of $4,092.66, $8,100.78 and $6,822.19 for the years 1991, 1992 and 1993 respectively. The challenged assessments were dated May 30, 1995 and the Notice of Confirmation by the Minister of National Revenue was dated December 20, 1995, stating:

The expenditures to the extent of $4,092.66, $8,100.78 and $6,822.19 in the 1991, 1992 and 1993 taxation years claimed as deductions from income as Rental Losses were not recurred by you for the purpose of gaining or producing income within the meaning of paragraph 18(l)(a) of the Act, but were personal or living expenses within the meaning of paragraph 18(l)(h) and subsection 248(1) of the Act.

I point this out, since the noted case of Tonn v. R., [1996] 1 C.T.C. 205, 96 D.T.C. 6001 was issued by the Federal Court of Appeal only on December 11, 1995. The Notice of Appeal (dated February 22, 1996) and the Reply to Notice of Appeal (dated April 30, 1996) therefore may not have reflected the comments from Zonn (supra) as the quotation below will indicate. A further document entitled by the Agent for the Appellant - Mr. Stephen Boland, Chartered Accountant, as Response to the Reply to Notice of Appeal” [1] was dated September 9, 1996, and did make reference to that current case law (T ann (supra)). This appeal was well documented, and well presented. Accordingly I will quote extensively from the above pleadings, as a foundation for the testimony provided at the trial.

From the Notice of Appeal (see Appendix “A” attached).

From the Reply to Notice of Appeal:

8. In so reassessing the Appellant, the Minister made the following assumptions of fact:

(a) in March 1989 the Appellant purchased 94 Galt Avenue, Toronto, Ontario (the “Property”) as her principal residence;

(b) on acquiring the property in 1989, the Appellant began renting a portion of the Property, and since commencing the purported rental operation, has never reported a profit;

(c) in the 1991, 1992 and 1993 taxation years, the Appellant reported rental income, expenses and losses as per Schedule “A”, attached;

(d) in the 1989 and 1990 taxation years, the Appellant claimed rental losses of $6,490.00 and $5,744.00 respectively;

(e) the rent charged was not sufficient to offset the fixed operating expenses (mortgage interest and property taxes) of the Property;

(f) the purported rental operation was a vehicle by which the Appellant hoped to defray the carrying costs of her principal residence;

(g) the Appellant had no reasonable expectation of profit from renting the Property during the 1991, 1992 and 1993 taxation years;

(h) the rental expenses were personal or living expenses of the Appellant.

B. Issues to be Decided

9. The issue is whether the Appellant had a reasonable expectation of profit from renting the Property in the 1991, 1992 and 1993 taxation years.

C. Statutory Provisions, Grounds Relied on and Relief Sought

10. He relies on sections 9 and 67, subsection 248(1) and paragraphs 18(l)(a), 18(l)(h) and 20(1)(c) of the Income Tax Act (the “Act”) as amended for the 1991, 1992 and 1993 taxation years.

11. He submits that the Appellant did not have a reasonable expectation of profit from renting the Property in the 1991, 1992 and 1993 taxation years, that the losses were personal or living expenses of the Appellant, and that the Appellant was properly reassessed in accordance with paragraphs 18(1)(a) and 18(l)(h) of the Act.

12. He further submits that the disallowed expenses were not incurred for the purpose of gaining or producing income from a business or property within the meaning of paragraph 18(l)(a) of the Act but were personal or living expenses of the Appellant within the meaning of paragraph 18(l)(h) and subsection 248(1) of the Act.

13. He further submits that the expenses were properly disallowed pursuant to section 67 as they were not reasonable in the circumstances.

From the Response to the Reply to Notice of Appeal (above):

8. The Appellant denies all allegations of fact, except that contained in subparagraph (c), made in this paragraph and specifically refutes each of the other allegations as follows:

(a) 94 Galt Avenue had been operated as a rental property for many years prior to 1989. In March 1989, the Appellant acquired the rental operation and decided to live on the property to facilitate the management of the rental operation.

(b) The Appellant did not commence the renting of the property, but rather took it over on acquiring the property in March 1989. To the best of her knowledge and belief the rental operation commenced many years before her involvement with the property.

(c) Agreed.

(d) As with all other years, the net losses reported in the 1989 and 1990 taxation years comprised the excess of interest deducted under paragraph 20(l)(c)(ii) of the Income Taxes Act net of profits from rental operations.

(e) This is factually incorrect. As shown in Appendix A, the rent charged exceeded mortgage interest and property taxes in both 1992 and 1993. Moreover, the difference between the rents charged and mortgage interest and property taxes demonstrates the classic trend of increasing returns which is the hallmark of profitable long-term rental operations.

(f) The purpose of the rental operation was (and still is) to produce longterm income and capital gains for the Appellant. The Deputy Attorney General has no direct or indirect knowledge of how the Appellant intends to use the proceeds of such income or gains, and therefore his comments are mere speculation. Nonetheless, it is significant that he believes that “the Appellant hoped to defray the carrying costs of her principal residence”. Since there would need to be some source of income to defray these costs, the Appellant clearly must have expected to profit from the rental operation. (underlining mine)

(g) The Appellant did in fact produce a profit (within the terms of paragraph 9 of the Income Tax Act) from renting the property during 1991, 1992 and 1993. Moreover, as demonstrated in the Appellant’s Notice of Appeal, she reasonably expected the profits to be significantly higher, but they were adversely affected by several unexpected events during this period (i.e. the severe downturn in the Toronto real estate market, the general economic decline in Canada, non-payment of rent, property damage by a tenant, particularly severe weather conditions etc.)

(h) The rental expenses are clearly not personal or living expenses within the meaning of the Income Tax Act as the definition of “personal or living expenses” in paragraph 248 only includes “properties maintained ... for the use or benefit of the taxpayer or any person connected with the taxpayer by blood relationship, marriage or adoption”. As none of the tenants of 94 Galt Avenue were so connected to the taxpayer, the expenses could not be defined as personal or living expenses within the meaning of the Income Tax Act.

The Agent for the Appellant gave the Court an Opening Statement which reviewed much of the documentation already submitted (above). He stressed the distinction the Court should make between “operating expenses” of the building, and the “interest charges”. The essence of this point was that the Appellant had met the challenge of showing there had been a “reasonable expectation of profit”, not taking into consideration the interest charges, which he regarded as of a different character.

The Appellant stated that she began looking for a property to buy in 1988 - her preference was one with two apartments, one she would occupy herself, one she would rent. But the best opportunity she found, was the subject property. She thought she could rent it at a profit - if not immediately at least in a short period - she trusted her real estate agent, but she agreed she had not done her homework properly. She had planned to profit from the venture both from net rental income and from eventual capital gain. There were three apartments which at the start showed:

Main Floor - 800 sq. ft. - Vacant (So she used it, and for a time she charged a person who roomed with her $500.00 per month. This main floor unit entitled her to use about 100 sq. ft. of the basement as part of the total space occupied. That made a total of about 900 sq. ft.). She considered to a third party entirely she would have asked about a $1,000.00 per month.

Second Floor - 700 sq. ft. - already rented at $750.00 per month and she continued with the same tenant, but raised the rent when she could by about a $100.00 per month.

Basement - 600 sq. ft. - as I understand it, she charged something moderate, perhaps about $500.00 per month when it could be rented. Whether the 600 sq. ft. (above) also included the 100 sq. ft. allocated to the main floor was not made clear.

The building had been purchased in 1989 for $262,000.00, carrying two mortgages, the first for $178,000.00, and the second for $25,000.00, a total of $203,000.00. Rental vacancies went up, rents that would be charged went down, and properly values went down, after her purchase according to the Appellant. She had some damage to the apartments, as well as difficulty and costs to evict a tenant, with the resulting loss of rental income. She listed the property for sale - but even at $205,000.00 - she had no solid offers. In 1993, she moved out to another location, as her principal residence, and tried to rent the entire building, with only limited success. She has now moved back into her building and occupies the second floor. She agreed her original plan (in 1989) had been to live in one of the units for several years - until she began to make money on it, or sold it at a profit - her estimate was maybe seven years.

No details for the years 1989, 1990 and 1994 were provided, but I accept the statement from the Respondent, that the operation has never shown a profit. However, since the gross rentals for 1993 are shown at $21,550, and those for 1995 (see Schedules from Agent for the Appellant) at $18,000.00, I can assume those for 1994 amounted to something between those two figures. The Schedules provided by the Agent for the Appellant were designed to show that profits could be expected almost immediately in the future. In calculating the “tax” results from the operation, the general deduction for any “personal” element (the use of a part of the property for the Appellant’s principal residence was about 20% of certain costs incurred according to the Agent). It seems to me, however, that in none of the years at issue, did the “personal element” calculation amount to 20%, and for the year 1993 it was about 15%. The important point, however, is that in each of the three years under appeal, the Appellant reported “3” apartments rented - one of which she apparently occupied with a friend. So we must assume she did not actually pay rent herself, but calculated the asserted percentage in lieu of her own rent. This might have been based on some rela- tionshipz to either or both square footage, or rentals reported (see above information) when she shared the main floor with another person and we are not sure how long that was, but it would not bear a proper relationship on any percentage basis when and if she occupied the one unit alone.

Argument

The Agent for the Appellant, having already filed the detailed information noted above, gave a clear and reasoned argument, essentially repeating that position. For purposes of this set of reasons, I would break it down into four basic areas:

(1) The rentals were on a “commercial basis”.

(2) It provided the taxpayer with rental income in excess of rental operating expenses.

(3) (It) includes an add back of the taxpayers personal expenses (in) connection with the property.

(4) A distinction for purposes of deduction should be made between “operating expenses” and “interest charges”.

The Agent quoted extensively from the comments of the learned Justices in Tonn (supra). While the Agent adopted a great deal of the rationale in Tonn (supra) and applied it to this appeal, he did make a serious effort to distinguish the “personal element” referenced in Tonn (supra) from the circumstances here. Since a portion of the expenses (20%) had been deducted as “personal”, he regarded the disallowance of the losses claimed by the Appellant as a form of “penalization” of the taxpayer. In addition, the Agent noted that the losses should be allowed as prescribed by Tonn (supra) because this was a “commercial venture”. Further as a back up position, they were “start-up costs” to which the Appellant was entitled.

Counsel for the Respondent pointed out the “personal element” connection with the property - the use of portions of it as a “principal residence” over several years. Further, the distinction desired and much cherished by the Agent for the Appellant between the “operating expenses” and “interest charges” simply did not fit into the terms and scheme of the Act. There was no reasonable expectation of profit at any time - hence no “business” from which losses could be deducted; and whether warranted or not on an objective basis the Respondent had allowed the deduction of the claims made for 1989 and 1990 taxation years, which might be considered as “start-up costs”.

Analysis

The Appellant’s reference to possible “profit” from the sale of the property (a capital gain) was not pursued vigorously by the Agent, but does arise from Tonn (supra). It is my view that there could be some basis for such a contention - providing the thrust of the appeal related to other sections of the Act, possibly 18(2), but not when the appeal (as in this case) is founded in a claim for deduction under section 18(l)(a) and (b) of the Act. But I need make no further comment on that aspect at this time.

I will deal with the four general categories of the argument proposed by the Agent for the Appellant:

(1) The rentals were on a “commercial basis”.

It is my assessment that by a “commercial basis” - the Agent means that the rent charged for the units rented to third parties was in line with the rents charged for similar accommodation on the area, and that was the maximum that could reasonably be expected for the use and occupancy of the units by the tenants. I do not agree that definition under these circumstances puts the operation in this context on a “commercial basis” analogous to a “business” conducted with “a reasonable expectation of profit”. I would quote from Heenan v. R., (sub nom. Heenan v. Canada) [1995] 2 C.T.C. 2969(D), 96 D.T.C. 1344 (T.C.C.) at page D.T.C. 1367:

The use of other wording such as - “business purpose”, “commercially motivated operation”, “money spent in good faith”, “overall economic impact”, “well accepted principles of business practice” etc., to be found in some publications and even in some case law, does not have the result sought by Counsel for the Appellants, of negating the value of the standard phrase “reasonable expectation of profit”.

(2) It provides the taxpayer with rental income in excess of rental operating expenses.

This comment is directly related to point (4) in the list -

(4) A distinction for purposes of deduction should be made between operating expenses and “interest charges”.

The point which the Agent attempts to make is simply incorrect - and I quote from Canada Tax Services - by H. Heward Stikeman, Q.C., Volume 4, pages 20-1052, 20-1053 and 20-1054:

Purpose

It has been long settled that in the absence of an express statutory allowance, as here provided, interest payable on capital indebtedness would be regarded as a non-deductible “payment on account of capital” within paragraph 18(l)(b) of the Act (Canada Safeway Ltd. v. M.N.R., [1957] C.T.C. 335 (S.C.C.) at 344; Inter provincial Pipe Line Co. v. M.N.R., [1967] C.T.C. 180 (Exch) at 187; Sher- ritt Gordon Mines Ltd. v. M.N.R., [1968] C.T.C. 262 (Exch) at 283). The purpose of paragraphs 20(l)(c) and (d) is to set aside the prohibition in paragraph 18(l)(b) as far as interest is concerned and to allow the deduction of a reasonable amount in prescribed circumstances.

Subparagraph 20(l)(c)(i) permits a taxpayer to deduct amounts paid in the year, or accruing due to be paid, pursuant to a legal obligation, as interest on “borrowed money” which is used for the purpose of earning income from a business or property of a taxpayer. In a parallel provision, subparagraph (ii) permits the deduction of interest on an amount payable for “property” (ie assets) purchased by the taxpayer for the same purpose.

Interest is not deductible under paragraph 20(1)(c) or (d) to the extent that the amount paid or payable is in excess of a “reasonable amount” or to the extent it relates to the acquisition of property the income from which would be exempt. Additionally, certain outlays or expenses relating to the construction, renovation or alteration of a building or to associated land owned during the period of construction, renovation or alteration are not currently deductible, and must be included in computing the cost or capital cost of the building according to the rules in subsections 18(3.1) to 18(3.7). See subsections 18(3.1) to 18(3.7) and the commentary thereto.

Interest on Borrowed Money

Legal Obligation

To be deductible under subparagraph 20(1)(c)(i), the amount must be paid or payable pursuant to a legal obligation to pay interest on borrowed money - that is to say, it must be paid in respect of an obligation under which the taxpayer is bound and in respect of which payment may be made the object of legal recourse by the creditor.

The Agent claiming as he does, that the “interest charges” on the capital indebtedness are not only separated from operating expenses, but deductible notwithstanding the losses generated, should review and consider the generous even debatable concession made under the Act in Canada for the deduction of such “capital costs” in addition to “operating expenses” for purposes of determining income as that is defined under sections 3 and 4 of the Act. That such charges might be more properly added to the capital cost rather than deducted from current income has often been contended. But that is not in issue here today. The “interest charges” on these capital costs, are deductible only under circumstances which would equate them with current operating expenses but only after it is established that the current expenses themselves qualify for deduction, for purposes of this appeal.

(3) (It) includes an add back of the taxpayers personal expense (in) connection with the priority.

As noted earlier, there may be some relationship on a square foot, or a total rent basis for the asserted 20% of certain expenses, allocated to the taxpayer. But it cannot be said simply that the Appellant purchased a rental building and then for whatever reason - economic or proximity - occupied one unit (or part of one unit for herself). It can be asserted with more validity in my view, that she acquired a building, one unit of which was to be a principal residence - the “personal element” contended by the Respondent and she rented out the other two units. Certainly she had no other “principal residence” at the time. Looked at from that viewpoint, without the rental of two units she would have been required to undertake the expenses of maintaining the entire building, at a cost not materially different from the totals now before us. By her own evidence that could not be supported. That leads to the next question - would she have purchased the building and assumed all the known costs (interest included) with the prospect in view of renting all three units - on Mr. Boland’s alleged “commercial basis”? There is nothing in either the documented evidence or the testimony to indicate she would have or could have done so - it was simply economically not viable. The immediate losses, easily calculated, would have been almost the same as those in evidence before the Court for the years 1989 and 1990, continuing into the years under appeals, since her own rental contribution was about what she contended would have been the rental from a third party.

Occupying as a “principal residence” a single family home means that all the costs of maintaining the property are personal. Occupying one unit as a “principal residence” does not mean that the “market” basis (what the traffic would bear) can necessarily be applied to the occupant - owner - taxpayer and the balance of the costs incurred shifted to the general public. The decision - a conscious one - to rent the other units at a rate less than their proportionate share of the total expenses, is for the owner to make, and no one should question that decision. But that basic decision, which often automatically results in unrecovered costs does not just automatically permit the owner to regard these uncovered costs as “rental losses”. They are unrecovered costs attributable to the basic decision, and therefore her occupancy of part of the building, has a direct bearing on the result. Simply put, when the rental charge is not sufficient to cover the proper proportion of costs involved, the owner occupier may be required to shoulder the financial responsibility for that decision. The rationale (“what the traffic would bear”) which produces a loss from charging a shortfall non-compensatory rent is the owners proprietary decision. When the same calculation base (“what the traffic would bear”) is applied to the personal use portion of a building, as in this case, it can produce a benefit to the owner (see “use or benefit” in section 248(1) of the Act under “Personal or Living expenses”) as I see it. Continuing for a moment on the “personal element” in this matter stated by the Respondent, that position has been reviewed before in Johnson v. Minister of National Revenue [1978] C.T.C. 2122, 78 D.T.C. 1109, a decision of the Tax Review Board. I examined therein the often conflicting assertions for the determination of “reasonable expectation of profit” and the appeal was allowed at that level based on the following perspective outlined on page 2126-27 (D.T.C. 1113):

It would seem to me that even when the investment activity and results of farming in certain years does not support the view that an appellant could have had a “reasonable expectation of profit” in those years, this cannot necessarily be construed to mean that the appellant could not have held “any expectation of profit” either in the years in question or in subsequent years. Even the information that the immediately subsequent years continued to show losses would not of itself invalidate the proposition that the efforts and intentions of the taxpayer during the years in question were directed to making a profit.

The appeal to the Federal Court of Appeal by Her Majesty the Queen was not contested by Fred L. Johnson, and the Board’s decision was reversed. That suggested approach (in the Tax Review Board decision), arguably more subjective than objective, seemed to be moribund for a lengthy period, but reverberates to some degree in the recent judgment of Tonn (supra). But I fail to see that the learned Justices in Tonn (supra) have advocated a position that would give primacy to the Appellant’s subjective assertions over the contrasting Respondent’s objective contentions in this matter.

This Appellant cannot claim either lack of prior information or knowledge (which eliminates the odious “hindsight accusation” sometimes levelled at the Respondent). Nor can she realistically claim that there was any viable prospect on the horizon to turn the loss results into profits within a reasonable period of time - and that this was financially sustainable and purposefully undertaken by her, a rather shaky proposition at best, but one that the Courts have considered. The contention by the Agent that dramatic and disastrous events occurred (see Notice of Appeal) which produced the losses is simply not viable. The Agent was unable to demonstrate that the situations he described were not simply the vicissitudes and exigencies of any operation, particularly one undertaken with the prospect of financial shortfall already on the horizon. The loss projections were clearly identifiable and unavoidable by any calculation right from the start. Nor is my rejection of that excuse moderated by the Appellant’s alleged reliance on the advice received from her real estate agent or banker, or by the “future” projections presented. The Income Tax Act provides relief under appropriate circumstances particularly for “capital losses”, but I am not aware that allowance should be made for taxpayers conscious decisions in these circumstances. Also, I would certainly reject the Appellant’s characterization of her treatment in the situation as “penalization”.

Even the Appellant’s contention at the trial that she had given some consideration to possible eventual capital gain (a highly debatable prospect) would have required continued financial support from her over a long period and there was no indication she would or could take that on. And I would add, the distinction between the use of the term “income", when actually “revenue” is meant, and “income" under the Act, which is “net income” should be recognized, and that is not always the case in the pleadings filed with the Court.

I would also note the theme of “start-up costs” which recurs in this appeal - and it was brought forward almost as an alternative by the Agent for the Appellant when questions arose regarding the alleged “disastrous” economic turndown (above). Losses which are incurred when a base for a “reasonable expectation of profit” can be established, might more easily be identifiable as such “start-up losses”, but I am not aware that the following oft-quoted phrase from Moldowan v. R., (sub nom. Moldowan v. Minister of National Revenue) [1978] 1 S.C.R. 480, [1977] C.T.C. 310, 77 D.T.C. 5213, at page 485-86 (C.T.C. 313, D.T.C. 5215) eliminates or even dilutes the requirement to demonstrate that “reasonable expectation of profit” in both examples in the quotation - the “productive going operation” and the “farm on raw land”:

One would not expect a farmer who purchased a productive going operation to suffer the same start-up losses as the man who begins a tree farm on raw land.

It seems to me that if the basic argument “reasonable expectation of profit” primarily relied upon by the Appellant in this case is viable, the “start-up costs” argument is superfluous. When calculable costs produce an unavoidable loss prospect, then “reasonable expectation of profit” - and “start-up costs” would seem to be mutually exclusive terms. While I need not rule on that point specifically in this appeal, I do point out that it seems to be a contradiction in terms to assert “start-up costs” for a business, where no reasonable expectation of profit can be demonstrated. The obvious question is what are you starting? If not a business, then why should “start-up costs” be deductible? These expenses termed euphemistically “start-up costs” might be the result of some experiment, some hope, or some speculation from which a business could arise, but that leaves considerable doubt about any claim for deductibility from other income, on a current basis. In this matter, it is clear that the Respondent allowed a period which might have been looked at by the Respondent as “start-up costs” of five years - 1989 through 1993 before re-assessing in 1995 for the three years at issue, leaving even then the years 1989 and 1990 as deductible “start-up costs”. That was the Respondent’s view and decision to make, and I have only expressed my views on the point at the trial level. In this vein I would refer to the case of Warden v. Minister of National Revenue [1981] C.T.C. 2379, 81 D.T.C. 322 (T.R.B.) at page 2389 (D.T.C. 329):

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 a 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.

As some comfort for the Appellant, I would refer to the provisions of section 111 of the Act, and the comments from Joseph v. R., [1996] 2 C.T.C. 2388 (T.C.C.).

The appeals are dismissed.

Appeals dismissed.