Caraberis v. R., [1998] 4 CTC 2173, 98 DTC 1865

Sarchuk T.C.J.:

These are the appeals of John G. Caraberis and Bonnie Bond (the Appellants) from assessments of tax with respect to their 1989, 1990, 1991 and 1992 taxation years. By agreement of all parties, the appeals were heard together on common evidence. Four separate issues were raised and with respect thereto, the parties filed an agreed statement of facts. Further testimony was adduced on behalf of the Appellants from Caraberis, Stephen

B. Maltby (Maltby), a chartered accountant who was the auditor and accountant for both Appellants and their corporations; from Craig Thompson (Thompson), a senior account manager with the Bank of Nova Scotia (the Bank), and from Don Cooper (Cooper), the comptroller during the relevant periods of times.

The shareholder loans issue

The facts agreed to by the parties with respect to the shareholder loans are:

1 The Appellants were the two shareholders in Seagull Pewter and Silversmiths Ltd. (Seagull Pewter) and Jonathan Bond Fine Gifts Inc. (Jonathan Bond) in 1989, 1990, 1991 and 1992. Seagull Pewter and Jonathan Bond were amalgamated as Seagull Pewter and Silversmiths Ltd. on April 30, 1994.

2 The following amounts have been added to the income of each Appellant pursuant to subsection 15(2) of the Income Tax Act as unpaid loan advances from Seagull Pewter and Jonathan Bond:

3 During the years in question, Seagull Pewter and Jonathan Bond would, from time to time, advanced (sic) in monies to the Appellants, the shareholders of these companies. During these same years, these companies declared bonuses and/or dividends payable to the shareholders which were taxable in their hands. 4 Records were maintained by each company to record any amounts advanced to the shareholders so that the use of the funds could be tracked. For instance, all advances to the shareholders to fund their ginseng farming operation were recorded in a separate account. Advances for other purposes were also recorded separately.

Taxation Year	1990	1991
Seagull Pewter	$152,614	$200,012
Jonathan Bond	$4,116
Total	$156,730	$200,012

5 The fiscal year end of each company was April 30.

6 The unaudited financial statements for the year ending April 30, 1990 for Seagull Pewter do not record any amount due from the shareholders to Seagull Pewter. They do indicate that there was a bonus payable of $506,887 and that a loan was payable to the shareholders of $65,532.

7 The unaudited financial statements for the year ending April 30, 1990 for Jonathan Bond do not show any amount due from the shareholders to Jonathan Bond but do indicate that there was a bonus payable of $285,000. The statements also have an entry for an amount payable to the shareholders indicating that the amount payable to the shareholders was “nil”.

8 Starting with the year ending April 30, 1991, the financial statements for Seagull Pewter and Jonathan Bond are audited financial statements.

9 The audited financial statements for the year ending April 30, 1991 for Seagull Pewter show and the fact is that there was an amount due from the shareholders to Seagull Pewter of $705,251. The entry for the loan payable to the shareholders indicates that this amount was “nil”. The bonuses payable were $1,993,696.

10 The audited financial statements for the year ending April 30, 1991 for Jonathan Bond indicate that there was an amount due from the shareholders to Jonathan Bond of $61,951. The statements indicate that there were bonuses payable of $950,000.

11 The audited financial statements for the year ending April 30, 1992 for Seagull Pewter show the amount due from the shareholders to Seagull Pewter to be “nil”. The entry for the loan payable to the shareholders shows that there was an amount payable of $322,622. Another entry indicates that there were bonuses payable of $922,618.

12 The audited financial statements for the year ending April 30, 1992 for Jonathan Bond indicate that the amount that was due from the shareholders to Jonathan Bond was “nil”. The entry for the amount payable to the shareholders indicates that this amount was $12,371. There is an entry that indicates bonuses payable of “nil”.

Maltby testified that at all relevant times, both Appellants received salaries paid on a periodic basis and in addition, both Seagull Pewter and Jonathan Bond advanced funds or made payments on their behalf. These payments were charged to a number of separate shareholder loan accounts, each identified by the purpose for the draw. The main reasons for this practice was for control and accounting purposes. In his words:

I guess an example would probably be the easiest way to explain it, the farm primarily. The farm was on a calendar year-end. And Seagull Pewter was the funding source for the farm, so all expenses of the farm were paid by Seagull. And what we intended to do was to have separate accounts set up, a separate shareholder account, because those expenses were personal in nature because it was part of a partnership. We would have any expenses paid by Seagull charged to that shareholder farm account. And the reason for that is we were having extreme difficulty ensuring that we were picking up all the personal expenses. And we spent hours going through the records trying to find the personal draws that related to the farm. So in our wisdom we thought we would set up a separate account for the two particular items, being Northwood Springs and Northwood Farms, so we could easily track those accounts. Therefore, when we did the farm statements, or did our tax planning for Seagull at the end of the year, we would identify what items related to those specific projects. The other secondary reason was to explain to the bank that we were investing money not just in personal draws for the shareholders, which was always a concern, but also on the long term that we were taking this money and investing in other projects which were going to provide future income sources to Seagull.

To demonstrate the manner in which the shareholder loans were accounted for, Maltby prepared a reconciliation to show the “continuity of shareholder loan account balances by year” from December 31, 1987 to June 30, 1994 (Exhibit A-10). In this reconciliation, Maltby listed all shareholder loan accounts Seagull Pewter maintained in the relevant years and calculated the accounts’ year end balances.[1] Maltby testified that as of the year end April 30, 1991, the Appellants owed Seagull Pewter $706,230.06 and that as at April 30, 1989, 1990 and 1992 Seagull Pewter owed the Appellants $215,768.14, $65,532.49 and $322,621.89, respectively. In all cases, these amounts were recorded in Seagull Pewter’s balance sheet for the relevant period in the liability account entitled payable to shareholder or shareholder’s liability, as the case may be. (Exhibits A-3, A-4, A-6, A-8).

According to Maltby, at all relevant times, the shareholder accounts were treated as one account in their working papers, in the financial statements and for tax purposes. However, these shareholder loan accounts were not consolidated monthly on the interim financial statements because they were essentially prepared for presentation to the Bank which wanted a breakdown of where the funds were being invested and assurance that the Appellants were keeping detailed track of the various expenses. At the end of the corporate fiscal years, the shareholders’ accounts were examined “in total on a net basis to see where they stood” and the result was reviewed with the Appellants and their chief financial officer, Cooper. They then considered what future drawings would be required for projects in the next year and examined the Appellants’ and corporations’ tax situation.

The usual practice of Seagull Pewter and Jonathan Bond was to declare sufficient income for these purposes to the shareholders by way of dividends or bonuses at the end of their respective fiscal periods. This was done to cover the amounts of any advances made to the shareholders during the course of the year and to ensure that the shareholders did not end up paying tax twice on the income, once as a dividend or bonus, and once as a shareholder loan outstanding pursuant to subsection 15(2) of the Income Tax Act (the Act). The actual setoff, according to Maltby, took place not when the bonuses were declared at the end of the fiscal period, but when the bonuses were actually paid to the Appellants which, as a rule, occurred within 180 days of the corporations’ fiscal year end. If a bonus was declared, deductions would be remitted to Revenue Canada and the net amount after deductions would be credited to the shareholder loan account. According to Maltby, that has been the practice in each and every year since 1988.

With respect to the postponement agreements, the parties have agreed as a fact that:

13. As part of the financial arrangements between Seagull Pewter and its bank, the Appellants had signed postponement agreements (also called “subordination

Northwood Springs, respectively. Amounts in brackets reflect amounts owing by Seagull Pewter to the shareholders.

agreements”) with the Bank of Nova Scotia with respect to amounts that were due from the companies to them.

14 Between June 28, 1988 and October 23, 1990 the subordination agreement between John Caraberis, Bonnie Bond and the Bank was for $600,000. Between October 24, 1990 and October 21, 1991 there were no subordination agreements between the Appellants and the Bank. On October 21, 1991, the Appellants entered into a subordination agreement with the Bank for $729,500.

The testimony of Maltby and of Thompson makes it clear that at all times, the Bank was aware of the system in place with respect to the manner of accounting for shareholder loans, was kept apprised of the extent of these loans on a month-to-month basis and with full knowledge of the circumstances, chose to waive its entitlement to enforce the provisions of the postponement agreement.

It was stressed by Thompson that the Bank was primarily concerned with the debt to tangible net worth ratio, which was not to exceed 4:1 and less with the amount of the postponement. The Bank was satisfied that as long as the debt to tangible net worth ratio remained relatively constant, it was not of concern to it if the amount of the postponement was reduced.

Appellants’ Position

The Appellants contend that in all taxation years, the amounts that were due from the Appellants to the corporations were set off against the amounts that were due from the corporations to the Appellants and the results of this setoff were reflected in the unaudited and audited financial statements of the corporations. Thus, all advances received from Seagull Pewter and Jonathan Bond were repaid within one year from the end of the taxation year of each corporation in which such advances were received.

The Appellants argue that the right of setoff arises when there is a mutuality of parties and a connection between the claims made by each.[2] This right was described by Middleton J. as follows:[3]

There is, however, another equity which has sometimes been called ‘set-off but which does not in any way depend upon the statute, which arises when the claims are upon the same contract or are so interwoven by the dealings between the parties that the Court can find there has been established a mutual credit, or an agreement, express or implied, that the claims should be set one against the other. In all such cases, the defendant can set up against the plaintiffs demand his claim for an abatement of the plaintiffs demand...

Counsel submitted that the dealings among the two corporations and the Appellants were so interwoven that it would be unfair to allow one party to sue the other for the full amount of their claim without allowing any setoff or deductions for the claim of the other.

Counsel for the Appellants contends that as contrasted to Gannon v. Minister of National Revenue,^[4] the evidence adduced provides clear evidence of the intention to set off the amounts. Furthermore, the corporations and the Appellants have historically always set off the claims of one against the other in each year in the financial records of the corporations and in the financial statements prepared by the auditors which, notwithstanding the submission made on behalf of the Respondent, do form part of the corporations’ books and records. Therefore, as in Docherty v. Minister of National Revenue,[5] the setoff of the amounts due from the Appellants against the amounts due to the Appellants should be recognized for the purposes of the Act.

With respect to the Respondent’s reliance on the postponement agreement, Counsel for the Appellants argued that Revenue Canada is not a party to the agreement between the shareholders and the Bank. Therefore, it has no right to obtain any benefit or enforce any provision of that agreement. Counsel submitted that:

...there can be no doubt that the House of Lords clearly and decisively affirmed the proposition that there must be privity of contract between the parties if one is to be able to make the other liable on a contract or otherwise enforce benefits alleged to accrue to him under such contract. That doctrine has unquestionably been received and adopted by Canadian courts.’^[6]

Respondent’s Position

The Respondent contends that a consolidation of all accounts had never been made nor was there any setoff of the various shareholder loan accounts recorded in the internal books and records of the corporations. With specific reference to Maltby’s reconciliation of the shareholder loan balances by year, Counsel argued that, by way of example, account 2610, a “draw ac- count”, was never set off on the books of the corporation against account 2615. Nor do any journal entries exist which reduced either of these accounts. Counsel argued that the reconciliation is no more than an enumeration of the various accounts and is not evidence of a setoff. At best, it establishes nothing more than that the accounts have been combined for presentation purposes.

It is the Respondent’s position that there is no authority to support the proposition that where mutual debts coexist, a setoff is automatically effective,[7] and that the Appellants are incorrect in the assertion that their accounts with the corporations should be examined on a net basis as if they had been set off instead of individually as has been done by the Minister.

The Respondent further contends that in the present appeals, the Appellants, for financing purposes, postponed their claims on the corporation to the Bank thus clearly indicating that there was not even an intention to set off the accounts.

Conclusion

The shareholder loan rules of the Act were designed to prevent corporations from utilizing loans (or any other form of indebtedness) as an indirect means of conferring an untaxed economic benefit on shareholders. This type of loan was viewed as an indirect way of withdrawing funds from the corporation and therefore is subject to taxation. Subsection 15(2) of the Act stipulates the circumstances required in order for the corporate loan to be taxable in the hands of the individual shareholder. There are three factors which determine whether a loan is included in the shareholder’s income: the relationship between the borrower and the lender; the purpose of the indebtedness; and the repayment arrangements. In the present appeals, the issue to be determined is whether the Appellants are correct in contending that the amounts due from the Appellants to the corporations were set off against the amounts due from the corporations to the Appellants so that the amounts advanced from the corporations were repaid within one year from the end of the taxation year of the corporations in which the advances were made.

In Docherty,^[8] the taxpayer was allowed to set off amounts due from the company against amounts due to the company where the taxpayer was able to demonstrate through the accountant’s working papers that this had been his intention. Brulé J. made the following comments in allowing the taxpayer’s appeal:

In the Gannon case (supra), the general principle that mutual debts cannot coexist and gives rise automatically to a right of set-off seems to have been rejected. A requirement of an agreement or contract calling for the liquidation of the indebtedness is mandatory. This statement of law is supported by Bank of Montreal v. Tudhope, Anderson & Company (1911) 21 MR 380.

It seems therefore that the issue revolves around how such an agreement to liquidate a debt by another will be evidenced. As was stated in Gannon, an automatic set-off between two parties will prevail only in the case of connected accounts of debt and credit. Without such connection, an equity to set-off will not necessarily be granted, an intention to liquidate a debt by the other would have to be found (see s. 130, Canadian Encyclopaedic Digest (Western) 3rd edition, Debtor and Creditor). This is discussed in the case of Bank of Montreal (supra). Reference is there made, at page 387, to Lundy v. McCulla, 11 Gr. 368 where the Court said:

In the view of equity the setting off one demand against. another between the same parties is extremely just and, where there is any technical difficulty in the way of its being done without an agreement, the Court accepts slighter evidence of such an agreement than is usually required in order to establish disputed facts.

(Emphasis added)

In the administration of a small corporation, it often occurs that decisions be [sic] made without registration of any records. Often, like in business, no written agreement between parties occurs as was pointed out by Mr. Justice Urie in Massey-Ferguson Limited v. Her Majesty The Queen, 77 D.T.C. 5013, at page 5017 as follows:

The whole development of commercial law over the centuries is replete with examples of the Courts recognizing that business men do not always depend on expert documentation to prove the true characterization of their transactions. Rather, they tend to achieve their desired ends, particularly when the relationships between them are close, in informal and expeditious ways which perhaps are abhorrent to lawyers. In doing so they can [run] the risks inherent in such a practice of determining their respective rights. Frequently no difficulties ensue, but if they do, in the absence of contracts or other documents, Courts must determine the intention of the parties and the nature of the obligations imposed on them by reference to credible evidence of another kind.

(Emphasis added)

In Docherty,?[9] the Court first looked for evidence of setoff in the financial statements and found none. Brulé J., however, concluded that the mere fact that the financial statements did not reflect the setoff was not sufficient to disallow that appeal. Accordingly, he resorted to other evidence such as, inter alia, the working papers and accounting books to determine the issue.

In the present appeal, the same approach is warranted. The evidence necessary to establish that a setoff occurred between the Appellants and the corporations is found in the financial records of the corporations and in the consistent testimony of the witnesses. More specifically, the accounting practice established by Maltby in 1988 provided a tracking and control mechanism for shareholder advances. He further testified that the bonuses declared by the corporations at year end were specifically structured to enable a setoff to be made against the amounts of the advances that had been made by the corporations in the course of the prior fiscal year. It is also a fact that the net result of the setoff was the amount that was, in all years, reported on the unaudited and audited corporate financial statements. In my view, this history is confirmatory of the parties’ intentions that the amounts would be set off against each other.

Much was made by the Respondent of the fact that the accounts had never been consolidated. This submission ignores the fact that although the shareholder loan accounts were segregated by “use” on the monthly statements, the audited or review engagement financial statements showed them as one account, payable to (or due from) shareholder.

Although of limited probative value, I must also observe that the position advanced by the Respondent is, to some extent, inconsistent given her admission that:

During the years in question. Seagull Pewter and Jonathan Bond would from time to time advance certain monies to the Appellants, the shareholders of these companies. During these same years, these companies would declare bonuses and/or dividends payable to shareholders which were taxable in their hands and which were set off against the amount due by the shareholders to the company’.^[10]

The Respondent further contends that the Appellants’ postponement of their claims on the corporations to the Bank indicated that there was no intention to set off the accounts.

With respect to the postponement agreement, I am inclined to agree with the submission made on behalf of the Appellants that the Minister of National Revenue has no right to enforce the provisions of the postponement agreement between the shareholders and the Bank since this is a matter between those two parties. In any event, it is not disputed that the Bank had the right under its commitment letters with the corporations and its postponement agreement with the Appellants to pursue any remedies that it may have had for any breach of the agreement to postpone the loans. However, the testimony of Thompson made it clear that the Bank chose not to enforce the provisions of the postponement agreement, was “prepared to tolerate a reduction in the amount of postponed funds” and did not object to the Appellants setting off amounts due from Seagull Pewter and Jonathan Bond to each of them against the amounts that were due to them from the corporations even though that would reduce the credit balance in the shareholder’s loan account to an amount that was less than the subordinated debt.[11] It seems passing strange that the Minister purports to look to a postponement agreement to argue that amounts due from a corporation to a shareholder cannot be set off as against amounts due from the shareholder to the corporation even where the Bank did not object.

I have concluded that the evidence clearly supports the existence of an agreement between the parties to set off amounts due from the corporations to the Appellants against amounts due from them to the corporations in the taxation years in issue. As the setoffs occurred, the shareholder loans were repaid within the required time limit pursuant to subsection 15(2) of the Act. Thus, the amount of the shareholder loans should not have been included in the Appellants’ income for the taxation years in issue.

Subsection 80.4 interest benefit issue

The Minister further assessed each Appellant pursuant to section 80.4 of the Act by including in the income of each an interest benefit as follows:

This issue arises with respect to amounts which were included in each Appellants’ income for 1990, 1991 and 1992 taxation years pursuant to section 80.4 of the Act as interest benefits arising from outstanding loans from Seagull Pewter and Jonathan Bond. In view of my conclusion with respect to the inclusion of the shareholder loans in each Appellants’ income, the appeal with respect to the interest benefit on those amounts is also allowed.

Farm Losses

In assessing the Appellants, the Minister calculated farm losses in accordance with subsection 31(1) of the Act (restricted farm losses) and consequently disallowed losses claimed in the following amounts:

With respect to this issue, the following facts are not in dispute:

15 The Appellants operate a ginseng farm as a partnership under the name North wood Farms. The farm was started in 1988. In 1990, 4 acres of ginseng were planted at the beginning of the year and another 5 acres were planted during the year. In 1991, 7.5 acres of ginseng were planted and 1 acres was harvested. At the end of 1991, there were 15.5 acres of ginseng that were planted but not harvested. In 1992, 1 acre was harvested and an additional 8.5 acres of ginseng were planted.

16 The Appellant, John Caraberis, visited the farm frequently during 1990 - 1992 and, except on occasion when he was away from Pugwash, visited the farm on a daily basis during the growing season. He also dealt with various administrative issues related to the farm from his office at Seagull Pewter.

17 The capital committed to the farm is substantial. The total funds invested by the partners in equipment, building, land improvement and expenses (as reflected in the partners’ equity on the balance sheet for the farm) was $1,228,813 as of December 31, 1992. The amount invested in the farm at that time exceeded the amount of the investment of the Appellants in Seagull Pewter.

18 The farm has a full time manager and 10 to 19 seasonal employees. During the years under appeal it was one of Nova Scotia’s largest ginseng farms.

19 A schedule of projected net income for the farm to the year 2000 is Document Number 17 in the Document Book. The projected incomes as set out in this schedule were reasonable projections of income when the projections were completed in 1992. The schedule indicates that the projected income for 1993 was approximately $76,000 to $77,000, for 1994 approximately $278,000, for 1995 approximately $530,000 and over $700,000 for each of the next four years. For 1994, the actual net income of each of the Appellants from the farm was $173,861. The total salary and the dividends actually received by each of the Appellants from the companies was approximately $164,185.

20 For each of 1990, 1991 and 1992, the losses related to the operation of the ginseng farm have, as a result of the reassessment, been treated as restricted farming losses.

In addition to the facts admitted, evidence was adduced from Caraberis and from Dr. Hak-Yoon Ju (Dr. Ju) with respect to this issue.

Dr. Ju is a professor in the Department of Plant Science at the Nova Scotia Agricultural College. He received his Ph.D. from McGill University (Department of Plant Science) in 1980 specializing in nutrition, vegetable toxin. The specific area of study he teaches includes small fruits, chili fruits and crops such as ginseng and mushrooms. Since 1982, he has conducted research on the subject of ginseng management (cultural practices; biological, disease, insect and weed control; nutritional requirements). He is also conducting studies on ginseng physiology and the embryo development of ginseng seeds during germination and stratification.

Ginseng is used in herbal medicines and health foods and there are a number of different products in both categories. Ginseng is also used in the production of specialty soap, candy, extracts, tea and beverages. The principal market is Hong Kong and other Asian countries where ginseng has been used for over 1,000 years. Dr. Ju testified that the root is the primary portion of the ginseng plant that is harvested and sold. There is no market for the two-year old root which is quite small. The three-year old root, although much larger, is generally not harvested unless there is a disease problem. The four-year old root is the one generally harvested but in Asian countries, five and even six or seven-year old roots are grown in order to obtain a better price.

In the early 1980s, Caraberis attended courses at the Florida Institute of Traditional Chinese Medicine and discovered that ginseng plays a fundamental role in “formulations that the Chinese create to deal with health issues”. He also learned that ginseng use was increasing, that projected de- mand was significant, and concluded that ginseng farming presented a profitable opportunity. In 1983 when Dr. Ju was giving a short course on ginseng at the college, Caraberis came to see him with respect to growing ginseng and was shown test plots at the Agricultural College. This was followed by a number of other visits expressly for the purpose of obtaining Dr. Ju’s input and advice with respect to a ginseng farm operation.[12] Their discussions satisfied Caraberis that the soil conditions and climate in Nova Scotia were adequate and convinced him that ginseng could be grown successfully. Dr. Ju, for his part, became interested in the Appellants’ project and when Northwood Farm commenced operations in 1988, began to use it as a research model. Since 1988, he visited the farm from five to ten times per year to more closely observe the operation and to take photographs and video films for his research and short courses.

Dr. Ju has also visited most of the other ginseng farms in Nova Scotia, one large farm in New Brunswick and a number of farms in Ontario. He observed that large farms are able to lower the cost of production because equipment is used more efficiently. Northwood Farm, although not considered to be of a large size, was according to Dr. Ju, the only farm in Nova Scotia:

that was operating properly and using the proper equipment and also that farm was the largest one which I like to see, - more success from that ginseng operation.

In 1987, a 220-acre parcel of land with approximately 100 acres cleared was purchased by the Appellants specifically for ginseng production. During this period, to learn everything he could about the growing of ginseng, Caraberis developed an on-going relationship with one of the largest ginseng producers in Ontario, David Huffman (Huffman). In the spring of 1988, several acres were prepared for ginseng by plowing, soil testing and manuring. On the advice of Huffman, the Appellants decided to utilize their first seeding as a testing/learning process and in result, only one acre was seeded to ginseng in that year. For that same reason, no acreage was seeded in 1989, however, when the seedlings appeared from the first seeding, spray and weeding programs were started and since ginseng’s natural habitat is the forest, shade covers to protect the crop from the sun were constructed. Satisfied with the initial results, the Appellants seeded four acres at the beginning of 1990 and another five during the year. Seven and one-half acres were added in 1991 and eight and one-half in 1992. Currently, approximately 45 acres are seeded to ginseng.

In the first years of operation, Caraberis frequently consulted Huffman with respect to various matters and arranged to have him visit the Northwood Farm on several occasions. As well, Caraberis deliberately carried out all vital farm functions himself in order to have a hands-on understanding of any problems and solutions. As the acreage seeded increased, it became necessary to hire a full-time manager (Gary Brumwell) to ensure that all necessary steps in the process were attended to in timely fashion. By 1992, 26 acres had been seeded and Caraberis’s hands-on involvement became more supervisory, generally amounting to more or less daily meetings with Brumwell during the growing season (April-November), inspection of the fields, checking for disease problems and “making sure that things are tracking the way they needed to”. Additional staff has since been hired and currently, the farm employs approximately 15 permanent workers during the growing season, with extra help being hired for the labour intensive weeding and harvesting periods. In more recent years, Brumwell's expertise has reached a level where Caraberis’s direct involvement has been less frequent and related principally to overall farm planning and strategy.

The capital committed was substantial and as of December 31, 1992, the amount of $1,228,813 had been invested by the Appellants in equipment, buildings and land improvement. It is also agreed that the amount invested in the farm operation exceeded the amount of the Appellants’ investment in Seagull Pewter as of that point of time. The capital invested was sourced by personal savings, Seagull bonus and dividend payments and loans from FBDB, the Royal Bank of Canada, and the Nova Scotia Farm Loan Board. All of the loans were personally guaranteed by the Appellants.

The primary source of revenue anticipated by the Appellants when the ginseng operation was commenced was the sale of mature ginseng root supplemented by the sale of seed to other ginseng farmers. In 1990, the price for ginseng root was, according to Dr. Ju, $40 per pound with prices dependent to some degree on quality. The Appellants were aware that corp yields would depend to a substantial extent on the quality of the soil and that as Dr. Ju observed, ginseng grown in poor soil might produce 2,000 pounds per acre while on good sandy loam, 3,000 pounds per acre was quite average. The Appellants were also aware that given the length of time to produce a mature root crop, they were facing, as Caraberis described it, four to five years of up-front cash without revenue.

In 1991, a small crop was harvested but no sales were recorded. In 1992, reported sales of ginseng amounted to $104,080 and reported expenses were $405,407.[13] In that year, the Appellants reviewed their farm operation with the comptroller, Cooper, and made projections with respect to acreage, yields and sales and expenses (Exhibit A-22). In a schedule prepared by Cooper the net incomes projected for 1993, 1994 and 1995 were $77,000, $278,000 and $530,000, respectively. For the next four years, annual net incomes were expected to exceed $700,000. The actual net incomes from the farm operations for 1992 and 1993 were $91,934 and $42,325, respectively.[14] As well, it has been admitted that the actual net income of each of the Appellants from the farm in 1994 was $173,861.[15]

Conclusion

The issue is whether the income from the farm business of the Appellants was a chief source of income within the meaning of subsection 31(1) of the Act, thereby enabling them to deduct from income the entire amount of allowable farming losses suffered by them in taxation years 1990, 1991 and 1992.

The Respondent concedes that the Appellants had a reasonable expectation of profit and it is common ground that the Appellants were engaged in farming activities which constituted a source of income for the purposes of the Act. Subsection 31(1) of the Act restricts the deduction available for such losses to $8,750 in circumstances where the chief source of income of a taxpayer is neither farming nor a combination of farming and some other source of income. The Respondent’s basic position is that the farm was not, and would not be, a chief source of income within the meaning of this provision.

The leading authority in respect of the interpretation to be given to subsection 31(1) of the Act is Moldowan v. R.16.[16] Dickson J. (as he then was) suggested that the test for determining whether a source of income constitutes a chief source of income for a taxpayer is both relative and objective. In this regard he observed that:

...The distinguishing features of ‘chief source’ are the taxpayer’s reasonable expectation of income from his various revenue sources and his ordinary mode and habit of work. These may be tested by considering, inter alia, in relation to a source of income, the time spent, the capital committed, the profitability, both actual and potential. A change in the taxpayer’s mode and habit of work or reasonable expectations may signify a change in the chief source, but that is a question of fact in the circumstances.

With these principles in mind, I turn to the evidence before the Court.

The Respondent contended that the Appellants, while investing considerable financial resources in the ginseng farm, did not change their normal routine of spending most of their time working with Seagull Pewter and Jonathan Bond. On the evidence before me, that does not appear to have been the case.

To determine the Appellant’s reasonable expectation of income from their various sources, it is necessary to consider the nature and scope of all of their endeavours. In terms of the allocation of time and effort, particularly by Caraberis, it is illustrative to examine the manner in which Seagull Pewter was commenced, developed and was being operated in the taxation years in issue. Initially, the Appellants, upon moving to Canada in 1974, made a living making and selling craft items. From this, they progressed to the making of sterling silver jewellery and acquired experience in technical craftwork. In 1978, they purchased a line of pewter production equipment and began operations as Seagull Pewter. That business was built “one step at a time, one employee at a time, one new account at a time, one new product at a time” to the point where currently Seagull Pewter is a major company with 350 employees and five retail stores, two in Halifax, one in Pugwash, one in Philadelphia and one in Banff. The manufacturing plant is in Pugwash and a smaller plant has been established in St. Lucia, one of the Caribbean Islands. Jonathan Bond was subsequently established as an umbrella company for the retail stores. As can be seen from the financial statements adduced in evidence, this business has been profitable and the in- come generated to the Appellants in the years in question and subsequently, has been substantial. What is of significance is that the same “step-by-step” approach has been taken by the Appellants with respect to the development of the ginseng farm.

In the present appeals, a simple comparison of the time spent on their various endeavours in an attempt to quantify the taxpayers’ mode and habit of work is of little assistance in determining which source of income constitutes their chief source of income. It is evident that by the time Northwood Farm was purchased, the day-to-day operations and managerial decisions for Seagull Pewter were being made by a general manager, Carol Faulise. In 1991, the management of the corporations was placed in the hands of a chief executive officer followed several years later by the appointment of a chief executive officer. Caraberis testified that it is about 10 years since he was involved in hands-on day-to-day management of the “Seagull corporations” and that his involvement has been focused on the off-shore market projects, “setting direction, looking at new opportunities and possibilities” and the periodic review of financial data with senior management. On these facts, it is most reasonable to conclude that Caraberis in particular had made a substantial commitment of time to the farming operation. In my view, to argue strenuously that there was no “change of occupational direction” is to ignore the facts.

The Respondent further contends that the prospect of Northwood Farm was such that it would never be a significant source of profit when compared to the extent, firmly established, of the Appellant’s income from other sources. As such, the farm could not be considered to be anything but a sideline business for the Appellants.

The Appellants do not suggest that their objective in commencing the farm operation was to replace Seagull Pewter as a source of income. Rather, Northwood Farm was seen as a profitable opportunity and another reasonable source of income for the Appellants. It is fair to say that at all times, the Appellants intended to have the two income streams co-exist.

With respect to profitability, Strayer J. observed in Mohl v. R.:^[17]

... I use the term “significantly profitable” because it appears from the Morrissey decision that the quantum of expected profit cannot be ignored and I take this to mean that one must have regard to the relative amounts expected to be earned from farming and from other sources. Unless the amount reasonably expected to be earned from farming is substantial in relation to the other sources of income then farming will at best be regarded as a “sideline business” to which the restriction on losses will apply in accordance with subsection 31(1).

The evidence in the present appeals is that in 1994, the net income of each Appellant from the farm was $173,861, an amount greater than the salary and dividends received by each from Seagull Pewter and Jonathan Bond in that year. In my view, the Appellants have established that the amounts reasonably expected to be earned from their farm are substantial in relation to their other sources of income. Furthermore, as was observed by Bowman J. in Hover v. Minister of National Revenue,^[18]

The Act does not specifically require that the other source of income be either subordinate or sideline. It would seem that if farming can be combined with another source of income, connected or unconnected, it can as readily be combined with a substantial employment or business as with a sideline employment or business. Indeed, if the other source were merely subordinate or sideline, it would not prevent farming alone from being itself the taxpayer’s chief source of income without combining it with some other unrelated subordinate source.

These comments are most appropriate with respect to the present appeals.

The Appellants’ initial plans were to produce both ginseng roots and seeds for sale. As time progressed, Caraberis observed that in any ginseng harvest “there is always some root that will not demand full dollar-value on the export market ... because of minor disease problems, colour problems, shape problems, or was broken in the processing”. Such root is now sold to a business they established in 1995 which utilizes it in the production of value-added products such as elixirs, teas, candies, granola bars, etc., to which ginseng has been added. This product can then be sold in the market at a higher price and a higher profit margin. It is self-evident that by the creation of a market for what otherwise might be waste product, the Appellants have taken steps to maximize the profitability, both actual and potential of the ginseng farm.

The establishment and development of Northwood Farm followed substantial consultation, a consideration of the risks involved followed by the investment of reasonable amounts of capital. Included in the risk assessment was the knowledge that no saleable crop could be produced until the fourth year of operation and that it would take several more years to have sufficient acreage in production to produce substantial revenue. To suggest that the taxation years in issue were nothing more than an experimental stage is to ignore both the planning and the time required to bring a ginseng farm into production. I am satisfied that this farm operation was not a sideline business within the meaning of subsection 31(1) of the Act and accordingly, the Appellants are entitled to deduct their full losses.

Real Estate Dispositions

The following facts are agreed upon:

21 In 1989 and 1990 for each of the Appellants, an amount was added to their income as a result of a reassessment based on the alleged profits realized on the transfer of certain properties to Seagull Pewter. This reassessment involves transfers of land to Seagull Pewter the Appellants had previously acquired in their individual names.

22 In the last twenty years, the Appellants acquired 53 parcels of land.

23 The auditor for Revenue Canada Taxation prepared a summary of land transactions involving the Appellant. The summary indicates that there have been only thirteen transfers of property since 1977. The summary further indicates that, of the thirteen, seven were transfers of property to either Seagull Pewter or Seagull Foundation.

The dispositions of four separate properties are involved in this issue.

Bayhead: In 1987, the Appellants acquired a vacant warehouse and land (Bayhead). Caraberis described the property as consisting of:

a couple of acres of land ... right on an inlet with a 6,000 sq. ft. building that’s got 16’ high ceilings in it, fully insulated, cement floor, furnace, plumbing and two big doors on either side. It’s steel with some light panels in the roof and it was originally designed for boat construction.

Bayhead was transferred to Seagull Pewter in 1989 at a price of $130,000 set on the basis of advice received from a land appraiser.[19] It had been, according to Caraberis, purchased for “around $60,000, in that ballpark”. Since its acquisition by Seagull Pewter, it has been used for storage and warehousing.

Northport: The Northport property is located approximately 12 miles from Pugwash and consisted of 1,700 acres of land and four large barns. It was acquired by the Appellants in 1988 for $177,000. In 1990, 300 acres (on which the barns were located) were transferred to Seagull Pewter at a price of $359,000. As was the case with Bayhead, the price was subsequently adjusted down to $185,000 which has been accepted as the prop- erty’s fair market value at the time of disposition.[20] Of the buildings acquired by Seagull Pewter, two are fully utilized for the storage of equipment and the warehousing of materials such as rubber moulds used for casting pewter and other components that are no longer required. The balance of the land which was retained by the Appellants personally is being used for Northwood Farm related functions with approximately 150 acres at various stages of development for the ginseng production.

Allen property: In 1988, the Appellants acquired two parcels of land known as the Allen property for $61,000. Caraberis described the property as consisting of about 30 or 40 acres of wooded land located adjacent to the Seagull Pewter factory. The Allen property was sold to Seagull Pewter in 1990 for $70,000. The price was set on the basis that:

it’s fairly close to the selling price, for starters, and I thought I got a good deal on the land and I felt there was a little bit of additional value there in it, that the fair - again, fair value would be slightly more than what I paid for it.

Caraberis also indicated that this property had been the subject of an appraisal conducted on their behalf but no further evidence with respect thereto was adduced.

MacEwan property: In 1992, the Appellants sold 158 acres of land to Seagull Pewter for $50,500. Located on the Pugwash River, the property consists of 130 acres of which approximately 20 acres have river frontage. To the best of Caraberis’s recollection, it was purchased in the late 1980s at a price of $40,400 in part for “land preservation” and because “I wanted to own a wood lot”. He also added that an incidental motivating factor was to assist a friend who wanted to sell the property and move on with his life. Although Caraberis said it had no real function for Seagull Pewter, when asked why the property was transferred to it, he said that it was to strengthen Seagull Pewter’s balance sheet. He observed:

it really - you know, you want to keep your - the equity in the company strong and to have the equity in the company strong creates good bank relations. So, it was about strengthening of equity in the company position that I did that.

Conclusion

The Appellants maintain that the gains realized in each of the sales in issue were on account of capital. That said, it is necessary for the Appellants to adduce sufficient evidence to establish that the purchase of each property was to hold for investment for the purpose of earning or producing income. The question thus becomes one of the intention of the Appellants at the time of the acquisition of the properties and in particular, was there either a primary or secondary intention to resell? Generally speaking, such intent is to be ascertained from the entire course of conduct of the Appellants and relevant circumstances and the inferences flowing therefrom: Gairdner Securities Ltd. v. Minister of National Revenue^[21] and Racine v. Minister of National Revenue.^.[22] In Racine, Noel J. observed:

In examining this question whether the appellants had, at the time of the purchase, what has sometimes been called a “secondary intention” of reselling the commercial enterprise if circumstances made that desirable, it is important to consider what this idea involves. It is not, in fact, sufficient to find merely that if a purchaser had stopped to think at the moment of the purchase, he would be obliged to admit that if at the conclusion of the purchase an attractive offer were made to him he would resell it, for every person buying a house for his family, a painting for his house, machinery for his business or a building for his factory would be obliged to admit, if this person were honest and if the transaction were not based exclusively on a sentimental attachment, that if he were offered a sufficiently high price a moment after the purchase, he would resell. Thus, it appears that the fact alone that a person buying a property with the aim of using it as capital could be induced to resell it if a sufficiently high price were offered to him, is not sufficient to change an acquisition of capital into an adventure in the nature of trade. In fact, this is not what must be understood by a “secondary intention” if one wants to utilize this term.

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 the 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....

(Emphasis added.)

I am satisfied that the Appellants must have had in mind that each of the properties in issue could be, at some point of time, sold in whole or in part at a profit to Seagull Pewter, which in this context can only be described as a captive buyer. That is the only logical inference to be drawn from the circumstances surrounding the transactions. Indeed, in the case of each property (excepting perhaps the MacEwan property), the primary reason advanced by Caraberis for the acquisition was for possible corporate use. With respect to Bayhead, the vacant warehouse had been used for storage when Caraberis learned that it was available. He saw it:

as a potential asset for future growth for our company. I didn’t know whether we’d need it or not for our company, but I though that it would be a wise thing to pick it up.

Question: Um-hm, Yes and you picked it up for future purposes of Seagull?

Answer: I thought that we may need it for Seagull in the future, yes.

With respect to Northport, Caraberis testified that the land was not purchased initially by Seagull Pewter because he “didn’t know what I wanted to do with the buildings”. At another point, he observed that “these buildings could function in the future as useful buildings for our expanding — the expansion of our business”. In his view, the farm was an asset that belonged to the Appellants until they could figure out what to do with it. As he put it:

So it was — my intention was — we bought the land and the buildings and then it just gave us time — as we sorted out what we wanted to do with them, then we — they ended up where they belonged.

As for the Allen property, Caraberis regarded it as a buffer property for Seagull Pewter’s production operation. In Caraberis's words:

it gives us space. It gives us space to do our thing. If we needed to expand facility, it’s there for that. It’s — it gives us our privacy. It gives us a piece of ground that we can control and beautify and have — and just — and have — sort of have — be how we want it to be.

With respect to the MacEwan property, the reasons for its acquisition appear to be imprecise, but it is not possible on the evidence, to conclude that its transfer to Seagull Pewter and its use by the latter, was not a factor in the mind of Caraberis at the time of the property’s acquisition. It was as he said: “an asset to be utilized to strengthen Seagull Pewter’s equity”. That this could be accomplished by selling the property at a profit would appear to be just icing on the cake.

Counsel for the Appellants contended that they were not traders in land and made reference to the fact that in the previous 20 years, they had acquired some 50-odd properties of which only 13 were disposed of, seven to Seagull Pewter or Seagull Foundation. That is one possible inference, however, it also suggests that given the number of transactions, the Appellants, and in particular, Caraberis, are knowledgeable and relatively sophisticated in the real estate market. One might also mention that all of the properties were purchased with borrowed funds, often considered to be a hallmark of an adventure in the nature of trade. The fact that these funds were borrowed from Seagull Pewter rather than from a lending institution is of marginal significance.

I have previously expressed the view that Seagull Pewter appeared to be at all relevant times, the contemplated market for resale at a profit of the properties in issue. In my view, it is not mere coincidence that the appraisals which the Appellants commissioned supported the inflated resale prices.

If these Appellants seriously contend that the properties were acquired as a capital investment, this must be done by way of clear and compelling evidence of such an intention. No strong declaration of an investment intention was advanced by the witness, Caraberis. The onus was on the Appellants to establish, on a balance of probabilities, that the Minister of National Revenue erred in assessing the gains from these transactions on income account. That onus has not been met.

Appeal allowed in part.