Cardella v. R., [1999] 2 CTC 2544, 99 DTC 631

Bonner 7.C.J.:

This is an appeal from assessments under the Income Tax Act (“Act”) for the Appellant’s 1989, 1990 and 1991 taxation years.

The Appellant is a physician practising in Metropolitan Toronto. He earns income from the practice of that profession and from teaching.

At issue is the deductibility in computing the Appellant’s income of expenses incurred in connection with two limited partnership units held by him, namely, one unit of Gerrard Associates Limited Partnership (“GA”) and one unit of Collegeway Associates Limited Partnership (“CA”).

GA was formed in December 1986 with a view to acquiring a rental real estate project at 86 Gerrard Street East, Toronto, Ontario. The project comprised 57 dwelling units together with parking spaces. The acquisition was financed in part by the sale to investors of limited partnership interests. In December 1988 the Appellant and other investors subscribed for units in GA.

Before investing in GA the Appellant reviewed financial projections which had been prepared by the promoters of GA. The projections showed that, for at least ten years, the limited partners would suffer losses after the deduction from income at the partnership level of payments on promissory notes which they were required to assume in partial payment of the purchase price of their partnership interests. The balance of the purchase price was $1,920 which was paid by the Appellant in cash.

The projections calculated proceeds which would be received by each limited partner if the underlying partnership property were to be sold after a ten-year period. They rested on various assumptions regarding annual compound rates of appreciation in value of the partnership real estate and on assumptions regarding net expenses to be incurred during the ten-year period.

The Appellant testified at the hearing of the appeal. His testimony made it clear that he invested in the partnership in the hope of realizing a gain on the sale by the partnership of its real estate. He did not intend to sell his partnership interest.

The financial arrangements pertaining to the purchase of the Appellant’s interest featured a guarantee by one of the promoting corporations of payment to GA of any cash flow deficiency from the Gerrard property. Such deficiency was defined to be the amount by which payments under the main purchase price note (designated as the A note) exceeded the difference between gross revenues and operating expenses. Payments under the guarantee were to be added to the principal outstanding under two other purchase price promissory notes (designated as B and C). The Appellant and other investors were required under the arrangements to make aggregate payments for each year up to but not exceeding 42 percent of their losses for tax purposes for the year. Such losses included the carrying costs of the A, B and C notes, the arranging fee, the guarantee fee and the investor’s pro rata share of the losses of the partnership from rental operations.

At the time that GA was marketed to the Appellant and the others, it was projected that the partnership would suffer losses for tax purposes over a ten-year period averaging $393,053 per unit.

In computing income for the 1989, 1990 and 1991 taxation years, the Appellant deducted the following amounts in respect of his investment in GA:

The term of GA was stated by the Limited Partnership Agreement to be: 3.1 The term of the Limited Partnership shall commence on the 31st day of December, 1986 and shall continue until the 31 st day of December, 2018, unless earlier terminated by the provision of article XIV. All provisions of the Agreement relative to dissolution, winding up and termination shall be cumulative, that is, the exercise or use of the provisions of this Agreement shall not preclude the exercise or use of any other provision.

The Limited Partnership Agreement does not contain provisions which seem to be designed to facilitate the sale by the partnership of the Gerrard property before December 31, 2018.

CA was formed on December 31, 1986 with a view to acquiring a rental real estate project at 2079 Collegeway, Mississauga, Ontario. The project consisted of 105 dwelling units. The acquisition of the project was financed in part by the sale to investors of limited partnership interests. According to the Offering Memorandum the objective of the partnership was to provide the limited partners with an opportunity to earn income from the project, realize capital appreciation and defer payment of income tax by utilizing the provisions of the Act permitting tax deferral.

In December 1987, 105 limited partnership units of CA were sold to investors at a price of $171,000 each. On subscription each investor was required:

a) to contribute $105,000 per unit by means of financing arranged for the investor (“Note A”)

b) to make a cash payment of $10,925:

c) to execute promissory notes (Notes “B” and “C” in the principal amounts, respectively of $35,000 and $31,000 — totalling $66,000) less the cash payment of $10,925.

Each investor pledged his unit in CA as security for the A note. The B and C notes were in favor of the promoters of CA and were also secured by a pledge of the investor’s unit.

Before investing in CA the Appellant glanced at the Offering Memorandum. At the hearing of the appeal he produced a projection of overall cash returns from his partnership unit based on disposition of the project by the partnership after ten years. That projection showed that the break even point for the limited partners, after taking into account losses from rental operations, interest on the notes, and a gain from the sale of the partnership property, would occur if the partnership property were to increase in value at an annual compound rate of approximately 9 percent. The Appellant testified that this projection was prepared recently but that it represented what was presented to the investors at the outset. An explanatory note to the projection stated “the income tax effects on a sale at that consideration are then taken into account on the basis that the proceeds and net profit would be subject to full income tax on the assumption of either a primary or secondary intention to derive at least a significant part of the economic reward through a sale of the project”. It will be observed that the view expressed in this recently prepared document on a point very much in issue in this appeal is at odds with the Offering Memorandum.

The projections made it clear that each limited partner’s cumulative deductions for tax purposes over the ten-year period would amount to $187,006 being the amount by which deductions for costs incurred by the partners individually exceeded pro rata income from the partnership.

One of the agreements governing the purchase of the interests of the limited partners of CA provided that any cash deficiencies arising because revenues from the rental operation did not cover operating costs of the partnership plus the interest costs of the limited partners were to be paid by one of the promoters. The amount of any cash deficiency so paid was to be added to the principal outstanding on the B and C notes. The Appellant and other limited partners were required to make annual payments on the A notes up to but not exceeding 43 percent of the following amounts:

a) the amount by which the actual interest expense in respect of the aggregate outstanding balance of the amount originally owing to Counsel Trust Company an evidenced by each limited partner’s Secured Note was less than the aggregate projected interest expense therefor, as calculated in the Schedule to “Promissory Note “B”; and

b) the amount by which the actual interest expense in respect of the aggregate outstanding balance of the amount originally owing to Collway was less than the aggregate projected interest expense therefor, in the year

The Offering Memorandum states the position succinctly as follows “...the annual investment (capital contributions to the partnership and financing payments) are funded through tax-sheltered cash flow and income tax savings”

In computing his income for the 1989, 1990 and 1991 taxation years, the Appellant deducted the following amounts in respect of his investment in CA:

1989 $21,534

1990 $23,235

Year Interest

The CA Partnership Agreement states that the term of the partnership shall continue until December 31, 2099 unless sooner dissolved or terminated. The Partnership Agreement does not contain terms which appear to have been designed to facilitate the sale of the real property by the partnership before the year 2099 in the course of some sort of adventure in the nature of trade. The Agreement further provides:

2.03 Business

The business of the Partnership is to invest in, acquire, hold, maintain, operate, improve, and otherwise use the Properties for profit and to engage in any and all activities related or incidental hereto (collectively the “Business”) but does not include the sale of the Property. The Partnership shall not undertake any action unrelated to those purposes without the prior consent of the partners given by Ordinary Resolution. (emphasis added)

In making the assessments under appeal the Minister of National Revenue (“Minister”) disallowed the deductions referred to in paragraphs 10 and 19 hereof. The Respondent pleaded that on assessment the Minister found or assumed that:

a) the Appellant had no reasonable expectation of profit from his participation in GA or from his interest in CA;

b) the Appellant participated in GA and CA for the purpose of obtaining the tax advantages which he understood would be associated with them and not for the purpose of gaining or producing income;

c) the only cash flowing to the Appellant and the other limited partners of GA and CA was generated by income tax refunds which resulted from the claiming of preplanned losses J [1]

The Respondent also pleaded that no partnership was created in the case of either GA or CA but the Minister did allow the deduction of losses at the partnership level in all three years. To the extent that the question whether the relationships among the groups of persons which made up GA and CA constituted partnerships the onus is on the Respondent.

Counsel for the Respondent commenced his argument by asserting that neither GA nor CA constituted a partnership because there did not exist in either case an intention to carry on business in common with a view to profit. He also argued that even if the two organizations did constitute partnerships the Appellant’s interest in them did not constitute a source of income within the meaning of section 3 of the Act. In this regard counsel relied on the test established by the decision of the Supreme Court of Canada in Moldowan v. R. (1977), 77 D.T.C. 5213 (S.C.C.) at page 5215 which holds that:

...in Order to have a “source of income” the taxpayer must have a profit or a reasonable expectation of profit. Source of income, thus, is an equivalent term to business:...

Counsel argued that because neither CA nor GA offered the limited partners any prospect of profit, at least prior to the sale of the partnership undertaking, there could be no business giving rise to the losses.

The theory of the Appellant was that where a transaction has been structured to generate income in the form of profit from sale rather than from rental operations, there is no legal basis for dissecting the rental operation from the intended resale and excluding the anticipated gains on resale from the profits which might reasonably be expected to be earned. Counsel for the Appellant argued that the acquisition by GA and CA of their respective properties constituted adventures or concerns in the nature of trade. He asserted that there exists no requirement that expenses incurred in connection with such adventures be deferred and added to the cost of the property which is the subject of the adventure. He pointed out as well in answer to the Respondent’s arguments with regard to reasonable expectation of profit that where, as here, the activity has no personal element the reasonable expectation of profit doctrine is to be applied sparingly and with latitude favoring the taxpayer.

In my view it cannot be said that either GA or CA embarked on an adventure in the nature of trade made up of the acquisition, rental for a period and resale of their respective rental properties. The classic statement of the test for deciding whether a profit is of a capital nature or is business income was laid down in California Copper Syndicate Ltd. v. Harris (Surveyor of Taxes) (1904), 5 T.C. 159 (Scot. Exch.), at page 165 as follows:

It is quite a well settled principle in dealing with questions of assessment of Income Tax, that where the owner of an ordinary investment chooses to realise it, and obtains a greater price for it than he originally acquired it at, the enhanced price is not profit in the sense of ... the Income Tax Act.... But it is equally well established that enhanced values obtained from realisation or conversion of securities may be so assessable, where what is done is not merely a realisation or change of investment, but an act done in what is truly the carrying on, or carrying out, of a business. The simplest case is that of a person or association of persons buying and selling lands or securities speculatively, in order to make a gain, dealing in such investments as a business, and thereby seeking to make profits....

The argument of counsel for the Appellant rested heavily on the theory that the partnerships intended or sought to make profits on the resale of their respective projects. It is therefore helpful to recall the words of Noël, J. in Racine v. Minister of National Revenue (1965), 65 D.T.C. 5098 (Can. Ex. Ct.) at page 5103:

To give to a transaction which involves the acquisition of capital the double character of also being at the same time an adventure in the nature of trade, the purchaser must have in his mind, at the moment of the purchase, the possibility of reselling as an operating motivation for acquisition; that is to say that he must have had in mind that upon a certain type of circumstances arising he had hopes of being able to resell it at a profit instead of using the thing purchased for purposes of capital. Generally speaking, a decision that such a motivation exists will have to be based on inferences flowing from circumstances surrounding the transaction rather than on direct evidence of what the purchaser had in mind.

It seems that the potential for gain on resale of the projects after ten years was used by the promoters as a lure to attract investors. However it is not the intention of the limited partners which is relevant for they, at least singly, were not in a position to manage the affairs of either partnership. Rather it is the intention of the two general partners which counts.

The evidence, far from suggesting that either general partner intended to resell its rental project instead of using it as a source of rental income, supports a conclusion that the general partners intended to hold and rent the projects for a very substantial period of time. The direct evidence of intention to be found in the description of the business in the partnership agreements and the terms of the two partnerships also as stated in the agreements are of very considerable importance. As well it will be noted that the partnerships have in fact from the outset to the present time held the projects and have derived rental income there from. There was no evidence adduced to suggest that any attempt has been made by either partnership to even test the market for resale. Finally I note that no one having knowledge of the intentions of the general partners was called to testify with regard to the notion that the partnerships bought the properties with a view to earning profit on a resale at the first favourable opportunity.

It follows that the Appellant cannot look to gains which may be realized on future sales by the partnerships of their properties as potential income to be taken into account in deciding whether he had a reasonable expectation of profit from his investments in GA and CA. When such gains are excluded from the equation the Appellant’s interests in the two partnerships cannot be regarded as sources of income. In Mastri v. R. (1997), 97 D.T.C. 5420 (Fed. C.A.), Robertson, J.A. made the following remarks at page 5423 with regard to the reasonable expectation of profit test laid down by the Supreme Court of Canada in Moldowan, supra:

First, it was decided in Moldawan that in order to have a source of income a taxpayer must have a reasonable expectation of profit. Second, “whether a taxpayer has a reasonable expectation of profit is an objective determination to be made from all of the facts” (supra at 485-86). If as a matter of fact a taxpayer is found not to have a reasonable expectation of profit then there is no source of income and, therefore, no basis upon which the taxpayer is able to calculate a rental loss....

In Mohammad v. R. (1997), 97 D.T.C. 5503 (Fed. C.A.), Robertson, J.A. made the following remarks at pages 5505-06 with regard to cases such as the present where a taxpayer has made an investment which must inevitably yield losses:

Frequently, taxpayers acquire a residential property for rental purposes by financing the entire purchase price. Typically, the taxpayer is engaged in unrelated full-time employment. Too frequently, the amount of yearly interest payable on the loan greatly exceeds the rental income that might reasonably have been earned. This is true irrespective of any unanticipated downturn in the rental market or the occurrence of other events impacting negatively on the profitability of the rental venture, e.g., maintenance and non-capital repairs. In many cases, the interest component is so large that a rental loss arises even before other permissible rental expenses are factored into the profit and loss statement. The facts are such that one does not have to possess the experience of a real estate market analyst to grasp the reality that a profit cannot be realized until such time as the interest expense is reduced by paying down the principal amount of the indebtedness. Bluntly stated, these are cases where the taxpayer is unable, prima [acte, to satisfy the reasonable expectation doctrine.... (emphasis added)

For the foregoing reasons I have concluded that the Minister was justified in assessing as he did. The appeals will be dismissed with costs.

Appeal dismissed.