Immeubles Chai Inc. v. R., [1999] 2 CTC 2447, 99 DTC 201

Dussault T.C.J.:

The appellant is challenging an assessment for its taxation year ending February 28, 1993. By that assessment the Minister of National Revenue (“the Minister”) added the sum of $110,250 to the appellant’s income as an additional capital gain resulting from the sale of a commercial property located at 1250 Boulevard Lafleche in Baie-Comeau, Quebec, on July 7, 1992.

The appellant sold the property to Claude Lévesque, the son of its sole shareholder Gilles Lévesque, for the sum of $325,000: $65,000 for the land and $260,000 for the building.

Following an audit the Minister concluded that the selling price was below the fair market value of the property, which he set at $472,000: $84,000 for the land and $388,000 for the building, hence the addition of $110,250 as an additional taxable capital gain.

Only the value set by the Minister in making the assessment was in dispute, the appellant contending that the fair market value of the property at the time of the sale did not exceed $360,000.

It should be noted at the outset that in his report the respondent’s expert witness Gaston Laberge used imperial measure while the appellant’s expert witness Marcel Furlong mostly used metric measure, and sometimes imperial measure, which does not help at all to simplify the task of determining the validity of the various assumptions or comparisons presented. As an aid to comprehension, all the information I consider to be relevant and worth mentioning has been converted into metric measure if it was not already in metric.

In his appraisal report the respondent’s expert witness Mr. Laberge, preferring the income approach, set the fair market value of the property at July 7, 1992 at $467,000.

The appellant’s expert witness Mr. Furlong, relying mainly on the income approach but also using the direct comparison approach, arrived at a value at the same date of $360,000.

Messrs. Laberge and Furlong set the fair market value of the land by itself at $84,000 and $82,000 respectively. It is a rectangular lot of 2,860.9 square metres (36.81 m x 77.72 m), the axis of which is perpendicular to Boulevard Laflèche. It is located in a commercial zone.

The building, a particularly detailed description of which is provided in Mr. Furlong’s report, [1] is also rectangular in shape and on the same axis in relation to Boulevard Laflèche. It has an area of 726.52 square metres (14.02 m X 51.82 m). The framework of the building is of steel. The foundation and the floor are of concrete. The exterior is finished with brick and enamelled sheeting. The interior is divided into three areas used as a salesroom, workshops or warehouses. Among other things, the building has, on one side, five garage doors measuring 4.27 metres by 4.27 metres, made of steel. The front and rear areas of the building are arranged in a similar way, with double glass entry doors, display windows on each side of the door and side windows. However, it is clear that the building was constructed primarily for use as a garage. The building also has three mezzanines differing from each other as to their dimensions and layout, with a total rental area of 727.78 square metres, that is, 282.05 square metres for the premises in front, 188.03 square metres for those located in the middle and 257.71 square metres for those located at the back of the building.

In fact, the building was put up in two separate stages. The front part, representing about 65 percent of the building’s total area (14.02 m x 33.53 m), was built in 1985. The back part, representing about 35 percent of the total area (14.02 m x 18.29 m), was built in 1989.

In 1985, Fortin & Lévesque Inc. (“Fortin & Lévesque”), of which Gilles Lévesque was one of the shareholders, built the first part of the building on a lot purchased from the Town of Baie-Comeau. Much of the materials, including the structural steel, was used and came from a dismantled garage in Forestville. Fortin & Lévesque was paid for the demolition work and obtained the materials for nothing. In February 1986 the building, constructed according to the specifications of Léonard and Laurent Charron, shareholders of the appellant, was sold to the appellant for $163,500, $3,500 of which was paid in cash. The balance was financed by a loan secured by a mortgage given by Fortin & Lévesque. Les Ateliers Laurent Charron Enr. (“Ateliers Charron”), which operated a business selling snowmobiles, Sea-Doos and boats, moved into the front premises. The other premises were leased to Technique Auto Enr. (“Technique Auto”), a car and truck repair business.

In May 1988 the appellant had been in default on its payments for several months and Fortin & Lévesque served a 60-day notice on it pursuant to a giving in payment clause. Gilles Lévesque then bought back the shares in the appellant’s capital stock owned by Léonard and Laurent Charron and thus became the appellant’s sole shareholder. In 1989 he obtained financing of $200,000 from the bank for the appellant and repaid Fortin & Lévesque.

In 1989, at the request of a customer, Pare-Brise Côte Nord, [2] Gilles Lévesque, now the appellant’s sole shareholder, agreed to add the third premises at the back since he felt at the time that the building was not profitable. Much used material was also used in building this addition in the back, including the structural steel. This back portion was built like the front portion, with glass doors, display windows and side windows, apparently in anticipation of the opening of a street parallel to Boulevard Laflèche at the back of the lot, which in fact never came about. The conversion of part of the premises to offices was apparently done by the tenant. According to Gilles Lévesque, whose testimony was confirmed by that of his son Claude, the back portion was never profitable. It was described as being unappealing to a merchant and was only sporadically rented, often for short periods, after the first tenant left the premises in September 1991. [3] The building of the back portion turned out to be a mistake for Gilles and Claude Lévesque and Laurent Charron..

In 1992 Gilles Lévesque, feeling he was getting old, tried, he said, to sell the property. In the spring he met with Laurent Charron, the tenant of the front premises, to propose that he buy the property. However, while Mr. Lévesque wanted to sell for $350,000, and certainly not less than $300,000, Mr. Charron, who was otherwise interested, was apparently only prepared to pay $250,000 to $275,000, in view of the price initially paid for the property in 1986. Mr. Lévesque admitted that he had not taken any further action since he said there was no demand. He said he knew the market as Fortin & Lévesque had built half the commercial buildings in Baie- Comeau.

For the period from March 1991 to February 1992 the rent paid by Ateliers Charron for the front premises was $1,452 a month. In the spring of 1992 the lease had expired but the tenant continued paying the same rent. Gilles Lévesque stated that he did not want to sign a new lease before selling. In fact it was his son Claude, who purchased the property in July 1992, who negotiated a five-year lease with the tenant at a monthly rental of $2,100 beginning in July 1992.

From June 1992, and for the last year of the lease, the rental paid by Technique Auto for the second premises was $1,460 a month.

The third premises, vacant since October 1991, were apparently leased only in February 1992 for $300, and in May and June 1992 for $700 a month, making a total of $1,700 for the first six months of 1992. They apparently then remained unoccupied until October 1992. They were then leased at $1,300 a month from November 1992 to January 1993 and at $1,500 a month from February to April 1993. No other rental was collected in 1993. [4]

Gilles Lévesque stated that ultimately it was his son Claude, who owned the adjoining property, who in the spring of 1992 indicated he was interested in purchasing the appellant’s property. In view of the fact that the back premises had been vacant for several months and that the lease for the front premises had not yet been signed, Claude Lévesque considered that it would not pay him to purchase the property for $350,000. As mentioned above, the sale was concluded on July 7, 1992 for $325,000.

In his testimony Mr. Laberge admitted that use of the comparable sales approach to arrive at the fair market value of the property sold to Claude Lévesque by the appellant was probably not the most suitable method in the circumstances, in view of the very significant adjustments which had to be made in some cases to sales which were nonetheless said to be comparable.

As to the cost approach, although it is referred to in his report and he testified regarding it, Mr. Laberge also discounted it in his report as less valid than the income approach for arriving at fair market value, since the property in question was in fact a rental property. The appellant’s expert witness, Mr. Furlong, also mainly used the income approach, but supported his conclusion by using the comparable sales approach, a point I will deal with briefly before discussing the analyses of the two expert witnesses with respect to the income approach.

Mr. Furlong’s analysis, based on the direct comparison approach, refers only to a single transaction, considered by him to be the only comparable one, concluded on November 15, 1991 and involving a property located at 1850 Boulevard Laflèche, in a different area but regarded as equivalent to that in which the appellant’s property was located. The comparable property, the structure of which appears at first sight to be similar to that of the appellant’s building, but which did not have the appearance of a garage, housed a grocery store and another small business. It was sold for $385,000. After a net negative adjustment of $25,600, Mr. Furlong arrived at a value of $359,400 for the appellant’s property. Mr. Furlong first made a positive adjustment of $10,400 as the area of the appellant’s lot was slightly larger (2,860.9 square metres) than that of the comparable property (2,505.5 square metres). He then made a negative adjustment of $11,000 as the floor area of the appellant’s building was less than that of the other building: 726.52 square metres as opposed to 760 square metres. Finally, Mr. Furlong made a negative adjustment of $25,000 with respect to functionality because of the difference in alignment in relation to Boulevard Lafléche. The axis of the appellant’s property was perpendicular to Boulevard Laflèche while the comparable property had a larger frontage on the boulevard, which, according to Mr. Furlong, would have allowed it to subdivide the building into several small premises that would be more attractive than the premises in the appellant’s building, especially those located at the back, the foreseeable rental loss on which he estimated would be about 30 percent, requiring an adjustment representing some 10 percent of the selling price of the building alone. [5]

For the moment, I will simply say that I am far from being persuaded that the choice of this allegedly comparable transaction is significant. In my opinion, the very different arrangement of the premises is clearly not likely to attract the same type of business unless extensive changes are made to one or the other of the buildings, assuming that such changes are possible. A garage is certainly not a grocery store. In any case, if there is one point on which I agree with the two expert witnesses, it is that in the circumstances the income approach is the most suitable and most valid one for determining the value of the appellant’s building. [6]

I thus come to the valuation of the appellant’s building by use of the income approach. It is important to note from the outset that the respondent’s expert witness, Mr. Laberge, did his analysis exclusively in terms of the appellant’s potential income based on leases regarded as comparable in buildings located in the same area. In his report the appellant’s expert witness, Mr. Furlong, went through the same exercise although he used different assumptions. In addition, he attempted to arrive at the value of the property based on the allegedly [TRANSLATION] “real” income received by the appellant. [7]

According to Mr. Laberge’s report the rental income reported by the appellant was $50,695, $53,223 and $46,859 for 1990, 1991 and 1992 respectively. Passing over these figures, as well as the rentals in effect at the time of the sale for the two premises rented at that time, and without providing any explanation whatever, though in both cases the tenants were dealing with the appellant at arm’s length, the respondent’s expert witness then proceeded to determine the value of the property using as a basis an effective potential net income of $59,386 a year and an overall discount rate of 0.127200, thereby arriving at a value for the property of $466,871, rounded off to $467,000.

For the purposes of his calculations Mr. Laberge first set the potential gross income at $67,216 a year, using the median rental in five leases of commercial premises located on Boulevard Laflèche out of 17 noted in the same area. The leases used were net net net leases, that 1s, leases under which all costs were the responsibility of the tenants. [8] Mr. Laberge therefore did not make any adjustments to those leases in determining the median rental. I would simply note that this is not necessarily a positive factor inasmuch as the appellant’s premises were not leased on this basis. Moreover - and I will return to this point a bit further on -, it is hard to see the relevance of selecting only such leases when the leased premises and their use are not necessarily comparable. One really wonders what was being compared.

The median rental for the five leases used by Mr. Laberge was $92.36 a square metre ($8.58 a square foot). Applied to the total rental area of 727.78 square metres (7,834 square feet), this figure gives a potential gross rental of $67,216 which, reduced by 7 percent, or $4,705, for losses resulting from vacancies and bad debts, gives an effective net income of $62,511. To arrive at a rental on a net net net basis Mr. Laberge then proceeded to deduct only one expense: administrative fees of 5 percent or $3,125. The annual net income was thus estimated at $59,386. Applying an overall discount rate of 0.127200 to this income, Mr. Laberge thus obtained a value of $466,871 for the property.

In July 1992, at the time of the sale of the appellant’s property to Claude Lévesque, Claude Lévesque had just renegotiated the lease with Ateliers Charron at a rental of $2,100 a month for a term of five years. The previous lease signed in 1989 provided for rental of $1,452 a month until February 1992. As mentioned above, the tenant continued to pay the same rental until the new lease was signed, under which the rental was increased by nearly 45 percent for a total of $25,200 annually, a figure which bears no relation to the $15,840 indicated in the comparative table of Mr. Laberge’s report under the heading [TRANSLATION] “annual rental”. [9] The latter amount also does not correspond to the rental of $1,452 a month paid in the year preceding the sale.

The rental for the second premises, leased to Technique Auto, was $1,460 a month at the time of the sale, which corresponds to an annual rental of $17,520. The amount of $14,400 indicated in the comparative table of Mr. Laberge’s report [10] does not correspond to the rental of $1,393.77 a month paid from June 1991 to May 1992 and to the rental of $1,460.33 paid in June 1992, for a total of $16,791.80 in the 12 months preceding the month of the sale. It should be noted that the rental increase on June 1, 1992 was nearly 5 percent.

In July 1992 the third premises were not rented. As mentioned earlier, between January and June 1992 they were rented in February for $300 and in May and June for $700 a month. They remained vacant until November 1992, when they were rented to Ferblanterie Perron for three months at $1,300 per month. For February to April 1993 the rental increased to $1,500 a month. The premises were thereafter vacant, at least until December 1993. In the same comparative table of his report Mr. Laberge indicated “Ferblantier Perron et Frère” as the tenant, “ 1990” as the rental period and the sum of “$22,192” as the annual rental. As can be seen, it is difficult to make any sense of this.

It is impossible for the Court to check the characteristics of the other leases used by Mr. Laberge in his analysis, but the figures shown regarding the annual rental for the three premises in the appellant’s building raise serious doubts as to the accuracy of the figures as a whole. This might lead the Court to the conclusion that the exercise in general probably did not have the validity claimed for it with respect to the determination of the net potential income that could be produced by the appellant’s property based on a median rental. But that is not all.

The five leases used by Mr. Laberge are all in buildings which have only a single tenant and which front onto Boulevard Laflèche. Of these, three are leases in which the rental is among the highest of the 17 leases noted. Lease No. 5 is for a property located at 1290 Boulevard Laflèche owned by Claude Lévesque and developed as air-conditioned offices leased to the Ministère de l’Énergie et des Ressources (Department of Energy and Resources) under a five-year lease. Lease No. 6 is for a property located at 1300 Boulevard Laflèche owned by Ginette Lévesque, built and developed in part as offices and in part as a warehouse according to the specifications of the Société immobilière du Québec, which signed a five-year lease. Lease No. 11 is for a building built expressly for the Labatt brewery, fitted up entirely according to the requirements of the tenant, in part as a warehouse and in part as offices and a reception area. The lease is for 10 years.

To begin with, I would say that I have some difficulty understanding how a five-year lease on adjoining property or a 10-year lease with the Labatt brewery is more relevant in determining the value of the appellant’s property than the leases concluded by the appellant with third parties with which it was dealing at arm’s length. Unless it can be shown that there was something unusual about the leases in effect at the time of the sale, there is no justification for ignoring them completely as Mr. Laberge did. This applies to the five-year lease concluded with Ateliers Charron beginning on July 1, 1992 and to the lease in effect until May 1993 with Technique Auto.

There was no lease in effect on the third premises at the time of the sale. In such a case it is proper to determine the potential rental on the basis of comparable leases. However, it is important in such a case that the comparison be with something comparable. As these premises located at the back of the appellant’s building were fitted up in much the same way as those at the front giving onto Boulevard Laflèche it seems to me to be more relevant to use as a basis for comparison the five-year lease that had just been concluded with Ateliers Charron for those premises, rather than allegedly comparable leases for premises fitted up differently and put in large part to different use. The functional aspect related to location was completely ignored by Mr. Laberge, although until then the appellant had encountered difficulty renting which had occasioned considerable losses. Nevertheless, it cannot be assumed that the rental for a well-positioned building, built according to the requirements of a single tenant, would be the same as that for premises giving onto a back yard and located in a building with several tenants. The inconvenience is no doubt not absolute, far from it: but it is there all the same.

In short, the exercise of establishing the potential income from these third premises located at the back of the appellant’s building on the basis of the median rental of the five leases selected is in my opinion of little evidentiary value.

The appellant’s expert witness, Mr. Furlong, also undertook to establish the fair market value of the property from an estimate of income based on a comparison of eight leases selected with respect to a period of 10 years on buildings located on Boulevard Laflèche. [11] With adjustments varying from 29 percent to 40 percent (except in one case, where the adjustment was 14 percent) to take into account operating expenses and convert all the figures to a net net net basis, he was able to establish an average adjusted rental of $74.56 a square metre and a median adjusted rental of $73.18 a square metre, despite the fact that the “real” rentals of $89.31, $93.18 and $69.83 a square metre for the three premises were respectively adjusted to $67.07, $70.94 and $47.59 a square metre also to take operating expenses into account.

From these figures he arrived at a potential gross rental of $74.00 a square metre for the first two premises (282.05 square metres and 188.03 square metres), that is, an annual rental of $34,785 (470.08 m2 x $74.00). He assigned a rental of $53.90 a square metre to the third premises, that is, $13,820 on an annual basis (256.40 m2 x $53.90)'2. According to these calculations the total potential gross income would be $48,605 ($34,785 and $13,820). This amount was reduced by $3,402 (7 percent) as a reserve for loss of rental and for vacancies, and by an additional amount of $1,000 as a reserve for major repairs. The so-called “net net” income obtained was $44,203. By applying a capitalization rate of 0.1237, Mr. Furlong arrived at a value of $357,340 for the property, rounded off to $357,300.

Mr. Furlong used a value of $53.90 a square metre for the third premises, that 1s, a value 27 percent less than the $74.00 assigned to the first two premises, as in his opinion the third premises would not be leased for more than the least expensive premises in the comparables used. Additionally, the value of $74.00 a square metre used for the first two premises is less than 10 percent greater than the real adjusted rental for those two premises ($67.07 and $70.94 a square metre).

Here again an attempt was made to determine the fair market value of the appellant’s property on the basis of allegedly comparable leases, some of which were also used by Mr. Laberge. However, Mr. Furlong made significant adjustments to take account of operating expenses and convert the rentals to a net net net basis. Those adjustments might seem high at first sight and cannot in fact be verified in any way given the evidence submitted. If, unlike Mr. Laberge, Mr. Furlong took into consideration the continuing rental problems affecting the third premises, he could have explained more clearly his conclusion regarding the potential rental that could be obtained from those premises. However, in view of the approach I intend to take, it is not necessary to analyse any further the comparable leases used.

Mr. Furlong’s report also contained figures on the rentals as adjusted to take into account operating expenses for the three premises located in the appellant’s building. Using the adjusted rental for these three premises according to Mr. Furlong’s calculations, namely $67.07, $70.94 and $47.59 a square metre, rather than the $74.00 a square metre arrived at in his report for the first two premises and the $53.90 a square metre arrived at for the third premises, we get a potential net income of $44,519. This income, reduced by a reserve of 7 percent for loss of rental and vacancies 3 [13] - that is, $3,116 -, translates, if we ignore the reserve of $1,000 for major repairs which does not seem justified for the purposes of these calculations, into a net income of $41,403, an amount almost equivalent to that of $41,456 appearing in another document prepared by Mr. Furlong [14] and based on the so-called “real” income less operating expenses.

In that document Mr. Furlong set the appellant’s potential gross income at $60,723 and his actual income at $57,623, after deducting from the potential gross income an amount equal to 5 percent, namely $3,100, for vacancies and bad debts. He next deducted expenses of $16,166.78 (26.6 percent of potential gross income), including $10,800 for municipal and school taxes, and arrived at a net income of $41,456.22. Using a 0.128 capitalization rate, he obtained a value of $323,876 for the property.

The foregoing calculations give potential gross income of $60,723 based on the real rental of $25,200 a year ($2,100 a month) for the first premises, leased by Ateliers Charron, on the amount of $17,520 a year ($1,460 a month) paid as rental for the second premises, leased by Technique Auto, and finally, on a suggested rental of $18,003 a year ($1,500 a month) [15] for the third premises, located at the back of the building.

There is no ambiguity as to the actual rental negotiated and paid for the first two premises. Since this was rental agreed upon between parties dealing with each other at arm’s length, and in the absence of evidence that there was anything artificial or unusual about the leases concluded, in my opinion this rental should be the basis for an appraisal using the capitalized income approach. [16] In the circumstances, it seems clear to me that actual income is a better yardstick for determining the value of the appellant’s property than a theoretical potential income based on approximations derived from an average or median income, using allegedly comparable data which often prove however to be questionable, as is the case here.

The evidence concerning the third premises did not show that the indicated rental of $18,003 a year, or $1,500 a month, represented actual rental collected by the appellant which could be treated as such in the calculations. However, all the figures submitted by the appellant and its expert witness take this amount into account. If we assume for the moment that this is a maximum potential rental for the third premises located at the back of the building, we find that at $69.85 a square metre ($6.49 a square foot) this rental is 78.18 percent of the actual rental of $89.34 a square metre ($8.30 a square foot) for the premises located at the front of the building and occupied by Ateliers Charron. The difference of 22 percent to take into account the poor location of the third premises might appear too high to some.

However, assuming that the potential rental of the back premises was only 5 percent less than that of the front premises, we would get a rental of $84.87 a square metre, that is, an annual rental of $21,871 and not $18,003. This difference of 5 percent between the potential rental that could be obtained for the back premises and the rental actually agreed upon under a five-year lease for the front premises seems minimal and, in the circumstances, more than reasonable. On this basis the total gross income would rise to $64,591 from $60,723. With a reserve of only 5 percent and not 7 percent, that is, $3,230, for vacancies and bad debts, actual gross income would amount to $61,361. After deducting operating expenses of $16,166.78, net income would be $45,194. Applying to that income the overall discount rate of 0.127200, namely that used by the respondent’s expert witness, we get a value of $355,300 for the appellant’s property. In arriving at this conclusion I am aware that in using an overall discount rate of 0.127200 any error of $1,000 in income or expenditures is likely to produce a distortion of over $7,860 in the estimated value of the property.

Clearly, I am not an appraisal expert. However, I have carefully reviewed the reports of the two expert witnesses and the evidence as a whole. It would be euphemistic to say that I am not completely satisfied with the analyses submitted. Nonetheless, having considered all the evidence before the Court, I feel that Mr. Furlong’s conclusions are closer to what I believe to be the reality of the situation than those of Mr. Laberge. The analysis using actual data relating to the property in question rather than so-called comparable data with respect to the first two premises, and the additional assumption which I have just made regarding the maximum potential rental which could be obtained by the appellant for the premises at the back of the building, have satisfied me on a balance of probabilities that the value of the property did not exceed $360,000 on July 7, 1992. I will not dwell any further or go into greater detail on the criticisms I have already expressed since, by virtue of the relief sought in its appeal, the appellant, although the sale of the property to Claude Lévesque was for $325,000, is only disputing the value set by the Minister of National Revenue in excess of $360,000.

In accordance with the foregoing, therefore, the appeal is allowed and the assessment referred back to the Minister of National Revenue for reconsideration and reassessment on that basis.

The whole with costs to the appellant.

Appeal allowed.